In July 2003, the Company acquired new offices at 70 Gracechurch Street, London which will become the Company’s new London headquarters. The acquisition was made through a purchase, sale and leaseback transaction. The move to the new offices is expected to be in the summer of 2004 and will consolidate the Company’s London businesses in one location. The Company has recorded a capital lease asset and liability of approximately $150.0 million related to this transaction.
Total rent expense for the years ended December 31, 2003, 2002 and 2001 was approximately $42.3 million, $30.4 million and $18.9 million, respectively. The increase in rent expense for 2003 was due to the expansion of the Company’s operations and, in 2002, was due primarily to the acquisition of Winterthur International. See Item 8, Note 18(d) to the Consolidated Financial Statements for discussion of the Company’s lease commitments for real property.
Information includes the results of NAC as though it had always been a part of the Company.
Equity in net income of investment affiliates in 2003 includes income on the alternative investment portfolio for eleven months ended November 30, 2003 as compared to twelve months in prior years. The fair market values of certain of these alternative investments often take longer to obtain as compared to the other of the Company’s investments and therefore are unavailable at the time of the close.
Net income per ordinary share is based on the basic and diluted weighted average number of Class A ordinary shares and ordinary share equivalents outstanding for each period. Net loss per ordinary share is based on the basic weighted average number of ordinary shares outstanding.
The loss and loss expense ratio is calculated by dividing the losses and loss expenses incurred by the net premiums earned for general insurance and reinsurance operations.
This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about the Company’s beliefs and expectations, are forward looking-statements. These statements are based upon current plans, estimates and expectations. Actual results may differ materially from those projected in such forward-looking statements, and therefore undue reliance should not be placed on them. See “- Cautionary Note Regarding Forward-Looking Statements” for a list of additional factors that could cause actual results to differ materially from those contained in any forward-looking statement.
The Company operates on a global basis primarily in the property and casualty industry and, to a lesser extent, the financial services industry. The Company serves the insurance, reinsurance and financial services needs of institutional or corporate clients, typically the global equivalent of the Fortune 2000. The Company operates in markets where the Company believes its underwriting expertise and financial strength represent a relative advantage. The Company does not operate in any retail markets.
The Company earns its revenue primarily from net premiums written and earned. Premium rates in the property and casualty industry began to increase in 2001 following five years of poor underwriting performance in the industry. These price increases were further compounded by the September 11 event. In the three years ended December 31, 2003, the Company experienced pricing increases and improved terms and conditions across most of the lines of business it writes. These, generally, across-the-board price increases were unprecedented meaning that, in the past, pricing increases and more favorable terms and conditions were not experienced across all of the Company’s product lines at one point in any one cycle. Accordingly, the Company does not expect that any potential downturn in the cycle will necessarily affect all the property and casualty lines simultaneously in the future.
A key challenge for the Company, as stated above, is to mange through the industry cycles. In relation to the insurance segment, with respect to the January 1, 2004 renewals, the Company has seen some moderation in pricing over the last several months. Although certain lines, principally liability, continue to see moderate increases, certain other lines, particularly property, which have benefited most from price increases over the last few renewals, are beginning to see increased competition and rate decreases as certain competitors improve their capital position and pursue premium growth through rate reductions and/or terms and conditions more favorable to buyers / customers. The Company still believes that the insurance business remains adequately priced and above the Company’s return requirements, with appropriate terms and conditions across the board. With respect to the reinsurance segment, January 1st is the most significant renewal date for the Company’s general reinsurance operations. With respect to the January 1, 2004 reinsurance segment renewals, the Company has continued to see double digit rate improvements in its casualty book. These improvements are at a lesser rate than in prior years. The Company expects that these increases will largely offset the pricing pressures that the Company is currently seeing in property, property catastrophe and some other specialty lines. The Company expects overall growth rate in net written and earned premiums will be in the single digits in 2004.
NM=Not Meaningful. In 2001, the Company had a net loss for the year due primarily to the September 11 event.
The combined ratio for general operations is used by the Company and many other insurance and reinsurance companies as another measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company’s general insurance and reinsurance operations. A combined ratio of less than 100% indicates an underwriting profit and over 100%, an underwriting loss. Changes in the Company’s combined ratio for the last three years have been negatively impacted by the net losses incurred as noted above.
net unrealized gains on the investment portfolio and also increased in 2002 due to an increase in net income. The Company’s book value per ordinary share in 2004 would be impacted by changes in market interest rates.
Return on average ordinary shareholder’s equity (“ROE”) is a widely used measure of any company’s profitability. It is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholder’s equity. The Company establishes minimum target ROE’s for its total operations, segments and lines of business. If the Company’s minimum ROE return targets over the longer term are not met with respect to any line of business, the Company seeks to exit these lines. In addition, the Company’s compensation of its senior officers is significantly dependant on the achievement of the Company’s performance goals to enhance shareholder value as measured by ROE. The Company’s ROE’s for the last three years have been mainly affected by its general operations’ underwriting results and investment income. In addition, there was a negative return on shareholders’ equity in 2001, primarily due to the September 11 event.
Management is focusing on the settlement and collection of certain post-closing balances under the SPA related to the 2001 acquisition of the Winterthur International operations. The SPA sets forth a process by which an adjustment payment may be made to the Company or the Seller by the other based on the unfavorable or favorable development of the acquired Winterthur International operations’ net reserves. Under this process, the Company is due to submit to the Seller in the third quarter of 2004 a statement of the net reserves of the acquired operations as of June 30, 2004 (the “Seasoned Net Reserves Amount”). The Seasoned Net Reserves Amount is then compared to such operations’ net reserves as of June 30, 2001 (the “Initial Net Reserves Amount”). If the Seasoned Net Reserves Amount is greater than the Initial Net Reserves Amount, a payment is due to be made by the Seller to the Company in accordance with a formula set forth in
The following table presents an analysis of the Company’s net income (loss) available to ordinary shareholders and other financial measures (described below) for the years ended December 31, 2003, 2002 and 2001.
Average stock options outstanding have been excluded where anti-dilutive to earnings per ordinary share.
1) Net adverse prior year loss development in general insurance and reinsurance operations.
4) A favorable underwriting environment with increased premium rates and improved terms and conditions, and
The following table summarizes the pre-tax net income effect of the first three items for the years presented:
The Company has exposure to the September 11, event with claims arising mainly from its aviation, property, personal accident and business interruption insurance and reinsurance coverages.
The Company realized losses on securities in its investment portfolio due to declines in fair value determined to be other than temporary of $130.7 million, $251.5 million and $115.6 million for the years ended December 31, 2003, 2002 and 2001, respectively.
The general economy in the United States and the investment markets improved in 2003 relative to 2002. For example, Moody’s Investor Service (“Moody’s”) reported that 77 issuers defaulted in 2003 as compared with 141 issuers in 2002. The Company experienced a reduction in the amount of write downs for securities with declines in value deemed to be other than temporary that was consistent with these figures. The write downs for 2003 occurred mainly in the first half of the year which was consistent with Moody’s monthly default statistics. As a percentage of the total fixed income portfolio, the write down for other than temporary declines was 0.6% in 2003 as compared with 1.4% in 2002 and 1% in 2001.
See the discussion of other than temporary declines in investments within “-Critical Accounting Policies” and “- Investment Activities” below.
See further discussion in the insurance segment and Item 8, Note 6(b) to the Consolidated Financial Statements.
The following are considered to be the Company’s critical accounting policies and estimates due to the judgments and uncertainties affecting the application of these policies and/or the likelihood that materially different amounts would be reported under different conditions or using different assumptions. If actual events differ significantly from the underlying assumptions or estimates applied for any or all of the accounting policies (either individually or in the aggregate), there could be a material adverse effect on the Company’s results of operations and financial condition and liquidity. These critical accounting policies have been discussed by management with the Audit Committee of the Company’s Board of Directors.
Other significant accounting policies are nevertheless important to an understanding of the Company’s Consolidated Financial Statements. Policies such as those related to revenue recognition, financial instruments and consolidation require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. See Item 8, Note 2 to the Consolidated Financial Statements.
As the Company earns premium for the underwriting risks it assumes, it also establishes an estimate of the expected ultimate losses related to the premium. Loss reserves or unpaid losses and loss expenses are established due to the significant periods of time that may lapse between the occurrence, reporting and settlement of a loss. Loss reserves include:
The Company writes both “short-tail” and “long tail” lines of business, meaning the time between the receipt of the premium from a policy and the final settlement of any loss. Short-tail lines include property catastrophe, other property and certain marine and aviation lines where, on average, the settlement period may be up to 24 months. Long-tail lines, on the other hand, include the Company’s casualty business in which claims may take up to 30 years to be reported and settled. The increase in the time associated with ultimate settlement of a claim is directly related to an increase in the amount of judgment required to establish loss reserves, especially IBNR reserves.
