(1) All prior period information includes the results of NAC as though it had always been a part of the Company.
(2) The loss and loss expense ratio is the calculated by dividing the losses and loss expenses incurred by the net premiums earned.
(4) Cash dividends per share have not been adjusted for the pooling effect of NAC.
(6) The combined ratio is the sum of the loss and loss expense ratio and the underwriting expense ratio. A combined ratio of under 100% represents an underwriting profit and over 100% represents an underwriting loss.
The following is a discussion of the Company's results of operations and financial condition. Prior period information presented is the combination of the results formerly presented by XL Capital and NAC, as required for a business combination accounted for by the pooling of interests method, which assumes NAC had always been a part of the Company. See Note 6 to the audited Consolidated Financial Statements for further details.
The insurance and reinsurance industry has remained competitive through 2000. The Company has experienced price increases on some of the short-tail business, such as the property and property catastrophe lines as the retrocession markets have become more capacity constrained. While the long tail business, such as the excess casualty lines, have not experienced the equivalent level of price increases, market pressure for rate reduction is no longer as prevalent as in 1999. During 2000, the Company continued to evaluate its product lines for profitability and exited certain lines where pricing remains at unsatisfactory levels.
The Company is organized into three underwriting segments - insurance, reinsurance, and financial products and services - and a corporate segment, which includes the investment operations of the Company. Lloyd's syndicates are included in the insurance segment but are shown separately as the nature of their operations and the market in which the syndicates underwrite is significantly different to the Company's other insurance subsidiaries. See Item 1 and Item 8, Note 3 to the Consolidated Financial Statements for further details.
The increase in net premiums earned in 1999 over 1998 is primarily the result of an increase in the gross premiums written in the primary property, aviation and satellite, marine and other lines of business. Net premiums earned in 1999 also reflect the purchase of Intercargo in May 1999, for which approximately $33.0 million was earned from the date of purchase. Partially offsetting this increase is a decrease in the general liability lines, where there was a reduction in the amount of gross premiums written due to increased competition that caused premium rates to decline.
There was a small increase in the net premiums earned in 1999 over 1998 in the other liability business, which comprises mostly professional lines, despite a decrease in the amount of gross premiums written in 1999 compared to 1998. The increase in net premiums earned is primarily as a result of several tailored programs written in 1998, which are earned over a period greater than one year.
Fee income and other relates to fees relating to the provision of risk management and other services. As the managing agencies write more business on behalf of the Company, fee income from agency fees is expected to decline in future years.
The increases in net losses and loss expenses, acquisition costs and operating expenses are also primarily attributable to the new business generated by ECS and XL Aerospace. These are included in the discussions below as part of the analysis of the Company's underwriting ratios.
The decrease in the underwriting profit in each year in this segment is due to higher loss and loss expense ratios as shown below. The following table presents the ratios for this segment for each of the three years ended December 31:
Excluding the effects of the stop loss arrangement, the loss ratio decreased in 1999 compared to 1998 due to the reduction of liability loss reserves relating to 1998 and prior years. Due to the lack of industry data available, the Company estimates loss reserves based upon its own experience. When the Company commenced writing this type of business in 1986, limited data was available and the Company has made its best estimates for loss reserves for each underwriting year since that time. Over time, the amount of data has increased, providing a larger statistical base for estimating reserves. Redundancies in prior year reserves have occurred where loss experience has developed more favorably than expected. This trend is not necessarily expected to continue.
The net decrease in the underwriting expense ratio in 2000 compared to 1999 is mainly due to the significant increase in net premiums earned year over year and, unlike acquisition costs, operational expenses do not change as a direct cost of net premiums earned. Partially offsetting this decrease is the inclusion of expense charges of $13.9 million relating to employee severance and other costs in 2000 associated with the realignment of operations and the discontinuation of certain business lines. Excluding these costs, the underwriting expense ratio in 2000 would have been 27.2%. The increase in the expense ratio in 1999 over 1998 is due to two factors: changes in the product mix towards U.S. primary business in 1999 which tends to have higher acquisition costs, and the additional operating expenses incurred by the Company in establishing its start up operations in the U.S. and new lines of business.
The increase in net premiums earned is mainly a result of an increase in net premiums written across most lines of business. The Company has experienced some premium rate increases in the other property, marine, aviation and satellite lines of business in 2000 over 1999. However, pricing also remained generally unchanged in the international property (excluding property catastrophe) and liability lines of business written by the Company. Partially offsetting this increase in net premiums earned is an increase in reinsurance costs incurred in 2000 over 1999, primarily relating to stop loss reinsurance policies. Under these policies, additional premiums become due once losses exceed certain levels. Additional reinsurance costs of $80.6 million, $20.5 million and $5.5 million were
The increase in net premiums earned in 1999 over 1998 is due to two factors: (i) the acquisition of Mid Ocean in August 1998 which results in only five months of net premiums earned included in 1998 compared to twelve months in 1999, and (ii) increases in gross premiums written and earned in the casualty reinsurance business in 1999 resulting from new business opportunities.
Operating expenses increased in 1999 over 1998 due to the acquisition of Mid Ocean.
The Company may provide financial guaranties in credit default swap form rather than in insurance form. Premiums received in respect of credit default swaps, net of estimated losses, are included as fee income and earned over the life of the policies. Fee income in 2000 relates primarily to credit default swaps. From time to time, the Company will assist in structuring other financial transactions that may result in fee income. These transactions tend to be irregular in nature.
