In the normal course of business, the Company evaluates the efficiency of its capital structure and its capital needs to support the volume of business written in order to maintain its claims paying and financial strength ratings. The Company addressed these needs during 2006 with several key business initiatives as described below.
In May 2007, purchase contracts associated with the Company’s 6.5% equity security units mature and the related 2.53% senior notes will be remarketed and the interest rate reset. Management continues to review the impact and on-going implications of this liquidity event and more broadly, the efficiency of our capital structure.
During 2005, there was an unprecedented quantum of natural catastrophes. Collectively, Hurricanes Katrina, Rita and Wilma had a substantial impact on the Company’s results of operations and financial condition. This impact should be considered when reviewing comparative results. In August 2005, Hurricane Katrina, a category 4 storm, hit the Gulf Coast of the United States and is estimated to have caused the largest ever insured loss from a natural disaster in the property and casualty insurance industry. In September 2005, Hurricane Rita, a Category 3 storm, hit the Gulf Coast on the United States and caused considerable damage, although Rita was less severe than Katrina. In October 2005, Hurricane Wilma hit South Florida after causing significant damage in Mexico and Cuba. In addition, there were several other natural loss events in the third and fourth quarter 2005, including hurricanes Dennis, Emily and Ophelia, the European and Mumbai Floods and Typhoon Mawar (collectively, the “Other Cats”). Collectively, Hurricanes Katrina, Rita, Wilma, and these Other Cats have had a substantial impact on the Company’s results of operations and financial condition. As a result of the substantial impact that Hurricanes Katrina, Rita, Wilma and the Other Cats had on the results of the Company for the year ended December 31, 2005, the Company incurred losses, net of reinsurance recoveries, of $1.27 billion, $357.9 million and $247.1 million and $96.0 million, respectively, as at year end December 31, 2005.
The Life operations, Financial lines and SCA segments were unaffected by these catastrophes and hence have been excluded from the table above.
The Company’s actuaries utilize one set of assumptions in determining its single point estimate, which includes actual loss data, loss development factors, loss ratios, reported claim frequency and severity. The actuarial reviews and documentation are completed in accordance with professional actuarial standards appropriate to the jurisdictions where the business is written. The selected assumptions reflect the actuary’s judgment based on historical data and experience combined with information concerning current underwriting, economic, judicial, regulatory and other influences on ultimate claim settlements.
Any estimate of future costs is subject to the inherent limitation on the Company’s ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and loss adjustment expenses will vary, perhaps materially, from any estimate.
The activities of the Company’s surveillance department are integral to the identification of specific credits that have experienced deterioration in credit quality and to the assessment of whether losses on such credits are probable, as well as any estimation of the amount of loss expected to be incurred with respect to such credits. Closely monitored credits are divided into four categories: (i) Special Monitoring List-investment grade credits where a covenant or trigger may be breached or is close to being breached and warrants closer monitoring; (ii) Yellow Flag List-credits that management determine to be non-investment grade but a loss or claim is unlikely; (iii) Red Flag List-credits where management do not expect an ultimate loss but a claim is possible but not probable; and (iv) Loss List-credits where management have either paid a loss or expect to suffer a loss and have recorded a case reserve. Out of over 2,100 credits in the Company’s in-force portfolio only 23 credits are in one of the four above categories. Credits that are not closely monitored credits are considered fundamentally sound, normal risk.
During 2006, the Company also began to provide reinsurance of U.S. based term assurance derived from new business written by client companies. 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. As at December 31, 2006, the benefit reserves for these contracts were immaterial.
A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Management reviews the premiums receivable balance at least quarterly and provides a provision for amounts deemed to be uncollectible. The Company recorded a provision for uncollectible premiums receivable at December 31, 2006 of $35.2 million.
Following the IPO of SCA and changes in certain executive management responsibilities in 2006, the Company changed the reporting segments under which certain business units are reported in order to reflect these changes. All periods presented reflect these changes. The Company is now organized into five operating segments: Insurance, Reinsurance, Life Operations, Financial Lines, and SCA-in addition to a corporate segment that includes the general investment and financing operations of the Company.
The increase in the underwriting expense ratio in year ended December 31, 2006, compared to the same period in 2005, was due to an increase in the operating expense ratio to 7.6%, as compared to 5.6% in the year ended December 31, 2005. The operating expense ratio increase was primarily due to an increase in performance-based compensation expenses and costs related to various strategic initiatives within the Reinsurance segment including the establishment of an integrated reinsurance platform in Europe. The increase in operating expenses was offset by a decrease in the acquisition expense ratio from 21.7% during the year ended December 31, 2005 to 20.7% in the same period in 2006. The decrease in the net acquisition expense ratio was due primarily to commissions received from Cyrus Re related to the property catastrophe retrocession.