With respect to the Company’s insurance operations, the Company is notified of insured losses and records a case reserve for the estimated amount of the settlement, if any. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. With respect
to the Company’s reinsurance general operations, case reserves for reported claims are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the estimated ultimate cost of a loss.
IBNR reserves relate mainly to the Company’s insurance and reinsurance casualty business. IBNR reserves are calculated by the Company’s actuaries using several standard actuarial methodologies including paid and incurred loss development, the Bornhuetter-Ferguson incurred loss method and frequency and severity approaches.
Loss and loss expenses are charged to income as they are incurred. These charges includes loss and loss expense payments and any changes in case and IBNR reserves. During the loss settlement period, additional facts regarding claims are reported. As these additional facts are reported, it may be necessary to increase or decrease the unpaid losses and loss expense reserves. The actual final liability may be significantly different than prior estimates.
IBNR reserves are calculated by the Company’s actuaries using standard actuarial methodologies as discussed above. Prior to the year ended December 31, 2003, the outcomes of the Company’s actuarial reviews, consistent with historical practice, provided either (i) a single point reserve estimate or (ii) a range of reserve estimates from which the Company selected a best estimate. For the year ended December 31, 2003, the Company adopted a methodology that provided a single point reserve estimate separately for each line of business and also a range of possible outcomes across each single point reserve estimate. This is discussed further below. As a result, reserve ranges disclosed previously are not comparable to the reserve ranges disclosed herein.
The following table shows the net unpaid loss and loss expense general and financial reserves for the Company at December 31, 2003 and 2002 by line of business:
The Company provides for estimated uncollectible reinsurance recoveries that are not allocated by line of business.
As shown in the table above and as noted above, for the year ended December 31, 2003 the Company developed a methodology for calculating reserve ranges around its single point reserve estimates for all its lines of business. Similar to VAR (Value At Risk) models commonly used to evaluate risk, the Company modeled a statistical distribution of potential reserve outcomes over a one year run-off period. The Company used the modeled statistical distribution to calcu-
late an 80% confidence interval for the potential reserve outcomes over this one-year run-off period. The high and low end points of the ranges set forth in the above table are such that there is a 10% modeled probability that the reserve will develop higher than the high point and a 10% modeled probability that the reserve will develop lower than the low point.
Reserve volatility was analyzed for each line of business within each of the reinsurance and insurance segments’ general operations using the Company’s historical data supplemented by industry data. These ranges were then aggregated to the lines of business shown above taking into account correlation between lines of business based on a study of the Company’s historical data supplemented by industry data. The practical result of the correlation approach to aggregation is that the ranges by line of business disclosed above are narrower than the sum of the ranges of the individual lines of business. Similarly, the range for the Company’s total reserves in the aggregate are narrower than the sum of the ranges for the lines of business disclosed above.
See further discussion within the Company’s operating segments below for prior year development of loss reserves.
The amounts disclosed above relating to the Company's high layer excess business include information from the Company’s subsidiaries that predominantly write high excess casualty insurance business. Other subsidiaries may write high excess casualty insurance
Casualty reinsurance business involves reserving methods that generally include historical aggregated claim information as reported by ceding companies, combined with the results of claims and underwriting reviews of a sample of the ceding company’s claims and underwriting files. Therefore, the Company does not ordinarily receive detailed claim information for this line of business.
Except for certain workers compensation and long-term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers compensation and long-term disability unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 5% at December 31, 2003 and 7% at December 31, 2002. The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. A 1% reduction in the interest rate would increase unpaid loss and loss expense reserves and net incurred loss and loss expenses by approximately $24.0 million and $22.0 million at December 31, 2003 and 2002, respectively, based on the current estimated amount and payout of the liabilities. See Item 8, Note 10 to the Consolidated Financial Statements.
The establishment of unpaid loss and loss expense reserves also includes the estimation of related reinsurance recoverables. Due to the size of the gross losses arising from the September 11 event and the effect on the reinsurance industry, the Company, in addition to its normal review process, further analyzed the recoverability of these assets. In addition to the potential effect of the non recoverability of these assets from reinsurers disputing claims, the reinsurance market in general has experienced significant capital erosion as a result of underwriting and investment losses. Accordingly, there
Claims and expenses for individual policies within these annuity reinsurance contracts are projected over the lifetime of the contract to calculate a net present value of future cash flows. Assumptions for each element of the basis (mortality, expenses and interest) are determined at the time of issuance of the contract and these assumptions are locked-in throughout the term of the contract unless a premium deficiency develops. The assumptions are best estimate assumptions plus provisions for adverse deviations on the key risk elements (i.e., mortality and interest). Provisions for adverse deviation are sufficient to cover reasonable deviations from the best estimate outcome of the contract. As the experience on the contracts emerges, the assumptions are reviewed. This occurs at least annually and includes both an analysis of experience and review of likely future experience. If such a review produced reserves in excess of those currently held then the locked-in assumptions would be revised and a loss recognized. During the years ended December 31, 2003, 2002 and 2001, there were no adjustments to the locked-in assumptions for any of these contracts.
The Company also provides reinsurance of disability income protection. The future policy benefit reserves for these contracts amounted to $90 million and $83 million at December 31, 2003 and 2002, respectively. The liabilities relate to in-force blocks of business, comprising underlying insurance policies that provide an income if the policyholder becomes sick or disabled. The liabilities are therefore driven mainly by the rates at which policyholders become sick (where sickness is defined by the policy conditions) and by the rates at which these policyholders recover or die. A 1% increase in the morbidity rate would increase the value of future claims by approximately $0.1 million, while a 1% decrease in the mortality rate would increase the value of future claims by approximately $0.4 million.
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These factors include (i) the time period during which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized in the period such determination is made.
The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company has capitalized net operating tax losses of $225.2 million and $296.0 million against which a valuation allowance of $18.3 million and $50.6 million at December 31, 2003 and 2002, respectively, has been established. The deferral of benefits from tax losses is evaluated based upon management’s estimates of the future profitability of the Company’s taxable entities based on current forecasts and the period for which losses may be carried forward. A valuation allowance may have to be established for any portion of a deferred tax asset that management believes will not be realized. Should the future income of these entities fall below expectations, a further valuation allowance would have to be established, which could be significant. In addition, if any further losses are generated by these entities, these losses may not be tax effected.
Intangible assets are carried at or below estimated fair value. There are many assumptions and estimates underlying the fair value calculation. Principally, the Company identifies the business entity that the intangible asset is attributed to, reviews historical and forecasted performance and other underlying factors affecting such analysis, including market conditions, premium rates and loss trends. Other assumptions used could produce a significantly different result which may result in a change in the value of the intangible asset and amortization charge in the Consolidated Statement of Income. Based on the current expectations of profitability, an impairment charge would only be recognized in the event of a significant decline in the expected profitability of those operations where such intangible assets are applicable. At December 31, 2003, intangible assets were $1.8 billion of which approximately $1.35 billion and $455.5 million related to the Company’s reinsurance and insurance segments, respectively.
In connection with its acquisition of Winterthur International in July 2001 in an all cash transaction, the Company has recorded a net recoverable from Winterthur Swiss Insurance Company (the “Seller”) of $740.9 million at December 31, 2003 based on provisions of the sale and purchase agreement between the parties (“SPA”). The amount of this recoverable remains subject to change pending expiration of the three-year seasoning period due to close on June 30, 2004.
The SPA provides the Company with post-closing protection with respect to adverse development of loss and unearned premium reserves relating to the acquired Winterthur International operations. This protection is based upon net loss development over a three-year post-closing seasoning period based on loss experience, collectible reinsurance, reinsurance recoveries and certain other factors set forth in the SPA. See “Financial Condition and Liquidity” for further informa-
tion. The SPA provides for independent actuarial determination should the Seller and the Company disagree on the final amounts due thereunder. The Company may recognize an impairment if the amount determined to be due to the Company is less than the carrying value of the SPA recovery balance deemed due from the Seller or to the extent that any amount proves to be uncollectible from the Seller for any reason.