In late 2000, the Company established operations to provide insurance form coverages that previously were available primarily in capital markets. No premiums were written relating to this business in 2000. The Company intends to hedge these risks as they are assumed.
The financial guaranty operations write business with an expected loss ratio of approximately 25%. Operating expenses for this segment include expenses associated with the Company's activities in writing financial solutions and in generating deposit liabilities. Revenues associated with these transactions are reflected in investment income, net realized gains on investments and equity earnings in affiliates. Thus, the expense ratio and combined ratio tend to be higher than traditional insurance results. Not all premiums written have related acquisition costs. The calculation of the expense ratio excludes fee income derived from credit default swap transactions. If this income were included, the expense ratio and the combined ratio would have been 81.8% and 107.6% respectively in 2000 and 70.4% and 95.6% respectively in 1999. The high expense ratio continues to reflect the start up nature of this segment.
The following table illustrates the change in net investment income and net realized gains and losses for each of the three years ended December 31, 2000 (U.S dollars in thousands):
Net realized gains in 2000 include a $54.1 million gain on the sale of the Company's investment in FSA Holdings, Inc. However, offsetting this gain, the Company incurred realized capital losses of approximately $66.2 million in certain other investments where the Company determined there to be an other than temporary decline in value of such investments.
The change in the income taxes of the Company principally reflects the decline in the profitability of the U.S. operations for each year. Deterioration of the casualty book in 2000 and 1999 resulted in pre-tax net losses for U.S. operations, generating an income tax benefit for both years. See Note 17 to the Consolidated Financial Statements.
As a holding company, the Company's assets consist primarily of its investments in subsidiaries and the Company's future cash flows 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 Bermuda, the United States, Ireland and the United Kingdom, including the Society of Lloyd's that are described more fully in Note 18 to Consolidated Financial Statements. No assurance can be given that the Company or its subsidiaries will be permitted to pay dividends in the future. The Company's shareholders' equity at December 31, 2000 was $5.6 billion, of which $3.2 billion was retained earnings.
Certain business written by the Company has loss experience characterized as low frequency and high severity exposures. This may result in volatility in both the Company's results and operational cash flows. However, the Company continues to generate positive cash flow from operating activities.
The Company establishes reserves to provide for estimated claims, the general expenses of administering the claims adjustment process and for losses incurred but not reported. These reserves are calculated by using actuarial and other reserving techniques to project the estimated ultimate net liability for losses and loss expenses. The Company's reserving practices and the establishment of any particular reserve reflect management's judgment concerning sound financial practice and does not represent any admission of liability with respect to any claims made against the Company's subsidiaries. No assurance can be given that actual claims made and payments related thereto will not be in excess of the amounts reserved.
(2) The Company acquired ECS Re, a subsidiary of ECS Inc, for $21.0 million in cash.
The Company assumed loss portfolio transfers during 2000 and 1999 that are accounted for on a deposit basis. These reserves are included in deposit liabilities and policy benefit reserves with the corresponding assets held in investments available for sale.
In 1999, the Company completed the purchase of Intercargo and ECS for a total of $222.8 million in cash. Both of these transactions are accounted for under the purchase method of accounting, and resulted in goodwill of $159.6 million. These transactions were financed in part through bank borrowings and internal funds.
(2) The Company invested $97.0 million in a joint venture with Les Mutuelles du Mans Assurances Group to form a new French reinsurance company, Le Mans Re.
The Company has had several stock repurchase programs as part of its capital management strategy. In June 1999, the Board of Directors rescinded the Company's share repurchase program in place at that time. On January 9, 2000, the Board of Directors authorized a new program for the repurchase of up to $500.0 million. The new share repurchase program was announced in conjunction with a dividend increase of $0.04 per share per annum. Under the current program, in 2000, the Company purchased 5.1 million shares at a cost of $247.7 million or an average of $48.82 per share.
As at December 31, 2000, the Company had bank, letter of credit and loan facilities available from a variety of sources, including commercial banks, totaling $2.6 billion comprising a 364-day facility, 5-year facilities, notes payable and letter of credit facilities. Debt and notes outstanding at December 31, 2000 were $450.0 million and letters of credit outstanding were $1.1 billion. Letters of credit issued and outstanding, 14% of which were collateralized by the Company's investment portfolio, primarily support U.S. non-admitted business and the Company's Lloyd's capital requirements. Approximately 40% of the letters of credit outstanding were issued in connection with intercompany reinsurance agreements.
During 2000 and 1999, borrowings under these facilities were $250.3 million and $328.7 million, respectively, and repayments under the facilities were $211.0 million and $339.7 million, respectively. The borrowings in 2000 were used as interim funding of share buybacks and were repaid using funds from the equity portfolio. The borrowings in 1999 facilitated the repurchase of shares and the purchase of Intercargo and ECS. In June 1999, the Company converted $100 million 5.25% Convertible Subordinate Debentures due 2002 through the issue of 1.8 million shares out of treasury. The total pre-tax interest expense on notes and debt outstanding during the year ended December 31, 2000 and 1999 was $32.1 million and $37.4 million, respectively. Associated with the Company's bank and loan commitments are various loan covenants with which the Company was in compliance throughout the period. See Note 10 to the Consolidated Financial Statements for further details.
There was no significant impact of Year 2000 issues on the Company's technology systems. The Company did not experience any significant disruption due to the impact of Year 2000 issues on its service providers.