The following table summarizes the net income for the Life operations segment:
Net realized and unrealized gains on derivative instruments represent changes in the market value of the Company’s insured credit derivative portfolio, weather and energy derivative instruments and certain structured deriv-
The Company records the income related to investment fund affiliates on a one month lag and the private investment fund affiliates on a three month lag in order for the Company to meet the accelerated filing deadlines as specified by the SEC.
The Company’s total investments available for sale and cash and cash equivalents less net pending payable for investments purchased was $41.5 billion at December 31, 2006 as compared to $38.8 billion at December 31, 2005. This increase of $2.7 billion includes cash flow from operations of $2.4 billion. The annualized effective yield of the total investment portfolio (excluding non-recurring items) was 5.1% for 2006 as compared to 4.4% for 2005, a 0.7% increase. The increase in the effective yield of the total investment portfolio was primarily due to general interest rate increases in the U.S, U.K., and Euro-zone.
On November 23, 2005, the Company received the draft report from the Independent Actuary in connection with the Company’s post-closing protection. The final report was received on December 6, 2005. 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, a loss of approximately $834.2 million was recorded in the fourth quarter of 2005.
Cash flow from operations was $2.4 billion in 2006, as compared to $5.0 billion in 2005. The decrease in 2006 is due primarily to the large U.K. immediate annuity portfolio contract written in 2005 of $1.8 billion, cash payments on the 2005 catastrophe losses during 2006 combined with the receipt of a net lump sum payment of $575.0 million from WSIC, related to the Winterthur Decision in 2005.
All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. The Company believes that these factors include, but are not limited to, the following: (i) the adequacy of rates and terms and conditions may not be as sustainable as the Company is currently projecting; (ii) changes to the size of the Company’s claims relating to Hurricanes Katrina, Rita and Wilma and other natural catastrophes; (iii) the Company’s ability to realize the expected benefits of the collateralized quota share reinsurance treaty that it entered into in the fourth quarter of 2005 with respect to specified portions of its property catastrophe and retrocessional lines of business; (iv) the timely and full recoverability of reinsurance placed by the Company with third parties, or other amounts due to the Company; (v) the projected amount of ceded reinsurance recoverables and the ratings and creditworthiness of reinsurers may change; (vi) the size of the Company’s claims relating to the hurricane and tsunami losses described herein may change; (vii) the timing of claims payments being faster or the receipt of reinsurance recoverables being slower than anticipated by the Company; (viii) ineffectiveness or obsolescence of the Company’s business strategy due to changes in current or future market conditions; (ix) increased competition on the basis of pricing, capacity, coverage terms or other factors; (x) greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than the Company’s underwriting, reserving or investment practices anticipate based on historical experience or industry data; (viii) developments in the world’s financial and capital markets that adversely affect the performance of the Company’s investments and the Company’s access to
Insurance premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums written are recorded at the inception of the policy and are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. Financial guaranty installment premiums are recorded as premiums written when due.
Changes in fair value of a derivative used as a hedge of a net investment in a foreign operation, to the extent effective as a hedge, are recorded in the foreign currency translation adjustments account within AOCI. Cumulative changes in fair value recorded in AOCI are reclassified into earnings upon the sale or complete or substantially complete liquidation of the foreign entity. Any hedge ineffectiveness is recorded immediately in current period earnings as
For the Company’s financial guaranty reserves, a case basis reserve for unpaid losses and loss adjustment expenses is recorded at the net present value of an estimated loss when, in management’s opinion, the likelihood of a future loss on a particular insured obligation is probable and determinable at a balance sheet date. The Company also maintains an unallocated reserve on its financial guaranty business which is based on actuarial reserving analysis. This reserve is available to be applied to new case basis reserves that may be established for claims on current outstanding insured principal and interest in the future. This non-specific reserve is established for expected levels of losses associated with currently insured issues and is based on a portion of premiums earned to date. The Company, on an ongoing basis, monitors these reserves and may periodically adjust such reserves based on the Company’s actual loss experience, its future mix of business, and its view of future economic conditions.
Fair values of investments and derivatives are based on published market values if available, estimates of fair values of similar issues or estimates of fair values determined by the Company. See Notes 2, 7, 15 and 16 for further information on other financial instruments.
In September 2006, the FASB issued FAS No. 158, Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”). Under the new standard, companies must recognize a net liability or asset to report the funded status of their defined benefit pension and other postretirement benefit plans on their balance sheets and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The recognition and disclosure provisions of SFAS 158 were adopted as of December 31, 2006. This guidance did not have a material impact on the Company’s financial condition and results of operations.
As at December 31, 2006 goodwill and other intangible assets primarily related to the Insurance and Reinsurance segments, and was $408.5 million, $1.4 billion, respectively. As at December 31, 2005 goodwill and other intangible assets related to the Insurance and Reinsurance segments was $450.0 million and $1.38 billion, respectively.