Gross and net premiums written increased in the year ended December 31, 2003 compared with 2002 primarily due to significant pricing increases across most lines of business and new business written. The largest pricing increases in 2003 were in the professional liability, other casualty and aviation lines of business. Partially offsetting the growth in net premiums written in 2003 was a reduction related to the non renewal of specialty workers compensation and certain Lloyd’s international programs. Gross and net premiums written increased in 2002 over 2001 primarily due to the acquisition of Winterthur International, effective July 1, 2001 whereby only half a year of premium written was included in 2001 and significant price increases in 2002 compared with 2001.
Net premiums earned increased in each of the three years ended December 31, 2003 due to the increases in net premium written in the current and prior year. Casualty insurance net premiums earned increased from $1.36 billion in the 2002 to $1.96 billion in 2003. Net premiums earned by the Winterthur International operations were $779.5 million in 2002 as compared to $353.1 million in 2001. This increase is due primarily to the inclusion of a full year of net premiums earned related to Winterthur International in 2002.
Net premiums earned are expected to increase in 2004 mainly due to the growth in net premiums written during 2003.
The increase in the underwriting profit in 2003 as compared with 2002 and 2002 as compared with 2001 is also reflective of the combined ratios as shown below. The following table presents the ratios for this segment for each of the three years ended December 31:
During 2003, the Company’s net adverse prior year development of $153 million was due primarily to increases in previously reported case reserves for excess professional liability lines of $143 million for the underwriting years 1997 through 2001. These increases in reported case reserves exceeded the Company’s expected losses based on historical patterns of loss development. Specifically, the increase related to reported case reserves for directors and officers and errors and omissions coverages. During 2003, there was an increase in the amount of litigation related to certain losses. In addition, there was adverse development of $37 million related to environmental business primarily for professional liability coverage underwritten in 2000 and 2001 that was offset by favorable development of $27 million primarily in aviation, property, marine and energy coverages.
During 2003, the Company’s net adverse development of its gross reserves exceeded its net reserve adverse development due principally to an increase in prior year reserves related to Winterthur International. The Company has protection with respect to any adverse development of loss and unearned premium reserves related to the acquired Winterthur International operations with effect from July 1, 2001 under the SPA with the Seller, and has recorded a recoverable of the same amount. See - Financial Condition and Liquidity and Item 8, Note 6(b) to the Consolidated Financial Statements for further information.
During 2002, the Company decreased the estimate of other reserves at the beginning of 2002 by a net amount of $45 million, consisting of a decrease in reserves relating to the excess casualty insurance business of $114 million partially offset by increases in prior year reserves for satellite lines of $30 million and other casualty insurance lines of $39 million. Estimated ultimate loss reserves were reduced for excess casualty insurance based upon lower than expected actual reported loss experience for business written in years 1997 and prior. A lack of available industry data resulted in more actuarial judgment being involved in establishing IBNR loss reserves for this line of business in the earlier years, as mentioned above under “Critical Accounting Policies and Estimates”-Unpaid losses and loss expenses and unpaid loss and loss expenses recoverable. Estimated loss reserves are then regularly updated to take into account actual claims reported. The adverse development experienced in the satellite lines was due to several satellite malfunctions that caused an increase in actual reported loss activity that was greater than expected. The adverse development for the other casualty lines was for business written in 1999 through 2001. In these years, premium rates for casualty business had declined due to competitive market pressures and in 2002, there was an increase in the size of claims reported that was higher than expected.
The decrease in the underwriting expense ratio in 2002 over 2001 is due to a reduction in the acquisition expense ratio that was partially offset by an increase in the operating expense ratio. The acquisition expense ratio decreased due to a change in the mix of business earned where there has been an increase in certain lines which typically carry a lower commission and brokerage cost. In addition, 2001 net premiums earned were reduced by $25.3 million related to the September 11 event that contributed to higher ratios in 2001. Operating expenses included $181.6 million and $69.8 million in 2002 and 2001, respectively, relating to the operations of Winterthur International. This increase reflects a full year of Winterthur International’s results in 2002 as well as costs associated with the building and integration of their infrastructure. In addition, 2002 was also affected by an increase in operating expenses at the Company’s Lloyd’s operations, where the Company has owned 100% of the syndicate capacity since January 1, 2002.
Gross premiums written increased 7.2% in 2003 as compared to 2002 due mainly to new business written and increases in premium rates, primarily in casualty and international property lines. This increase was partially offset by some cancellations in treaty renewals on certain contracts in 2003 and also a reduction of $18.0 million in 2003 of reinstatement premiums related to the release of loss reserves for the September 11 event, discussed further below. Gross premiums written increased 74.6% in 2002 as compared to 2001 due primarily to new business written, premium rate increases and the acquisition of Le Mans Ré, now known as XL Re Europe, which had gross premiums written of $307.3 million and which was consolidated into the Company’s results with effect from January 1, 2002. This was partially offset by the inclusion of reinstatement premiums of $147.9 million in 2001 related to losses arising from the September 11 event.
Fee income and other in 2002 relates primarily to the earning of fees on two deposit liability contracts that were commuted in the second and third quarters of 2002. Fee income and other in 2001 was negative due to non-underwriting costs for an outward reinsurance contract.
Exchange gains in 2003 and 2002 were mainly attributable to a decline in the value of the U.S. dollar against U.K. sterling and the Euro in those operations that write business globally.
In the fourth quarter 2003, the Company reduced aviation loss reserves related to the September 11 event by $197 million. This reduction in reserves was due to higher than expected levels of participation (97%) in the September 11 Victim Compensation Fund, a no-fault compensation scheme funded by the U.S. government, which closed on December 22, 2003. This resulted in a reduction in the estimated ultimate losses by the Company for this event.
During 2003, the Company increased its estimated reserves related to its reinsurance segment (excluding the September 11 event) by $996 million of which approximately $877 million related primarily to the Company’s North American reinsurance operations for casualty business underwritten during the 1997 through 2001 underwriting years. Of the $877 million, $184 million was recorded in the third quarter of 2003 and $663 million in the fourth quarter of 2003 as described below.
reinsurance contract. Such notices do not contain an incurred loss amount to the Company. The development of the number of open claim files for potential asbestos and environmental claims is as follows:
one U.K. and one European, for a total of approximately $390.0 million.
2. Third quarter of 2002 - one U.K. portfolio of approximately $762.7 million
Excluding these large contracts, net premiums earned in life reinsurance increased in 2003 compared with 2002 and 2002 compared with 2001 as the Company expanded its life and annuity reinsurance operations in Europe, as well as new annuity business and term life assurance business in 2003.
Net investment income is included in the calculation of net income from life operations as it relates to income earned on portfolios of separately identified and managed life investment assets and other allocated assets. The accretion of the related future policy benefit reserves is included in claims and policy benefits.
In 2003, the Company has reclassified all credit derivatives from the general operations insurance segment into the financial products and services segment. Prior period information has been reclassified to conform to current year presentation. There was no net income impact of this change in presentation.
Gross and net premiums written increased in 2003 as compared to 2002, and 2002 as compared to 2001 primarily due to new financial guaranty business written.
The growth in net premiums earned in 2003 as compared to 2002 was greater than the increase in net premiums written over the same period. This is due to net premiums that were earned from business written in the current and prior years that earn out over the life of the underlying exposures, which are typically longer than the risk periods related to the Company’s insurance and reinsurance general operations.
The Company commenced writing financial guaranty business in 1998 and had relied entirely upon industry data to establish reserves until the end of 2001. In 2002, the Company refined its assumptions to take into account its actual historical loss experience and revised its estimated claim reporting pattern for the IBNR losses that the Company records during each loss year. The Company uses this expected loss reporting pattern, combined with changes in reported losses, to determine the prior year development amount. Using the new methodology developed in 2002, actual reported loss development was less than expected in 2003, resulting in a release of prior period reserves of $15 million. In 2002, reported losses for this business were also less than expected and with the refinement in assumptions resulted in a decrease in the estimate of reserves for prior years of $13 million.
Net investment income related to the financial guaranty business decreased in 2003 as compared to 2002 due primarily to a decline in general market interest rates.
Equity in net income of financial affiliates increased in 2003 as compared to 2002 due primarily to increased earnings of $29.6 million from the Company’s investment in Primus Guaranty, Ltd (“Primus”), which specializes in providing credit risk protection through credit derivatives. Primus had growth in underlying business written and a positive mark to mark adjustment of approximately $19.0 million due to a significant narrowing of credit spreads in the second and third quarters of 2003 relative to spreads when the protection was originally sold.