The Company continues to be subject to risks associated with Year 2000 issues based upon the underwriting exposures that it assumed. All insurance and reinsurance subsidiaries of the Company examined the potential exposure to Year 2000-related risks associated with the coverages that they provided. In some instances, Year 2000-related risks were expressly excluded from or included in certain coverages, and in other instances, coverage in respect of such risks is neither expressly excluded nor included. To the extent that Year 2000-related risks materialize, participants in the property and casualty insurance and reinsurance industry, including the Company, could pay or incur significant claims, losses or defense costs which could have a material adverse effect on the Company's results of operations and financial condition. In view of the apparent lack of significant Year 2000-related losses, the Company does not expect to have substantial exposure to Year 2000-related coverage claims. See generally "-Cautionary Note Regarding Forward-Looking Statements".
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 (U.S. dollars in thousands)
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 (U.S. dollars in thousands)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31 2000, 1999 AND 1998
XL Capital Ltd (sometimes referred to as the "Company") is a holding company organized under the laws of the Cayman Islands. XL was incorporated on March 16, 1998, as the successor to EXEL Limited, a Cayman Islands corporation organized in 1986, in connection with EXEL's merger with Mid Ocean Limited, a Cayman Islands corporation. The merger was accounted for as a purchase under U.S. generally accepted accounting principles ("GAAP") and as such, results of operations of Mid Ocean are included from August 1, 1998, the effective date of the merger. In the merger, all of the shares of EXEL and Mid Ocean were exchanged for shares in the Company according to two schemes of arrangement under Cayman Islands law. The Company operated under the name "EXEL Limited" from completion of the merger until February 1, 1999 when its current name was approved by the requisite vote of the Company's shareholders. References herein to XL Capital or the Company also shall include EXEL unless the context otherwise requires. The Company is a leading provider of insurance and reinsurance, including coverages relating to certain financial risks, to industrial, commercial and professional service firms, insurance companies and other enterprises on a worldwide basis.
In 1999, XL Capital merged with NAC Re Corp, a Delaware corporation. The merger has been accounted for as a "pooling of interests" under U.S. GAAP. Under pooling of interests accounting, it is assumed that XL Capital and NAC have been merged from the date of incorporation of the Company, and accordingly, all prior period information contained in these financial statements includes the results of NAC. NAC was organized in 1985 and, through its subsidiaries, writes property and casualty insurance and reinsurance in the U.S., Canada and Europe. Subsequent to the merger agreement, XL Capital amended its financial year from November 30 to December 31 as a conforming pooling adjustment and to facilitate year end reporting for its subsidiaries.
XL Insurance, a company organized under the laws of Bermuda, was formed in 1986 in response to a shortage of high excess liability coverage for Fortune 500 companies in the U.S. In 1990, XL Insurance formed XL Europe, an insurance company organized under the laws of Ireland to serve European clients and, in 1998, formed two companies now known as XL Insurance Company of New York and XL Capital Assurance.
1. HISTORY (CONTINUED) Denham Syndicate Management Limited was acquired in 1998 and it also provides underwriting and similar services to one corporate syndicate, whose capital is partially provided by the Company. This syndicate writes a specialized book of international business, concentrating on long-tail casualty and non-marine physical damage.
The Company has pursued a strategy of entering into ventures with other organizations that possess expertise in lines of business that the Company wishes to write. These ventures are considered to be of strategic importance. The Company's principal ventures are in the areas of financial guaranty insurance, life insurance for high net worth individuals, political risk insurance and currency and related risk management. In July 1999, the Company entered into a venture with Les Mutuelles du Mans Assurances Group to form a new French reinsurance company, Le Mans Re. The Company owns a 49% shareholding in the new company, which underwrites a worldwide portfolio comprising most classes of property and casualty reinsurance business together with a selective portfolio of life reinsurance business.
In 1998, the Company entered into a venture with FSA Holdings Ltd to write financial guaranty insurance and reinsurance. Under the terms of the venture, each of the Company and FSA formed a Bermuda insurance company in which it is the majority shareholder and made a minority investment in the company formed by its co-venturer.
The Company formed Reeve Court Insurance, a Bermuda company organized as a venture with such company's management for the purpose of providing life insurance to high net worth individuals in 1998.
In 1997, the Company acquired a 75% holding in Latin American Re, a Bermuda reinsurance company. The remaining minority interest was purchased in 2000.
Premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums assumed are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. Financial guaranty installment premiums are recorded as premiums written when reported. Premiums are earned on a monthly pro-rata basis over the period the coverage is provided. Financial guaranty insurance premiums are earned over the life of the exposure. Unearned premiums represent the portion of premiums written which is applicable to the unexpired terms of policies in force. Premiums written and unearned premiums are presented after deductions for reinsurance ceded to other insurance companies.
In the normal course of business, the Company seeks to reduce the loss that may arise from events that could cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. Reinsurance premiums ceded are expensed and the commissions recorded thereon are earned on a monthly pro-rata basis over the period the reinsurance coverage is provided. Prepaid reinsurance premiums represent the portion of premiums ceded that is applicable to the unexpired term of policies in force. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Provision is made for estimated unrecoverable reinsurance.
Fee income and other includes fees earned for services, together with premiums, net of loss reserve estimates, on credit default swaps. The Company recognizes fee income over the estimated performance or risk period of the related services provided. Any adjustments to those estimated periods any cumulative adjustments resulting therefrom are reflected in income in the year in which the adjustment is made.