The significant investment management affiliates are Highfields Capital Management LP, a global equity investment firm, MKP Capital Management, a fixed income investment manager, specializing in mortgage-backed securities, Stanfield Capital Partners, a credit-oriented asset management firm specializing in CLO’s and event-driven strategies, Stanfield Global Strategies, a structured investment vehicle and conduit manager, OneCapital Management Partners, a diversified alternative investment management firm, Banquo Credit Management LLP, a European-based credit asset management firm, Artemis Advisor LLC, a U.S. focused equity firm, Polar Capital Holdings plc, an investment firm offering traditional and alternative products, and Cinnamon Capital Management LLP, an asset management firm that invests in the residuals of European asset backed securities.
In certain investments, the carrying value is different from the share of the investee’s underlying net assets. The difference represents goodwill on acquisition.
Except for certain workers’ compensation and long-term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation and long-term disability unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 5% (2005: 5%). The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2006 and 2005 were $812.1 million and $716.7 million, respectively. The related discounted unpaid losses and loss expenses were $367.1 million and $322.2 million as of December 31, 2006 and 2005, respectively.
In August 2005, the Company created a new unsecured bilateral credit facility of $100 million that was unutilized at December 31, 2005.
Weather and energy derivatives are recorded at fair value, which is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair values are estimated using available market data and internal pricing models based upon consistent statistical methodologies. Estimating fair value of instruments that do not have quoted market prices requires management’s judgment in determining amounts that could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.
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 thereunder prior to such date). The Ceding Insurers may thereafter extend the Reinsurance Agreement at their option for additional calendar quarters without limit (unless coverage is exhausted there under). The contingent put option is recorded at fair value with changes in fair value recognized in earnings. For the year ended December 31, 2006, a charge of $6.4 million was recorded in relation to this option. The Stoneheath Preferred Securities and, if issued, the XL Capital Ltd Series D Preference Shares will pay dividends on a non-cumulative basis at a fixed rate of 6.868% per annum through October 15, 2011 and thereafter at a floating rate based on 3-month LIBOR.
In April 2006, the Company completed a restructuring of the terms of the redeemable preferred shares as defined in its Bye-laws. The restructuring effectively eliminated the participating dividend, which was based on a financial guaranty industry average dividend rate, and increased the fixed dividend rate from 5% to 8.25%. Amounts disclosed include all dividends payable to minority interest holders.
Effective August 4, 2006, the Board of Directors of Security Capital Assurance Ltd (“SCA”) a consolidated subsidiary of the Company as discussed in Note 4, adopted the 2006 Long-Term Incentive and Share Award Plan, which is referred to as the “SCA Plan”. The SCA Plan provides for the grant to eligible employees, consultants and directors of stock options, share appreciation rights (“SARs”), restricted shares, restricted share units, performance shares, performance units, dividend equivalents, and other share-based awards (“Awards”). An aggregate of 3,848,182 common shares have been reserved for issuance under the SCA Plan, subject to anti-dilution adjustments in the event of certain changes in our capital structure. Shares issued pursuant to the SCA Plan will be either authorized but unissued shares or treasury shares.
Elections under the Exchange Offer became effective on December 12, 2006. Based on the final count of the depositary for the offer, 443,532 eligible options and 97,144 shares of eligible restricted stock of the Company were exchanged under the Exchange Offer and SCA issued SCA LTIP Awards with an aggregate target amount of $4.6 million and $6.8 million, respectively. These options and restricted stock exchanged under the Exchange Offer are included in the cancelled and forfeited line items in the continuity schedules disclosed below for stock options and unvested restricted stock, respectively. Approximately $2.5 million of eligible outstanding unvested restricted Class A Ordinary Shares of XL Capital and $1.6 million of options to purchase Class A Ordinary Shares of XL Capital were not exchanged under the Exchange Offer and remain outstanding under the Company’s plans.
During 2006, the Company incurred no additional stock based compensation due to the adoption of FAS 123(r) related to the vesting in 2006 of options granted prior to January 1, 2003, as all options granted prior to that date had been fully vested by December 31, 2006.
During 2006, 2005, and 2004, the Company granted 798,862, 895,484 and 660,535 shares, respectively, of its restricted common stock to its directors and employees related to incentive compensation plans, with a weighted average grant date fair value per share of $66.54, $75.38 and $77.00, respectively. During the years ended December 31, 2006, 2005, and 2004, $56.2 million, $33.0 million and $28.4 million, respectively, was charged to compensation expense related to restricted stock awards. As a result of the tender offer to employees of SCA, $1.9 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 unrecognized stock based compensation expense related to non-vested restricted stock awards was approximately $93.8 million as of the end of December 31, 2006, related to approximately 1.8 million restricted stock awards, which is expected to be recognized over 2.4 years.
The weighted average expected tax provision has been calculated using the pre-tax accounting income (loss) in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years December 31, 2006 and 2005 is provided below: