The Company operates in Bermuda, the United States, Europe and various other locations around the world. In 1997, the Company acquired commercial real estate in Hamilton, Bermuda for the purpose of securing long-term office space for its worldwide headquarters. The development was completed in April 2001. The total cost of this development, including land, was approximately $126.6 million. The Company has subsequently sub-leased portions of this property as a part of its broader expense reduction initiatives.
In July 2003, the Company acquired new offices at 70 Gracechurch Street, London, which have become the Company’s new London headquarters. The acquisition was made through a purchase, sale and leaseback transaction. The move to the new offices was completed in 2004 and consolidated the Company’s London businesses in one location. The capital lease asset and liability associated with this transaction totaled $118.0 million at December 31, 2009.
Effective April 1, 2009 the Company adopted final authoritative guidance that addressed the treatment of credit losses on investments. This guidance was not applied retroactively. For additional information see Item 8, Note 2(r) to the Consolidated Financial Statements “Recent Accounting Pronouncements”.
The Company has grown through acquisitions and development of new business opportunities. Acquisitions included Global Capital Re in 1997, Mid Ocean Limited in 1998, ECS, Inc. and NAC Re Corp. in 1999, Winterthur International in 2001 and Le Mans Re in 2002. All acquisitions were entered into in order to further support the Company’s strategic plan to develop a global platform in insurance and reinsurance. The Company competes as an integrated global business and at December 31, 2009 employed 3,565 employees in 24 countries. For further information in relation to the Company’s Operations, see Item 1, Business.
Given the challenging economic environment that has been experienced throughout 2008 and 2009 including the downgrade of the financial strength ratings of the Company’s leading insurance and reinsurance subsidiaries by leading rating agencies, the Company shifted focus to those lines of business
While the actions taken in 2009 have impacted both gross and net premiums written, the Company’s decision to focus on those lines of business that provide the best return on capital was successfully implemented. In fact, indications from recent underwriting activity highlight that renewals from the Company’s European book, where just less than 50% of the book renews on January 1, were strong across all product lines, particularly casualty, at 88%, and property, at 86%. Pricing based on the January 2010 renewals continued to show rate improvement with an aggregate rate increase of 1% compared to rate declines in January 2009 of minus 2%.
Looking ahead for the remainder of 2010, while the reinsurance market remains disciplined, the segment is impacted by the competitive conditions already outlined in the insurance segment above. The reinsurance segment will continue its philosophy of disciplined underwriting and will shrink the portfolio if market conditions do not warrant deploying capital.
During the year ended December 31, 2009, financial market conditions continued to be extremely volatile, characterized by increasing long term global interest rates over the course of the year, combined with deterioration in credit markets early in the year, followed by rallies in credit markets in the latter half of the year. There was also significant quarter-to-quarter volatility during the year. The Company’s results of operations and investment portfolio during the year ended December 31, 2009 were impacted by these trends. Net investment income yields were negatively impacted as a result of lower short-term interest rates, particularly U.S. LIBOR, on floating rate assets, higher allocations to lower yielding government, agency and cash securities as a result of the Company’s derisking efforts, and reduced prevailing yields on reinvestment income. Net realized losses resulted from sales transactions in relation to the Company’s “de-risking” efforts, and other- than-temporary impairment charges relating to the deterioration of future cash flow estimates, particularly in the non-agency RMBS and medium-term notes asset classes. Net unrealized losses for the Company declined as a result of both the mark-to-market impact of the credit rally during the year and the impact of realized losses on the year, offset by the effect of increasing interest rates. For further information, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Investment Activities”
Net investment income related to property and casualty operations, excluding structured products, decreased by $114.7 million during the year ended December 31, 2008, as compared to 2007. Overall, investment portfolio yields decreased in 2008 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 overall during 2008. The investment portfolio mix also changed as a result of the settlement of the GIC and funding agreement 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 accordingly, net investment income is more sensitive to changes in short-term interest rates. The Company also increased allocations to lower yielding cash, government and agency RMBS investments.
Book value per ordinary share decreased by $34.83 in the year ended December 31, 2008 as compared to a decrease of $2.72 during 2007. 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
As noted above, fully diluted book value per ordinary share represents book value per ordinary share combined with the impact from dilution of share based compensation including in-the-money stock options at any period end. Fully diluted book value per ordinary share increased by $9.14 and decreased by $34.83 during the years ended December 31, 2009 and 2008, respectively, as a result of the factors noted above.
In 2008, ROE was negative, mainly as a result of the impact of the closing of the Master Agreement in August 2008 as described above, the goodwill impairment charge recorded in late 2008, as well as from catastrophe losses, net realized losses on investments and losses from the Company’s investment fund affiliates during the year ended December 31, 2008.
impact of the closing of the Master Agreement (discussed below) in August 2008 and the impact in 2007 of the Company’s investment in and relationships with Syncora;
impact of increased property risk and catastrophe activity in 2008 and limited property risk catastrophe activity in 2009 and 2007;
redemption of a portion of the Company’s Series C Preference Ordinary Shares;
1. Impact of credit market movements in 2009, 2008 and 2007 on the Company’s investment portfolio and investment fund affiliates
quarters of the year. The net impact of the market conditions on the Company’s investment portfolio for the year resulted in a decrease in net unrealized losses on available for sale investments as compared to December 31, 2008 of $2.1 billion. This represents approximately a 4.5% appreciation on average assets for the year ended December 31, 2009.
Of the $921.4 million, there was net realized losses of $406.6 million related to credit impairments on structured credit securities. Primarily these represented below investment grade non-Agency RMBS, including those with sub-prime and Alt-A collateral. A further $226.9 million in net realized losses related to impairments of medium term notes backed primarily by investment grade European credit and $160.6 million of impairments related primarily to the intent to sell certain Tier One and Upper Tier Two securities. The remaining impairment during the year was spread across the investment portfolio including equities and other fixed income investments. Consistent with prior years, management continues to evaluate the impairment of the investment portfolio and satisfy itself that the remaining gross unrealized losses are temporary in nature.
Given management’s view of the risk exposure along with the uncertainty facing the entire financial guarantee industry in the latter part of 2007, the Company reduced the reported value of its investment in Syncora to nil at December 31, 2007, from the reported equity method value of $669.8 million as at September 30, 2007. In addition, net losses were recorded in 2007 within “loss from operating affiliates” with respect to the previous excess of loss and facultative reinsurance of Syncora subsidiaries in the amounts of $300.0 million and $51.0 million, respectively. In addition, during 2007, the Company incurred $17.9 million in additional mark-to-market losses related to those underlying contracts in credit default swap form subject to the provisions noted above.
Soft market conditions were experienced across most lines of business throughout 2007, 2008 and 2009, resulting in an overall decrease in gross and net premiums written. For further information in relation to the underwriting environment, including details relating to rates and retention, see “Executive Overview - Underwriting Environment”, above.
The following table presents the net (favorable) adverse prior year loss development of the Company’s loss and loss expense reserves for its property and casualty operations which include the Insurance and Reinsurance segments for each of the years indicated:
During 2009, net favorable prior year development totaled $284.7 million in the Company’s property and casualty operations and included net favorable development in the Insurance and Reinsurance segments of $62.9 million and $221.8 million, respectively. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 12 to the Consolidated Financial Statements, “Losses and Loss Expenses”, for further information regarding the developments in prior year loss reserve estimates for each of the years indicated within each of the Company’s operating segments.
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 unit goodwill associated with the merger of Mid Ocean Limited (“Mid Ocean”) in 1998. The fair value of the Mid Ocean reporting unit was calculated using the methodologies as described within “Critical Accounting Policies and Estimates” below, 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,” and see further discussion under “Critical Accounting Policies and Estimates”.
7. Redemption of a portion of the Company’s Series C Preference Ordinary Shares
On March 26, 2009, the Company completed a cash tender offer for its outstanding Series C Preference Ordinary Shares that resulted in approximately 12.7 million Series C Preference Ordinary Shares with a liquidation value of $317.3 million being purchased by the Company for approximately $104.7 million plus accrued and unpaid dividends, combined with professional fees totaling $0.8 million. As a result, a book value gain to ordinary shareholders equity of approximately $211.8 million was recorded.
During the third quarter of 2008 and the first quarter of 2009, expense reduction initiatives were implemented in order to reduce the Company’s operating expenses. The goal of these initiatives 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 reductions in 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 authoritative guidance over accounting for costs associated with exit or disposal activities and guidance over 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. 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. For the years ended December 31, 2009 and 2008 costs incurred in relation to the restructuring and asset impairment charges noted above are $81.5 million and $50.8 million, respectively. These charges have been recorded in the Company’s income statement under “Operating Expenses”. See Item 8, Note 5 to the Consolidated Financial Statements, “Restructuring and Asset Impairment Charges”, for further information regarding the actual and expected costs for each of the years indicated within each of the Company’s operating segments.
Throughout the latter part of 2008 and 2009 and into 2010, the Company remains focused on, among other things, simplifying the Company’s business model to focus on core property and casualty business and enhancing its enterprise risk management capabilities. Details relating to these initiatives are highlighted below.
In relation to this top management priority, certain initiatives that have taken place or are underway include the following:
The Company estimates that its derisking efforts within the P&C investment portfolio are now approximately 80% complete in terms of the potential mark-to-market that would arise from a repeat of the credit crisis of January 2007 to March 2009. The estimated mark to market represents estimated modeled portfolio level results, rather than individual security level results. Although the actual P&C investment portfolio lost approximately $4.0 billion of mark to market over this period, it is estimated that the P&C investment portfolio, as structured at December 31, 2009, would have lost $1.6 billion over this period. The Company’s target P&C SAA benchmark would have lost approximately $1.0 billion over the same period. As a result of this progress, the Company will now focus on optimizing the P&C investment portfolio, as compared to its previous focus on pure de-risking. Accordingly, the remaining positions in legacy asset classes such as Agency RMBS and
Core CDO’s are most likely to be reduced through natural bond maturities and opportunistic sales based on underlying fundamentals and economics.
Management reduced the aggregate CMBS and non-Agency US RMBS (includes sub-prime, Alt-A, second lien, ABS CDO’s, and Prime assets) portfolio holdings significantly, through maturities and paydowns and certain opportunistic sales by $2.2 billion during 2009 ($4.6 billion cumulatively since 2008), in particular $1.4 billion in the CMBS portfolio. As well, the aggregate corporate portfolio was reduced by $1.8 billion during 2009 ($2.9 billion cumulatively since 2008).
Management reduced overall exposure to hybrid bank capital securities by $126.0 million and reinvested those proceeds in higher quality issues.
In addition, management also reduced exposure to $51.0 million of other investment grade and below investment grade securities as market opportunities presented.
While the Company seeks to reduce the overall risk within its P&C and Life investment portfolios, it will continue to attempt to balance investment returns against market and credit risks taken. Market risk may arise due to interest rate variability and exposure to foreign denominated currencies, which the Company seeks to manage through asset/liability management, and due to the allocation to non-fixed income assets, including global equity securities and alternative investments, which the Company seeks to manage through diversification. Credit risk arises from investments in fixed income securities and is managed with aggregate and portfolio limits and by establishing minimum credit quality guidelines. The Company guidelines require a minimum Aa3/AA - weighted-average rating for its fixed income portfolio.
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.
Following the settlement of the purchase contracts associated with the 7.0% ESUs in February 2009, the Company issued 11,461,080 Shares for net proceeds of approximately $743.1 million, which was used to retire the senior notes previously due February 2011 which had a fixed coupon of 5.25% (the “2011 Senior Notes”).
In February 2009, the Board of Directors approved a 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 paid in March 2009.
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 experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. Loss reserves include:
a) Case reserves - reserves for reported losses and loss expenses that have not yet been settled; and
The Company’s actuaries utilize one set of assumptions in determining its single point estimate, which includes actual loss data, loss development factors, loss ratios, reported claim frequency and severity. The actuarial reviews and documentation are completed in accordance with professional actuarial standards with reserves established on a basis consistent with US GAAP. The selected assumptions reflect the actuary’s judgment based on historical data and experience combined with information concerning current underwriting, economic, judicial, regulatory and other influences on ultimate claim settlements.
Over time, as a greater number of claims are reported, actuarial estimates of IBNR are based on the BF and loss development techniques. The BF method utilizes actual loss data and the expected patterns of loss emergence, combined with an initial expectation of ultimate losses to determine an estimate of ultimate losses. This method may be appropriate when there is limited actual loss data and a relatively less stable pattern of loss emergence. The chain ladder method utilizes actual loss and expected patterns of loss emergence to determine an estimate of ultimate losses that is independent of the initial expectation of ultimate losses. This method may be appropriate when there is a relatively stable pattern of loss emergence and a relatively larger number of reported claims. Multiple estimates of ultimate losses using a variety of actuarial methods are calculated for each of the Company’s (150+) classes of business for each year of loss experience. The Company’s actuaries look at each class and determine the most appropriate point estimate based on the characteristics of the particular class and other relevant factors, such as historical ultimate loss ratios, the presence of individual large losses, and known occurrences that have not yet resulted in reported
Reinsurance operations by their nature add further complications to the reserving process, particularly for casualty business written, in that there is an inherent lag in the timing and reporting of a loss event
The Company’s net unpaid losses and loss expenses relating to the Company’s operating segments at December 31, 2009 and 2008 was as follows:
The ratio of IBNR to total reserves has increased in recent years due to the growth of casualty and professional 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 (including professional) 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).
Property catastrophe IBNR includes event specific reserves for losses that the Company’s insureds and cedants have informed it they expect to incur but have not yet had reported known claims.
insured by the Company, changes in the litigation environment that decrease claim awards, filings or verdicts, and/or unexpected decreases in loss inflation.
The Company’s methodology in 2009 for calculating reserve ranges around its single point reserve estimate is consistent with that used in 2008. 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 distribution parameters 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.
The development of a reserve range models the uncertainty of the claim environment as well as the limited predictive power of past loss data. These uncertainties and limitations are not specific to the Company. The ranges represent an estimate of the range of possible outcomes over a one year development period. A range of possible outcomes should not be confused with a range of best estimates. The range of best estimates will generally be much narrower than the range of possible outcomes as it will reflect reasonable actuarial best estimates of the expected reserve.
Reserve volatility was analyzed for each line of business (excluding structured indemnity) within each of the Reinsurance and Insurance segments using the Company’s historical data supplemented by industry data. These ranges were then aggregated to the lines of business shown above taking into account correlation between lines of business. The practical result of the correlation approach to aggregation is that the ranges by line of business disclosed above, are narrower than the sum of the ranges of the individual lines of business. Similarly, the range for the Company’s total reserves in the aggregate, is narrower than the sum of the ranges for the lines of business disclosed above.
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Segments” below for further discussion on prior year development of loss reserves.
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 $4.6 billion and $4.4 billion at December 31, 2009 and 2008 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 $34 million increase in the value of future claims related to annuity portfolio reinsurance.
The Company also provides reinsurance of disability income protection, for an in-force block of business. The future policy benefit reserves for these contracts amounted to approximately $94 million and $97 million at December 31, 2009 and 2008, respectively. Future policy benefit reserves include the lock-in of assumptions at inception with periodic review against experience. The liabilities relate to in-force blocks of business, comprising underlying insurance policies that provide an income if the policyholder becomes sick or disabled. The liabilities are therefore driven mainly by the rates at which policyholders become sick (where sickness is defined by the policy conditions) and by the rates at which these policyholders recover or die. A 1% increase in the incidence rate would increase the value of future claims by approximately $1.6 million, while a 1% decrease in the termination rate would increase the value of future claims by approximately $3.0 million. While no changes to the locked-in assumptions were made in 2009 or in 2008, following a review of claim termination experience in 2007, the reserving assumptions were revised, resulting in a reduction in income of $10.0 million during the year.
The Company also provides reinsurance of term assurance and critical illness policies written in the U.K., Ireland and the US. The future policy benefit reserves for these contracts amounted to approximately $229 million and $279 million at December 31, 2009 and 2008, respectively. $23 million of this reduction resulted from the sale of the U.S. life reinsurance business, XL Re Life America Inc. $124 million of this reduction resulted from the novation and recapture of a number of U.K. and Irish term assurance and critical illness treaties, which was offset by increases in reserves due to new business, ageing of the portfolio and the weakening of the U.S. dollar against the U.K. Pound Sterling and Euro in 2009. Future policy benefit reserves include the lock-in of assumptions at inception with periodic review against experience. The provisions for adverse deviation in these reserves amounted to approximately $20 million and $25 million at December 31, 2009 and 2008, respectively.
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 $259 million and $254 million at December 31, 2009 and 2008, respectively. Future policy benefit reserves are established in accordance with the provisions of general authoritative guidance on accounting for insurance enterprises, including the lock-in of assumptions at inception with periodic review against experience.
The liabilities relate to in-force blocks of business, which are comprised of underlying insurance policies that provide mainly lump sum benefits if the policyholder dies. The liabilities are therefore driven by the rates of mortality, and a 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $9 million. The liabilities are also affected by lapse experience, and a 1% decrease in lapse rates relative to the reserving assumption would increase the reserve by approximately $1.5 million. While no changes to the locked-in assumptions were made in 2009 or in 2008, following a review of mortality and lapse experience in 2007, the locked-in assumptions were revised, resulting in a reduction in income of $25.4 million during the year.
The Company held credit derivative exposures through a limited number of contracts written as part of the Company’s previous financial lines businesses, and through the Company’s prior reinsurance agreements with Syncora, as described below. 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. 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 during August 2008, as described in Item 8, Note 4, to the Consolidated Financial Statements “Syncora Holdings Ltd.” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, which terminated certain reinsurance and other agreements, these credit derivative exposures were eliminated by virtue of the commutation of the relevant reinsurance agreements.
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.”
Credit loss on structured credit securities is determined through a comparison of the security’s discounted cash flow to the amortized cost of the security. To the extent that the discounted cash flow is estimated to be lower than the amortized cost of the security, the security is impaired to the discounted cash flow value of all security cash flows, including both coupon and principal repayment, discounted at the original security coupon, or for certain securities, the rate which represents the current yield of the securities.
upon default. Loan loss severities depend on the borrower, geographic location and loan to value characteristics of the underlying collateral. The Company estimates that loss severities will range from 40-60% for sub prime and Alt-A loans and 10-20% for Prime loans. These cumulative losses results are then compared to the level of subordination within the Company’s holdings to measure if impairment exists.
Optimistic/pessimistic cases assuming assets have a default rate equivalent to 1 rating notch higher/lower than their current rating and if on positive/negative watch then 2 notches higher/lower than their current rating
A market implied scenario based on the current asset market price, assuming that lower priced loans have a higher default rate
Credit losses on corporate securities are generally determined on an individual security basis. The Company reviews the circumstances and conditions associated with its credit issuers, including considering credit rating and forecast operating and financing activities of the issuer, and will make a determination as to whether it believes the issuer is likely to fully meet its contractual principal and interest obligations. To
the extent the Company does not believe the issuers will meet these obligations, it recognizes a credit loss as the difference between amortized cost and the estimated present value of cash flows expected to be received. The Company reviews the ability to pay at the lowest tier (i.e. most subordinated) of the capital structure at which it holds securities, and to the extent it is satisfied in the performance of the lower tier, concludes that any more senior tiers are also likely to meet obligations.
The company evaluates separately credit losses associated with below investment grade hybrid securities, representing Tier One and Upper Tier Two perpetual preferred securities that have been rated below investment grade by at least one major rating agency. The Company completes a debt-based impairment review, including an analysis of whether these securities are expected to meet their obligations, and whether the issuer has the ability to call these obligations at their call date. In addition, the Company uses an equity-impairment model to evaluate these holdings, including assessing the expected recovery period of the securities, the length of time these securities have been rated below investment grade, and whether alternative ratings were available that indicates these securities remain investment grade, or only slightly below investment grade. In addition, the Company evaluates the likelihood of how various governments have treated the perpetual preferred shareholdings in the event of government intervention in these institutions’ operations or management’s decision to defer calls or coupons.
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 $314.0 million and $317.3 million against which a valuation allowance of $220.7 million and $224.3 million at December 31, 2009 and 2008, respectively, was established. The Company had capitalized realized and unrealized capital losses of approximately $262.4 million and $32.3 million, respectively, against which a valuation allowance of approximately $294.7 million at December 31, 2009 was established. Included within the capitalized realized losses are $168.7 million of losses arising from the sale of investments to a group company, against which a valuation allowance of $168.7 million has been established. The deferral of benefits from tax losses is evaluated based upon management’s estimates of the future profitability of the Company’s taxable entities based on current forecasts, the character of income and the period for which losses may be carried forward. A valuation allowance may have to be established for any portion of a deferred tax asset that management believes will not be realized. Should the future income of these entities fall below expectations, a further valuation allowance would have to be established, which could be significant. In addition, if any further losses are generated by these entities, these losses may not be tax affected.
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 issued final authoritative guidance on goodwill and other intangible assets, 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 in accordance with the authoritative guidance on intangibles and goodwill. For the reinsurance segment, a
For further detailed information, see Item 8, Note 7 to the Consolidated Financial Statements, “Goodwill and Other Intangible Assets.”
At December 31, 2009 and 2008, the amount of premiums receivable related to the Company’s reinsurance operations amounted to $1.8 billion and $1.7 billion, respectively.
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
Excluding prior year development, the loss ratio for the year ended December 31, 2009 decreased by 6.8 loss percentage points as compared 2008 due primarily to lower levels of large property risk and catastrophe losses occurring in 2009 combined with the impact of anticipated sub prime and credit related losses in 2008. These decreases were partially offset by increased current year loss ratios in certain casualty lines including US risk management. The remainder of the benefit was attributable to better loss experience on the excess and surplus lines of business as compared to 2008.
strengthening were reserve releases from the casualty primary business due to better than expected loss activity from the more recent accident years, and US risk management lines due to greater reliance on actual loss experience over initial target loss ratios.
For professional lines, net prior year development was $70.4 million favorable, primarily as a result of lower incurred activity than expected based on the Company’s prior valuation in global D&O lines, primarily for underwriting years 2002 to 2006. This release was partially offset by strengthening of global E&O reserves primarily in the 2000 and 2001 years due to large claims. In addition, there was a reallocation of subprime and related credit crisis reserves from the 2007 to 2008 report year to better reflect the indications of our latest exposure-based reserve analysis for these years.
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 2008 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 the property line of business, 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 of $305.5 million for the year ended December 31, 2008 was mainly attributable to the following:
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 0.6 points (17.2% 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.
Fee income decreased in 2009 as compared to 2008 mainly as a result of lower engineering fee income associated with the Company’s loss prevention consulting services business coupled with other expenses in professional lines due to the cost of the National Indemnity facility. Fee income increased in 2008 as compared to 2007 mainly as a result of higher engineering fee revenue associated with XL GAPS.
The following table presents the ratios for the Reinsurance segment for the last three years ended December 31:
Excluding prior year development, the loss ratio for the year ended December 31, 2009 decreased by 14.8 loss percentage points as compared to an increase in the same period in 2008 with 11.3 loss ratio points attributable primarily to the impact of catastrophe losses occurring in 2008 compared to 2009. Losses related to 2009 catastrophes included Hailstorm Wolfgang, Japan Earthquake, Windstorm Klaus, Typhoon Ketsana, Asian Earthquake/Tsunami and Australian Wildfires. 2008 catastrophes included losses related to Hurricanes Ike & Gustav, Midwest Floods, Windstorm Emma, China Snowstorm, Australian Floods, Greece Earthquake, China Earthquakes and Hailstorm Detmold.
$46.2 million in favorable property catastrophe development due to lower than expected loss development, particularly on the 2008 underwriting year and $12.3 million in reserve reductions for several 2005 natural catastrophe events including European floods, windstorm Erwin and California wildfires.
$21.0 million in favorable casualty development related primarily to the European General Liability and UK Motor portfolios in underwriting years 2004-2007.
The increase in the underwriting expense ratio in the year ended December 31, 2009, as compared to 2008, was due to an increase in both operating expense and acquisition expense ratios to 12.0% and 21.8%, respectively, as compared with 9.5% and 19.2%, in 2008. Despite the marginal increase in operating expenses, there was a disproportionately larger increase in the operating expense ratio due to a greater percentage decrease in net premiums earned. The increase in the acquisition expense ratio relates to changes in the mix of business, increased commissions associated with the U.S. agricultural program as well as increased profit related commissions associated with certain Bermuda-based property catastrophe business.
The decrease in the underwriting expense ratio in the year ended December 31, 2008, as compared with the same period in 2007, was due to a decrease in the acquisition expense ratio of 1.7 points (19.2% compared to 20.9%) and was partially offset by an increase in the operating expense ratio of 0.6 points (9.5% compared to 8.9%). The decrease in the acquisition expense ratio was primarily due to a favorable variance in performance-related commissions in 2008 as compared to 2007. Although operating expenses were lower in the year ended December 31, 2008 as compared to the same period in 2007, the lower level of net premiums earned as noted above caused an increase in the operating expense ratio. The decrease in operating expenses was mainly as a result of a bad debt provision and higher performance related compensation expenses both recorded in 2007 and was partially offset by the impact in 2008 of costs associated with the Company’s restructuring activities as well as administrative expenses associated with the expansion of the Company’s reinsurance operations in Brazil.
Fee income decreased by $3.1 million during 2009 as compared to 2008 mainly as a result of fees associated with capacity utilization with certain Lloyd’s syndicates in 2008 that were not repeated in 2009. 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.