Short-term investments comprise investments with a maturity equal to or greater than 90 days but less than one year. Equity securities include investments in open end mutual funds. All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of equities and fixed income investments are determined on the basis of average cost and amortized cost, respectively. Investment income is recognized when earned and includes
Financial futures and forward currency contracts are carried at fair value, with the corresponding realized or unrealized gain or loss included in income, except in the instance of forward foreign currency contracts that are used to hedge currency risks on specific investments. Gains and losses from these contracts are deferred and included in accumulated other comprehensive income until the corresponding investment asset is sold.
Other monetary assets and liabilities denominated in foreign currencies are translated at the exchange rate in effect at the balance sheet date with the resulting foreign exchange gains and losses recognized in income, unless the foreign currency exposure is directly hedged as discussed above. Revenue and expense transactions are translated at the average exchange rates prevailing during the year.
The Company accounts for its other investments, including investments in limited partnerships, on a cost basis as it has no significant influence over these entities. Investments are written down to their realizable value where management considers there is an other than temporary decline in value. Income is recorded when received.
Intangible assets represent goodwill recorded in connection with the Company's business combinations and are amortized on a straight-line basis over the expected life of the related operations acquired, not exceeding 40 years. The Company evaluates the recoverability of its intangible assets whenever changes in circumstances warrant. If it is determined that an impairment exists, the excess of the unamortized balance over the fair value of the intangible asset will be charged to earnings at that time.
Unpaid losses and loss expenses includes reserves for unpaid reported losses and loss expenses and for losses incurred but not reported. The reserve for unpaid reported losses and loss expenses is established by management based on amounts reported from insureds or ceding companies and consultation with independent legal counsel, and represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company.
Management believes that the reserves for unpaid losses and loss expenses are sufficient to pay losses that fall within coverages assumed by the Company. However, there can be no assurance that losses will not exceed the Company's total reserves. The methodology of estimating loss reserves is periodically reviewed to ensure that the assumptions made continue to be appropriate and any adjustments resulting therefrom are reflected in income of the year in which the adjustments are made.
The Company will periodically re-assess the amount of deposit liabilities and policy benefit reserves. Any changes to the estimated ultimate liability will be reflected as an adjustment to earnings to reflect the cumulative effect to date of the period the contract has been in force and by an adjustment to the future accretion rate of the liability over the remaining estimated contract term.
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
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized.
The Company accounts for stock compensation plans in accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees". Accordingly, compensation expense for stock option grants and stock appreciation rights is recognized to the extent that the fair value of the stock exceeds the exercise price of the option at the measurement date.
Basic earnings per share is based on weighted average common shares outstanding and excludes any dilutive effects of options and convertible securities. Diluted earnings per share assumes the conversion of dilutive convertible securities and the exercise of all dilutive stock options.
Fair value of certain assets and liabilities are based on published market values, if available, or estimates of fair value of similar issues. Fair values are reported in Notes 4 and 10.
The Company is organized into three underwriting segments - insurance, reinsurance, and financial products and services - in addition to a corporate segment that includes the investment operations of the Company. Lloyd's syndicates are part of the insurance segment but are described separately as the nature of the business written and the market in which the Lloyd's syndicates underwrite are significantly different to the Company's other insurance
3. SEGMENT INFORMATION (CONTINUED) subsidiaries. Certain business written by the Company has loss experience characterized as low frequency and high severity. This may result in volatility in both the Company's results and operational cash flows.
Insurance business written includes general liability, other liability including directors and officers, professional and employment practices liability, environmental liability, property, program business, marine, aviation, satellite and other product lines including U.S. Customs bonds, surety, political risk and specialty lines.
Financial products and services business written includes insurance and reinsurance solutions for complex financial risks. These include financial guaranty insurance and reinsurance, credit enhancement swaps and other collateralized transactions. While each of these is unique and is tailored for the specific needs of the insured, they are typically multi-year policies. Due to the nature of these types of policies, premium volume as well as profit margin can vary significantly from period to period. The Company has approached this market on a "net-line" basis, but may cede a portion of some risks to third parties from time to time. In 1999, the Company began assuming large loss portfolios as part of its new asset accumulation strategy.
(4) Corporate operating expenses include one-time charges of $45.3 million related to the merger with NAC.
3. SEGMENT INFORMATION (CONTINUED) The following table shows an analysis of the Company's net premiums written by geographical location of subsidiary:
During 2000, 1999 and 1998, approximately 22%, 21% and 34%, respectively, of the Company's consolidated gross written premiums were generated from or placed by Marsh & McLennan Companies. During 2000, 1999 and 1998, approximately 16%, 13% and 19%, respectively, of the Company's consolidated gross written premiums were generated from or placed by AON Corporation and its subsidiaries. No other broker accounted for more than 10% of gross premiums written in each of the three years ended December 31, 2000.
The following represents an analysis of realized gains (losses) and the change in unrealized appreciation on investments:
4. INVESTMENTS (CONTINUED) The contractual maturities of fixed maturity securities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The Company has two facilities available for the issue of letters of credit collateralized against the Company's investment portfolio with a value of $483.0 million at December 31, 2000 and $791.4 million at December 31, 1999. At December 31, 2000 and 1999, approximately $160.0 million and $591.0 million, respectively, of letters of credit were issued and outstanding under these facilities.
