The selected consolidated financial data below is based upon the Company’s fiscal year end of December 31. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements and the Notes thereto presented under Item 8.
The Company operates on a global basis and is a leading provider of insurance and reinsurance coverages to industrial, commercial and professional service firms, insurance companies and other enterprises, typically the global equivalent of the Fortune 2000. The Company operates in markets where it believes its underwriting expertise and financial strength represent a relative advantage.
In the Reinsurance segment, the year ended December 31, 2008 reflected a decline in premium rates across most major lines of business, as market conditions continued to soften and the reinsurance industry continued to experience pricing erosion, increased competitive pressures and increased retentions by cedants. Renewals and new business in 2008 continued to be assessed against internal hurdle rates with a continued focus on underwriting discipline. U.S. and non-U.S. catastrophe exposed property lines experienced rate declines of approximately 10% while other property lines of business saw rates decrease by 10% to 15%. Ocean marine pricing rates remained flat to down 5%, while rates within the aviation market decreased by up to 10%. Casualty pricing trends in the reinsurance market experienced deterioration in rates of up to 15%, however, rate changes on business actually bound in this line of business decreased between 10 to 15%. However, with increased hurricane and other loss activity during the latter half of 2008, taken together with the distressed state of the financial markets, rate declines across all lines of business began to slow in the latter half of 2008.
Throughout 2007 and the majority of 2008, the property and casualty insurance and reinsurance markets experienced soft market conditions across most, if not all lines of business, as evidenced by decreases in market pricing and a weakening of policy terms and conditions. However, following catastrophe activity throughout 2008, most notably, losses resulting from Hurricanes Ike and Gustav, and more importantly, following severe economic conditions and the impacts of the financial crisis, which reduced the available capital of many property and casualty (re)insurers, market capacity decreased and in conjunction, market pricing across most insurance and reinsurance lines of business began to improve and is expected to continue improving throughout 2009. The following is a summary of the January 2009 rate indications and recent renewal activity for each of the Insurance and Reinsurance segments of the Company:
During 2008, the Company reported significant decreases in both its structured credit and corporate portfolios as a result of the negative conditions described above. Within the structured credit portfolio, the market conditions particularly impacted the Company’s holdings in sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral and Alt-A mortgages (“Topical Assets”), core collateralized debt obligations (“CDOs”) and commercial mortgage-backed securities (“CMBS”). Within the corporate portfolio, the Company’s financial sector holdings were particularly affected as credit spreads, which widened across the entire rating spectrum impacted all spread assets classes, particularly financials following the bankruptcy of Lehman Brothers Holdings Inc. (“Lehman”) in September 2008 and the subsequent failure or near failure of other financial institutions. The impact of the credit spread widening was partially offset by the increase in the fixed income portfolio which resulted from declining government interest rates.
The Company’s profitability in any given period is based upon its premium and investment revenues as noted above, less net losses incurred and expenses. Net losses incurred are based upon claims paid and changes to unpaid loss reserves. Unpaid loss reserves are estimated by the Company and include both reported loss reserves and reserves for losses incurred but not reported, or IBNR. The Company’s lower underwriting results for 2008 as compared to 2007 were largely a reflection of the increase in catastrophe and property risk losses experienced in 2008. However, offsetting the current year incurred losses was $610.7 million of net favorable prior year reserve development in various lines of business within the Company’s Insurance and Reinsurance segments. In contrast, the Company’s positive underwriting results for 2007 and 2006 were partly a result of the lack of significant catastrophe events occurring throughout these years as well as net favorable development of prior year reserves. However, consistent with 2006 and 2007, net favorable development was partially offset in 2008 by the continuing increase in current period loss ratios during this period. The increase in 2008 reflects the impact of the softening rate environment as well as higher levels of catastrophe and attritional losses as noted above. In addition, in 2008, claims activity within the D&O and Errors and Omissions (“E&O”) insurance markets overall, rose as a result of an increase in class action lawsuits filed against public companies due to market losses and related stock price depreciation associated with the sub-prime mortgage and credit crisis in the U.S. Management actively monitors its potential exposure to such events and gives due consideration to emerging claim trends in determining its loss reserve requirements at each quarter end. For further analysis of this exposure, see “- Results of Operations” below.
increased underwriting expense ratio was driven largely by increased compensation costs and continued pricing pressures that have resulted in less premium earned.
Net investment income related to property and casualty operations is an important measure that affects the Company’s overall profitability. The largest liability of the Company relates to its unpaid loss reserves, and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due, and thus a significant part of the portfolio is in fixed income securities. Net investment income is influenced by a number of factors, including the amounts and timing of inward and outward cash flows, the level of interest rates and credit spreads and changes in overall asset allocation.
The increase in net investment income in 2007 was primarily due to several years of positive operating cash flows which resulted in a higher overall average invested asset base. In addition, during 2007, portfolio yields increased in the Company’s investment portfolio, due primarily to the full 2007 financial year impact of the higher interest rates experienced in the U.S., U.K. and Euro-zone, during the latter part of 2006 and the beginning part of 2007.
Book value per ordinary share decreased by $34.84 in the year ended December 31, 2008 as compared to a decrease of $2.82 during 2007 as noted below. The decrease in 2008 was primarily as a result of the Company’s issuance of Class A ordinary shares issued at a discount to book value (as described below), the Company’s net loss of $2.6 billion during the year ended December 31, 2008 and the increase in net unrealized losses on investments of approximately $2.9 billion, net of tax, during the same period. In addition, book value per ordinary share decreased as a result of unfavorable foreign currency translation adjustments of $472.3 million during the year ended December 31, 2008. In August 2008, the Company issued 143.8 million Class A ordinary shares at a price of $16.00 per share, which was lower than the Company’s book value per ordinary share at the time and thus dilutive. The Company’s net loss of $2.6 billion was mainly due to the impact of the closing of the Master Agreement in August 2008 as described above, the goodwill impairment charge recorded in 2008 of $990.0 million, catastrophe and attritional losses, as well as from net realized losses on investments and losses from investment fund affiliates during the year ended December 31, 2008. The increase in net unrealized losses on investments of $2.9 billion, net of tax, during the year ended December 31, of 2008 was mainly as a result of widening credit spreads on corporate and structured credit assets, offset by declines in interest rates, while unfavorable foreign currency translation adjustments during the same period resulted from the increase in value of the U.S. dollar against most major currencies, predominately the Euro and U.K. Sterling.
unrealized losses on investments of $743.0 million, net of tax, partially offset by net income of $206.4 million for the year ended December 31, 2007, which increased book value, together with an increase in currency translation adjustments due to the impact of the decline in the value of the U.S. dollar on the net assets of European-based subsidiaries. In addition, certain capital and financing activities impacted book value per ordinary share, including the Company’s share repurchase activity throughout 2007 which decreased book value per ordinary share, as the price paid for such shares was at a premium to book value; however, this was partially offset by the issuance of Class A ordinary shares upon maturity of the purchase contracts associated with the 6.5% Equity Security Units (the “6.5% Units”), as the ordinary shares were issued at a premium to book value.
After the closing of the Master Agreement on August 5, 2008, approximately $64.6 billion of the Company’s total net exposure (which was $65.7 billion as at June 30, 2008) under reinsurance agreements and guarantees with Syncora subsidiaries was eliminated. Pursuant to the terms of the Master Agreement, Syncora is required to use commercially reasonable efforts to commute the agreements that are the subject of the Company’s guarantee of Syncora Guarantee’s obligations under certain financial guarantees issued by Syncora Guarantee to the European Investment Bank (the “EIB Policies”), subject to certain limitations. As at December 31, 2008, the Company’s exposures relating to the EIB Policies (which relate to project finance transactions) was approximately $955.4 million reduced from $1.1 billion at June 30, 2008 mainly due to the strengthening of the U.S. dollar against the currencies of the underlying obligations. As of December 31, 2008, there had been no reported events of default on the underlying obligations, accordingly, no reserves have been recorded.
2. Impact of credit market movements in 2008 and 2007 on the Company’s investment portfolio and investment fund affiliates
During the year ended December 31, 2008, financial market conditions continued to be extremely challenging as the global credit crisis that began in July 2007, continued to adversely impact global markets. This unprecedented market volatility directly and materially affected the Company’s results of operations and investment portfolio during the year ended December 31, 2008. The credit markets experienced a period of extreme deterioration during 2008, negatively impacting market liquidity conditions. As a result, the market for fixed-income instruments experienced decreased liquidity, increased price volatility, credit downgrade events, and increased probability of default. Domestic and international equity markets also experienced heightened volatility and turmoil during this period.
The following table details the Company’s corporate credit exposures by certain asset classes as well as ratings levels within the Company’s fixed maturity portfolio and the current net unrealized (loss) position as at December 31, 2008:
Of the total Topical Assets with fair value exposure as at December 31, 2008 and December 31, 2007 of $1.0 billion and $2.0 billion, respectively, approximately $40.5 million and $76.8 million, respectively, of the related securities had ratings dependent on guarantees issued by third party guarantors (i.e., monoline insurers). Decreases in the ratings of such third party guarantors would typically decrease the fair value of guaranteed securities; however, at December 31, 2008, in the event of non-performance at such date on the part of these third party guarantors, the Company estimated that the average credit quality of this portfolio would be ‘A’ and that approximately 96.1% would have remained investment grade at such date. In addition, of the total fixed income portfolio as at December 31, 2008 and December 31, 2007, of $31.9 billion and $39.6 billion, respectively, less than 2% were guaranteed by such third parties with no individual third party representing more than 1%.
During the year ended December 31, 2008, net realized losses of $400.0 million related to the write-down of certain of the Company’s fixed income and equity investments, where, although management’s analysis of the securities indicated that these assets were expected to pay out all expected cash flows, management can no longer assert that it intends to hold these securities until such time as they recover, as management intends to pursue sales of these securities in connection with its efforts to reduce the risk within the Company’s the investment portfolio.
Included in the impairment charge for the year ended December 31, 2008, was $121.4 million of related exposures to financial institutions, primarily related to Lehman. The remaining impairment during 2008 was spread across the portfolio including structured credit, equity and other fixed income investments, with $228.5 million related to securities with sub-prime and Alt- A collateral which are included in the table below. Consistent with prior quarters, management continues to evaluate the impairment of the portfolio and satisfy itself that the remaining gross unrealized losses are temporary in nature.
negatively impacted. See Item 1A, “Risk Factors - Deterioration in the public debt and equity markets could lead to additional investment losses,” above.
In addition, in the latter part of 2008, unprecedented economic conditions continued to impact the Company. These conditions, combined with the recent volatility in the Company’s share price, rating agency actions with respect to the Company and issues faced by some of the Company’s competitors, resulted in the creation of challenges as well as certain opportunities for the Company’s P&C operations.
During 2008, net favorable prior year development totaled $610.7 million in the Company’s property and casualty operations and included net favorable development in the Insurance and Reinsurance segments of $305.5 million and $305.2 million, respectively. Within the Reinsurance segment, net favorable prior year reserve development included casualty and other lines reserve releases in both European and U.S. casualty and professional portfolios as well as reserve releases associated with the RITC relating to the 2005 year of account on certain Lloyd’s sourced business. In the same period, property and other short-tail lines net favorable development was attributable to most business units globally. The Insurance segment net favorable prior year reserve development was due to reserve releases in global property lines of business as a result of favorable claim development as well as reserve releases in certain casualty lines primarily in accident years 2003 to 2006 years due to lower than expected reported loss activity. In addition, net reserve releases of approximately $80.9 million resulted from an agreement with Axa/Winterthur in the fourth quarter of 2008 in regards to certain reinsurance recoverable balances relating to casualty lines and to a lesser extent, certain property lines of business. Offsetting this favorable development was modest reserve strengthening within environmental lines as well as strengthening associated with certain structured indemnity contracts. Within the professional lines, reserve releases in the 2003 to 2006 accident years were largely offset by strengthening of reserves in the 2007 year.
During 2007, the Company had net favorable prior year reserve development in property and casualty operations of $425.4 million compared to $110.6 million for the same period in 2006. Reinsurance net favorable development accounted for $267.3 million of the release in 2007, while net favorable development within the Insurance segment totaled $158.1 million for the same period. The corresponding prior year development on a gross basis was $259.7 million for the Reinsurance segment and $177.6 million for the Insurance segment. Within the Reinsurance segment, reserve releases of $188.7 million in property and other short-tail lines of business and $87.4 million in casualty and other lines, were partially offset by adverse prior year development of $8.8 million within the structured indemnity line of business. The Insurance segment’s net prior year reserve releases consisted of $95.0 million in property and $162.1 million in casualty lines of business, partially offset by net adverse development of $23.0 million, $7.0 million and $69.0 million in certain professional, marine and other lines of business, respectively.
During 2006, the Company had net favorable prior year reserve development in property and casualty operations of $110.6 million. Within the Insurance segment, net overall favorable prior year reserve development for the year ended December 31, 2006, was $13.2 million, while net favorable development within the Reinsurance segment during the same period was $97.4 million.
See Item 8, Note 12 to the Consolidated Financial Statements and see further discussion under “Critical Accounting Policies and Estimates”.
5. Impact of increased property risk and catastrophe activity in 2008 and limited property risk and catastrophe activity in 2007 and 2006
As compared to 2006 and 2007, 2008 saw increases in property risk losses as well as catastrophe activity and resulting incurred losses, primarily related to U.S. windstorm activity. On September 1, 2008, Hurricane Gustav hit the Louisiana coast of the U.S. as a Category 2 hurricane, causing considerable damage to insured property and loss of life. On September 13, 2008, Hurricane Ike made landfall near Galveston, Texas as a strong Category 2 hurricane, causing significantly more damage and loss of life than Hurricane Gustav. Based on market estimates, Hurricane Ike is estimated to have caused the third largest ever insured loss in the U.S. from a wind storm. The Company has estimated losses incurred, net of reinsurance recoveries and reinstatement premiums, of $22.5 million and $210.0 million related to Hurricanes Gustav and Ike, respectively. Actual losses may vary from this estimate based on a number of factors, including receipt of additional information from insureds and brokers, the attribution of losses to coverages that had not previously been considered as exposed and inflation in repair costs due to additional demand for labor and materials. In addition to natural peril catastrophes, there was also an increase in large property risk losses globally during 2008 that contributed to higher loss ratios in both the Insurance and Reinsurance segments.
Enterprise Risk Management: The Company is focused on enhancing its risk management capabilities throughout all facets of its operations. This initiative is led by the Company’s newly hired Chief Enterprise Risk Officer (“CERO”) as noted below. The CERO is supported by, among others, the Company’s Enterprise Risk Management Committee (the “ERM Committee”) comprised of the most senior risk takers and managers of the Company. The ERM Committee will continue to assist with the efficient identification, assessment, monitoring, and reporting of key risks across the Company. On September 15, 2008, Mr. Jacob D. Rosengarten joined the Company as Executive Vice President and CERO. Mr. Rosengarten reports directly to the Company’s Chief Executive Officer, Michael S. McGavick, and chairs the Company’s ERM Committee. In addition, the Board of Directors has created a special committee of the Board to oversee endeavours in this area.
Simplify Investment Portfolio Over Time: In order to reposition the Company’s investment portfolio to one that supports a P&C focused operation, the Company began repositioning the portfolio in 2008 so that a) book value volatility particularly related to credit spreads arising from the portfolio is reduced, b) a reduction in lower rated corporate securities and financial issuers is achieved, c) exposure to CMBS securities is reduced and d) a reduction in asset classes such as subprime, Alt-A and Core CDO’s previously supporting Other Financial Lines activities is achieved. Realignment will be achieved primarily through cash generated from bond maturities and coupon reinvestment, cash flow from business operations as well as certain opportunistic sales.
Consistent with this strategy, management continued the process of reducing risk in the investment portfolio during the latter part of 2008. Fannie Mae and Freddie Mac preferred positions were sold as well as securities of a number of regional banks and other financial institutions. Most of this was accomplished prior to the Lehman bankruptcy in September 2008 when credit markets became even more disrupted. In addition, management reduced the aggregate sub-prime, Alt A, CMBS and CDO portfolio holdings significantly, through natural cash flows and certain opportunistic sales.
Management further reduced interest rate risk exposure during 2008 by shortening the duration of the portfolio supporting the U.S. property and casualty operations by 0.6 years. Cash and government agency holdings were increased by approximately $2.4 billion to approximately $13.2 billion representing approximately 41.2% of the fixed income portfolio at December 31, 2008.
In relation to the Company’s capital position, several activities occurred throughout 2008 and early 2009, including the following:
In order to fund payments under the Master Agreement described above, in August 2008, the Company raised approximately $2.8 billion of additional capital through an issuance of both ordinary shares and equity security units (the “ESUs”). The ESUs consist of: (i) forward purchase contracts to purchase, and the Company to issue, its ordinary shares and (ii) debt securities. For further details relating to the Master Agreement, see Note 4 to the Consolidated Financial Statements, “Syncora Holdings Ltd. (“Syncora”).”
In addition to the payments to Syncora, the Company used the net proceeds from the offerings for general corporate purposes, and the redemption of X.L. America, Inc.’s $255 million 6.58% Guaranteed Senior Notes due April 2011 (the “6.58% Notes”) and capital funding of certain of the Company’s subsidiaries.
Concurrent with the closing of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent capital facility entered into in July 2003 resulting in net proceeds to the Company of approximately $500.0 million in exchange for the issuance by the Company of 20,000,000 redeemable Series C Preference Ordinary Shares. On February 27, 2009, the Company initiated a cash tender offer for all of the outstanding Series C Preference Shares. See “ - Capital Resources” below for further details relating to the redeemable Series C Preference Ordinary Shares.
