The following table sets forth other revenues and expenses for the three months ended June 30, 2004 and 2003:
Corporate operating expenses in the second quarter ended June 30, 2004 increased compared to the three months ended June 30, 2003 due to the continued build out of the Company’s global infrastructure in developing its network of shared service organizations to support operations in certain locations, costs related to compliance with the Sarbanes-Oxley Act and costs related to the Company’s global branding campaign.
The increase in interest expense was primarily due to additional interest expense related to the 2.53% Senior Notes issued in March 2004 which was partially offset by the commutation of certain finite reinsurance contracts. For more information on the Company’s financing structure, see “Financial Condition and Liquidity.”
The increase in the Company’s income taxes arose principally from an improvement in the profitability of the Company’s U.S. and European operations.
Gross and net premiums written increased by 19.3% and 26.8%, respectively, in the half year ended June 30, 2004 compared with the half year ended June 30, 2003. These increases are primarily due to new business written across most lines and favorable foreign exchange movements. The most significant growth due to new business was seen in casualty, professional and marine lines of business combined with several new product offerings in the professional liability and property catastrophe lines. The new insurance initiatives added, in total, approximately $150.0 million to gross written premium. The weakening of the U.S. dollar against the U.K. sterling and the Euro as compared
to the second half of 2003 accounted for approximately $140.0 million of the increase in gross premiums written in the six months ended June 30, 2004. Partially offsetting the growth in net and gross premiums written in 2004 were moderate rate reductions in certain property lines and growing rate pressures on most casualty lines. Net premiums written have grown by a larger percentage than gross premiums written as a result of a ceded reinsurance commutations related to professional lines.
Net premiums earned increased by 14.1% in the six months ended June 30, 2004 compared with the six months ended June 30, 2003. The increase was due to the earning of additional net premiums written in the current and prior year combined with an increase in net retentions as a result of a ceded reinsurance commutation noted above. Growth in net premiums earned was partially offset by several non-renewed portfolios (specialty workers’ compensation, certain Lloyd’s international programs, and accident & health) as the earned premium impact of the non-renewed business lags the written premium impact.
Exchange losses in the six months ended June 30, 2004 were primarily due to the strengthening of the U.S. dollar in the first half of 2004 against the Euro and other major currencies in those entities whose functional currency is other than U.S. dollars and which are exposed to net U.S. dollar liabilities.
The decrease in the underwriting profit in the first half of 2004 as compared with the very strong performance in the first half of 2003 was also reflective of the combined ratios as shown below.
The following table presents the ratios for this segment:
| | | (Unaudited)
Six Months Ended
June 30, |
|
| | | 2004 | | 2003 | |
|
| Loss and loss expense ratio | | 62.8% | | 61.3% | |
| Underwriting expense ratio | | 26.9% | | 26.9% | |
|
| Combined ratio | | 89.7% | | 88.2% | |
|
The loss and loss expense ratio includes net losses incurred for both the current year and any adverse or favorable prior year development of loss and loss reserves held at the beginning of the year. The loss ratio for the six months ended June 30, 2004 increased compared with the six months ended June 30, 2003 largely due to minor prior period reserve strengthening in the first half of 2004.
The underwriting expense ratio in the half year ended June 30, 2004 compared to the same period in 2003 was flat as an increase in the operating expense ratio of 1.5 points (13.1% as compared to 11.6%) was offset by a reduction in the acquisition expense ratio of 1.5 points (13.8% as compared to 15.3%). The increase in the operating expense ratio was due primarily to the increased costs associated with supporting new business growth in the segment operations globally and in particular the start up operations, the impact of foreign exchange movements and an allocation of certain corporate expenses to the segment. The reduction in the acquisition expense ratio was due primarily to a change in the mix of business earned during the first half of the year compared to the same period in the prior year.
40Reinsurance
Reinsurance — General Operations
The following table summarizes the underwriting results for the general operations of this segment:
(U.S. dollars in thousands)
| | | | | (Unaudited) | | | |
| | | | | Six Months Ended | | | |
| | | | | June 30, | | | |
|
| | | | | 2004 | | 2003 | | % Change | |
|
| Gross premiums written | | | $ | 2,312,592 | $ | 2,130,573 | | 8.5% | |
| Net premiums written | | | | 2,025,816 | | 1,781,729 | | 13.7% | |
| Net premiums earned | | | | 1,407,477 | | 1,150,101 | | 22.4% | |
| Fee income and other | | | | 6,104 | | 17,793 | | (65.7)% | |
| Net losses and loss expenses | | | | 799,781 | | 727,338 | | 10.0% | |
| Acquisition costs | | | | 317,833 | | 246,215 | | 29.1% | |
| Operating expenses | | | | 92,823 | | 71,254 | | 30.3% | |
| Exchange gains | | | | (5,887) | | (23,208) | | NM | |
|
| Underwriting profit | | | $ | 209,031 | $ | 146,295 | | 42.9% | |
|
Gross and net premiums written increased 8.5% and 13.7%, respectively, in the first half of 2004 as compared to the first half of 2003. The growth in gross written premiums was seen primarily in the U.S. casualty business and the property lines of business. These increases reflect increases in volume of new and renewal business combined with underlying rate improvements in the range of 10%-15% on the U.S. and London casualty portfolio and rate decreases generally in the range of up to 15% across U.S. property lines. Some international property rates also saw reductions but to a lesser extent. Rate decreases also occurred in the marine, aviation and satellite lines. Favorable foreign exchange movements also contributed to the growth in gross written premiums. Net written premiums reflect the above gross changes, together with higher retentions, including approximately $49.0 million of quota share premiums from Le Mans Re previously ceded but now retained within the group.
Net premiums earned in the first half of 2004 increased 22.4% as compared to the first half of 2003, due primarily to the earning of net written premium growth in the last year. Casualty reinsurance net premiums earned were $606.0 million in the first half of 2004 as compared to $455.0 million in the same period in 2003.
Fee income and other relates primarily to fees earned on deposit liability contracts which are earned based on individual underlying contractual terms and conditions. The decrease in fee income was in line with management expectations given those terms and conditions.
The following table presents the ratios for this segment:
| | | | | (Unaudited) |
| | | | | Six Months Ended |
| | | | | June 30, |
|
| | | | | 2004 | | 2003 |
|
| Loss and loss expense ratio | | | | 56.8% | | 63.2% |
| Underwriting expense ratio | | | | 29.2% | | 27.6% |
|
| Combined ratio | | | | 86.0% | | 90.8% |
|
|
The loss and loss expense ratio includes net losses incurred for both the current year and any adverse or favorable prior year development of loss reserves held at the beginning of the year.
There were no significant catastrophic loss events affecting the Company in the first half of 2004 or 2003. The decrease in the loss and loss expense ratio in the half year ended June 30, 2004 compared to the same period in 2003 primarily reflected lower than expected incurred loss development in the first half of the year relating to recent underwriting years, including a release of $12 million related to the September 11 event, and price improvements on earned premiums from prior periods.
41
The increase in the underwriting expense ratio in the first half of 2004 as compared with the first half of 2003 was primarily due to an increase in the acquisition expense ratio to 22.6% as compared to 21.4% in the first half of 2003. This increase was mainly due to increased profit commissions which resulted from favorable loss development in the period. The operating expense ratio remained relatively consistent increasing to 6.6% for the first half of 2004 from 6.2% in the same period in 2003.
Exchange gains in the six months ended June 30, 2004 were mainly attributable to an overall weakening in the value of the U.S. dollar against the UK Sterling and the Euro in those operations with U.S. dollars as their functional currency and net U.K. sterling and Euro assets.
Reinsurance — Life and Annuity Operations
The following summarizes net income from life operations:
(U.S. dollars in thousands)
| | | | | (Unaudited) | | | |
| | | | | Six Months Ended | | | |
| | | | | June 30, | | | |
|
| | | | | 2004 | | 2003 | | % Change | |
|
| Gross premiums written | | | $ | 1,062,495 | $ | 150,333 | | NM | |
| Net premiums written | | | | 1,062,409 | | 137,730 | | NM | |
| Net premiums earned | | | | 1,064,336 | | 139,842 | | NM | |
| Fee income and other | | | | 93 | | — | | NM | |
| Claims and policy benefits | | | | 1,102,244 | | 183,536 | | NM | |
| Acquisition costs | | | | 11,839 | | 13,869 | | (14.6)% | |
| Operating expenses | | | | 6,680 | | 4,221 | | 58.3% | |
| Exchange gains | | | | (946) | | (3,614) | | (73.8)% | |
| Net investment income | | | | 89,550 | | 65,144 | | 37.5% | |
| Interest expense | | | | 117 | | — | | NM | |
|
| Net income from life operations | | | $ | 34,045 | $ | 6,974 | | NM | |
|
|
Gross and net premiums written as well as net premiums earned and claims and policy benefits increased significantly in the first half of 2004 as compared to the first half of 2003 primarily as a result of a large immediate annuity portfolio contract bound in the second quarter, representing $898.0 million in net premium earned. In addition, the Company wrote several new regular premium term assurance contracts in the fourth quarter of 2003, which were generating further written premiums in the current and subsequent quarters. The increase in percentage of net premiums written to gross premiums written was primarily due to the termination of a retrocession agreement with an insurance affiliate in the third quarter of 2003.
Claims and policy benefits also increased significantly as a result of the annuity payout liabilities accepted under the contract noted above. Changes in claims and policy benefits also included the movement in policy benefit reserves related to other contracts where investment assets were acquired with the assumption of the policy benefit reserves at the inception of the contract.
Acquisition costs decreased in the first half of 2004 as compared to the first half of 2003 due to a timing difference arising from late renewal of a contract in France. Operating expenses increased in the first half of 2004 compared to the first half of 2003 reflecting the build out of existing operations and start-up costs of new Life operations in the U.S. Net investment income increased in the first half of 2004 compared to the first half of 2003 reflecting the increase in life business invested assets primarily arising from new large annuity contracts written since June 30, 2003.
Financial Products and Services
Financial Products and Services – Financial Operations
The following table summarizes the underwriting results for this segment:
42
(U.S. dollars in thousands)
| | | | | (Unaudited) | | | |
| | | | | Six Months Ended | | | |
| | | | | June 30, | | | |
|
| | | | | 2004 | | 2003 | | % Change | |
|
| Gross premiums written | | | $ | 131,677 | $ | 151,032 | | (12.8)% | |
| Net premiums written | | | | 124,184 | | 148,462 | | (16.4)% | |
| Net premiums earned | | | | 66,612 | | 62,780 | | 6.1% | |
| Fee income and other | | | | 829 | | 509 | | 62.9% | |
| Net losses and loss expenses | | | | 9,530 | | 22,283 | | (57.2)% | |
| Acquisition costs | | | | 8,633 | | 9,039 | | (4.5)% | |
| Operating expenses | | | | 33,202 | | 22,306 | | 48.8% | |
|
| Underwriting profit | | | $ | 16,076 | $ | 9,661 | | 66.4% | |
| Net investment income — financial guarantee | | | $ | 17,005 | $ | 10,673 | | 59.3% | |
Net realized and unrealized (losses) gains on weather
and energy derivatives | | | | (4,616) | | 15,633 | | (129.5)% | |
| Operating expenses — weather and energy | | | | 13,941 | | 10,810 | | 29.0% | |
| Equity in net (loss) income of financial affiliates | | | | (1,203) | | 17,176 | | NM | |
| Minority interest | | | | 7,087 | | 5,298 | | 33.8% | |
Net realized and unrealized gains (losses) on credit
default swaps | | | | 39,649 | | (21,930) | | NM | |
|
| Net contribution from financial operations | | | $ | 45,883 | $ | 15,105 | | 204% | |
|
|
Gross and net premiums written primarily relate to the financial guaranty line of business and reflect premiums received and accrued for in the period and do not include the present value of future cash receipts expected from installment premium policies written in the period. Decreases in gross and net premiums written of 12.8% and 16.4%, respectively, in the first half of 2004 as compared to the same period in 2003 were primarily due to the combination of conscious underwriting discipline during generally weaker market conditions in the quarter and the absence in the current quarter of several large upfront premium contracts written in the second quarter of 2003. Market conditions are being driven by credit spread compression, higher interest rates, increased competition and reduced public financing.
Net premiums earned in the first half of 2004 as compared to the same period in 2003 showed growth in contrast to the decrease in net premiums written over the same period. This is because these premiums earn out over the life of the underlying exposures, which are typically longer than the risk periods related to the Company’s insurance and reinsurance general operations. The increase was partially offset by the earning of a large benefit relating to short term contract enhancements in the first half of 2003. Premiums earned do not include premiums on contracts written in derivative form, which are included in “Net realized and unrealized gains (losses) on credit default swaps”.
As with the Company’s property and casualty insurance and reinsurance operations, net losses and loss expenses include current year net losses incurred and adverse or favorable development of prior year net loss and loss expenses reserves. Net losses and loss expenses in the six months ended June 30, 2004 decreased significantly compared to the same period in 2003. This decrease was primarily a result of the release of prior period reserves related to financial guaranty exposures as the underlying in force policies get closer to maturity.
In the six months ended June 30, 2004, acquisition costs as a percentage of net premiums earned decreased as compared to the first half of 2003. This was due to a change in the average term over which the acquisition costs were being expensed which more accurately reflected the life of the exposures.
Operating expenses increased in the first half of 2004 as compared to the first half of 2003 due to the investment in segment infrastructure over the last year as well as an increase in the allocation of certain corporate expenses.
Net investment income related to the financial guaranty business increased in 2004 due to the larger investment portfolio created by growth in premium receipts and a $100.0 million capital infusion in the fourth quarter of 2003.
43
The net realized and unrealized positions on weather and energy risk management derivative instruments resulted in a loss in the half year ended June 30, 2004 as compared to a significant gain in the same period in 2003. During the first half of 2004 the winter weather and gas portfolios experienced losses due to higher than expected temperature volatility. During the first half of 2003, $9.1 million in gains were recognized on derivative contracts related to natural gas exposures that were not repeated in 2004. In the period since June 30, 2003 the positions and activity in the gas area has been significantly reduced, those in the weather area have been increased slightly, and new contingent risk products were introduced.
Equity in net income of financial affiliates decreased in the first half of 2004 as compared to the second half of 2003 due primarily to the Company’s investment in Primus. Primus specializes in providing credit risk protection through credit derivatives. Primus had a negative mark-to-market adjustment in the period.
The increase in minority interest in 2004 compared to 2003 is due to an increase in the profitability of XL Financial Assurance Ltd., of which 15% is held by a minority shareholder.
The Company’s credit derivative transactions relate primarily to financial guaranty coverage that is written in swap form and pertains to tranches of collateralized debt obligations and asset backed securities. The net realized and unrealized gains in the six months ended June 30, 2004 related to the fair value adjustment for transactions written in derivative form as well as the premiums earned associated with these transactions. These gains were mainly unrealized and related to the improvement of credit quality for certain credit pools. In the first half of 2003 the opposite conditions existed and the fair value change was negative. The Company continues to monitor its credit exposures and adjust the fair value of these derivatives as required.
Financial Products and Services — Life and Annuity Operations
The following summarizes net income from life operations:
(U.S. dollars in thousands)
| | | | | (Unaudited) | | | |
| | | | | Six Months Ended | | | |
| | | | | June 30, | | | |
|
| | | | | 2004 | | 2003 | | % Change | |
|
| Gross premiums written | | | $ | 46,425 | $ | 36,880 | | 25.9% | |
| Net premiums written | | | | 46,644 | | 23,286 | | 100.3% | |
| Net premiums earned | | | | 46,644 | | 23,411 | | 99.1% | |
| Fee income and other | | | | 137 | | 50 | | 174.0% | |
| Claims and policy benefits | | | | 38,328 | | 19,247 | | 99.1% | |
| Acquisition costs | | | | 9,995 | | 1,460 | | NM | |
| Operating expenses | | | | 5,552 | | 4,091 | | 35.7% | |
| Net investment income | | | | 38,459 | | 12,549 | | NM | |
| Interest expense | | | | 20,674 | | 4,927 | | NM | |
|
| Net income from life and annuity operations | | | $ | 10,691 | $ | 6,285 | | 70.1% | |
|
|
Gross and net premiums written and earned relate to the blocks of U.S.-based mortality reinsurance business. Claims and policy benefits from this book of business are in line with management’s expectations.
In December 2002, certain blocks of U.S.-based mortality reinsurance business written were novated to the Company from an insurance affiliate. Gross and net premiums earned, claims and policy benefit reserves and acquisition costs are all related to this novated block of business. During the quarter ended September 30, 2003, the Company exercised its right and terminated a retrocession agreement of certain of these exposures which led to the significant increase in net premiums written in the first half of 2004 compared to the same period in 2003. In the quarter ended June 30, 2004 approximately $3.0 million in additional claims and policy benefit reserves were recorded related to this block of business.
Net investment income and interest expense relate to municipal reinvestment contracts and funding agreements
44
transactions. The increase in investment income and the related interest expense was due to the initiation of the funding agreements in the second quarter of 2003 combined with increases in the average balances outstanding related to the book of municipal reinvestment contracts. The balances outstanding for funding agreements and municipal reinvestment contracts have increased from $0.3 and $1.0 billion, respectively, as at June 30, 2003 to $0.9 million and $1.9 billion, respectively, as at June 30, 2004.
Investment Activities
The following table illustrates the change in net investment income from general operations, equity in net income of investment affiliates, net realized gains and losses on investments and net realized and unrealized gains and losses on investment derivatives from general operations for the six months ended June 30, 2004 and 2003:
(U.S. dollars in thousands)
| | | | | (Unaudited) | | | |
| | | | | Six Months Ended | | | |
| | | | | June 30, | | | |
|
| | | | | 2004 | | 2003 | | % Change | |
|
| Net investment income — general operations | | | $ | 318,509 | $ | 294,089 | | 8.3% | |
| Equity in net income of investment affiliates | | | | 97,109 | | 61,104 | | 58.9% | |
| Net realized gains on investments | | | | 124,100 | | 89,024 | | NM | |
Net realized and unrealized gains on
investment derivative instruments — general operations | | | | 18,704 | | 8,533 | | NM | |
|
|
Net investment income related to general operations increased in the first six months of 2004 as compared to the first six months of 2003 due primarily to a higher investment base. The growth in the investment base reflects the Company’s cash flow from operations. The market yield to maturity on the total fixed income portfolio was 4.1% at June 30, 2004 as compared to 3.7% at June 30, 2003.
Equity in net income of investment affiliates increased in the first six months of 2004 compared to the first six months of 2003 mainly due to strong performance in both the alternative portfolio and financial results of the investment managers where the Company has a minority stake.