Included in cash and invested assets at December 31, 2000 and 1999 are approximately $18.0 million and $16.6 million, respectively, of assets held in an escrow account in accordance with U.S. insurance regulations.
In certain investments, the carrying value is different from the underlying share of the investee's net assets. The difference represents goodwill on acquisition that is being amortized.
6. BUSINESS COMBINATIONS AND CHANGE IN FISCAL YEAR END (CONTINUED) The following table presents a reconciliation of the total revenues, net income, and earnings per share of the Company as previously reported as adjusted for the change in fiscal year end, combined with the results of NAC:
In 1999, the Company acquired Intercargo, which underwrites specialty insurance products for companies engaged in international trade, including U.S. Customs bonds and marine cargo insurance.
Cash and cash equivalents totaling $137 million is included in other assets. Net cash acquired as a result of this merger was $41 million.
Several aspects of the Company's casualty insurance operations complicate the actuarial reserving techniques for loss reserves as compared to other insurance operations. Among these aspects are the differences in the policy forms from more traditional forms, the lack of complete historical loss data for losses of the same type intended to be covered by the policies and the expectation that losses in excess of the attachment level of the Company's policies generally will be characterized by low frequency and high severity, limiting the utility of claims experience of other insureds for similar claims. While management believes it has made a reasonable estimate of ultimate losses, the ultimate claims experience may not be as reliably predicted as may be the case with other insurance operations, and there can be no assurance that losses and loss expenses will not exceed the total reserves.
7. LOSSES AND LOSS EXPENSES (CONTINUED) ultimate losses recorded, loss reserves will be reduced at that time. This occurred for the 1993 through 1996 underwriting years, resulting in a reduction in prior year losses.
Net losses incurred for 2000 also reflects reserve adjustments to several unprofitable lines of business that the Company has now exited, including trucking, inland energy and certain classes of aviation. A net reserve charge of $114.0 million has been recorded for these lines.
In 1999, the Lloyd's operations experienced loss deterioration on the U.K. motor business principally from the 1998 and 1999 underwriting years of approximately $20.0 million. The motor business was sold in December 1999 and the Company retains residual liability on this business.
1999 incurred losses also include an increase to reinsurance loss reserves of $95.0 million for NAC Re due to an alignment of reserving methodologies at the time of the merger with the Company in June 1999.
The decrease in prior year incurred losses in all three years is driven primarily by the Company's insurance liability excess of loss reserves. The basis for establishing IBNR for these lines is relatively judgmental due to the lack of industry data available. Consequently, the Company estimates loss reserves through actuarial models based upon its own experience. When the Company commenced writing this type of business in 1986, limited data was available and the Company has made its best estimate of loss reserves for each underwriting year since that time. Over time, the amount of data has increased, providing a larger statistical base for estimating reserves. Redundancies in prior year loss reserves have occurred where loss experience has developed more favorably than expected. This trend is not necessarily expected to continue.
The Company's net incurred losses and loss expenses includes a charge of $2.8 million, $10.6 million and $1.2 million in 2000, 1999 and 1998, respectively, for estimates of actual and potential non-recoveries from reinsurers. Such charges for non-recoveries relate mainly to reinsurance ceded for casualty business written prior to
7. LOSSES AND LOSS EXPENSES (CONTINUED) 1986. As at December 31, 2000 and 1999, the reserve for potential non-recoveries from reinsurers was $25.6 million and $25.8 million, respectively.
Incurred but not reported ("IBNR") losses, net of reinsurance, included in the above table was $14.0 million in 2000, $16.1 million in 1999 and $17.0 million in 1998. Unpaid losses recoverable are net of potential uncollectable amounts.
As of December 31, 2000 and 1999, the Company had approximately 374 and 370 open claim files, respectively, for potential asbestos exposures and 613 and 689 open claim files, respectively, for potential environmental exposures on business written prior to 1986. Approximately 45% and 46% of the open claim files for 2000 and 1999, respectively, are due to precautionary claim notices. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to receive coverage under the reinsurance contract. Such notices do not contain an incurred loss amount to the Company.
7. LOSSES AND LOSS EXPENSES (CONTINUED) The Company believes it has made reasonable provision for its asbestos and environmental exposures and is unaware of any specific issues that would significantly affect its estimate for losses and loss expenses.
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $1.1 billion, $390.9 million and $294.0 million for the years ended December 31, 2000, 1999 and 1998, respectively. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $371.0 million at December 31, 2000, collateralizing reinsurance recoverables with respect to certain retrocessionnaires.
The Company has entered into certain contracts that transfer insufficient risk to be accounted for as reinsurance under SFAS No. 113. These contracts have been recorded as deposit liabilities and are matched by an equivalent amount of investments. At December 31, 2000 and 1999, total deposit liabilities were $628.4 million and $310.4 million, respectively.
In December 1999, the Company entered into a contract reinsuring a portfolio of life and annuity business that has been accounted for as an investment contract under SFAS No. 97, with a corresponding liability for estimated future policy benefits in the amount of $635.6 million. The Company transferred liabilities of $108.1 million in 2000 to a third party for an equivalent consideration.
As at December 31, 2000, the Company had bank, letter of credit and loan facilities available from a variety of sources, including commercial banks, totaling $2.6 billion (1999: $2.16 billion) of which $450.0 million (1999: $410.7 million) was outstanding. In addition, $1.1 billion (1999: $891.6 million) of letters of credit were outstanding, 14% of which were collateralized by the Company's investment portfolio, supporting U.S. non-admitted business and the Company's Lloyd's capital requirements. Approximately 40% of the non-collateralized letters of credit were issued in connection with intercompany quota share agreements between subsidiaries.
