XL Capital Ltd. CEO MICHAEL S MCGAVICK bought 110000 shares on 7-31-2008 at $18.19
XL Capital Ltd, through its subsidiaries (the ‚ÄúCompany‚ÄĚ or ‚ÄúXL‚ÄĚ), is a leading provider of global insurance and reinsurance coverages to industrial, commercial and professional service firms, insurance companies and other enterprises on a worldwide basis. XL Capital Ltd was incorporated with limited liability under the Cayman Islands Companies Act on March 16, 1998, as EXEL Merger Company. XL Capital Ltd was formed as a result of the merger of EXEL Limited and Mid Ocean Limited on August 7, 1998, and the Company was named EXEL Limited on that date.
EXEL Limited and Mid Ocean are companies that were incorporated in the Cayman Islands in 1986 and 1992, respectively. At a special general meeting held on February 1, 1999, the shareholders of the Company approved a resolution changing the name of the Company to XL Capital Ltd.
On June 18, 1999, XL Capital Ltd merged with NAC Re Corp. (‚ÄúNAC‚ÄĚ), a Delaware corporation organized in 1985, in a stock merger. This merger was accounted for as a pooling of interests under U.S. generally accepted accounting principles (‚ÄúGAAP‚ÄĚ). Following the merger, the Company changed its fiscal year end from November 30 to December 31 as a conforming pooling adjustment.
On July 25, 2001, the Company acquired certain Winterthur International insurance operations (‚ÄúWinterthur International‚ÄĚ) to extend its predominantly North American-based large corporate insurance business globally. Results of operations of Winterthur International have been included from July 1, 2001, the date from which the economic interest was transferred to the Company. In 2003, the Company re-branded ‚ÄúXL Winterthur International‚ÄĚ to ‚ÄúXL Insurance Global Risk.‚ÄĚ
Effective January 1, 2002, the Company increased its shareholding in Le Mans R√© from 49% to 67% in order to expand its international reinsurance operations. On September 3, 2003, the Company exercised its option to buy the remaining 33% from MMA and changed the name of Le Mans R√© to XL Re Europe S.A. On October 18, 2006, the Company received approval to form a new European company, XL Re Europe Ltd, based in Dublin, Ireland, which is licensed to write all classes of reinsurance business. XL Re Europe Ltd is the headquarters of the Company‚Äôs European reinsurance platform with branch offices in France and the U.K.
On August 4, 2006, the Company completed the sale of 37% of XL Capital Assurance Ltd (‚ÄúXLCA‚ÄĚ) and XL Financial Assurance Ltd. (‚ÄúXLFA‚ÄĚ) through the initial public offering (‚ÄúIPO‚ÄĚ) of Security Capital Assurance (‚ÄúSCA‚ÄĚ). XLCA and XLFA represented the Company‚Äôs financial guarantee insurance and financial guarantee reinsurance platforms, respectively. On June 6, 2007, the Company completed the sale of a portion of SCA‚Äôs common shares owned by the Company through a secondary offering and thereby reduced its ownership of SCA‚Äôs outstanding common shares from approximately 63% to approximately 46%. Following this sale, the Company‚Äôs proportionate share of the results of SCA is reported as ‚ÄúNet income (loss) from operating affiliates.‚ÄĚ
See further information under Item 7, ‚ÄúManagement‚Äôs Discussion and Analysis of Financial Condition and Results of Operations‚ÄĚ and Item 8, Note 6 to the Consolidated Financial Statements, ‚ÄúBusiness Combinations.‚ÄĚ
To better align the Company‚Äôs operating and reporting structure with its current strategy, the Company revised its segment structure during the second quarter of 2007. Depending on the nature of the business written, the following product lines or transactions previously managed by and reported as part of the Financial Lines segment are now managed as part of the Insurance and Reinsurance segments and reported therewith: (i) structured indemnity products managed through the Company‚Äôs financial solutions operations (‚ÄúXLFS‚ÄĚ), (ii) political risk products, (iii) weather and energy management products, and (iv) legacy financial guarantee business. The earnings on the Company‚Äôs investment in Primus Guaranty Ltd. (‚ÄúPrimus‚ÄĚ) and other financial operating affiliates as well as the results of certain structured finance products are reported as a part of the Corporate segment that includes the general investment and financing operations of the Company. In addition, the guaranteed investment contract and funding agreement businesses are now reported separately within the Other Financial Lines segment.
On June 6, 2007, the Company completed the sale of a portion of SCA‚Äôs common shares owned by the Company through a secondary offering and thereby reduced its ownership of SCA‚Äôs outstanding common shares from approximately 63% to approximately 46%. Subsequent to this date, SCA was no longer a consolidated subsidiary or a separate operating segment of the Company and its remaining investment in SCA was accounted for using the equity method of accounting. However, historical consolidated results of the Company include the separately reported net income of SCA through to June 6, 2007.
Given the changes in the Company‚Äôs operating and reporting structure as described above, the Company is organized into four operating segments: Insurance, Reinsurance, Life Operations, and Other Financial Lines ‚ÄĒ in addition to a Corporate segment that includes the general investment and financing operations of the Company.
The Company evaluates the performance for both the Insurance and Reinsurance segments based on underwriting profit and evaluates the contribution from each of the Life Operations and Other Financial Lines segments. Other items of revenue and expenditure of the Company are not evaluated at the segment level for reporting purposes. In addition, the Company does not allocate investment assets by segment for its property and casualty operations. Investment assets related to (i) the Company‚Äôs Life Operations and Other Financial Lines segments and (ii) certain structured products included in the Insurance and Reinsurance segments, are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each of these segments.
The following table sets forth an analysis of gross premiums written by segment for the years ended December 31, 2007, 2006 and 2005. Additional financial information about the Company‚Äôs segments, including financial information about geographic areas, is included in Item 8, Note 4 to the Consolidated Financial Statements, ‚ÄúSegment Information.‚ÄĚ
The Company provides commercial property and casualty insurance products on a global basis. Products generally provide tailored coverages for complex corporate risks and include the following lines of business: Property, casualty, professional liability, environmental liability, aviation and satellite, marine and offshore energy, equine, fine art and specie, excess and surplus lines and other insurance coverages including program business.
Property and casualty products are typically written as global insurance programs for large multinational companies and institutions and include umbrella liability, product recall, U.S. workers‚Äô compensation, property catastrophe and primary master property and liability coverages. Property and casualty products generally provide large capacity on a primary, quota share or excess of loss basis. Global insurance programs are targeted to large worldwide companies in major industry groups including aerospace, automotive, consumer products, pharmaceutical, pulp and paper, high technology, telecommunications, transportation and basic metals. In North America, the casualty business written is generally long-tail, umbrella and high layer excess business, meaning that the Company‚Äôs liability attaches after large deductibles, including self insurance or insurance from other companies. Primary casualty programs (including workers‚Äô compensation) generally require customers to take large deductibles or self-insured retentions. Outside of North America, casualty business is also written on a primary basis. Policies are written on an occurrence, claims-made and occurrence reported basis. The Company‚Äôs property business written is short-tail by nature and written on both a primary and excess of loss basis. Property business written includes exposures to man-made and natural disasters, and generally, loss experience is characterized as low frequency and high severity. This may result in volatility in the Company‚Äôs results of operations, financial condition and liquidity. See Item 7, ‚ÄúManagement‚Äôs Discussion and Analysis of Financial Condition and Results of Operations‚ÄĚ, for further information.
Professional liability insurance includes directors‚Äô and officers‚Äô liability, errors and omissions liability and employment practices liability coverages. Policies are written on both a primary and excess of loss basis. Directors‚Äô and officers‚Äô coverage includes primary and excess directors‚Äô and officers‚Äô liability, employment practices liability, company securities and private company directors‚Äô and officers‚Äô liability. Products are targeted at a variety of different sized companies, with a heavy concentration on small to medium-sized firms when written on a primary basis. Employment practices liability is written primarily for very large corporations and covers those firms for legal liability in regard to the treatment of employees. Errors and omissions coverage is written on a primary and excess basis. Errors and omissions insurance written on a primary basis is targeted to small to medium-sized firms and coverage is provided for various professional exposures, including, but not limited to, insurance brokers, consultants, architects and engineers, lawyers, public entities and real estate agents.
Environmental liability products include pollution and remediation legal liability, general and project-specific pollution and professional liability, commercial general property redevelopment and contractor‚Äôs pollution liability. Business is written for both single and multiple years on a primary or excess of loss, claims-made or, less frequently, occurrence basis. Targeted industries include chemical facilities, environmental service firms, contractors, healthcare facilities, manufacturing facilities, real estate redevelopment, transportation and construction. The Company also offers commercial general liability and automobile liability insurance to environmental businesses.
Aviation and satellite products include comprehensive airline hull and liability, airport liability, aviation manufacturers‚Äô product liability, aviation ground handler liability, large aircraft hull and liability, corporate non-owned aircraft liability, space third party liability and satellite risk including damage or malfunction during ascent to orbit and continual operation, and aviation war. Aviation liability and physical damage coverage is offered for large aviation risks on a proportional basis, while smaller general aviation risks are offered on a primary basis. Satellite risks are generally written on a proportional basis. The target markets for aviation and satellite products include airlines, aviation product manufacturers, aircraft service firms, general aviation operators and telecommunications firms.