The Company’s credit derivative transactions relate primarily to financial guaranty coverage that is written in swap form and pertains to tranches of collateralized debt obligations and asset backed securities, particularly the higher rated tranches with 83% covering “A” to “AAA” tranches at December 31, 2003. Prior to January 1, 2003, the Company’s credit derivative transactions written at primary layers on a partially funded or finite basis were included in the insurance segment. Effective January 1, 2003 the Company has managed all credit default swap transactions in this segment and prior
The increase in operating expenses in 2003 related to the growth of this business.
The Company’s total investments available for sale and cash and cash equivalents less net pending payable for investments purchased was $23.1 billion at December 31, 2003 as compared to $18.1 billion at December 31, 2002. This increase of $5.0 billion includes (i) cash flow from operations of $3.4 billion and (ii) cash flow of $1.5 billion from spread product transactions. The annualized effective yield of the total investment portfolio was 3.46% for 2003 as compared to 4.28% for 2002, a 0.82% reduction. The reduction in the effective yield of the total investment portfolio was primarily due to compression in the spreads of corporate securities and other sectors relative to government bonds and the shortening of the average duration of the total portfolio. For example, during 2003 the U.S. mortgage spread to treasuries declined 0.14%, the US investment grade corporate index spread to treasuries declined 0.91% and the U.S. high yield index spread to treasuries declined 4.53%. The reduction in the spreads offset a gradual rise in treasury yields during the year. As a result, the yield on the portfolio was lower at the end of 2003 in comparison with the end of 2002.
The increase in net investment income in 2002 as compared to 2001 was due to an increase in the total investment base that was partially offset by a decline in the investment yield of the total portfolio. The annualized effective yield on the total investment portfolio was 5.52% in 2001. The reduction in the effective yield of the total investment portfolio was due to a general decline in interest rates in the U.S. and Europe, with the reduction in
rates attributed to markets discounting a slowdown in economic activity. For example, during 2002 the yield on 5-Year U.S. Treasury securities declined by approximately 1.60%, the yield on the 5-Year Euro-denominated government securities declined by approximately 1.00% and the yield on 5-Year U.K. Government securities declined by approximately 0.90%. The growth in the total investment base in 2002 included cash related to (i) the issuance of preference shares in the third and fourth quarters of 2002 generating proceeds of $501.2 million, (ii) $250.0 million of net proceeds relating to the issue of $600.0 million 6.5% Guaranteed Senior Notes due January 2012, after debt repayment of $350.0 million; (iii) cash flow from operations of $3.0 billion; and (iv) investment assets of approximately $653.3 million relating to the consolidation of XL Re Europe, formerly known as Le Mans Ré, as a subsidiary with effect from January 1, 2002.
“n/a” indicates that portfolios comparable to this benchmark have been in existence for less than the period indicated. Returns are time-weighted and have been annualized for periods in excess of one year. U.S. equity indices are shown net of withholding taxes.
The Company’s investment portfolio is classified as available for sale. Realized investment gains and losses occur through the normal turnover of the Company’s investment portfolio. Realized investment losses include impairment charges relating to declines in value of securities that are considered to be other than temporary. See “- Critical Accounting Policies” for further information.
In 2003, net realized gains on investments were $120.2 million which included $344.8 million of gross realized losses on fixed income and $162.5 million of gross realized losses on equity securities. Gross realized losses in 2003 included $130.7 million of provisions for declines in fair value considered to be other than temporary. The general economy in the United States and the investment markets improved in 2003 relative to 2002. For example, Moody’s Investor Service (“Moody’s”) reported that 77 issuers defaulted in 2003 as compared with 141 issuers in 2002. The Company experienced a reduction in the amount of write downs for securities with declines in value deemed to be other than temporary that was consistent with these figures. The write downs for 2003 occurred mainly in the first half of the year which was consistent with Moody’s monthly default statistics. As a percentage of the total fixed income portfolio, the write down for other than temporary declines was 0.6% in 2003 as compared with 1.6% in 2002 and 1% in 2001.
During the year ended December 31, 2001, the Company had net realized losses on investments of $93.2 million. This included gross realized losses on fixed income and equity securities of $373.6 million and $140.9 million, respectively. Gross and net realized losses on investments included $115.5 million of provisions for declines in fair value considered to be other than temporary, $66.4 million of which related to fixed income and equity securities and $49.1 million of which related to the Company’s other investments.
The significant circumstances that contributed to the realized losses in 2002 and 2001 included the high level of distress and default in the telecommunications sector, the Enron Corp. bankruptcy and a general rise in corporate defaults across other sectors in response to the general economic decline in the United States and elsewhere.
During the year ended December 31, 2003, the Company realized losses of $20.9 million and $4.7 million upon the sale of fixed income securities and equity securities, respectively, that had been in an unrealized loss position for greater than twelve months. During the year ended December 31, 2002, the Company realized a loss of $38.4 million and $7.2 million upon the sale of fixed income securities and equity securities, respectively, that had been in an unrealized loss position for greater than twelve months. The decisions to sell these securities were made by the Company’s investment managers based upon a change in market conditions and other factors (which decisions were independent of the Company’s previously stated intent and ability to hold such securities).
The significant circumstances that contributed to the realized losses on the Company’s fixed income and equity securities during the years ended December 31, 2003 and 2002 also affected the Company’s other investments. Of the total impairment charges taken in 2003 and 2002 of $130.7 million and $251.5 million, respectively, $8.1 million and $29.4 million related to the Company’s other investments. The Company’s other investments include investments in private equity limited partnerships which also experienced significant market-wide declines. In 2003 and 2002, the Company wrote down the carrying value of its investment in Mutual Risk Management Ltd by $3.2 million and $20.0 million, respectively. In 2001, declines in value of the Company’s other investments were greatest in the technology sector and write-downs in the portfolio were mainly a result of re-evaluations of technology and financial services investments, reflecting the reduced business prospects of these companies.
FOR THE YEARS ENDED DECEMBER 31, 2003, 2003 AND 2001 (Continued)
Effective January 1, 2002, the Company increased its shareholding in Le Mans Ré from 49% to 67% in order to expand its international reinsurance operations. Due to certain contractual arrangements between the Company and Les Mutuelles du Mans Assurances Group (“MMA”), MMA did not have any economic interest in the earnings of Le Mans Ré with effect from January 1, 2002 and accordingly, no minority interest was recorded from that date. In September 2003, the Company purchased the remaining 33% and Le Mans Ré was renamed “XL Re Europe”. XL Re Europe underwrites a worldwide portfolio comprising most classes of property and casualty reinsurance business, together with a selective portfolio of life reinsurance business. See Note 6 (a) for additional information.
These consolidated financial statements include the accounts of the Company and all of its subsidiaries, including variable interest entities for which the Company has effective control. These consolidated financial statements have been prepared in accordance with U.S. GAAP (“GAAP”). The results include the consolidation of XL Re Europe, accounted for as a subsidiary effective January 1, 2002, described in Note 6(a). In addition, the results also include the acquired Winterthur International operations, effective July 1, 2001, under the purchase method of accounting, described in Note 6(b). All significant intercompany accounts and transactions have been eliminated. Certain amounts in 2002 and 2001 have been reclassified to conform with the current year presentation.
Normally control of a subsidiary or variable interest entity reflects ownership of majority voting interests. However, control can be attained when less than a majority voting interest is held. Factors considered in determining whether control exists include whether the Company provides significant financial support or makes other operating decisions that significantly affect the entity’s results of operations or whether the Company holds a majority of the financial risks and rewards of the entity.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. While
Life and annuity premiums from long duration contracts that transfer significant mortality or morbidity risks are recognized as revenue and earned when due from policyholders. Life and annuity premiums from long duration contracts that do not subject the Company to risks arising from policyholder mortality or morbidity are accounted for as deposit liabilities.
Acquisition costs, which vary with and are related to the acquisition of policies, consist primarily of commissions paid to brokers and cedents, and certain underwriting costs, are deferred and amortized over the period the premiums are earned. Acquisition costs are shown net of commissions earned on reinsurance ceded. Future earned premiums, the anticipated losses and other costs (and in the case of a premium deficiency, investment income) related to those premiums, are also considered in determining the level of acquisition costs to be deferred.
Credit derivatives are recorded at fair value which is determined using models developed by the Company and is dependent upon a number of factors including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change resulting from movements in credit and credit quality spreads is unrealized as the credit derivatives are not traded to realize this resultant value.
Fair value for the Company’s natural gas contracts are determined through the use of quoted market prices. As quoted market prices are not widely available in the weather and electricity derivative markets, management uses available market data and internal pricing models based upon consistent statistical methodologies to estimate fair values. Estimating the fair value of instruments which do not have quoted market prices requires management’s judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair val-
ues are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.