The Company entered a $500.0 million 364-day revolving credit facility effective June 5, 2000 to replace previous facilities of $650.0 million that expired during the year. A syndicate of banks provides this facility and borrowings are unsecured. The Company borrowed and repaid $200.0 million under the expired facility during the first quarter of 2000. There were no borrowings under the facilities during the remainder of the year ended December 31, 2000. The weighted average interest rate on the funds borrowed was approximately 6.3% during 2000 and approximately 5.41% during 1999.
The Company repaid an $11.0 million term note on September 29, 2000.
$100.0 million of 8% Senior Notes due June 15, 1999 were issued in June 1992 through a public offering. These Notes were repaid in June 1999 through additional borrowings and internal funds.
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of its foreign currency fixed maturities and equity investments. These contracts are not designated as specific hedges for financial reporting purposes and therefore, realized and unrealized gains and losses recognized on them are recorded in income in the period in which they occur. These contracts generally have maturities of three months or less. In addition, where the Company's investment managers are of the opinion that potential gains exist in a particular currency, then a forward contract will not be entered into. At December 31, 2000 and 1999, forward foreign exchange contracts with notional principal amounts totaling $111.9 million and $339.3 million, respectively, were outstanding. The fair value of these contracts as at December 31, 2000 was $109.6 million (1999: $341.1 million) with unrealized losses of $2.3 million (1999: $1.8 million). Gains of $28.1 million and losses of $2.7 million were realized during 2000 and 1999, respectively.
In addition, the Company also enters into foreign exchange contracts to buy and sell foreign currencies in the course of trading its foreign currency investments. These contracts are not designated as specific hedges for financial reporting purposes, and generally have maturities of two weeks or less. As such, any realized or unrealized gains or losses are recorded in income in the period in which they occur. At December 31, 2000, the Company had $54.9 million of such contracts outstanding, and had recognized $1.5 million in realized and unrealized losses for the year. At December 31, 1999, the value of such contracts outstanding was not significant.
The Company attempts to hedge directly the foreign currency exposure of a portion of its foreign currency fixed maturity investments using forward foreign exchange contracts that generally have maturities of three months or less, and which are rolled over to provide continuing coverage for as long as the investments are held. Where an investment is sold, the related foreign exchange sale contract is closed by entering into an offsetting purchase contract. At December 31, 2000, the Company had, as hedges, foreign exchange contracts for the sale of $121.0 million (1999: $94.0 million) and the purchase of $25.7 million (1999: $7.4 million) of foreign currencies at fixed rates, primarily Euros. The notional value of fixed maturities denominated in foreign currencies that were hedged and held by the Company as at December 31, 2000 and 1999 was $100.6 million and $85.2 million, respectively.
The Company attempts to manage the exchange volatility arising from certain administration costs denominated in foreign currencies. Throughout the year, forward contracts are entered into to acquire the foreign currency at an agreed rate in the future. Any gains or losses on the forward contracts are deferred and included as a component of shareholders' equity. As the administration expenses are incurred, the gains and losses are recognized in the income statement. At December 31, 2000, the Company had forward contracts outstanding for the purchase of $12.8 million of Euros and U.K. Sterling at fixed rates. Gains and losses deferred in accumulated other comprehensive income and realized throughout the year were insignificant.
11. COMMITMENTS AND CONTINGENCIES (CONTINUED) The Company is exposed to credit risk in the event of non-performance by the other parties to the forward contracts, however the Company does not anticipate non-performance. The difference between the notional principal amounts and the associated market value is the Company's maximum credit exposure.
Derivative investments are also utilized to add value to the portfolio where market inefficiencies are believed to exist and also to adjust the duration of a portfolio of fixed income securities to match related deposit liabilities. At December 31, 2000, bond and stock index futures outstanding were $40.1 million (1999: $241.1 million), with underlying investments having a market value of $2.5 billion (1999: $2.5 billion).
The Company's investment portfolio is managed by external managers in accordance with guidelines that have been tailored to meet specific investment strategies, including standards of diversification which limit the allowable holdings of any single issue. The Company did not have an aggregate investment in a single entity, other than the U.S. government, in excess of 10% of shareholders' equity at December 31, 2000 and 1999.
The Company has committed to invest in several limited partnerships as part of its overall corporate strategy. The primary purpose of these partnerships is to invest capital provided by the partners in various insurance and reinsurance ventures. The Company had invested $103.0 and $65.4 million as at December 31, 2000 and 1999, respectively, with commitments to invest a further $149.7 million over the next ten years. The Company received income from its investments of $4.0 million and $9.4 million and for the years ended December 31 2000 and 1999, respectively. The Company continually reviews the performance of the partnerships to ensure there is no other than temporary decline in the values of its investments. The Company is a limited partner and, as such, does not actively participate in the management of the partnerships.
In 1997, the Company acquired commercial real estate in Bermuda for the purpose of securing long-term office space for its worldwide headquarters. The total cost of this development, including the land, is expected to be approximately $110.0, of which $101.0 million had been spent as at December 31, 2000. It is estimated that the development will be completed in April 2001.
The Company is a Cayman Islands corporation and, except as described below, neither it nor its non-U.S. subsidiaries have paid United States corporate income taxes (other than withholding taxes on dividend income) on the basis that they are not engaged in a trade or business or otherwise subject to taxation in the United States; however, because definitive identification of activities which constitute being engaged in trade or business in the United States is not provided by the Internal Revenue Code of 1986, regulations or court decisions, there can be no assurance that the Internal Revenue Service will not contend that the Company or its non-U.S. subsidiaries are engaged in trade or business or otherwise subject to taxation in the United States. If the Company or its non-U.S. subsidiaries were considered to be engaged in trade or business in the United States (and, if the Company or such subsidiaries were to qualify for the benefits under the income tax treaty between the United States and Bermuda or Ireland, such businesses were attributable to a "permanent establishment" in the United States), the Company or such subsidiaries could be subject to U.S. tax at regular tax rates on its taxable income that is effectively connected with its U.S. trade or business plus an additional 30% "branch profits" tax on such income remaining after the regular tax, in which case there could be a significant adverse effect on the Company's results of operations and financial condition.
The Company insures and reinsures financial guaranties issued to support public and private borrowing arrangements. Financial guaranties are conditional commitments that guaranty the performance of a customer to a third party. The Company's potential liability in the event of non-performance by the issuer of the insured obligation is represented by its proportionate share of the aggregate outstanding principal and interest payable ("insurance in force") on such insured obligation. At December 31, 2000, the Company's aggregate insurance in force was $16.6 billion. The Company manages its exposure to credit risk through a structured underwriting process which includes detailed credit analysis, review of and adherence to underwriting guidelines, surveillance policies and procedures and the use of reinsurance.
The authorized share capital is 999,990,000 ordinary shares of a par value of $0.01 each. Holders of Class A shares are entitled to one vote for each share. In June 2000, the Company's Class B ordinary shares were converted into Class A ordinary shares on a one-for-one basis.
The Company has had several stock repurchase plans in the past as part of its capital management program. In June 1999, the Board of Directors rescinded the Company's share repurchase plans. On January 9, 2000, the Board of Directors authorized the repurchase of shares up to $500 million. During 2000, the Company repurchased 5.1 million shares at a total cost of $247.7 million, or an average cost of $48.82 per share.
The Company's executive stock plan, the "1991 Performance Incentive Program", provides for grants of non- qualified or incentive stock options, restricted stock awards and stock appreciation rights ("SARs"). The plan is administered by the Company and the Compensation Committee of the Board of Directors. Stock options may be granted with or without SARs. 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 10 years and vest annually over three years from date of grant.
Restricted stock awards issued under the 1991 Performance Incentive Program plan vest over a five year period from the date of grant. These shares contained certain restrictions, for said period, relating to, among other things, forfeiture in the event of termination of employment and transferability. As the shares are issued, deferred compensation equivalent to the difference between the issue price and the estimated fair market value on the date of the grant is charged to shareholders' equity and subsequently amortized over the five-year restriction period. Restricted stock issued under the plan totaled 77,472 shares, 113,100 shares and 147,836 shares in 2000, 1999 and 1998, respectively. Restricted stock awards granted by NAC prior to the merger amounted to 3,627 shares and 23,700 shares in 1999 and 1998. Vesting for such shares generally occurs over a six year period.
The Company also has stock plans in place for its non-employee directors. The "Stock and Option Plan" issues non-qualified options to the directors-4,000 shares at the commencement of their directorship and 5,000 shares
12. SHARE CAPITAL (CONTINUED) each year thereafter. All options vest immediately on the grant date. Effective April 11, 1997, all options granted to non-employee directors are granted under the 1991 Performance Incentive Program. Directors may also may make an irrevocable election preceding the beginning of each fiscal year to defer cash compensation that would otherwise be payable as his or her annual retainer in increments of $5,000. The deferred payments are credited in the form of shares calculated by dividing 110% of the deferred payment by the market value of the Company's stock at the beginning of the fiscal year. Each anniversary thereafter, 20% of these shares are distributed. Shares issued under the plan totaled 7,846, nil and 2,737 in 2000, 1999 and 1998, respectively.
Total stock based compensation expensed was $9.5 million, $7.7 million and $5.8 million, in 2000, 1999 and 1998, respectively.
* Available for grant includes shares that may be granted as either stock options or restricted stock.
12. SHARE CAPITAL (CONTINUED) The following table summarizes information about the Company's stock options (including stock appreciation rights) for options outstanding as of December 31, 2000:
The Company's Articles of Association restrict the voting power of any person to less than approximately 10% of total voting power.
Rights to purchase Class A ordinary shares ("the Rights") were distributed as a dividend at the rate of one Right for each Class A ordinary share held of record as of the close of business on October 31, 1998. Each Right entitles holders of Class A ordinary shares to buy one ordinary share at an exercise price of $350. The Rights would be exercisable, and would detach from the Class A ordinary shares, only if a person or group were to acquire 20% or more of XL's outstanding Class A ordinary shares, or were to announce a tender or exchange offer that, if consummated, would result in a person or group beneficially owning 20% or more of Class A ordinary shares. Upon a person or group without prior approval of the Board acquiring 20% or more of Class A ordinary shares, each Right would entitle the holder (other than such an acquiring person or group) to purchase Class A ordinary shares (or, in certain circumstances, Class A ordinary shares of the acquiring person) with a value of twice the Rights exercise price upon payment of the Rights exercise price. The Company will be 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 become exercisable. The Rights will expire at the close of business on September 30, 2008, and do not initially have a fair value. The Company has initially reserved 119,073,878 Class A ordinary shares being authorized and unissued for issue upon exercise of Rights.