45
The Company manages portfolios consisting of structured portfolios (i.e., assets supporting deposit liabilities and future policy benefit reserves) and Asset/Liability portfolios where, due to the unique nature of the underlying liabilities, customized liability-based benchmarks are used to measure performance. The Company also manages Risk Asset portfolios, which constitute approximately 10% of the Company’s invested assets. These are compared to applicable public indices. The following is a summary of the investment performance for the six months ended June 30, 2004 and June 30, 2003, respectively:
| | | | | (Unaudited) |
| | | | | Six Months Ended |
| | | | | June 30, |
|
| | | | | 2004 | | 2003 | |
|
| | | | | (Note 1) | | |
| U.S. High Yield | | | | 0.7% | | 13.7% | |
| CS First Boston High Yield Index | | | | 2.5% | | 17.3% | |
|
| Relative Performance | | | | (1.8)% | | (3.6)% | |
|
| Risk Asset Portfolios — Equities | | | | |
| U.S. Large Cap Growth Equity | | | | 2.3% | | (12.8)% | |
| Russell 1000 Growth Index | | | | 2.6% | | (13.0)% | |
|
| Relative Performance | | | | (0.3)% | | 0.2% | |
|
| U.S. Large Cap Value Equity | | | | 4.6% | | 12.4% | |
| Russell 1000 Value Index | | | | 3.7% | | 11.4% | |
|
| Relative Performance | | | | 0.9% | | 1.0% | |
|
| U.S. Small Cap Equity | | | | 6.7% | | 19.2% | |
| Russell 2000 Index | | | | 6.7% | | 17.8% | |
|
| Relative Performance | | | | — | | 1.4% | |
|
| Non-U.S. Equity | | | | 4.2% | | 8.2% | |
| MSCE ACWI ex US Index (Note 2) | | | | 3.6% | | 9.5% | |
|
| Relative Performance | | | | 0.6% | | (1.3)% | |
|
| Risk Asset Portfolios — Alternative Investments | | | | | | | |
| Alternative Investments (Note 3) | | | | 4.4% | | 4.7% | |
| Standard and Poor’s 500 Index (Note 3) | | | | (0.1)% | | 10.4% | |
|
| Relative Performance | | | | 4.5% | | (5.7)% | |
|
|
| Note 1 — All U.S. and Sterling fixed income portfolios within Asset/Liability investment portfolios are now managed relative to custom liability benchmarks. | |
| Note 2 — The benchmark for the Non-U.S. Equity portfolios changed from the MSCI EAFE to the MSCE ACWI ex US Index in the quarter. Comparative figures reflect the previous index. | |
| Note 3 — Effective June 30, 2003, alternative investments are priced one month in arrears; however, cash flows are reflected in the current reporting period. For comparative purposes, effective June 2003, the Standard & Poor’s 500 Index returns are lagged one month. | |
Net Realized Gains and Losses and other than temporary declines in the value of investments
Net realized gains on investments in the first six months of 2004 included net realized gains of $128.2 million from sales of investments and net realized losses of approximately $4.1 million related to the write-down of certain of the Company’s fixed income and equity investments where the Company determined that there was an other than temporary decline in the value of those investments.
Net realized gains on investments in the first six months of 2003 included net realized gains of $202.7 million from sales of investments and net realized losses of approximately $113.7 million related to the write-down of certain of the Company’s fixed income and equity investments where the Company determined that there was an other than temporary decline in the value of those investments.
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These factors include: (i) the time period during which there has been a
46
significant decline in value; (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer; (iii) the significance of the decline; (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question; and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized.
Net realized and unrealized gains on investment derivatives in the first six months of 2004 resulted from the Company’s investment strategy to economically hedge against interest and foreign exchange risk within the investment portfolio.
Other Revenues and Expenses
The following table sets forth other revenues and expenses for the six months ended June 30, 2004 and 2003:
(U.S. dollars in thousands)
| | | | | (Unaudited) | | | |
| | | | | Six Months Ended | | | |
| | | | | June 30, | | | |
|
| | | | | 2004 | | 2003 | | % Change | |
|
| Equity in net income (loss) of insurance affiliates | | | $ | 3,184 | $ | (41,741) | | NM | |
| Amortization of intangible assets | | | | 6,514 | | 750 | | NM | |
| Corporate operating expenses | | | | 80,397 | | 68,953 | | 16.6% | |
| Interest expense | | | | 74,227 | | 87,495 | | (15.2)% | |
| Income tax expense | | | | 66,533 | | 31,039 | | 114.4% |
|
The equity in net loss of insurance affiliates for the six months ended June 30, 2003 includes an other than temporary decline of $40.9 million in the value of the Company’s investment in Annuity and Life Re. The investment was written down to its fair value of $2.1 million at March 31, 2003.
Corporate operating expenses in the six months ended June 30, 2004 increased compared to the six months ended June 30, 2003 due to the continued build-out of the Company’s global infrastructure in developing its network of shared service organizations to support operations in certain locations, costs related to compliance with the Sarbanes-Oxley Act, and new costs related to the Company’s global branding campaign.
The decrease in interest expense primarily reflected a lower accretion charge on the deposit liabilities due to the commutation of certain finite reinsurance contracts offset by additional interest expense related to the 2.53% Senior Notes issued in March 2004. For more information on the Company’s financing structure, see “Financial Condition and Liquidity.”
The increase in the Company’s income taxes arose principally from an increase in the profitability of certain of the Company’s U.S. and European operations during the first half of 2004.
Financial Condition, Liquidity and Capital Resources
As a holding company, the Company’s assets consist primarily of its investments in subsidiaries, and the Company’s future cash flows depend on the availability of dividends or other statutorily permissible payments from its subsidiaries. The ability to pay such dividends is limited by the applicable laws and regulations of the various countries the Company operates in, including, among others, Bermuda, the United States, Ireland, Switzerland and the United Kingdom, and those of the Society of Lloyd’s and certain contractual provisions. No assurance can be given that the Company or its subsidiaries will be permitted to pay dividends in the future.
The Company and its subsidiaries provide no guarantees or other commitments (express or implied) of financial support to the Company’s subsidiaries or affiliates, except for express written financial support provided by XL Insurance (Bermuda) Ltd in connection with the Company’s financial guaranty subsidiaries and where other express written guaranty or other financial support arrangements are in place.
The Company’s ability to underwrite business is dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company is downgraded,
47
its ability to write business would be adversely affected in financial guaranty and long-tailed insurance and reinsurance lines of business. In the normal course of business, the Company evaluates its capital needs to support the volume of business written in order to maintain its claims paying and financial strength ratings. In January 2004 several of the internationally recognized rating agencies amended their financial strength ratings of the Company’s principal insurance and reinsurance subsidiaries and pools following the announcement by the Company of an increase in the prior period loss reserves in the fourth quarter of 2003. The Company regularly provides financial information to rating agencies to both maintain and enhance existing ratings.
The following are the current financial strength and claims paying ratings from internationally recognized rating agencies in relation to the Company’s principal insurance and reinsurance subsidiaries and pools:
| Rating agency | | Rating | | | | |
|
| Standard & Poor’s | | AA– | | (Outlook Stable) | | |
| Fitch | | AA | | (Stable) | | |
| A.M. Best | | A+ | | (Outlook Negative) | | |
| Moody’s Investor Services | | Aa2 | | (except members of the XL America Pool, XL Re Ltd and XL Life Insurance and Annuity Company, which are rated Aa3, outlook for both ratings is stable) | | |
|
The following are the financial strength ratings from internationally recognized rating agencies in relation to the Company’s principal financial guaranty insurance and reinsurance subsidiaries:
| Rating agency | | Rating | |
|
| Standard & Poor’s | | AAA | |
| Fitch | | AAA | |
| Moody’s Investor Services | | Aaa | |
|
There can be no assurance that any such ratings will be retained for any period of time or that they will not be qualified, suspended, revised downward or withdrawn entirely by such agencies.
In addition, XL Capital Ltd. currently has the following long term debt ratings: “a–” (Outlook Negative) from A.M. Best, “A” (Negative) from Standard and Poor’s, “A2” (Stable) from Moody’s and “A” (Stable) from Fitch.
Financial Condition
At June 30, 2004 total investments available for sale and cash, net of unsettled investment trades, were $26.0 billion compared to $23.1 billion at December 31, 2003. This increase in investment assets related primarily to proceeds of notes payable and the issuance of equity units of $800.2 million, cash flow generated from operating activities for the quarter of $2.0 billion, and the receipt of deposit liabilities of $682.3 million. Of the Company’s total investments available for sale, including fixed maturities, short-term investments and equity securities, at June 30, 2004, approximately 99% was managed by several outside investment management firms. Approximately 95.5% of fixed maturity and short-term investments are investment grade, with 67.5% rated “Aa” or “AA” or better by a nationally recognized rating agency. Using the Standard & Poor’s rating scale, the average quality of the fixed income portfolio was “AA”.
As a significant portion of the Company’s net premium written incepts in the first half of the year, certain assets and liabilities have increased at June 30, 2004 compared to December 31, 2003. This includes deferred acquisition costs, unearned premiums, premiums receivable and prepaid reinsurance premiums. For the six months ended June 30, 2004, currency translation adjustment losses were $17.8 million. This is shown as part of accumulated other comprehensive income and primarily related to unrealized losses on foreign currency exchange rate movement in those operations where the functional currency is not the U.S. dollar.
The Company establishes reserves to provide for estimated claims, the general expenses of administering the claims adjustment process and for losses incurred but not reported. These reserves are calculated using actuarial and other reserving techniques to project the estimated ultimate net liability for losses and loss expenses. The Company’s reserving practices, and the establishment of any particular reserve, reflect management’s judgment concerning sound financial practice and do not represent any admission of liability with respect to any claims made against the Company. No assurance can be given that actual claims made and payments related thereto will not be in excess of the amounts reserved.
48
Included in unpaid loss and loss expenses recoverable at June 30, 2004 is an unsecured, net recoverable from Winterthur Swiss Insurance Company (the “Seller”) of $925 million, related to certain contractual arrangements from the Company’s acquisition of Winterthur International in July 2001. This amount is subject to ongoing adjustment as described below, and the Seller is currently rated “A” (negative credit watch) by S&P. The sale and purchase agreement, as amended, including the amendments filed as Exhibits 10.15 and 10.16 to this Report (“SPA”), provides the Company with post-closing protection determined as of June 30, 2004 with respect to, among other things, adverse development of net loss and unearned premium reserves relating to the acquired Winterthur International business. This protection is based upon net loss experience and development over a three-year, post-closing seasoning period based on actual loss development experience, collectible reinsurance and certain other factors set forth in the SPA. The SPA includes a process for determining the adjustment amount due from the Seller, which process contemplates negotiation between the parties and, if no agreement is reached, a binding determination by an independent actuary in London who must select one of the two numbers submitted by the parties based on which of these is closest to the amount determined by the independent actuary. In addition, the Seller provides protection to the Company with respect to reinsurance recoverables related to the Winterthur International acquisition in the aggregate amount of $2.3 billion as of June 30, 2004; certain reinsurers responsible for some portions thereof have raised issues as to whether amounts claimed are due and the resolution of those discussions is also currently ongoing. The Company expects that the process will likely result in a material increase in the net recoverable from the Seller, the ultimate amount of which presently is not determinable. The Company may recognize a loss in future periods if the amount finally agreed or determined to be due to the Company from the Seller is less than the adverse development of net loss and unearned premium reserves and any unrecovered amounts included within reinsurance recoverables related to the Winterthur International acquisition or to the extent that any amount proves to be uncollectible from the Seller for any reason.
Inflation can, among other things, potentially result in larger claims. The Company’s underwriting philosophy is to adjust premiums in response to inflation.
Liquidity and Capital Resources
As at June 30, 2004, the Company had bank, letter of credit and loan facilities available from a variety of sources including commercial banks totaling $7.6 billion, of which $2.7 billion in debt was outstanding. In addition, $2.8 billion of letters of credit were outstanding as of June 30, 2004, 8% of which were collateralized by the Company’s investment portfolio, principally supporting U.S. non-admitted business and the Company’s Lloyd’s capital requirements.
In May 2004, the Company paid $15.0 million to the holders of record as at close of business on May 26, 2004, of its Zero Coupon Convertible Debentures (“CARZ”) originally issued in May 2001. No bondholders put bonds to the Company and, consequently, all bonds remain outstanding. The next put date for these securities is May 23, 2006. The LYONs may be “put” at their accreted value or converted by the bondholders at various times prior to the 2021 redemption date. The next “put” date is September 7, 2004. The Company may also choose to “call” the debt at its accreted value from that same date. To the extent that holders of the LYONs tender any debentures for repurchase by the Company on September 7, 2004, the Company has elected to pay all of the purchase price for such debentures in cash. The Company believes that it has the appropriate liquid resources in place to make such a payment should the holders elect to exercise this option.
In March, 2004 the Company issued 33 million 6.5% Equity Security Units (“Units”) in a public offering. The Company received approximately $800.2 million in proceeds from the sale of the Units after deducting underwriting discounts. The Company intends to use the net proceeds from the sale of the Units for general corporate purposes.
Each Unit has a stated amount of $25 and consists of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Company’s Class A Ordinary Shares (“ordinary shares”) on May 15, 2007 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due May 15, 2009 with a principal amount of $1,000. The senior notes are pledged by the holders to secure their obligations under the purchase contract. The number of shares issued under the purchase contract is contingently adjustable based on, among other things the share price of the Company on the stock purchase date and the dividend rate of the Company. The Company will make quarterly payments at the annual rate of 3.97% and 2.53% under the purchase contracts and senior notes, respectively. The Company may defer the contract payments on the purchase contract, but not the senior notes, until the stock purchase date. In May 2007, the senior notes will be remarketed whereby the interest
49
rate on the senior notes will be reset in order to generate sufficient remarketing proceeds to satisfy the Unit holders’ obligation under the purchase contract. If the senior notes are not successfully remarketed, then the Company will exercise its rights as a secured party and may retain or dispose of the senior notes to satisfy in full the holder’s obligation to purchase its ordinary shares under the purchase contracts.
The Company entered into three new bilateral unsecured letter of credit facilities in 2004 to provide additional capacity to support the Company’s U.S. non-admitted business. The new facilities totaled $125.0 million of which $50.0 million was utilized at June 30, 2004. Two of these facilities totaling $75.0 million were subsequently cancelled effective June 30, 2004.
The Company replaced its principal $2.5 billion credit and letter of credit facility which expired on June 23, 2004, with a new $1.0 billion facility which expires on June 22, 2005, and a new $2.0 billion facility which expires on June 22, 2007. Both facilities are available to provide revolving credit ($600.0 million in the aggregate) and letters of credit ($3.0 billion in the aggregate) and are syndicated and unsecured. The $1.0 billion facility was unutilized at June 30, 2004, and approximately $1.7 billion of the $2.0 billion facility was utilized to provide letters of credit at June 30, 2004.
The following tables present the Company’s indebtedness under outstanding securities and lenders’ commitments as at June 30, 2004:
(U.S. dollars in thousands)
(Unaudited)
| | | | | | | | | Payments Due By Period | |
|
| | | | | | | Year Of | | Less Than | | 1 To 3 | | 4 To 5 | | After 5 | |
| Notes Payable And Debt | | Commitment | | In Use | | Expiry | | 1 Year | | Years | | Years | | Years | |
|
| Revolving credit facilities | $ | 600,000 | $ | — | | 2004 | $ | — | $ | — | $ | — | $ | — | |
| 7.15% Senior Notes | | 99,990 | | 99,990 | | 2005 | | — | | 100,000 | | — | | — | |
| 6.58% Guaranteed Senior Notes | | 255,000 | | 255,000 | | 2011 | | — | | — | | — | | 255,000 | |
| 6.50% Guaranteed Senior Notes (1) | | 597,600 | | 597,600 | | 2012 | | — | | — | | — | | 600,000 | |
Zero Coupon Convertible
Debentures (“CARZ”) (1) | | 650,670 | | 650,670 | | 2021 | | — | | — | | — | | 1,010,833 | |
Liquid Yield Option Notes™
(“LYONS”) (1) | | 315,108 | | 315,108 | | 2021 | | — | | — | | — | | 514,622 | |
| 2.53% Senior Notes (2) | | 825,000 | | 825,000 | | 2009 | | — | | — | | 825,000 | | — | |
|
| Total | $ | 3,343,368 | $ | 2,743,368 | | | $ | — | $ | 100,000 | $ | 825,000 | $ | 2,380,455 | |
|
|
| |
| |
| | | (1) | | “Commitment” and “In Use” data represent June 30, 2004 accreted values. “Payments due by period” represents ultimate redemption values. The convertibles may be “put” or converted by the bondholders at various times prior to the 2021 redemption dates. The next “put” date is May 23, 2006 for the CARZ and September 7, 2004 for the LYONs. The Company may also choose to “call” the debt from May and September 2004 onwards for the CARZ and LYONS, respectively. | |
| | | (2) | | The 2.53% Senior Notes are a component of the Units issued in March 2004. In addition to the Senior Notes coupon of 2.53%, contract adjustment payments of 3.97% per annum are being paid on forward purchase contracts for ordinary shares for a total distribution per annum on the Units of 6.50%. The forward purchase contracts mature on May 15, 2007, and the Senior Notes will mature on May 15, 2009. | |
The total pre-tax interest expense on the borrowings described above was $28.8 million and $21.8 million for the three months ended June 30, 2004 and 2003, respectively.
The following table presents, as at June 30, 2004, the Company’s letter of credit facilities available and in use and when those facilities are due to expire:
(U.S. dollars in thousands)
(Unaudited)
| | | | | | | | | Amount of Commitment | |
| | | | | | | | | Expiration Per Period | |
|
| | | | | | | Year Of | | Less Than | | 1 To 3 | | 4 To 5 | | After 5 | |
| Other Commercial Commitments | | Commitment | | In Use | | Expiry | | 1 Year | | Years | | Years | | Years | |
|
| Letter of Credit Facilities | $ | 4,264,153 | $ | 2,843,563 | | 2004-7 | $ | 2,264,153 | $ | 2,000,000 | $ | — | $ | — | |
|
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are principally utilized to support non-admitted insurance and reinsurance operations in the United States and capital requirements at Lloyd’s. In addition to letters of credit, the Company has established insurance
50
trusts in the U.S. that provide cedents with statutory relief under state insurance regulations in the U.S. It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedents. This could take the form of additional insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business.
For information regarding cross-default and certain other provisions in the Company’s debt and convertible securities documents, see Item 7 of the Company’s Form 10-K for the year ended December 31, 2003.
The Company has had several share repurchase programs in the past as part of its capital management strategy. On January 9, 2000, the Board of Directors authorized a program for the repurchase of shares up to $500.0 million. Under this plan, the Company has purchased 6.6 million shares at an aggregate cost of $364.6 million or an average cost of $55.24 per share. The Company has $135.4 million remaining in its share repurchase authorization. During the six months ended June 30, 2004, no shares were repurchased in the open market. The Company has repurchased shares from employees and directors in relation to withholding tax on restricted stock. See Part II Item 2
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. Any prospectus, prospectus supplement, the Company’s Annual Report to ordinary shareholders, any proxy statement, any other Form 10-K, Form 10-Q or Form 8-K of the Company or any other written or oral statements made by or on behalf of the Company may include forward looking statements which reflect the Company’s current views with respect to future events and financial performance. Such statements include forward-looking statements both with respect to the Company in general, and to the insurance, reinsurance and financial products and services sectors in particular (both as to underwriting and investment matters). Statements which include the words “expect”, “intend”, “plan”, “believe”, “project”, “anticipate”, “will”, and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the PSLRA or otherwise.
All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. The Company believes that these factors include, but are not limited to, the following: (i) the timely and full recoverability of reinsurance placed by the Company with third parties, or other amounts due to the Company, including, without limitation, amounts due to the Company from the Seller in connection with the Company’s acquisition of the Winterthur International operations; (ii) the projected amount of ceded reinsurance recoverables and the ratings and creditworthiness of reinsurers may change; (iii) the timing of claims payments being faster or the receipt of reinsurance recoverables being slower than anticipated by the Company; (iv) ineffectiveness or obsolescence of the Company’s business strategy due to changes in current or future market conditions; (v) increased competition on the basis of pricing, capacity, coverage terms or other factors; (vi) greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than the Company’s underwriting, reserving or investment practices anticipate based on historical experience or industry data; (vii) developments in the world’s financial and capital markets which adversely affect the performance of the Company’s investments and the Company’s access to such markets; (viii) the potential impact on the Company from government-mandated insurance coverage for acts of terrorism; (ix) the potential impact of variable interest entities or other off-balance sheet arrangements on the Company; (x) developments in bankruptcy proceedings or other developments related to bankruptcies of companies insofar as they affect property and casualty insurance and reinsurance coverages or claims that the Company may have as a counterparty; (xi) availability of borrowings and letters of credit under the Company’s credit facilities; (xii) changes in regulation or tax laws applicable to the Company or its subsidiaries, brokers or customers; (xiii) acceptance of the Company’s products and services, including new products and services; (xiv) changes in the availability, cost or quality of reinsurance; (xv) changes in the distribution or placement of risks due to increased consolidation of insurance and reinsurance brokers; (xvi) loss of key personnel; (xvii) the effects of mergers, acquisitions and divestitures; (xviii) changes in rating agency policies or practices; (xix) changes in accounting policies or practices or the application thereof; (xx) legislative or regulatory developments; (xxi) changes in general economic conditions, including inflation, foreign currency exchange rates and other factors; (xxii) the effects of business disruption or economic contraction due to war, terrorism or other hostilities; and (xxiii) the other factors set forth in the Company’s other documents on file with the SEC. The foregoing review of important factors should not be construed
51
as exhaustive and should be read in conjunction with the other cautionary statements that are included herein or elsewhere. The Company undertakes no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Except as described below, there have been no material changes in the Company’s market risk exposures, or how those exposures are managed, since December 31, 2003. The following discussion should be read in conjunction with “Quantitative and Qualitative Disclosures About Market Risk” presented under Item 7A of the Company’s Form 10-K for the year ended December 31, 2003.
The Company enters into derivatives and other financial instruments primarily for risk management purposes. The Company’s derivative transactions can expose the Company to credit default swap risk, weather and energy risk, investment market risk, interest rate risk and foreign currency exchange rate risk. The Company attempts to manage these risks based on guidelines established by senior management. Derivative instruments are carried at fair value with resulting changes in fair value recognized in income in the period in which they occur.
Value-at-risk (“VaR”) is one of the tools used by management to estimate potential losses in fair values using historical rates, market movements and credit spreads to estimate the volatility and correlation of these factors to calculate the potential loss that could occur over a defined period of time given a certain probability.
This risk management discussion and the estimated amounts generated from the sensitivity and VaR analyses presented in this document are forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these estimated results due to, among other things, actual developments in the global financial markets. The results of analysis used by the Company to assess and mitigate risk should not be considered projections of future events of losses. See generally “Cautionary Note Regarding Forward-Looking Statements.”
Credit Default Swaps
The Company has written certain financial guaranty transactions in derivative or swap form. The Company does not actively trade these transactions and generally issues and holds these contracts to maturity. Changes in fair value can result from changes in market credit spreads, supply and demand for similar type instruments, changes in future loss and/or recovery estimates, interest rates and credit rating upgrades or downgrades. The Company therefore is at risk for changes in fair value due to changes in any of the above factors.
Weather and Energy Market Risk
The Company offers weather and energy risk management products in insurance or derivative form to end-users, while managing the risks in the over-the-counter and exchange traded derivatives markets in a weather and energy derivatives trading portfolio.
Fair values for the Company’s natural gas derivative contracts are determined through the use of quoted market prices. As quoted market prices are not widely available in the weather derivative market, management uses available market data and internal pricing models based upon consistent statistical methodologies to estimate fair values. Estimating fair value of instruments which do not have quoted market prices requires management judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, realized and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.
52
The following table summarizes the movement in the fair value of weather and energy contracts outstanding during the six months ended June 30, 2004:
(U.S. dollars in thousands)
| | | | | (Unaudited) | |
| | | | | Six Months | |
| | | | | Ended | |
| | | | | June 30, 2004 | |
|
| Fair value of contracts outstanding, beginning of the year | | | $ | (11,490) | |
| Option premiums received, net of premiums realized (1) | | | | 19,436 | |
| Reclassification of settled contracts to realized (2) | | | | 40,677 | |
| Other changes in fair value (3) | | | | (42,583) | |
|
| Fair value of contracts outstanding, end of period | | | $ | 6,040 | |
|
|
| |
| |
| | | (1) | | The Company collected $17.4 million of paid premiums and realized $36.8 million of premiums on expired transactions for a net increase in the balance sheet derivative asset of $19.4 million. | |
| | | (2) | | The Company paid $40.7 million to settle derivative positions during the period resulting in a reclassification of this amount from unrealized to realized and an increase in the derivative asset on the balance sheet. | |
| | | (3) | | This represents the effects of changes in commodity prices, the time value of options, and other valuation adjustments of ($42.6) million on the Company’s derivative positions, primarily attributable to hedges of the positions that realized $36.8 million of premiums. | |
The change in the fair value of contracts outstanding at June 30, 2004 as compared to the beginning of the year is primarily due to the expiration of natural gas positions, which were not replaced due to management’s decision to reduce the size of its natural gas portfolio.
The following table summarizes the maturity of contracts outstanding as of June 30, 2004:
(U.S. dollars in thousands)
(Unaudited)
| | | | | Less Than | | | | | | Greater Than | | Total | |
| Source Of Fair Value | | | | 1 Year | | 1-3 Years | | 4-5 Years | | 5 Years | | Fair Value | |
|
| Prices actively quoted | | | $ | (1,502) | $ | — | $ | — | $ | — | $ | (1,502) | |
Prices based on models and other
valuation methods | | | | (1,910) | | 9,326 | | 126 | | | | 7,542 | |
|
| Total fair value of contracts outstanding | | | $ | (3,412) | $ | 9,326 | $ | 126 | $ | — | $ | 6,040 | |
|
|
The Company manages its weather and energy portfolio through the employment of a variety of strategies. These include geographical and directional diversification of risk exposures and direct hedging within the capital and reinsurance markets. Risk management is undertaken on a product portfolio-wide basis, to maintain a portfolio that the Company believes is well diversified and which remains within the aggregate risk tolerance established by the Company’s senior management.
The Company’s aggregate average, low and high seasonal VaR amounts for its weather risk management portfolio, calculated at a 99% confidence level, during the period ended June 30, 2004 were $163.2 million, $126.5 million and $214.0 million, respectively. The corresponding levels for the weather risk management portfolio during the period ended June 30, 2003 were $151.8 million, $131.8 million and $175.6 million, respectively. The Company calculates its aggregate VaR by summing the VaR amounts for each of its seasonal portfolios. The Company’s aggregation methodology yields a conservative aggregate portfolio VaR, given that current weather events and patterns have an immaterial effect on expectations for future seasons and the Company could therefore greatly reduce or eliminate its VaR on future seasons by selling its positions prior to the beginning of a season. At present, the Company’s VaR calculation does not exceed $80.0 million in any one season or $95.0 million prior to the start of the winter season in the then current year.
