Total rent expense for the years ended December 31, 2006, 2005 and 2004 was approximately $35.8 million, $34.9 million and $31.2 million, respectively. See Item 8, Note 19(d) to the Consolidated Financial Statements, “Commitments and Contingencies - Properties,” for discussion of the Company’s lease commitments for real property.
Net income from investment affiliates in 2003 includes income on the alternative investment portfolio for eleven months ended November 30, 2003 as compared to the twelve months ended December 31, 2002 and the twelve months ended November 30 in subsequent years. The fair market values of certain of these alternative investments often take longer to obtain as compared to our other investments and the Company records the investment fund affiliates on a one month lag and the private investment fund affiliates on a three month lag in order for us to meet the accelerated filing deadlines as specified by the SEC.
The underwriting expense ratio is the sum of acquisition expenses and operating expenses for the Insurance and Reinsurance segments divided by net premiums earned for the Insurance and Reinsurance segments. See Item 8, Note 4 to the Consolidated Financial Statements, “Segment Information”, for further information.
needed next year as certain U.S. catastrophe exposures run off. Property results for 2006 also reflect exceptionally low recent loss activity. In casualty lines, the Company experienced pricing pressures throughout 2006, particularly in Europe and U.S. primary business. Management continues to monitor these lines closely for price and term movements.
Generally, the Reinsurance segment has experienced pricing trends similar to those noted in the Insurance segment. With regards to U.S. property catastrophe business, significant rate increases were experienced in 2006 despite the increase in available capacity, while modest rate increases were also experienced in continental Europe. In casualty reinsurance lines, pricing pressure has been noted similar to that described in the Insurance segment.
In 2006, the Company’s net investment income increased primarily due to the increase in the size of the investment portfolio and also a rise in the level of the U.S., U.K., and Euro zone interest rates. In 2006, the Company generated net realized losses from its investment portfolio primarily due to other-than-temporary impairments. Net gains from the equity and non-U.S. dollar fixed income portfolios were offset by net losses on U.S. dollar fixed income portfolios, reflecting higher U.S. interest rates. In 2005, the Company generated net realized gains from both its equity and fixed income portfolios, reflecting the current and accumulated performance of the capital markets. In 2004, the Company generated net realized gains from both its equity and fixed income portfolios reflecting the overall performance of capital markets and the deterioration of the U.S. dollar relative to foreign currencies.
The Company’s profitability in any given period is based upon its premium and investment revenues as noted above, less net losses incurred and expenses. Net losses incurred are based upon claims paid and changes to unpaid loss reserves. Unpaid loss reserves are estimated by the Company and include both reported loss reserves and reserves for losses incurred but not reported, or IBNR. The Company’s positive financial results for 2006 were partly a result of the lack of significant catastrophe events occurring throughout the year as well as net favorable development of prior year reserves, primarily in reinsurance property lines of business. The Company’s results for 2005 were significantly impacted by the unprecedented insured hurricane losses during the 2005 Atlantic hurricane season, the charge related to the conclusion of the independent actuarial process with Winterthur Swiss Insurance Company (“the Winterthur Decision”) and adverse development of prior year loss reserves in both insurance professional lines and reinsurance casualty lines. The Company’s results for 2004 were also significantly impacted by the catastrophe activity in that year, combined with adverse prior year development in certain lines of the Company’s Insurance segment. For a further discussion of these events see “Results of Operations” below.
Management intends to maximize the Company’s ability to achieve profitable growth by focusing on leveraging the Company’s operational platforms and building out the Company’s capabilities, teams and product offerings in its chosen markets. Such markets include Excess & Surplus, Private Company D&O, U.K. closed block life reinsurance, U.S. term life reinsurance and other lines and regions where management believes positive market indicators exist.
In the Insurance Segment, initial indications show a gradually softening market with variations by line and geography. In addition, competitive pressures are making new business more difficult to win. December and January rate changes range from flat to down 5% on the property and casualty global risk business, with perhaps as much as a 10% decrease in some other lines. Renewals in the U.S. for 2007 have shown that traditional D&O and E&O professional rates are down approximately 10% with flat to modest increases in the design and select professional books. Specialty lines pricing remains generally flat. Aviation and marine lines are the exceptions to this as they face increasing competition.
One way that the Company evaluates the performance of its insurance and reinsurance general operations is the underwriting profit or loss. The Company does not measure performance based on the amount of gross premiums written. Underwriting profit or loss is calculated from premiums earned and fee income, less net losses incurred and expenses related to underwriting activities, plus unrealized foreign exchange gains and losses on underwriting balances. As noted above, the Company’s positive results for 2006 were partly a result of the lack of significant catastrophe events occuring throughout the year and net favorable prior year loss development. In addition, underwriting profit also
increased based on the addition of certain new business lines and the increase in premium rates within certain lines of business. The Company’s underwriting profit and loss in 2005 and 2004 was negatively impacted by net losses incurred from catastrophic events, the results of the Winterthur Decision and adverse development of prior year loss reserves. Any changes to loss reserves affect the calculation of underwriting profit or loss but most often do not directly affect the Company’s cash flow in the same period. See further discussion below.
The combined ratio for general operations is used by the Company and many other insurance and reinsurance companies as another measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company’s general insurance and reinsurance operations. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss. The Company’s improved combined ratio in 2006 was primarily due to the lack of significant catastrophe events occuring throughout the year, while in 2005 and 2004 the combined ratio was negatively impacted by the factors affecting the underwriting profit (loss), noted above. Excluding the catastrophe losses and the impact of the Winterthur Decision, the combined ratio in 2005 was 92.1%. The relative decrease in 2006 is as a result of a decrease in the loss ratio due to the net favorable development on prior year reserves partially offset by an increased operating expense ratio.
Net investment income from general operations is an important measure that affects the Company’s overall profitability. The largest liability of the Company relates to its unpaid loss reserves, and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due, and thus a significant part of the portfolio is in fixed income securities. Net investment income is affected by the size of the portfolio and also the level of market interest rates. The average size of the investment portfolio outstanding during the year ended December 31, 2006 increased as compared to 2005 due to the Company’s issuance of ordinary shares and equity units in the fourth quarter of 2005 and its positive operating cash flow. Total investments as at December 31, 2006 were $42.1 billion as compared to $38.2 billion as at December 31, 2005. In 2006, the U.S. yield curve shifted upwards with short-term U.S. interest rates increasing markedly while medium to long-term interest rates had a less dramatic rise. U.K. and the Euro zone interest rates also increased over the course of the year. In 2005, the U.S. yield curve flattened significantly with U.S. short to medium term interest rates increasing markedly while long term rates showed a small decline. U.K. rates declined, while in the Euro-zone short term rates rose while medium to long term rates declined.
Management also views the change in the Company’s book value per ordinary share as an additional measure of the Company’s performance. Book value per share is calculated by dividing ordinary shareholders’ equity by the number of outstanding ordinary shares at any period end. Book value per ordinary share is affected primarily by the Company’s net income and also by any changes in the net unrealized gains and losses on its investment portfolio. Book value per ordinary share has increased by $8.81 in 2006 as compared to a decrease of $7.67 in 2005. The factors noted above have created $1.7 billion in net income throughout 2006, which has been the main contributor to the increase in the book value. However, the net unrealized gains associated with the Company’s investment portfolio have decreased by $103.8 million net of tax during 2006. These movements were generally due to interest rate increases, which were offset by the positive impact of equity and currency movements. The Company’s book value per ordinary share decreased in 2005 as a result of the underwriting losses incurred, partially offset by the significant capital-raising during December 2005, where ordinary shares were issued at a premium to the book value at that time. During 2005, book value per share also decreased as a result of a decrease in the unrealized gains on the Company’s investment portfolio. The decrease was primarily as a result of increasing short to medium term U.S. interest rates, partially offset by declining longer term U.K. interest rates.
As part of the overall structuring of the IPO, certain formation transactions occurred in order to move all units included in the IPO under SCA. In addition, in connection with the IPO, the Company has entered into reinsurance agreements with SCA to retain certain insurance risks along with the related liabilities. At their inception, these contracts had no effect on the Company’s income. In addition, the Company has entered into arrangements to provide adverse development protection to SCA related to certain limited risks where the Company would pay up to the limits of the underlying coverages. The Company has also entered into a number of agreements with SCA that govern certain aspects of the relationship after the IPO, including service agreements under which the Company will provide certain services to SCA for a limited period of time.
In 2006, management entered into certain catastrophe risk reduction measures and strategic initiatives intended to reduce volatility while, at the same time, improving the quality of the Company’s risk adjusted returns. These measures include the Company’s cessions to Cyrus Reinsurance Limited (“Cyrus Re”) and reducing the Company’s catastrophe exposures in the Company’s global risk property Insurance book, the International Catastrophe Insurance Managers, LLC portfolio, the reinsurance property risk book and the Company’s offshore marine & energy books in both the Insurance and Reinsurance segments.
In addition, on December 5, 2006, the Company and certain operating subsidiaries entered into a securities issuance agreement and certain of its foreign insurance and reinsurance subsidiaries entered into an excess of loss reinsurance agreement with Stoneheath Re. The net effect of these agreements to the Company is the creation of a contingent put option to issue $350.0 million of preference ordinary shares in the aggregate. The agreements provide the Company with a reinsurance collateral account in support of certain covered perils named in the reinsurance agreement. The initial covered perils include United States wind, European wind, California earthquake and terrorism worldwide.
Another important matter on which management is focused (and which also affects the Company’s ability to underwrite business) is the availability of collateral. Collateral includes letters of credit, insurance trusts and other credit facilities required to provide security to cedants (which are companies who reinsure their liabilities to the Company), particularly as required by state insurance regulation in the U.S. and at Lloyd’s, and also to provide the Company with liquidity as required. These facilities are provided to the Company from commercial banks. Our principal credit facilities have tenors of two, three, and five years. The Company has also utilized “off balance sheet” transactions in order to obtain more collateral capacity (these transactions are described below under “Variable Interest Entities and Other Off Balance Sheet Arrangements”). As the Company writes more business, its collateral requirements will increase. A key challenge for management is to ensure that sufficient collateral capacity is available to support future writing of business.
A new Office of the Chief Executive Officer (“OCEO”) was formed effective July 1, 2006. It is comprised of five senior executive functions including the Company’s Chief Financial Officer, Chief Investment Officer, Chief Executive - Global Business Services and two newly-created roles, Chief Operating Officer and Chief of Staff.
This new structure is designed to provide a focused, enterprise-wide framework to allow the Company’s business leaders to leverage strategic opportunities and execute on business priorities.
Fiona E. Luck, formerly Global Head of Corporate Services, was appointed Chief of Staff. As such, Ms. Luck is responsible for management of the Company’s legal and corporate actuarial functions in addition to her existing role managing a wide range of other holding company functions including Corporate Strategy, Human Resources, Corporate Communications, Marketing and Corporate Social Responsibility.
In conjunction with the SCA IPO, Mr. Paul S. Giordano, formerly Executive Vice President and Chief Executive of XL’s Financial Products & Services segment, was appointed to the position of President and Chief Executive Officer of SCA and Chief Executive Officer of XLCA.
Under the terms of the Sale and Purchase Agreement (the “SPA”), as amended, between XL Insurance (Bermuda) Ltd (“XLI”) and Winterthur Swiss Insurance Company (“WSIC”), WSIC provided the Company with post-closing protection with respect to, among other things, adverse development of reserves and premium on certain Winterthur International Insurance business as well as protection with respect to third party reinsurance receivables and recoverables related to the acquisition of certain Winterthur International insurance operations (the “Winterthur Business”).
On December 6, 2005, the Company received the final report from the Independent Actuary in connection with the resolution process in place to settle the Company’s post-closing protection related to adverse reserve and premium developments. The Independent Actuary’s determinations resulted in the Company receiving a net lump sum payment in the amount of approximately $575.0 million (including interest receivable) from WSIC. As the Company had
recorded $1.4 billion in unpaid losses and loss expenses recoverable related to this protection, a loss of approximately $834.2 million was recorded in the fourth quarter of 2005.
During 2006, management focused on resolving all remaining outstanding matters with WSIC including the remaining protection related to third party reinsurance receivables and recoverables.
The Agreement further provides for a four-year term, collateralized escrow arrangement (the “Fund”) of up to $185 million (plus interest) to protect subsidiaries of the Company from future nonperforming third party reinsurance related to the Winterthur Business. The Fund has been structured to align the parties’ interests by providing for any sums remaining in the Fund at the end of its term to be shared in agreed percentages.
In the normal course of business, the Company is exposed to foreign exchange fluctuations on various items on its financial statements, in particular investments, future policy benefit reserves and unpaid losses and loss expenses. This exposure also exists on certain inter-company balances, which are eliminated for consolidation purposes. The Company attempts to manage this economic exposure through matching foreign currency denominated liabilities with foreign currency denominated assets. While unrealized foreign exchange gains and losses on underwriting balances are reported in earnings, the offsetting unrealized gains and losses on invested assets are recorded as a separate component of shareholders’ equity, to the extent that the asset currency does not match that entity’s functional currency. This results in an accounting mismatch, that will result in foreign exchange gains or loss depending on the movement in certain currencies. In order to improve administrative efficiencies as well as to address this accounting imbalance, the Company formed several branches with Euro and U.K. Sterling functional currencies during the second and fourth quarters of 2006. Management will continue to focus on attempting to limit this type of exposure in the future.
The Company continues to identify opportunities for growth and profit within various emerging markets. On September 1, 2006 the Company announced that they had entered a definitive agreement to form a joint venture insurance company in Brazil. The new insurance company, ITAÚ XL Seguros Corporativos S.A. (“ITAÚ XL”), will combine the current Brazilian property, casualty and specialty commercial insurance business of Banco Itaú Holding Financeira S.A. (“ITAÚ”) and the Company and will operate in Brazil’s commercial lines insurance market. Given the recent decision by the Brazilian government to privatize the domestic reinsurance market, the Company should be well positioned in the future to grow both its insurance and reinsurance lines of business in Brazil.
The Company’s ability to compete is influenced by its operational efficiency and effectiveness, including the development and retention of its people. In recognition of this, the Company has in place and continues to develop, programs and initiatives aimed at enhancing its position in these areas. For example, the Company continues to make significant investments in information technology in both the Insurance and Reinsurance segments, develop and implement a new framework for Financial Reporting and Controls, and continues to develop an operations center based in India. Each of these projects requires considerable investment and commitment of the Company’s resources in an effort to achieve the ultimate goals of increased operational efficiency and effectiveness.
The Company believes that effective talent management and succession planning processes are key to the long-term success of the Company. As such, the Company has implemented various development programs and succession planning efforts across the Company. The Company’s development programs include the global development program for its high potential junior employees, the performance development program for its managers and team leaders, and the leadership development program for its senior managers. Succession planning efforts include identifying and monitoring the various talent pools within the Company to match the future needs and long-term strategy of the Company.
1. Limited number of natural catastrophes during 2006 as compared to 2005 and 2004
During 2006, there were a limited number of natural catastrophes as compared to 2005 and 2004. Specifically, there were only five hurricanes in the Atlantic region in 2006 as compared to fifteen in 2005. More importantly, for the hurricanes that did make landfall in 2006, the resulting insured damage was minimal. Total property catastrophe losses for events in 2006 were insignificant, however, there was net adverse development on the 2005 catastrophes of $119.4 million. This overall low level of catastrophe losses was a significant factor in the successful results achieved by the Company in 2006.
The year ended December 31, 2004 was negatively impacted by four hurricanes, Frances, Charley, Ivan and Jeanne, for a total net loss of $516.6 million, net of reinsurance recoveries. In addition, the Company incurred net losses and loss expenses of $74.6 million in 2004 as a result of the earthquake and the subsequent tsunami that struck South Asia on December 26, 2004.
The Life operations segment was unaffected by these catastrophes and hence has been excluded from the table above.
During 2006, net reserves established for the events noted above adversely developed by $119.4 million primarily in the Reinsurance segment. These developments were partially offset by additional loss sensitive premium received.
The Independent Actuary’s report concluded that WSIC’s submitted Seasoned Net Reserve Amount (“SNRA”) and Net Premium Receivable Amount (“NPRA”) were closest to the Independent Actuary’s determinations of SNRA and NPRA. These determinations resulted in the Company receiving a net lump sum payment in the amount of
Within the Insurance segment, net overall favorable prior year reserve development for the year ended December 31, 2006 was $13.2 million. This overall favorable development included reserve releases of $94.4 million in property lines and $91.1 million in casualty lines, partially offset by $96.5 million, $3.0 million and $72.8 million of prior year adverse development in certain professional, marine and aviation, and other lines of business, respectively. Property reserve releases resulted from favorable experience in the 2005 accident year for both attritional and catastrophe losses. Casualty reserve releases were noted largely in Europe including $69.2 million related to casualty business acquired from Winterthur combined with continued favorable development of the business re-underwritten post acquisition. The professional adverse development relates primarily to the Bermuda portfolio. This development is split into the 2002 and prior periods for D&O and 2004 and subsequent periods for employment practices liability as new types of actions based on employment demographics have emerged. Adverse development from the 2005 hurricanes impacted marine, but was offset by favorable development in aviation reserves. Other adverse development resulted primarily from discontinued lines such as surety and political risk, combined with an unrecoverable reinsurance balance from an accident and health line reinsurer. The gross prior year favorable development for the Insurance segment was $371.4 million. This gross favorable development exceeds the corresponding net development as gross reported losses in casualty have developed more favorably than net losses. Lower gross reported loss amounts reflect reductions in several large recoverable losses on older years and an absence of new large losses, with consequent reductions to reinsurance recoveries.
Within the Reinsurance segment, net overall favorable prior year reserve development for the year ended 2006 was $125.7 million. This overall favorable development was made up of releases of $190.2 million in property and other shorter-tail lines of business and $10.9 million in casualty lines, partially offset by $75.4 million in adverse development specifically related to the 2005 catastrophes. Net releases in casualty lines reflect positive claims experience in the core U.S. reinsurance and primary books including those years subject to the CAR review in 2003 partially offset by some older asbestos and environmental development and $18.0 million related to a disputed claim impacting underwriting years 1996-2000 that settled during the year. The gross prior year development for the Reinsurance segment totals $46.0 million favorable. This gross favorable development is less than the corresponding net development as net strengthening on the 2005 catastrophes was less significant than the gross strengthening due to reinsurance recoveries.
Within the Financial lines segment, net adverse development for the year ended December 31, 2006 totaled $28.3 million which primarily related to adverse Hurricane Rita development on a structured property and casualty contract.
During 2005, the Insurance segment’s net adverse prior year development of $1.02 billion includes the results of the independent actuarial process noted above. Excluding this development the remaining $185.8 million was driven primarily by increases in reported case reserves for excess professional liability. Strengthening of $259.5 million in professional lines was caused primarily by the establishment of case reserves on both directors’ and officers’ claims in pre-2002 business, and errors and omissions claims. Strengthening of $34.7 million within other specialty lines was caused primarily by increases in reported losses for specialty lines of business currently in run-off including certain Lloyd’s business, discontinued programs business, and surety. A net release of $108.4 million for global risks lines of business was driven by the reduction in case reserves for pre-2002 claims primarily relating to casualty business written out of Europe including the Winterthur Business.
The majority of the workers’ compensation reserve increase during 2005 was related to an XL Reinsurance America Inc. (“XLRA”) working layer program written across multiple underwriting years with a single cedant. This program was not renewed at the end of 2001. Other than this program, XLRA has not written significant working layer workers’ compensation business. The remaining source of the workers’ compensation reserve strengthening relates to an update of the mortality tables used in our tabular reserving methodology.
The remainder of the strengthening in the casualty and professional lines reserves was driven by a small number of increases in reported claims in the other liability and errors and omissions lines of business in the pre-1997 underwriting years as well as recently reported claims in umbrella liability, errors and omissions and directors’ and officers’ lines of business in the 1997-2001 underwriting years. The professional lines claims activity arose largely from a limited number of cedants. This reserve increase was partially offset by favorable development in the 1997- 2001 underwriting years in the medical malpractice business line. Activity in the post-2001 underwriting years relates primarily to certain large individual claims affecting a number of lines, including surety, umbrella liability and errors and omissions.
4. Growing asset base and positive performance from investments in affiliates
Net investment income was $2.0 billion in 2006 as compared to $1.5 billion in 2005. This increase was primarily due to a larger investment base combined with higher investment yields. The increase in the size of the investment portfolio resulted from the Company’s issuance of ordinary shares and equity units in the fourth quarter of 2005, positive cash flows from operations, and growth in average structured and spread balances. Higher investment yields were primarily due to an increase in U.S. interest rates. Equity earnings from the Company’s affiliates also contributed pos-
Since the Company relies on information regarding paid losses, case reserves and IBNR provided by ceding companies in order to assist it in estimating its liability for unpaid losses and LAE, the Company maintains certain procedures in order to help determine the completeness and accuracy of such information. Periodically, management assesses the reporting activities of these companies on the basis of qualitative and quantitative criteria. In addition to conferring with ceding companies or brokers on claims matters, the Company’s claims personnel conduct periodic audits of specific claims and the overall claims procedures of our ceding companies at their offices. The Company relies on its ability to effectively monitor the claims handling and claims reserving practices of ceding companies in order to help establish the proper reinsurance premium for reinsurance agreements and to establish proper loss reserves. Disputes with ceding companies have been rare and generally have been resolved through negotiation.
As noted above, case reserves for the Company’s reinsurance general operations are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the Company’s estimated ultimate cost of a loss. In addition to information received from ceding companies on reported claims, the Company also utilizes information on the pattern of ceding company loss reporting and loss settlements from previous catastrophic events in order to estimate the Company’s ultimate liability related to these hurricane loss events. Commercial catastrophe model analyses and zonal aggregate exposures are utilized to assess potential client loss before and after an event. Initial cedant loss reports are generally obtained shortly after a catastrophic event, with subsequent updates received as new information becomes available. The Company actively requests loss updates from cedants periodically for the first year following an event. The Company’s claim settlement processes also incorporate an update to the total loss reserve at the time a claim payment is made to a ceding company.
While the reliance on loss reports from ceding companies may increase the level of uncertainty associated with the estimation of total loss reserves for property reinsurance relative to direct property insurance, there are several factors which serve to reduce the uncertainty in loss reserve estimates for property reinsurance. First, for large natural catastrophe events such as Hurricane Katrina, aggregate limits in property catastrophe reinsurance contracts are generally fully exhausted by the loss reserve estimates. Second, as a reinsurer, the Company has access to information from a broad cross section of the insurance industry. The Company utilizes such information in order to perform consistency checks on the data provided by ceding companies and is able to identify trends in loss reporting and settlement activity and incorporate such information in its estimate of IBNR reserves. Finally, the Company also supplements the loss information received from cedants with loss estimates developed by market share techniques and/or from third party catastrophe models applied to exposure data supplied by cedants.
With respect to the Company’s financial lines operations, financial guaranty claims incurred on policies written on an insurance basis are established consistent with the Company’s insurance operations and financial guaranty claims incurred on policies written on a reinsurance basis are established consistent with the Company’s reinsurance operations.
Generally, initial actuarial estimates of IBNR reserves not related to a specific event are based on the loss ratio method applied to each class of business. Actual paid losses and case reserves (“reported losses”) are subtracted from expected ultimate losses to determine IBNR reserves. The initial expected ultimate losses involve management judgment and are based on historical information for that class of business; which includes loss ratios, market conditions, changes in pricing and conditions, underwriting changes, changes in claims emergence, and other factors that may influence expected ultimate losses.
In the Company’s reinsurance general operations, case reserves for reported claims are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the Company’s estimated ultimate cost of a loss.
Except for certain workers’ compensation and long-term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation and long-term disability unpaid losses that are considered fixed and determinable. For further discussion see the Consolidated Financial Statements.
The Company’s net unpaid losses and loss expenses for its general and financial operations broken down by operating segment and line of business at December 31, 2006 and December 31, 2005 were as follows:
Property and catastrophe IBNR includes event specific reserves for losses that our insureds and cedants have informed us they expect to incur but have not yet had reported known claims.
Other specialty lines within the Insurance segment includes environmental, programs, equine, warranty and excess and surplus lines.
IBNR reserves are calculated by the Company’s actuaries using standard actuarial methodologies as discussed above. Prior to the year ended December 31, 2003, the outcomes of the Company’s actuarial reviews, consistent with historical practice, provided either (i) a single point reserve estimate or (ii) a range of reserve estimates from which the Company selected a best estimate. Since the year ended December 31, 2003, the Company adopted a methodol-
ogy that provided a single point reserve estimate separately for each line of business and also a range of possible outcomes across each single point reserve estimate. This is discussed further below. As a result, reserve ranges disclosed previously are not comparable to the reserve ranges disclosed herein.
The following table shows the recorded estimate and the high and low ends of the range of reserves for each of the lines of business noted above at December 31, 2006:
Within the insurance segment Other includes political risk, accident & health, surety, and other discontinued lines. Within the reinsurance segment, Other includes political risk, surety, warranty, accident and health, and other lines.
Actual development of recorded reserves as of December 31, 2005 during 2006 was within the estimated reserve range.
There are factors that would cause reserves to increase or decrease within the context of the range provided. The magnitude of any change in ultimate losses would be determined by the magnitude of any changes to our assumptions or combined impact of changes in assumptions. Factors that would increase reserves include, but are not limited to, increases in claim severity, increases in expected level of reported claims, changes to the regulatory environment which expand the exposure insured by the Company, changes in the litigation environment that increase claim awards, filings or verdicts, unexpected increases in loss inflation, and/or new types of claims being pursued against the Company. Factors that would decrease reserves include, but are not limited to, decreases in claim severity, reductions in the expected level of reported claims, changes to the regulatory environment which contract the exposure insured by the Company, changes in the litigation environment that decrease claim awards, filings or verdicts, and/or unexpected decreases in loss inflation.
As shown in the table above and as previously noted, the Company developed a methodology for calculating reserve ranges around its single point reserve estimates for all its lines of business. Similar to Value At Risk (“VAR”) models commonly used to evaluate risk, the Company modeled a statistical distribution of potential reserve outcomes over a one year run-off period. The Company used the modeled statistical distribution to 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.
Reserve volatility was analyzed for each line of business within each of the Reinsurance and Insurance segments’ general operations using the Company’s historical data supplemented by industry data. These ranges were then aggregated to the lines of business shown above taking into account correlation between lines of business. 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.
During 2006, the Company reviewed the correlation assumptions between our various lines of business. There has been growth in certain lines of business as well as changes in the groupings of the data used in the reserving process. These changes necessitated a review of the correlation matrix used to develop our reserve ranges. The Company took a simplified approach of assigning ratings of low, medium or high to our correlation assumptions for each line of business pairing based on the judgment of the reserving actuaries, as there was both limited historical experience within our portfolio and limited applicable industry data. However, our actual historical experience and industry data were used to judgmentally select a range of values for the low, medium and high correlations, respectively, of 15%, 30% and 50%. It should be noted that both our own experience and the industry data exhibit negative correlations in reserve developments between certain lines of business. However, as a measure of prudence in evaluating the reserve ranges, the Company has used a minimum of 15% correlation between any two lines of business. The analysis of correlations and the reflection of potential diversification benefits across lines of business represent another area of uncertainty in the development of estimated reserve ranges.
The Company is not aware of any generally accepted model to perform the reserve range analysis described above, however, and other models may be employed to develop these ranges.
See further discussion under “-Segments” below for prior year development of loss reserves.
Case basis reserves on financial guaranty insurance business written are established by the Company with respect to a specific policy or contract upon receipt of a claim notice or when management determines that (i) a claim is probable in the future based on specific credit events that have occurred and (ii) the amount of the ultimate loss that the Company will incur can be reasonably estimated. As specific case basis reserves are established the Company considers whether any changes are required to the assumptions underlying the calculation of unallocated reserves (which are discussed below) as a result of such activity. As case basis reserve activity to date has been limited, management has not adjusted the unallocated reserves assumptions due to such activity. 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. A number of quantitative and qualitative factors are considered when determining or assessing, in management’s judgment, the need for a case basis reserve. These factors may include the creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured, the projected cash flow or market value of any assets that collateralize or secure the insured obligation, and the historical and projected loss rates on such assets. Other factors that may affect the actual ultimate loss include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. Case basis reserves are generally discounted at a rate reflecting the yield on the Company’s investment portfolio during the period the case basis reserve is established. The Company believes this yield is an appropriate rate to discount the Company’s reserves because it reflects the rate of return on the assets supporting such business. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an upfront basis, the Company continues to record premium earnings on such policy over its remaining life, unless it has recorded a full limit loss with respect to such policy, in which case the remaining deferred premium revenue relating thereto is immediately reflected in earnings. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an installment basis, those premiums, if expected to be received prospectively, are considered a form of recovery and are no longer earned as premium revenue.
In assessing whether a loss is probable, management considers all available qualitative and quantitative evidence. Qualitative evidence may take various forms and the nature of such evidence will depend upon the type of insured obligation and the nature and sources of cash flows to fund the insured obligation’s debt service. For example, such evidence with respect to an insured special revenue obligation such as an obligation supported by cash flows from a toll road would consider traffic statistics such as highway volume and related demographic information, whereas an insured mortgage backed securitization would consider the quality of the mortgage loans supporting the insured obligation including delinquency and foreclosure rates, loan to value statistics, market valuation of the mortgaged properties and other pertinent information. In addition, management will make qualitative judgments with respect to the amount by which certain other structural protections built into the transaction are expected to limit the Company’s loss exposure. Examples of such structural protections may include: (i) rate covenants, which generally stipulate that issuers (i.e. public finance issuers) set rates for services at certain pre-determined levels (i.e. water and sewer rates which support debt obligations supported by such revenues), (ii) springing liens, which generally require the issuer to provide additional collateral upon the breach of a covenant or trigger incorporated into the terms of the transaction, (iii) consultant call-in rights, which provide, under certain circumstances, for a consultant to be engaged to make certain binding recommendations, such as raising rates or reducing expenses, (iv) the ability to transfer servicing of collateral assets to another party, and (v) other legal rights and remedies pursuant to representations and warranties made by the issuer and written into the terms of such transactions. Quantitative information may take the form of cash flow projections of the assets supporting the insured debt obligation (which may include, in addition to collateral assets supporting the obligation, structural protections subordinate to the attachment point of the Company’s risk,
In addition to case basis reserves, the Company maintains an unallocated loss reserve for expected losses inherent in the Company’s in-force business (consisting of both financial guaranty insurance and reinsurance business) that management expects to emerge in the future. The unallocated loss reserves represent management’s estimated ultimate liability from claims expected to be incurred in the future under in-force insured and reinsured policies less outstanding case basis reserves and cumulative paid claims to date on such policies. Unallocated reserves are estimated by management based upon an actuarial reserving analysis. The actuarial methodology applied by us is in accordance with Actuarial Standards of Practice No. 36, “Determination of Reasonable Provision.” The methodology applied is based on the selection of an initial expected loss ratio, as well as an expected loss emergence pattern (i.e., the expected pattern of the expiration of risk on insured and reinsured in-force policies). Salvage and subrogation recoveries are implicit in the Company’s selected expected ultimate loss ratio as such ratio is derived from industry loss experience, which is net of salvage and subrogation recoveries (i.e., from the liquidation of supporting or pledged collateral assets). The implicit inclusion of salvage and subrogation recoveries in the Company’s selected expected ultimate loss ratio is consistent with management’s explicit consideration of collateral support in the establishment of its case basis reserves.
The initial selection of an initial expected loss ratio (and subsequent periodic updates thereof) is based on management’s judgment and considered: (i) the characteristics of the Company’s in-force financial guaranty insurance and reinsurance business (e.g., principally the mix of the Company’s in-force financial guaranty insurance and reinsurance business between public finance and structured finance business; however, management also considered the various bond sectors comprising the Company’s insured and reinsured in-force business, as well as the credit profile of the Company’s insured and reinsured portfolio of business), (ii) actual loss experience, (iii) the characteristics, discussed above, of the Company’s in-force financial guaranty insurance and reinsurance business in relation to the insured in-force business of companies comprising the financial guaranty industry and (iv) the actual loss experience of companies comprising the industry from the Company’s analysis referred to above. Other factors impacting market default levels and the assumptions important to the Company’s reserving methodology are implicit in the Company’s initial expected loss ratio. Such factors may include interest rates, inflation, taxes, industry trends in the valuation of certain asset classes and the overall credit environment. Based on this comparison, the Company adjusts its expected loss
Since the selection of the initial expected loss ratio of 25%, management’s periodic update and analysis of the adequacy of such loss ratio resulted in no change to the ratio for each of the years ended December 31, 2002 and 2003. During the three months ended September 30, 2004 the Company adjusted the initial expected loss ratio to 20% in recognition of the cumulative experience of business to that point in time, as well as the increasing percentage of in-force business from public finance insurance which resulted from the decision of management in 2003 to expand its insurance business in that sector. This change resulted in approximately a $15.0 million decrease in unallocated loss reserves, which decrease was substantially offset by a change in the estimated expected loss emergence pattern of the Company’s in-force business due to the availability of more detailed information as a result of the implementation in 2004 of a new automated information system. Management also considered its industry studies described above as supportive of management’s change in the initial expected loss ratio in 2004, for the reasons described above. The Company’s updated analysis in 2005 indicated that no change was necessary in the expected loss ratio of 20% from that in 2004. During the third quarter of 2006 the aforementioned analysis was updated again. Based on this analysis management did not change the Company’s expected loss ratio and there was no material change to the loss emergence pattern.
The Company’s expected loss emergence pattern is determined by underwriting year based on the par amortization schedules of the underlying insured and reinsured debt obligations comprising the Company’s in-force business. Management adjust or realign the expected loss emergence pattern each quarter to reflect the underlying changes in the Company’s in-force business (for example, changes in the average life of in-force business resulting from changes in the mix of business and risk or par expiration). Analysis of the risk demographic by underwriting year demonstrates that, while the proportionate mix of municipal versus structured finance business may fluctuate from year to year, the average outstanding life parameter within each product type remains fairly stable between underwriting years. Structured finance business will typically have an aggregate average life of 5 to 10 years and municipal finance business will typically have an aggregate average life of 15 to 20 years.
The Company’s unallocated loss reserve is established on an undiscounted basis and represents management’s best estimate of losses that management will incur in the future as a result of credit deterioration in our in-force business but which have not yet been specifically identified. Management does not attempt to apportion unallocated reserves by type of product.
The Company’s total reserves for losses and loss adjustment expenses represent a small fraction of its insured and reinsured in-force par outstanding, which reflects the nature of the business underwritten and the loss experience of the industry. Management believes that its reserves are adequate to cover the Company’s expected ultimate losses. However, due to the inherent uncertainties of estimating reserves for loss and loss adjustment expenses, actual experience may differ from the estimates reflected in the Company’s consolidated financial statements, and the differences may be material. Differences exist within the financial guaranty industry with regard to the methodology and measurement of such reserves. While management believes that the principles it applies are the most appropriate for its business and have applied them consistently within the periods presented, alternate methods may produce different estimates as compared to the current methodology currently used. Accounting practices in the financial guaranty insurance and reinsurance industry are currently being reviewed by applicable regulatory bodies and any changes
The Company’s surveillance department also analyzes whether a claim on its policy is probable. In some cases, management will engage an outside consultant with appropriate expertise in the underlying collateral assets and respective industries to assist management in examining the underlying collateral and determining the projected loss frequency and loss severity. In such case, management will use that information to run a cash flow model, which includes enhancement levels and debt service to determine whether a claim is probable, possible or not likely.
Management establishes reserves for losses and loss adjustment expenses following consultation with the Loss Reserve Committee, which is comprised of senior members of management, including senior management of the surveillance department. Both qualitative and quantitative factors are used in establishing such reserves. In determining the reserves, management considers all factors in the aggregate, and does not attribute the reserve provisions or any portion thereof to any specific factor.
The reserving methodology for these annuity portfolio reinsurance contracts is described in FAS 60 as amended by FAS 97. These contracts subject the Company to risks arising from policyholder mortality over a period that extends beyond the periods in which premiums are collected. Liabilities for future policy benefit reserves are established in accordance with the provisions of FAS 60.
Claims and expenses for individual policies within these annuity reinsurance contracts are projected over the lifetime of the contract to calculate a net present value of future cash flows. Assumptions for each element of the basis (mortality, expenses and interest) are determined at the issue of the contract and these assumptions are locked-in throughout the term of the contract unless a premium deficiency exists. The assumptions are best estimate assumptions plus provisions for adverse deviations on the key risk elements (i.e., mortality and interest). Provisions for adverse deviation are designed to cover reasonable deviations from the best estimate outcome of the contract. As the experience on the contracts emerges, the assumptions are reviewed. This occurs at least annually and includes both an analysis of experience and review of likely future experience. If such review would produce reserves in excess of those currently held then lock-in assumptions will be revised and a loss recognized. During the years ended December 31, 2006, 2005 and 2004, there were no adjustments to the locked-in assumptions for any of these contracts.
The liabilities relate to in-force blocks of business and to treaties accepting new business, comprising underlying insurance policies that provide mainly lump sum benefits if the policyholder dies or becomes sick. For term assurance, the liabilities are therefore driven by the rates of mortality and for critical illness cover, the liabilities are driven predominantly by the rates at which policyholders become sick (where sickness is defined by the treaty conditions), i.e., the morbidity rates. A 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $1.3 million, and a 1% increase in the morbidity rate would increase the value of future claims by approximately $1.2 million.
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 $204 million and $184 million at December 31, 2006 and 2005, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience.
The 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. No changes to the locked-in assumptions have been made in 2006, although changes were made in 2005 which resulted in the removal of the provisions for adverse deviation.
The fair value of weather and energy derivatives is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair value is estimated using available market data and internal pricing models using consistent statistical methodologies. Estimating fair value of instruments that do not have quoted market prices requires management’s judgment in determining amounts that could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for sensitivity analysis and Item 8, Note 15 to the Consolidated Financial Statements, “Derivative Instruments.”
Intangible assets are carried at or below estimated fair value. There are many assumptions and estimates underlying the fair value calculation. Principally, the Company identifies the business entity that the intangible asset is attributed to, and reviews historical and forecasted performance and other underlying factors affecting such analysis, including market conditions, premium rates and loss trends. Other assumptions used could produce a significantly different result which may result in a change in the value of the intangible asset and related amortization charge in the Consolidated Statement of Income. Based on the current expectations of profitability, an impairment charge would only be recognized in the event of a significant decline in the expected profitability of those operations where such intangible assets are applicable. At December 31, 2006, intangible assets were $1.8 billion of which approximately $1.4 billion and $0.4 billion related to the Company’s Reinsurance and Insurance segments, respectively. See “ Other Revenue and Expenses” for further information.
The Company utilizes variable interest entities both directly and indirectly in the ordinary course of business. The Company must assess consolidation of variable interest entities based on whether the Company is the primary beneficiary of the entity. The company that absorbs a majority of the expected losses or residual rewards of the entity is deemed to be the primary beneficiary and is therefore required to consolidate the entity. The determination of expected losses and expected residual returns requires the Company to estimate the expected cash flows of the entities and measure the expected variability of these cash flows. The use of different assumptions to determine the expected cash flows and variability could affect the Company’s determination of the primary beneficiary. The assumptions used to determine the expected cash flows depend on the type of structure and the nature of the Company’s variable interest. The Company has made assumptions primarily regarding default rates, the timing of defaults and recovery rates to estimate these expected cash flows of the variable interest entities that it utilizes.
The amount of premiums receivable related to reinsurance operations amounted to $2.2 billion as at December 31, 2006.
The amount of proportional and excess of loss reinsurance gross premiums written and gross acquisition expenses recognized by the Company’s reinsurance general operations for each line of business for the years ended December 31, 2006, 2005 and 2004 was as follows:
Other includes political risk, surety, warranty, accident and health, and other lines of business.
Gross and net premiums written decreased by 3.7% and 2.4%, respectively, in the year ended December 31, 2006 compared with the year ended December 31, 2005. The decrease in gross premiums written was primarily due to continued competitive pressures across most non-catastrophe exposed lines, corporate risk management initiatives to reduce catastrophe exposures, fewer multi-year contracts, and the impact of foreign exchange movements on premium. Decreases in casualty premiums and the discontinuation of the segment’s surety business were partially offset by volume increases in certain specialty lines of business such as environmental and aerospace. The decrease in net premiums written was primarily a result of the factors impacting gross premiums written, partially offset by return premium associated with the commutation of ceded reinsurance policies in professional lines of business, the cancellation of certain property catastrophe reinsurance programs and the absence of catastrophe related ceded reinstatement premiums.
Gross and net premiums written decreased by 2.3% and 3.4%, respectively, in the year ended December 31, 2005 compared with the year ended December 31, 2004. These decreases were also primarily due to competitive pricing across most lines, most notably property. Decreases were partially offset by continued growth in the newer select and design professional and U.S. primary casualty units, and the impact of foreign exchange movements on premiums. Net premiums written declined in line with gross premiums written combined with increased ceded reinstatement premiums payable as a result of the catastrophe activity in the year.
Net premiums earned increased by 1.2% in 2005 compared with 2004. Growth in net premiums earned was primarily as a result of the earn-out of higher net premiums written in 2004, including the newer business initiatives mentioned above and increased net retentions. This growth was partially offset by the decreased volume in 2005, noted above, and net $89.1 million ceded reinstatement premiums as a result of the natural catastrophes in 2005.
Fee income and other increased in 2006 compared to 2005 primarily due to a favorable legal settlement in relation to a U.K. contract.
Exchange losses (gains) are primarily generated by movement in foreign exchange rates applied to loss reserves held in currencies other than the functional currency of the reporting subsidiary.
The increase in the underwriting profit in 2006 as compared with 2005 was reflective of the combined ratios, as shown below, and foreign exchange impacts. The following table presents the ratios for the Insurance segment for each of the last three years ended December 31:
The Company did not change its methodology or key assumptions used in 2006, 2005 or 2004 to determine ultimate loss reserves for any line of insurance business written.
The following tables present the prior year favorable or adverse development of the Company’s gross and net loss and loss expense reserves for its insurance general operations:
Within the Insurance segment, the loss and loss expense ratio for the year ended December 31, 2006 decreased compared with the year ended December 31, 2005, primarily as a result of the absence of large natural catastrophe events and the unfavorable result of Winterthur Decision during 2005. Excluding the impact of these events, the loss ratio in 2005 was 67.1%. The relative decrease in 2006 relates to net favorable prior year reserve releases. Net overall favorable prior year reserve development for the year ended 2006 was $13.2 million. This overall favorable develop-
The loss and loss expense ratio for the Insurance segment for the year ended December 31, 2005 increased compared with the year ended December 31, 2004, primarily reflecting the net losses of $947.0 million incurred in the property catastrophe and property lines of business as a result of Hurricanes Katrina, Rita and Wilma and the Other Cats combined with the impact of overall continued softening market conditions in 2005, losses of $834.2 million representing the unfavorable outcome of the Winterthur Decision and net adverse prior year development.
As noted above, net adverse prior year development in 2005 includes the loss associated with the Winterthur Decision. The Independent Actuary’s report concluded that WSIC’s submitted SNRA and NPRA were closest to the Independent Actuary’s determinations of SNRA and NPRA. These determinations resulted in the Company receiving a net lump sum payment in the amount of approximately $575.0 million (including interest receivable) from WSIC. As the Company had recorded $1.4 billion in unpaid losses and loss expenses recoverable related to this protection, incurred losses of approximately $834.2 million were recorded in the fourth quarter of 2005.
During 2005, the Insurance segment’s net adverse prior year development, excluding the impact of the result of the Winterthur Decision, of $185.8 million was driven primarily by increases in reported case reserves for excess professional liability. Strengthening of $259.5 million in professional lines was caused primarily by the establishment of case reserves on both directors’ and officers’ claims in pre-2002 business, and errors and omissions claims. Strengthening of $34.7 million within other specialty lines was caused primarily by increases in reported losses for specialty lines of business currently in run-off including certain Lloyd’s business, discontinued programs business, and surety. A net release of $112.5 million for global risk lines of business was driven by the reduction in case reserves for pre-2002 claims primarily relating to casualty business written out of Europe including business acquired from Winterthur.
The underwriting expense ratio for the year ended December 31, 2005 decreased compared with the same period in 2004 as a result of a decrease in the operating expense ratio of 0.5 points (12.6% as compared to 13.1%)
combined with a decrease in the acquisition expense ratio of 0.8 points (12.4% as compared to 13.2%). The reduction in the operating expense ratio was due to productivity expense management initiatives and certain compensation cost adjustments. The reduction in the acquisition expense ratio was due primarily to a change in the commission structure with certain brokers, partially offset by the impact of ceded reinstatement premiums.
Gross and net premiums written decreased 9.6% and 13.5%, respectively, in year ended December 31, 2006 as compared to year ended December 31, 2005. The decrease in gross and net premiums written is primarily attributable to rate and volume reductions within the casualty line of business, and catastrophe gross and net reinstatement premiums of $138.7 million and $34.7 million, respectively, recorded in 2005. These decreases were partially offset by a change in accrual methodology and both written and ceded premiums adjustments for certain U.S. property programs in 2006. On a net premiums written basis, the decrease is also attributable to the new catastrophe quota share reinsurance treaty with Cyrus Re. In addition, as part of the Company’s aggregate risk reduction initiatives, there has been a net reduction in catastrophe exposure and a restructuring of the Company’s marine and energy exposures.
Net premiums earned in the year ended December 31, 2006 decreased 6.5% as compared to the year ended December 31, 2005, and 5.5% in 2005 as compared to the year ended December 31, 2004, due primarily to the earn out of the impact of rate pressures on gross premiums written over the last 24 months.
In addition, during 2005, net prior year reserves across the Reinsurance segment developed adversely by $93.5 million. Reserve strengthening of $266.9 million in casualty and professional lines was partially offset by releases in other lines of business of $173.4 million. The casualty strengthening is primarily attributable to workers’ compensation, umbrella liability and certain professional lines of business written in the Company’s North American operations. The reserve releases relate primarily to the property line where releases of $135.6 million occurred across all business units globally in the 2002 to 2004 underwriting years. Releases also occurred in the marine and aviation classes of business across the Reinsurance segment.
The remainder of the strengthening in the casualty and professional lines reserves was driven by a small number of increases in reported claims in the other liability and errors and omissions lines of business in the pre-1997 underwriting years as well as recently reported claims in umbrella liability, errors and omissions and directors’ and officers’ lines of business in the 1997-2001 underwriting years. The professional lines claims activity arises largely from a limited number of cedants. This reserve increase was partially offset by favorable development in the 1997-2001 underwriting years in the medical malpractice business line. Activity in the post-2001 underwriting years relates primarily to certain large individual claims affecting a number of lines, including surety, umbrella liability and errors and omissions.
The decrease in the underwriting expense ratio in the year ended December 31, 2005, as compared with the year ended December 31, 2004, was due to a decrease in both the acquisition expense ratio and operating expense ratio to 21.7% and 5.6%, respectively, as compared to 22.1% and 6.5%, respectively, for the year ended 2004. The decrease in the acquisition expense ratio was mainly due to decreased profit commissions, which resulted from the 2005 hurricane activity. The operating expense ratio decrease primarily reflects severance costs incurred during 2004 for reduction of staff as well as productivity expense management initiatives in 2005 and adjustments to certain 2005 compensation costs.
1. Second and fourth quarters of 2006 - two Irish immediate annuity portfolios bound, for which net premium earned totaled $152.5 million.
Claims and policy benefits decreased significantly in 2006 as compared to 2005, and increased in 2005 as compared to 2004, as a result of the annuity payout liabilities accepted under the contracts noted above. Changes in claims and policy benefits included the movement in policy benefit reserves related to contracts where investment assets were acquired with the assumption of the policy benefit reserves at the inception of the contract. Claims and policy benefits in all years also include incurred losses from the growing installment premium term assurance portfolio. Furthermore, in 2005, $37.4 million in losses were recorded related to certain novated blocks of U.S.-based term life mortality reinsurance business as a result of the actuarially modeled impact of actual paid losses being greater than expected. In accordance with U.S. GAAP treatment for life business, a loss recognition test process was carried out in 2005 to determine if expected future premiums would be sufficient to pay for expected future losses. This process led to management’s decision to unlock the then current policy benefit reserve basis and record a loss.
Acquisition costs increased in 2005 as compared to 2004, reflecting the write-off of the deferred costs of $25.9 million, related to the U.S. mortality business noted above. Operating expenses increased in 2005 compared to 2004 due to build-out of existing operations and start-up costs of new life operations in the U.S.
Net investment income has increased reflecting the increase in life business invested assets primarily arising from new large annuity contracts written since 2004, combined with increased yields. Net investment income is included in the calculation of net income from life operations as it relates to income earned on portfolios of separately identified and managed life investment assets and other allocated assets. The accretion of the related future policy benefit reserves is included in claims and policy benefits.
The following table summarizes the net contribution for the Financial lines segment:
Gross and net premiums written relating to the Financial lines include premiums from structured financial and alternative risk transfer products, political risk insurance products, weather and energy risk management products, and legacy financial guaranty business. Gross premiums written increased by 29.4 % for the year ended December 31, 2006, as compared to the comparable period in 2005. This increase was due to a loss portfolio transfer contract written in 2006, additional premiums associated with a structured property and casualty reinsurance contract, and growth in certain weather and energy books of business including power outage products. Increases in net premiums written of 19.0% for 2006 as compared to the same period of 2005 were primarily due to the factors affecting gross premiums written noted above, partially offset by the inter-segment portfolio transfer to SCA of in-force financial guaranty contracts in connection with the SCA IPO.
The following table provides a line of business breakdown of the financial lines segment’s net premiums earned:
Net premiums earned increased during the year ended December 31, 2006, as compared to the same period in 2005. The increase primarily resulted from the factors affecting gross premiums written noted above as well as the earn-out of increased net premiums written over the past 24 months. These increases were offset by the impact of the inter-segment portfolio transfer.
Net losses and loss expenses include current year net losses incurred and adverse or favorable development of prior year net loss and loss expense reserves. Net losses and loss expenses for the year ended December 31, 2006 increased by 105.9%, as compared to the comparable period in 2005. This increase was a result of case reserve provisions relating to several structured finance transactions, including a $51.9 million loss on a contract which guaranteed a certain amount of revenue from a pool of equipment leases, losses assumed in relation to the loss portfolio transfer contract written in 2006, and adverse Hurricane Rita development on a structured property and casualty contract.
Net losses and loss expenses during 2005 increased by 84.9%, as compared to 2004. This increase primarily resulted from losses incurred on structured property and casualty contracts related to Hurricanes Katrina and Rita.
Total operating expenses increased in 2006 as compared to 2005 due to higher performance-based compensation costs as well as reallocations of certain costs resulting from the restructuring of the Company’s segments. For 2005, operating expenses decreased as compared to 2004 due to a reduction in both compensation expense and professional fees.
Net investment income increased by 39.1% for the year ended December 31, 2006, as compared to the same period in 2005, primarily as a result of significant increases in the combined average funding agreement and guaranteed investment contract balances from $5.1 billion to $6.2 billion for the years ended December 31, 2005 and 2006, respectively, together with increased yields.
Net investment income increased by 86.5% for the year ended December 31, 2005, as compared to the same period in 2004, primarily as a result of significant increases in the combined average funding agreement and guaranteed investment contract balances from $2.9 billion to $5.1 billion for the years ended December 31, 2004 and 2005, respectively, together with increased yields.
Interest expense on structured products relates to deposit liabilities associated with funding agreements, guaranteed investment contracts and certain structured property and casualty contracts. The increase in interest expense during 2006 as compared to 2005, and 2005 as compared to 2004, related primarily to the increase in the average funding agreement and guaranteed investment contract deposits discussed above.
The decrease in net earned premiums in 2005, as compared to 2004, was primarily attributable to the inclusion in 2004 of $23.4 million in earned premiums related to a project financing loss noted below, partially offset by the growth of in-force business and earned premiums from the early retirement or refunding of insured securities of $14.8 million in 2005, as compared to $6.0 million in 2004.
Net losses and loss expenses for the year ended December 31, 2006, decreased by 44.5% compared to the same period in 2005. Lower net losses and loss adjustment expenses during the year ended December 31, 2006 reflected nominal case basis provisions for net losses and loss adjustment expenses during the year ended December 31, 2006 relating to certain insured transactions, whereas the year ended December 31, 2005 included a provision for case basis reserves of $12.2 million, of which $12.1 million related to two insured transactions. There was an additional gross case basis reserve related to one of these transactions in the current year of $15.2 million, however this loss was reinsured by and was included in the Financial lines segment.
The decrease in net losses and loss adjustment expenses in 2005, as compared to 2004, was primarily attributable to the inclusion of $41.7 million of incurred losses in 2004 relating to the subordinate layer of an insured project financing structure, combined with net favorable development in 2005 of unallocated loss reserves.
Net realized and unrealized losses on derivative instruments represent changes in the market value of the Company’s insured credit derivative portfolio. The net losses from derivatives for the year ended December 31, 2006 primarily related to an increase in the volume of insured interest rate swaps. During the year ended December 31, 2005, spreads widened slightly compared to prior years, decreasing the value of credit default swaps.
Minority interest expense relating to the preferred shares of XLFA has decreased due to changes in the structure of the related dividends. Minority interest expense relating to the common shares of SCA has increased following the SCA IPO in August 2006 and primarily represents the 37% ownership interest in SCA common shares held by the public.
Income tax charge (benefit) represents the taxes associated with the net income of SCA.
The following table illustrates the change in net investment income from general operations, net income from investment affiliates from general operations, net realized (losses) gains on investments, and net realized and unrealized gains (losses) on investment derivative instruments from general operations for each of the three years ended December 31:
Net investment income related to general operations increased in 2005 as compared to 2004 primarily due to growth in the investment base, as well as increases in the yield of the portfolio. The growth in the investment base reflected the Company’s positive cash flow from operations. In 2005, the Company also received a distribution associated with the unwinding of a collateral debt obligation, which resulted in a one-time benefit to investment income of $31.0 million as well as $25.3 million related to the Winterthur Decision.
Net income from investment 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 affiliates increased in 2006 as compared to 2005 primarily due to a strong result in private investment portfolios due to a series of positive liquidity events and fair value adjustments, with continued good returns on the alternative portfolios.
Portfolio returns are calculated by dividing the sum of the net investment income or net income from investment affiliates, realized gains (losses) and unrealized gains (losses) by the average market value of each portfolio. Non-U.S. dollar fixed income performance is measured in either the underlying currency or in U.S. dollars.
In 2006, net realized losses on investments were $116.5 million which includes $390.4 million of gross realized losses on fixed income and $88.5 million of gross realized losses on equity securities. Gross realized losses in 2006 included $151.4 million of provisions for declines in fair value considered to be other than temporary. In the U.S., the general level of corporate defaults was lower than in recent years. For example, Moody’s Investors Service, Inc. (“Moody’s”) reported that 21 issuers defaulted in 2006 compared with 31 issuers in 2005 and 36 issuers in 2004. The Company’s exposure to these defaults was limited in both 2006 and 2005, resulting in a low level in the write-down for other than temporary declines related to credit events. As a percentage of the total fixed income portfolio, the write-down for other than temporary declines was 0.3% in 2006 as compared to 0.1% in 2005 and a negligible amount in 2004.
With respect to those securities that were sold at a loss during the year ended December 31, 2006, the following is an analysis of the period of time that those securities had been in a continual unrealized loss position, the amount of the realized loss recorded in the Company’s results of operations as of the sale date and the amount of the impairment charge taken in the year:
The information shown below about the unrealized losses on the Company’s investments at December 31, 2006 and 2005, concerns the potential effect upon future earnings and financial position should management later conclude that some of the current declines in the fair value of these investments are other than temporary declines.
As discussed under Item 1, “Investments - Investment Structure and Strategy,” the Company operates a risk asset portfolio that includes high yield (below investment grade) fixed income securities. These securities are more sensitive to credit risk than investment grade securities. At December 31, 2006, approximately 2.3% of the Company’s fixed income investment portfolio was invested in securities that were below investment grade or not rated. Approximately 5.4% of the unrealized losses in the Company’s fixed income securities portfolio at December 31, 2006, related to securities that were below investment grade or not rated. At December 31, 2005, approximately 2.4% of the Company’s fixed income investment portfolio was invested in securities that were below investment grade or not rated. Approximately 4.3% of the unrealized losses in the Company’s fixed income securities portfolio at December 31, 2005, related to securities that were below investment grade or not rated. The following is an analysis of the length of time each of those below investment grade and unrated securities had been in a continual unrealized loss position at the date indicated.
porate fixed income securities, approximately 52.9% of the losses were in the financial sector, 11.9% in the communications sector, 8.8% in the consumer non-cyclical sector, 5.4% in the utilities sector and 5.1% in the industrial sector. No other sector was greater than 5%. The largest unrealized loss in the fixed income portfolio was $1.8 million. No equity securities held by the Company at December 31, 2006 were in a continual unrealized loss position for at least 12 months. The largest individual unrealized loss in the equity portfolio was $0.5 million.
The Company records the income related to the operating affiliates on a three month lag in order for the Company to meet the accelerated filing deadlines as specified by the SEC.
Interest expense from general operations includes costs related to the Company’s debt and collateral facilities as well as certain deposit liability accretion. The increase in interest expense primarily reflected the increase in average outstanding debt for the year ended December 31, 2006, compared to 2005. For more information on the Company’s financial structure, see “Liquidity and Capital Resources.”
The Company reviews on a regular basis its corporate debt concentration, credit quality and compliance with established guidelines. At December 31, 2006 and 2005, the average credit quality of the Company’s total fixed income portfolio was “AA.” At December 31, 2006 approximately 55.5% of the fixed income portfolio was rated AAA by one or more of the principal ratings agencies. Approximately 2.3% was below investment grade or not rated.
Unpaid losses and loss expenses include reserves on the Company’s general and financial operations and relates primarily to the casualty insurance and reinsurance business written by the Company. The balance was $23.1 billion at December 31, 2006, which is a decrease of $0.7 billion from December 31, 2005. The decrease was due primarily to the lack of significant catastrophe events in 2006, a reduction in reserves related to payments made in 2006 relating to 2005 catastrophe events, and favorable net prior year development of $110.6 million in 2006.
reserved. In the future, if such reserves develop adversely, such deficiency would have a negative impact on future results of operations. See Item 1, “Unpaid Losses and Loss Expenses”, “Critical Accounting Policies and Estimates” and Item 8, Note 10 to the Consolidated Financial Statements, “Losses and Loss Expenses”, for further discussion.
Unpaid losses and loss expense recoverables were $5.0 billion and $6.4 billion at December 31, 2006, and 2005, respectively. At December 31, 2006 and 2005, reinsurance balances receivable were $1.1 and $1.0 billion, respectively. The table below presents the Company’s net reinsurance recoverable at December 31, 2006 and 2005.
As the Company and WSIC were unable to come to an agreement, the Company submitted to WSIC notice to trigger the independent actuarial process as contemplated by the SPA. On February 3, 2005, both the Company and WSIC made submissions for the independent actuarial process. There were two separate numbers submitted, that for
the Seasoned Net Reserves Amount (“SNRA”) and that for the Net Premium Receivable Amount (“NPRA”). Subsequent to this date neither party had the opportunity to submit revised figures to the Independent Actuary.
As noted above the independent actuarial process followed a “baseball-type” arbitration whereby there were only two possible outcomes, not a range of outcomes. The nature of the process was that the final SNRA was either the SNRA submitted by the Company or the SNRA submitted by WSIC. Accordingly, until the receipt of the Independent Actuary’s report in the fourth quarter of 2005, the Company’s best estimate was the SNRA it had submitted, as it could only ever have been either that number or the number that WSIC submitted.
The Independent Actuary made downwards and upwards adjustments to the Company’s established case reserves and then used the revised reserves as source data for his actuarial analysis and the related calculation of the resultant IBNR. The Company’s established case reserves previously had been reviewed both internally and by independent claims analysts (which were outside legal counsel in most instances).
The Independent Actuary adopted a methodology different from that of the Company to estimate the application of reinsurance treaties against loss reserves across underwriting years and types of business.
The conversion into U.S. dollars of the underlying reserve development in local currency between July 2001 and September 2004 also generated a difference. The impact of the decrease in the value of the U.S. dollar on the Independent Actuary’s lower levels of local currency adverse development was to increase the difference between XL and the Independent Actuary in U.S. dollars. This was an issue peculiar to the interpretation of the SPA and does not affect the conversions of the loss reserves under U.S. GAAP.
The differences between the Independent Actuary’s and the Company’s evaluations of the factors described above were the result of the application of judgments in, the application of actuarial methodology, assessment of loss on individual claims events and/or interpretation of the provisions of the SPA. Because these factors are interdependent, quantification of a single factor’s individual contribution to the overall difference is not always possible. The quantification of certain reasonably discrete items has been given below. The Company’s loss reserves and actuarial methodologies were reviewed both internally and externally by outside actuaries and claims analysts throughout the seasoning period up to the date of our submission to the Independent Actuary and thereafter. Any adjustments to the underlying carried reserves (both upward and downward) since that date have been the result of new information and have been recorded in the period during which the information became available. In particular during our ongoing assessments of unpaid losses in 2005 it was noted that in certain instances reported experience indicated that the distribution of gross losses to existing reinsurance treaties had developed such that net losses were reduced by approximately $90 million. In addition certain claim settlements and new claim emergence resulted in positive development of approximately $110 million as required by the application of actuarial methodologies on a basis consistent with historical practices. As a result, changes in estimates were recorded as the new information and other developments became available contributing to the net positive development for global risk lines of business during 2005 noted in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These developments did not change the Company’s assessment of the outcome of the Independent Actuarial process.
The difference between the independent actuary’s conclusion on the NPRA and that of the Company related almost exclusively to an interpretation of the SPA with respect to the application of certain accruals for premiums payable at the closing of the purchase in 2001. The Company accordingly has not made any adjustment to its current premiums receivable balances.
Under FAS 5, paragraph 8, a loss contingency shall be accrued to income if information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact that of the loss. At no time prior to the Company’s receipt of the draft actuarial report did this condition exist.
Under the terms of the SPA, WSIC also provided the Company with protection with respect to third party reinsurance receivables and recoverables related to the acquisition of the Winterthur Business.
On June 7, 2006, subsidiaries of the Company, entered into an agreement (the “Agreement”) with WSIC. The purpose of this Agreement is to release all actual or potential disputes, claims or issues arising out of or related in any
way to: (i) the Liquidity Facility and the Sellers Retrocession Agreements, as well as (ii) subject to certain exceptions, the SPA.
Approximately 78% of the total unpaid loss and loss expense recoverable and reinsurance balances receivable (excluding collateral held) outstanding at December 31, 2006, were 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, 2006, by reinsurers owing more than 3% of such total:
As a holding company, the Company’s assets consist primarily of its investments in subsidiaries and affiliates, and the Company’s future cash flows depend upon the availability of dividends or other statutorily permissible payments from its subsidiaries and affiliates. The ability to pay such dividends is limited by the applicable laws and regulations of the various countries in which the Company operates, including, among others, Bermuda, the United States, Ireland, Switzerland, the United Kingdom, and those of the Society of Lloyd’s and certain contractual provisions. See
As an insurance company, one of our principal responsibilities to our clients is to ensure that the Company has ready access to funds to settle large unforeseen claims. The Company expects that positive cash flow from operations (underwriting activities and investment income) will be sufficient to cover cash outflows under most future loss scenarios. However, there is a possibility that unforeseen demands could be placed on the Company due to unforeseen claims activity. Potential events causing such a liquidity strain could be several significant catastrophes occurring in a relatively short period of time or large scale uncollectible reinsurance recoverables on paid losses (as a result of coverage disputes, reinsurers’ credit problems or decreases in the value of collateral supporting reinsurance recoverables). Additional strain on liquidity could occur if the investments sold to fund loss payments were sold at depressed prices. Because each subsidiary focuses on a more limited number of specific product lines than is collectively available from the consolidated group of companies, the mix of business tends to be less diverse at the subsidiary level. As a result, the probability of a liquidity strain, as described above, may be greater for individual subsidiaries than when liquidity is assessed on a consolidated basis. If such a liquidity strain were to occur in a subsidiary, the Company may be required to contribute capital to the particular subsidiary and/or curtail dividends from the subsidiary to support holding company operations.
Net cash received from underwriting activities is comprised of receipt of premiums, minus payment of claims and operating and acquisition costs. Premiums and acquisition expenses are settled based on terms of trade as stipulated by an underwriting contract, and generally are received within the first year of inception of a policy when the premium is written, but can be up to three years on certain reinsurance business assumed. Operating expenses are generally paid within a year of being incurred. Claims especially for casualty business, may take a much longer time before they are reported and ultimately settled and this is why the Company establishes reserves for unpaid losses and loss expenses. Therefore, the amount of claims paid in any one year is not necessarily related to the amount of net losses incurred, as reported in the consolidated statement of income.
During 2006, 2005 and 2004, the total amounts of net losses paid for general and financial operations were $3.9 billion, $2.6 billion and $3.1 billion, respectively, whereas the amount of net losses incurred was $4.2 billion, $7.4 billion and $4.9 billion, respectively. The increase in losses paid in 2006 related primarily to payments on losses resulting from hurricanes Katrina, Rita, and Wilma. The decrease in net paid losses in 2005, is due to the receipt of a net lump sum payment of approximately $575 million related to the Winterthur Decision, partially offset by payments related to the 2005 and 2004 Atlantic hurricane losses. The payout of the Company’s casualty reserves at December
Generally, positive cash flow from operations and financing activities is invested in the Company’s portfolio, including affiliates or acquisition of subsidiaries. Investing activities in 2006 and 2005, were primarily related to the renewal purchase and sale of portfolio investments. In addition to purchases and sales of the Company’s total investment portfolio, the Company sold a portion of its interest in SCA through a secondary offering for $104.7 million and its interests in Frontpoint Investment Managers in 2006 for $66.8 million. In 2004, the Company sold its interests in Admiral Group Ltd and Pareto Partners L.P. and its affiliated companies for $66.7 million and $45.1 million, respectively.
In addition, in the years ended December 31, 2006, 2005 and 2004 the Company executed a number of debt and equity transactions which affected the cash flow from financing activities described below in “Capital Resources,” below.
Sufficient capital to maintain its financial strength, claims paying and debt ratings, as issued by several ratings agencies, at levels considered necessary by management to enable the Company’s key operating subsidiaries to compete.
At December 31, 2006, banks and investors provided the Company and its subsidiaries with $4.8 billion of debt capacity, of which $3.4 billion was utilized by the Company. These facilities consist of:
At December 31, 2005, the Company had revolving credit facilities of $1.2 billion in aggregate of which $45 million was outstanding at that date. This borrowing was repaid in January 2006. Of the $1.2 billion, $1.0 billion was provided by the Company’s $2.0 billion 3-year syndicated facility that matures in June 2007, and its $2.35 billion 5-year syndicated facility that matures in June 2010. Both facilities provide letters of credit in addition to the revolving credit sublimit. In addition, at December 31, 2005, the Company had two bilateral revolving credit facilities of $100 million each, of which one facility was a 364-day facility that matured in December 2006, and the other is a 5-year facility that matures in August 2010.
Senior Unsecured Notes of approximately $3.4 billion. These notes require the Company to pay a fixed rate of interest during their lives. At December 31, 2006, there were six outstanding issues of senior unsecured notes:
The following tables present the Company’s debt under outstanding securities and lenders’ commitments as at December 31, 2006:
On December 5, 2006, the Company and certain operating subsidiaries (“Ceding Insurers”) entered into a securities issuance agreement (the “Securities Issuance Agreement”), and certain of its foreign insurance and reinsurance subsidiaries (“Ceding Insurers”) entered into an excess of loss reinsurance agreement (the “Reinsurance Agreement”), Stoneheath Re (“Stoneheath”). The net effect of these agreements to the Company is the creation of a contingent put option to issue $350.0 million of preference ordinary shares in the aggregate. The agreements provide the Company with a Reinsurance Collateral Account in support of certain Covered Perils named in the Reinsurance Agreement. The initial Covered Perils will 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 Stoneheath an amount of XL Capital Ltd Series D Preference Shares (the “XL Preferred Securities”) 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 will be for the period from the Closing Date through June 30, 2007, with four annual mandatory extensions 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 XL Preferred Securities, if issued, 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.
The Company amortizes this liability that resulted in an interest expense of approximately $3.5 million in 2004 and $2.0 million in 2003.
Of the total letter of credit facilities above, $1,000 million is also included in the revolvers under notes payable and debt.
It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company, or other financial institutions. 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 insurance trusts supported by the Company’s investment portfolio or funds withheld (amounts retained by ceding companies to collateralize loss or premium reserves) using the Company’s cash resources or combinations thereof. The face amount 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. 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.
The following letter of credit facilities were originated or renewed during 2006:
The Company replaced its letter of credit facility utilized to support the capital requirements of its syndicates at Lloyd’s of London (“Lloyd’s”), with a new £500 million credit facility that closed on March 14, 2006. Commitments from the participating banks expire on November 30, 2007, which will enable the Company to use this facility to meet its letter of credit needs for the 2008 year of account at Lloyd’s.
In general, all of the Company’s bank facilities, indentures and other documents relating to the Company’s outstanding indebtedness, including the Credit Facilities discussed above (collectively, the “Company’s Debt Documents”), contain cross default provisions to each other and the Company’s Debt Documents contain affirmative covenants. These covenants provide for, among other things, minimum required ratings of the Company’s insurance and reinsurance operating subsidiaries (other than its AAA financial guaranty companies) and the level of secured indebtedness in the future. In addition, generally each of the Company’s Debt Documents provide for an event of default in the event of a change of control of the Company or some events involving bankruptcy, insolvency or reorganization of the Company. The Company’s credit facilities and the 6.58% Guaranteed Senior Notes also contain minimum consolidated net worth covenants.
On December 5, 2006, the Company and certain operating subsidiaries (“Ceding Insurers”) entered into a securities issuance agreement (the “Securities Issuance Agreement”), and certain of its foreign insurance and reinsurance subsidiaries (“Ceding Insurers”) entered into an excess of loss reinsurance agreement (the “Reinsurance Agreement”), with Stoneheath Re (“Stoneheath”). The net effect of these agreements to the Company is the creation of a contingent put option in the amount of $350.0 million in the aggregate. The agreements provide the Company with a Reinsurance Collateral Account in support of certain Covered Perils named in the Reinsurance Agreement. The initial Covered Perils will 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 will be for the period from the Closing Date through June 30, 2007, with four annual mandatory extensions 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.
The Company provides various forms of credit enhancement including financial guaranty insurance and reinsurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and structured single risk-based obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through variable interest entities. In synthetic transactions, the Company guarantees payment obligations of counterparties including special purpose vehicles under credit derivatives referencing asset portfolios. The Company invests in collateralized debt obligations, and other investment vehicles that are issued through variable interest entities as part of the Company’s risk asset portfolio.
In 2003, the Company entered into an aggregate of $500.0 million of commercial paper-based credit facilities (the “Credit Facilities”). The proceeds of advances under the Credit Facilities were used to fund a trust account (“Trust”) to collateralize the reinsurance obligations of the Company under an intercompany quota share reinsurance agreement. The issued securities and the Company’s repayment obligations will be recorded as a net balance on the Company’s balance sheet because the Company has a contractual legal right of offset. In the event that in the future the Company were to not have the right to offset such assets (as, for example, would be the case if the assets in the Trust were withdrawn in order to satisfy the Company’s reinsurance obligations or if lender-issued securities could not be held in the Trust because they did not qualify as permitted assets under the trust agreement), then all or a portion of the assets in the Trust and the Company’s repayment obligations under the Credit Facilities would be required to be included as assets and liabilities on a gross basis, respectively, on the Company’s balance sheet. See also “Liquidity and Capital Resources” for more details regarding this off-balance sheet collateral arrangement.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction also provides the Company with an insurance trust that provides the Company with statutory relief under state insurance regulations in the U.S. Under the terms of this facility, the Company has acquired an irrevocable put option to issue preference ordinary shares into a trust in return for proceeds raised from investors. This put option may be exercised by the Company at any time. In addition, the Company may be required to issue preference ordinary shares to the trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a ratings downgrade of the Company.
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. Any prospectus, prospectus supplement, the Company’s Annual Report to ordinary shareholders, any proxy statement, any other Form 10-K, Form 10-Q or Form 8-K of the Company or any other written or oral statements made by or on behalf of the Company may include forward-looking statements that reflect the Company’s current views with respect to future events and financial performance. Such statements include forward-looking statements both with respect to the Company in general, and to the insurance, reinsurance and financial products and services sectors in particular (both as to underwriting and investment matters). Statements that include the words “expect”, “intend”, “plan”, “believe”, “project”, “anticipate”, “will”, “may”, and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the PSLRA or otherwise.
such markets; (ix) the potential impact on the Company from government-mandated insurance coverage for acts of terrorism; (x) the potential impact of variable interest entities or other off-balance sheet arrangements on the Company; (xi) developments in bankruptcy proceedings or other developments related to bankruptcies of companies insofar as they affect property and casualty insurance and reinsurance coverages or claims that the Company may have as a counterparty; (xii) availability of borrowings and letters of credit under the Company’s credit facilities; (xiii) changes in regulation or tax laws applicable to the Company or its subsidiaries, brokers or customers; (xiv) acceptance of the Company’s products and services, including new products and services; (xv) changes in the availability, cost or quality of reinsurance; (xvi) changes in the distribution or placement of risks due to increased consolidation of insurance and reinsurance brokers; (xvii) loss of key personnel; (xviii) the effects of mergers, acquisitions and divestitures; (xix) changes in ratings, rating agency policies or practices; (xx) changes in accounting policies or practices or the application thereof; (xxi) legislative or regulatory developments; (xxii) changes in general economic conditions, including inflation, foreign currency exchange rates and other factors; (xxiii) the effects of business disruption or economic contraction due to war, terrorism or other hostilities; and (xxiv) the other factors set forth in the Company’s other documents on file with the SEC as well as management’s response to any of the aforementioned factors. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included herein or elsewhere. The Company undertakes no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. While management believes that the amounts included in the consolidated financial statements reflect the Company’s best estimates and assumptions, actual results could differ from these estimates.
The Company restated its Consolidated Statement of Cash Flows for the years ended December 31, 2005, 2004, 2003, each of the quarters in the years 2004 and 2005, and the quarters ended March 31, and June 30, 2006. On November 5, 2006, management of the Company determined that the Company had incorrectly included the impact of foreign exchange rate changes on “Cash flows provided by operating activities,” “Cash flows used in investing activities”, “Cash flows provided by financing activities,” and “Effects of exchange rate changes on foreign currency cash” in the Company’s Consolidated Statements of Cash Flows and, therefore, a restatement was required to eliminate the impact of those rate changes on balances held in certain foreign currency denominated subsidiaries. For additional information about this restatement see our Annual Report on Form 10-K/A for the year ended December 31, 2005 (Note 29 to the Consolidated Financial Statements, “Restatement of Consolidated Statements of Cash Flows”). All amounts included herein for the current and prior periods have been adjusted to reflect the restatement.
The Company reviews the fair value of its investment portfolio on a periodic basis to identify declines in fair value below the carrying value that are other than temporary. This review involves consideration of several factors including (i) the time period during which there has been a significant decline in fair value below carrying value, (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question, (v) expected future interest rate movements, and (vi) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company concludes that declines in fair values are other than temporary, the cost of the security is written down to fair value below carrying value and the previously unrealized loss is therefore realized in the period such determination is made.
The Company uses investment derivative instruments, primarily interest rate swaps, to manage the interest rate exposure associated with certain assets and liabilities. All derivatives are recorded at fair value. On the date the derivative contract is entered into, the Company may designate the derivative as a hedge of the fair value of a recognized asset or liability (“fair value” hedge); a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset or liability (“cash flow” hedge); a hedge of a net investment in a foreign operation; or the Company may not designate any hedging relationship for a derivative contract.
“net realized and unrealized gains and losses on derivative instruments.” Periodic derivative net coupon settlements are recorded in net investment income.
Short-term investments comprise investments with a remaining maturity less than one year. Equity securities include investments in open end mutual funds and shares on publicly traded alternative funds.
Unpaid losses and loss expenses include reserves for reported unpaid losses and loss expenses and for losses incurred but not reported. The reserve for reported unpaid losses and loss expenses for the Company’s general and financial operations is established by management based on amounts reported from insureds or ceding companies, and represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company.
Certain life insurance and annuity contracts provide the holder with a guaranty that the benefit received upon death will be no less than a minimum prescribed amount. The contracts are accounted for in accordance with SOP 03-1 “Accounting and Reporting by Insurance Enterprises for certain Long-Duration Contracts and for Separate Accounts”, which requires that the best estimate of future experience be combined with actual experience to determine the benefit ratio used to calculate the policy benefit reserve.
During November 2005, the FASB issued FASB Staff Position No. FAS 123(r)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company has elected to adopt the alternative transition method provided in this FASB Staff Position for calculating the tax effects of share-based compensation pursuant to FAS 123(r). The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee share-based compensation, which is available to absorb tax deficiencies which could be recognized subsequent to the adoption of FAS 123(r).
FAS 123(r) requires that compensation costs be recognized for unvested stock-based compensation awards over the period through the date that the employee is no longer required to provide future services to earn the award, rather than over the explicit service period. Accordingly, the Company has adopted this policy of recognizing compensation cost to coincide with the date that the employee is eligible to retire, rather than the actual retirement date, for all options granted. During 2006, the Company incurred $6.4 million of additional stock based compensation expense due to the adoption of FAS 123(r) related to this treatment of retirement eligible employees as compared to the previous attribution methodology.
In February 2006, the FASB issued FAS 155, Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140. This standard permits fair value re-measurement of an entire hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; narrows the scope exemption applicable to interest-only strips and principal-only strips from FAS 133, clarifies that only the simplest separations of interest payments and principal payments qualify as not being subject to the requirements of FAS 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends FAS140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This statement is intended to require more consistent accounting that eliminates exemptions and provides a means to simplify the accounting for hybrid financial instruments. This statement is effective for all financial instruments acquired or issued after January 1, 2007. As at December 31, 2006 the Company has not elected to apply the fair value option for any hybrid financial instruments.
January 1, 2007. The effects of adoption cannot be reasonably estimated.
In November 2006, the FASB issued FSP FAS 123(R)-5, Amendment of FASB Staff Position FAS 123(R)-1, which addresses whether the modification of an instrument in connection with an equity restructuring or a business combination should be considered a modification for purposes of applying FSP FAS 123(R)-1, Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R). The FASB staff has taken the position that for instruments that were originally issued as employee compensation and then exchanged or changed, where the only change is a change to the terms of an award to reflect an equity restructuring or a business combination that occurs when the holders are no longer employees, then no change in the recognition and measurement (due to a change in classification) of these instruments will result if, there is (i) no increase in value to the holders of the instrument or (ii) the exchange or change in the terms of the award is not made in contemplation of an equity restructuring or a business combination and (iii) all holders of the same class of equity instruments (for example, stock options) are treated in a similar manner. These provisions were applicable beginning in November after the date the final FSP was posted to the FASB’s website. This guidance did not have a significant impact on the Company’s financial condition or results of operations.
In January 2007, the FASB issued FAS 133 Implementation Issue No. B40, Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets (“Issue B40”). This guidance clarifies circumstances under which a securitized interest in prepayable financial assets would not be subject to certain testing for embedded derivatives required under FAS 133. This guidance provides a narrow scope exception from paragraph 13(b) of FAS 133 for securitized interests that: (i) contain only an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets and for which the right to accelerate the settlement of the interest cannot be controlled by the investor and (ii) the securitized interest itself does not contain an embedded derivative for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets. The guidance in Issue B40 must be applied as of January 1, 2007 (the adoption date of FAS 155 as previously discussed) except for the criteria outlined in (ii) above, which is not applicable to securitized interests that were issued before June 30, 2007, and that only include embedded derivatives (other than an embedded derivative that results solely from the embedded call options in the underlying financial assets) that have an extremely remote possibility of having greater than a trivial fair value at any time during the instrument’s life as determined at the later of the adoption date of FAS 155 or the purchase of the instrument. The Company is evaluating the impact of this guidance in conjunction with the guidance in FAS 155. The impact on the Company’s financial condition and results of operations will not be known until the evaluation of these standards is complete.
During February 2007, the FASB issued FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”) which permits entities to choose to measure many financial instruments and certain other items at fair value. A company must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option may be applied on an instrument by instrument basis, with a few exceptions; the fair value option is irrevocable (unless a new election date occurs); and the fair value option may be applied only to entire instruments and not to portions of instruments. FAS 159 will be effective for interim and annual financial statements issued after January 1, 2008. The Company is currently evaluating the potential impact of this guidance.
On August 4, 2006, the Company completed the sale of approximately 37% of its financial guaranty reinsurance and insurance businesses (the “Transferred Business”) through an initial public offering (“IPO”) of 23.4 million common shares of SCA at $20.50 per share. SCA was incorporated in Bermuda in March 2006 for the sole purpose of becoming the parent company for the Transferred Business.
As part of the overall structuring of the IPO, certain formation transactions occurred in order to move all units included in the IPO under SCA. Also in connection with the IPO, the Company has entered into reinsurance agreements with SCA to retain certain insurance risks along with the related liabilities. At their inception, these contracts had no effect on the Company’s income. In addition, the Company has entered into arrangements to provide adverse development protection to SCA related to certain limited risks where the Company would pay up to the limits of the underlying coverages. The Company has also entered into a number of agreements with SCA that govern certain aspects of the relationship, including service agreements under which the Company will provide certain services to SCA for a limited period of time. For further details on related party transactions with SCA, see SCA’s reports filed with the SEC.
Pursuant to SCA’s bye-laws, the votes conferred by the common shares owned by the Company may not exceed, with respect to any matter presented to SCA’s shareholders for their action or consideration,
The Company has the right to appoint four out of the nine directors of SCA, and pursuant to formation agreements, SCA is required to maintain a majority of directors on its board who are independent under applicable New York Stock Exchange Rules, and are neither a director nor an officer of any member of the XL Capital group.
From an accounting perspective, these limitations did not result in a loss of control and as such, the Company continues to consolidate SCA based upon the aggregate impact of its retained controlling interest established through the Company’s economic interests and voting rights as well as through its level of participation in certain committees of the SCA board of directors, including its majority representation on SCA’s Finance and Risk Oversight Committee. The voting limitations noted above can be reduced or eliminated upon receipt by SCA of written confirmation from each nationally recognized rating agency, then providing a financial strength rating for SCA, that such financial strength rating is or will be determined without reference to the ratings of any member of the XL Capital Ltd group or that the then financial strength rating issued by it will not at the time of such confirmation be adversely affected by the elimination or adjustment of such limitations. The 37% ownership interest in SCA held by the public and SCA management is recorded as a minority interest in the Company’s financial statements.
The Company has also realized portions of SCA’s accumulated other comprehensive loss as a result of the primary and secondary offerings of $11.0 million and $3.2 million, respectively. These amounts have no impact on total net shareholders’ equity and have been recorded in a manner consistent with the losses above.
The Company evaluates the performance of each segment based on underwriting results for general operations, and contribution from both life and financial operations. 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 assets by segment for its general operations.
Insurance business written includes risk management and specialty lines. Risk management products comprise global property and casualty insurance programs for large multinational companies, including umbrella liability, products recall, U.S. workers’ compensation, property catastrophe, and primary property and liability coverages. Specialty lines products include the following lines of business: professional liability, environmental liability, political risk insurance, aviation and satellite, marine and offshore energy insurance, equine and other insurance coverages including program business.
Reinsurance business written includes treaty and facultative reinsurance to primary insurers of casualty and property risks, principally: general liability; professional liability; accident and health; automobile and workers’ compensation; commercial and personal property risks; specialty risks including fidelity and surety and ocean marine; property catastrophe; property excess of loss; property pro-rata; marine and energy; aviation and satellite; and various other reinsurance to insurers on a worldwide basis.
Life operations covers life reinsurance business written with life insurance companies, principally to help them manage mortality, morbidity, survivorship, investment and lapse risks. This includes a broad range of underlying lines of life assurance business, including term assurances, group life, critical illness cover, immediate annuities and disability income. This also covers a range of geographic markets, with an emphasis on the U.K., U.S., and Continental Europe. In addition, a specialized “Life Fund Integration” team is actively seeking to acquire closed life companies or blocks of closed life assurance business for run-off, principally in the U.K.
The SCA segment comprises the triple-A rated financial guaranty insurance and reinsurance business. SCA provides credit protection through the issuance of financial guaranty insurance policies and credit default swaps, as well as the reinsurance thereof. Financial guaranty insurance provides an unconditional and irrevocable guaranty to the holder of a debt obligation of full and timely payment of principal and interest. In the event of a default under the obligation, the insurer has recourse against the issuer and/or any related collateral (which is more common in the case of insured asset-backed obligations or other non-municipal debt) for amounts paid under the terms of the policy. Credit default swaps are derivative contracts which offer credit protection relating to a particular security or pools of specified securities.
This includes net realized losses on investments of $116.5 million, net realized and unrealized gains on investment and other derivatives of $71.6 million, but does not include unrealized appreciation or depreciation on investments, which are included in accumulated other comprehensive income (loss).
Ratios are based on net premiums earned from general operations. The underwriting expense ratio excludes exchange gains and losses.
Within the Insurance segment Other includes political risk, accident & health, surety, and other discontinued lines of business. Within the Reinsurance segment, Other includes political risk, surety, warranty, accident and health, and other lines.
The acquisition was accounted for under the purchase method of accounting and, therefore, the identifiable assets and liabilities of the Winterthur Business were recorded at their estimated fair value on June 30, 2001. The process of determining the fair value of such assets and liabilities acquired, as required under purchase accounting, included management’s estimates and independent valuations. The purchase price was initially allocated to the acquired assets and liabilities based upon their estimated fair value at June 30, 2001. The excess of the purchase price over acquired tangible net assets was then applied to intangible assets with finite and indefinite lives.
The Company has gross unrealized losses totaling $249.5 million which it considers to be temporary impairments. 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 and length of time securities have been impaired, along with management’s ability and intent to hold the securities to recovery, among other factors. At December 31, 2006, there were $244.1 million of gross unrealized losses on fixed income and short-term investments, and $5.4 million of gross unrealized losses on equity securities. At December 31, 2005, there were $312.7 million of gross unrealized losses on fixed income and short-term investments, and $8.8 million of gross unrealized losses on equity securities. At December 31, 2006, approximately 2.3% of the Company’s fixed income investment portfolio was invested in securities which were below investment grade or not rated. At December 31, 2005, approximately 2.4% of the Company’s fixed income investment portfolio was invested in securities which were below investment grade or not rated. Approximately 5.4% of the unrealized losses in the Company’s fixed income securities portfolio at December 31, 2006 related to securities that were below investment grade or not rated. The information shown below about the unrealized losses on the Company’s investments at December 31, 2006 concerns the potential affect upon future earnings and financial position should management later conclude that some of the current declines in the fair value of these investments are other than temporary declines.
The fair values of securities on loan at December 31, 2006 and 2005 are detailed below.
The Company has three facilities available for the issue of letters of credit collateralized against the Company’s investment portfolio with a value of $1,336.0 million at December 31, 2006 and $904.9 million at December 31, 2005. At December 31, 2006 and 2005, approximately $171.9 million and $182.9 million, respectively, of letters of credit were issued and outstanding under these facilities.
The Company has invested in certain closed end funds, certain limited partnerships, LLC’s and similar investment vehicles, including funds managed by certain of its investment management affiliates. At December 31, 2006, investments affiliates totaled $1.9 billion of which $1.6 billion was invested in the alternative investment portfolio and $0.3 billion consisted of private investments. At December 31, 2005, investment affiliates totaled $1.7 billion of which $1.5 billion was included in the alternative investment portfolio and $0.2 billion consisted of private investments.
The Company’s significant financial affiliate investments at December 31, 2006 included Primus Guaranty, Ltd. with ownership of 31.1%.
The Company’s insurance affiliate investments at December 31, 2006 included American Strategic Holdings and ITAÚ XL, with ownership in these entities at 47.3% and 49.9%, respectively.
During the years ended December 31, 2006, 2005, and 2004, the Company recorded other than temporary declines in the values of certain affiliates totaling $19.8 million, $2.5 million, and $21.0 million, respectively. 2006 and 2005 declines related primarily to investment management affiliates whereas 2004 declines related to certain insurance affiliates.
Other investments include investments over which the Company does not have significant influence and whose fair value is generally unquoted. This includes investments in limited partnerships where the Company does not participate in the management of the partnerships, and investments in non-rated collateralized debt/equity instruments. Income from other investments was $9.1 million and $55.0 million for the years ended December 31, 2006 and 2005, respectively. Unrealized gains from these limited private investment partnerships was $10.0 million and $7.5 million as at December 31, 2006 and 2005 respectively.
Income on unrated tranches of collateral debt obligations is reflected only to the extent the Company’s principal has been fully recovered. Income on alternative investments included in other investments is realized only on ultimate sale of these investments. The Company had net unrealized gains of $49.1 million and $19.3 million, respectively, at December 31, 2006 and 2005, related to these alternative investments. In 2006, the Company had realized gains related to the alternative investments of $5.0 million.
The following table presents the net (favorable) adverse development of reserves analyzed by each of the Company’s operating segments:
Within the Insurance segment, net overall favorable prior year reserve development for the year ended 2006 was $13.2 million. This overall favorable development included reserve releases of $94.4 million in property lines and $91.1 million in casualty lines, partially offset by $96.5 million, $3.0 million and $72.8 million of prior year adverse development in certain professional, marine and aviation, and other lines of business, respectively. Property reserve releases resulted from favorable experience in the 2005 accident year for both attritional and catastrophe losses. Casualty releases were noted largely in Europe including $69.2 million related to casualty business acquired from WSIC combined with continued favorable development of the business re-underwritten post acquisition. The professional adverse development relates primarily to the Bermuda portfolio. This development is split into the 2002 and prior periods for D&O and 2004 and subsequent periods for employment practices liability as new types of actions based on employment demographics have emerged. Adverse development from the 2005 hurricanes impacted marine, but was offset by favorable development in aviation reserves. Other adverse development resulted primarily from discontinued lines such as surety and political risk, combined with an unrecoverable reinsurance balance from an accident and health line reinsurer. The gross prior year favorable development for the Insurance segment was $371.4 million. This gross favorable development exceeds the corresponding net development as gross reported losses in casualty have developed more favorably than net losses. Lower gross reported loss amounts reflect reductions in several large recoverable losses on older years and an absence of new large losses, with consequent reductions to reinsurance recoveries.
During 2005, the Insurance segment’s net adverse prior year development of $1.02 billion includes $834.2 million of incurred loss related to the conclusion of the independent actuarial process with WSIC. Excluding this development the remaining $185.8 million was driven primarily by increases in reported case reserves for excess professional liability. Strengthening of $259.5 million in professional lines was caused primarily by the establishment of case reserves on both directors’ and officers’ claims in pre-2002 business, and errors and omissions claims.
During 2006, net overall favorable prior year reserve development was $125.7 million. This overall favorable development was made up of releases of $190.2 million in property and other shorter-tail lines of business and $10.9 million in casualty lines, partially offset by $75.4 million in adverse development specifically related to the 2005 catastrophes. Net releases in casualty lines reflect positive claims experience in the core U.S. reinsurance and primary books including those years subject to the CAR review in 2003 partially offset by some older asbestos and environmental development and $18.0 million related to a disputed claim impacting underwriting years 1996-2000 that settled during the year. The gross prior year development for the Reinsurance segment totals $46.0 million favorable. This gross favorable development is less than the corresponding net development as net strengthening on the 2005 catastrophes was less significant than the gross strengthening due to reinsurance recoveries.
The remainder of the strengthening in the casualty and professional lines reserves was driven by a small number of increases in reported claims in the other liability and errors and omissions lines of business in the pre-1997 underwriting years as well as recently reported claims in umbrella liability, errors and omissions and directors and officers lines of business in the 1997-2001 underwriting years. The professional lines claims activity arises largely from a limited number of cedants. This reserve increase was partially offset by favorable development in the 1997- 2001 underwriting years in the medical malpractice business line. Activity in the post-2001 underwriting years relates primarily to certain large individual claims affecting a number of lines, including surety, umbrella liability and errors and omissions.
Management believes that in the financial guaranty industry it is not appropriate to characterize revisions in loss estimates as development and therefore all reserve provisions are considered as current period reserves, because all changes in our reserve estimates are made to reflect conditions and events that have occurred in the current period. In property and casualty insurance, reserves are estimated for a particular underwriting year for events that have already occurred, whereas in financial guaranty insurance reserves are estimated for a particular underwriting year based on estimates of expected future economic and market events (e.g. events that continually conspire to affect the value of underlying collateral until such time a claim is paid and the collateral is liquidated and paid to the insurer as salvage).
Incurred but not reported losses, net of reinsurance, included in the above table was $24.1 million in 2006, $16.7 million in 2005 and $22.5 million in 2004. Unpaid losses recoverable are net of potential uncollectible amounts.
As of December 31, 2006, the Company had approximately 1,447 open claim files for potential asbestos exposures and 589 open claim files for potential environmental exposures on business written prior to 1986. Approximately 56% of the open claim files in both 2006 and 2005 are due to precautionary claim notices. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to receive coverage under the reinsurance contract. Such notices do not contain an incurred loss amount to the Company. The development of the number of open claim files for potential asbestos and environmental claims is as follows:
The estimation of loss and loss expense liabilities for asbestos and environmental exposures is subject to much greater uncertainty than is normally associated with the establishment of liabilities for certain other exposures due to several factors, including: (i) uncertain legal interpretation and application of insurance and reinsurance coverage and liability; (ii) the lack of reliability of available historical claims data as an indicator of future claims development; (iii) an uncertain political climate which may impact, among other areas, the nature and amount of costs for remediating waste sites; and (iv) the potential of insurers and reinsurers to reach agreements in order to avoid further significant legal costs. Due to the potential significance of these uncertainties, the Company believes that no meaningful range of loss and loss expense liabilities beyond recorded reserves can be established. As the Company’s net unpaid loss and loss expense reserves related to asbestos and environmental exposures are less than 1% of the total net reserves at December 31, 2006, further adverse development is not expected to be material to the Company’s overall net loss reserves. The Company believes it has made reasonable provision for its asbestos and environmental exposures and is unaware of any specific issues that would significantly affect its estimate for loss and loss expenses.
The following table presents an analysis of total unpaid losses and loss expenses recoverable between general, life, and financial operations for the year ended December 31:
At December 31, 2006, the total reinsurance assets of $6.1 billion included reinsurance receivables for paid losses and loss expenses of $1.1 billion and $5.0 billion with respect 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 their ability to meet these obligations and while they may continue to acknowledge their contractual obligation to do so, they may not have the financial resources or willingness to fully meet their obligation to the Company.
At December 31, 2006 and 2005, the provision for uncollectible reinsurance relating to both reinsurance balances receivable and unpaid losses and loss expenses recoverable was $218.3 million and $260.7 million, respectively. To estimate the provision for uncollectible reinsurance recoverable, the reinsurance recoverable must first be allocated to applicable reinsurers. This determination is based on a process rather than an estimate, although an element of judgment must be applied. As part of this process, ceded IBNR is allocated by reinsurer. The allocations are generally based on historical relationships between gross and ceded losses. If actual experience varies materially from historical experience, the allocation of reinsurance recoverable by reinsurer will change.
The Company uses a default analysis to estimate uncollectible reinsurance. The primary components of the default analysis are reinsurance recoverable balances by reinsurer, net of collateral, and default factors used to determine the portion of a reinsurer’s balance deemed uncollectible. The definition of collateral for this purpose requires some judgment and is generally limited to assets held in trust, letters of credit, and liabilities held by us with the same legal entity for which the Company believes there is a right of offset. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $2.2 billion at December 31, 2006, collateralizing reinsurance recoverables with respect to certain reinsurers. In addition, the Company has a four year collateralized escrow agreement with WSIC for up to $185 million to protect certain subsidiaries from non-performing third party reinsurers related to the Winterthur Business. For further information see Note 6 to the Consolidated Financial Statements, “Business Combinations.” Default factors require considerable judgment and are determined using the current rating, or rating equivalent, of each reinsurer as well as other key considerations and assumptions.
During 2006 and 2005, the Company entered into long duration contracts that subject the Company to mortality and morbidity risks and which were accounted for as life premiums earned. Future policy benefit reserves were established using appropriate assumptions for investment yields, mortality, and expenses, including a provision for adverse deviation. The average interest rate used for the determination of the future policy benefits for these contracts was 4.7% and 4.8% at December 31, 2006 and 2005, respectively. Total future policy benefit reserves for the year ended December 31, 2006 and 2005 were $6.3 billion and $5.6 billion, respectively.
As at December 31, 2006, the Company had bank and loan facilities available from a variety of sources, including commercial banks, totaling $4.8 billion (2005: $4.6 billion) of which $3.4 billion (2005: $3.4 billion) of debt was outstanding. In addition, the Company has letter of credit facilities totaling $6.4 billion available of which $3.8 billion (2005: $3.5 billion) were outstanding as at December 31, 2006, 4.5% (2005: 5.3%) of which were collateralized by certain of the Company’s investment portfolios, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates’ capital requirements. Of these amounts, $1.0 billion is available in the form of revolving credit or letters of credit.
“Commitment” and “In Use” data represent December 31, 2006 accreted values.
In March 2006, the Company replaced its letter of credit facility utilized to support the capital requirements of its syndicates at Lloyd’s of London (“Lloyd’s”), with a new £500 million credit facility that closed on March 14, 2006. Commitments from the participating banks expire on November 30, 2007, which will enable the Company to use this facility to meet its letter of credit needs for the 2008 year of account at Lloyd’s.
In May 2006, the Company closed a new $500 million syndicated credit facility which has a tenor of 364-days and is available for letters of credit only.
The number of ordinary shares to be issued under each purchase contract depends on, among other things, the average market price of the ordinary shares. The maximum number of ordinary shares to be issued under the purchase
contracts is approximately 11.5 million. The Company accounts for the effect on the number of weighted average ordinary shares, assuming dilution, using the treasury stock method. The purchase contract component of the 7.0% Units will have no effect on the number of weighted average ordinary shares, assuming dilution, except when the average market price of the Company’s ordinary shares is above the threshold appreciation price of $80.6 per share. Because the average market price of the Company’s ordinary shares during the period the 7.0% Units were outstanding was below this price, the shares issuable under the purchase contracts were excluded from the computation of net income per ordinary share assuming dilution for the three and twelve month periods ended December 31, 2006.
In March 2004, the Company issued 33 million 6.5% Equity Security Units (the “6.5% Units”) in a public offering. The Company received approximately $800.2 million in net proceeds from the sale of the Units after deducting underwriting discounts. Each 6.5% 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 May 15, 2007 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due May 15, 2009 with a principal amount of $1,000. The senior notes are pledged by the holders to secure
their obligations under the purchase contract. The number of shares issued under the purchase contract is contingently adjustable based on, among other things, the share price of the Company on the stock purchase date and the dividend rate of the Company. The Company will make quarterly payments at the annual rate of 3.97% and 2.53% under the purchase contracts and senior notes, respectively. The Company may defer the contract payments on the purchase contract, but not the senior notes, until the stock purchase date. In May 2007, the senior notes will be remarketed whereby the interest rate on the senior notes will be reset in order to generate sufficient remarketing proceeds to satisfy the 6.5% Unit holders’ obligations under the purchase contract. If the senior notes are not successfully remarketed, then the Company will exercise its rights as a secured party and may retain or dispose of the senior notes to satisfy, in full, the 6.5% Unit holders’ obligations to purchase its ordinary shares under the purchase contracts.
Under the Company’s 364-day facilities, three-year credit facility, and five-year credit facilities described above, in the event that the Company XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A-” from A.M. Best, an event of default would occur. The Company currently has an “A+ (stable)” rating from A.M. Best.
aggregate letters of credit outstanding at that time. If this were to occur, the Company may not be able to provide the collateral required in order to maintain this facility.
Under this methodology, the fair value is determined using a cash flow model developed by the Company which is dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. In general, the Company holds credit derivatives to maturity. Accordingly, changes in the fair value of such credit derivatives are unrealized. For the years ended December 31, 2006, 2005 and 2004 the change in the fair value of credit derivatives issued in connection with the Company’s financial guaranty business was a gain of $3.9 million, $10.5 million and $48.3 million, respectively.
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities and equity securities investments. These contracts are not designated as specific hedges for financial reporting purposes and therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of twelve months or less. In addition, certain of the Company’s investment managers may, subject to investment guidelines, enter into forward contracts where potential gains may exist. The Company has exposure to foreign currency exchange rate fluctuations through its operations and in its investment portfolio. The Company’s net foreign currency denominated receivable on foreign exchange contracts was $211.5 million and a payable of $603.0 million as at December 31, 2006 and 2005, respectively, with a net unrealized gain of $15.5 million and $15.9 million as at December 31, 2006 and 2005, respectively.
The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments, primarily to reduce its exposure to interest rate risks associated with certain of its assets and liabilities. The Company uses interest rate swaps to convert certain liabilities from a fixed rate to a variable rate of interest and to convert a variable rate of interest from one basis to another. The Company is exposed to credit risk in the event of non-performance by the other parties to the forward contracts.
Interest rate swaps are used to hedge a portion of the Company’s floating rate guaranteed investment contracts. These derivatives convert the floating rate guaranteed investment contract payments to a different floating rate basis to better match the cash receipts earned from the supporting investment portfolio. At December 31, 2006, 2005, and 2004, contracts designated as cash flow hedges were in a net unrealized gain position of $11.4 million, nil, and nil, respectively. These interest rate swap hedges resulted in a reduction in interest expense of $6.1 million, nil, and nil for the years ended December 31, 2006, 2005, and 2004, respectively. The ineffective portion of the hedges amounted to $3.5 million as part of net realized losses at December 31, 2006, while the ineffective portion of the hedges was nil and nil at December 31, 2005 and 2004, respectively.
the comparable U.S. Treasury issue between the initiation of the transaction and the pricing of the transaction. The total cost of the hedge was $4.2 million. In 2001, a loss of $5.6 million was recorded in net realized and unrealized gains and losses related to the cancellation of the treasury lock agreement relating to the 6.58% notes due 2011 due to the September 11, 2001 event.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction also provides the Company with an insurance trust that provides the Company with statutory relief under state insurance regulations in the U.S. Under the terms of this facility, the Company has acquired an irrevocable put option to issue preference ordinary shares into a trust in return for proceeds raised from investors. This put option may be exercised by the Company at any time. In addition, the Company may be required to issue preference ordinary shares to the trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a ratings downgrade of the Company. In connection with this transaction, the fair value of the put premiums and other related costs, in total of $109.9 million was charged to “Additional Paid in Capital” and a deferred liability was established (included with “Other liabilities”) of $102.5 million in the Consolidated Balance Sheet at December 31, 2003.
the Company were to not have the right to offset such assets (as, for example, would be the case if the assets in the Trust were withdrawn in order to satisfy the Company’s reinsurance obligations or if lender-issued securities could not be held in the Trust because they did not qualify as permitted assets under the trust agreement), then all or a portion of the assets in the Trust and the Company’s repayment obligations under the Credit Facilities would be required to be included as assets and liabilities on a gross basis, respectively, on the Company’s balance sheet.
The Company utilizes variable interest entities both indirectly and directly in the ordinary course of business. The Company provides various forms of credit enhancement including financial guaranty insurance and reinsurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and structured single risk based obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through variable interest entities. In synthetic transactions the Company guarantees payment obligations of counterparties including special purpose vehicles under credit derivatives referencing asset portfolios. The Company invests in equity tranches (or similar instruments) of collateralized debt obligations (“CDOs”), collateralized bond obligations (“CBOs”) and other investment vehicles that are issued through variable interest entities as part of the Company’s risk asset portfolio. Certain collateral facilities and contingent capital facilities are also structured using variable interest entities, in which the Company has a variable interest. The Company was not the primary beneficiary of any of these entities. In addition, the Company does not believe that any of such interests would be characterized as significant to XL. The Company believes that the significance of the variability absorbed by XL as contemplated in paragraph 24 of FIN 46(R) must be considered in the context of XL Capital’s consolidated financial statements. The Company considers the significance of its share of the entity’s expected losses and expected residual returns in relation to the Company’s consolidated results of operations, whether the Company holds a first loss portion in the entity, and the rating of its exposure and probability of loss.
The Company manages its exposures to underwriting risk on these transactions through a structured process which includes but is not limited to detailed credit analysis, review of and adherence to underwriting guidelines and the use of reinsurance. The Company has also implemented surveillance policies and procedures to monitor its exposure throughout the life of the transactions. In addition, the structures of the transactions are such that the insured
obligation is backed by a stream of cash flows, pools of assets or some other form of collateral. This collateral would typically become the Company’s upon the payment of a claim by the Company.
The following tables presents financial guaranty aggregate insured portfolios at December 31, 2006 where the net par outstanding was $121.1 billion, which includes credit default swap exposures of $25.2 billion. The net principal and interest insured, as of December 31, 2006 and 2005 was $187.6 billion and $130.8 billion, respectively. The liability for these credit derivatives had a carrying value of $25.6 million and $31.5 million at December 31, 2006 and 2005, respectively.
In addition, the Company underwrites a significant amount of its general insurance and reinsurance business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances to the Company. During the three years ended December 31, 2006, 2005 and 2004, approximately 18%, 21% and 22%, respectively, of the Company’s consolidated gross written premiums from general operations were generated from or placed by Marsh & McLennan Companies. During 2006, 2005 and 2004, approximately 16%, 17% and 17%, respectively, of the Company’s consolidated gross written premiums from general operations were generated from or placed by AON Corporation and its subsidiaries. Both of these companies are large, well established companies and there are no indications that either of them is financially troubled. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written from general operations in any of the three years ended December 31, 2006, 2005, or 2004.
The Company’s available for sale 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 the Company’s shareholders’ equity at December 31, 2006, 2005, or 2004.
The Company has committed to invest in several limited partnerships as part of its overall corporate strategy. As of December 31, 2006, the Company has commitments which include potential additional add-on clauses, to invest a further $4.2 million over the next five years.
During 2003, the Company entered into a purchase, sale and leaseback transaction to acquire new office space in London. The Company has recognized a capital lease asset of $166.3 million and $152.9 million, and deferred a gain of $50.4 million and $46.5 million related to this lease at December 31, 2006 and 2005, respectively. The gain is being amortized to income in line with the amortization of the asset. The future minimum lease payments in the aggregate are expected to be $344.7 million and annually for the next five years are as follows:
The authorized share capital is 999,990,000 ordinary shares of a par value of $0.01 each, 23,000,000 Series A preference ordinary shares of par value $0.01 each, 27,000,000 Series B preference ordinary shares of par value $0.01 each, 20,000,000 Series C preference ordinary shares of par value $0.01 each and 350,000 Series D preference shares of par value $0.01 each. Holders of Class A ordinary shares are entitled to one vote for each share. All ordinary shares in issue at December 31, 2006 are Class A ordinary shares.
In December 2005, the Company issued 38.9 million ordinary shares at a price of $65.00 per share to support capital requirements subsequent to the insured hurricane losses during the 2005 Atlantic hurricane season and the conclusion of the loss related to the independent actuarial process with Winterthur Swiss Insurance Company. The net proceeds from this issuance was $2.4 billion.
The Company issued 9.2 million shares during November 2001 at a price of $89.00 per share to support capital requirements subsequent to the September 11 event. Net proceeds received were $787.7 million.
The Company has had several stock repurchase plans as part of its capital management program. On January 9, 2000, the Board of Directors authorized the repurchase of shares up to $500.0 million. During 2001, the Company repurchased 1.5 million ordinary shares at a total cost of $116.9 million, or an average cost of $76.40 per ordinary share. During 2000, the Company repurchased 5.1 million ordinary shares at a total cost of $247.7 million, or an average cost of $48.82 per ordinary share. During 2006, 2005 and 2004 no share repurchases took place under the January 9, 2000 authorization. The Company has repurchased shares from employees and directors in relation to share swaps on option exercises and withholding tax on restricted stock.
On February 23, 2007, the Board of Directors of the Company approved a new share repurchase program authorizing the Company to repurchase up to $1.0 billion of its Class A ordinary shares. The new program includes the unused amounts allocated to the share repurchase program authorized in January 2000.
The Employee Share Purchase Plan (the “ESPP”) was approved by the shareholders of the Company on May 10, 2002; however, the Company discontinued the ESPP effective January 1, 2006. The ESPP was administered by a committee which consisted of members of the Compensation Committee of the Company’s Board of Directors. The ESPP had two offering periods a year. The first period commenced on July 1, 2002. All employees of the Company and its designated participating subsidiaries, were eligible to participate in the ESPP provided they have been employed at least one month prior to the start of the offering period and they did not hold more than 5% of the Company’s total stock, including stock acquired in the current period. Employees could invest up to 20% of their total monthly cash compensation towards the purchase of the Company’s shares up to a total market value (measured on the first day of the offering period) of U.S. $25,000. The total number of shares purchased in any offering period could not exceed 1,000 shares. Employees who enrolled in the ESPP could purchase the Company’s shares at a 15% discount on the lesser of the market price at the beginning or at the end of the six month offering period. Once purchased, employees could sell or transfer their shares to someone else’s name only during an Open Trading Window. Participants in the ESPP were eligible to receive dividends on the Company’s shares. A total of 1,255,000 ordinary shares were authorized to be issued under the ESPP. The number of shares issued during the years ended December 31, 2005 and 2004 were 114,177 and 167,890, respectively.
The SCA Plan will be administered by SCA’s Compensation Committee or such other Board committee (or the entire Board) as may be designated by SCA’s Board, which is referred to as the “Committee.” The Committee will determine which eligible employees, consultants and directors receive Awards, the types of Awards to be received and the terms and conditions thereof. However, the exercise price of options and SARs will not be less than the fair market value of the shares on the date of grant, and the term will not be longer than ten years from the date of grant. In the event of a change in control (as defined in the SCA Plan), all awards granted under the SCA Plan then outstanding but not then exercisable (or subject to restrictions) shall become immediately exercisable, all restrictions shall lapse, and any performance criteria shall be deemed satisfied, unless otherwise provided in the applicable Award agreement.
During the years ended December 31, 2006, 2005 and 2004, the Company granted 187,804, 1,877,500 and 1,871,746 options, respectively, to purchase its ordinary shares to directors and employees related to incentive compensation plans, with a weighted average grant-date fair value of $16.95, $17.17 and $19.04, respectively. During the years ended December 31, 2006, 2005, and 2004, the Company recognized $23.4 million, $17.6 million and $12.7 million, respectively, of compensation expense, net of tax, related to its stock option plan. As a result of the tender offer to employees of SCA, $0.6 million of this expense was transferred out of shareholders equity and established as a liability, as settlement of the SCA plan is not share based. Total intrinsic value of stock options exercised during the years ended December 31, 2006, 2005 and 2004 was $14.7 million, $17.4 million and $22.0 million, respectively.
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between XL’s closing stock price on the last trading day of the 2006 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, 2006. Total unrecognized stock based compensation expense related to non-vested stock options was approximately $25.1 million as of the end of December 31, 2006, related to approximately 10.9 million options, which is expected to be recognized over a weighted-average period of 1.4 years. The Company received cash of $32.0 million from exercises of stock options and recorded associated tax benefits of $1.0 million on stock options exercised during the year ended December 31, 2006.
At the effective date of the IPO of SCA, SCA awarded 647,963 stock options (the “IPO Awards”) to directors and employees at an exercise price of $20.50. Of the total stock options awarded, 200,000 were granted to directors, of which 50,000 relate to directors, who as officers of the Company, pledged such options to the Company. There were no other stock option awards made through December 31, 2006. The Awards vest as set forth in the applicable Award agreements and the requisite service period is equivalent to the vesting period. The IPO Awards contain certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability. The IPO Awards awarded had a weighted average grant-date fair value of $6.06, a weighted average remaining contractual term of 7.65 years, and an aggregate intrinsic value of $4.7 million. The fair value of these awards was determined under the Black Scholes Model using assumptions consisting of a dividend yield of 0.0%, a risk free interest rate of 5.0%, expected volatility of 25.0%, and an expected life of 4.4 years. None of these options were exercisable at December 31, 2006. During the year ended December 31, 2006, SCA recognized approximately $0.6 million of compensation expense, net of tax, related to its stock option awards. There were no stock options exercised or cancelled during the year ended December 31, 2006. Total unrecognized stock based compensation expense related to non-vested stock options was approximately $3.1 million as of the end of December 31, 2006, related to 647,963 options, which is expected to be recognized over a weighted-average period of 2.1 years.
Restricted stock awards issued under the 1991 Performance Incentive Program and under the SCA Plan vest as set forth in the applicable award agreements. These shares contained certain restrictions prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability.
The Company has a qualified defined contribution plan which is managed externally and whereby employees and the Company contribute a certain percentage of the employee’s gross salary into the plan each month. The Company’s contribution generally vests over five years. The Company’s expenses for its qualified contributory defined contribution retirement plans were $50.0 million, $40.9 million and $38.8 million in the years ended December 31, 2006, 2005 and 2004, respectively.
A qualified non-contributory defined benefit pension plan exists to cover a number of its U.S. employees. This plan also includes a non-qualified supplemental defined benefit plan designed to compensate individuals to the extent their benefits under the Company’s qualified plan are curtailed due to Internal Revenue Code limitations. Benefits are based on years of service and compensation, as defined in the plan, during the highest consecutive three years of the employee’s last ten years of employment. Under these plans, the Company’s policy is to make annual contributions to the plan that are deductible for federal income tax purposes and that meet the minimum funding standards required by law. The contribution level is determined by utilizing the entry age cost method and different actuarial assumptions than those used for pension expense purposes. The projected benefit obligation, accumulated benefit obligation and fair value of the assets for this plan were $28.6 million, $28.6 million and $15.9 million, respectively, as of December 31, 2006, and $29.4 million, $29.4 million and $14.2 million, respectively, as of December 31, 2005.
Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2006 and 2005 were as follows:
The valuation allowance at December 31, 2006 and December 31, 2005 of $218.6 million and $154.5 million, respectively, relates to net operating loss carry forwards in Switzerland and net unrealized capital losses and realized capital loss carry forwards in the U.S. that may not be realized within a reasonable period. As of December 31, 2006, the Company has net unrealized capital losses and realized capital loss carry forwards of approximately $8.4 million and $11.3 million respectively in the U.S., against which a valuation allowance of $19.7 million has been established. Management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized.
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 limited by applicable laws and statutory requirements of the various countries the Company operates in, including Bermuda, the U.S. and the U.K., among others. Statutory capital and surplus, based on draft unaudited filings for the principal operating subsidiaries of the Company for the years ended December 31, 2006 and 2005 was as follows:
Required statutory capital and surplus represents 100% RBC level for principle U.S. operating subsidiaries.
Certain statutory restrictions on the payment of dividends from retained earnings by the Company's subsidiaries are further detailed below.
Dividends are non-cumulative and paid as declared by the Board of Directors of the XL Life Insurance and Annuity (XLLIA). Pursuant to regulatory requirements, the payment of dividends without prior approval from the Illinois Department of Insurance for life insurance companies is limited to the greater of 10 percent of XLLIA’s policyholder surplus as of the preceding December 31, or the net gain from operations for the preceding 12-month period ending December 31. The payment of dividends cannot be made except from the XLLIA’s surplus profits arising from its business. As at December 31, 2006, XLLIA’s surplus profits were negative. Under these restrictions, XLLIA cannot declare or distribute any dividends in 2007. Under these circumstances, XLLIA would need to request permission for an extraordinary dividend from the Illinois Department of Insurance.
At December 31, 2006, 2005 and 2004, the Company owned minority stakes in nine, eight and eight independent investment management companies (“Investment Management Affiliates”), respectively. These ownership stakes are part of the Company’s asset management strategy, pursuant to which the Company seeks to develop relationships with specialty investment management organizations, generally acquiring an equity interest in the business. The Company also invests in certain of the funds and limited partnerships and other legal entities managed by these affiliates and through these funds and partnerships pay management and performance fees to the Company’s Investment Management Affiliates.