In July 2008, the Board of Directors approved a reduction in the quarterly dividend payable on the Company’s Class A Ordinary Shares to $0.19 per ordinary share beginning with the quarterly dividend paid in September 2008. In addition, in February 2009, the Board of Directors approved a further reduction in the quarterly dividend payable on the Company’s Class A Ordinary Shares to $0.10 per ordinary share beginning with the quarterly dividend payable in March 2009.
In addition to the above noted key priorities of the Company, other key focuses of management during the year ended December 31, 2008 included the following:
As the Company earns premiums 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. The process of establishing reserves for unpaid property and casualty claims can be complex and is subject to considerable variability, as it requires the use of informed estimates and judgments. These estimates and judgments are based on numerous factors, and may be revised as additional
While the reliance on loss reports from ceding companies may increase the level of uncertainty associated with the estimation of total loss reserves for property reinsurance relative to direct property insurance, there are several factors which serve to reduce the uncertainty in loss reserve estimates for property reinsurance. First, for large natural catastrophe events such as Hurricane Ike, aggregate limits in property catastrophe reinsurance contracts are generally fully exhausted by the loss reserve estimates. Second, as a reinsurer, the Company has access to information from a broad cross section of the insurance industry. The Company utilizes such information in order to perform consistency checks on the data provided by ceding companies and is able to identify trends in loss reporting and settlement activity and incorporate such information in its estimate of IBNR reserves. Finally, the Company also supplements the
loss information received from cedants with loss estimates developed by market share techniques and/or from third party catastrophe models applied to exposure data supplied by cedants.
not yet resulted in reported losses. Once the Company’s actuaries make their determination of the most appropriate point estimate for each class, this information is aggregated and presented to management for review and approval.
Due to the low frequency and high severity nature of some of the business underwritten by the Company, the Company’s reserve estimates are highly dependent on actuarial and management judgment and are therefore uncertain. In property classes, there can be additional uncertainty in loss estimation related to large catastrophe events. With wind events, such as hurricanes, the damage assessment process may take more than a year. The cost of claims is subject to volatility due to supply shortages for construction materials and labor. In the case of earthquakes, the damage assessment process may take several years as buildings are discovered to have structural weaknesses not initially detected. The uncertainty inherent in IBNR reserve estimates is particularly pronounced for casualty coverages, such as excess liability, professional liability coverages, and workers compensation, where information emerges relatively slowly over time.
As noted above, management reviews the IBNR estimates produced by the Company’s actuaries and determines its best estimate of the liabilities to record in the Company’s financial statements. The Company considers this single point estimate to be one that has an equal likelihood of developing a redundancy or deficiency as the loss experience matures. Management believes that the actuarial methods utilized adequately provide for loss development.
The ratio of IBNR to total reserves has increased in recent years due to the growth of casualty business written over that period. The ratio of IBNR to total reserves is higher for more recent years’ business because these immature years have relatively fewer claims reported and, as a result, a higher proportion of claims reserves are based on experience in respect of incurred but not reported losses. As each prior year of business matures and claims become known, the ratio of IBNR to total reserves will typically decline, all other factors remaining constant. Since the Company has experienced premium volume growth in recent years, the ratio of IBNR to total reserves has increased because the Company’s aggregate exposure has become relatively less mature. Conversely, in a situation of declining premium volume, this ratio will typically decline, all other factors remaining constant. The Company writes insurance and reinsurance business in many different lines. Typically, the ratio of IBNR to total reserves is greater for casualty lines (which are longer-tail in nature) than for property lines due to the policy forms utilized and timing of loss reporting. In recent years, casualty lines have increased as a proportion of the Company’s business when compared to property lines (which are shorter-tail in nature).
The following table shows the recorded estimate and the high and low ends of the range of the Company’s net unpaid losses and loss expenses (excluding, in 2007, financial guarantee reserves related to reinsurance agreements with Syncora that are recorded within “Net loss from operating affiliates”) for each of the lines of business noted above at December 31, 2008:
Actual development of recorded reserves as of December 31, 2007 during 2008 was within the estimated reserve range.
The Company’s methodology in 2008 for calculating reserve ranges around its single point reserve estimate is consistent with that used in 2007. The Company modeled a statistical distribution of potential reserve outcomes over a one year run-off period for each of the approximately 35 lines of business. In doing so the Company evaluated a number of alternative models, and for each line of business the Company’s actuaries selected the one deemed to be most appropriate. Factors affecting this decision included an assessment of the model fit, availability and relevance of data and the impact of changes in business mix. The Company used the modeled statistical distribution to calculate 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.
negative correlations in reserve developments between certain lines of business. However, as a measure of prudence in evaluating the reserve ranges, the Company has used a minimum of 15% correlation between any two lines of business. The analysis of correlations and the reflection of potential diversification benefits across lines of business represent another area of uncertainty in the development of estimated reserve ranges.
See further discussion under “ - Segments” below for prior year development of loss reserves.
As of December 31, 2008, the Company’s outstanding financial guarantee contracts that were subject to FAS 163 included the reinsurance of 48 financial guarantee contracts with total insured contractual payments outstanding of $936.6 million ($798.5 million of principal and $138.1 million of interest) with a remaining weighted-average contract period of 7.9 years. The total gross claim liability and unearned premiums recorded at December 31, 2008 were $14.5 million and $3.1 million, respectively. Of the contractual exposure existing at December 31, 2008, the Company has reinsured $360.5 million with a third party. There are no gross claim liabilities or recoverables recorded relating to this exposure. Surveillance procedures to track and monitor credit deteriorations in the insured financial obligations are performed by the primary obligors for each transaction on the Company’s behalf. Information regarding the performance status and updated exposure values is provided to the Company on a quarterly basis and evaluated by management in recording claims reserves. Of the 48 contracts noted above, 5 contracts with total insured contractual payments outstanding of $18.4 million had experienced an event of default and were considered by the Company to be non-performing at December 31, 2008, while the remaining 43 contracts were considered to be performing at such date.
Management establishes reserves for losses and loss adjustment expenses on such business based on management’s best estimate of the ultimate expected incurred losses. The Company’s estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. Establishment of such reserves requires the use and exercise of significant judgment by management, including with respect to estimates regarding the occurrence and amount of a loss on an insured obligation. Estimates of losses may differ from actual results and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred. Examples of these events include changes in the level of interest rates, credit deterioration of insured obligations, and changes in the value of specific assets supporting insured obligations. Both qualitative and quantitative factors are used in establishing such reserves. In determining the reserves, management considers all factors in the aggregate, and does not attribute the reserve provisions or any portion thereof to any specific factor.
In addition to case basis reserves, the Company maintains an unallocated loss reserve for expected losses inherent in the Company’s in-force business (consisting of both financial guarantee insurance and reinsurance business) that is expected to emerge in the future. The unallocated loss reserves represent the Company’s estimated ultimate liability from claims expected to be incurred in the future under in-force insured and reinsured policies less outstanding case basis reserves and cumulative paid claims to date on such policies.
The recognition of unpaid losses and loss expenses recoverable requires two key judgments. The first judgment involves the Company’s estimation of the amount of gross IBNR to be ceded to reinsurers. Ceded IBNR is generally developed as part of the Company’s loss reserving process and consequently, its estimation is subject to similar risks and uncertainties as the estimation of gross IBNR (see “Critical Accounting Policies and Estimates - Unpaid losses and loss expenses and unpaid loss and loss expense recoverable”). The second judgment involves the Company’s estimate of the amount of the reinsurance recoverable balance that the Company will ultimately be unable to recover from related reinsurers due to insolvency, contractual dispute, or for other reasons. Amounts estimated to be uncollectible are reflected in a bad debt provision that reduces the reinsurance recoverable balance and shareholders’ equity. Changes in the bad debt provision are reflected in net income. See Item 8, Note 13 to the Consolidated Financial Statements, “Reinsurance”, for further information.
The future policy benefit reserves for these annuity portfolio reinsurance contracts amounted to $4.4 billion and $5.8 billion at December 31, 2008 and 2007 respectively. The Company holds the investment assets backing these liabilities. These investments are primarily fixed income securities with maturities that closely match the expected claims settlement profile. A 0.1% decrease in the investment yield assumption would result in approximately a $28 million increase in the value of future claims related to annuity portfolio reinsurance.
As stated above, the future policy benefit reserves include provisions for adverse deviation in excess of best estimate assumptions that amounted to approximately $178 million and $410 million at December 31, 2008 and 2007, respectively. The future policy benefit reserves would only be increased if these provisions for adverse deviation became insufficient in the light of emerging claims experience. The present value of future claims would increase by approximately $17 million if mortality rates were to decrease by 1% in all future years, relative to the reserving assumptions.
The Company also provided reinsurance of a block of U.S. based term assurance, which was novated to the Company from an insurance affiliate in December 2002. The future policy benefit reserves for these contracts amounted to approximately $254 million and $245 million at December 31, 2008 and 2007, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience.
The Company’s deposit liabilities at December 31, 2008 reflect obligations assumed under funding agreements, payment undertaking agreements and certain structured insurance and reinsurance agreements. Previously, deposit liabilities included GICs; however, based on the terms and conditions of the underlying GICs, upon the downgrade of Syncora Guarantee below certain ratings levels, all or portions of outstanding principal balances on such GICs would come due. Throughout 2008, several rating agencies downgraded Syncora and its subsidiaries and as a result, the Company settled, during 2008, all of the GIC liabilities. For existing deposit liability contracts at December 31, 2008, the Company establishes a deposit liability equal to the net cash received at inception. Each deposit liability accrues at a rate equal to the internal rate of return of the payment receipts and obligations due during the life of the agreement. Where the timing and/or amount of future payments are uncertain, cash flows reflecting the Company’s actuarially determined best estimates are utilized. The ultimate size of underlying losses, the impact of the contractual limits upon settlement of such losses, and the impact of the underlying loss settlement process on the timing of payments are considered as appropriate. Where uncertainty is present, an increase in the ultimate claims cost or accelerated claims settlement would potentially lead to an increase in the deposit liability accretion rate or lead to incurred losses if significant. The interest expense reported due to the accretion of deposit liabilities associated with structured insurance and reinsurance contracts was $74.8 million, $76.6 million and $37.8 million for the years ended December 31, 2008, 2007 and 2006, respectively. For some of the Company’s deposit liabilities, the accretion rate is recorded at its contractual maximum level. For all other contracts, a 1% increase in the average accretion rate would result in an increase in deposit liabilities and
interest expense by $23.7 million on an annualized basis. See Item 8, Note 14 to the Consolidated Financial Statements, “Deposit Liabilities.”
With regards to derivative instruments, the Company conducts activities mainly in investment-related derivative instruments, which may include credit derivatives. In addition, outside of the Company’s investment portfolio, the Company previously wrote credit derivatives and weather and energy derivatives. The estimate of fair value for credit derivatives and weather and energy derivatives requires management’s judgment. These two activities are discussed below:
The fair value of previously written weather and energy derivatives is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair value is estimated using available market data and internal pricing models using consistent statistical methodologies. Estimating fair value of instruments that do not have quoted market prices requires management’s judgment in determining amounts that 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. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for sensitivity analysis and Item 8, Note 17 to the Consolidated Financial Statements, “Derivative Instruments.”
rate movements, and (vi) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. In addition, EITF 99-20 requires that OTTI for certain asset backed and mortgage backed securities are recognized if the fair value of the security is less than its cost or amortized cost and there has been a decrease in the present value of the expected cash flows since the last reporting period. 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.
As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security’s unrealized loss represents an other than temporary decline. Management reviews any significant sales of securities for a loss to determine if such sale impacts the assertion with respect to the intent and ability to hold to recovery. For further details on management’s assessment of OTTI, see Item 8, Note 9 to the Consolidated Financial Statements, “Investments.” However, this factor on its own does not dictate whether or not the Company recognizes an impairment charge. The Company believes its ability to hold such securities is supported by positive and sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment obligations arising from its underwriting operations without selling such investments. In this regard, cash flow from operating activities, excluding the payment to Syncora under the Master Agreement, was $1.3 billion and $2.2 billion in 2008 and 2007, respectively.
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 had capitalized net operating tax losses of $301.3 million and $396.9 million against which a valuation allowance of $224.3 million and $204.4 million at December 31, 2008 and 2007, respectively, was established. The Company had capitalized realized and unrealized capital losses of approximately $196.3 million and $134.6 million, respectively, against which a valuation allowance of approximately $327.4 million at December 31, 2008 was established. Included within the capitalized realized losses are $173.7 million of losses arising from the sale of investments to a group company,
The Company has recorded goodwill in connection with various acquisitions in prior years. Goodwill represents the excess of the purchase price over the fair value of net assets acquired. In accordance with FASB Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”), the Company tests goodwill for potential impairment annually as of June 30 and between annual tests if an event occurs or circumstances change that may indicate that potential exists for the fair value of a reporting unit to be reduced to a level below its carrying amount. The Company tests for impairment at the reporting unit level, which is generally one level below its business segments. The Company evaluates goodwill for impairment using the two-step process prescribed in FAS 142. The first step is to identify potential impairment by comparing the fair value of a reporting unit to the estimated book value, including goodwill. The fair value of each reporting unit is derived based upon valuation techniques and assumptions the Company believes market participants would use to value the business. The estimated fair values of the reporting units are generally determined utilizing methodologies that incorporate discounted cash flow analyses, price-to-net- tangible-book, and price-to-earnings multiples of certain comparable companies. The Company derives the net book value of its reporting units by estimating the amount of shareholders’ equity required to support the activities of each reporting unit. If the estimated fair value of a reporting unit exceeds the estimated book value, goodwill is not considered impaired. If the book value exceeds the estimated fair value, the second step of the process is performed to measure the amount of impairment.
The Company completed its annual goodwill impairment testing, as of June 30, 2008 and June 30, 2007, which did not result in any goodwill impairment. However, due to the financial market and economic events that occurred in the fourth quarter of fiscal 2008, the Company performed an interim impairment test for goodwill subsequent to its annual testing date of June 30. The interim impairment test resulted in a non-cash goodwill impairment charge of $990.0 million. The charge relates primarily to certain reinsurance units’ goodwill associated with the merger of Mid Ocean in 1998. The fair value of the Mid Ocean reporting unit was calculated using the methodologies noted above and by comparison with similar companies using their publicly traded price multiples as the basis for valuation.
For further information, see Item 8, Note 7 to the Consolidated Financial Statements, “Goodwill and Other Intangible Assets.”
The amount of premiums receivable related to the Company’s reinsurance operations amounted to $1.7 billion as at December 31, 2008.
A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Management reviews the premiums receivable balance at least quarterly and provides a provision for amounts deemed to be uncollectible. The Company recorded a provision for uncollectible premiums receivable related to its reinsurance operations at December 31, 2008 of $19.0 million.
The amount of proportional and excess of loss reinsurance gross premiums written and gross acquisition expenses recognized by the Company’s reinsurance operations for each line of business for the years ended December 31, 2008, 2007 and 2006 was as follows:
Gross premiums written decreased by 3.4% during the year ended December 31, 2007 compared with the year ended 2006, while net premiums written increased slightly during the same period. Decreases in gross premiums written were due primarily to a combination of a decrease in rates, reduced shares and selective non-renewals in certain property and marine lines of business, as well as the runoff of certain property catastrophe exposures. Partially offsetting these decreases was growth in the excess and surplus book of business in the U.S., increases in the number of long-term agreements, strong new business and higher renewal retentions within certain casualty lines of business, and favorable foreign exchange rate
Net premiums earned decreased by 2.9% in 2008 as compared 2007 and by 1.0% in 2007 as compared to 2006. These decreases were primarily a reflection of the overall reduction of net premiums written over the last 12 to 24 months.
Fee income increased in 2008 as compared to 2007 mainly as a result of higher engineering fee revenue associated with XL GAPS, which formed in late 2007 following the acquisition of GAPS, a loss prevention consulting service provider. Fee income and other decreased in 2007 as compared to 2006, primarily due to a favorable legal settlement recorded in 2006 in relation to a U.K. contract as well as certain foreign exchange adjustments recorded in 2006.
Excluding prior year development, the loss ratio for the year ended December 31, 2008 increased by 9.1 loss percentage points as compared to 2007 with 2.6 points of the loss ratio increase attributable to a higher level of catastrophe losses in the current year, including the impacts of Hurricanes Ike and Gustav, which resulted in net incurred losses in the Company’s Insurance segment of $54.0 million and $10.4 million, respectively, net of reinsurance recoverables and reinstatement premiums. The remainder of the increase in loss ratio was attributable to an increase in loss activity in property, loss activity anticipated for professional lines related to sub-prime and related credit events, premium adjustments booked in the third and fourth quarters as well as the softening rate environment impacting most lines of business.
Net favorable prior year development in the year ended December 31, 2008, totaled $305.5 million, primarily due to reserve releases in certain casualty lines primarily in 2003 to 2006 accident years due to lower than expected reported loss activity and favorable reserve development in global property lines of business as a result of favorable claim development. In addition, net reserve releases resulted from an agreement with Axa/Winterthur of approximately $80.9 million in the fourth quarter of 2008 in regards to certain reinsurance recoverable balances relating to casualty lines and to a lesser extent, certain property lines of business. Offsetting this favorable development was modest reserve strengthening within specialty lines, primarily in the environmental lines of business, as well as strengthening associated with certain structured indemnity contracts. Within the professional lines, reserve releases in the 2003 to 2006 accident years were largely offset by strengthening of reserves in the 2007 year. Gross prior year favorable development for the year ended December 31, 2008 of $609.6 million exceeded the corresponding net favorable development during the same period of $305.5 million, as the impact of reductions in gross reported losses on older years in certain casualty lines was mostly offset by the impact of the reinsurance recoverable component on such losses. In addition, the impact of gross reserve releases in professional and specialty lines was mostly offset by the impact of a reduction in estimated ceded IBNR following reserve reviews in these lines.