The Company's expenses for its retirement plans are not considered to be significant.
XL Brockbank, NAC Re International and XL Re's London branch office are subject to United Kingdom corporation taxes. Other branches of the Company are subject to relevant local taxes.
The tax charge (benefit) in each of the three years ended December 31, 2000 is comprised of amounts from the various taxable jurisdictions in which the Company operates. For all countries other than the U.S., there generally is no significant difference between the effective tax rate and the statutory rate in that jurisdiction. For U.S. operating income (loss), the effective rate differs from the statutory rate of 35% primarily due to tax-exempt investment income in all years, merger related costs in 1999 and a change in management's valuation allowance.
Significant components of the Company's deferred tax assets and liabilities, which principally relate to U.S. subsidiaries as of December 31, 2000 and 1999 were as follows:
Shareholders' equity at December 31, 2000 and 1999 reflects tax benefits of $3.3 million and $1.5 million, respectively, related to compensation expense deductions for stock options exercised for one of the Company's U.S. subsidiaries.
The Company's ability to pay dividends is subject to certain regulatory restrictions on the payment of dividends by its subsidiaries. The payment of such dividends is restricted by applicable laws of Bermuda, Ireland, the U.S. and U.K., including Lloyd's. The Company relies primarily on cash dividends from XL Insurance and XL Re.
The Company's U.S. insurance and reinsurance subsidiaries, the most significant of which is NAC Re, are subject to regulatory oversight under the insurance statutes and regulations of the jurisdictions in which they conduct business.
18. STATUTORY FINANCIAL DATA (CONTINUED) The following table shows statutory net income and GAAP net income (loss) and consolidated statutory surplus and consolidated shareholders' equity of NAC Re.
XL Brockbank, via Lloyd's, is a licensed insurer in the states of Illinois and Kentucky and in the U.S. Virgin Islands ("USVI"). It is also an eligible surplus lines writer in all states other than Kentucky and in the USVI, and an accredited reinsurer in every state other than Michigan, Kansas and Arizona. XL Aerospace is licensed in California as a fire and casualty broker, surplus lines broker and special lines surplus lines broker.
The insurance laws of each state of the U.S. and of many foreign countries regulate the sale of insurance within their jurisdiction by alien insurers, such as XL Insurance and XL Re. The Company believes it is not in violation of the insurance laws of any state in the U.S. or any foreign country. From time to time, various proposals for federal legislation within the United States have been circulated which could require the Company to, among other things, register as a surplus lines insurer. The Company believes that generally it could meet and comply with the requirements to be registered as a surplus lines insurer and such compliance would not have a significant impact on the ability of the Company to conduct its business. There can be no assurances, however, that the activities of the Company will not be challenged in the future or that the Company will be able to successfully defend against such challenges or that legislation will not be enacted that will affect the Company's ability to conduct its business.
18. STATUTORY FINANCIAL DATA (CONTINUED) Accounts) Regulations, 1995, the European Communities (Non-Life Insurance) Framework Regulations, 1994 and related administrative rules (the "Irish Regulations").
In addition, XL Europe's insurance activities are subject to minimum solvency and reserve standards and auditing and reporting requirements. The Minister for Enterprise, Trade and Employment has wide powers to supervise, investigate and intervene in the affairs of such insurers.
The Company, XL Brockbank and Denham are subject to the regulatory jurisdiction of the Council of Lloyd's (the "Council"). Unlike other financial markets in the U.K., Lloyd's is not subject to direct U.K. government regulation through The Financial Services Act of 1986 but, instead, is self regulating by virtue of the Lloyd's Act of 1982 through the bye-laws, regulations and codes of conduct written by the Council, which governs the market. It is expected that the U.K. FSA will become ultimately responsible for Lloyds regulation in 2001. Under the Council, there are two boards, the Market Board and the Regulatory Board. The former is led by a number of the working members of the Council and is responsible for the development and growth of Lloyd's worldwide business. The Regulatory Board is responsible for developing and monitoring regulatory practice and procedures. Under the regulations, the approval of the Council has to be obtained before any person can be a "major shareholder" or "controller" of a corporate Name or managing agency. The Company has been approved as both a "major shareholder" and a "controller" of its corporate Names (the "CCVs") and managing agencies.
As a "controller", the Company is required to give certain undertakings, directed principally towards ensuring that there is no direct interference in the conduct of the business of the relevant managing agency, but there are no provisions in the Lloyd's Act of 1982, the bye-laws or the regulations which provide for any liabilities of the CCVs or the XL Brockbank group as a whole to be met by the Company. In addition, a managing agency is required to comply with various capital and solvency requirements and to submit to regular monitoring and compliance procedures. The CCVs, as corporate members of Lloyd's are each required to commit a specified amount approximately equal to 50% of their underwriting capacity on the syndicates to support its underwriting on those syndicates.
In the fourth quarter of 2000, the Company incurred after-tax charges of $124.6 million, or $0.98 per share, which included certain reserve adjustments together with employee severance charges and other costs associated with the realignment of the Company's operations and the discontinuation of certain business lines. In the fourth quarter of 1999, the Company incurred after-tax losses of $125.0 million, or $0.97 per share, as a result of two major European windstorms in December 1999. The second quarter of 1999 included charges relating to merger with NAC.