Marine and offshore energy, equine and fine art and specie insurance are also provided by the Company. Marine and energy coverage includes marine hull and machinery, marine war, marine excess liability, cargo and offshore energy insurance. Equine products specialize in providing bloodstock, livestock and fish farm insurance. Fine art and specie coverages include fine art, jewelers block, cash in transit and related coverages for financial institutions.
Excess and surplus lines products include both general liability and property coverages. For general liability, most Insurance Services Office, Inc. products are written. For property, limits are relatively low and coverages exclude flood, earthquake and difference in conditions.
The Company exited the surety business in mid-2005. Prior to that time, business was written on a broad range of surety products and services throughout North America, with a focus on contract, commercial and international trade surety bonds, targeting all segments of the construction marketplace. Surety products included bid, performance, payment, maintenance and supply bonds, commercial surety bonds, U.S. customs and international trade surety bonds, license bonds, permit bonds, court bonds, public official bonds and other miscellaneous bonds.
The Company‚Äôs program business specializes in insurance coverages for distinct market segments in North America, including program administrators and managing general agents who operate in a specialized market niche and have unique industry backgrounds or specialized underwriting capabilities. Products encompass automobile extended warranty and other property and casualty coverage. The Company implemented an exit strategy for its small commercial property catastrophe coverage program in 2006.
Certain structured indemnity products, structured by XLFS, are included within the results of the Insurance segment covering a range of insurance risks including property and casualty insurance, certain types of residual exposures and other market risk management products.
The excess nature of many of the Company‚Äôs insurance products, coupled with historically large policy limits, results in a book of business that can have losses characterized as low frequency and high severity. As a result, large losses, though infrequent, can have a significant impact on the Company‚Äôs results of operations, financial condition and liquidity. The Company attempts to mitigate this risk by, among other things, using strict underwriting guidelines and various reinsurance arrangements, discussed below.
The U.S. Terrorism Risk Insurance Act of 2002 (‚ÄúTRIA‚ÄĚ), as amended, established the Terrorism Risk Insurance Program (‚ÄúTRIP‚ÄĚ) which became effective on November 26, 2002 and was a three-year federal program effective through 2005. On December 22, 2005, President George Bush signed a bill extending TRIA (‚ÄúTRIAE‚ÄĚ) for two more years, continuing TRIP through 2007. On December 26, 2007, President George Bush signed the Terrorism Risk Insurance Program Reauthorization Act of 2007 (‚ÄúTRIPRA‚ÄĚ) which further extended TRIP for 7 years until December 31, 2014 and also eliminated the distinction between foreign and domestic acts of terrorism.
TRIA voided in force terrorism exclusions as of November 26, 2002 for certified terrorism on all TRIA specified property and casualty business. TRIA required covered insurers to make coverage available for certified acts of terrorism (other than NBCR) on all new and renewal policies issued after TRIA was enacted. Legislation approved under TRIP, as noted above, allows the Company to assess a premium charge for terrorism coverage and, if the policyholder declines the coverage or fails to pay the buy-back premium, certified acts of terrorism may then be excluded from the policy, subject, however, to state specific requirements. Terrorism coverage cannot be excluded from workers‚Äô compensation policies. Subject to a premium-based deductible and provided that the Company has otherwise complied with all the requirements as specified under TRIPRA, the Company is eligible for reimbursement by the Federal Government for up to 85% of its covered terrorism-related losses arising from a certified terrorist attack. Such payment by the government will, in effect, provide reinsurance protection on a quota share basis. Entitlement to such reimbursement ends once the aggregated insured losses for the entire insurance industry exceed $100 billion in a single program year.
The Company had, prior to the passage of TRIP and the related legislation, underwritten exposures under certain insurance policies that included coverage for terrorism. The passage of TRIP and the related legislation, has required the Company to make a mandatory offer of ‚ÄúCertified‚ÄĚ terrorism coverage with respect to relevant covered insurance policies as specified under the related legislation.
The Company provides coverage for terrorism under casualty policies on a case-by-case basis. The Company generally does not provide significant limits of coverage for terrorism under first party property policies outside of the U.S. unless required to do so by local law, or as required to comply with any national terrorism risk pool which may be available. Various countries have enacted legislation to provide insurance coverage for terrorism occurring within their borders, to protect registered property, and to protect citizens traveling abroad. The legislation typically requires registered direct insurers to provide terrorism coverage for specified coverage lines and then permits them to cede the risk to a national risk pool. The Company has subsidiaries that participate in terrorism risk pools in various jurisdictions, including Australia, France, Spain, the Netherlands and the United Kingdom.
The Company underwrites and prices most risks individually following a review of the exposure and in accordance with the Company‚Äôs underwriting guidelines. Most of the Company‚Äôs insurance operations have underwriting guidelines that are industry-specific. The Company seeks to control its exposure on individual insurance contracts through terms and conditions, policy limits and sublimits, attachment points, and facultative and treaty reinsurance arrangements on certain types of risks.
The Company‚Äôs underwriters generally evaluate each industry category and subgroups within each category. Premiums are set and adjusted for an insured based, in large part, on the industry group in which the insured is placed and the insured‚Äôs perceived risk relative to the other risks in that group. Rates may vary significantly according to the industry group of the insured as well as the insured‚Äôs risk relative to the group. The Company‚Äôs rating methodology for individual insureds seeks to set premiums in accordance with claims potential as measured by past experience and future expectations, the attachment point and amount of underlying insurance, the nature and scope of the insured‚Äôs operations, including the industry group in which the insured operates, exposures to loss, natural hazard exposures, risk management quality and other specific risk factors relevant in the judgment of the Company‚Äôs underwriters to the type of business being written.
Underwriting and loss experience is reviewed regularly for, among other things, loss trends, emerging exposures, changes in the regulatory or legal environment as well as the efficacy of policy terms and conditions.
As the Company‚Äôs insurance products are primarily specialized coverages, underwriting guidelines and policy forms differ by product offering as well as by legal jurisdiction. Liability insurance is written on both a primary and excess of loss basis, on occurrence, occurrence reported and claims-made policy forms. Occurrence reported policies typically cover occurrences causing unexpected and unintended personal injury or property damage to third parties arising from events or conditions that commence at or subsequent to an inception date, or retroactive date, if applicable, and prior to the expiration of the policy provided that proper notice is given during the term of the policy or the discovery period. Traditional occurrence coverage is also available for restricted classes of risk and is generally written on a follow-form basis where the policy adopts the terms, conditions and exclusions of the underlying policy. Property insurance risks are written on a lead or follow-form basis that usually provides coverage for all risks of physical damage and business interruption. Maximum limits are generally subject to sublimits for coverage in critical earthquake and flood zones, where the Company seeks to limit its liability in these areas.
In certain cases, the risks assumed by the Company in the Insurance segment are partially reinsured with third party reinsurers. Reinsurance ceded varies by location and line of business based on a number of factors, including market conditions. The benefits of ceding risks to third party reinsurers include reducing exposure on individual risks, protecting against catastrophic risks, maintaining acceptable capital ratios and enabling the writing of additional business. Reinsurance ceded does not legally discharge the Company from its liabilities to the original policyholder in respect of the risk being reinsured.
The Company uses reinsurance to support the underwriting and retention guidelines of each of its subsidiaries as well as to control the aggregate exposure of the Company to a particular risk or class of risks. Reinsurance is purchased at several levels ranging from reinsurance of risks assumed on individual contracts to reinsurance covering the aggregate exposure on a portfolio of policies issued by groups of companies. See Item 7, ‚ÄúManagement‚Äôs Discussion and Analysis of Financial Condition and Results of Operations‚ÄĚ, for further information.
Premium rates and underwriting terms and conditions for all lines of business written vary by jurisdiction principally due to local market conditions, competitor product offerings and legal requirements.
The Company competes globally in the property and casualty reinsurance markets. Its competitors include the following companies and their affiliates: The ACE Group of Companies (‚ÄúACE‚ÄĚ); Allianz Aktiengesellschaft (‚ÄúAllianz‚ÄĚ); American International Group, Inc. (‚ÄúAIG‚ÄĚ); Factory Mutual Global (‚ÄúFMG‚ÄĚ) for Property only; Hartford Financial Services (‚ÄúHartford‚ÄĚ); Lloyd‚Äôs of London Syndicates (‚ÄúLloyd‚Äôs‚ÄĚ); Munchener Ruckversicherungs-Gesells chaft Aktiengesellschaft (‚ÄúMunich Re‚ÄĚ); Swiss Reinsurance Company (‚ÄúSwiss Re‚ÄĚ); The Chubb Corporation (‚ÄúChubb‚ÄĚ); The Travelers Companies (‚ÄúTravelers‚ÄĚ); and Zurich Financial Services Group (‚ÄúZurich‚ÄĚ).
The Company‚Äôs major geographical markets for its property and casualty insurance operations are North America, Europe and Bermuda. The Company‚Äôs main competitors in each of these markets include the following:
North America ‚Äď AIG, ACE, Chubb, FMG, Zurich, Travelers, CNA Financial Corporation, Hartford, FMG, Liberty Mutual Group and Lloyd‚Äôs.
Europe ‚Äď Allianz, AIG, FMG, Zurich, AXA, Munich Re, ACE, Lloyd‚Äôs, Swiss Re, Assicurazioni Generali and HDI-Gerling Industrie Versicherung AG.
Bermuda ‚Äď ACE, Allied World Assurance Company, Axis Capital Group, Max Re Ltd., Endurance Specialty Insurance Ltd (‚ÄúEndurance‚ÄĚ) and Arch Capital Group Ltd.
See Item 7, ‚ÄúManagement‚Äôs Discussion and Analysis of Financial Condition and Results of Operations ‚ÄďExecutive Overview‚ÄĚ for further discussion.
Marketing and Distribution
Clients (insureds) are referred to the Company through a large number of international, national and regional brokers, acting as their agents, and captive managers who receive from the insured or ceding company a set fee or brokerage commission usually equal to a percentage of gross premiums. In the past, the Company has also entered into contingent commission arrangements with some intermediaries that provide for the payment of additional commissions based on such variables as production of new and renewal business or the retention of business. These arrangements are currently limited to program business where additional commissions are generally based on profitability of business submitted to the Company. In general, the Company has no implied or explicit commitments to accept business from any particular broker and neither brokers nor any other third party have the authority to bind the Company, except in the case where underwriting authority may be delegated contractually to selected program administrators. Such administrators are subject to a financial and operational due diligence review prior to any such delegation of authority and ongoing reviews and audits are carried out as deemed necessary by the Company with the goal of assuring the continuing integrity of underwriting and related business operations. See Item 8, Note 18(a) to the Consolidated Financial Statements for information on the Company‚Äôs major brokers, ‚ÄúCommitments and Contingencies ‚Äď Concentrations of Credit Risk.‚ÄĚ
Claims management for the insurance operations includes the review of initial loss reports, administration of claims databases, generation of appropriate responses to claims reports, identification and handling of coverage issues, determination of whether further investigation is required and, where appropriate, retention of claims counsel, establishment of case reserves, payment of claims and notification to reinsurers. With respect to the establishment of case reserves, when the Company is notified of insured losses, claims personnel record a case reserve as appropriate for the estimated amount of the exposure at that time. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process.
Claims in respect of business written by the Company‚Äôs Lloyd‚Äôs syndicates are primarily notified by various central market bureaus. Where a syndicate is a ‚Äúleading‚ÄĚ syndicate on a Lloyd‚Äôs policy, its underwriters and claims adjusters will deal with the broker or insured on behalf of itself and the following market for any particular claim. This may involve appointing attorneys or loss adjusters. The claims bureaux and the leading syndicate advise movement in loss reserves to all syndicates participating on the risk. The Company‚Äôs claims department may adjust the case reserves it records from those advised by the bureaux as deemed necessary.
Certain of the Company‚Äôs product lines have arrangements with third party administrators (‚ÄúTPAs‚ÄĚ) to provide claims handling services to the Company in respect of such product lines. These agreements set forth the duties of the TPA, limits of authority, protective indemnification language and various procedures that are required to meet statutory compliance. These arrangements are also subject to audit review by the Company‚Äôs claim department.
The Company provides casualty, property risk (including energy and engineering), property catastrophe, marine, aviation, and other specialty reinsurance on a global basis with business being written on both a proportional and non-proportional basis. Business written on a non-proportional basis generally provides for an indemnification by the Company to the ceding company for a portion of losses both individually and in the aggregate, on policies with limits in excess of a specified individual or aggregate loss deductible. For business written on a proportional including ‚Äúquota share‚ÄĚ or ‚Äúsurplus‚ÄĚ basis, the Company receives an agreed percentage of the premium and is liable for the same percentage of each/all incurred loss. For proportional business, the ceding company normally receives a ceding commission for the premiums ceded and may also, under certain circumstances, receive a profit commission. Occasionally this commission could be on a sliding scale depending on the loss ratio performance in which case there is generally no profit commission. Reinsurance may be written on a portfolio/treaty basis or on an individual risk/facultative basis. The treaty business is mainly underwritten using reinsurance intermediaries while the individual risk business is generally underwritten directly with the ceding companies, especially for business written in the U.S.
The Company‚Äôs casualty reinsurance includes general liability, professional liability, automobile and workers‚Äô compensation. Professional liability includes directors‚Äô and officers‚Äô, employment practices, medical malpractice, and environmental liability. Casualty lines are written as treaties, programs as well as on an individual risk basis and on both a proportional and a non-proportional basis. The treaty business includes clash programs which cover a number of underlying policies involved in one occurrence or a judgment above an underlying policy‚Äôs limit, before suffering a loss.
The Company‚Äôs property business, primarily short-tail in nature, is written on both a portfolio/treaty and individual/facultative basis and includes property catastrophe, property risk excess of loss and property proportional. A significant portion of the property business underwritten consists of large aggregate exposures to man-made and natural disasters and, generally, loss experience is characterized as low frequency and high severity. This may result in volatility in the Company‚Äôs results of operations, financial condition and liquidity. See Item 7, ‚ÄúManagement‚Äôs Discussion and Analysis of Financial Condition and Results of Operations.‚ÄĚ
The Company seeks to manage its reinsurance exposures to catastrophic events by limiting the amount of exposure written in each geographic or peril zone worldwide, underwriting in excess of varying attachment points and requiring that contracts exposed to catastrophe loss provide for aggregate limits. The Company also seeks to protect its total aggregate exposures by peril and zone through the purchase of reinsurance programs.
The Company‚Äôs property catastrophe reinsurance account is generally ‚Äúall risk‚ÄĚ in nature. As a result, the Company is exposed to losses from sources as diverse as hurricanes and other windstorms, earthquakes, freezing, riots, floods, industrial explosions, fires, and many other potential disasters. In accordance with market practice, the Company‚Äôs policies generally exclude certain risks such as war, nuclear contamination or radiation. Following the terrorist attacks at the World Trade Center in New York City, in Washington, D.C. and in Pennsylvania on September 11, 2001 (collectively, ‚Äúthe September 11 event‚ÄĚ), terrorism cover, including nuclear, biological, radiological and chemical, has been restricted or excluded in many territories and classes. Some U.S. States make it mandatory to provide some cover for ‚ÄúFire Following‚ÄĚ terrorism and some countries make terrorism coverage mandatory. The Company‚Äôs predominant exposure under such coverage is to property damage.
The Company had, prior to the passing of TRIA, underwritten reinsurance exposures in the U.S. that included terrorism coverage. Since the passage of TRIA in the U.S., together with the TRIEA and TRIPRA extensions noted above, the Company has underwritten a very limited number of stand-alone terrorism coverage policies in addition to coverage included within non-stand-alone policies. In the U.S., in addition to nuclear, biological, radiological and chemical (‚ÄúNBRC‚ÄĚ) acts, the Company generally excludes coverage included under TRIA from the main catastrophe exposed policies. In other cases, both within and outside the U.S., the Company generally relies on either a terrorism exclusion clause, which does not include personal lines, excluding NBRC, or a similar clause that excludes terrorism completely. There are a limited number of classes underwritten where no terrorism exclusion exists.
Property catastrophe reinsurance provides coverage on an excess of loss basis when aggregate losses and loss adjustment expenses from a single occurrence of a covered event exceed the attachment point specified in the policy. Some of the Company‚Äôs property catastrophe contracts limit coverage to one occurrence in any single policy year, but most contracts generally enable one reinstatement to be purchased by the reinsured.
The Company also writes property risk excess of loss reinsurance. Property risk excess of loss reinsurance covers a loss to the reinsured on a single risk of the type reinsured rather than to aggregate losses for all covered risks on a specific peril, as is the case with catastrophe reinsurance. The Company‚Äôs property proportional account includes reinsurance of direct property insurance. The Company seeks to limit the catastrophe exposure from its proportional and per risk excess business through extensive use of occurrence and cession limits.
Other specialty reinsurance products include energy, marine, aviation, space, engineering, fidelity, trade credit, and political risk.
The Company underwrites a small portfolio of contracts covering political risk and trade credit. Exposure is assumed from a limited number of trade credit contracts and through Lloyd‚Äôs quota shares. In addition, there are runoff exposures from discontinued writings in the Company‚Äôs marine portfolio.
The results of certain transactions structured by XLFS that are generally written on an aggregrate stop loss or excess of loss basis are included within the results of the Reinsurance segment.
Underwriting risks for the reinsurance property and casualty business are evaluated using a number of factors including, but not limited to, the type and layer of risk to be assumed, the actuarial evaluation of premium adequacy, the cedant‚Äôs underwriting and claims experience, the cedant‚Äôs financial condition and claims paying rating, the exposure and/or experience with the cedant, and the line of business to be reinsured.
Other factors assessed by the Company include the reputation of the proposed cedant, the geographic area in which the cedant does business and its market share, a detailed evaluation of catastrophe and risk exposures, and historical loss data for the cedant where available and for the industry as a whole in the relevant regions, in order to compare the cedant‚Äôs historical loss experience to industry averages. On-site underwriting reviews are performed where it is deemed necessary to determine the quality of a current or prospective cedant‚Äôs underwriting operations, with particular emphasis on proportional and working excess of loss placements.
For property catastrophe reinsurance business, the Company‚Äôs underwriting guidelines generally limit the amount of exposure it will directly underwrite for any one reinsured and the amount of the aggregate exposure to catastrophic losses in any one geographic zone. The Company believes that it has defined geographic and peril zones such that a single occurrence, for example an earthquake or hurricane, should not affect more than one peril zone. While the exposure to multiple zones is considered remote for events such as a hurricane, the Company does manage its aggregate exposures for such a scenario where the Company considers it appropriate to do so. The definition of the Company‚Äôs peril zones is subject to periodic review. The Company also generally seeks an attachment point for its property catastrophe reinsurance at a level that is high enough to produce a low frequency of loss. The Company seeks to limit its aggregate exposure in the proportional business through extensive use of occurrence and cession limits.
The Company uses third party reinsurance to support the underwriting and retention guidelines of each reinsurance subsidiary as well as seeking to limit the aggregate exposure of the Company to a particular risk or class of risks. Reinsurance is purchased at several levels ranging from reinsurance of risks assumed on individual contracts to reinsurance covering the aggregate exposures. The benefits of ceding risks to other reinsurers include reducing exposure on individual risks, protecting against catastrophic risks, maintaining acceptable capital ratios and enabling the writing of additional business. Reinsurance ceded does not legally discharge the Company from its liabilities in respect of the risk being reinsured. Reinsurance ceded varies by location and line of business based on factors including, among others, market conditions and the credit worthiness of the counterparty.
The Company‚Äôs property catastrophe exposures are subject to a detailed review twice a year following the main January and July renewal seasons. Following the increased frequency of Atlantic hurricanes in 2004 and 2005, significant changes were made to the proprietary models used by the Company to both price and monitor catastrophe risk accumulations. In order to maximize the benefit from the new market environment, while limiting the Company‚Äôs net risk appetite, the Company utilized capacity available from a reinsurance vehicle Cyrus Reinsurance Limited (‚ÄúCyrus Re‚ÄĚ), to which the Company ceded a share of its property catastrophe risks. In so doing, the Company was able to reduce its net retained risk and shares in the profitability of the reinsurance business ceded to this new vehicle in the form of market based profit commissions and other commissions for business ceded by the Company to this facility. Business was ceded to this vehicle on a risks attaching basis up to July 1, 2007, which includes the inception date of the majority of the Company‚Äôs property catastrophe business. Effective January 1, 2008, the Company entered into a quota share reinsurance treaty with a newly-formed Bermuda reinsurance company, Cyrus Reinsurance II Limited (‚ÄúCyrus Re II‚ÄĚ). Pursuant to the terms of the quota share reinsurance treaty, Cyrus Re II will assume a 10% cession of certain lines of property catastrophe reinsurance and retrocession business underwritten by certain operating subsidiaries of the Company for the 2008 underwriting year. In connection with such cessions, the Company will pay Cyrus Re II reinsurance premium less a ceding commission, which includes a reimbursement of direct acquisition expenses incurred by the Company as well as a commission to the Company for generating the business. The quota share reinsurance treaty also provides for a profit commission payable to the Company.
The traditional catastrophe retrocession program was renewed in June 2007 to cover certain of the Company‚Äôs exposures net of Cyrus Re cessions. These covers give protection in various layers and excess of varying attachment points according to territorial exposure. The Company has co-reinsurance retentions within this program. The Company bought an additional structure with a restricted territorial scope for 12 months at July 2007. The Company continued to buy additional protection for the Company‚Äôs marine and offshore energy exposures. These covers provide protection in various layers and excess of varying attachment points according to the scope of cover provided. The Company has co-reinsurance participations within this program.
The Company continues to buy specific reinsurances on its credit and bond, motor third party liability, property and aviation portfolios to manage its net exposures in these classes.
See Item 7, ‚ÄúManagement‚Äôs Discussion and Analysis of Financial Condition and Results of Operations‚ÄĚ and Item 8, Note 11 to the Consolidated Financial Statements ‚ÄúReinsurance‚ÄĚ for further information.
The Company competes globally in the property and casualty markets.
The Company‚Äôs major geographical markets for its property and casualty reinsurance operations are North America, Europe, Bermuda and Emerging Markets (covering Asia/Pacific and South America). The main competitors in each of these markets include the following:
North America ‚Äď Berkshire Hathaway, Munich Re Corporation, Swiss Re America Corporation,
Transatlantic Re, Everest Re Group Ltd, Hannover Re, and PartnerRe Ltd.
Europe ‚Äď Munich Re, Swiss Re, Lloyd‚Äôs, SCOR Reinsurance Company, and PartnerRe Ltd.
Bermuda ‚Äď ACE Tempest Reinsurance Ltd, AXIS Specialty Limited, Arch Reinsurance Limited, Renaissance Reinsurance Limited, Montpelier Reinsurance Ltd, Platinum Underwriters Bermuda Ltd and PartnerRe Ltd.
See Item 7, ‚ÄúManagement‚Äôs Discussion and Analysis of Financial Condition and Results of Operations ‚ÄďExecutive Overview‚ÄĚ for further discussion.
Marketing and Distribution
See Insurance Operations ‚Äď ‚ÄúMarketing and Distribution‚ÄĚ and Item 8, Note 18(a) to the Consolidated Financial Statements, ‚ÄúCommitments and Contingencies ‚Äď Concentrations of Credit Risk‚ÄĚ, for information in the Company‚Äôs marketing and distribution procedures and information on the Company‚Äôs major brokers.
Structure of Reinsurance Operations
The Company‚Äôs reinsurance operations are structured geographically into Bermuda operations, North American operations, European operations and Emerging Markets operations (covering Asia/Pacific and South America).
Claims management for the reinsurance operations includes the receipt of loss notifications, review and approval of claims through a claims approval process, establishment of loss reserves and approval of loss payments. Case reserves for reported claims are generally established based on reports received from ceding companies with additional case reserves being established when deemed appropriate. Additionally, claims audits are conducted for specific claims and claims procedures at the offices of selected ceding companies, particularly in the U.S. and the U.K.
Brian M. O‚ÄôHara has been President and Chief Executive Officer of the Company since 1994 and a Director of the Company since 1986, having previously served as Vice Chairman of the Company from 1987. He is Chairman of XL Insurance (Bermuda) Ltd and was Chief Executive Officer of XL Insurance (Bermuda) Ltd until 1998, having previously served as Chairman, President and Chief Executive Officer from 1994, President and Chief Executive Officer from 1992 and as President and Chief Operating Officer from 1986. In late October 2007, the Company announced that Mr. Brian M. O‚ÄôHara had informed the Company‚Äôs Board of Directors of his decision to retire as President and CEO in mid-2008. On December 28, 2007, Mr. Michael P. Esposito Jr., then Chairman of the Board, resigned from the Company and on the same day, Mr. O‚ÄôHara was appointed as Acting Chairman of the Board.
Henry C.V. Keeling was appointed Executive Vice President, Chief Operating Officer in June 2006 having previously served as, Chief Executive of Reinsurance Operations from July 2000 until November 2004 when he was appointed Chief Executive of Reinsurance Operations and Global Head of Business Services, and January 2006 when he became Global Head of Business Services and Chief Executive, Reinsurance Life Operations. Mr. Keeling was Chief Executive Officer of XL Re Ltd since August 1998. Mr. Keeling was President and Chief Operating and Underwriting Officer of Mid Ocean Re (now known as XL Re Ltd) from 1992 to 1998. He previously served as a director of Taylor Clayton (Underwriting Agencies) Ltd and deputy underwriter for Syndicate 51 at Lloyd‚Äôs from 1984 through 1992.
Fiona E. Luck was appointed Executive Vice President, Chief of Staff in June 2006 having previously served as Executive Vice President and Global Head of Corporate Services since November 2004 and Assistant Secretary since January 2002. In addition, Ms. Luck served as the Company‚Äôs Interim Chief Financial Officer from March 2007 to August 2007. From 1999 to 2004, Ms. Luck was Executive Vice President of Group Operations of the Company. Ms. Luck was previously employed at ACE Bermuda as Executive Vice President from 1998, and Senior Vice President from 1997. From 1992 to 1997, Ms. Luck was the Managing Director of the Marsh & McLennan Global Broking office in Bermuda.
Brian W. Nocco was appointed Executive Vice President, Chief Financial Officer in August 2007. Mr. Nocco was previously employed at Nationwide Insurance Group as Chief Risk Officer from 2006 to 2007, and Senior Vice President and Treasurer from 2001 to 2005. Prior to Nationwide, Mr. Nocco served as Executive Vice President, Corporate Development of Imperial Bank and Chief Financial Officer of two of its subsidiaries. From 1994 to 1998, Mr. Nocco served as Senior Vice President, Chief Compliance Officer with The Chubb Corporation.
Michael C. Lobdell was appointed Executive Vice President, Chief Executive ‚Äď Global Business Services in July 2006. Prior to joining the Company, Mr. Lobdell held numerous leadership positions at New York-based JPMorganChase, including Senior Partner of the Mergers & Acquisitions Group, Managing Director and Chief Operating Officer of Global Investment Banking, Chairman of JPMorgan North American Investment Banking Management Committee, Head of Risk Technology Operations for Europe, and Managing Director and Head of Chase Middle Market Treasury Service Integration Project.
Sarah E. Street was appointed to the position of Executive Vice President and Chief Investment Officer in October 2006. Ms. Street is also the Chief Executive Officer of XL Capital Investment Partners. Prior to joining XL, Ms. Street held numerous leadership positions at JPMorganChase and its predecessor organizations, working in a number of corporate finance units as well as in the capital markets business of the bank.
Clive R. Tobin has been Executive Vice President and Chief Executive of Insurance Operations since April 2004. Mr. Tobin was President and Chief Executive of XL Winterthur International from February 2002, having previously served as Deputy Chief Executive and Chief Underwriting Officer of XL Winterthur International following the Company‚Äôs acquisition of the risk management business from Credit Suisse in 2001, and President and Chief Executive of XL Insurance (Bermuda) Ltd since July 1999. From 1995 to 1999, Mr. Tobin held a variety of senior management positions at XL. Prior to joining XL in 1995, Mr. Tobin served as President of Rockefeller Insurance Company and Acadia Risk Management Services, Inc., in New York. From 1979 to 1986, Mr. Tobin served as Vice President of Risk Management Services for Marsh & McLennan, Inc. On January 7, 2008, the Company announced that Mr. Tobin will retire effective April 1, 2008 from his role as Chief Executive of the Company‚Äôs Insurance Operations, and will concentrate on assisting the Company with strategic opportunities in emerging markets. David B. Duclos, currently Chief Operating Officer of the Company‚Äôs Insurance Operations, will succeed Mr. Tobin as Chief Executive.
James H. Veghte was appointed Executive Vice President, Chief Executive of Reinsurance Operations in January 2006. Mr. Veghte was Chief Executive Officer of XL Reinsurance America Inc. (XLRA) having previously served as Chief Operating Officer of XL‚Äôs reinsurance operations and President, Chief Operating Officer & Chief Underwriting Officer of XL Re Ltd. Previously held roles with the Company include President of XL Re Latin America Ltd., Chief Operating Officer of Le Mans Re (now the French branch of XL Re Europe Ltd.), General Manager of XL Re Ltd‚Äôs London branch and Executive Vice President and Underwriter of XL Mid Ocean Reinsurance Ltd in Bermuda. Prior to joining XL, Mr. Veghte was Senior Vice President and Chief Underwriting Officer of Winterthur Reinsurance Corp of America.
Kirstin Romann Gould was appointed to the position of Executive Vice President, General Counsel in September 2007 and this new position includes her prior responsibilities as General Counsel, Corporate Affairs and Corporate Secretary. Ms. Gould was previously Executive Vice President, General Counsel of Corporate Affairs from July 2006 to September 2007 and has also served as Chief Corporate Legal Officer and Associate General Counsel. Prior to joining the Company, Ms. Gould was associated with the law firms of Clifford Chance and Dewey Ballantine in New York and London.
MANAGEMENT DISCUSSION FROM LATEST 10K
The Company‚Äôs net income (loss) and other financial measures as shown above for the three years ended December 31 have been affected by among other things, the following significant items:
The impact due to the Company‚Äôs investment in and relationships with SCA;
Impact of credit market movements on the Company‚Äôs investment portfolio;
Prior year loss development;
Reduction in insured losses from natural catastrophes during 2007 and 2006 as compared to 2005;
The Company‚Äôs growing invested asset base and higher net investment income.
1. Impact of the Company‚Äôs investment in and relationships with SCA
The Company has multiple relationships with SCA as a result of SCA‚Äôs initial origins as a wholly-owned subsidiary and its subsequent IPO. These relationships are detailed in Note 3 to the Consolidated Financial Statements, ‚ÄúSecurity Capital Assurance‚ÄĚ, and include, most significantly, a 46% investment along with certain guarantees and reinsurance arrangements. The Company is not a primary originator or insurer of mortgages, nor does it guarantee mortgages other than indirectly through the activities of SCA, and as such the negative impact to the Company during the year with respect to deterioration in the credit markets and its impact on credit enhancement activities is largely limited to the SCA investment and related reinsurance agreements and guarantees.
The financial guarantees issued by SCA are generally guarantees of payments under financial guarantee insurance policies or credit default swaps. The financial guarantee business model generally provides for a guarantee of payment of interest and principal over the defined expected life of a transaction, with no acceleration or need for collateralization by the guarantor in the case of any weakness or default by the underlying obligor. These characteristics reduce the need for liquidity within the financial guarantor in case of underlying deterioration in the guaranteed transaction, since the calendar of payments remains as set in the original transaction. As a general matter, the obligations of XLCA under credit default swaps issued in connection with their business accrue in a similar manner, except in events of default, however, they do not qualify for the financial guarantee insurance scope exception under FAS 133 and, therefore, are reported at fair value, with changes in fair value included in earnings. Under most of the credit default swap contracts insured by XLCA, it would be an event of default if XLCA should become insolvent. If there were an event of default, the holders of these credit default swap contracts would have the right to terminate the swaps and to obtain a termination payment from XLCA, based on the market value of the swaps at the time of termination.
The Company records 46.9% of the net income of SCA as earnings from operating affiliates. Subsequent to the secondary sale of shares in June 2007 and the associated deconsolidation of financial results, the Company reports such earnings on a one quarter lag due to the limited availability and timing of SCA‚Äôs final audited financial results. Management expects to continue this practice on the same basis with appropriate consideration given by disclosure or otherwise to the effects of any known intervening events that materially affect the Company‚Äôs financial position or results of operations.
Management has done extensive analysis of SCA‚Äôs financial guarantee portfolio to evaluate the exposures and underlying possible losses arising from recent credit market turbulence. Given management‚Äôs view of the potential scale of SCA‚Äôs estimated losses along with the uncertainty facing the entire financial guarantee industry, the Company has reduced the reported value of its investment in SCA to nil from the reported equity method value of $669.8 million as at September 30, 2007. Recent market developments with respect to monoline industry and industry analyst reports have indicated that the fair value of any investment in the financial guarantee sector has very uncertain value at this point in time. Subsequent to December 31, 2007, SCA was downgraded by several rating agencies, which significantly limits SCA‚Äôs ability to write new business. In addition, the shares in SCA held by the Company are unregistered and thus illiquid. Based on the nature of the Company‚Äôs investment in SCA and the resultant limitations on any future business models, management believes that the fair value of the Company‚Äôs investment in SCA is substantially less than the traded market value at December 31, 2007 of $3.89 per share. Management believe this decline in value is other than temporary.
In addition, net losses were recorded within ‚Äúloss from operating affiliates‚ÄĚ with respect to the excess of loss and facultative reinsurance of SCA subsidiaries in the amounts of $300.0 million and $51.0 million, respectively, and not within property and casualty underwriting results. These amounts represent the discounted value of expected losses net of related premiums and are discounted at approximately 5%. In the case of the excess of loss cover the recorded loss represents the discounted value of a $500.0 million full limit loss. In addition, the Company incurred $17.9 million in additional mark-to-market losses related to those underlying contracts in credit default swap form subject to the provisions noted above.
As of December 31, 2007, the Company‚Äôs total net exposure under its facultative agreements with SCA subsidiaries was approximately $7.7 billion of net par outstanding. Of this total, $138.0 million and $769.0 million of net par outstanding was related to RMBS and ABS CDOs, with greater than 50% RMBS collateral, respectively. Based on the Company‚Äôs examination of exposures under these facultative agreements, the Company has reported loss reserves of $51.0 million on a net present value basis.
In addition, there are certain guarantees in place between the Company and SCA subsidiaries. It is important to note that the guarantees the Company has provided contain a dual trigger, such that losses are paid only if two events occur. First, the underlying guaranteed obligation must default on payments of interest and principal, and second, the relevant SCA subsidiary must fail to meet its obligations under the applicable reinsurance or guarantee. As of December 31, 2007, the Company‚Äôs total net par outstanding under these guarantees was $75.2 billion. Indirect consumer mortgages exposures as a result of these guarantee agreements totaled approximately $2.9 billion related to RMBS and $3.3 billion related to ABS CDOs with greater than 50% RMBS collateral. Again, it is important to note that SCA subsidiaries must fail to meet their obligations under the applicable reinsurance or guarantee before the Company would be required to respond to claims under these guarantees and as such, these exposures must be compared to the relevant SCA subsidiary‚Äôs current financial resources.
Based on all of the above factors along with the Company‚Äôs extensive analysis of the relevant exposures, the Company has concluded that no losses are expected under these guarantees and accordingly no loss reserves have been recorded. Recently published loss estimates by S&P appear to support this view.
Where appropriate, further details of each of the items noted above can be found in the related section of See Item 7, ‚ÄúManagement‚Äôs Discussion and Analysis of Financial Condition and Results of Operations‚ÄĚ and Item 8, Notes 3 and 8 to the Consolidated Financial Statements, ‚ÄúSecurity Capital Assurance‚ÄĚ and ‚ÄúInvestments in Affiliates.‚ÄĚ
2. Impact of credit market movements on the Company‚Äôs investment portfolio
In 2007, financial market conditions were extremely challenging as the global credit crisis that begun in July 2007 continued to adversely impact global fixed income markets. Elements which contributed to this included continued weakness in the U.S. housing market and increased mortgage delinquencies, investor anxiety over recessionary pressures, rating agency downgrades of various structured products, unresolved issues with structured investment vehicles and a serious dislocation in the interbank market. All of these elements led to significant declines in mortgage and structured credit prices. Continued declines in government rates did little to alleviate the concerns in either residential mortgage markets or the short-term funding market during the fourth quarter of 2007. These elements were the primary drivers behind the $603.3 million in net realized losses on investments reported for the year ended December 31, 2007.
The Company‚Äôs management has been diligently engaged in market developments and has reduced the Company‚Äôs exposure to lower rated investment grade 2005, 2006 and 2007 vintage sub-prime securities given concerns about future deterioration. Management has performed in depth analyses of the Company‚Äôs holdings in all of the ‚Äútopical asset‚ÄĚ classes, which are defined to be structured assets with underlying collateral of sub-prime first liens, Alt-A, second liens, and asset-backed CDOs with sub-prime collateral. In addition to extensive holding level reviews with the Company‚Äôs third party managers, the Company has undertaken an independent evaluation of its topical assets to help further identify areas of potential economic loss to principal due to potentially deteriorating underlying fundamentals.
These market developments have negatively impacted the Company‚Äôs results from operations through both impairment charges and realized losses largely in the specialised mortgage portfolios, spread business portfolios, losses related to exposure to the capital notes of a structured investment vehicle (‚ÄúSIV‚ÄĚ) and a loss recorded by one of the Company‚Äôs investment manager affiliates.
Realized losses and impairments in the topical asset exposed portfolios totaled $385.1 million during the year ended December 31, 2007 and represented a combination of losses on sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures. These losses and impairments were principally concentrated in 2005, 2006, and 2007 vintage securities.
The Company‚Äôs sub-prime and Alt-A exposures remain primarily highly rated, have strong underlying loan characteristics and are supported by adequate subordination levels. The remaining net unrealized losses are primarily in higher rated securities, and the Company believes these losses are a result of technical spread widening rather than any fundamental deterioration. Based on the Company‚Äôs stress testing, even in an extreme scenario, management believes principal impairments to these remaining pools is unlikely.
Net realized and unrealized losses on investment derivatives for 2007 resulted primarily from a mark-to-market loss of $37.0 million in the third quarter with respect to a total return swap on an SIV impacted by the challenging credit markets. During the fourth quarter, the Company terminated the swap, recognized an additional $3.9 million mark-to-market loss and took delivery of the underlying asset. The asset was subsequently written off to nil in the fourth quarter resulting in a realized loss on investments of $57.3 million.
Much of the negative impact of credit markets during 2007 was contained in the Company‚Äôs Other Financial Lines segment which comprises the GIC and FA businesses which are largely credit spread activities and have a higher component of floating rate structured credit assets. During 2007, net realized losses and impairments within the Other Financial Lines segment totaled $370.7 million and net unrealized losses increased by $329.6 million.
In addition to the impact on net income, the Company‚Äôs book value also declined through the increase of net unrealized losses on the portfolio as a whole as a result of the overall widening of global credit spreads on corporate and structured credit assets, partially offset by declining U.S. and U.K. government interest rates for the year.
As at December 31, 2007, approximately 14.1% of the asset and mortgage-backed holdings were classifed as part of the Company‚Äôs exposure to topical assets. This represented approximately 5.2% of the total fixed income portfolio and 29.0% of the total net unrealized loss position. Of the topical asset securities, approximately 99% are rated as investment grade. All portfolio holdings, including those with sub-prime exposure, are reviewed as part of the ongoing other-than-temporary-impa irment monitoring process. The Company continues to actively monitor its exposures, and to the extent market disruptions continue, including but not limited to residential mortgages, the Company‚Äôs financial position could be negatively impacted.
3. Prior year loss development
Net prior year favorable loss development occurs when there is a decrease to loss reserves recorded at the beginning of the year, resulting from actual or reported loss development for prior years that is less than expected loss development. Net prior year adverse loss development occurs when there is an increase to loss reserves recorded at the beginning of the year, resulting from actual or reported loss development for prior years exceeding expected loss development.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Results of Operations
The following table presents an analysis of the Company‚Äôs net income available to ordinary shareholders and other financial measures (described below) for the three months ended June 30, 2008 and 2007:
The Company‚Äôs net income and other financial measures as shown below for the three and six months ended June 30, 2008 have been affected, among other things, by the following significant items:
1) Impact of credit market movements on the Company‚Äôs investment portfolio and investment fund affiliates
In the first six months of 2008, particularly in the first quarter, financial market conditions continued to be extremely challenging as the global credit crisis that began in July 2007 continued to adversely impact global fixed income markets. While credit spreads on both corporate and structured credit rallied modestly in the second quarter, spread levels remain wide resulting in continuing depressed pricing on credit product. Continuing challenges included continued weakness in the U.S. housing market and increased mortgage delinquencies, investor anxiety over the U.S. economy, rating agency downgrades of various structured products and financial issuers, unresolved issues with structured investment vehicles and monolines, deleveraging of financial institutions and hedge funds and a significant dislocation in the inter-bank market.
The lingering issues in the credit market were compounded during the second quarter as government rates in the U.S., U.K. and Eurozone all increased markedly. As such, both the widening in credit spreads and the increase in interest rates were the primary drivers behind the increase of $1.8 billion in net unrealized losses and $100.2 million in net realized losses on investments reported for the six months ended June 30, 2008.
Realized losses and impairments as a result of securities where the Company determined its unrealized losses were other than temporary impairments totaled $74.7 million during the six months ended June 30, 2008 in the Company‚Äôs holdings of sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures (‚ÄúTopical Assets‚ÄĚ). In addition, the Company realized losses of $19.5 million on lower-rated Jumbo mortgage securities. These losses and impairments continued to be principally concentrated in 2005, 2006, and 2007 vintage securities. The level of topical impairments have declined in the second quarter of 2008 relative to the first quarter of 2008 and the latter half of 2007, as a number of the lower tranched securities were previously written off to security values ranging from five to thirty percent of par value. Liquidations necessary to fund the repayment of the guaranteed investment contract (‚ÄúGIC‚ÄĚ) liabilities following the downgrade of XL Capital Assurance Inc. (‚ÄúXLCA‚ÄĚ) were funded through sales of assets in the Other Financial Lines segment investment portfolios as well as the general investment portfolios. Management‚Äôs approach was to avoid the sale of assets where current market prices did not reflect intrinsic values or where transaction costs for liquidation were excessive. As a result, the Company continues to hold a number of the Topical Assets and these have been transferred to the general portfolio in exchange for those assets that were liquidated.
The following table details the current exposures to Topical Assets within the Company‚Äôs fixed income portfolio as well as the current net unrealized (loss) gain position as at June 30, 2008 and December 31, 2007:
The Company‚Äôs sub-prime and Alt-A exposures remain primarily highly rated, have strong underlying loan characteristics and are supported by adequate subordination levels. The Company had approximately $208 million of topical investments downgraded during the quarter ended June 30, 2008 and approximately $353 million during the six months ended June 30, 2008.
Of the total Topical Asset exposure as at June 30, 2008 and December 31, 2007 of $1.4 billion and $2.0 billion, respectively, approximately $56.9 million and $76.8 million, respectively, of the related securities had ratings dependent on guarantees issued by third party guarantors (i.e. monoline insurers). Decreases in the ratings of such third party guarantors would typically decrease the fair value of guaranteed securities; however, at June 30, 2008, in the event of non-performance on the part of these third party guarantors, the Company estimates that the average credit quality of this portfolio would be ‚ÄėA‚Äô and that approximately 95.9% would remain investment grade. In addition, of the total fixed income portfolio as at June 30, 2008 and December 31, 2007, of $34.3 billion and $39.1 billion, respectively, less than 2% were guaranteed by such third parties with no individual third party representing more than 1%.
As noted above, the remaining changes in net unrealized losses during the six months ended June 30, 2008 were primarily as a result of spread widening in both corporate credit, particularly financials, and CMBS assets, as well as increases in government interest rates. Spreads widened significantly in the first quarter, followed by modest tightening in second quarter. Government rates declined significantly in first quarter but increased even more significantly in second quarter. The Company believes these losses are a result of either technical spread widening as a result of the market events noted above, or changes in prevailing market rates for government securities, rather than any fundamental deterioration or other-than-temporary impairment.
Net realized and unrealized gains on investment derivatives for the six months ended June 30, 2008 resulted primarily from corporate credit deterioration and the resulting appreciation of certain credit derivative swaps held in the investment portfolio.
Net income from investment fund affiliates was marginally negative in the first half of 2008 as the markets were particularly challenging for strategies employed by the Company‚Äôs alternative investment managers given the extreme volatility and overall pull back of credit availability. The Company‚Äôs alternative investments are managed to maximize total-return on a risk-adjusted basis, and the results over the first half of 2007 as compared to the first half of 2008 are reflective of different market conditions and opportunities available over these periods.