For the year ended December 31, 2007, net prior year reserve releases in the Insurance segment consisted of $95.0 million in property and $162.1 million in casualty lines of business, partially offset by net adverse development of $23.0 million, $7.0 million and $69.0 million in certain professional, marine and other lines of business, respectively. Casualty releases relate primarily to the European casualty portfolio in accident years 2002-2005. The professional lines development reflects net adverse prior year development of the Bermuda E&O portfolio and releases from the U.S. and European professional lines portfolios. Strengthening in other insurance lines relates to adverse development in discontinued specialty lines, surety and environmental, partially offset by favorable development in aerospace and political risk. Gross prior year development was also favorable at $177.6 million. Excluding prior year development, the loss ratio increased by 1.0 point partly due to an increase in attritional and catastrophe-related property experience and partly due to softening market conditions primarily in certain specialty lines.
The increase in the underwriting expense ratio in the year ended December 31, 2008, compared to 2007, was due to an increase in the operating expense ratio of 1.8 points (18.4% as compared to 16.6%) and partially offset by a decrease in the acquisition expense ratio of 0.2 points (11.6% as compared to 11.8%). The increase in the operating expense ratio was mainly as a result of a higher headcount which increased compensation, increases in professional fees and the impact of employee termination benefits recorded in the latter half of 2008, against lower net premiums earned. The increase in headcount and professional fees both supported new segment initiatives as well as the formation of XL GAPS in late 2007. Offsetting these increases in 2008 were decreases in performance related compensation. The acquisition expense ratio decreased mainly due to a reduction in foreign excise taxes as a result of a decrease in the cession percentage of an internal quota share from 75% to 50%, lower guarantee fund assessments and the impact of changes in the mix of business written.
Foreign exchange gains in the year ended December 31, 2008 and foreign exchange losses in the years ended December 31, 2007 and 2006 were due primarily to the change in the value of the U.S. dollar against certain European currencies including the U.K. Sterling and the Euro on certain inter-company balances.
Net results from structured insurance products include certain structured indemnity contracts that are accounted for as deposit contracts. Results from these contracts for the year ended December 31, 2008, decreased compared to the same period in 2007 mainly due to lower net investment income and higher operating expenses, partially offset by lower interest expense. Net investment income decreased as a result of lower yields earned on investment income while operating expenses increased as a result of costs recorded in the latter half of 2008 associated with employee termination benefits relating to the closure of the XLFS business unit as noted above. Interest expense decreased mainly due to negotiated cancellation of certain contracts in 2008 that resulted in gains totaling $16.3 million and was partially offset by an accretion adjustment recorded during the same period, based on changes in expected cash flows on a structured indemnity contract. Results from these contracts for the year ended December 31, 2007, decreased compared to the same period in 2006 due to an unfavorable accretion adjustment recorded in 2007 based on changes in expected cash flows and the accelerated earnings recorded in 2006 resulting from a commutation. Offsetting these decreases in 2007 was higher net investment income as a result of higher yields and overall larger investment asset balances.
Gross and net premiums written decreased by 15.1% and 16.9%, respectively, in the year ended December 31, 2008 as compared to the same period in 2007. These decreases resulted from the Company declining business due to competitive pressures continuing to drive certain rates below the Company’s acceptable underwriting return levels together with increased client retentions. Partially offsetting these decreases in gross premiums written were favorable foreign exchange rate movements of $55.0 million and increases of $118.4 million associated with a U.S. agricultural program whose rates are tied to commodity prices, which have increased in 2008. Ceded premiums written decreased mainly as a result of the impact of a reduction in property catastrophe cessions to Cyrus Re II of 10% in 2008 as compared to a 35% cession to Cyrus Re throughout 2007, partially offset by ceded premiums totaling $23.3 million associated with the purchase of additional catastrophe loss protection in the form of industry loss warranty covers. However, the overall ceded ratio increased mainly due to lower net retention in 2008 as compared to 2007, mainly due to higher cession ratios associated with the U.S. agricultural program noted above, causing net premiums written to decrease at a higher percentage than gross premiums written.
Net premiums earned in the year ended December 31, 2008 decreased 13.4% as compared to the same period in 2007. Net premiums earned in the year ended December 31, 2007 decreased 10.5% as compared to the same period in 2006. The decrease in both 2008 and 2007 was a reflection of the overall reduction of net premiums written over the last three years.
Fee income increased by $7.6 million during 2008 as compared to 2007 mainly as a result of fees associated with capacity utilization with certain Lloyd’s syndicates.
The loss and loss expense ratio includes net losses incurred in the current year and any favorable or adverse prior year development of loss reserves held at the beginning of the year.
Excluding prior year development, the loss ratio for the year ended December 31, 2008 increased by 11.3 loss percentage points as compared to the same period in 2007 with 7.7 points attributable to an increase in catastrophe losses occurring during 2008 (12.0 points in 2008 versus 4.3 points in 2007), mainly as a result of the impacts of Hurricanes Ike and Gustav, which resulted in net incurred losses in the Company’s Reinsurance segment of $155.9 million and $12.1 million, respectively, net of reinsurance recoverables and reinstatement premiums. The remaining increase of 3.6 loss ratio points was attributable to
For the year ended December 31, 2008, net favorable prior year reserve development included casualty and other lines reserve releases in both European and U.S. casualty and professional portfolios as well as reserve releases associated with the reinsurance-to-close relating to the 2005 year of account on certain Lloyd’s sourced business. In the same period, property and other short-tail lines net favorable development was attributable to most business units globally. Gross prior year favorable development for the year ended December 31, 2008 of $444.3 million exceeded the corresponding net favorable development during the same period of $305.2 million as the impact of favorable loss experience related to a large crop program was mostly offset by the impact of retrocession protection related to this program.
Within the Reinsurance segment, reserve releases of $188.7 million during the year ended December 31, 2007 primarily in property and other short-tail lines of business and $87.4 million in casualty and other lines, was partially offset by adverse prior year development of $8.8 million within the structured indemnity line of business. Releases in the short-tail lines relate primarily to the 2005 and 2006 accident years. The casualty and other lines favorable development of $87.4 million reflects the net result of releases of $121.4 million primarily in the U.S. and non-U.S. casualty portfolios, partially offset by net adverse development of $13.0 million associated with the results of an external review of the Company’s asbestos and environmental reserves and $21.0 million related to a commutation of a stop loss reinsurance agreement. Favorable gross prior year development of $259.7 million was in line with the net development. Excluding prior year development, the loss ratio for the year ended December 31, 2007 increased by 5.1 loss percentage points as compared to the same period in 2006 as a result of higher attritional losses within the property risk book of business as well as losses recorded relating to certain catastrophe losses including European windstorms Kyrill and Per/Hanno, California wildfires and the Peru earthquake.
The increase in the underwriting expense ratio in the year ended December 31, 2007, as compared with the year ended December 31, 2006, was due to an increase in both operating expense and acquisition expense ratios to 8.9% and 20.9%, respectively, as compared with 7.4% and 19.9%, respectively, in the year ended December 31, 2006. The increase in acquisition expenses was primarily due to a change in the mix of business as well as an adjustment related to the earning of acquisition expenses within the U.S. individual risk portfolio recorded in the first quarter of 2007. The operating expense ratio increase was due primarily to higher compensation expenses and corporate allocations, combined with a lower level of net premiums earned.
Foreign exchange gains in the years ended December 31, 2008, 2007 and 2006 were due primarily to the change in the value of the U.S. dollar against certain European currencies including the U.K. Sterling and the Euro on certain inter-company balances and net underwriting liability balances.
2. Second and fourth quarters of 2006 - two Irish immediate annuity portfolios bound, for which net premium earned totaled $152.5 million.
The Company acquired cash and investment assets related to the future policy benefit reserves assumed at inception of these large contracts. While the Company may write more of these contracts, the frequency of these transactions will likely continue to be irregular and their sizes will differ from transaction to transaction.
Gross premiums written relating to other life business increased by $63.0 million in the twelve months ended December 31, 2008 as compared to the same period in 2007 mainly due to premium growth in the core underlying book of term assurance and critical illness business of $47.0 million, premium growth in U.S. business of $25.0 million and partially offset by unfavorable foreign exchange rate movements of $16.0 million. In addition, gross premiums written related to short-term life, accident and health business
Gross premiums written relating to other life business increased by $98.9 million or 29.4% in the year ended December 31, 2007 as compared to the year ended December 31, 2006 primarily as a result of growth in the underlying book of term assurance and critical illness business of $79.6 million, combined with favorable foreign exchange movements of $19.3 million. Gross premiums written relating to annuity business decreased by $42.6 million or 12.2% in the year ended December 31, 2007 as compared to the year ended 2006 mainly due to a lower level of single premium annuity portfolio business of $57.8 million, offset by favorable foreign exchange rate movements of $15.2 million. Ceded premium ratios remained roughly consistent with the prior year.
Net investment income is included in the calculation of contribution from Life Operations, as it relates to income earned on portfolios of separately identified and managed life investment assets and other allocated assets. Net investment income decreased by $7.2 million or 1.9% in the year ended December 31, 2008, as compared to the same period in 2007 primarily as a result of negative foreign exchange rate impacts and partially offset by higher net investment income associated with growth in the average size of the investment asset balances due to premiums associated with regular premium business. However, it
Net investment income increased by $38.3 million or 10.9% in 2007 as compared to 2006, primarily as a result of favorable foreign exchange rate movements of $23.9 million and increases in the average size of investment asset balances.
At December 31, 2007, a significant component of the investments held in the Company’s Other Financial Lines segment portfolios was comprised of Topical Assets and CDOs. Liquidations necessary to fund the repayment of the GIC liabilities following the downgrade of Syncora Guarantee and the maturity of certain funding agreements, were funded through sales of assets in these portfolios as well as the general investment portfolios. Management’s approach was to avoid the sale of assets where current market prices did not reflect intrinsic values or where transaction costs for liquidation were excessive. As a result, the Company continues to hold a number of the Topical Assets and CDOs and these were transferred to the general investment portfolio in exchange for those assets that were liquidated.
For the year ended December 31, 2008, the net results from these structured products were $18.1 million and included net investment income, interest expense and operating expenses of $100.4 million, $72.6 million, and $9.7 million, respectively, while for the year ended December 31, 2007, the net results from these structured products were $48.1 million and included net investment income, interest expense and operating expenses of $389.0 million, $326.4 million, and $14.5 million, respectively. For the year ended December 31, 2006, the net results from these structured products were $34.7 million and included net investment income, interest expense and operating expenses of $341.9 million, $296.9 million, and $10.4 million, respectively. For the year ended December 31, 2008, net investment income, interest expense and operating expenses decreased primarily as a result of a decrease in the average deposit liability balance and the associated asset portfolios as a result of the settlement of the GIC portfolio and certain funding agreements noted above. In addition, operating expenses decreased due to a reduction in compensation expense associated with a lower headcount. While not reported within the contribution from the Other Financial Lines segment, approximately $97.1 million of the reported realized losses on investments during 2008 related to portfolios associated with GICs and funding agreements.
For further information on Syncora, see “Results of Operations” and “Other Revenues and Expenses” within Management’s Discussion and Analysis of Financial Condition and Results of Operations. In
addition, see Notes 4 and 10 to the Consolidated Financial Statements, “Syncora Holdings Ltd.” and “Investments in Affiliates”, for further information.
The following table illustrates the change in net investment income from property and casualty operations, net income from investment fund affiliates, net realized (losses) gains on investments, and net realized and unrealized (losses) gains on investment derivative instruments for each of the three years ended December 31:
For a summary of realized and unrealized gains and losses on all derivative instruments, see Item 8, Note 17 to the Consolidated Financial Statements, “Derivative Instruments.”
Net investment income related to property and casualty operations decreased in the year ended December 31, 2008 as compared to the same period in 2007 due primarily to declining portfolio yields. Portfolio yields decreased as yields earned on investment of cash flows and reinvestment of maturing or sold securities were generally lower than on securities previously held, as prevailing market interest rates, particularly in the U.S., decreased over the last year. As well, the portfolio mix changed as a result of the settlement of the GIC and funding agreements liabilities, as the property and casualty operations assumed a number of the floating rate securities previously held in the Company’s Other Financial Lines segment and as a result is more sensitive to changes in short-term U.S. interest rates as well as increased allocations to lower yielding government, agency and cash securities.
Net investment income related to property and casualty operations increased in 2007 as compared to 2006 due primarily to a higher investment base and increases in the yield of the portfolio. The increase was primarily due to the full 2007 financial year impact of the higher interest rates experienced in the U.S., U.K. and Euro-zone, during the latter part of 2006 and the beginning part of 2007.
The Company manages its investment grade fixed income securities using an asset/liability management framework. Due to the unique nature of the underlying liabilities, customized benchmarks are used to measure investment performance and comparison to standard market indices is not meaningful.
Investment performance is not monitored for certain assets primarily consisting of operating cash and special regulatory deposits. The following is a summary of the investment portfolio returns for the years ended December 31, 2008 and 2007 of the asset/liability portfolio and risk asset portfolios:
Performance on the alternative portfolio reflects the twelve months ended November 30, 2008 and 2007, respectively.
Net Realized Gains and Losses on Investments and Other than Temporary Declines in the Value of Investments
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 and Estimates” for further information.
During the fourth quarter of 2008, management recorded a charge for OTTI of $400.0 million on assets for which it could no longer assert its intent to hold until recovery. Management believes that these securities were at-risk for further mark-to-market declines, and potentially real economic losses, to the extent that economic conditions were to deteriorate further than present estimates and the Company’s allocation to these asset classes is overweight relative to a traditional P&C portfolio. Accordingly, in conjunction with its risk reduction exercise, management is likely to pursue targeted sales of these assets over the course of 2009, and expects to realize the associated losses on these securities. The assets are concentrated in certain holdings within the Company’s BBB and lower corporate, CMBS, equity and consumer ABS portfolios.
In 2007, net realized losses on investments were $603.3 million which included $1,012.8 million of gross realized losses on fixed income and $46.9 million of gross realized losses on equity securities. Gross realized losses in 2007 included $611.0 million of provisions for declines in fair value considered to be other than temporary. As a percentage of the total fixed income portfolio, the write-down for other than temporary declines was 1.5% in 2007 as compared to 0.3% in 2006.
In 2006, net realized losses on investments were $116.5 million which includes $390.4 million of gross realized losses on fixed income and $88.5 million of gross realized losses on equity securities. Gross realized losses in 2006 included $151.4 million of provisions for declines in fair value considered to be other than temporary.
With respect to those securities that were sold at a loss during the year ended December 31, 2008, the following is an analysis of the period of time that those securities had been in a continual unrealized loss position, the amount of the realized loss recorded in the Company’s results of operations as of the sale date and the amount of the impairment charge taken in the year:
Net realized and unrealized losses on investment derivatives for the year ended December 31, 2008 resulted from the Company’s investment strategy to manage interest rate risk, foreign exchange risk and credit risk, and to replicate permitted investments. Included in these amounts are gains associated with purchased credit default swaps offset by losses related to interest rate swap positions. Net realized and unrealized losses on investment and other derivatives for the same period in 2007 resulted primarily from a mark-to-market loss of $37.0 million with respect to a total return swap on the capital notes of a structured investment vehicle impacted by the markdown in the underlying net asset value of the assets of the capital notes, combined with mark-to-market losses associated with the Company’s capital, investment and hedging activities.
The net loss from financial operating affiliates for the year ended December 31, 2008 was primarily a result of the loss of approximately $1.4 billion recorded in August 2008 in relation to the closing of the Master Agreement as well as losses recorded throughout 2008 and up until the closing of the Master Agreement that were associated with previous reinsurance and guarantee agreements with Syncora. Net losses from financial operating affiliates in 2007 include the results and related write-downs associated with Syncora and Primus as well as the impact of losses recorded on previous reinsurance transactions with Syncora of approximately $351.0 million. For further details relating to Syncora and the closing of the Master Agreement, see “Results of Operations” above as well as Note 4 to the Consolidated Financial Statements, “Syncora Holdings Ltd. (“Syncora”).”
Investment manager affiliate income decreased by $83.8 million or 88.5% during the twelve months ended December 31, 2008 as compared to the same period in the prior year primarily as a result of recent volatility in both the credit and equity markets, impacting investment manager affiliates specializing in global equities and fixed income securities most significantly. Investment manager affiliate income increased in 2007 as compared to 2006 mainly due to strong results generated from certain global equity and mortgage specialist investment manager affiliates, partially offset by the write-off of the Company’s investment in a manager that managed a series of structured investment vehicles and conduits.
Amortization of intangible assets increased in 2008 as a result of the increase in intangible assets related to the XL GAPS acquisition in 2007. Amortization of intangible assets decreased in 2007 as a result of certain intangible assets that were fully amortized during 2006.
In connection with the early redemption of the 6.58% Notes as noted above, the Company recorded debt extinguishment costs of approximately $22.5 million in 2008.
The decrease in the Company’s income taxes in 2008 as compared to 2007 was primarily a result of a change in the geographical locations of the profits earned primarily by the Company’s U.S. and European operations, including the impact of losses associated with the Master Agreement and goodwill impairment charges related to operating entities in jurisdictions not subject to income tax. The Company’s effective tax rate for the year ended December 31, 2008 differed as compared to the same period in 2007 mainly due to significant charges for which no tax benefit accrued and which resulted in a loss before tax. Income tax expense for the year ended December 31, 2007 increased as compared to the same period in 2006, principally from an improvement in the profitability of the Company’s U.S. and European property and casualty operations in those respective years. The Company’s effective tax rate for the year ended December 31, 2007 increased from that in 2006 due primarily to non-deductible asset impairment charges recorded in Bermuda, the U.S. and the U.K.
Minority interest expense in 2007 related primarily to the 37% ownership interest in Syncora common shares held by the public prior to the secondary offering of Syncora common shares on June 6, 2007, while minority interest expense in 2006 related primarily to the 37% ownership interest in Syncora following the
The Company reviews on a regular basis its issuer concentration, credit quality and compliance with established guidelines. At December 31, 2008 and 2007, the average credit quality of the Company’s total fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased) was “AA.” At December 31, 2008 approximately 53.9% of the fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net receivable (payable) for investments sold (purchased)) was rated “AAA” by one or more of the principal ratings agencies. Approximately 2.5% of the fixed income portfolio was below investment grade or not rated.
At December 31, 2008 and 2007, total investments, cash and cash equivalents, accrued investment income and net receivable (payable) for investments sold (purchased) were $34.3 billion and $43.7 billion, respectively. This decrease of $9.4 billion was primarily due to the settlement of the Company’s GIC liabilities in 2008, the mark-to-market effect as a result of the challenging credit markets, depreciation of the Sterling assets as measured in U.S. dollars, the payment of $1.8 billion to Syncora under the Master Agreement and was partially offset by cash flow from the Company’s financing activities in August 2008. The annualized effective yield of the total investment portfolio (excluding non-recurring items) was 4.8% for 2008 as compared to 5.2% for 2007, a 0.4% decrease. The decrease in the effective yield of the total investment portfolio was primarily due to declines in U.S. interest rates and the resulting impact on the Company’s floating rate assets, as well as increased allocations to lower yielding government, agency and cash securities.
The following is an analysis of how long each of those investment securities with an unrealized loss at December 31, 2008 and 2007 had been in a continual unrealized loss position:
At December 31, 2008, the total gross unrealized losses represented approximately 7,800 fixed income securities out of a total of approximately 14,100 fixed income securities (representing fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased) and approximately 30 equity securities out of a total of approximately 1,475. At December 31, 2007, the total gross unrealized losses represented approximately 7,600 fixed income securities out of a total of approximately 17,100 fixed income securities (representing fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased) and approximately 300 equity securities out of a total of approximately 1,000.
Of the gross unrealized investment losses on the fixed income and short term investments portfolio at December 31, 2007 of $1.1 billion, approximately $546.1 million related to corporate fixed income securities. Within the corporate fixed income securities, approximately 68.0% of the losses were in the financial sector and 12.3% in the diversified sector. No other sector was greater than 5%. The largest unrealized loss in the fixed income portfolio was $7.9 million.
Gross unrealized losses of $4.1 billion at December 31, 2008 can be attributed to the following significant drivers:
gross unrealized losses of $602.9 million related to the Topical Asset portfolio (which consists of the Company’s holdings of sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures), which had a fair value of $963.3 million as at December 31, 2008. The Company undertook a security level review of these securities and recognized charges to the extent it believed the intrinsic value of any security was below its amortized cost. The Company has recognized realized losses, consisting of charges for OTTI and realized losses from sales, of approximately $660.8 million since the beginning of 2007 and through December 31, 2008 on these asset classes.
The Company purchased a number of these assets to support the previously written GIC and funding agreement contracts and has announced its intention to reduce its exposure to this asset class as part of its strategic portfolio realignment. The Company believes that based on market conditions and liquidity needs at December 31, 2008, this reduction will be realized through natural cash flows of the portfolio, and limited selective sales, rather than selling these assets into markets which continue to be illiquid and not reflective of the intrinsic value of these assets. The weighted average term-to-maturity of the sub-prime and Alt-A residential holdings within this portfolio at December 31, 2008 were 3.6 years and 3.5 years, respectively. The Company, based on current market conditions and liquidity needs as well as its assessment of the holdings, believes it will continue to hold these securities until either maturity, or a return of liquidity and valuations more reflective of the intrinsic value of these holdings.
gross unrealized losses of $469.9 million related to the non-life portfolio of Core CDO holdings (defined by the Company as investments in non-mortgage collateralized debt obligations), which consisted primarily of collateralized loan obligations and had a fair value of $665.5 million as of December 31, 2008. The Company undertook a security level review of these securities and recognized charges to the extent it believed the intrinsic value of the security was below the amortized cost. The Company believes that the level of impairment is primarily a function of historically wide spreads in the collateralized loan obligations market during the period, driven by the high level of illiquidity in this market. The Company purchased a number of these assets to support the previously written GIC and Funding Agreement contracts and has announced its intention to reduce its exposure to this asset class over time as a part of its strategic portfolio realignment. The Company, based on current market conditions and liquidity needs as well as its assessment of the holdings, believes it is likely that the Company will continue to hold these securities until either maturity or a recovery of value, following which the Company intends to reduce its exposure to this asset class.
The following table summarizes the fair value, gross unrealized losses, credit rating and asset class of securities in a gross unrealized loss position within the Company’s structured credit and corporate portfolios, which comprised $4.3 billion of the Company’s total gross unrealized loss position of $4.1 billion at December 31, 2008:
Included in the gross unrealized losses on corporate financials are gross unrealized losses of $637.1 million on Tier One and Tier Two securities of financials institutions (“Hybrids”), as well as $159.2 million of subordinated debt.
The Company defines Core CDOs as investments in non-mortgage collateralized debt obligations, primarily consisting of collateralized loan obligations.
Structured credit securities with gross unrealized losses representing greater than 50% of amortized cost represent $680.1 million of gross unrealized losses, with a fair value of $384.1 million. Of these gross unrealized losses, $621.6 million are rated investment grade. The Company has evaluated each of these holdings on a security-by-security basis in conjunction with its investments managers and utilizing
The table below represents a reconciliation of the Company’s unpaid losses and loss expenses for the year ended December 31, 2008:
Unpaid losses and loss expense recoverables were $4.0 billion and $4.7 billion at December 31, 2008, and 2007, respectively. At December 31, 2008 and 2007, reinsurance balances receivable were $0.6 and $0.8 billion, respectively. The table below presents the Company’s net reinsurance recoverable and reinsurance balances receivable at December 31, 2008 and 2007:
The Company has credit risk should any of its reinsurers be unable or unwilling to settle amounts due. Of the $4.6 billion total unpaid losses and loss expenses recoverable and reinsurance balances receivable at December 31, 2008, no individual reinsurer accounted for 15% or more of the total. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $2.0 billion at December 31, 2008, collateralizing reinsurance recoverables with respect to certain reinsurers. The provision for uncollectible reinsurance is required principally due to the failure of reinsurers to indemnify the Company primarily because of disputes under reinsurance contracts and insolvencies. As at December 31, 2008 and 2007, the Company had a reserve for potential non-recoveries from reinsurers of $187.6 million and $193.1 million, respectively.
CDO’s have become extremely illiquid due to a number of factors including risk aversion and reduction among institutional buyers. As a result, the Company believes that current broker bids reflect loss expectations that do not reflect fair values at which willing buyers and sellers would transact. The Company determined that internal models would be more appropriate and better representative of the fair value these securities would be sold at in an orderly market. Although similar conditions exist in other portions of the Company’s holdings, primarily RMBS, the Company believes that there was only sufficient and robust historical data covering previously stressed market conditions in its CLO portfolio.
20% weighting to current cash flow estimates discounted at managements view of current market spreads, with a fair value of $316.8 million, which the Company believes includes the current market liquidity premium;
While a number of the Level 3 investments have been written down as a result of the Company’s impairment analysis, the Company continues to report, at December 31, 2008, gross unrealized losses of $535.0 million related to Level 3 available-for-sale investments. Management completed a detailed review; in conjunction with its external investment managers and third party advisors, of the Company’s underlying sub-prime and related residential mortgage exposures, as well as a consideration of the broader structured credit market, and concluded that the unrealized gains and losses in these asset classes are the result of a decrease in value due to technical spreads widening and broader market sentiment, rather than fundamental collateral deterioration and are temporary in nature.
external sources and completing recurring reviews of third party pricing services methodologies. As a result of this analysis, if the Company determines there is a more appropriate fair value based upon available market data, the price received from one third party may be substituted for another, or in limited circumstances management may determine that an adjustment is required to a third party value. In addition, similar valuation controls are followed by external parties responsible for sourcing appropriate valuations from third parties on the Company’s behalf which provides additional comfort over the reasonableness of the fair values recorded in the Company’s financial statements.
The other investments balance excludes certain unrated tranches of collateralized loan obligations which are carried under the cost recovery method given the uncertainty of future cash flows, as well as certain investments in project finance transactions which are carried at amortized cost. See Note 2 of the Consolidated Financial Statements for further details.
Financial instruments sold, but not yet purchased are included within “Net receivable (payable) for investments sold (purchased)” on the balance sheet.
See Note 3 of the Consolidated Financial Statements, “Fair Value Measurements”, for an analysis of the change in fair value of Level 3 Assets and Liabilities.
Financial Data”, for further discussion and details regarding dividend capacity of the Company’s major operating subsidiaries. See “Risk Factors - Risks Related to the Company - Because we are a holding company, if our subsidiaries do not make dividend and other payments to us, we may not be able to pay dividends or make payments on our debt securities and other obligations” in Item 1A. The ability to pay such dividends is also limited by the regulations of the Society of Lloyd’s and certain contractual provisions. No assurance can be given that the Company’s subsidiaries will pay dividends in the future to XL Capital Ltd. Subsequent to December 31, 2008, dividends of approximately $620 million were paid to XL Capital Ltd. from various subsidiaries.
As at December 31, 2008, the Company had cash and cash equivalents of approximately $4.4 billion as compared to approximately $3.9 billion at December 31, 2007. There are three main sources of cash flows for the Company - those provided by operations, investing activities and financing activities.
Historically, cash receipts from operations, consisting of premiums and investment income, generally have provided sufficient funds to pay losses as well as operating expenses of the Company’s subsidiaries and to fund dividends to XL Capital Ltd. Cash receipts from operations is generally derived from the receipt of investment income on the Company’s total investment portfolio as well as the net receipt of premiums less claims and expenses related to the Company’s underwriting activities in its property and casualty operations as well as its Life Operations segment. The Company’s operating subsidiaries provide liquidity in that premiums are generally received months or even years before losses are paid under the policies related to such premiums. Premiums and acquisition expenses are settled based on terms of trade as stipulated by an underwriting contract, and generally are received within the first year of inception of a policy when the premium is written, but can be up to three years on certain reinsurance business assumed. Operating expenses are generally paid within a year of being incurred. Claims especially for casualty business, may take a much longer time before they are reported and ultimately settled and this is why the Company establishes reserves for unpaid losses and loss expenses. Therefore, the amount of claims paid in any one year is not necessarily related to the amount of net losses incurred, as reported in the consolidated statement of income.
Generally, positive cash flow from operations and financing activities is invested in the Company’s portfolio, including affiliates or acquisition of subsidiaries.
Net cash used in investing activities in 2007 and 2006 was primarily related to the purchase and sale of portfolio investments, with purchases of investments exceeding the related sales and redemptions. In addition, in 2007, the Company sold a portion of its interest in Syncora, through a secondary offering for $316.3 million. However, as a result of the sale and subsequent deconsolidation of Syncora, investing cash flows were reduced by $110.8 million.
payable on the Company’s Class A Ordinary Shares to $0.10 per ordinary share beginning with the quarterly dividend payable in March 2009.
As noted above, the Company settled during 2008, approximately $4.0 billion of GIC liabilities through the sale of certain assets from its fixed income portfolio. In addition, $1.2 billion of funding agreements were settled during 2008. At December 31, 2007, a significant component of the investments held in the Company’s Other Financial Lines segment portfolios was comprised of Topical Assets and CDOs. Liquidations necessary to fund the repayment of the GIC liabilities following the downgrade of Syncora Guarantee and the maturity of certain funding agreements, were funded through sales of assets in these portfolios as well as the general investment portfolios. Management’s approach was to avoid the sale of assets where current market prices did not reflect intrinsic values or where transaction costs for liquidation were excessive. As a result, the Company continues to hold a number of the Topical Assets and CDOs and these were transferred to the general investment portfolio in exchange for those assets that were liquidated. At December 31, 2008, the remaining balance of funding agreements, excluding accrued interest of $6.6 million, was $600.0 million, with settlements scheduled as follows: $150.0 million in October 2009 and $450.0 million in August 2010. The Company continues to manage its liquidity needs through changes in the mix of its investment portfolio as well as through other available capital resources and lines of credit as noted below.
In 2006, the Company received $342.2 million related to the sale of a portion of its interest in Syncora through a primary offering.
sufficient capital to enable its regulated subsidiaries to meet the regulatory capital levels required in the U.S., the U.K., Bermuda, Ireland, Switzerland and other key markets.
letters of credit and other forms of collateral that are required to be posted or deposited, as the case may be, by the Company’s operating subsidiaries that are “non-admitted” under U.S. state insurance regulations in order for the U.S. cedant to receive statutory credit for reinsurance. The Company also uses letters of credit to support its operations at Lloyd’s
the Company may be downgraded by one or more rating agencies which could materially and negatively impact the Company’s business, financial condition, results of operations and/or liquidity.
At December 31, 2008, the Company had total combined common and preferred share capital of $6.6 billion. In addition to ordinary and preferred share capital, the Company depends on external sources of financing such as debt, credit facilities and contingent capital to support its underwriting activities. The continuation of the current capital and credit market disruption, as well as any future disruptions or rating agency actions, could limit the Company’s ability to raise capital in the future. If the Company’s sources of liquidity described above prove to be insufficient, the Company may not be able to successfully obtain additional financing on favorable terms, or at all.
Pursuant to the Company’s shelf registration statement, the Company issued 143.8 million Class A ordinary shares in August 2008 at a price of $16.00 per share, with net proceeds totaling approximately $2.2 billion. The proceeds were used to fund the payments described above in relation to the Master Agreement as well as to redeem X.L. America’s 6.58% Notes as described below. In addition, proceeds were used for general corporate purposes and capital funding for certain of the Company’s subsidiaries. In addition, as part of the Master Agreement, the Company issued 8,000,000 Class A ordinary shares, valued at $16.00 per share, to Syncora and its subsidiaries. The shares are subject to a registration rights agreement.
The Company’s Rights Plan expired in accordance with its terms on September 30, 2008. Rights to purchase Class A ordinary shares (the “Rights”) were distributed as a dividend at the rate of one Right for each Class A ordinary share held of record as of the close of business on October 31, 1998. Each Right entitled holders of Class A ordinary shares to buy additional ordinary shares with a value of $700 at the then current market price, at an exercise price of $350. The Rights would have been exercisable, and would have detached from the Class A ordinary shares, only if a person or group were to have acquired 20% or more of the Company’s outstanding Class A ordinary shares, or were to have announced a tender or
In February 2009, in connection with the maturity of the purchase contracts associated with the 7.00% Units, the Company issued 11,461,080 Class A ordinary shares for net proceeds of approximately $743.1 million, which was used to retire the 2011 Senior Notes.
Concurrent with the issuance of Class A ordinary shares as described above and pursuant to the Company’s shelf registration statement, the Company, in August 2008, issued 23.0 million 10.75% Equity Security Units (the “10.75% Units”) in a public offering in order to fund payments described above in relation to the Master Agreement and remaining net proceeds were used for general corporate purposes. The Company received approximately $557.8 million in net proceeds from the sale of the 10.75% Units after deducting underwriting discounts. Each 10.75% Unit has a stated amount of $25 and consists of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Company’s Class A Ordinary Shares on August 15, 2011 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due August 15, 2021 with a principal amount of $1,000 (the “2021 Senior Notes ”). The 2021 Senior Notes are pledged by the holders to secure their obligations under the purchase contract.
The number of ordinary shares to be issued under each purchase contract depends on, among other things, the average market price of the ordinary shares on the settlement date. The maximum number of ordinary shares to be issued under the purchase contracts is approximately 35.9 million. The Company accounts for the effect on the number of weighted average ordinary shares, assuming dilution, using the treasury stock method. The purchase contract component of the 10.75% Units will have no effect on the number of weighted average ordinary shares, assuming dilution, except when the average market price of
As noted above, the Company utilized a portion of the net proceeds from the capital raising activities described above, to redeem, in August 2008, X.L. America, Inc.’s $255 million 6.58% Notes. In connection with the early redemption of the 6.58% Notes, the Company incurred debt extinguishment costs of approximately $22.5 million.
$600 million senior notes due January 2012, with a fixed coupon of 6.5%. The security is publicly traded. The notes were issued at $99.469 and gross proceeds were $596.8 million. Related expenses of the offering amounted to $7.9 million.
$350 million senior notes due November 2024, with a fixed coupon of 6.375%. The security is publicly traded. The notes were issued at 100.0% and gross proceeds were $350 million. Related expenses of the offering amounted to $2 million.
$325 million of senior notes due 2027, with a fixed coupon of 6.25%. The security is publicly traded. The notes were issued at 99.805% and gross proceeds were $324.4 million. Related expenses of the offering amounted to $2.5 million.
The following tables present the Company’s debt under outstanding securities and lenders’ commitments as at December 31, 2008:
basis, when, as and if declared by the Company’s Board of Directors, on January 15 and July 15 of each year at a fixed rate equal to 6.102% per annum on the liquidation preference. From and after July 15, 2013, dividends on the Series C Preference Shares are payable quarterly on a cumulative basis, when, as and if declared by the Company’s Board of Directors, on January 15, April 15, July 15 and October 15 of each year at a floating rate equal to three-month LIBOR plus 3.145% on the liquidation preference. The Series C Preference Shares have no stated maturity and are not subject to any sinking fund or mandatory redemption and are not convertible into any of the Company’s other securities. On February 27, 2009, the Company initiated a cash tender offer for all of the outstanding Series C Preference Shares.
The following letter of credit facilities were originated, renewed or terminated during 2008:
A downgrade below “A-” of the Company’s principal insurance and reinsurance subsidiaries by either S&P or A.M. Best, which is two notches below the current S&P financial strength rating of “A” (Negative) and the A.M. Best financial strength rating of “A” (Stable) of these subsidiaries, may trigger cancellation provisions in a significant amount of the Company’s assumed reinsurance agreements and may potentially require the Company to return unearned premiums to cedants. In addition, due to collateral posting requirements under the Company’s letter of credit and revolving credit facilities, such a downgrade may
require the posting of cash collateral in support of certain “in use” portions of these facilities (see “- Liquidity and Capital Resources”). Specifically, a downgrade below “A-” by A.M. Best would trigger such collateral requirements for the Company’s two largest credit facilities. In certain limited instances, such downgrades may require the Company to return cash or assets to counterparties or to settle derivative and/or other transactions with the respective counterparties. See Item 1A, “Risk Factors,” “A downgrade or potential downgrade in our financial strength and credit ratings by one or more rating agencies could materially and negatively impact our business, financial condition, results of operations and/or liquidity.”
Under the Company’s 2-year Lloyd’s and five-year U.S. credit facilities placement notes described above, in the event that the XL Capital Group, XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A-” from A.M. Best, an event of default would occur.
The 6.5% Guaranteed Senior Notes indentures contain a cross default provision. In general, in the event that the Company defaults in the payment of indebtedness in the amount of $50.0 million or more, an event of default would be triggered under the Guaranteed Senior Notes indentures. Given that all of the Company’s Debt Documents contain cross default provisions, this may result in all holders declaring such debt due and payable and an acceleration of all debt due under those documents. If this were to occur, the Company may not have funds sufficient at that time to repay any or all of such indebtedness.
The following table presents the Company’s long term contractual obligations and related payments as at December 31, 2008, due by period. This table excludes further commitments of $104.5 million to the Company’s related investment funds and certain limited partnerships, and letter of credit facilities of $3.7 billion. See Item 8, Note 17 to the Consolidated Financial Statements, “Derivative Instruments,” and Note 20 to the Consolidated Financial Statements, “Commitments and Contingencies.” See Item 8, Note 16 to the Consolidated Financial Statements, “Notes Payable and Debt and Financing Arrangements,” for further information.
Deposit liabilities on the Company’s Consolidated Balance Sheet at December 31, 2008 were $2,710,987. The difference from the amount included above relates to the discount on payments due in the future. The payment related to these liabilities varies primarily based on interest rates. The ultimate payments associated with these liabilities could differ from the Company’s estimate. See Item 8, Note 14 to the Consolidated Financial Statements, “Deposit Liabilities,” for further information.
The unpaid loss and loss expenses were $21,650,315 on the Company’s Consolidated Balance Sheet at December 31, 2008. The difference from the amount included above relates to the discount on certain workers’ compensation and financial guarantee liabilities. The timing and amounts of actual claims payments related to these P&C and financial guarantee reserves vary based on many factors including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claims payments could differ materially from the Company’s estimated amounts. For information regarding the estimates for unpaid loss and loss expenses as well as factors effecting potential payment patterns of reserves for actual and potential claims related the Company’s different lines of business see “Critical Accounting Policies and Estimates” above. Certain lines of business written by the Company, such as excess casualty, have loss experience characterized as low frequency and high severity. This may result in significant variability in loss payment patterns and, therefore, may impact the related asset/liability investment management process. In order to be in a position, if necessary, to make these payments, the Company’s liquidity requirements are supported by having revolving lines of credit facilities available to the Company and significant reinsurance programs, in addition to the Company’s general high grade fixed income investment portfolio.
On December 5, 2006, the Company and certain operating subsidiaries (“Ceding Insurers”) entered into a securities issuance agreement (the “Securities Issuance Agreement”), and certain of its foreign insurance and reinsurance subsidiaries (“Ceding Insurers”) entered into an excess of loss reinsurance agreement (the “Reinsurance Agreement”), with Stoneheath Re (“Stoneheath”). The net effect of these agreements to the Company is the creation of a contingent put option in the amount of $350.0 million in the aggregate.
insurance and reinsurance sectors in particular (both as to underwriting and investment matters). Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “anticipate,” “will,” “may” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the PSLRA or otherwise.
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2008, 2007 and 2006
FOR THE YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006 (Continued)
XL Capital Ltd, through its operating subsidiaries (collectively the “Company” or “XL”), is a leading provider of insurance and reinsurance coverages to industrial, commercial and professional service firms, insurance companies and other enterprises on a worldwide basis. The Company and its various subsidiaries operate globally in 28 countries, through its four business segments: Insurance, Reinsurance, Life Operations, and Other Financial Lines. These segments are further discussed in Note 6 to the Consolidated Financial Statements, “Segment Information.”
These consolidated financial statements include the accounts of the Company and all of its subsidiaries. These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated. Certain amounts in 2007 and 2006 have been reclassified to conform to the current year presentation.
In addition, FAS 157 prohibits the recognition of “block discounts” for large holdings of unrestricted financial instruments where quoted prices are readily and regularly available for an identical asset or liability in an active market. The provisions of FAS 157 are to be applied prospectively, except changes in fair value measurements that result from the initial application of FAS 157 to existing derivative financial instruments measured under EITF Issue No. 02-3, existing hybrid financial instruments measured at fair value and block discounts, all of which are to be recorded as an adjustment to beginning retained earnings in the year of adoption.
In February 2008, the FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP FAS 157-2”), which permits a one-year deferral of the application of FAS 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). FSP FAS 157-2 is effective in conjunction with FAS 157 for interim and annual financial statements issued after January 1, 2009. Accordingly, the provisions of FAS 157 have not been applied to goodwill and other intangible assets held by the Company which are measured periodically for impairment testing purposes only.
In October 2008, the FASB issued FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”). This FSP clarifies the application of FAS 157 in a market that is not active and provides an example to illustrate key considerations in the determination of the fair value of a financial asset when the market for that asset is not active. The key considerations illustrated in the FSP FAS 157-3 example include the use of an entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates, appropriate risk adjustments for nonperformance and liquidity risks, and the reliance that an entity should place on quotes that do not reflect the result of market transactions. FSP FAS 157-3 was preceded by a press release that was jointly issued by the Office of the Chief Accountant of the SEC and the FASB staff on September 30, 2008 which provided immediate clarification on fair value accounting based on the measurement guidance of FAS 157. FSP FAS 157-3 was effective upon issuance. The Company determined that applying the principles of FSP FAS 157-3 with respect to the CLO portfolio was appropriate.
Fair values of investments and derivatives are based on published market values if available, estimates of fair values of similar issues, estimates of fair values provided by independent pricing services or estimates of fair values determined by the Company. Fair values of financial instruments for which quoted market prices are not available or for which the Company believes current trading conditions represent distressed transactions are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rates and the estimated amounts and timing of future cash flows. In such instances, the derived fair value estimates cannot be substantiated by comparison to independent markets and are not necessarily indicative of the amounts that would be realized in a current market exchange. Certain financial instruments, particularly insurance contracts, are excluded from fair value disclosure requirements of FAS 107, Disclosures about Fair Value of Financial Instruments. For further information on accounting policies relating to other financial instruments, investments, other investments, notes payable and debt, derivative instruments, and off-balance sheet arrangements, see Notes 3, 9, 11, 16, 17, and 18, respectively.
In the normal course of business, the Company seeks to reduce the potential amount of loss arising from claims events by reinsuring certain levels of risk assumed in various areas of exposure with other insurers or reinsurers. Reinsurance premiums ceded are expensed (and any commissions recorded thereon are earned) on a monthly pro-rata basis over the period the reinsurance coverage is provided. Prepaid reinsurance premiums represent the portion of premiums ceded applicable to the unexpired term of policies in force. Mandatory reinstatement premiums ceded are recorded at the time a loss event occurs. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Provisions are made for estimated unrecoverable reinsurance.
derivatives are designated as hedging instruments. The accounting for derivatives which are designated as hedging instruments is discussed below. Changes in fair value of derivatives may create volatility in the Company’s results of operations from period to period. Amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) are offset against net fair value amounts recognized in the consolidated balance sheet for derivative instruments executed with the same counterparty under the same master netting arrangement.
Certain OTC derivatives trade in less liquid markets with limited pricing information, or required model inputs which are not directly market corroborated, which causes the determination of fair value for these derivatives to be inherently more subjective. Accordingly, such derivatives are classified within Level 3 of the fair value hierarchy. The valuations of less standard or liquid OTC derivatives are typically based on Level 1 and/or Level 2 inputs that can be observed in the market, as well as unobservable Level 3 inputs. Level 1 and Level 2 inputs are regularly updated to reflect observable market changes, with resulting gains and losses reflected within Level 3. Level 3 inputs are only changed when corroborated by evidence such as similar market transactions, pricing services and/or broker or dealer quotations.
The Company conducts its derivative activities in four main areas: investment related derivatives, credit derivatives, other non-investment related derivatives, and weather and energy derivatives.
The Company’s direct use of derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, reference rates or a combination of these factors. The Company uses derivatives to manage duration, credit and foreign currency exposure for its investment portfolio as well as to add value to the investment portfolio through replicating permitted investments, provided the use of such investments is incorporated into the overall portfolio evaluation and complies with the Company’s investment guidelines.
The Company uses derivative instruments, primarily interest rate swaps, to manage the interest rate exposure associated with certain assets and liabilities. All derivatives are recorded at fair value. On the date the derivative contract is entered into, the Company may designate the derivative as a hedge of the fair value of a recognized asset or liability (“fair value” hedge); a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset or liability (“cash flow” hedge); a hedge of a net investment in a foreign operation; or the Company may not designate any hedging relationship for a derivative contract.
Changes in fair value of a derivative used as a hedge of a net investment in a foreign operation, to the extent effective as a hedge, are recorded in the foreign currency translation adjustments account within AOCI. Cumulative changes in fair value recorded in AOCI are reclassified into earnings upon the sale or complete or substantially complete liquidation of the foreign entity. Any hedge ineffectiveness is recorded immediately in current period earnings as “net realized and unrealized gains and losses on derivative instruments.” Periodic derivative net coupon settlements are recorded in net investment income. There were hedges of net investment in a foreign operation in place at December 31, 2006.
The Company also has investment related derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of GMIB over the account balance upon the policyholder’s election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return based on a portfolio of fixed income securities; as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated and recorded at fair value with changes in fair value recognized in earnings.
All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of equities and fixed income investments are determined on the basis of average cost and amortized cost, respectively. Investment income is recognized when earned and includes interest and dividend income together with the amortization of premium and discount on fixed maturities and short-term investments. Amortization of discounts on fixed maturities includes amortization to expected recovery values for investments which have previously been recorded as other than temporarily impaired. For mortgage-backed securities, and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Prepayment fees or call premiums that are only payable to the Company when a security is called prior to its maturity, are earned when received and reflected in net investment income.
Investments in which the Company has significant influence over the operating and financial policies of the investee are classified as investments in affiliates on the Company’s balance sheet and are accounted for 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 as well as its portion of movements in certain of the investee shareholders’ equity balances. When financial statements of the affiliate are not available on a timely basis to record the Company’s share of income or loss for the same reporting periods as the Company, the most recently available financial statements are used. This lag in reporting is applied consistently until timely information becomes available. Significant influence is generally deemed to exist where the Company has an investment of 20% or more in the common stock of a corporation or an investment of 3% or greater in closed end funds, limited partnerships, LLCs or similar investment vehicles. The Company records its alternative and private fund affiliates on a one month and three month lag, respectively, and its operating affiliates on a three month lag. Significant influence is considered for other strategic investments on a case- by-case basis. Investments in affiliates are not subject to FAS 157 as they are not considered to be fair value measurements under FAS 157. However, impairments associated with investments in affiliates that are deemed to be other-than-temporary are calculated in accordance with FAS 157 and appropriate disclosures included within the financial statements during the period the losses are recorded.
Income on unrated tranches of collateralized debt obligations is reflected only to the extent the Company’s principal has been fully recovered. This is not considered to be a fair value measurement under FAS 157 and accordingly these investments have been excluded from FAS 157 disclosures. These investments are carried under the cost recovery method given the uncertainty of future cash flows. The carrying value of these investments held by the Company at December 31, 2008 and December 31, 2007 was $14.7 million and $22.7 million, respectively.
In addition, the Company historically participated in structured transactions in project finance related areas under which the Company provides a cash loan supporting a trade finance transaction. These transactions are accounted for in accordance with SOP 01-6, “Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others” under which the loans are considered held for investment as the Company has the intent and ability to hold for the foreseeable future or until maturity or payoff. Accordingly, these funded loan participations are reported in the balance sheet at outstanding principal adjusted for any allowance for loan losses as considered necessary by management. These investments are not considered to be fair value measurements under FAS 157 and accordingly they have been excluded from the FAS 157 disclosures. The carrying value of these investments held by the Company at December 31, 2008 and December 31, 2007 was $80.1 million and $125.1 million, respectively.
The Company engages in a securities lending program whereby certain securities from the Company’s portfolio are loaned to other institutions for short periods of time. The market value of the loaned securities is monitored on a daily basis, with additional collateral obtained or refunded as the market value of the loaned securities changes. The Company’s policy is to require fixed maturities and initial cash collateral equal to between 102% and 105% of the fair value of the loaned securities depending on the class of assets loaned. The Company continues to earn interest on the securities loaned. In addition, the Company shares a portion of the interest earned on the collateral with the lending agent. The proceeds from securities lending collateral is invested and included in cash and cash equivalents or investments available for sale with a corresponding liability related to the Company’s obligation to return the collateral plus interest included in net payable for investments purchased. During 2008, the Company capped its maximum participation in the securities lending program at $300 million and is in the process of unwinding its participation.
The Company has recorded goodwill in connection with various acquisitions in prior years. Goodwill represents the excess of the purchase price over the fair value of net assets acquired. In accordance with FASB Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”), the Company tests goodwill for potential impairment annually as of June 30 and between annual tests if an event occurs or circumstances change that may indicate that potential exists for the fair value of a reporting unit to be reduced to a level below its carrying amount. The Company tests for impairment at the reporting unit level, which is generally one level below its business segments. The Company evaluates goodwill for impairment using the two-step process prescribed in FAS 142. The first step is to identify potential impairment by comparing the fair value of a reporting unit to the estimated book value, including goodwill. The Company derives the net book value of its reporting units by estimating the amount of shareholders’ equity required to support the activities of each reporting unit. If the fair value of a reporting unit exceeds the estimated book value, goodwill is not considered impaired. If the book value exceeds the fair value, the second step of the process is performed to measure the amount of impairment.
The Company’s indefinite lived intangible assets consist primarily of acquired insurance and reinsurance licenses. These assets are deemed to have indefinite useful lives and are therefore not subject to
For the Company’s financial guarantee reserves, a case basis reserve for unpaid losses and loss adjustment expenses is recorded at the net present value of an estimated loss when, in management’s opinion, the likelihood of a future loss on a particular insured obligation is probable and determinable at a balance sheet date. The Company also maintains an unallocated reserve on its legacy financial guarantee business which is based on actuarial reserving analysis. This non-specific reserve is established for expected levels of losses associated with currently insured credits and is based on a portion of premiums earned to date. The Company, on an ongoing basis, monitors these reserves and may periodically adjust such reserves based on the Company’s actual loss experience, its future mix of business, and its view of future economic conditions.
The deposit accretion rate is the rate of return required to fund expected future payment obligations (this is equivalent to the “best estimate” of future cash flows), which are determined actuarially based upon the nature of the underlying indemnifiable losses. Accretion of the liability is recorded as interest expense. The Company periodically reassesses the estimated ultimate liability. Any changes to this liability are reflected as adjustments to interest expense to reflect the cumulative effect of the period the contract has
been in force, and by an adjustment to the future accretion rate of the liability over the remaining estimated contract term.
Effective January 1, 2003, the Company adopted the fair value recognition provisions of FASB Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”), as amended by FASB Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (“FAS 148”), under the prospective method for options granted subsequent to January 1, 2003. Prior to 2003, the Company accounted for options under the
During February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”), which permits entities to choose to measure many financial instruments and certain other items at fair value. A company must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option may be applied on an instrument by instrument basis, with a few exceptions. The fair value option is irrevocable (unless a new election date occurs) and the fair value option may be applied only to entire instruments and not to portions of instruments. FAS 159 is effective for interim and annual financial statements issued after January 1, 2008. The Company did not elect to apply the fair value option to any existing assets or liabilities as of January 1, 2008.
In May 2008, the FASB issued FAS 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FAS 60” (“FAS 163”) to address current diversity in practice with respect to accounting for financial guarantee insurance contracts by insurance enterprises under FAS 60, “Accounting and
Reporting by Insurance Enterprises” (“FAS 60”). That diversity results in inconsistencies in the recognition and measurement of claim liabilities because of differing views regarding when a loss has been incurred under FAS 5, “Accounting for Contingencies”. FAS 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. FAS 163 also clarifies how FAS 60 applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. Those clarifications will increase comparability in financial reporting of financial guarantee insurance contracts by insurance enterprises. FAS 163 also requires expanded disclosures about financial guarantee insurance contracts. The standard is effective for the Company beginning January 1, 2009, and must be applied to all interim periods within 2009, except for certain disclosures about the Company’s risk management activities which were required and included within the Company’s quarterly report on Form 10-Q for the period ended September 30, 2008. Except for those disclosures, earlier application is not permitted. The Company had reserves for financial guarantee insurance contracts of $14.5 million and $427.4 million, respectively, recorded within “Unpaid Losses and Loss Expenses”, at December 31, 2008 and December 31, 2007, respectively. At December 31, 2007 the most significant financial guarantee exposures were related to the Company’s reinsurance agreements with Syncora and its subsidiaries. Following the closing of the Master Agreement, the Company’s financial guarantee exposures associated with Syncora were eliminated, with the exception of the guarantee of Syncora’s obligations under certain policies with European Investment Bank which are not subject to FAS 163. For further details on this guarantee see Note 4, “Syncora Holdings Ltd. (“Syncora”).”
whether an instrument (or an embedded feature) is indexed to an entity’s own stock for the purposes of determining whether an instrument is a derivative. To the extent a derivative instrument or embedded derivative feature is deemed indexed to an entity’s own stock, it may be exempt from the requirements of FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). EITF 07-5 concluded that an entity should determine whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock first by evaluating the instrument’s contingent exercise provisions, if any, and then by evaluating the instrument’s settlement provisions. EITF 07-5 will be effective for financial statements issued for the Company’s fiscal year beginning on January 1, 2009, and interim periods within the 2009 year. Earlier application is prohibited. EITF 07-5 must be applied to outstanding instruments as of January 1, 2009. This guidance is not expected to have an impact on the Company’s financial condition and results of operations.
Effective January 1, 2008, the Company adopted FAS 157, which requires disclosures about the Company’s assets and liabilities that are carried at fair value. As required by FAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
Cash equivalents balances subject to fair value measurements include certificates of deposit and money market funds. Operating cash balances are not subject to FAS 157.
The derivative balances included in each category above are reported on a gross basis by level with a netting adjustment presented separately in the “Collateral and Counterparty Netting” column. The Company often enters into different types of derivative contracts with a single counterparty and these contracts are covered under an ISDA master netting agreement. In addition, the company holds cash collateral related to derivative assets of $346 million. This balance is included within cash and cash equivalents and the corresponding liability to return the collateral has been offset against the derivative asset within the balance sheet as appropriate under the ISDA master netting agreement. The fair value of the individual derivative contracts are reported gross in their respective levels based on the fair value hierarchy.
Financial instruments sold, but not purchased are included within “Net receivable for investments sold” on the balance sheet.
The table below presents additional information about assets and liabilities measured at fair value on a recurring basis and for which Level 3 inputs were utilized to determine fair value. The table reflects gains and losses for the twelve month period ended December 31, 2008 for all financial assets and liabilities categorized as Level 3 as of December 31, 2008. The table does not include gains or losses that were reported in Level 3 in prior periods for assets that were transferred out of Level 3 prior to December 31, 2008. Gains and losses for assets and liabilities classified within Level 3 in the table below may include changes in fair value that are attributable to both observable inputs (Levels 1 and 2) and unobservable inputs (Level 3). Further, it should be noted that the following table does not take into consideration the effect of offsetting Level 1 and 2 financial instruments entered into by the Company that are either economically hedged by certain exposures to the Level 3 positions or that hedge the exposures in Level 3 positions.
In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments as is currently the case for certain U.S. collateralized mortgage obligations (“CMOs”), asset backed securities (“ABSs”), commercial mortgage backed securities (“CMBSs”), collateralized debt obligations (“CDOs”), and other Topical Assets (which the Company defines as sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures) for which sufficient information, such as cash flows or other security structure or market information, is not available to enable a model derived price to be determined. Generally, securities that are less liquid are more difficult to value and/or dispose of. Fixed maturities and short term investments classified within Level 3 are made up of those securities for which the values were obtained from brokers where either significant inputs were utilized in determining the value that were difficult to corroborate with observable market data, or sufficient information regarding the specific inputs utilized by the broker was not obtained to support a Level 2 classification, or for which the Company determined current trading conditions represent distressed transactions. The fair values of the majority of the Company’s holdings in securities
During the fourth quarter of 2008, the Company determined that for certain of its CDO holdings with a fair value of $483.2 million and a par value of $801.5 million, valuations were as a result of broker bids that used recent market trading which the Company considered to be stressed transactions. The markets for CDO’s have become extremely illiquid due to a number of factors including risk aversion and reduction among institutional buyers. As a result, the Company believes that current broker bids reflect loss expectations that do not reflect fair values at which willing buyers and sellers would transact. The Company determined that internal models would be more appropriate and better representative of the fair value these securities would be sold at in an orderly market. Although similar conditions exist in other portions of the Company’s holdings, primarily RMBS, the Company believes that there was only sufficient and robust historical data covering previously stressed market conditions in its CLO portfolio.
The Company’s internal models resulted in a fair value that was $211.7 million higher than those that would have been determined by its previous methodology of utilizing third party values sourced through brokers or pricing services. This variance represents 26.4% of par value of these holdings, which based on the portfolio’s spread duration of 4.7 years corresponds to a 560 basis point decrease relative to the spread levels implied in current market levels of trading which management believes are distressed trades. The Company believes that, in the aggregate, this is appropriate as compared to current estimates of market credit spreads.
20% weighting to current cash flow estimates, adjusted to double the current underlying loss estimates, discounted at the coupon of the securities, with a further reduction in value representing a liquidity premium equal to double the prevailing total credit spread levels of the most severe previous CLO market deterioration, which resulted in a fair value of $410.1 million; and
40% weighting to likely loss outcomes, representing current cash flow estimates discounted at the coupon of the securities, with a further reduction in value representing a liquidity premium
equal to the prevailing credit spread levels of the most severe previous CLO market deterioration, which resulted in a fair value of $702.0 million.
Included within the Other Investments component of the Company’s Level 3 valuations are private equity investments where the Company is not deemed to have significant influence over the investee. The fair value of these investments is based upon net asset values received from the investment manager or general partner of the respective entity. The nature of the underlying investments held by the investee which form the basis of the net asset value include assets such as private business ventures and are such that significant Level 3 inputs are utilized in the determination of the individual underlying holding values and accordingly the fair value of the Company’s investment in each entity is classified within Level 3. The Company also incorporates factors such as the most recent financial information received, the values at which capital transactions with the investee take place, and management’s judgment regarding whether any adjustments should be made to the net asset value in recording the fair value of each position.
project financing transaction while the facultative covers generally reinsured certain policies up to the amount necessary for Syncora Guarantee and Syncora Guarantee Re to comply with certain regulatory and risk limits. The excess of loss reinsurance provided indemnification for the portion of any individual paid loss covered by Syncora Guarantee Re in excess of 10% of Syncora Guarantee Re’s surplus, up to an aggregate amount of $500 million, and excluded coverage for liabilities arising other than pursuant to the terms of the underlying policies. In 2007, in relation to the excess of loss and facultative reinsurance agreements described above, the Company recorded within “loss from operating affiliates”, losses in the amount of $300.0 million and $51.0 million, respectively. As detailed below, subsequent to June 30, 2008 the Company executed the Master Agreement in connection with, among other things, the termination of these reinsurance agreements. As at June 30, 2008 and December 31, 2007, the Company’s total net exposure under its facultative agreements with Syncora subsidiaries was approximately $6.4 billion and $7.7 billion, respectively, of net par outstanding.
Previously, the Company also entered into certain guarantee agreements with subsidiaries of Syncora. These guarantee agreements terminated with respect to any new business written by Syncora through the underlying agreements after the effective date of Syncora’s IPO, but the agreements remained in effect with respect to cessions or guarantees written under these agreements prior to the IPO. The agreements unconditionally and irrevocably guaranteed: (i) Syncora Guarantee for the full and complete performance when due of all of Syncora Guarantee Re’s obligations under its facultative quota share reinsurance agreement with Syncora Guarantee, (ii) the full and complete payment when due of Syncora Guarantee’s obligations under certain financial guarantees issued by Syncora Guarantee and arranged by Syncora Guarantee (U.K.) Limited for the benefit of the European Investment Bank (“EIB”) and (iii) Financial Security Assurance (“Financial Security”) for the full and complete performance of Syncora Guarantee Re’s obligations under a Financial Security Master Facultative Agreement. The guarantees the Company provided contained a dual trigger, such that the guarantees responded only if two events were to occur. First, the underlying guaranteed obligation must have defaulted on payments of interest and principal, and secondly, the relevant Syncora subsidiary must have failed to meet its obligations under the applicable reinsurance or guarantee. As detailed below, subsequent to June 30, 2008 the Company executed the Master Agreement in connection with, among other things, the termination of reinsurance agreements with Syncora and its subsidiaries. As a result of the termination of these reinsurance agreements, the related guarantee agreements described above, with the exception of certain exposures relating to the European Investment Bank as described below, no longer have any force or effect. As at June 30, 2008 and December 31, 2007, the Company’s total net par outstanding falling under these guarantees was $59.2 billion and $75.2 billion, respectively.
Agreement with Syncora with Respect to Pre-IPO Guarantee and Reinsurance Agreements and Service Agreements
The Master Agreement provided for the payment by the Company to Syncora of $1.775 billion in cash, the issuance by the Company to Syncora of eight million of its Class A Ordinary Shares which were newly issued by the Company and the transfer by the Company of all of its voting, economic or other rights in the shares it owned in Syncora (representing approximately 46% of Syncora’s issued and outstanding shares) (the “Syncora Shares”) to an escrow agent in accordance with an escrow agreement between Syncora and the Counterparties. This consideration was made in exchange for, among other things, the full and unconditional:
termination of certain indemnification and services agreements between the Company and Syncora.
building risk with an average rating of BBB, written between 2001 and 2006 with anticipated maturities ranging between 2027 and 2038. As at December 31, 2008, the Company’s exposures relating to the EIB Policies (which relate to project finance transactions) was approximately $955.4 million, reduced from $1.1 billion at June 30, 2008, mainly due to the strengthening of the U.S. dollar against the currencies of the underlying obligations. As of December 31, 2008, there have been no reported events of default on the underlying obligations, accordingly, no reserves have been recorded.
Given the softening property and casualty market conditions, the Company implemented in the third quarter of 2008, an expense reduction initiative designed to reduce the Company’s operating expenses. The goal of this initiative was to achieve enhanced efficiency and an overall reduction in operating expenses by streamlining processes across all geographic locations, with a primary emphasis on corporate functions. To date, this has been achieved through redundancies, increased outsourcing and the cessation of certain projects and activities. Charges have been recognized and accrued as restructuring and asset impairment charges and allocated to the Company’s reportable segments in accordance with FAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” and FAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Other costs that do not meet the criteria for accrual are being expensed as restructuring charges as they are incurred. In relation to this initiative, the Company recorded restructuring and asset impairment charges totaling $50.8 million during the year ended December 31, 2008 and expects to record further charges of approximately $1.9 million through the expected completion date of the activities under the expense reduction initiative in the second quarter of 2009. Restructuring charges relate mainly to employee termination benefits as well as costs associated with ceasing to use certain leased property accounted for as operating leases. Asset impairment charges relate primarily to the write-off of certain IT system and equipment costs previously capitalized. The Company recognizes an asset impairment charge when net proceeds expected from disposition of an asset are less than the carrying value of the asset and reduces the carrying amount of the asset to its estimated fair value. Restructuring and asset impairment charges noted above have been recorded in the Company’s income statement under ‘Operating Expenses.’
In February 2009, the Company announced further restructuring initiatives that will result in a reduction of approximately 10% of the Company’s global workforce in 2009, resulting in approximately $60 to $80 million of further restructuring charges.
Costs incurred through December 31, 2008 and total estimated costs the Company expects to incur in connection with the restructuring and asset impairment are as follows:
This includes net realized losses on investments of $962.0 million and net realized and unrealized losses on investment and other derivatives of $73.4 million, but does not include unrealized losses on investments for which the decline was considered temporary, which are included in accumulated other comprehensive (loss) income.
Net loss from investment fund and operating affiliates for the year ended December 31, 2008 included losses totaling approximately $1.4 billion related to the closing of the Master Agreement as well as losses recorded throughout 2008 and up until the closing of the Master Agreement that were associated with previous reinsurance and guarantee agreements with Syncora.
This includes net realized losses on investments of $603.3 million, net realized and unrealized losses on investment and other derivatives of $55.4 million, but does not include unrealized appreciation or depreciation on investments for which the decline was considered temporary, which are included in accumulated other comprehensive income (loss).
Net (loss) from investment and operating affiliates includes the equity earnings from the Company’s investment in Syncora since June 6, 2007, reported on a one quarter lag as well losses, including OTTI, associated with this investment and losses relating to reinsurance agreements with Syncora.
The Other Financial Lines segment is comprised of the guaranteed investment contract and funding agreement businesses. The net results from these products include net investment income, interest expense and operating expenses of $341.9 million, $296.8 million, and $10.4 million, respectively.
The Company tests goodwill for impairment on an annual basis and on an interim basis when certain events or circumstances exist. The Company tests for impairment at the reporting unit level, which is generally one level below its business segments in accordance with FAS 142. The first step is to identify potential impairment by comparing the fair value of a reporting unit to the estimated book value, including goodwill. The fair value of each reporting unit is derived based upon valuation techniques and assumptions the Company believes market participants would use to value the business and this is the compared to the book value of the business. The Company derives the net book value of its reporting units by estimating the amount of shareholders’ equity required to support the activities of each reporting unit. If the estimated fair value exceeds the book value, goodwill at the reporting unit level is not deemed to be impaired. If the book value exceeds the estimated fair value, the second step of the process is performed to measure the amount of impairment. The estimated fair values of the reporting units are generally determined utilizing methodologies that incorporate discounted cash flow analyses, price-to-net-tangible-book, and price-to-earnings multiples of certain comparable companies.
In performing its impairment analysis, the Company developed a range of fair values for its insurance and reinsurance reporting units using a discounted cash flow methodology and market multiple methodologies. The discounted cash flow methodology establishes fair value by estimating the present value of the projected future cash flows to be generated from the reporting unit. The discount rate applied to the projected future cash flows to arrive at the present value is intended to reflect all risks of ownership and the associated risks of realizing the stream of projected future cash flows. The discounted cash flow methodology uses the Company’s projections of financial performance for a ten-year period combined with an estimated terminal value. The most significant assumptions used in the discounted cash flow methodology are the discount rate, the terminal value and expected future revenues, gross margins and operating margins, which vary among reporting units.
share price continues to be impacted by the perceived risk associated with both credit and other financial exposures. In particular, analyst reports indicate that the continued general market volatility and uncertainties in the credit markets may disproportionately impact the Company’s investment portfolio due to the weighting of certain asset classes held. For further details on certain risks associated with the Company’s investment portfolio, the Master Agreement and related commutations signed with Syncora, relationships with Rating Agencies and other factors that may be contributing to the downward pressure on the Company’s stock price, see Item 1A, Risk Factors, within this document. These risks combined with the recent downgrades from major rating agencies have increased investor uncertainty regarding the Company’s operating model and overall value. While these factors impact the trading value of the Company’s common shares, management believe that they do not directly impact the stand alone value of the Company’s core property and casualty underwriting reporting units.
After recording the impairments as described above, the Company has goodwill of $824.8 million remaining as at December 31, 2008, of which $426.7 million relates to the Company’s Insurance segment while $398.1 million relates to the Company’s Reinsurance segment. The estimated fair values of these reporting units exceeded their net book values and therefore no further impairments were required.
Net realized losses on investments in the twelve months ended December 31, 2008 included net realized losses of approximately $1,023.6 million related to the write-down of certain of the Company’s fixed income, equity and other investments, including Lehman, where the Company determined that there was an other than temporary decline in the value of those investments, including a charge of $400.0 million related to assets for which the Company could no longer assert its intent to hold until recovery. See below for further information.
During the fourth quarter of 2008, management recorded a charge for OTTI of $400.0 for which it could no longer assert its intent to hold until recovery. Although management believes that these securities are likely to recover to their current amortized cost, it determined that these securities were at risk for further mark-to-market declines, and potentially real economic losses, to the extent that economic conditions were to deteriorate further than present estimates and the Company’s allocation to these asset classes is overweight relative to a traditional P&C portfolio. Accordingly, in conjunction with its risk reduction exercise, management will pursue targeted sales of these assets over the course of 2009. The assets are concentrated in certain holdings within the Company’s BBB and lower corporate, CMBS, equity and consumer ABS portfolios.
The total amount of other than temporary declines in value in 2008 included $912.2 million related to fixed income securities and short-term investments, $109.9 million on equity securities and $1.5 million on other investments. The total amount of other than temporary declines in value in 2007 included $608.3 million related to fixed income securities, $2.6 million on equity securities, and $0.1 million on other investments.
At December 31, 2008, there were $4,122.3 million of gross unrealized losses on fixed maturities and short-term investments, and $7.6 million of gross unrealized losses on equity securities. At December 31, 2007, there were $1,069.5 million of gross unrealized losses on fixed maturities and short-term investments, and $14.9 million of gross unrealized losses on equity securities. At both December 31, 2008 and 2007, approximately 2.5% and 2.3%, respectively, of the fair value of the Company’s fixed income investment portfolio was invested in securities which were below investment grade or not rated. Approximately 8.8% of the unrealized losses in the Company’s fixed income securities portfolio at December 31, 2008 related to securities that were below investment grade or not rated. The information shown below about the unrealized losses on the Company’s investments at December 31, 2008 concerns the potential affect upon future earnings and financial position should management later conclude that some of the current declines in the fair value of these investments are other than temporary declines.
The following is an analysis of how long each of those securities at December 31, 2008 had been in a continual unrealized loss position:
Factors considered in determining that additional OTTI charges were not warranted include management’s consideration of current and near term liquidity needs and other available sources, an evaluation of the factors and time necessary for recovery, and the results of on-going retrospective reviews of security sales and the basis for such sales.
Structured credit securities with gross unrealized losses representing greater than 50% of amortized cost represent $680.1 million of gross unrealized losses, with a fair value of $384.1 million. Of these gross unrealized losses, $621.6 million are rated investment grade. The Company has evaluated each of these holdings on a security-by-security basis in conjunction with its investments managers and utilizing additional corroborative modeling techniques, and believes these securities will satisfy all principal and interest payments. These securities include $305.4 million of Topical investments, $265.9 million of Core CDOs, $69.6 million of prime RMBS and $25.6 million of CMBS holdings.
Corporate securities with gross unrealized losses representing greater than 50% of amortized cost represent $494.5 million of gross unrealized losses, with a fair value of $340.8 million. Of these gross unrealized losses, $394.1 million are rated investment grade. Gross unrealized losses of $238.3 million are related to holdings of financial issuers, with the majority ($190.6 million) representing hybrid instruments. The Company believes these are high-grade issuers which will continue to service their principal and interest obligations. Gross losses of $186.9 million are related to diversified notes for which the Company has evaluated the underlying collateral and believes the notes will fully perform.
Included in the table above are $980.6 million and $1,236.9 million in Tier One and Tier Two securities, representing committed term debt and hybrid instruments senior to the common and preferred equities of the financial institutions, at fair value as at December 31, 2008 and 2007, respectively. These securities have been distributed in the table based on their call date and have net unrealized losses of $637.1 million and $114.0 million as at December 31, 2008 and 2007, respectively.
Certain of the Company’s invested assets are held in trust and pledged in support of insurance and reinsurance liabilities. Such pledges are largely required by the Company’s operating subsidiaries that are “non-admitted” under U.S. state insurance regulations, in order for the U.S. cedant to receive statutory credit for reinsurance. In addition certain deposit liabilities and annuity contracts require the use of pledged assets. As at December 31, 2008 the Company had approximately $13.7 billion in pledged assets.
The Company has invested in certain closed end funds, certain limited partnerships, LLC’s and similar investment vehicles, including funds managed by certain of its investment manager affiliates. Collectively, these investments in funds, partnerships and other vehicles are classified as “investment fund affiliates”. At December 31, 2008, investment fund affiliates totaled $1.2 billion of which $0.9 billion was invested in the alternative investment portfolio and $0.3 billion consisted of private investments. At December 31, 2007, investments affiliates totaled $2.2 billion of which $1.8 billion was invested in the alternative investment portfolio and $0.4 billion consisted of private investments.
The Company’s significant financial operating affiliate investments at December 31, 2007 included Syncora and Primus Guaranty, Ltd. (“Primus”) with ownership of 46.9% and 33.1%, respectively. Given management’s view of the risk exposure, expected losses in 2007 by both Syncora and Primus, along with the uncertainty facing the entire financial guarantee industry, the Company reduced the reported value of its investment in both Syncora and Primus to nil at December 31, 2007. The write down in the Syncora and Primus equity investments in 2007, combined with net losses recorded in the same period under the excess of loss and facultative reinsurance agreements with Syncora of $300.0 million and $51.0 million, respectively, were the primary drivers behind the net loss from financial operating affiliates of $1.2 billion recorded during the year ended December 31, 2007.
Market developments with respect to the monoline industry continued to be largely negative throughout 2008 and during the same period, Syncora was downgraded by several rating agencies. Accordingly, throughout 2008 and up until the closing of the Master Agreement in August 2008 which resulted in the transfer by the Company of all of the shares it owned in Syncora, the Company reported its investment in Syncora at nil and less than the traded market value during this time, as it was believed the decline in value was other than temporary. In addition to the transfer of the Company’s shares it owned in Syncora as described above, under the Master Agreement, the Company paid consideration to Syncora of $1.775 billion
cash as well as eight million ordinary shares valued at $128.0 million. The Master Agreement terminated certain reinsurance and service agreements with Syncora and as a result, related guarantee agreements with Syncora, with the exception of certain exposures relating to the European Investment Bank, no longer had any force or effect. As the total value of the consideration paid to Syncora significantly exceeded the liabilities related to such reinsurances and guarantees, the Company recorded a loss of approximately $1.4 billion, in “net (loss) income from operating affiliates”, in respect of the closing of the Master Agreement in the third quarter of 2008. See Note 4, “Syncora Holdings Ltd” for further details.
While the Company continues to hold its shares in Primus, which continued to be valued at nil, no equity earnings were recorded during 2008 in relation to Primus as a result of the significant losses and negative book value reported by Primus throughout 2008.
The Company’s investment manager affiliates include Highfields Capital Management LP, a global equity investment firm, MKP Capital Management, a fixed income investment manager specializing in mortgage-backed securities, Stanfield Capital Partners, a credit-oriented asset management firm specializing in collateralized loan obligations, OneCapital Management Partners, a diversified alternative investment management firm, Banquo Credit Management LLP, a European-based credit asset management firm, Polar Capital Holdings plc, an investment firm offering traditional and alternative products, Cinnamon Capital Management LLP, an asset management firm that invests in the residuals of European asset backed securities, HighVista Strategies LLC, a diversified wealth management firm, and Finisterre Cayman Limited, an emerging market specialist asset management firm.
During 2006, the Company sold its interest in FrontPoint Partners LLC, an integrated alternative asset firm, resulting in equity earnings of $41.7 million recorded in 2006 related to the initial sale and $32.4 million recorded in 2007, primarily related to the receipt of contingent proceeds and the balance of $2.3 million received in 2008.
In addition to the write downs recorded in 2007 as noted above, during the years ended December 31, 2008, 2007, and 2006, the Company recorded other than temporary declines in the values of certain affiliates totaling $0.2 million, $63.5 million, and $19.8 million, respectively. Such other than temporary declines in 2008, 2007 and 2006 related primarily to investment management affiliates.
Income on unrated tranches of collateralized debt obligations is reflected only to the extent the Company’s principal has been fully recovered. Income on alternative investments included in other investments is realized only on ultimate sale of these investments. The Company had net unrealized gains of $40.8 million and $78.9 million, respectively, at December 31, 2008 and 2007, related to these
In 2006, net favorable prior year reserve development in the Insurance segment was $13.2 million and consisted of reserve releases of $94.4 million in property lines and $91.1 million in casualty lines, partially offset by $96.5 million, $46.5 million and $29.3 million of prior year adverse development in certain professional, marine and other lines of business, respectively. The gross prior year favorable development for the Insurance segment was $371.4 million. This gross favorable development exceeds the corresponding net development as gross reported losses in casualty developed more favorably than net losses. Lower gross reported loss amounts reflect reductions in several large recoverable losses on older years and an absence of new large losses, with consequent reductions to reinsurance recoveries.
Within the Reinsurance segment, net prior year releases of $267.3 million in the year ended December 31, 2007 consisted of $188.7 million primarily in property and other short-tail lines of business and $87.4 million in casualty and other lines, was partially offset by adverse prior year development of $8.8 million within the structured indemnity line of business. Releases in the short-tail lines relate primarily to the 2005 and 2006 accident years. The casualty and other lines favorable development of $87.4 million reflects the net result of releases of $121.4 million primarily in the U.S. and non-U.S. casualty portfolios, partially offset by net adverse development of $13.0 million associated with the results of an external review of the Company’s asbestos and environmental reserves and $21.0 million related to a commutation of a stop loss reinsurance agreement. Favorable gross prior year development of $259.7 million was in line with the net development.
Total net paid losses were $3.8 billion in each of 2008 and 2007, and $3.9 billion and 2006, respectively.
determined using cash flow or similar models to estimate the net present value of the anticipated shortfall between (i) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (ii) anticipated cash flow from the proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries.
During 2006, the Company acquired $40.2 million in losses through a loss portfolio transfer contract of which $18.3 million in losses related to asbestos and environmental claims. Given the terms of the policy,
The Company’s exposure to asbestos and environmental claims arises from contracts written, both on a proportional and excess basis, after 1972. The Company’s predecessor company discontinued writing contracts with these exposures in 1985. Business written was across many different policies, each with a relatively small contract limit. The Company’s reported asbestos claims related to both traditional products and premises and operations coverage.
The estimation of loss and loss expense liabilities for asbestos and environmental exposures is subject to much greater uncertainty than is normally associated with the establishment of liabilities for certain other exposures due to several factors, including: (i) uncertain legal interpretation and application of insurance and reinsurance coverage and liability; (ii) the lack of reliability of available historical claims data as an indicator of future claims development; (iii) an uncertain political climate which may impact, among other areas, the nature and amount of costs for remediating waste sites; and (iv) the potential of insurers and reinsurers to reach agreements in order to avoid further significant legal costs. Due to the potential significance of these uncertainties, the Company believes that no meaningful range of loss and loss expense liabilities beyond recorded reserves can be established. As the Company’s net unpaid loss and loss expense reserves related to asbestos and environmental exposures are less than 1% of the total net reserves at December 31, 2008 and 2007, further adverse development is not expected to be material to the Company’s overall net loss reserves. The Company believes it has made reasonable provision for its asbestos and environmental exposures and is unaware of any specific issues that would significantly affect its estimate for loss and loss expenses.
In February 2009, the Swiss Reinsurance Company entities were downgraded by S&P to “A+” (Stable).
On July 25, 2001, the Company completed the acquisition of certain Winterthur International insurance operations (the “Winterthur Business”) primarily to extend its predominantly North American-based large corporate insurance business globally. Under the terms of the Sale and Purchase Agreement, as amended, between XL Insurance (Bermuda) Ltd and Winterthur Swiss Insurance Company (“WSIC”), (the “SPA”) WSIC provided the Company with post-closing protection with respect to third party reinsurance receivables and recoverables related to the acquisition of certain Winterthur International insurance operations (the “Winterthur Business”). Such protection was provided in the form of Sellers Retrocession Agreements and a Liquidity Facility.
On December 16, 2008, the Company entered into an agreement with AXA Insurance Ltd (the successor company to WSIC) (“AXA”), (the “AXA Agreement”). The AXA Agreement releases to the parties all funds from the Fund that was put in place in June 2006 as described above and releases both parties from all further obligations thereunder. Since the Fund was created, the Company was able to successfully collect more than 95% of such third-party reinsurance receivables on paid claims enabling the Company to agree with AXA to terminate the Fund early.
At December 31, 2008, deposit liabilities include remaining funding agreement contracts as well as reinsurance and insurance deposits. Previously, deposit liabilities included GICs. As at December 31, 2007, the Company had approximately $4.0 billion of deposit liabilities associated with GICs which were correspondingly matched with invested assets. Based on the terms and conditions of the underlying GICs, upon the downgrade of Syncora Guarantee below certain ratings levels, all or portions of outstanding principal balances on such GICs would come due. Throughout 2008, several rating agencies downgraded Syncora and its subsidiaries and, as a result, the Company settled, in 2008 all of the GIC liabilities. In addition, certain funding agreement contracts matured, resulting in the settlement of the underlying principal and accrued interest. At December 31, 2008, the remaining balance of funding agreements, excluding accrued interest of $6.6 million, was $600.0 million, with settlements scheduled as follows: $150.0 million in October 2009 and $450.0 million in August 2010.
Interest expense of $146.6 million, $421.1 million and $350.1 million was recorded related to the accretion of deposit liabilities for the years ended December 31, 2008, 2007 and 2006, respectively.
As at December 31, 2008, the Company had bank and loan facilities available from a variety of sources, including commercial banks, totaling $4.3 billion (2007: $4.0 billion) of which $3.2 billion (2007: $2.9 billion) of debt was outstanding. In addition, the Company has letter of credit facilities totaling $6.9 billion of which $3.7 billion (2007: $3.7 billion) were outstanding as at December 31, 2008 and 3.9% (2007: 4.3%) of which were collateralized by certain of the Company’s investment portfolios, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates’ capital requirements. Of these amounts, $1.0 billion was available in the form of revolving credit or letters of credit.
The fair value of the Company’s notes payable and debt outstanding as at December 31, 2008 and 2007, is estimated to be $1.2 billion and $2.6 billion, respectively, and is based on quoted prices.
The revolving credit facilities were not utilized at December 31, 2007.
The number of ordinary shares to be issued under each purchase contract depends on, among other things, the average market price of the ordinary shares on the settlement date. The maximum number of ordinary shares to be issued under the purchase contracts is approximately 35.9 million. The Company accounts for the effect on the number of weighted average ordinary shares, assuming dilution, using the treasury stock method. The purchase contract component of the 10.75% Units will have no effect on the number of weighted average ordinary shares, assuming dilution, except when the average market price of the Company’s ordinary shares is above the threshold appreciation price of $18.88 per share. Because the average market price of the Company’s ordinary shares during the period the 10.75% Units were outstanding was below this price, the shares issuable under the purchase contracts were excluded from the computation of net income per ordinary share assuming dilution for the year ended December 31, 2008.
On November 30, 2008, the £450 million letter of credit facility issued on November 14, 2007 that was supporting the Company’s syndicates at Lloyd’s of London terminated. However, this facility was structured so that the letters of credit issued on it are effective and support the syndicates for the 2009 underwriting year.
On December 16, 2006, the Company replaced a $100 million credit facility that matured in December 2006 with a new 364-day facility of the same amount.
In December 2005, the Company issued 29.8 million 7.0% Equity Security Units (the “7.0% Units”) in a public offering. Each 7.0% Unit had a stated amount of $25 and consisted of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Company’s Class A ordinary shares on February 15, 2009 and (b) a one-fortieth, or 2.5% in the 2011 Senior Notes. The 2011 Senior Notes were pledged by the holders to secure their obligations under the purchase
contracts. The number of shares issued under the purchase contracts was adjustable based on, among other things, the average share price of the Company for the twenty consecutive trading days ending on the third trading day immediately preceding the stock purchase date and the dividend rate of the Company. In mid- February 2009, the 2011 Senior Notes were remarketed whereby the interest rate was reset in order to generate sufficient remarketing proceeds to satisfy the 7.0% Unit holders’ obligations under the purchase contracts. The Company purchased and retired the aggregate principle amount of the 2011 Senior Notes as a part of that remarketing. On February 15, 2009, the purchase contracts matured and the Company issued Class A ordinary shares in connection therewith. Each purchase contract provided for the sale by the Company of 0.38461 Class A Ordinary shares (the “Shares”) at a price of $25.00. The settlement of the purchase contracts resulted in the Company’s issuance of an aggregate of 11,461,080 Shares for net proceeds of approximately $743.1 million, which was used to retire the 2011 Senior Notes.
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 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 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 also contain minimum consolidated net worth covenants and debt to total capitalization covenants (both of which exclude the impact of unrealized gains and losses on securities).
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 derivative instruments for both risk management and speculative purposes. The Company is exposed to potential loss from various market risks, and manages its market risks based on guidelines established by management. The Company recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value with the changes in fair value of derivatives shown in the consolidated statement of income as “net realized and unrealized gains and losses on derivative instruments” unless the derivatives are designated as hedging instruments. The accounting for derivatives which are designated as hedging instruments is described in Note 2(g), Derivative Instruments. The following table summarizes these instruments by category and the effect on net income in the years ended December 31, 2008, 2007 and 2006:
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 securities 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 twelve months or less. In addition, certain of the Company’s investment managers may, subject to investment guidelines, enter into forward contracts where potential gains may exist. The Company has exposure to foreign currency exchange rate fluctuations through its operations and in its investment portfolio. In relation to foreign exchange contracts, the Company had a net payable of $3.2 million and a net receivable of $0.9 million, at December 31, 2008 and 2007, respectively, and the Company recorded net losses of $73.6 million and $7.5 million and net gains of $42.8 million, during the years ended December 31, 2008, 2007 and 2006, respectively.
hedge an existing position or concentration of holdings. The credit derivatives are recorded at fair value. Following the secondary sale of Syncora common shares, the Company retained some credit derivative exposures written by Syncora and certain of its subsidiaries through reinsurance agreements that had certain derivatives exposures embedded within them. Subsequent to June 6, 2007, the Company received Syncora related derivative fair values from Syncora management and reviewed the methodology applied in developing those estimates. In addition, the change in value of the derivative portion of the financial guarantee reinsurance agreements the Company had with Syncora was included in “Net (loss) income from operating affiliates.” Following the closing of the Master Agreement which terminated certain reinsurance and other agreements, these credit derivative exposures were eliminated by virtue of the commutation of the relevant reinsurance agreements. As of December 31, 2008, the remaining credit derivative exposure outside of the Company’s investment portfolio consisted of 23 contracts written by the Company that provide credit protection on senior tranches of structured finance transactions with total net par values outstanding of $639.5 million, a weighted average contractual term to maturity of 5.7 years, a total liability recorded of $28.6 million, and an average rating of AA on the underlying obligations. As of December 31, 2008, there were no reported events of default on the underlying obligations.
Valuation of investment related credit derivatives is based on portfolio manager sourced valuations. In determining the fair value of credit derivatives written within financial operations, 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 appropriate market indices are not readily available. Accordingly, the Company uses an alternative fair value methodology. Under this methodology, the fair value is determined using a cash flow model developed by the Company which 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. For certain credit derivatives sold within the Financial Solutions business providing protection on senior tranches of structured finance transactions, the fair values are obtained directly from the investment bank counterparty. In general, the Company holds credit derivatives to maturity. Accordingly, changes in the fair value of such credit derivatives are unrealized.
The Company holds warrants in conjunction with certain of its other investments. These warrants are recorded at fair value based on quoted market prices, where available.
In addition, the Company enters into derivatives as part of its contingent capital facilities including put options, interest rate swaps, and asset return swaps. These derivatives are recorded at fair value with changes in fair value recognized in earnings.
embedded derivative is bifurcated from the funds withheld balance and recorded at fair value with changes in fair value recognized in earnings through net realized and unrealized gains and losses on derivative instrument. The change in fair value recorded for these agreements was not material for any of the years ended December 31, 2008, 2007 or 2006.
On December 5, 2006, the Company and certain operating subsidiaries (“Ceding Insurers”) entered into a securities issuance agreement (the “Securities Issuance Agreement”), and certain of its foreign insurance and reinsurance subsidiaries (“Ceding Insurers”) entered into an excess of loss reinsurance agreement (the “Reinsurance Agreement”) with Stoneheath Re (“Stoneheath” or the “Issuer”). The net effect of these agreements to the Company is the creation of a contingent put option in the amount of $350.0 million in the aggregate. The agreements provide the Company with a Reinsurance Collateral Account in support of certain Covered Perils named in the Reinsurance Agreement. The Covered Perils will include United States wind, European wind, California earthquake and terrorism worldwide. The covered perils as well as the attachment points and aggregate retention amounts may be changed by the Ceding Insurers in their sole discretion. This may result in a material increase or decrease in the likelihood of payment under the Reinsurance Agreement. On each date on which a Ceding Insurer withdraws funds from the Reinsurance Collateral Account, the Company shall issue and deliver to the Issuer an amount of XL Capital Ltd Series D Preference Shares having an aggregate liquidation preference that is equal to the amount of funds so withdrawn from the Collateral Account. The Company is obligated to reimburse Stoneheath for certain fees and ordinary expenses. The initial term of the Reinsurance Agreement was for the period from the Closing Date through June 30, 2007, with four annual mandatory extensions through June 30, 2011 (unless coverage is exhausted thereunder prior to such date). The Ceding Insurers may thereafter extend the Reinsurance Agreement at their option for additional calendar quarters without limit (unless coverage is exhausted there under). The contingent put option is recorded at fair value with changes in fair value recognized in earnings. For the year ended December 31, 2008, a charge of $8.2 million was recorded in relation to this option. The Stoneheath Preferred Securities and, if issued, the XL Capital Ltd Series D Preference Shares will pay dividends on a non-cumulative basis at a fixed rate of 6.868% per annum through October 15, 2011 and thereafter at a floating rate based on 3-month LIBOR, plus 3.12%.
Concurrent with the execution of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent capital facility entered into in July 2003, resulting in net proceeds to the Company of approximately $500 million in exchange for the issuance by the Company of 20,000,000 Series C Preference Ordinary Shares, par value U.S. $0.01 per share (the “Series C Preference Shares”).
The Company’s reinsurance assets at December 31, 2008 and 2007 amounted to $4.6 billion and $5.5 billion respectively and resulted from reinsurance arrangements in the course of its operations. A credit exposure exists with respect to reinsurance assets as they may be uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound, and if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.
In addition, the Company underwrites a significant amount of its insurance and reinsurance property and casualty business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances to the Company. During the three years ended December 31, 2008, 2007 and 2006, approximately 17%, 18% and 18%, respectively, of the Company’s consolidated gross written premiums from property and casualty operations were generated from or placed by Marsh & McLennan Companies. During 2008, 2007 and 2006, approximately 17%, 17% and 16%, respectively, of the Company’s consolidated gross written premiums from property and casualty operations were generated from or placed by AON Corporation and its
subsidiaries. Both of these companies are large, well established companies and there are no indications that either of them is financially troubled. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written from property and casualty operations in any of the three years ended December 31, 2008, 2007, or 2006.
The Company has committed to invest in several limited partnerships as part of its overall corporate strategy. As of December 31, 2008, the Company has commitments which include potential additional add-on clauses, to invest a further $46.8 million over the next five years.
The Company owns a minority interest in certain closed-end funds, certain limited partnerships and similar investment vehicles, including funds managed by those companies. The Company has commitments, which include potential additional add-on clauses, to invest a further $57.7 million over the next five years.
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 $129.3 million and $160.8 million, and deferred a gain of $34.2 million and $48.9 million related to this lease at December 31, 2008 and 2007, respectively. The gain is being amortized to income in line with the amortization of the asset. The future minimum lease payments in the aggregate are expected to be $242.9 million and annually for the next five years are as follows:
At December 31, 2008 and 2007, $3.7 billion of letters of credit were outstanding, of which 3.9% and 4.3%, respectively, were collateralized by the Company’s investment portfolios, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates’ capital requirements.
The Company is subject to litigation and arbitration in the normal course of its business. These lawsuits and arbitrations principally involve claims on policies of insurance and contracts of reinsurance and are typical for the Company and for the property and casualty insurance and reinsurance industry in general. Such legal proceedings are considered in connection with the Company’s loss and loss expense reserves. Reserves in varying amounts may or may not be established in respect of particular claims proceedings based on many factors, including the legal merits thereof. In addition to litigation relating to insurance and reinsurance claims, the Company and its subsidiaries are subject to lawsuits and regulatory actions in the normal course of business that do not arise from or directly relate to claims on insurance or reinsurance policies. This category of business litigation typically involves, amongst other things, allegations of underwriting errors or misconduct, employment claims, regulatory activity, shareholder disputes or disputes arising from business ventures. The status of these legal actions is actively monitored by management. If management believed, based on available information, that an adverse outcome upon resolution of a given legal action was probable and the amount of that adverse outcome was reasonable to estimate, a loss would be recognized and a related liability recorded. No such liabilities were recorded by the Company at December 31, 2008 and 2007. In addition, the Company believes that the expected ultimate outcome of all outstanding litigation and arbitration will not have a material adverse effect on its consolidated financial condition, operating results and/or liquidity, although an adverse resolution of one or more of these items could have a material adverse effect on the Company’s results of operations in a particular fiscal quarter or year. The following information highlights ongoing legal proceedings related to the Company.
In November 2006, a subsidiary of the Company received a grand jury subpoena from the Antitrust Division of the U.S. Department of Justice (“DOJ”) and a subpoena from the SEC, both of which sought documents in connection with an investigation into the municipal guaranteed investment contract (“GIC”) market and related products. In June 2008, subsidiaries of the Company also received a subpoena from the Connecticut Attorney General and an Antitrust Civil Investigative Demand from the Office of the Florida Attorney General in connection with a coordinated multi-state Attorneys General investigation into the matters referenced in the DOJ and SEC subpoenas. The Company is fully cooperating with these investigations.
From time to time, the Company has also received and responded to additional requests from Attorneys General, state insurance regulators and federal regulators for information relating to the Company’s contingent commission arrangements with brokers and agents and/or the Company’s insurance and reinsurance practices in connection with certain finite-risk and loss mitigation products. Similarly, the Company’s affiliates outside the U.S. have, from time to time, received and responded to requests from regulators relating to the Company’s insurance and reinsurance practices regarding contingent commissions or finite-risk and loss mitigation products. The Company has fully cooperated with the regulators in these matters.
In August 2005, plaintiffs in a proposed class action (the “Class Action”) that was consolidated into a multidistrict litigation in the United States District Court for the District of New Jersey, captioned In re Insurance Brokerage Antitrust Litigation, MDL No. 1663, Civil Action No. 04-5184 (the “MDL”), filed a consolidated amended complaint (the “Amended Complaint”), which named as new defendants
approximately 30 entities, including Greenwich Insurance Company, Indian Harbor Insurance Company and XL Capital Ltd. In the MDL, the Class Action plaintiffs asserted various claims purportedly on behalf of a class of commercial insureds against approximately 113 insurance companies and insurance brokers through which the named plaintiffs allegedly purchased insurance. The Amended Complaint alleged that the defendant insurance companies and insurance brokers conspired to manipulate bidding practices for insurance policies in certain insurance lines and failed to disclose certain commission arrangements and asserted statutory claims under the Sherman Act, various state antitrust laws and the Racketeer Influenced and Corrupt Organizations Act (“RICO”), as well as common law claims alleging breach of fiduciary duty, aiding and abetting a breach of fiduciary duty and unjust enrichment. By Opinion and Order dated August 31, 2007, the Court dismissed the Sherman Act claims with prejudice and, by Opinion and Order dated September 28, 2007, the Court dismissed the RICO claims with prejudice. The plaintiffs then appealed both orders to the U.S. Court of Appeals for the Third Circuit. Oral argument before the appellate court is expected in April 2009.
Three purported class actions on behalf of shareholders of Syncora have been filed in the Southern District of New York against the Company and one of its subsidiaries (collectively “XL”), Syncora, four Syncora officers, and various underwriters of Syncora securities. The Judge ordered that these be consolidated. The consolidated amended complaint, filed in August 2008, alleges violations of the Securities Act of 1933 arising out of the secondary public offering of Syncora common shares held by XL on June 6, 2007 and sales/exchanges by Syncora of certain preferred shares as well as under the Securities Exchange Act of 1934 arising out of trading in Syncora securities during the asserted class period of March 15, 2007 to March 17, 2008. The principal allegations are that Syncora failed to appropriately and timely disclose its exposures under certain derivative contracts and insurance of tranches of structured securities. XL is named as a party that “controlled” Syncora during the relevant time period. On October 14, 2008, XL and other defendants filed motions to dismiss the consolidated amended complaint. Plaintiffs filed opposition briefs on December 22, 2008, and XL and the other defendants filed reply briefs on February 5, 2009. The Company intends to vigorously defend these actions.
The authorized share capital is 999,990,000 ordinary shares of a par value of $0.01 each, 20,000,000 Series C preference ordinary shares of par value $0.01 each, 350,000 Series D preference shares of par value $0.01 each, and 1,000,000 Series E preferable ordinary shares of par value $0.01 each. Holders of Class A ordinary shares are entitled to one vote for each share. All ordinary shares in issue at December 31, 2008 are Class A ordinary shares.
Includes share repurchases associated with authorized share repurchase programs as well as purchases related to satisfying tax withholding obligations of employees in connection with the vesting of restricted shares granted under the Company’s restricted stock plan.
Shares (the “Series B Preference Shares”) for approximately $25.26 per Series B Preference Share including accrued dividends. The aggregate redemption price was approximately $290.5 million.
Concurrent with the execution of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent capital facility entered into in July 2003, resulting in net proceeds to the Company of approximately $500 million in exchange for the issuance by the Company of 20,000,000 Series C Preference Ordinary Shares, par value U.S. $0.01 per share (the “Series C Preference Shares”). The liquidation preference of the Series C Preference Shares is $25 per share, plus accrued and unpaid dividends. The Company may redeem the Series C Preference Shares, in whole or in part, on or after July 15, 2013, at a redemption price of $25 per share, plus accrued and unpaid dividends. The Company may, under certain circumstances, redeem the Series C Preference Shares before July 15, 2013 at specific redemption prices, plus accrued and unpaid dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Series C Preference Shares are entitled to a class vote ($26 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Series C Preference Shares ($25 per share redemption price). The Series C Preference Share may be redeemed by the holders after July 15, 2033. Until July 15, 2013, dividends on the Series C Preference Shares are payable semiannually on a cumulative basis, when, as and if declared by the Company’s Board of Directors, on January 15 and July 15 of each year at a fixed rate equal to 6.102% per annum on the liquidation preference. From and after July 15, 2013, dividends on the Series C Preference Shares are payable quarterly on a cumulative basis, when, as and if declared by the Company’s Board of Directors, on January 15, April 15, July 15 and October 15 of each year at a floating rate equal to three-month LIBOR plus 3.145% on the liquidation preference. The Series C Preference Shares have no stated maturity and are not subject to any sinking fund or mandatory redemption and are not convertible into any of the Company’s other securities.
On February 27, 2009, the Company initiated a cash tender offer for all of the outstanding Series C Preference Shares.
The Company’s 1999 Performance Incentive Program for Employees (the “1999 Program”) provides for grants of non-statutory stock options, restricted stock, performance shares and performance units to employees of the Company and its subsidiaries who are not subject to the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934. The 1999 Program is administered by the Board of Directors of the Company or the Compensation Committee, as determined from time to time by the Board of Directors. See Note 21(d), “Share Capital - Options”, for additional disclosures of stock option awards.
A second stock plan is provided for the directors that grants share units equal to their annual retainer divided by the 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 21,899, 8,688, and 8,410 were issued in 2008, 2007 and 2006, respectively. Total units are granted as shares upon retirement from the Board.
A stock plan is also maintained for non-employee directors. Options expire ten years from the date of grant and are fully exercisable as of the grant date.
In connection with the Syncora IPO during 2006, the Company and Syncora offered eligible employees of Syncora the opportunity to exchange all of their outstanding unvested restricted Class A Ordinary Shares of the Company and options to purchase Class A Ordinary Shares of the Company, which were awarded to
such employees under the Company’s plans prior to the IPO, for a long term incentive plan award (the “Syncora LTIP Award”) from Syncora to be granted under Syncora’s Plan (the “Exchange Offer”). Elections under the Exchange Offer became effective on December 12, 2006. Based on the final count of the depositary for the offer, 443,532 eligible options and 97,144 shares of eligible restricted stock of the Company were exchanged under the Exchange Offer and Syncora issued Syncora LTIP Awards with an aggregate target amount of $4.6 million and $6.8 million, respectively. In the Company’s financial statements prior to 2007, these options and restricted stock exchanged under the Exchange Offer were included in the cancelled and forfeited line items in the continuity schedules disclosed for stock options and unvested restricted stock, respectively. In conjunction with the execution of the Master Agreement on August 5, 2008, all remaining unvested restricted stock and options not previously exchanged under the Exchange Offer by eligble employees of Syncora were forfeited and canceled.
Apart from the Exchange Offer, awards of restricted stock and stock options under the Company’s plans to certain senior executives and officers of Syncora were involuntarily converted to Syncora options and restricted stock awards at the IPO date. The aggregate values of such awards at the IPO date were $2.6 million and $2.2 million for stock options and restricted stock, respectively.
The risk free interest rate is based on U.S. Treasury rates. The expected lives are estimated using the historical exercise behavior of grant recipients. The expected volatility is determined based upon a combination of the historical volatility of the Company’s stock and the implied volatility derived from publicly traded options.
The exercise price of the Company’s options granted is the market price of the Company’s Class A ordinary shares on the grant date, except that during 2004, 295,000 options were granted with an exercise price of $88.00 and the market price was $77.10.
During 2008, 2007, and 2006, the Company granted 1,349,620, 645,438 and 798,862 shares, respectively, of its restricted common stock to its directors and employees related to incentive compensation plans, with a weighted average grant date fair value per share of $37.61, $70.89 and $66.54, respectively. During the years ended December 31, 2008, 2007, and 2006, $57.6 million, $49.7 million and $56.2 million, respectively, was charged to compensation expense related to restricted stock awards. Total unrecognized stock based compensation expense related to non-vested restricted stock awards was approximately $64.2 million as of the end of December 31, 2008, related to approximately 1.9 million restricted stock awards, which is expected to be recognized over 2.6 years.
The Company’s Articles of Association restrict the voting power of any person to less than approximately 10% of total voting power.
The Company’s Rights Plan expired in accordance with its terms on September 30, 2008. Rights to purchase Class A ordinary shares (the “Rights”) were distributed as a dividend at the rate of one Right for each Class A ordinary share held of record as of the close of business on October 31, 1998. Each Right entitled holders of Class A ordinary shares to buy additional ordinary shares with a value of $700 at the then current market price, at an exercise price of $350. The Rights would have been exercisable, and would have detached from the Class A ordinary shares, only if a person or group were to have acquired 20% or more of the Company’s outstanding Class A ordinary shares, or were to have announced a tender or exchange offer that, if consummated, would have resulted in a person or group beneficially owning 20% or more of Class A ordinary shares. Upon a person or group without prior approval of the Board acquiring 20% or more of Class A ordinary shares, each Right would have entitled the holder (other than such an acquiring person or group) to purchase Class A ordinary shares (or, in certain circumstances, Class A ordinary shares of the acquiring person) with a value of twice the Rights exercise price upon payment of the Rights exercise price. The Company would have been entitled to redeem the Rights at $0.01 per Right at any time until the close of business on the tenth day after the Rights became exercisable.
The Company has qualified defined contribution plans which are 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 five years. The Company’s expenses for its qualified contributory defined contribution retirement plans were $43.3 million and $46.5 million at December 31, 2008 and 2007, respectively.
A qualified non-contributory defined benefit pension plan exists to cover a number of its U.S. employees. This plan also includes a non-qualified supplemental defined benefit plan designed to compensate individuals to the extent that their benefits under the Company’s qualified plan are curtailed due to Internal Revenue Code limitations. Benefits are based on years of service and compensation, as defined in the plan, during the highest consecutive three years of the employee’s last ten years of employment. Under these plans, the Company’s policy is to make annual contributions to the plan that are deductible for federal income tax purposes and that meet the minimum funding standards required by law. The contribution level is determined by utilizing the entry age cost method and different actuarial assumptions than those sued for pension expense purposes.