Gross premiums written relating to total life business decreased by $114.8 million in the year to December 31, 2009 as compared to the same period in 2008 mainly due to $79.7 million of lower renewal premiums associated with the short-term life, accident and health business as the renewal rights for this business were sold in late 2008. In addition, while premium growth of $25.6 million was experienced in the core underlying book of term assurance and critical illness business, unfavorable foreign exchange rate movements of $33.7 million more than offset such growth during the year. Partially offsetting these decreases was premium growth of $3.2 million related to U.S. life business. Gross premiums written relating to annuity business decreased by $30.2 million during the year, mainly due to unfavorable exchange rate movements of $26.5 million. While gross premiums written decreased during the year to December 31, 2009, ceded premiums written increased slightly by $2.2 million mainly as a result of the 100% retrocession ratio of the small amount of short-term life, accident and health business underwritten in the 2009 underwriting year, which occurred as part of the sale of the renewal rights as noted above.
While in 2009 and 2008 the Company’s Life Operations did not assume any new long duration single premium annuity portfolios, gross and net premiums written, net premiums earned and claims and policy benefits in the year ended December 31, 2007 included the assumption of one Irish immediate annuity portfolio bound, for which net premium earned totaled $94.6 million.
The Company acquired cash and investment assets related to the future policy benefit reserves assumed at inception of this large contract.
Net premiums earned in the year ended December 31, 2009 decreased 14.6% as compared to the same period in 2008 and in the year ended December 31, 2008 decreased by 7.3% as compared to the same period in 2007. The decrease in 2009 and 2008 were consistent with the movements in total gross and net premiums written as described above.
Changes in claims and policy benefit reserves were generally consistent with movements in gross and net premiums written. Claims and policy benefit reserves decreased by $91.4 million or 11.9% in the year ended December 31, 2009 as compared to the same period in 2008, primarily as a result of the factors noted above affecting gross and net premiums written. Claims and policy benefit reserves decreased by $119.7 million or 13.5% in the year ended December 31, 2008 as compared to the same period in 2007, primarily as a result of the factors noted above affecting gross and net premiums written, combined with a loss recognition adjustment of $25.4 million recorded in 2007 relating to certain novated blocks of U.S.-based term life mortality reinsurance business and partially offset by higher incurred losses of $11.5 million associated with certain short-term life, accident and health business.
Acquisition costs in 2008 increased by 5.9% as compared to the same period in 2007, largely as a result of the growth in regular premium business as noted above and partially offset by a favorable profit commission adjustment associated with the short-term life, accident and health business and favorable foreign exchange rate impacts. Operating expenses decreased by 4.8% in the twelve months ended December 31, 2008 as compared to the same period in the prior year mainly due to lower performance-based compensation expenses and a decrease in professional fees as a result of costs recorded in 2007 related to an actuarial loss reserve review.
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 $50.6 million or 13.2% in the year ended December 31, 2009, as compared to the same period in 2008, primarily as a result of negative foreign exchange rate and yield impacts and partially offset by higher net investment income associated with growth in the average size of the investment asset balances and higher capital allocated to the Life operations. However, it should be noted that, as at December 31, 2009, approximately $0.4 billion of the gross unrealized losses on the Company’s investments related to portfolios of Life Operations investment assets primarily as a result of increases in credit spreads during this period, primarily in the U.K. and Euro-zone, and the long duration of the underlying assets. Refer to “Balance Sheet Analysis” below for further discussion of unrealized losses and gains on investments.
Net investment income decreased by $7.2 million or 1.9% in 2008 as compared to 2007, primarily as a result of negative foreign exchange rate impacts and partially offset by increases in the average size of investment asset balances as a result of putting in more capital.
The following table illustrates the change in net investment income from property and casualty operations, net income (loss) from investment fund affiliates, net realized (losses) on investments, and net
Net investment income related to property and casualty operations decreased in the year ended December 31, 2009 as compared to the same period in 2008 due primarily to declining portfolio yields. Overall, investment portfolio yields have decreased as a result of the impact of declines in short-term U.S. interest rates, and particularly the impact of decreased U.S. Dollar Libor on the Company’s floating rate securities previously supporting the GIC and funding agreement business. In addition, the Company increased its holdings in lower-yielding cash, government and agency securities in connection with its portfolio de-risking efforts as the Company re-aligns its portfolio to one more in line with a P&C portfolio and to increase liquidity.
Net income from investment fund affiliates includes earnings from the Company’s investments in closed-end investment funds and partnerships and similar vehicles that are equity accounted.
Net income from investment fund affiliates in the year ended December 31, 2009 resulted from the significant improvement in market sentiment and rallies in risk assets. Credit sensitive and relative value managers particularly benefited from tightening credit spreads and normalization of previously dislocated relative value relationships. Volatility remained high relative to historical levels, allowing alternative managers to be more opportunistic and take advantage of pricing dislocations, but offset by the negative mark-to-market in its private investment portfolio reflecting fair value adjustments, particularly from fourth quarter of 2008.
Performance on the alternative portfolio reflects the twelve months ended November 30, 2009 and 2008, respectively.
Net realized losses on investments in the twelve months ended December 31, 2009 included net realized losses of approximately $812.5 million related to the write-down of certain of the Company’s fixed income, equity and other investments, as compared to $1.0 billion for the year ended December 31, 2008. Impairment charges to March 31, 2009 include charges of OTTI related to the non-credit impairment of unrealized losses. From April 1, 2009, as a result of changes in GAAP, the non-credit impairment is excluded from net impairments. In addition, included in the net realized losses noted above are net realized losses of $131.9 million from sales of investments and net realized losses of $10.9 million from the sale of the U.S. life reinsurance business.
The significant assumptions and inputs associated with the net impairment charges of $812.5 million consist of:
In addition, the Company recorded impairments totaling $226.9 million for the year ended December 31, 2009 in relation to medium term notes backed primarily by investment grade European credit. Management has concluded that, following credit spread movements during 2009, future yields within the supporting collateral were not sufficient to support the previously reported amortized cost.
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.
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.
Net realized and unrealized losses on investment derivatives for the years ended December 31, 2009, 2008 and 2007 resulted from the Company’s investment strategy to manage interest rate risk, foreign exchange risk and credit risk, and to replicate permitted investments. Derivative losses in 2009 relate primarily to the impact of tightening credit spreads on certain credit derivatives purchased within the investment portfolio. In 2008, derivative losses were driven by foreign currency exchange losses recognized on a Sterling forward currency contract hedging US dollar assets supporting Sterling liabilities in the life operations during the year. In 2007, the results were driven 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 underlying the capital notes, combined with mark-to-market losses associated with the Company’s capital, investment and hedging activities.
For a further discussion see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” and “- Liquidity and Capital Resources.”
Equity earnings from financial operating affiliates increased during the year ended December 31, 2009 as compared to the same period of 2008 as a result of the Company’s disposition of its interest in Syncora. During the year ended December 31, 2008, the Company recorded $1.4 billion in losses related to reinsurance and guarantee arrangements with Syncora. Net losses from financial operating affiliates in 2007 include the results and related write-downs associated with Syncora and Primus Guaranty Ltd as well as the impact of losses recorded on previous reinsurance transactions with Syncora. 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”).”
Corporate operating expenses decreased by 35.9% during the year ended December 31, 2009 as compared to 2008 primarily as a result of the cost savings achieved from the restructuring activities implemented in 2008 and early 2009 as well as higher professional fees associated with the capital raise and associated costs related to the Master Agreement that was executed in July 2008. For further information, see Note 5 to the Consolidated Financial Statements, “Restructuring and Asset Impairment Charges.”
Interest expense from property and casualty operations includes costs related to the Company’s debt and collateral facilities as well as certain deposit liability accretion. Interest expense for the year ended December 31, 2009 as compared to the same period in 2008 was lower mainly as a result of lower interest associated with the retirement of the 2011 Senior Notes in February 2009 partially offset by interest
associated with 8.25% senior notes which are part of the 10.75% Equity Security Units issued in August 2008. Interest expense for the year ended December 31, 2008 as compared to the same period in 2007 was lower primarily due to costs associated with the retirement of the 2009 Senior Notes recorded in 2007, lower interest expense as a result of the early redemption, in August 2008, of X.L. America, Inc.’s 6.58% Notes and was partially offset by interest expense associated with the 10.75% Equity Security Units (the “10.75% Units”) issued in August 2008. For more information on the Company’s financial structure, see “Liquidity and Capital Resources.”
At December 31, 2009 and 2008, total investments, cash and cash equivalents, accrued investment income and net receivable for investments sold were $35.9 billion and $34.3 billion, respectively. The following table summarizes the composition of the Company’s invested assets at December 31, 2009 and 2008:
The Company reviews on a regular basis its issuer concentration, credit quality and compliance with established guidelines. At December 31, 2009 and 2008, 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, 2009, approximately 55.2% of the fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net receivable for investments sold) was rated “AAA” by one or more of the principal ratings agencies. Approximately 3.5% of the fixed income portfolio was below investment grade or not rated.
At December 31, 2009, the Company had net unrealized losses on available for sale fixed maturities and short-term investments of $1,276.3 million and net unrealized gains on equity securities of $5.4 million. Of these amounts, gross unrealized losses on fixed maturities and short-term investments and equities were $1,847.9 million and $0.4 million, respectively. At December 31, 2008, the Company had net unrealized losses on fixed maturities and short-term investments of $3,388.6 million and net unrealized gains on equity securities of $24.1 million. Of these amounts, gross unrealized losses on fixed maturities and short-term investments and equities were $4,122.3 million and $7.6 million, respectively. The impact of tightening credit spreads during the twelve months ended December 31, 2009 was the primary reason for the improvement in the net unrealized position on fixed maturities and short-term investments combined with net realized losses over the course of the year, offset by the impact of increasing government rates. The information shown below about the unrealized losses on the Company’s investments at December 31, 2009
and 2008 may affect 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.
At December 31, 2009 and 2008, the following table sets forth the maturity profile of the fixed income securities that were in a gross unrealized loss position:
The following table details the Company’s corporate credit exposures by certain asset classes as well as ratings levels within the Company’s aggregate fixed income portfolio and the current net unrealized (loss) position as at December 31, 2009 and 2008:
At December 31, 2009, approximately $1.7 billion of the Company’s $3.9 billion in corporate financial sector securities was held in the portfolios supporting the Company’s life reinsurance business. Management completed a strategic review of the Company’s life reinsurance business, which are now in run-off. The assets associated with that business are more heavily weighted towards longer term securities from financial institutions, including Tier 1 and Upper Tier 2 securities, with a fair value of $0.7 billion representing committed term debt and hybrid instruments senior to the common and preferred equity of the financial institutions, and accounted for $175.9 million of the Company’s net unrealized loss as at December 31, 2009. As at December 31, 2009, subordinated debt securities (including Lower Tier Two) had a fair value of $0.5 million and a net unrealized loss of $54.3 million. As at December 31, 2009 approximately 42.7% of the overall sensitivity to interest rate risk and 36.2% to credit risk was related to the Life investment portfolio, despite these portfolios accounting for only 19.0% of the Company’s aggregate fixed income portfolio.
Topical assets represent non-agency RMBS securities with sub-prime, Alt-A, second lien or ABS CDO collateral.
The following table details the current exposures to Topical Assets and Core CDOs within the Company’s fixed income portfolio as well as the current net unrealized gain (loss) positions as at December 31, 2009 and December 31, 2008:
Of the total Topical Assets with fair value exposure as at December 31, 2009 and December 31, 2008 of $0.7 billion and $1.0 billion, respectively, approximately $32.8 million and $40.5 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, 2009, 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 90.9% would have remained investment grade at such date. In addition, of the Company’s aggregate fixed income portfolio as at December 31, 2009 and December 31, 2008, of $33.9 billion and $31.9 billion, respectively, less than 2% were guaranteed by such third parties with no individual third party representing more than 1%. In assessing these securities for other-than-temporary impairment, the Company reviews forecasted cash flows from the underlying collateral only, and does not assume that any payment will be made by these third party guarantors.
During the year ended December 31, 2008, 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 the Other Financial Lines segment investment portfolios as well as the general investment portfolio. 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 Topical Assets and core CDOs, with a fair value of $1.4 billion which it has primarily transferred to the general portfolio.
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 $3.9 billion of the Company’s total gross unrealized loss position of $4.1 billion at December 31, 2008:
Included within Corporate are certain floating rate medium term notes supported primarily by pools of European credit with varying degrees of leverage. The notes have a fair value of $499.0 million and an amortized cost of $922.7 million. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.
Structured credit securities with gross unrealized losses representing greater than 50% of amortized cost account for $379.4 million of gross unrealized losses, with a fair value of $202.3 million. Of these gross unrealized losses, $112.0 million are rated investment grade. The Company has evaluated each of these holdings on a security-by-security basis in conjunction with its investment manager service providers and utilizing additional corroborative modeling techniques, and believes these securities will provide adequate principal and interest payments to satisfy the current amortized cost. These securities include $213.1 million
of Topical assets, $131.1 million of Core CDOs, $1.2 million of prime RMBS and $12.8 million of CMBS holdings.
As noted in Item 8, Note 2 to the Consolidated Financial Statements, “Significant Accounting Policies,” the determination of the amount of OTTI varies by investment type and is based upon management’s periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management considers a wide range of factors about the security issuer and uses their best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near- term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Management updates its evaluations regularly and reflects additional impairments in net income as determinations are made. Management’s determination of the amount of the impairment taken on investments is highly subjective and could adversely impact the Company’s results of operations. There can be no assurance that management has accurately assessed the level of OTTI taken and reflected in the Company’s financial statements. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments.
As disclosed in Note 3 to the Consolidated Financial Statements, “Fair Value Measurements”, effective January 1, 2008, the Company adopted the authoritative guidance on fair value measurements and has accordingly provided required disclosures by level within the fair value hierarchy of the Company’s assets and liabilities that are carried at fair value. As defined in the hierarchy, those assets and liabilities categorized as Level 3 have valuations determined using unobservable inputs. Unobservable inputs may include the entity’s own assumptions about market participant assumptions, applied to a modeled valuation, however, this is not the case with respect to the Company’s Level 3 assets and liabilities. The vast majority of the assets and liabilities classified as 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 were not obtained to support a Level 2 classification or the Company utilized internal valuation models.
At December 31, 2009, certain assets which were previously classified as Level 3 assets due to a lack of observable market data are now classified as Level 2 assets due to sufficient market data now being available to determine a price and to allow the use of broker quotes.
The Company performs quarterly reviews of the prices received from its third party valuation sources to assess if the prices represent a reasonable estimate of the fair value. This process is completed by investment and accounting personnel who are independent of those responsible for obtaining the valuations. The approaches taken to gain comfort include, but are not limited to, comparing valuations between 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.
Refer to Notes 2 and 3 of the Consolidated Financial Statements, “Significant Accounting Policies” and “Fair Value Measurements” for a description of the valuation methodology utilized to value Level 3 assets and liabilities, how the valuation methodology is validated as well as further details associated with various assets classified as Level 3. As at December 31, 2009, the Company did not have any liabilities that were carried at fair value based on Level 3 inputs other than derivative instruments in a liability position at December 31, 2009.
The Other investments balance excludes certain structured transactions including certain investments in project finance transactions, a payment obligation (as described in Note 11, “Other Investments”), and has provided liquidity financing to a structured credit vehicle as a part of a third party medium term note facility. These investments are carried at amortized cost that totaled $365.6 million at December 31, 2009 and $94.8 million at December 31, 2008.
As at December 31, 2009, the balance of Level 3 assets as a percentage of the Company’s total assets that were carried at fair value was 1.7%. The comparable percentage at December 31, 2008 was 4.5%. The decrease was primarily as a result of a change in the mix of assets during 2009. During 2009, the Company recorded the fair value of CDO holdings based upon pricing service valuations where available due to increased volumes of trading and increased new issuance of CDOs, resulting in transfers being recorded from Level 3 to Level 2.
Unpaid losses and loss expense recoverables were $3.7 billion and $4.0 billion at December 31, 2009, and 2008, respectively. At December 31, 2009 and 2008, reinsurance balances receivable were $0.5 billion and $0.6 billion, respectively. The table below presents the Company’s net reinsurance recoverable and reinsurance balances receivable at December 31, 2009 and 2008:
The Company has credit risk should any of its reinsurers be unable or unwilling to settle amounts due. Of the $4.0 billion total unpaid losses and loss expenses recoverable and reinsurance balances receivable at December 31, 2009, one 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 $1.7 billion at December 31, 2009, 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, 2009 and 2008, the Company had a reserve for potential non-recoveries from reinsurers of $189.8 million and $187.6 million, respectively.
As a holding company, XL Capital Ltd has no operations of its own and its assets consist primarily of its investments in its subsidiaries. Accordingly, XL Capital Ltd’s future cash flows largely depend on the availability of dividends or other statutorily permissible payments from its subsidiaries. The ability to pay such dividends is limited by the applicable laws and regulations of the various countries and states in which XL Capital Ltd’s subsidiaries operate, including, among others, Bermuda, New York, Ireland, Switzerland and the United Kingdom. See Item 8, Note 26 to the Consolidated Financial Statements, “Statutory 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.
XL Capital Ltd’s principal uses of liquidity are for dividend payments to holders of its ordinary shares and preferred shares, interest and principal payments on debt, capital investments in its subsidiaries and corporate operating expenses.
As at December 31, 2009, the consolidated Company had cash and cash equivalents of approximately $3.6 billion as compared to approximately $4.4 billion at December 31, 2008. 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. However, as a result of the combination of current soft market conditions, the decision to put the life segment and certain P&C lines into run-off and lower investment yields, operating cash flows excluding extraordinary events are expected to be lower than prior years. Cash receipts from operations is generally derived from the receipt of investment income on the Company’s 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, requiring the establishment of 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.
During the year ended 2008, net cash flows used in operating activities were $427.3 million primarily as a result of the payment of approximately $1.8 billion to Syncora under the Master Agreement. The Company funded the payment to Syncora by using proceeds from the offering of both ordinary shares and ESUs, as well as from the proceeds received following the exercise by the Company of the put option under its Mangrove Bay contingent capital facility as described below. Excluding the payment to Syncora, net cash flows from operations was approximately $1.3 billion in 2008. For the same period in 2007, net cash flows from operations was $2.2 billion. The decrease in net cash flow from operations, excluding the payment to Syncora, was primarily a result of decreases in net premiums written in the Company’s P&C operations as described above and of lower net investment income related to both P&C operations and structured products mainly due to a lower asset base and changes in the portfolio mix following the sale of assets used to settle the GIC liabilities. In addition, yields earned on investment of cash flows and
Total net paid losses were $3.9 billion in 2009 and $3.8 billion in each of 2008 and 2007, respectively. Net losses incurred were $3.2 billion, $4.0 billion and $3.8 billion in 2009, 2008 and 2007, respectively.
Generally, positive cash flow from operations and financing activities is invested in the Company’s investment portfolio, including affiliates or acquisition of subsidiaries.
Net cash provided by investing activities of $3.8 billion in 2008 was mainly associated with the sale and redemption of the Company’s investments in fixed maturities, short-term investments and equity securities. The sales of such securities exceeded related purchases, due mainly to the sale of assets used to settle the GIC liabilities and as a result of the Company’s intention to reposition its investment portfolio and increase its holdings of cash as well as government agency holdings.
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, 2009 and 2008, the Company had $16.7 billion and $13.7 billion in pledged assets, respectively.
In order to fund the payment of approximately $1.8 billion to Syncora under the Master Agreement and the payment of approximately $283 million to consummate the redemption of X.L. America, Inc.’s 6.58% Notes, the Company raised approximately $2.8 billion in August 2008 through an issuance of both ordinary shares and ESUs. 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”). For further details on these transactions, see “Capital Resources”, below.
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, 2008, 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, which were transferred to the general investment portfolio in exchange for those assets that were liquidated. At December 31, 2009, the remaining balance of funding agreements, excluding accrued interest of $6.5 million, was $450 million, with the full balance scheduled for settlement 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 2007, the Company repurchased approximately $1.1 billion of ordinary shares through its share repurchase programs and issued approximately $825.0 million of ordinary shares in connection with the maturity of the purchase contracts associated with the 6.5% Equity Security Units. In addition, the Company issued Series E preference ordinary shares for $1 billion and redeemed both its Series A and Series B preference ordinary shares for $230.0 million and $287.5 million, respectively. With regards to debt transactions in 2007, the Company purchased and retired the 2009 Senior Notes for $825.0 million in connection with the 6.5% Units and issued the 2027 Senior Notes for gross proceeds of approximately $324.4 million. In 2007, dividends paid were $274.0 million for ordinary shares and $69.5 million for preferred shares. In 2007, the Company paid out $360.0 million of net cash relating to deposit liability contracts.
The Company is considered a Well Known Seasoned Issuer (“WKSI”) under the rules of the SEC. The Company maintains a shelf registration statement on Form S-3 and is eligible for automatically effective future registration statements for the potential offering and sale of an unlimited amount of debt and equity securities. The Registration Statement allows for the following types of securities to be offered: (i) debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, (ii) preferred securities of any of one or more capital trusts organized by the Company and guarantees of such securities by the Company and (iii) debt securities of XL Capital Finance (Europe) plc and guarantees of such securities by the Company.
In addition the Company maintains letter of credit facilities which provide liquidity. Details of these facilities are described below in “Capital Resources.”
The following risks are associated with the Company’s requirement to renew its credit facilities:
the credit available from banks may be reduced resulting in the Company’s need to pledge its investment portfolio to customers. This could result in a lower investment yield;
the volume of business that the Company’s subsidiaries that are not admitted in the U.S. are able to transact could be reduced if the Company is unable to renew its letter of credit facilities at an appropriate amount.
The following table summarizes the components of the Company’s current capital resources at December 31, 2009 and 2008:
The following table reconciles the opening and closing common equity positions at December 31, 2009 and 2008:
“In Use” and “Outstanding” data represent December 31, 2009 accreted values. “Payments Due by Period” data represent ultimate redemption values.
In addition, see Note 16 to the Consolidated Financial Statements, “Notes Payable and Debt Financing Arrangements” for further information.
$600 million senior notes due September 2014, with a fixed coupon of 5.25%. The security is publicly traded. The notes were issued in two tranches of $300 million aggregate principal amount each-one tranche at 99.432% and the other at 98.419%. Aggregate gross proceeds were $593.6 million. Related expenses of the offering amounted to $4 million.
As at December 31, 2009 the Company’s preferred share capital is made up of $1.0 billion Series E Preference ordinary shares and $182.7 million Series C Preference ordinary shares. As at December 31,
2008 the company’s preferred share capital is made up of $1.0 billion Series E Preference ordinary shares and $500 million Series C Preference ordinary shares.
On March 26, 2009, the Company completed a cash tender offer for its outstanding Series C Preference Ordinary Shares that resulted in approximately 12.7 million Series C Preference Ordinary Shares with a liquidation value of $317.3 million being purchased by the Company for approximately $104.7 million plus accrued and unpaid dividends, combined with professional fees totaling $0.8 million. As a result, a book value gain of approximately $211.8 million was recorded in the first quarter of 2009 to ordinary shareholders. In addition, see Note 21 to the Consolidated Financial Statements, “Share Capital” for further information.
At December 31, 2009, the Company has one contingent capital transaction where the outstanding put option has not been exercised. No up-front proceeds were received by the Company under this transaction. In the event that the associated irrevocable put option agreement is exercised, proceeds previously raised from investors from the issuance of pass-through trust securities would be received in return for the issuance of preferred shares. See below for further details on this transaction.
At December 31, 2009, the Company had six letter of credit facilities in place with total availability of $7.25 billion, of which $3.0 billion was utilized.
On December 14, 2009, 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. This was replaced by a $750 million bilateral secured letter of credit facility.
The following outlines the covenant requirements and actual amounts as of December 31, 2009:
Secured indebtedness excludes secured letter of credit facilities as permitted under the schedules to the credit facilities. At December 31, 2009, such secured letter of credit facilities amounted to $642.8 million.
Covenants require that, none of the XL Capital Group, XL Insurance (Bermuda) Ltd or XL Re Ltd have financial strength ratings of less than “A-” from A.M. Best. The financial strength ratings as at December 31, 2009 were - XL Capital Group, “A” (Stable), XL Insurance (Bermuda) Ltd “A” (Stable) and XL Re Ltd “A” (Stable).
As noted in the table above, at December 31, 2009, the Company was in compliance with all covenants by significant margins and the Company currently remains in compliance.
The following table presents the Company’s long term contractual obligations and related payments as at December 31, 2009, due by period. This table excludes further commitments of $134.4 million to the Company’s related investment funds and certain limited partnerships, and letter of credit facilities of $3.0 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.
Future policy benefit reserves related to Life operations were $5,490,119 on the Company’s Consolidated Balance Sheet at December 31, 2009. Amounts reflected above include an allowance for future premiums in respect of contracts under which premiums are payable throughout the life of the underlying policy. The value of the discount is also included for those lines of business that have reserves where future claim payments and future premium receipts can be estimated using actuarial principles. The timing and amounts of actual claims payments and premium receipts related to these reserves vary based on the underlying experience of the portfolio. Typical elements of the experience include mortality, morbidity and persistency. The ultimate amount of the claims payments and premium receipts could differ materially from the Company’s estimated amounts.
The unpaid loss and loss expenses were $20,823,524 on the Company’s Consolidated Balance Sheet at December 31, 2009. The difference from the amount included above relates to the discount on payments due in the future for certain workers compensation lines. The timing and amounts of actual claims payments related to these P&C 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.
The agreements provide the Company with a Reinsurance Collateral Account in support of certain covered perils named in the Reinsurance Agreement. The covered perils include United States wind, European wind, California earthquake and terrorism worldwide. After an initial three-month period, 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 thereafter through June 30, 2011 (unless coverage is exhausted there under 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. The Stoneheath preferred securities and, if issued, the XL 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%.
The Company has performed an evaluation of subsequent events through March 1, 2010, which is the date the financial statements were issued.
Details on assets and liabilities that have been included under the requirements of authoritative guidance on fair value measurements to illustrate the bases for determining the fair values of these items held by the Company are detailed in each respective significant accounting policy section of this note.
Investments that are considered available for sale (comprised of the Company’s fixed maturities, equity securities and short-term investments) are carried at fair value. The fair values for available for sale investments are generally sourced from third parties. The fair value of fixed income securities is based upon quoted market values where available, “evaluated bid” prices provided by third party pricing services (“pricing services”) where quoted market values are not available, or by reference to broker or underwriter bid indications where pricing services do not provide coverage for a particular security. To the extent the Company believes current trading conditions represent distressed transactions, the Company may elect to utilize internally generated models. The pricing services use market approaches to valuations using primarily Level 2 inputs in the vast majority of valuations, or some form of discounted cash flow analysis, to obtain investment values for a small percentage of fixed income securities for which they provide a price. Pricing services indicate that they will only produce an estimate of fair value if there is objectively verifiable
information available to produce a valuation. Standard inputs to the valuations provided by the pricing services listed in approximate order of priority for use when available include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data. The pricing services may prioritize inputs differently on any given day for any security, and not all inputs listed are available for use in the evaluation process on any given day for each security evaluation; however, the pricing services also monitor market indicators, industry and economic events. Information of this nature is a trigger to acquire further corroborating market data. When these inputs are not available, they identify “buckets” of similar securities (allocated by asset class types, sectors, sub-sectors, contractual cash flows/structure, and credit rating characteristics) and apply some form of matrix or other modeled pricing to determine an appropriate security value which represents their best estimate as to what a buyer in the marketplace would pay for a security in a current sale. While the Company receives values for the majority of the investment securities it holds from pricing services, it is ultimately management’s responsibility to determine whether the values received and recorded in the financial statements are representative of appropriate fair value measurements. It is common industry practice to utilize pricing services as a source for determining the fair values of investments where the pricing services are able to obtain sufficient market corroborating information to allow them to produce a valuation at a reporting date. In addition, in the majority of cases, although a value may be obtained from a particular pricing service for a security or class of similar securities, these values are corroborated against values provided by other pricing services.
Broker quotations are used to value fixed maturities where prices are unavailable from pricing services due to factors specific to the security such as limited liquidity, lack of current transactions, or trades only taking place in privately negotiated transactions. These are considered Level 3 valuations, as significant inputs utilized by brokers may be 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.
Prices provided by independent pricing services and independent broker quotes can vary widely even for the same security. The use of different methodologies and assumptions may have a material effect on the estimated fair value amounts. During periods of market disruption including periods of significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain of the Company’s securities, for example, collateralized loan obligations (“CLOs”), Alt-A and sub-prime mortgage backed securities, if trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes that were in active markets with significant observable data that become illiquid due to the current financial environment. In such cases, more securities may fall to Level 3 meaning that more subjectivity and management judgment is required with regard to fair value. As such, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods which are more sophisticated or require greater estimation, thereby resulting in values which may be different than the value at which the investments may be ultimately sold.
Short-term investments comprise investments with a remaining maturity of less than one year and are valued using the same external factors and in the same manner as fixed income securities.
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. 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.
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 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. Significant influence is considered for other strategic investments on a case- by-case basis. Investments in affiliates are not subject to fair value measurement guidance as they are not considered to be fair value measured investments under U.S. GAAP. However, impairments associated with investments in affiliates that are deemed to be other-than-temporary are calculated in accordance with fair value measurement guidance and appropriate disclosures included within the financial statements during the period the losses are recorded.
or loss on investments, net of tax, is included in “Accumulated other comprehensive income (loss)”. Any unrealized loss in value considered by management to be other than temporary is charged to income in the period that it is determined.
The Company has periodically written retroactive loss portfolio transfer (“LPT”) contracts. These contracts are evaluated to determine whether they meet the established criteria for reinsurance accounting, and if so, at inception, written premiums are fully earned and corresponding losses and loss expense recognized. The contracts can cause significant variances in gross premiums written, net premiums written, net premiums earned, and net incurred losses in the years in which they are written. Reinsurance contracts sold not meeting the established criteria for reinsurance accounting are recorded using the deposit method.
From April 1, 2009, in instances in which the Company determines that a credit loss exists but the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before the anticipated recovery of its remaining amortized cost basis, the OTTI is separated into (1) the amount of the total impairment related to the credit loss and (2) the amount of the total impairment related to all other factors (i.e. the noncredit portion). The amount of the total OTTI related to the credit loss is recognized in earnings and the amount of the total OTTI related to all other factors is recognized in accumulated other comprehensive loss. The total OTTI is presented in the income statement with an offset for the amount of the total OTTI that is recognized in accumulated other comprehensive loss. Absent the intent or requirement to sell a security, if a credit loss does not exist, any impairment is considered to be temporary.
The noncredit portion of any OTTI losses on securities classified as available for sale is recorded as a component of other comprehensive income with an offsetting adjustment to the carrying value of the security. The fair value adjustment could increase or decrease the carrying value of the security. The noncredit portion of any OTTI losses recognized in accumulated other comprehensive loss for debt securities classified as held to maturity would be accreted over the remaining life of the debt security (in a pro rata manner based on the amount of actual cash flows received as a percentage of total estimated cash
(g) Other Than Temporary Impairments (“OTTI”) of Available for Sale Securities (Continued)
In periods subsequent to the recognition of an OTTI loss, the other-than-temporarily impaired debt security is accounted for as if it had been purchased on the measurement date of the OTTI at an amount equal to the previous amortized cost basis less the credit-related OTTI recognized in earnings. For debt securities for which credit-related OTTI is recognized in earnings, the difference between the new cost basis and the cash flows expected to be collected is accreted into interest income over the remaining life of the security in a prospective manner based on the estimated amount and timing of future estimated cash flows.
With respect to securities where the decline in value is determined to be temporary and the security’s amortized cost is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information, market conditions generally and assessing value relative to other comparable securities. Day-to-day management of the Company’s investment portfolio is outsourced to third party investment manager service providers. While these investment manager service providers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company’s portfolio as available for sale.
Management reviews any significant sales of securities for a loss to determine if such sale calls into question its previous intention with respect to that security. However, this factor on its own does not dictate whether or not the Company recognizes an impairment charge. The Company believes its assertion that it does not have the intent to sell nor is it more likely than not it will be required to sell certain 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.
There are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary. These include subsequent significant changes in general economic conditions as well as specific business conditions affecting particular issuers, the Company’s liability profile, subjective assessment of issue-specific factors (seniority of claims, collateral value, etc.), future financial market effects, stability of foreign governments and economies, future rating agency actions and significant disclosure of accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, significant assumptions and management judgment are involved in determining if the decline is other than temporary. If management determines that a decline in fair value is temporary, then a security’s value is not written down at that time. However, there are potential effects upon the Company’s future earnings and financial position should management later conclude that some of the current declines in the fair value of the investments are other than temporary declines. For further details on the factors considered in evaluation other than temporary impairment see Note 9, “Investments”.
The Company recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value. The changes in fair value of derivatives are 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 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
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 non-hedging derivatives activities in four main areas: investment related derivatives, credit derivatives, other non- investment related derivatives, and until late 2008 it also utilized weather and energy derivatives.
The Company uses derivative instruments, primarily interest rate swaps, to manage the interest rate exposure associated with certain assets and liabilities. These 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. In addition, the company previously wrote a number of resettable strike swaps contracts relating to an absolute return index and diversified basket of funds which are recorded within Investment Related Derivatives-Financial Market Exposures.
Cash equivalents include fixed interest deposits placed with a maturity of under 90 days when purchased. Bank deposits are not considered to be fair value measurements and as such are not subject to the authoritative guidance on fair value measurement disclosures. Money market funds are classified as Level 1 as these instruments are considered actively traded; however, certificates of deposit are classified as Level 2.
Share-based payments to employees, including grants of employee stock options (for all grant years), are recognized in the financial statements over the vesting period based on their grant date fair values.
In April 2009, the FASB issued final authoritative guidance on accounting for assets acquired and liabilities assumed in a business combination that arise from contingencies. This guidance requires an asset acquired or liability assumed in a business combination that arises from a contingency to be recognized at fair value at the acquisition date, if the acquisition date fair value of that asset or liability can be determined during the measurement period. If the acquisition date fair value of an asset acquired or liability assumed in a business combination that arises from a contingency cannot be determined during the measurement period, the asset or liability shall be recognized at the acquisition date using the guidance governing accounting for contingencies. This guidance also amends disclosure requirements and is effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after January 1, 2009. The Company’s adoption of this guidance effective January 1, 2009 did not have a material effect on the Company’s financial position or results of operations.
In May 2009, the FASB issued final authoritative guidance on accounting for and reporting of subsequent events. This standard incorporates into authoritative accounting literature certain guidance that already existed within generally accepted auditing standards, but the rules concerning recognition and disclosure of subsequent events will remain essentially unchanged. Subsequent events guidance addresses events which occur after the balance sheet date but before the issuance of financial statements. Under the new guidance, as under current practice, an entity must record the effects of subsequent events that provide evidence about conditions that existed at the balance sheet date and must disclose but not record the effects of subsequent events which provide evidence about conditions that did not exist at the balance sheet date. This guidance was effective for interim and annual periods ending after June 15, 2009. The adoption of this guidance did not have any impact on the Company’s financial condition or results of operations.
In June 2009, the FASB issued final authoritative guidance over accounting for transfers of financial assets which removes the concept of a qualifying special-purpose entity from existing accounting guidance over transfers of financial assets and also removes the exception from applying guidance surrounding consolidation of variable interest entities to qualifying special-purpose entities. This new guidance must be applied from January 1, 2010 for the Company, for both interim and annual periods. Earlier application is prohibited. The guidance must be applied to transfers occurring on or after the effective date. The Company is currently evaluating the potential impact of this guidance. However, it is not currently expected to have a material impact on the Company’s financial condition or results of operations.
In September 2009, the FASB issued authoritative guidance associated with estimating the fair value for investments in certain entities that do not have a quoted market price but calculate net asset value per share or its equivalent. This guidance covers investments often referred to as “alternative investments” that would include hedge funds, private equity funds, venture capital funds, offshore fund vehicles and funds of funds. When certain criteria are met, this guidance would permit an entity, as a practical expedient, to estimate the fair value of an investment within the scope of this guidance using the net asset value per share of the investment. Therefore, certain attributes of the investment (such as restrictions on redemption) and transaction prices from principal-to-principal or brokered transactions will not be considered in measuring the fair value of the investment if the practical expedient is used. The proposed amendments also require disclosures by major category of investment about the attributes of those investments, such as the nature of any restrictions on the investor’s ability to redeem its investments at the measurement date, any unfunded commitments, and the investment strategies of the investees. These amendments were effective for the Company for the December 31, 2009 year end reporting. The disclosures required by this standard are included in Note 11, “Other Investments”. This guidance did not have an impact on the Company’s financial condition or results from operations.
In January 2010, the FASB issued an accounting standards update on Improving Disclosures about Fair Value Measurements. The provisions of this authoritative guidance require new disclosures about recurring and nonrecurring fair value measurements including significant transfers into and out of Level 1 and Level 2 fair value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. This guidance is effective for annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual periods beginning after December 15, 2010. This standard affects disclosures only and accordingly will not have an impact on the Company’s financial condition or results of operations.
return the collateral has been offset against the derivative asset within the balance sheet as appropriate under the netting agreement. The fair value of the individual derivative contracts are reported gross in their respective levels based on the fair value hierarchy.
Included within Corporate are certain floating rate medium term notes supported primarily by pools of European credit with varying degrees of leverage. The notes have a fair value of $587.7 million and $499.0 million and an amortized cost of $707.9 million and $922.7 million at December 31, 2009 and December 31, 2008, respectively. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.
The tables below present 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 periods ended December 31, 2009 and 2008 for all financial assets and liabilities categorized as Level 3 as of December 31, 2009 and 2008, respectively. The tables do 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, 2009 and 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 general, Level 3 assets include 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 available to support a Level 2 classification. Level 3 assets also include securities for which the Company determined current market trades represent distressed transactions, and accordingly, the Company determined fair value using certain inputs that are not observable to market participants. Transfers from Level 3 to Level 2 during the year ended December 31, 2009, were primarily as a result of the Company utilizing values provided by pricing services not containing significant unobservable inputs, rather than other valuations for certain assets that would have been considered Level 3.
The remainder of the Level 3 assets relate to private equity investments where the nature of the underlying assets held by the investee include positions such as private business ventures and are such that significant Level 3 inputs are utilized in the valuation, and certain derivative positions.
Included within the Other Investments component of the Company’s Level 3 valuations are private investments and alternatives 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.
Derivative instruments classified within Level 3 include: (i) certain interest rate swaps where the duration of the contract the Company holds exceeds that of the longest term on a market observable input, (ii) weather and energy derivatives, (iii) GMIB benefits embedded within a certain reinsurance contract, (iv) a put option included within the Company’s remaining contingent capital facility and (v) credit derivatives sold providing protection on senior tranches of structured finance transactions where the value is obtained directly from the investment bank counterparty for which sufficient information regarding the
inputs utilized in the valuation was not obtained to support a Level 2 classification. The majority of inputs utilized in the valuations of these types of derivative contracts are considered Level 1 or Level 2; however, each valuation includes at least one Level 3 input that was significant to the valuation and accordingly the values are disclosed within Level 3.
Deposit liabilities include obligations under structured insurance and reinsurance transactions as well as funding agreements issued. For purposes of fair value disclosures, the Company determines the fair value of the deposit liabilities by assuming a discount rate equal to the appropriate U.S. Treasury rate plus 108 basis points and the appropriate U.S. Treasury Rate plus 902 basis points at December 31, 2009 and December 31, 2008, respectively, to determine the present value of projected contractual liability payments through final maturity. The discount rate incorporates the Company’s own credit risk into the determination of estimated fair value.
The fair value of the Company’s notes payable and debt outstanding are determined based on quoted market prices.
The fair value of the Company’s redeemable series C preference ordinary shares outstanding is determined based on indicative quotes provided by brokers.
Given management’s view of the risk exposure along with the uncertainty facing the entire financial guarantee industry, the Company reduced the reported value of its investment in Syncora to nil at December 31, 2007. The Company’s shares in Syncora were unregistered and thus illiquid. Throughout 2008 market developments with respect to the monoline industry continued to be largely negative and Syncora was downgraded by several rating agencies during this period. Accordingly, throughout 2008 and up until the closing of the Master Agreement with Syncora 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.
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, 2008, the Company’s total net par outstanding falling under these guarantees was $59.2 billion and $75.2 billion, respectively.
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. These guarantees were provided for the benefit of EIB and are made up of transportation and public
These costs are allocated to the Company’s segments were as follows:
The Company evaluates the performance for both the Insurance and Reinsurance segments based on underwriting profit and contribution from its Life Operations segment. Other items of revenue and expenditure of the Company are not evaluated at the segment level for reporting purposes. In addition, the Company does not allocate investment assets by segment for its property and casualty (“P&C”) operations. Investment assets related to the Company’s Life Operations and certain structured products included in the Insurance, Reinsurance and Corporate segments are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each of these segments.
Corporate includes institutional investment business with guaranteed investment contracts and funding agreements. These items were included in the Other Financial Lines Segment prior to 2009.
Represents debt extinguishment costs associated with the early redemption of the 6.58% Notes.
Ratios are based on net premiums earned from property and casualty operations.
Net income from Syncora represents consolidated earnings for the period from January 1, 2007 through to June 6, 2007, the date on which the Company completed the sale of a portion of Syncora’s common shares then owned by the Company, through a secondary offering and thereby reduced its ownership of Syncora’s outstanding common shares from approximately 63% to approximately 46%. From June 6, 2007 until the execution of the Master Agreement, the Company accounted for its remaining investment in Syncora using the equity method of accounting. Subsequent to August 5, 2008, the Company has no further ownership interest in Syncora.
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 in accordance with the authoritative guidance on intangibles and goodwill. For the reinsurance segment, a reporting unit is one level below the business segment, while for insurance, the segment is also the reporting unit. The first step is to identify potential impairment by comparing the estimated 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 then 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. The estimated fair values of the reporting units are generally determined utilizing methodologies that incorporate price-to-net-tangible-book and price-to-earnings multiples of certain comparable companies, from an operational and economic standpoint. If such estimated fair value, combined with an estimate of an appropriate control premium, indicates a “close call” or potential impairment, further analysis using discounted cash flows is performed. A control premium represents the value an investor would pay above minority interest transaction prices in order to obtain a controlling interest in the respective company. 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 Company completed its annual goodwill impairment testing, as of June 30, 2009, June 30, 2008 and June 30, 2007, which did not result in any goodwill impairments. The results of the annual impairment tests were revisited at each respective year end to confirm that no impairments were required. As at June 30, 2009, 2008 and 2007, estimated fair values exceeded the related net book values of the respective units carrying goodwill. However, at December 31, 2008, due to the financial market and economic events that occurred in the fourth quarter of fiscal 2008, the Company’s interim impairment testing resulted in a non-cash goodwill impairment charge of $990.0 million. The charge related primarily to certain reinsurance unit goodwill associated with the merger of Mid Ocean Ltd. (“Mid Ocean”) in 1998.
The fair value of the Mid Ocean reporting unit was calculated using the discounted cash flow methodology noted below as well as by comparison with similar companies’ publicly traded price multiples as the basis for valuation. The most significant assumptions affecting the market multiples methodology were the choice of comparable companies for each reporting unit and the level of control premium considered. The discounted cash flow methodology established 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 was 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 used 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 were the discount rate, the terminal value and expected future revenues of each reporting unit, gross margins and operating margins, which vary among reporting units. The results of both the price to earnings and price to net tangible book value multiple analyses indicated ranges of fair values of the reporting units within which goodwill is carried was sufficient to support the goodwill balances during the June 30, 2008 annual impairment testing. However, after considering the significantly reduced industry price to tangible book value market multiples during the fourth quarter, and undertaking a discounted cash flows analysis applying stressed scenario assumptions within the discounted cash flow analysis as a result of the distressed environment during 2008, and applying an approximately equal weighting to each of the methodologies utilized (discounted cash flows, price to earnings multiples and price to tangible book value multiples), management concluded the Mid Ocean reporting unit did not pass step one of the process outlined in the authoritative accounting rules and therefore step two was required to quantify the amount of goodwill impairment. Following the step two valuation process, the resulting impairment was determined to be $975.0 million. Although the Company did not believe that the future earnings potential of this business or the cash flows it is expected to produce had declined significantly, as a result of the distressed state of investment and credit markets, the Company believed that the rate of return a market participant would require at the end of 2008 was higher than it was during prior periods. In addition, the market multiples considered had also deteriorated from prior periods, particularly price to tangible book ratios. These factors taken together, combined with the significance of the goodwill value as a percentage of the total net book value of the Mid Ocean reporting unit led to the conclusion that the impairment of $975.0 million was required.
In addition, consistent with the process and factors outlined above, the goodwill balances relating to certain Latin American reinsurance operations and certain life operations of $10.0 million and $5.0 million, respectively, were determined to be impaired and the full balances were written off during the fourth quarter of 2008.
substantially ended its relationship with Syncora and its involvement with financial guarantee business with the exception of certain limited residual guarantees, management believed that the Company’s share price continued to be impacted by the perceived risk associated with both credit and other financial exposures. In particular, analyst reports at the end of 2008 and early 2009 indicated 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 have contributed to the downward pressure on the Company’s stock price during 2008 and may still be impacting the Company’s stock price, although to a lesser degree during 2009, see Item 1A, Risk Factors, within this document. These risks combined with the downgrades from major rating agencies that XL experienced during 2008 increased investor uncertainty regarding the Company’s operating model and overall value. While these factors impacted the trading value of the Company’s common shares during both 2008 and to a lesser degree during 2009, management believes that they do not directly impact the stand alone value of the Company’s core property and casualty underwriting reporting units.
In addition, during 2009 certain internal use software acquired as part of the GAPS acquisition, with a carried value of $4.4 million was reclassified from intangible assets with a definite life into other assets. No impairments were recorded on intangible assets during any of the years ended December 2009, 2008 and 2007.
U.S. Government and Government-Related/Supported and Non U.S. Sovereign Government, Supranationals and Government-Related includes government-related securities with an amortized cost of $2,325.4 million and fair value of $2,326.6 and U.S. Agencies with an amortized cost of $1,361.6 million and fair value of $1,395.0 million.
Included within Corporate are certain floating rate medium term notes supported primarily by pools of European credit leveraged by a factor of 0.44 (i.e. $144 of Bonds held for every $100 of note). The notes have a fair value of $587.7 million and an amortized cost of $707.9 million. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.
The Company had gross unrealized losses totaling $1.8 billion at December 31, 2009 on its available for sale portfolio, which it considers to be temporarily impaired. Individual security positions comprising this balance have been evaluated by management, based on specified criteria, to determine if these impairments should be considered other than temporary. These criteria include an assessment of the severity
Time of impairment on securities impacted by April 1, 2009 changes to OTTI values is measured from the point at which securities returned to a net unrealized loss position (i.e. from April 1, 2009).
Included in the table above are $904.3 million and $980.6 million in Tier One and Upper 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, 2009 and December 31, 2008, respectively. These securities have been distributed in the table based on their call date and have net unrealized losses of $225.2 million and $637.1 million as at December 31, 2009 and December 31, 2008, respectively.
Gross unrealized losses of $1.8 billion on available for sale assets at December 31, 2009 can be attributed to the following significant drivers:
gross unrealized losses of $428.3 million related to the Company’s Life Operations investment portfolio, which had a fair value of $6.4 billion as at December 31, 2009. Of this, $262.7 million of gross unrealized losses related to $1.7 billion of exposures to corporate financial institutions including $904.3 million Tier One and Upper Tier Two securities. At December 31, 2009, this portfolio had an average interest rate duration of 8.7 years, primarily denominated in U.K. Sterling and Euros. As a result of the long duration, significant gross losses have arisen as the fair values of these securities are more sensitive to prevailing government interest rates and credit spreads. This portfolio is matched to corresponding long duration liabilities. A hypothetical parallel increase in interest rates and credit spreads of 50 and 25 basis points, respectively, would increase the unrealized losses related to this portfolio at December 31, 2009 by approximately $273.8 million and $114.2 million, respectively on both the available for sale and held to maturity portfolios. Given the long term nature of this portfolio, and the level of credit spreads as at December 31, 2009 relative to historical averages within the U.K. and Euro-zone as well as the Company’s liquidity needs at December 31, 2009, the Company believes that these assets will continue to be held until such time as they mature, or credit spreads revert to levels more consistent with historical averages.
gross unrealized losses of $261.8 million related to the corporate holdings within the Company’s non-life fixed income portfolios, which had a fair value of $6.9 billion as at December 31, 2009. During the year ended December 31, 2009, as a result of declining credit spreads, the gross unrealized losses on these holdings has declined substantially. Despite the rally during the last three quarters of 2009, corporate credit spreads remain at elevated levels relative to historical averages. The Company continues to believe that the gross unrealized losses are a reflection of a premium being charged by the market for credit, rather than fundamental deterioration in the debt service capabilities of the issuers.
The Company purchased a number of these assets to support the previously written GIC and funding agreement contracts and has reduced its exposure to this asset class as part of its strategic portfolio
gross unrealized losses of $92.7 million related to the Company’s holdings in non-agency RMBS secured by prime mortgages which had a fair value of $484.0 million at December 31, 2009. In the U.S., the average price on these securities declined to approximately 84.9% of par value at December 31, 2009, reflecting concerns over rising unemployment in the U.S. and the potential impact on previously high quality borrowers to meet their obligations. The Company undertook a security level review in conjunction with its investment manager service providers of these securities and recognized charges to the extent it believed the intrinsic value of any security was below its amortized cost.
The Company recorded net impairment charges of $812.5 million and $1.0 billion for the year ended December 31, 2009 and for the year ended December 31, 2008, respectively. Impairment charges to March 31, 2009 include charges of OTTI related to the non-credit impairment of unrealized losses. From April 1, 2009, the non-credit impairment is excluded from net impairments. The significant assumptions and inputs associated with these securities consist of:
In addition the Company recorded impairments totaling $226.9 million for the year ended December 31, 2009 in relation to medium term notes backed primarily by investment grade European credit. Management has concluded that, following recent credit spread movements during 2009, future yields within the supporting collateral were not sufficient to support the previously reported amortized cost.
The determination of credit losses is based on detailed analyses of underlying cash flows. Such analyses require the use of certain assumption in developing the estimated performance of underlying collateral. Key assumptions used include, but are not limited to, items such as, RMBS default rates based on collateral duration in arrears, severity of losses on default by collateral class, collateral reinvestment rates and expected future general corporate default rates.
The company had no significant financial operating affiliates as at December 31, 2009 or December 31, 2008. Previously the Company’s significant financial operating affiliate investments 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.
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.
The Company’s other strategic operating affiliates at December 31, 2009 and included investments in ARX Holding Corporation and ITAÙ XL Seguros Corporativos S.A. (“ITAU”), with ownership in these entities at 45.9% and 49.9%, respectively. The Company expects to complete the sale of its interest in ITAU in 2010.
Financial operating affiliates includes an investment in Primus Guaranty, Ltd. (“Primus”). In 2009 Primus reported significant gains and negative book value accounting for the excess of liabilities over assets and the majority of the total revenues and net income disclosed above under the combined investee summarized financial data.
Financial operating affiliates includes an investment in Primus Guaranty, Ltd. (“Primus”). In 2008 Primus reported significant losses and negative book value accounting for the excess of liabilities over assets and the majority of the total losses and net loss disclosed above under the combined investee summarized financial data.
As of December 31, 2009, the alternative fund portfolio employed four strategies invested in 11 underlying funds. The Company is able to redeem the hedge funds on the same terms that the underlying funds can be redeemed. In general, the funds in which the Company is invested require at least 30 days notice of redemption, and may be redeemed on a monthly, quarterly, semi-annual, annual, or longer basis, depending on the fund.