The Company uses investment derivatives to manage duration and currency exposure for its investment portfolio.
The Company uses investment derivatives, substantially interest rate swaps, to manage the interest rate exposure of the Company’s guaranteed investment contracts (“GICs”). All interest rate swaps are recorded at fair value which is determined using fixed income analytical models and is dependent upon interest rate conditions and relationships among interest rates and indices. Changes in the value of fair value hedges are recorded as adjustments to the hedged items to the extent that the hedge is effective. Changes in the value of cash flow hedges are recorded in other comprehensive income to the extent that the hedge is effective. The ineffective portion of both fair value and cash flow hedges are recorded in the consolidated statement of income as “net realized and unrealized gains and losses on derivative instruments”.
Investments that are considered available for sale are carried at fair value. The fair value of investments is based upon quoted market values where available or by reference to broker or underwriter bid indications. The net unrealized appreciation or depreciation on investments, net of tax, is included in “accumulated other comprehensive income (loss)”. Any unrealized depreciation in value considered by management to be other than temporary is charged to income in the period that it is determined.
Investments in which the Company has significant influence over the operations are classified as investments in affiliates for accounting purposes and are carried under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss from such investments in its results for the period. Significant influence is deemed to exist where the Company has an investment of 3% or greater in closed end funds, limited partnerships or similar investment vehicles. Significant influence is considered for other strategic investments on a case-by-case basis. The determination of whether an entity is classified as an affiliate for GAAP accounting purposes may be different from the determination of whether such entity would constitute an affiliate for any other purposes, including regulatory purposes. The equity in net income of affiliates is shown separately between equity in net income of insurance and financial affiliates and equity in net income of investment affiliates. Any decline in value of an affiliate investment considered by management to be other than temporary is charged to income in the period that it is determined.
The Company accounts for its other investments at estimated fair value based on financial information received, as it has no significant influence over these entities.The net unrealized appreciation or depreciation on investments, net of tax, is included in “accumulated other comprehensive income/(loss)”. Any unrealized depreciation in value considered by management to be other than temporary is charged to income in the period that it is determined.
Assets and liabilities of foreign operations whose functional currency is not the U.S. dollar are translated at prevailing year end exchange rates. Revenue and expenses of such foreign operations are translated at average exchange rates during the year. The net effect of the translation adjustments for foreign operations, net of applicable deferred income taxes, is included in “accumulated other comprehensive income (loss)”.
Other monetary assets and liabilities denominated in foreign currencies are revalued at the exchange rate in effect at the balance sheet date with the resulting foreign exchange gains and losses recognized in income.
Certain workers’ compensation, long term disability liabilities and financial guarantee case reserve contracts are considered fixed and determinable and are subject to tabular reserving. Reserves associated with these liabilities are discounted.
Effective January 1, 2003, the Company has adopted the fair value recognition provisions of FAS 123 “Accounting for Stock-Based Compensation”, using the prospective method allowed under FAS 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” for options granted subsequent to January 1, 2003. Prior to 2003, the Company accounted for options under the disclosure-only provisions of FAS 123 and no stock based employee compensation cost was included in net income as all options granted had an exercise price equal to the market value of the Company’s ordinary shares on the date of grant. Awards under the Company’s stock plans vest over periods ranging from three to four years. If the fair value based method had been applied to all awards since the original effective date of FAS 123, the cost related to employee stock based compensation included in the determination of net income would have been higher. FAS 148 amends FAS 123 by providing alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, FAS 148 amends the disclosure requirements of FAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.
In April 2003, the FASB cleared Derivative Implementation Guidance Issue No. B36, “Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures that Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments”(“Issue B36”). The accounting guidance states that modified coinsurance arrangements, in which funds are withheld by the ceding insurer and a return on those withheld funds is paid based on the ceding company’s return on certain of its investments, contain an embedded derivative feature that will require bifurcation. This guidance was adopted as of October 1, 2003. The application of the new guidance did not have a material effect on the Company’s financial condition and results of operations.
In July 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-01, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.” AcSEC has developed the SOP to address the evolution of product designs since the issuance of SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” and SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” and the need for interpretive guidance to be developed in three areas: separate account presentation and valuation; the accounting for sales inducements to contract holders; and the classification and valuation of certain long-duration contract liabilities. The provisions of the SOP are effective for fiscal years beginning after December 15, 2003, as such, the Company will adopt the SOP effective January 1, 2004. The Company is currently completing an assessment of the impact of the SOP on its operations; however, the Company does not believe that the implementation of the SOP will have a material effect on the Company’s financial condition or results of operations.
The Company is organized into three underwriting segments-insurance, reinsurance, and financial products and services-in addition to a corporate segment that includes the investment and financing operations of
the Company. General, life and annuity, and financial operations are disclosed separately within each segment. General operations include property and casualty lines of business.
Interest expense excludes interest expense related to life and annuity operations shown separately.
This includes net realized losses on investments of $214.2 million and net realized and unrealized losses on investment derivatives of $22.2 million.
Ratios are based on net premiums earned from general operations, excluding fee income and other. The underwriting expense ratio excludes exchange gains and losses.
Corporate operating expenses include charges of $14.0 million related to the acquisition of Winterthur International.
The following table is an analysis of the Company’s gross premiums written, net premiums written and net premiums earned, by line of business for the years ended December 31, 2003, 2002 and 2001:
During the fourth quarter of 2003, the Company reduced loss reserves by $197.25 million related to the reinsurance segment, primarily aviation lines, due to higher than expected levels of participation (97%) in the September 11 Victim Compensation Fund, a no-fault compensation scheme funded by the U.S government, which closed on December 22, 2003. This resulted in a reduction in the estimated ultimate losses by the Company for this event and after tax, this resulted in an increase in net income of approximately $130.0 million.
This process was complicated in the reinsurance operations where the Company is not a direct insurer. Potential losses on certain business lines were easily estimated, such as aviation and direct property catastrophe. Estimates related to the retrocessional book of business were more difficult to ascertain due to the inherent nature of determining the effect from losses arising on the underlying contracts. A net loss of $795.9 million related to the September 11 event was recorded in the year ended December 31, 2001.
The Company has paid approximately 50% of its estimated ultimate net losses related to the September 11 event as at December 31, 2003.
FASB issued FAS 141, “Business Combinations,” and FAS 142, “Goodwill and Other Intangible Assets,” in July 2001. FAS 141 addresses financial accounting and reporting for the acquisition of other companies and is applicable for new transactions effective after June 30, 2001. For previous transactions, this standard is effective for fiscal years beginning after December 15, 2001. FAS 142 addresses financial accounting and reporting for goodwill and other intangible assets both upon acquisition and after these assets have initially been recognized in the financial statements. Adoption of FAS 142 has resulted in the Company ceasing to amortize goodwill and certain intangible assets.
The increase in goodwill in 2003 related primarily to the settlement of the purchase price for Winterthur International (see note 6(b)). As at December 31, 2003 goodwill and intangible assets related to the insurance segment was $455.5 million, the reinsurance segment was $1.4 billion and the financial products and services segment was $4.6 million.
In connection with the acquisition, under the Sale and Purchase Agreement (“SPA”), the Company has post-closing protection with respect to adverse development of loss and unearned premium reserves related to Winterthur International. This protection is based upon actual net loss experience and development over a three-year post-closing seasoning period based on loss development experience, collectible reinsurance, reinsurance recoveries and certain other factors set forth in the SPA. At December 31, 2003, included in unpaid losses and loss expenses recoverable, is an unsecured reinsurance recoverable from the seller of $740.9 million based on provisions of the SPA. The amount of this recoverable remains subject to change pending expiration of the three-year seasoning period due to close on June 30, 2004.
The acquisition was accounted for under the purchase method of accounting and, therefore, the identifiable assets and liabilities of Winterthur International were recorded at their estimated fair value on June 30, 2001. The process of determining the fair value of such assets and liabilities
acquired, as required under purchase accounting, included management’s estimates and independent valuations. The purchase price was preliminarily allocated to the acquired assets and liabilities based upon their estimated fair value at June 30, 2001. The excess of the purchase price over acquired tangible net assets was then applied to intangible assets with finite and indefinite lives. With the settlement of the final purchase price in December 2003, the Company has finalized its allocation of the purchase price to the fair value of the acquired tangible net assets based on additional information now available. This information primarily related to loss reserves, adjustment and reinstatement premiums, reinsurance balances payable and receivable and other assets and liabilities. Once the final excess purchase price was known, the Company amended the amount attributed to goodwill by $171.0 million. This settlement of the purchase price and related adjustments represents the completion of the Company’s allocations to the fair value of net assets. Any subsequent adjustments to the carrying value will be reflected in income in the year in which the adjustments are made.
The Company recognized goodwill in excess of the fair value of the net assets of Winterthur International operations to increase its global platform for its insurance operations.
The Company estimated the total value of intangible assets acquired at $29.8 million, including $14.7 million for insurance licenses and sales force, which have an indefinite life and are not therefore subject to amortization. The remaining $15.1 million relates to the value of business in force, which is estimated to have a finite life of up to five years and is being amortized over that period.
Net realized gains and losses in 2003 and 2002 included a loss of $130.7 million and $251.5 million, respectively, relating to certain fixed income, equity securities and other investments where the Company determined that there was an other than temporary decline in the value of those investments.
The total amount of an other than temporary decline in value in 2002 related to $144.3 million on fixed income securities, $77.8 million on equity securities and $29.4 million on other investments. Of the decline in value of fixed income and equity securities considered to be other than temporary in 2002, approximately 44% was due to investments in the communications sector. The total amount of an other than temporary decline in value in 2001 related to $66.4 million on fixed income and equity investments and $49.1 million on other investments.
The general economy in the United States and the investment markets improved in 2003 relative to 2002. For example, Moody’s Investor Service (“Moody’s”) reported that 77 issuers defaulted in 2003 as compared with 141 issuers in 2002. The Company experienced a reduction in the amount of write downs for securities with declines in value deemed to be other than temporary that was proportional with these figures. The write downs for 2003 occurred mainly in the first half of the year which was consistent with Moody’s monthly default statistics. As a percentage of the total fixed income portfolio, the write down for other than temporary declines was 0.6% in 2003 as compared with 1.4% in 2002 and 1% in 2001.
At December 31, 2003 and 2002, approximately $322.4 million and $242.1 million, respectively, of securities were on deposit with various U.S. state or government insurance departments in order to comply with relevant insurance regulations.
The Company has two facilities available for the issue of letters of credit collateralized against the Company’s investment portfolio with a value of $291.7 million at December 31, 2003 and $243.9 million at December 31, 2002. At December 31, 2003 and 2002, approximately $234.4 million and $160.0 million, respectively, of letters of credit were issued and outstanding under these facilities.
The equity in net loss of insurance affiliates in 2003 included an other than temporary decline of $40.9 million in the first quarter of 2003 in the value of the Company’s investment in Annuity & Life Re (Holdings), Ltd. (“ANR”). The investment was written down to its fair market value. In the fourth quarter of 2002, the Company wrote down $13.3 million of its investment in ANR due to a significant decline in the book value of ANR.
The Company recorded losses of $8.1 million and $29.4 million in the years ended December 31, 2003 and 2002, respectively, due to other than temporary declines in values of these investments.
Unpaid losses and loss expenses for the Company’s general and financial operations are comprised of:
The following table represents an analysis of paid and unpaid losses and loss expenses incurred and a reconciliation of the beginning and ending unpaid losses and loss expenses for the years indicated:
During 2003, the Company’s net adverse prior year development of $153 million was due primarily to increases in previously reported case reserves for excess professional liability lines of $143 million for the underwriting years 1997 through 2001. These increases in reported case reserves exceeded the Company’s expected losses based on historical patterns of loss development. Specifically, the increase related to reported case reserves for directors and officers and errors and omissions coverages. During 2003, there was an increase
in the amount of litigation related to certain losses. In addi-
tion, there was adverse development of $37 million related to environmental business primarily for professional liability coverage underwritten in 2000 and 2001 that was offset by favorable development of $27 million primarily in aviation, property, marine and energy coverages.
During 2002, the Company decreased the estimate of other reserves at the beginning of 2002 by a net amount of $45 million, consisting of a decrease in reserves relating to the excess casualty insurance business of $114 million partially offset by increases in prior year reserves for satellite lines of $30 million and other casualty insurance lines of $39 million. Estimated ultimate loss reserves were reduced for excess casualty insurance based upon lower than expected actual reported loss experience for business written in years 1997 and prior. A lack of available industry data resulted in more actuarial judgment being involved in establishing IBNR loss reserves for this line of business in the earlier years. Estimated loss reserves are then regularly updated to take into account actual claims reported. The adverse development experienced in the satellite lines was due to several satellite malfunctions that caused an increase in actual reported loss activity that was greater than expected. The adverse development for the other casualty lines was for business written in 1999 through 2001. In these years, premium rates for casualty business had declined due to competitive market pressures and in 2002, there was an increase in the size of claims reported that was higher than expected.
The following is an analysis of the net adverse prior year development during each of the three years ended December 31, 2003:
The Company commenced writing financial guaranty business in 1998 and had relied entirely upon industry data to establish reserves until the end of 2001. In 2002, the Company refined its assumptions to take into account its actual historical loss experience and revised its estimated claim reporting pattern for the IBNR losses that the Company records during each loss year. The Company uses this expected loss reporting pattern, combined with changes in reported losses, to determine the prior year development amount. Using this new methodology actual reported loss development was less than expected in 2003, resulting in a release of prior period reserves of $15 million. In 2002, reported losses for this business were also less than expected and with the refinement in assumptions resulted in a decrease in the estimate of reserves for prior years of $13 million.
Except for certain workers’ compensation and long-term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation and long-term disability unpaid losses that are considered fixed and determinable, and from January 1, 2003, discounts such losses using an interest rate of 5% (7% was used in 2002). The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The Company decreased the interest rate in 2003 in line with current investment yields on this portfolio. The effect of the decrease in the interest rate resulted in an increase in loss reserves of approximately $35.0 million in 2003. The amount of the discount credit included in net losses and loss expenses incurred was $22.6 million in 2002. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2003 and 2002 were $538.8 million and $374.5 million, respectively. The related discounted unpaid losses and loss expenses were $263.8 million and $151.7 million as of December 31, 2003 and 2002, respectively.
Incurred but not reported losses, net of reinsurance, included in the above table was $27.0 million in 2003, $33.1 million in 2002 and $8.0 million in 2001. Unpaid losses recoverable are net of potential uncollectible amounts.
As of December 31, 2003, the Company had approximately 594 open claim files for potential asbestos exposures and 490 open claim files for potential environmental exposures on business written prior to 1986. Approximately 43% in 2003 and 44% of the open claim files for both 2002 and 2001 are due to precautionary claim notices. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to receive coverage under the reinsurance contract. Such notices do not contain an incurred loss amount to the Company. The development of the number of open claim files for potential asbestos and environmental claims is as follows:
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $1.9 billion, $1.4 billion and $3.0 billion for the years ended December 31, 2003, 2002 and 2001, respectively. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $1.7 billion at December 31, 2003, collateralizing reinsurance recoverables with respect to certain reinsurers.
Included in unpaid loss and loss expenses recoverable at December 31, 2003 from general operations is an unsecured reinsurance recoverable from Winterthur Swiss Insurance Company (currently rated A by Standard and Poor’s) of $740.9 million related to the acquisition of Winterthur International. Also, of the total unpaid loss and loss expense recoverable and reinsurance balances receivable at December 31, 2003 of $7.1 billion, approximately $2.2 billion related to Winterthur International and these recoverable balances are also guaranteed by Winterthur Swiss Insurance Company. See Note 6(b).
Interest expense of $105.1 million, $65.9 million and $57.2 million was recorded related to the accretion of deposit liabilities for the years ended December 31, 2003, 2002 and 2001, respectively.
“Commitment” and “In Use” data represent December 31, 2002 accreted values.
Borrowings in 2002 were used to pay down two 5-year revolvers and for general corporate purposes. The total pre-tax interest expense on notes and debt outstanding during the years ended December 31, 2003 and 2002 was $94.3 million and $102.2 million, respectively. Associated with the Company’s bank and loan commitments are various loan covenants with which the Company was in compliance throughout the year ended December 31, 2003. These facilities contain var-
ious cross default provisions and covenants, including a minimum rating requirement, as further described under “Cross Defaults and Other Provisions In Debt Documents”.
In November 2003, the Company renewed its unsecured syndicated letter of credit facility that supports its operations at Lloyd’s. The renewed facility is denominated in U.K. sterling and was approximately $712 million at December 31, 2003.
In May 2001, the Company issued $1,010.8 million principal amount at maturity (subject to potential upward adjustment ) of Zero Coupon Convertible Debentures (“CARZ”) at $593.57 per bond and, unless converted or repaid before their due date of May 2021, they will be repaid in May 2021 at $1,000 per bond, at a total cost of $1.01 billion. The accretion rate is 2.625% per annum on a semi-annual basis or 2.6422% per annum on an annual basis.
In September 2001, the Company also issued $508.8 million principal amount at maturity (subsequently increased to $514.6 million under the provisions of the upward interest adjustment described below) of Liquid Yield Option NotesTM (“LYONs”) at an initial price of $565.01 per bond. The LYONs will also be repaid at $1,011.36 each (originally $1,000.00 each but subsequently increased as a result of the accretion rate adjustment described below), unless converted or repaid before their due date of September 2021, at a total cost of $514.6 million. The accretion rate on the LYONs was originally 2.875% per annum on a semi-annual basis or 2.896% per annum on an annual basis. The accretion rate for the year to September 7, 2004, was increased by 0.645% per annum on a semi-annual basis to 3.52% on a semi-annual basis and 3.551% per annum on an annual basis as a result of the of the Company’s ordinary share price in the 30-day period leading up to the second put date in September 2003. The accretion rates will revert to their original rates in September 2004
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are utilized to support non-admitted insurance and reinsurance operations in the U.S. and capital requirements at Lloyd’s. All of the commercial facilities are scheduled for renewal during 2004. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedents with statutory relief required under state insurance regulation in the U.S. It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedents. This could take the form of additional insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business.
The holders of each of the CARZ and LYONs also have the right to convert the bonds for ordinary shares in the event that the trading price of the bonds for a predetermined period falls below 95% of the value of the equivalent number of ordinary shares, provided however, if the ordinary shares are trading at a predetermined premium to the accreted price of the bonds, holders may receive cash, ordinary shares or a combination thereof in lieu of ordinary shares upon conversion.
In addition, in the event that the credit ratings assigned to the bonds by S&P fall below BBB+, the bonds would be convertible into ordinary shares at 5.9467 ordinary shares per CARZ and 5.277 ordinary shares per LYONs. The rating assigned to the bonds at the time of issue was A+. The ratings were lowered to A by S&P in January 2004. Some corporate transactions, such as a change of control of the Company, would give the bondholders the right to require the Company to repurchase the bonds at the accreted value of the bonds at that time.
In general, all of the Company’s bank facilities, indentures and other documents relating to the Company’s outstanding indebtedness (collectively, the “Company’s Debt Documents”), as described above, contain cross default provisions to each other and the Company’s Debt Documents (other than the LYONs, CARZ and 6.5% Guaranteed Senior Notes indentures) contain affirmative covenants. These covenants provide for, among other things, minimum required ratings of the Company’s insurance and reinsurance operating subsidiaries (other than its “AAA” financial guaranty companies) and the level of secured indebtedness in the future. In addition, generally each of the Company’s Debt Documents provide for an event of default in the event of a change of control of the Company or some events involving bankruptcy, insolvency or reorganization of the Company. The Company’s credit facilities and the 6.58% Guaranteed Senior Notes also contain minimum consolidated net worth covenants.
Under the Company’s 364-day facility, five-year credit facilities and ten-year private placement notes described above, in the event that the Company fails to maintain a financial strength rating of at least “A” from A.M. Best or the Company’s insurance and reinsurance rated operating subsidiaries (other than its “AAA” financial guaranty companies) fail to maintain a rating of at least “A” from S&P, an event of default would occur. The company currently has an “A+ under review” rating from A.M. Best and “AA-” from S&P.
In addition, the Company’s unsecured Lloyd’s letter of credit facility provides that, in the event that the Company’s insurance and reinsurance rated operating subsidiaries fall below “A” (as generally measured by the lower of the financial strength rating from A.M. Best or S&P at any time), the facility would then be required to be fully secured by the Company, at which time the Company would be required to either (i) provide an amount in cash to cover an amount equal to the aggregate letters of credit outstanding at that time or (ii) deposit assets in trust securing 105% of the aggregate letters of credit outstanding at that time. If this were to occur, the Company may not be able to provide the collateral required in order to maintain this facility.
The Company enters into credit derivatives in connection with its financial guaranty business and the Company intends to hold these contracts to maturity. In determining fair value, management differentiates between investment and non-investment grade exposures and models them separately. Management estimates fair value for investment grade exposures by monitoring changes in credit quality and selecting appropriate market indices to determine credit spread movements over the life of the contracts. The determination of the credit spread movements is the basis for calculating the fair value. For credit derivatives that are non-investment grade and therefore do not have a readily determinable market value, the Company uses an alternative fair value methodology. The fair value is determined using a cash flow model developed by the Company and is dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. Installment premiums are also considered in the determination of discounted net cash flows. Other elements of the change in fair value are based upon pricing established at the inception of the contract. Changes in fair value are unrealized as the credit derivatives are not traded to realize this value.
Weather and energy derivatives are recorded at fair value, which is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair values are estimated using available market data and internal pricing models based upon consistent statistical methodologies. Estimating fair value of instruments which do not have quoted market prices requires management’s judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities and equity investments. These contracts are not designated as specific hedges for financial reporting purposes and therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of three months or less. In addition, where the Company’s investment managers believe potential gains exist in a particular currency, a forward contract may not be entered into. At December 31, 2003 and 2002, forward foreign exchange contracts with notional principal amounts totaling $193.0 million and $30.2 million, respectively were outstanding. The fair value of these contracts as at December 31, 2003 and 2002 was $189.4 million and $28.6 million, respectively, with unrealized gains of $3.5 million in 2003 and unrealized losses of $1.6 million in 2002. For the years ended December 31, 2003 and 2002, realized gains of $1.0 million and losses of $3.4 million, respectively, and unrealized gains of $3.3 million and losses of $0.8 million, respectively, were recorded in net realized and unrealized gains and losses on derivative instruments.
The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments, primarily to reduce its exposure to interest rate risks associated with guaranteed investment contracts. The Company uses interest rate swaps to convert certain liabilities from a fixed rate to a variable rate of interest (fair value hedge), and to convert a variable rate of interest from one basis to another (cash flow hedge). The Company formally and contemporaneously documents all relationships between the hedging instruments and hedged items and links the hedge to specific liabilities. The Company assesses the effectiveness of the hedge, both at inception and on an on-going basis and determines whether the hedge is highly effective in offsetting changes in fair value or cash flows of the linked hedged item.
In 2002, the Company entered into a treasury rate lock agreement with the underwriters of the 6.50% Guaranteed Senior Notes due 2012 (2001: 6.58% Guaranteed Senior Notes due 2011). The Notes were priced using a margin over the yield of a U.S. Treasury note with a similar maturity. The treasury rate lock agreement was designed to eliminate underlying pricing risk of the Company’s debt that would have resulted from an increase in the yield of the comparable U.S. Treasury issue between the initiation of the transaction and the pricing of the transaction. The total cost of the hedge was $4.2 million. In 2001, a loss of $5.6 million was recorded in net realized and unrealized gains and losses related to the cancellation of the treasury lock agreement relating to the 6.58% notes due 2011 due to the September 11, 2001 event.
The Company utilizes variable interest entities both indirectly and directly in the ordinary course of business. The Company provides various forms of credit enhancement including financial guaranty insurance and reinsurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and structured single risk based obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through variable interest entities. In synthetic transactions the Company guarantees payment obligations of counterparties including special purpose vehicles under credit derivatives referencing asset portfolios. The Company invests in equity tranches (or similar instruments) of collateralized debt obligations (“CDOs”), collateralized bond obligations (“CBOs”) and other investment vehicles that are issued through variable interest entities as part of the Company’s risk asset portfolio.
in the Trust were withdrawn in order to satisfy the Company’s reinsurance obligations or if lender-issued securities could not be held in the Trust because they did not qualify as permitted assets under the trust agreement), then all or a portion of the assets in the Trust and the Company’s repayment obligations under the Credit Facilities would be required to be included as assets and liabilities on a gross basis, respectively, on the Company’s balance sheet.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction also provides the Company with an insurance trust that provides the Company with statutory relief under state insurance regulations in the U.S. Under the terms of this facility, the Company has acquired an irrevocable put option to issue preference ordinary shares into a trust in return for proceeds raised from investors. This put option may be exercised by the Company at any time. In addition, the Company may be required to issue preference ordinary
shares to the trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a ratings downgrade of the Company.
The following table presents financial guaranty aggregate insured portfolios at December 31, 2003 where the net par outstanding was $54.2 billion, which includes credit default swap exposures of $9.5 billion. The liability for these credit derivatives had a carrying value of $131.6 million and $160.3 million at December 31, 2003 and December 31, 2002, respectively.
The Company has committed to invest in several limited partnerships as part of its overall corporate strategy. The Company has commitments which include potential additional add-on clauses, to invest a further $4.7 million over the next five years.
The Company rents space for certain of its offices under leases that expire up to 2017. Total rent expense under operating leases for the years ended December 31, 2003, 2002 and 2001 was approximately $42.3 million, $30.4 million and $18.9 million, respectively. Future minimum rental commitments under existing operating leases are expected to be as follows:
During 2003, the Company entered into a purchase, sale and leaseback transaction to acquire new office space in London. The Company has recognized a capital lease asset of $150.0 million and deferred a gain of $50.0 million related to the sale at December 31, 2003 related to this lease. The gain will be amortized to income in line with the amortization of the asset. The future minimum lease payments in the aggregate are expected to be $352.7 million and annually for the next five years are as follows :
Restricted stock awards issued under the 1991 Performance Incentive Program vest as set forth in the applicable award agreements. These shares contained certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability. As the shares are issued, deferred compensation equivalent to the fair market value on the date of the grant is charged to shareholders’ equity and subsequently amortized over
the vesting period. Restricted stock issued under the plan totaled 496,671 shares, 225,960 shares, and 227,795 shares in 2003, 2002, and 2001, respectively.
A second stock plan is provided for the directors that grants share units equal to their annual retainer divided by market price of the Company’s ordinary stock on January 1 of each year. These units receive dividends in the form of additional units equal to the cash value divided by the market price on the payment date. Stock units totaling 8,598, 6,659, and 7,318 were issued in 2003, 2002 and 2001, respectively. Total units are granted as shares upon retirement from the Board.
The Employee Share Purchase Plan (the “ESPP”) was approved by the shareholders of the Company on May 10, 2002. The ESPP is administered by a committee which consists of members of the Compensation Committee of the Company’s Board of Directors. The ESPP has two offering periods a year. The first period commenced on July 1, 2002. All employees of the Company and its designated participating subsidiaries, are eligible to participate in the ESPP provided they have been employed at least one month prior to the start of the offering period and they do not hold more than 5% of the Company’s total stock, including stock acquired in the current period. Employees can invest up to 20% of their total monthly cash compensation towards the purchase of the Company’s shares up to a total market value (measured on the first day of the offering period) of U.S. $25,000. The total number of shares purchased in any offering period cannot exceed 1,000 shares. Employees who enroll in the ESPP may purchase the Company’s shares at a 15% discount on the lesser of the market price at the beginning or at the end of the six months offering period. Once purchased, employees can sell or transfer their shares to someone else’s name only during an Open Trading Window. Participants in the ESPP are eligible to receive dividends on the Company’s shares. A total of 1,255,000 ordinary shares may be issued under the ESPP. The number of share issued during the year ended December 31, 2003 and 2002 was 99,059 and 47,399, respectively.
The following table summarizes information about the Company’s stock options (including stock appreciation rights) for options outstanding as of December 31, 2003:
(1) Includes 13,404 options outstanding and exercisable, with an average exercise price of $23.52 that have no expiration date. These options are not included in the calculation of the average remaining contractual life.
The Company has a qualified defined contribution plan which is managed externally and whereby employees and the Company contribute a certain percentage of the employee’s gross salary into the plan each month. The Company’s contribution generally vests over 5 years. The Company’s expenses for its qualified contributory defined contribution retirement plans were $27.5million, $22.2 million and $9.7 million in the years ended December 31, 2003, 2002 and 2001, respectively.
The income tax provisions for the years ended December 31, 2003, 2002 and 2001 are as follows:
The weighted average expected tax provision has been calculated using the pre-tax accounting income (loss) in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years December 31, 2003 and 2002 is provided below:
Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2003 and 2002 were as follows:
The valuation allowance of $18.3 million at December 31, 2003 relates to net operating loss carryforwards that may not be realized within a reasonable period. The valuation allowance of $50.5 million at December 31, 2002 relates to net operating loss carryforwards that may not be realized within a reasonable period. The deferred tax asset for certain net operating loss carryforwards and valuation allowance was reduced by $22.4 million for amounts attributable to the pre-acquisition period of certain affiliates. U.S. net operating loss carryforwards at December 31, 2003 were approximately $450 million and will expire in future years through 2023. As of December 31, 2003, net operating loss carryforwards in the U.K. were $289 million and have no expiration.
Management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized. Management is required to determine if there is sufficient positive evidence to conclude that it is more likely than not that the deferred tax asset attributable to its U.S. group net operating losses would be utilized within a reasonable period. Management has reviewed historical taxable income and future taxable income projections for the U.S. group and has determined that in its judgment, the net operating losses will more likely than not be realized as reductions of future taxable income within a reasonable period. Specifically with regard to the United States group, management has determined that the projected U.S. consolidated income will be sufficient to utilize the net operating losses of approximately $450 million within a reasonable period. Management will continue to evaluate income generated in future periods by the U.S. group in determining the reasonableness of its position. If management determines that future income generated by the U.S. group
Shareholders’ equity at December 31, 2003 and 2002 reflected tax benefits of $2.9 million and $3.7 million, respectively, related to compensation expense deductions for stock options exercised for one of the Company’s U.S. subsidiaries.
Except as noted below, there are no statutory restrictions on the payment of dividends from retained earnings by any of the Company’s subsidiaries as applicable minimum levels of solvency and liquidity have been met and all regulatory requirements and licensing rules complied with. At December 31, 2003, and 2002 XL Reinsurance America (“XLRA”), the Company’s lead property and casualty subsidiary in the United States, had a statutory deficit of $210.3 million and $155.5 million. As a result, XLRA is not currently able to make a dividend distribution under New York insurance law without obtaining prior approval of the New York Insurance Department. Similarly, five of the six property & casualty subsidiaries directly or indirectly owned by XLRA also had statutory deficits ranging from $3.6 million to $77.0 million at December 31, 2003 and from $6.0 million to $24.0 million at December 31, 2002. As a result, these subsidiaries
are similarly unable to currently make a dividend distribution under the insurance law of their respective states of domicile, which include Delaware, New York and North Dakota. At December 31, 2003 and 2002, XL Insurance Company Limited (previously known as Winterthur International Insurance Company Limited) had a statutory earned deficit and is restricted from making a dividend distribution at this time under U.K. Company law.
On December 31, 2002, the Company entered into an agreement with Annuity and Life Reinsurance, Ltd. (“ALRE”), a subsidiary of Annuity and Life Re (Holdings), Ltd. (“ANR”), pursuant to which the Company assumed certain blocks of life reinsurance business. The Company has an investment in ANR that is accounted for as an affiliate under the equity method pursuant to APB Opinion 18, but the Company does not have the ability to control ANR or direct its operating and financial policies. Under the agreement, the Company has assumed five blocks of life reinsurance business from ALRE and entered into a 50% quota share reinsurance contract with ALRE with respect to four of those blocks of business. As consideration for the novation of the five blocks of business from ALRE, the Company made a payment of approximately $44.0 million. As consideration for the 50% quota share reinsurance contract, the Company received a ceding commission of approximately $26.0 million. In connection with the transferred blocks of business, ALRE also transferred to the Company approximately $66.0 million in assets and related future policy benefit reserves. The 50% quota share reinsurance contract is structured as a modified coinsurance arrangement, as such, the Company recorded a liability for the funds withheld in reinsurance balances payable on the balance sheet in the amount of $25.0 million.
XL Capital Finance (Europe) plc (“XLFE”) is a wholly owned finance subsidiary of the Company. In January 2002, XLFE issued $600 million par value 6.5% Guaranteed Senior Notes due January 2012. These Notes are fully and unconditionally guaranteed by the Company. The Company’s ability to obtain funds from its subsidiaries to satisfy any of its obligations under this guarantee is subject to certain contractual restrictions, applicable laws and statutory requirements of the various countries in which the Company operates including Bermuda, the U.S. and the U.K., among others. Required statutory capital and surplus for the principal operating subsidiaries of the Company was $3.0 billion as of December 31, 2003.
The following is a summary of the unaudited quarterly financial data for 2003 and 2002:
(2) Average stock options outstanding have been excluded where anti-dilutive to earnings per share. Consequently, where there is a net loss, basic weighted average ordinary shares outstanding are used to calculate net loss per share.
Results for the third quarter of 2002 included a large life contract consisting of a U.K. portfolio of annuities which increased net premiums earned and claims and policy benefits by $762.7 million and $776.8 million respectively.