As at June 30, 2008, approximately 13.2% of the asset and mortgage-backed holdings were classified as part of the Company‚Äôs exposure to Topical Assets. This represented approximately 4.2% of the total fixed income portfolio and 17.6% of the total net unrealized loss position. Of the Topical Asset securities, approximately 97.2% were rated as investment grade. All portfolio holdings, including those with sub-prime exposure, are reviewed as part of the ongoing other-than-temporary-impa irment monitoring process. The Company continues to actively monitor its exposures, and to the extent market disruptions continue, including but not limited to disruptions in the residential mortgage market and the related impacts on the assumptions embedded in the Company‚Äôs impairment assessments and estimates of future cash flows, the Company‚Äôs financial position could be negatively impacted.
Consistent with the Company‚Äôs overall focus on core property and casualty operations, management is committed to an overall strategic realignment of its property and casualty investment portfolio over time. Such realignment will support reduced volatility through reduced credit spread exposure, reduced exposure to lower-rated and particularly BBB-rated securities, reduced CMBS and financial sector exposure. The realignment will be achieved through bond maturity and coupon reinvestment, cash flows from business operations and certain opportunistic sales. This strategic realignment will also include an assessment of the Company‚Äôs risk asset portfolio.
2) Relationships with SCA
The Company has multiple relationships with SCA as a result of SCA‚Äôs initial origins as a wholly-owned subsidiary and its subsequent IPO. These relationships are detailed in Note 4 to the Consolidated Financial Statements, ‚ÄúSecurity Capital Assurance Ltd‚ÄĚ, and include, most significantly, a 46.9% investment along with certain guarantees and reinsurance arrangements. The Company is not a primary originator or insurer of mortgages, nor does it guarantee mortgages other than indirectly through the activities of SCA, and as such the impact to the Company with respect to credit enhancement activities is largely limited to the SCA investment and related reinsurance agreements and guarantees.
At December 31, 2007, the Company wrote down its investment in SCA to zero. The write down of SCA to zero in the fourth quarter of 2007 was based, in part, on the losses SCA recorded in the fourth quarter of 2007. No equity earnings have been recorded in the first six months of 2008 relating to the common equity interest in SCA as a result of their reported results throughout 2008.
As a result of a significant increase in expected losses in the SCA portfolio of insured credits the Company has recorded additional losses related to both the reinsurance agreements as well as pre-IPO guarantees. The following table summarizes the income statement impact of these relationships for both the three and six months ended June 30, 2008:
David Radulski - Director of Investor Relations
Thank you, Laurie. Good morning and welcome to XL Capital's first quarter 2008 earnings conference call. This call is being simultaneously webcast on XL's website, at www.xlcapital.com. Also on our website you will find last night's press release, our financial supplement and a webcast presentation.
On our call today, Brian O'Hara, XL Capital's President, CEO and Acting Chairman, will offer opening remarks. Brian Nocco, our CFO, will review our financial results, followed by Sarah Street, XL's Chief Investment Officer, will discuss results in our investment portfolio. Henry Keeling, our Chief Operating Officer, will review current market conditions.
We will open it up for your questions before returning to Brian O'Hara for closing remarks and for his introduction of XL's CEO-Designate, Mike McGavick. While Mike will be making some comments he will not be participating in Q&A. As you recall, it's not our practice to update guidance on a quarterly basis so nothing today should be construed as updating or reaffirming previously provided guidance.
Certain of the matters we will discuss today are forward-looking statements. These statements are based on current plans, estimates and expectations. Forward-looking statements involve inherent risks and uncertainties and a number of factors could cause actual results to differ materially from those contained in the forward-looking statements. Forward-looking statements are sensitive to many factors, including those identified in our most recent Annual Report on Form-10-K, our quarterly reports on Form-10-Q and other documents on file with the SEC that could cause actual results to differ materially from those contained in the forward-looking statements.
Forward-looking statements speak only as of the date on which they are made and we undertake no obligation publicly to revise any forward-looking statement in response to new information, future developments or otherwise. And with that, I will turn it over to Brian O'Hara.
Brian O'Hara - Acting Chairman, President and Chief Executive Officer
Thank you, David and good morning everyone. Before turning to our review of the first quarter, I would like to make a few comments of our management of the SCA situation. We remain intensely focused on the resolution of this issue. We have added to our strong team of advisors and have placed two XL nominated Directors on SCA's Board. Continuing our commit to transparency, on March 27 we posted to our website updated SCA related exposures and we have made no changes to our assessment of ultimate losses for our SCA related reinsurance or guarantees since the filing of our 10-K.
Many of the same forces driving market uncertainty regarding SCA have also impacted our investment portfolio and Sarah Street will be providing an update on the portfolio and related activities.
Turning to our underlying business; our dual platforms of insurance and reinsurance continue to demonstrate solid performance. The first quarter of 2008 was quite active, with global property loss events and individual risk losses totaling in excess of $10 billion. But thanks to our underwriting discipline, we expect the exposure to these events to be less than 1.5% of industry losses. We believe this to be a testament to our Property & Casualty Risk Management practices.
Finally we intend to publish our second annual Global Loss Triangle report during the week of May 4. As was the case with last year's Triangles, our intend is to provide continued transparency and we welcome your feedback. And now with Brian Nocco for a review of our financial results, Brian?
Brian Nocco - Executive Vice President and Chief Financial Officer
Thank you, Brian, and good morning everyone. Turning to our summary of financial results on slide four; operating income was $1.57 per share for the quarter, when annualized to our operating ROE to 12.9%, as compared to $3.01 and 22.3% respectively for the prior year quarter. Our Property & Casualty underwriting profit of $108 million reflect the generally softer market conditions and active quarter for property losses, Henry will talk about this further. Income from both Investment Fund and Investment Management Affiliates were down from last year's exceptionally high levels which Sarah will discuss.
Our total operating expenses of $264 million for the quarter were lower than last year's $281 million when SCA's expenses were included. On a like-for-liked basis, expenses were essentially flat with the prior year. We reported a foreign exchange loss of $68 million on our income statement. This was largely due to the weakening of the US dollar and sterling against other currencies. While we attempt to moderate FX income statement volatility, our primary focus continues to be on managing the economics. In this regard, FX had a positive impact of $30 million in capital in the quarter.
As Brian indicated, we have analyzed and posted updated and expanded SCA related data, and are committed to do continuing disclosure on transparency related to this exposure.
We have made no changes to our assessment of ultimate losses for our SCA related reinsurance for guarantee since the filing of our 10-K. Accordingly, the only entries in this regard have been for the accretion of the discount on loss reserves established at year end, for which we recorded a charge of $5 million in the quarter: We wrote-off our remaining investments in SCA and Primus at year end, and have included no share of earnings for either this quarter.
The paid to incurred ratio for our P&C operations is 110% for the current quarter. Excluding the impacts of the favorable year prior year development, paid losses related to the 2005 hurricanes and recoveries recorded related to the Lloyd's adverse development cover, the paid to incurred ratio is 92%.
Our fully diluted book value of $50.29 per share at year end declined to $46.11 per share as unrealized losses on our investment portfolio more than offset our net income. In these challenging conditions with extraordinarily thin market liquidity, we successfully raised $4 billion of cash from our fixed income portfolio to repay the muni-GIC liabilities trigged by SCA's rating down grades.
We have developed a contingency plan and executed with minimum financial impact on XL. The related asset sales resulted in a small gain during the quarter. We now have only have $11 million of muni-GIC liabilities outstanding. And now to our Chief Investment Officer, Sarah Street to review our investment portfolio and results.
Sarah E. Street - Executive Vice President and Chief Investment Officer
Thank you, Brian, and good morning. Today I am going to cover three areas. First I'll review the market for the quarter and its marked-to-market impact on our portfolio. Second, I'll discuss the asset sales that we made to pay down the muni-GIC liabilities and finally I'll review investment earnings for the quarter.
So to begin; the market turbulence of fourth quarter 2007 gained further momentum during the first quarter of 2008. It was a brutal period in the compartment triggered by increased concerns about the US economy, massive de-leveraging by financial institutions and an enormous flight to quality with sell off of risk assets without regards to economic value. While the overall tone of the market has improved somewhat in recent weeks, large [inaudible] of store remains with the capital markets due to ongoing recessionary and housing concerns.
On slide eight, we show the decline in the quarter of our net-unrealized position, before tax of $1.1 billion. Approximately $130 million of this decline in our unrealized position is due to the impact of the dollars declined which was included in the overall book value impact previously noted by Brian. Not surprisingly, given the asset price erosion that we witnessed across all credit sectors of fixed income, this was a significant decline.
Falling government rates in both the US and abroad positively impacted our net-unrealized position. However, what we've seen since mid 2007, these movements were more than offset by the impact of corporate and structured credit spreads. The main difference so far in 2008 has been that the spread widening in corporate and particularly the financials have had a much larger driver than in previous quarters.
Our aggregate holdings and financials are $6.6 billion with an average rating of A+. We also saw further price decline in mortgage related assets. The deleveraging of financial institutions and hedge funds led to significant amounts of forced liquidations which had a real negative pricing impact. The Fed actions on Bear Stearns making the discount window available to brokerage firms certainly stabilized markets towards the ends of March. This was most transparent in the tightening that we saw in most credit and mortgage indices.
However cash markets have not reacted as quickly, given the lack of liquidity in those markets and spreads were still at their wide at the end of the quarter for many assets. We continue to be comfortable with the quality of our portfolio and watch [inaudible] and principally reflect a liquidity in the market, we do not believe our remaining impairments are permanent.
The second area I'll discuss which Brian previously mentioned is the repayment of $4 billion of muni-GICs during the quarter. The repayment of these obligations was funned by the sale of assets in both muni-GIC segregated portfolios as well as the general investment portfolio. Our approach was to avoid selling assets at the low intrinsic value, or those with excessive liquidity costs. As a result, we have retained many of the topical assets originally purchased for the muni-GIC facilities, and selling in today's markets which where pricing reflects poor sales with both un-economic and also inappropriate given the fact that we have the ability to hold them until markets stabilize.
As a number of the US assets have floating rate, by retaining these, our P&C general dollar portfolio duration declined which we feel will help protect book value if interest rates rise.
The trade-off was at the yield on this portfolio declined by ten to 15 basis points, although it will be more responsive to increases should rates rise. When we weighed the current yield give outs against the book value benefit of shorter duration in the US, shorter duration won.
You will see the changes in our portfolio mix in the financial supplement. Our overall credit sector allocation is relatively consistent after the impact of sales and Marked-to-markets. Most notable was a decline in our structured credit securities as we use many of these to fund the muni-GIC liabilities. Our average credit rating remains at AA.
Moving to our financial results, on slide nine, we have summarized the net losses... net realized losses on investments for $102 million which was driven by charges for other than temporary impairments for $115 million including $49 million related to Topical assets and $30 million of sales and for losses for asset sales we expect to make in the next couple of quarters to satisfy $900 million of maturing funding agreements.
Last May we announced that we would exit this business and these maturities marked good progress towards that goal.
On slide ten, you will see that our total net investment income for the quarter was $499 million. Of this net investment income from our primary P&C operation, excluding structured products was $308 million. This declined by $19 million relative to fourth quarter 2007, principally due to lower rates and the slightly lower asset base. Turning to slide 11, net income from investment fund affiliates was $12 million for the quarter and was principally driven by a flat return in our term sheet [ph] portfolio.
The markets during the quarter were and continue to be in March challenging for alternative strategies given the extreme volatility and the overall pull back of credit availability. Our fund results reflect December to February returns. We are pleased with our performance relative to equities and the results further reinforce the strong risk adjusted returns of this asset class.
Before I turnover to Henry to discuss our insurance and Reinsurance Operations, I'd like to emphasize the depth of analysis we've undertake to validate the quality of our portfolio and the appropriateness of our positions going forward. We have clearly felt the pain of the most credit markets in history. However we believe financial stability will ultimately return and when it does we are well-positioned. Henry?
Henry C.V. Keeling - Executive Vice President and Chief Operating Officer
Thank you, Sarah. The strength of XL's global franchise again exhibited itself in a quarter with cat activity and individual risk losses significantly higher than the seasonal average. Published losses list... publishes sources list 19 separate loss events that produced individual risk losses of greater than $100 million each, totaling over $5.5 billion. In addition there were various tornado losses in the US and another large winter storm loss in Europe known as Emma, making it the third year in a row that Europe has suffered a storm loss in excess of $2 billion. In total we are aware of 27 risk and/or cat events in Q1 exceeding $100 million per occurrence and $10 billion in the aggregate.
Due to disciplined and selective underwriting, our involvement was limited to just three of these accounts on the insurance side. Total estimated losses from both segments as Brian O'Hara mentioned earlier, are less than 1.5% of the industry estimated losses for these events.
The quarter source spending even more time with our customers and brokers, emphasizing our commitments to them through our customer service and communications efforts, which have been and will continue to be pillars of XL's business franchise. While there will undoubtedly be some impact to our writings, especially new business as we see the effects of rating agency actions on our business, but we see these as remaining very manageable as our customers and brokers understand the strength of our core business operations.
Turning to the insurance segment; gross premiums written increased by 3.1% year-over-year. The main drivers for this were positive foreign exchange movements, favorable customer retention and selective writing of new business. These were partially offset by the impact of declining market pricing and the run off of ICAP business. We saw an increase in long-term agreement premiums, largely in Europe, where we also achieved better than expected pricing on our January 1 renewal book. Net premiums earned were down 4.1%, primarily due to an increase in seeded premiums related to the purchase of an adverse development cover which closed out the open years of certain of our Lloyds operations.
The insurance segment loss ratio for the first quarter was seven-points higher than the previous year quarter after adjusting for prior year development in both quarters and benefit from the adverse development cover I just mentioned. Approximately four-point of this difference relates to an increase in natural peril property losses with the remainder primarily attributable to the impact of premium rate decreases and an anticipated increase in loss activity in professional lines that I will discuss later.
Favorable prior year development in the quarter was $17 million with $13 million counting from property and other short tail lines. The amount of net prior year reserve releases was consistent with Q1 2007.
Market conditions generally followed recent trends, with early indication showing insurance premium rates on renewals down on average by approximately 7%. We also saw strong renewal retention ratios of just over 90% across our core Property & Casualty lines reflective of the strong loyalty of our European client base of the January 1 renewals. And, of course, our insurance segment results do not included the results from ITAU XL, which we report in from affiliates. Our share of the premiums from this Brazilian joint venture was approximately $73 million for the quarter.
In reinsurance, the fact that we do not focus on our top line was particularly apparent this quarter. While we did take advantage of some new business opportunities, much of the reduction in gross premiums written resulted from selective non-renewal or un-attractive business. This was most notable in our U.S. casualty portfolio.
Another area impacted was our portfolio of quota share reinsurances of Lloyd Syndicates. This portfolio has performed very well in recent years, but given where we are in the cycle, we took a more conservative underwriting position and this together with some impact from the well publicized recent M&A activity in that market, resulted in $17 million of foregone gross premiums written.
We also saw premiums affected by the timing of renewals and we expect to bind approximately $15 million of business in the second quarter that was previously written in the first quarter of last year. Net premiums earned were substantially flat year over year as lower net premiums written in prior quarters were partially offset by the positive earned impact of cessions to Cyrus Re were reduced. The reinsurance current year loss ratio was 4.7 points lower than in Q1 2007 driven by lower cat losses with the segment's exposure to Emma being only $20 million compared to Kyrill's $45 million in the prior year quarter. Prior year development in Q1 2008 was $50 million versus $45 million in Q1 2007.
We discussed January renewal conditions on our last call. Since then, the only significant news is that rates on our nowadays small and selective portfolio of Japanese business renewing on April 1 remained generally flat, which given the very competitive nature of the Japanese market was in itself something of a victory for pricing.
Turning to our life operations, these contributed earnings of $27 million this quarter compared to $23 million in the previous year quarter. Our life operations segment continues its trends of growth in long-term regular premium business in both the U.K. and the U.S. though this growth is not immediately parents this quarter due to a single premium annuity contract having been written in the prior year quarter.
We spent a fair amount of time on our call last quarter discussing the sub-prime issue and its impact on our insurance and reinsurance segments. We presented a snapshot analysis of our book of business and discussed our product and geographic diversification as well as underwriting related risk management. Since that basic profile doesn't change materially on a quarter to quarter basis, I would refer you to last quarter's comments for an overview of our operations and I will use the time this quarter to give you a quick update.
As this is an evolving issue, we regularly review our position in regard to sub-prime in both insurance and reinsurance. Specifically, we have updated our analysis of 2007 losses for the insurance professional lines portfolio. While there has been an increase in the number of notices for 2007 from 26 to 50, this increase is within that anticipated in our year end analysis and we continue to be comfortable with the adequacy of the inherent clash load and our overall loss pick for 2007.
With regard to the 2008 year, 27 notices have been received during the first quarter and we continue to track potential exposure associated with insurers that have been linked in the media to credit market related activity. In recognition of the potential for heightened loss activity in 2008, we have increased the clash provision in our 2008 loss ratio over 2007 for our major professional lines businesses by five points. We believe that this is prudent given the evolving and long-term nature of this issue from an insurance perspective, and we have done this despite the fact that at this early stage attritional losses continue to be favorable and in line with prior years.
Also general rate reductions this year have been less than expected and we see signs of price firming in portions of the market most impacted by sub-prime. In reinsurance, please recall that the potential sub-prime exposure in our assumed reinsurance portfolio is much more limited as our average treaty line size is in the $2 million to $3 million range and our experience here continues in line with our previously discussed analysis.
In summary, we continue to monitor our exposure to sub-prime very closely and remain comfortable with our reserve position for 2007 and feel that our loss picks for 2008 are currently appropriate. We do expect to pay claims related to the sub-prime issue, but that is our business, and we are comfortable with the idea now we have put up for those potential losses. I would also emphasize that based on our current loss picks we would expect both 2007 and 2008 years to be profitable and give us returns in excess of our long-term hurdle rates.
In closing, I'd like to also mention that strategic initiatives for organic and profitable expansion across our organization continue to bear fruits. Our insurance branch in Singapore has now been open for a full quarter and has already landed several key accounts in property, casualty, marine and professional. We have successfully integrated XL Gas, our recent engineering services acquisition, and this generated $11 million of additional insurance premiums through cross-selling.
And we recently announced that with the opening of the Brazilian reinsurance market, we have applied for both admitted and local reinsurance licenses and we expect to commence operations there as soon as possible. And with that we will open it up for Q&A.