As these hedge funds, private equity and alternative investments included in other investments do not pay dividends, income is realized only on partial or ultimate sale of these investments. The Company had net unrealized gains of $51.9 million and $40.8 million, respectively, at December 31, 2009 and 2008, related to these alternative investments. On sales related to the alternative investments, the Company had realized gains of $21.8 million and realized losses of $13.1 million in 2009 and 2008, respectively, with no gains or losses in 2007.
The Company historically participated in structured transactions in project finance related areas under which the Company provided a cash loan supporting trade finance transactions. These transactions are accounted for in accordance with guidance governing 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. The Company has also provided liquidity facility financing to a structured credit vehicle as a part of a third party medium term note facility. These investments are not considered to be fair value measurements under U.S. GAAP and accordingly they have been excluded from the fair value measurement disclosures. See Note 3, “Fair Value Measurements” for details surrounding the estimated fair value of these investments.
On June 9, 2009, XL Specialty Insurance Company (“XL Specialty”), a wholly-owned subsidiary of XL Capital Ltd, entered into an agreement with National Indemnity Company, an insurance company subsidiary of Berkshire Hathaway Inc. (“National Indemnity”). Under the agreement, and a related reinsurance agreement, National Indemnity will issue endorsements (“Endorsements”) to certain directors and officers liability insurance policies known as “Side A” coverage policies underwritten by XL Specialty (the “Facility”).
The outstanding payment obligation was recorded in Other Investments at an estimated fair value of $128.1 million, pays a coupon of 3.5%, and will be accreted to $150 million over the 11.5 year term of the payment obligation. The difference between the estimated fair value of the Obligation and the cost of that Obligation at the time of the transaction was approximately $21.9 million and is recorded in Other Assets. This difference is being amortized in relation to the earning of the underlying policies written. $5.5 million of amortization was recorded during the year ended December 30, 2009.
The Company regularly reviews the performance of these other investments. The Company recorded losses of $0.9 million, $1.5 million and $0.1 million in the years ended December 31, 2009, 2008 and 2007, respectively, due to other than temporary declines in values of these other investments.
Net losses incurred decreased by $794.1 million in 2009 as compared to 2008, mainly as a result of the current year loss ratio decreasing by 9.4 loss percentage points during the same period. This decrease is due primarily to lower levels of large property risk and catastrophe losses occurring in 2009 combined with the impact of anticipated sub prime and credit related losses in 2008. The lower level of property losses in 2009 as well as business mix changes more than offset the impacts of a softening rate environment. The decrease in net losses incurred is also due to a reduction in business volume as net premiums earned decreased 14.0% in 2009 relative to 2008.
Net losses incurred increased by $307.1 million in 2008 as compared to 2007, mainly as a result, of the 2008 year loss ratio increasing by 10.0 loss percentage points, mainly due to an increase in attritional and catastrophe-related property losses. Business volume reduced as net premiums earned related to the Company’s P&C operations decreased by 6.7% over this period. Overall, windstorm activity in the Atlantic and Gulf regions increased in 2008 as compared to 2007 and included the impacts of Hurricanes Gustav and Ike, which both made landfall in the U.S. in the third quarter of 2008. Hurricane Ike was estimated to have caused the third largest ever insured loss in the U.S. from a windstorm. Combined, Hurricanes Gustav and Ike had a significant impact on the results of the Company for the year ended December 31, 2008. In 2008, the Company incurred losses, net of reinsurance recoveries and reinstatement premiums, of $22.5 million and $210.0 million related to Hurricanes Gustav and Ike, respectively.
The following table presents the net (favorable) adverse prior years loss development of the Company’s loss and loss expense reserves for its property and casualty operations by operating segment for each of the years indicated:
For casualty lines, net prior year development during the year was $29.4 million unfavorable due to reserve strengthening on the European excess lines for accident years 2000-2004, and the recognition of potential excess casualty exposures on the discontinued casualty lines. Offsetting this reserve strengthening were reserve releases from the casualty primary business due to better than expected loss activity from the more recent accident years, and US risk management lines due to greater reliance on actual loss experience over initial target loss ratios.
Net favorable prior year reserve development of $158.1 million for the year ended December 31, 2007 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. Net adverse prior year development in other insurance lines relates to adverse development in
For the year ended December 31, 2008 net favorable prior year development totaled $305.2 million as explained below.
Net favorable prior year development of $166.8 million for the casualty and other lines 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.
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 $3.9 billion in 2009 and $3.8 billion in each of 2008 and 2007.
The Company did not dispose of or acquire net loss reserves in 2009 or 2008.
The Company’s net unpaid losses and loss expenses included estimates of actual and potential non-recoveries from reinsurers. As at December 31, 2009 and 2008, the reserve for potential non-recoveries from reinsurers was $189.8 million and $187.6 million, respectively.
With respect to financial guarantee liabilities the amount of the case basis reserve is based on the net present value of the expected ultimate loss and loss adjustment expense payments that the Company expects to make, net of expected recoveries under salvage and subrogation rights. Case basis reserves are 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.
The net income impact in 2007 of case basis reserves with respect to reinsurance previously provided to Syncora subsequent to the secondary sale of Syncora common shares on June 6, 2007 of $351.0 million was included in “Net loss from operating affiliates”, and the unpaid case reserves related to such losses were recorded in unpaid losses and loss expenses. However, following the closing of the Master Agreement
The Company utilizes tabular reserving for workers’ compensation (including long-term disability) unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 5% in 2009 and 2008. The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2009 and 2008 on an undiscounted basis were $734.1 million and $755.8 million, respectively. The related discounted unpaid losses and loss expenses were $343.7 million and $346.0 million as of December 31, 2009 and 2008, respectively.
A review in 2007 of older policy years revealed outstanding claims reported in prior years that were deemed to have asbestos exposure.
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 combined aggregate limit on the total acquired reserves is limited to $60.0 million, not including coverage for claims handling costs over a defined period.
The Company utilizes reinsurance and retrocession agreements principally to increase aggregate capacity and to reduce the risk of loss on business assumed. The Company’s reinsurance and retrocession
agreements provide for recovery of a portion of losses and loss expenses from reinsurers and reinsurance recoverables are recorded as assets. The Company is liable if the reinsurers are unable to satisfy their obligations under the agreements. Under its reinsurance security policy, the Company seeks to cede business to reinsurers generally rated “A” or better by Standard & Poor’s (“S&P”) or, in the case of Lloyd’s syndicates, “B+” from Moody’s Investors Service, Inc. (“Moody’s”). The Company considers reinsurers that are not rated or do not fall within the above rating categories and may grant exceptions to the Company’s general policy on a case-by-case basis. The effect of reinsurance and retrocessional activity on premiums written and earned from property and casualty operations is shown below:
At December 31, 2009 and 2008, the total reinsurance assets of $4.0 billion and $4.6 billion respectively, included reinsurance receivables for paid losses and loss expenses of $0.4 billion and $0.6 billion, respectively, with $3.6 billion and $4.0 billion respectively, relating to the ceded reserve for losses and loss expenses, including ceded losses incurred but not reported. Although the contractual obligation of individual reinsurers to pay their reinsurance obligations is based on specific contract provisions, the collectibility of such amounts requires significant estimation by management. The majority of the balance the Company has accrued as recoverable will not be due for collection until sometime in the future. Over this period of time, economic conditions and operational performance of a particular reinsurer may impact its ability to meet these obligations and while it may continue to acknowledge its contractual obligation to do so, it may not have the financial resources or willingness to fully meet its obligations to the Company.
Approximately 88% of the total unpaid loss and loss expense recoverable and reinsurance balances receivable (excluding collateral held) outstanding at December 31, 2009 was due from reinsurers rated “A” or better by S&P. The following is an analysis of the total recoverable and reinsurance balances receivable at December 31, 2009, by reinsurers owing more than 3% of such total:
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, (the “SPA”) between XL Insurance (Bermuda) Ltd and Winterthur Swiss Insurance Company (“WSIC”), 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.
At December 31, 2009, deposit liabilities include remaining funding agreement contracts as well as reinsurance and insurance deposits. Funding agreements do not meet the definition of an insurance contract under FASB issued authoritative guidance. These contracts were sold with a guaranteed rate of return and the proceeds from the sale of such contracts were invested with the intent of realizing a greater return than is called for in the investment contracts. The Company has also entered into certain insurance and reinsurance policies that transfer insufficient risk under GAAP to be accounted for as insurance or reinsurance transactions and are deposit accounted. These structured property and casualty agreements, guaranteed investment contracts and funding agreements have been recorded as deposit liabilities and are initially matched by an equivalent amount of investments. The Company has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the ultimate liability. See Note 9, “Investments” for further information relating to the Company’s net investment income as well as realized and unrealized investment (losses) gains. 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. Deposit liabilities are initially recorded at an amount equal to the assets received. At December 31, 2009, the remaining balance of funding agreements, excluding accrued interest of $6.5 million, was $450 million, with the full balance scheduled for settlement in August 2010.
As at December 31, 2009 and 2008, the Company had bank and loan facilities available from a variety of sources, including commercial banks, totaling $3.5 billion and $4.3 billion, respectively, of which $2.4 billion and $3.2 billion, respectively, of debt was outstanding. In addition, at December 31, 2009 and 2008 the Company had letter of credit facilities totaling $7.25 billion and $6.9 billion, respectively, available of which $3.0 billion and $3.7 billion, respectively, were outstanding as at December 31, 2009 and 2008, 21.3% and 3.9%, respectively, of which were collateralized by certain of the Company’s investment portfolios, primarily 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.
Concurrent with the issuance of Class A ordinary shares 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 $557.0 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 senior notes are pledged by the holders to secure their obligations under the purchase contract.
On June 22, 2007, the Company closed a new $4 billion unsecured revolving credit and letter of credit facility. The new facility has a term of five years. The facility is available in the form of revolving credit
in the amount of $1 billion (such limit is shared with the Company’s other syndicated revolving credit facility that closed in June 2005) and in the form of letters of credit in the aggregate amount of $4 billion.
On May 7, 2007, the Company issued $325.0 million aggregate principal amount of 6.25% senior notes due 2027 (the “2027 Senior Notes”). The 2027 Senior Notes were issued at 99.805% and gross proceeds were approximately $324.4 million. Related expenses of the offering, including underwriting discounts, amounted to approximately $2.5 million. Interest on the 2027 Senior Notes is payable on May 15, and November 15 of each year, beginning November 15, 2007. The Company may redeem the 2027 Senior Notes in whole at any time, or in part from time to time, at a make-whole redemption price. The Company may also redeem the 2027 Senior Notes in whole, but not in part, at any time upon the occurrence of certain tax events. The 2027 Senior Notes are unsecured and rank equally with all the Company’s existing and future unsecured senior debt.
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are utilized primarily to support non-admitted insurance and reinsurance operations in the U.S. and capital requirements at Lloyd’s. The commercial facilities are scheduled for renewal during 2010 through 2012. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedants with statutory relief required under state insurance regulation in the U.S. It is anticipated that the commercial facilities may be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedants. This could take the form of additional insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business.
The 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
The following table summarizes information on the location and gross amounts of derivative fair values contained in the consolidated balance sheet as at December 31, 2009:
The Company designates certain of its derivative instruments as fair value hedges, cash flow hedges, or hedges of the net investment in a foreign operation and formally and contemporaneously documents all relationships between the hedging instruments and hedged items and links the hedging derivative to specific assets and liabilities. The Company assesses the effectiveness of the hedge, both at inception and on an on-going basis and determines whether the hedge is highly effective in offsetting changes in fair value or cash flows of the linked hedged item.
As at December 31, 2009, a portion of the Company’s liabilities are hedged against changes in the applicable designated benchmark interest rate. Interest rate swaps are also used to hedge the changes in fair value of certain fixed rate liabilities and fixed income securities due to changes in the designated benchmark interest rate. In addition, the company utilizes foreign exchange contracts to hedge the fair value of certain fixed income securities as well as to hedge certain net investments in foreign operations.
The following table provides the total impact on earnings relating to derivative instruments formally designated as fair value hedges along with the impacts of the related hedged items for the year ended December 31, 2009:
During March 2007, the Company entered into an interest rate swap agreement in anticipation of the issuance of the 2027 Senior Notes, as described in Note 16, “Notes Payable and Debt Financing Arrangements”. This transaction, which met the requirements of a cash flow hedge of a forecasted transaction accounting guidance for derivative instruments and hedging activities, was entered into to mitigate the interest rate risk associated with the subsequent issuance of the 2027 Senior Notes. The gain on the settlement of the swap transaction on May 2, 2007 of $3.8 million was credited to AOCI and is being amortized to interest expense over the 20-year term of the related debt. In addition, the Company entered into a treasury rate guarantee agreement in anticipation of the issuance of $300.0 million of 5.25% Senior Notes due September 15, 2014 during 2004. The loss on the settlement of the treasury rate guarantee transaction on August 18, 2004 of $6.3 million was charged to AOCI and is being amortized to interest expense over the 10-year term of the related debt. The impact on earnings relating to these derivative instruments formally designated as cash flow hedges for each of the years ended December 31, 2009 and 2008 were increases to interest expense of $0.4 million.
(c) Derivative Instruments Designated as Hedges of the Net Investment in a Foreign Operation
The company utilizes foreign exchange contracts to hedge the fair value of certain net investments in foreign operations. During 2009, the Company entered into foreign exchange contracts which were formally designated as hedges of foreign subsidiaries with functional currencies of U.K. Sterling and the Euro. The U.S. Dollar equivalent of foreign denominated net assets of $425 million was hedged which resulted in a derivative gain of $7.5 million being recorded in the cumulative translation adjustment account within AOCI. There was no ineffectiveness resulting from these transactions.
The Company utilizes risk management and overlay strategies that incorporate the use of derivative financial instruments, primarily to manage its fixed income portfolio duration and exposure to interest rate risks associated with certain of its assets and liabilities primarily in relation to certain legacy other financial lines and structured indemnity transactions. The Company uses interest rate swaps to convert certain liabilities from a fixed rate to a variable rate of interest and may also use them to convert a variable rate of interest from one basis to another.
The Company held credit derivative exposures through a limited number of contracts written as part of the Company’s previous financial lines businesses, and through the Company’s prior reinsurance agreements with Syncora, as described below. 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. 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 during August 2008, as described in Note 4, “Syncora Holdings Ltd.” 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, 2009 and December 31, 2008 the remaining credit derivative exposures outside of the Company’s investment portfolio consisted of 2 and 23 contracts, respectively, written by the Company that provide credit protection on senior tranches of structured finance transactions with total insured contractual payments outstanding of $271.7 million ($244.9 million principal and $26.8 million interest), and $639.5 million ($499.5 million principal and $140.0 million of interest), weighted average contractual term to maturity of 6.0 years and 5.7 years, a total liability recorded of $18.4 million and $28.6 million, respectively, and an average rating of A and AA underlying obligations at December 31, 2009 and December 31, 2008, respectively. As of December 31, 2009, there were no reported events of default on the underlying obligations. Credit derivatives are recorded at fair value, which is determined using either models developed by the Company or third party prices and are dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change resulting from movements in credit and credit quality spreads is unrealized as the credit derivatives are not traded to realize this resultant value.
Prior to August 2008, the Company offered weather and energy risk management products in insurance or derivative form to end-users and managed the risks in the OTC and exchange traded derivative markets or through the use of quota share or excess of loss arrangements. However, as part of the Company’s strategy to focus on its core lines of business within its Insurance and Reinsurance segments, the Company closed this unit in August 2008 and ceased writing such weather and energy risk management products. Weather and energy derivatives are recorded at fair value, which is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair values are estimated using available market data and internal pricing models based upon consistent statistical methodologies. Estimating fair value of instruments 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. The majority of existing weather and energy contracts expired at the end of 2008 and the remainder expired during 2009.
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 Redeemable Series C Preference Ordinary Shares, par value U.S. $0.01 per share.
The Company invests in CDOs, and other investment vehicles that are issued through variable interest entities as part of the Company’s investment portfolio. The activities of these VIEs are generally limited to holding the underlying collateral used to service investments therein. Our involvement in these entities is passive in nature and we are not the arranger of these entities. The Company has not been involved in establishing these entities. The Company is not the primary beneficiary of these variable interest entities as contemplated in current authoritative accounting guidance.
The Company’s reinsurance assets at December 31, 2009 and 2008 amounted to $4.0 billion and $4.6 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.
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, 2009 and 2008. 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 cash flow, 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.
Commencing in March 2008, the Company and two of its subsidiaries were named, along with approximately 20 other providers and insurers of municipal Guaranteed Investment Contracts and similar derivative products in the U.S. (collectively “Municipal Derivatives”) as well as fourteen brokers of such products, in several purported federal antitrust class actions. The Judicial Panel on Multidistrict Litigation ordered that these be consolidated for pretrial purposes and assigned them to the Southern District of New York. The consolidated amended complaint filed in August 2008 alleges that there was a conspiracy among the defendants during the period from January 1, 1992 to the present to rig bids and otherwise unlawfully decrease the yield for Municipal Derivative products. The purported class of plaintiffs consists of purchasers of Municipal Derivatives. On October 21, 2008 most of the defendants filed motions to dismiss the consolidated amended complaint. The District Judge granted the motions by order dated April 29, 2009, but allowed plaintiffs leave to file a second amended complaint within 20 days of the order. Plaintiffs filed a Second Consolidated Amended Class Action Complaint on June 18, 2009, but did not include the Company or any subsidiaries as a defendant. In addition, the Company and three subsidiaries of the Company were named in eleven individual (i.e., non-class) actions filed by various municipalities or other local government bodies in California state courts. The Defendants removed those cases to federal court and the cases were then transferred to the Southern District of New York by the Judicial Panel on Multidistrict Litigation. On February 9, 2010, the Company and subsidiaries filed a motion to dismiss all eleven actions and intends to vigorously defend them.
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 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 was held on April 21, 2009. In accordance with the Third Circuit’s April 23, 2009 directive, the parties submitted on May 13, 2009 their respective supplemental letter briefs addressing a question raised by the Court. The appeal remains pending.
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. In October 2008, XL and other defendants filed motions to dismiss the consolidated amended complaint, which motions have been fully briefed. The Company intends to vigorously defend these actions.
In August 2002, the Company issued 9.2 million 8.00% Series A Preference Ordinary Shares at $25.00 per share. Gross proceeds were $230.0 million and related expenses were $7.2 million. On August 14,
In November 2002, the Company issued 11.5 million 7.625% Series B Preference Ordinary Shares at $25.00 per share. Gross proceeds were $287.5 million and related expenses were $9.1 million. On November 18, 2007, the Company redeemed all of its outstanding 7.625% Series B Preference Ordinary 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.
The Company’s 1991 Performance Incentive Program, as amended and restated effective February 27, 2009, provides for grants of non-qualified or incentive stock options, restricted stock, restricted stock units, performance shares, performance units and stock appreciation rights (“SARs”). The plan is administered by the Management Development & Compensation Committee of the Board of Directors. Stock options may be granted with or without SARs. No SARs have been granted to date. Grant prices are established at the fair market value of the Company’s common stock at the date of grant. Options and SARs have a life of not longer than ten years and vest as set forth at the time of grant. Generally, options currently vest annually over three years from date of grant; however, options granted to NEOs in August, 2008, vest in full on the later of (i) three years from the grant date or (ii) the date that the closing price of the Company’s common shares on the NYSE equals or exceeds 130% of the option exercise price (approximately $25.51 per share) for a period of at least 10 consecutive trading days.
Prior to January 1, 2009, directors also received grants of share units equal to their annual retainer divided by the market price of the Company’s ordinary shares on the crediting date. These units receive dividend equivalents in the form of additional units equal to the cash value divided by the market price on the dividend payment date. Shares equal to the total units held are distributed upon retirement from the Board.
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the 2009 fiscal year and the exercise price, multiplied by the number of in-the-money-options) that would have been received by the option holders had all option holders exercised their options on December 31, 2009. Total unrecognized stock based compensation expense related to non-vested stock options was approximately $15.3 million as
of the end of December 31, 2009, related to approximately 4.6 million options, which is expected to be recognized over a weighted-average period of 1.3 years. No options were exercised during 2008 or 2009.
The exercise price of the Company’s outstanding 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 when the market price was $77.10.
During 2009, 2008, and 2007, the Company granted 146,895, 1,349,620 and 645,438 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 $11.24, $37.61 and $70.89, respectively. During the years ended December 31, 2009, 2008, and 2007, $32.2 million, $57.6 million and $49.7 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 $28.3 million as of the end of December 31, 2009, related to approximately 1.0 million restricted stock awards, which is expected to be recognized over 1.8 years.
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.
In addition, certain former employees have received benefit type guarantees, not formally a part of any established plan. The liability recorded with respect to these agreements as at December 31, 2009 and 2008 was $3.3 million and $3.4 million, respectively, representing the entire unfunded projected benefit obligations.
The status of the above mentioned plans at December 31, 2009 and 2008 is as follows:
In 2009, the Company paid dividends of $65.0 million and $23.2 million to Series E and Series C preference shareholders, respectively.
In 2008, two quarterly dividends of $0.38 per share were paid to all ordinary shareholders of record as of March 14 and June 13 and two quarterly dividends of $0.19 per share were paid to all ordinary shareholders on record as of September 12 and December 2009.
The Company’s Indian subsidiary is not subject to certain income and capital gains taxes under current Indian law. Following a change in the law this subsidiary is exempt from these taxes for a further year until March 31, 2011 pursuant to the Income Tax Act 1961. The subsidiary is subject to a Minimum Alternative Tax as of April 1, 2007.
The Company has operations in subsidiary and branch form in various other jurisdictions around the world, including but not limited to the U.K., Switzerland, Ireland, Germany, France, India, and various countries in Latin America that are subject to relevant taxes in those jurisdictions.
The Company adopted the provisions of the final authoritative guidance on accounting for uncertainty in income taxes, on January 1, 2007. The Company did not recognize any liabilities for unrecognized tax benefits as a result of its implementation.
The Company has open tax years, that are potentially subject to examinations by local tax authorities, in the following major tax jurisdictions, the U.S. 2009, the U.K. 2008 to 2009, Switzerland 2007 to 2009; Ireland 2005 to 2009, Germany 2006 to 2009 and France 2007 to 2009.
The Company’s policy is to recognize any interest accrued related to unrecognized tax benefits as a component of interest expense and penalties in the tax charge. At December 31, 2009 and 2008, the Company had accrued liabilities, relating to interest and penalties of nil and $1.0 million, respectively.
The income tax provisions for the years ended December 31, 2009, 2008 and 2007 are as follows:
As of December 31, 2009, net operating loss carry forwards in the U.K. were approximately $166.6 million and have no expiration. As of December 31, 2009, net operating loss carry forwards in Switzerland were approximately $980.1 million and will expire in future years through 2015.
Management has reviewed historical taxable income and future taxable income projections for its U.K. group and has determined that in its judgment, the net operating losses will more likely than not be realized as reductions of future taxable income within a reasonable period. Specifically with regard to the U.K. group, management has determined that the projected U.K. group taxable income (using U.K. rules for group loss relief) will be sufficient to utilize the net operating losses of approximately $166.6 million. Management will continue to evaluate income generated in future periods by the U.K. group in determining the reasonableness of its position. If management determines that future income generated by the U.K. group is insufficient to cause the realization of the net operating losses within a reasonable period, a valuation allowance would be required for the U.K. portion of the net deferred tax asset, in the amount of $46.6 million.
Under the Insurance Act 1978, amendments thereto and related regulations of Bermuda, the Company’s Bermuda subsidiaries, XL Re Ltd and XL Insurance (Bermuda) Ltd. are prohibited from declaring or paying dividends of more than 25% of each of their prior year’s statutory capital and surplus unless the Company filed with the Bermuda Monetary Authority a signed affidavit by at least two members of the Company’s Board of Directors and the Company’s Principal Representative attesting that a dividend in excess of this amount would not cause the company to fail to meet its relevant margins is required. At December 31, 2009 and 2008, the maximum dividend that the Bermuda operating entities could pay, without a signed affidavit, having met minimum levels of statutory capital and surplus and liquidity requirements, was approximately $1.3 billion and $2.4 billion, respectively.
Basic and diluted earnings per ordinary share were adjusted for 2008 and 2007 as noted below.
27. Computation of Earnings Per Ordinary Share and Ordinary Share Equivalent (Continued)
For detailed information regarding the Company’s transactions with Syncora see Note 4 “Syncora Holdings Ltd.”
In the normal course of business, the Company enters into cost sharing and service level agreement transactions with certain other strategic affiliates, which management believes to be conducted consistent with arms-length rates. Such transactions, individually and in the aggregate, are not material to the Company’s financial condition, results of operations and cash flows.
XL Capital Finance (Europe) plc (“XLFE”) is a wholly owned finance subsidiary of the Company. In January 2002, XLFE issued $600 million par value 6.5% Guaranteed Senior Notes due January 2012. These notes are fully and unconditionally guaranteed by the Company. The Company’s ability to obtain funds from its subsidiaries to satisfy any of its obligations under this guarantee is subject to certain contractual restrictions, applicable laws and statutory requirements of the various countries in which the Company operates including among others, Bermuda, the U.S., Ireland and the U.K. Required statutory capital and surplus for the principal operating subsidiaries of the Company was $7.0 billion as of December 31, 2009.
During the third quarter of 2008, the Company executed the Master Agreement with Syncora and the Counterparties in connection with the termination of certain reinsurance and other agreements, resulting in a net loss of approximately $1.4 billion. In addition, the Company’s results of operations were negatively impacted by both Hurricanes Gustav and Ike with estimated losses incurred at September 30, 2008, net of reinsurance recoveries and reinstatement premiums of $27.4 million and $194.4 million, respectively. Further contributing to the Company’s net loss attributable to ordinary shareholders of $1.6 billion during the third quarter of 2008 were net realized losses from the Company’s investment portfolio of $252.6 million and net losses from the Company’s investment fund affiliates of $54.9 million.