For the natural gas portfolio, VaR is calculated using a one-day holding period. Management has established a daily VaR limit for this portfolio of $0.3 million. The Company’s average, low and high daily VaR amounts calculated at a 99% confidence level, during the period ended June 30, 2004 were $0.1 million, nil and $0.2 million, respectively. The corresponding amounts during the period ended June 30, 2003 were $2.4 million, $1.8 million and $2.9 million, respectively.
53
For electricity generation outage insurance products, VaR is calculated using an annual holding period. Management has established an annual VaR limit of $25 million for this book of business. The Company’s average, low and high annual VaR amounts, calculated at a 99% confidence level, during the period ended June 30, 2004 were $4.2 million, $2.6 million, and $7.6 million, respectively. The corresponding amounts during the period ended June 30, 2003 were $3.2 million, $1.3 million, and $5.3 million, respectively.
Investment Market Risk
The Company’s investment portfolio consists of exposures to fixed income securities, equities, alternative investments, derivatives, business and other investments and cash. These securities and investments are denominated in both U.S. dollar and foreign currencies.
Through the structure of the Company’s investment portfolio, the Company’s book value is directly affected by changes in the valuations of the securities and investments held in the investment portfolio. These valuation changes reflect changes in fixed income security prices (e.g. slope and curvature of the yield curves, volatility of interest rates, credit spreads and mortgage prepayment speeds), equity prices (e.g. changes in prices and volatilities of individual securities, equity baskets and equity indices) and foreign currency exchange rates (e.g. changes in spot prices, forward prices and volatilities of currency rates). Market risk therefore arises due to the uncertainty surrounding the future valuations of these different assets, the factors that impact their values and the impact that this could have on the Company’s book value.
The Company generally seeks to manage the risks of the investment portfolio through a combination of asset class, country, industry and security level diversification and investment manager allocations. Further, individual security and issuer exposures are generally controlled and monitored at the investment portfolio level, via specific investment constraints outlined in investment guidelines and agreed with the appropriate external investment professionals. Additional constraints may be agreed with the external investment professionals that may address exposures to eligible securities, prohibited investments/transactions, credit quality and general concentration limits.
The Company’s direct use of investment derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, references rates or a combination of these factors. When investment guidelines allow for the use of derivatives, these can generally only be used for the purposes of managing interest rate risk, foreign exchange risk and credit risk, provided the use of such instruments is incorporated in the overall portfolio duration, spread, convexity and other relevant portfolio metrics. The direct use of derivatives is not permitted to economically leverage the portfolio outside of the stated guidelines. Derivatives may also be used to add value to the investment portfolio where market inefficiencies are perceived to exist, to utilize cash holdings to purchase equity indexed derivatives and to adjust the duration of a portfolio of fixed income securities to match the duration of related deposit liabilities.
Investment Value-At-Risk
In the third quarter of 2003, the Company introduced a new, more widely used risk management system to generate the investment VaR and to stress test the investment portfolio. Although the overall methodology is consistent between the two systems, there are certain differences between these systems relating to security pricing models, time series, time periods and proxies used for individual instruments. Accordingly, the VaR for the investment portfolio and the stress tests on the investment portfolio are not directly comparable to periods prior to the fourth quarter of 2003.
The VaR of the total investment portfolio at June 30, 2004, based on a 95% confidence level with a one month holding period, was approximately $564.1 million. The VaR of all investment related derivatives as at June 30, 2004 was approximately $11.3 million. The Company’s investment portfolio VaR as at June 30, 2004 is not necessarily indicative of future VaR levels.
To complement the VaR analysis which is based on normal market environments, the Company considers the impact on the investment portfolio in several different historical stress periods to analyze the effect of unusual market conditions. The Company establishes certain historical stress test scenarios which are applied to the actual investment portfolio. As these stress tests and estimated gains and losses are based on historical events, they will not necessarily reflect future stress events or gains and losses from such events. The results of the stress test scenarios are reviewed on a regular basis to ensure they reflect current shareholders equity, market conditions and the Company’s total risk profile. Given the investment portfolio allocations as at June 30, 2004, the Company would expect to lose approximately
54
5.6% of the portfolio if the most damaging event stress tested was repeated, all other things held equal. Given the investment portfolio allocations as at June 30, 2004, the Company would expect to gain approximately 18.4% on the portfolio if the most favorable event stress tested was repeated, all other things held equal. The Company assumes that no action is taken during the stress period to either liquidate or rebalance the portfolio and believes that this fairly reflects the potential decreased liquidity that is often associated with stressed market environments.
Fixed Income Portfolio
The Company’s fixed income portfolio is exposed to credit and interest rate risk through its portfolio of debt securities. The fixed income portfolio includes fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased.
As at June 30, 2004, the value of the Company’s fixed income portfolio, including cash and cash equivalents and net payable for investments purchased, was approximately $25.4 billion as compared to approximately $20.0 billion at June 30, 2003. As at June 30, 2004, the fixed income portfolio consisted of approximately 89.1% of the total investment portfolio (including cash and cash equivalents, and net payable for investments purchased) as compared to approximately 87.8% as at June 30, 2003.
The table below shows the Company’s fixed income portfolio by credit rating in percentage terms of the Company’s total fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased) as at June 30, 2004.
| | | Total |
|
| AAA | | 55.7% |
| AA | | 11.8% |
| A | | 17.5% |
| BBB | | 10.5% |
| BB & BELOW | | 4.1% |
| NR | | 0.4% |
|
| Total | | 100.0% |
At June 30, 2004 the average credit quality of the Company’s total fixed income portfolio was “AA”.
As at June 30, 2004, the top 10 corporate holdings represented approximately 8.2% of the total fixed income portfolio and approximately 33.8% of all corporate holdings. The top 10 corporate holdings listed below utilizes a conservative approach to aggregation as it includes unsecured as well as securitized, credit enhanced and collateralized securities issued by parent companies and their affiliates.
| Top 10 Corporate Holdings (2) | | | | Percentage of Total Fixed Income Portfolio (1) | |
|
| Citigroup Inc | | | | 1.31% | |
| JPMorgan Chase & Co (3) | | | | 1.29% | |
| Bank of America Corporation | | | | 1.11% | |
| Morgan Stanley | | | | 0.83% | |
| Bear, Stearns & Co. Inc | | | | 0.65% | |
| MBNA Corp | | | | 0.63% | |
| General Electric Company | | | | 0.60% | |
| DaimlerChrysler AG | | | | 0.60% | |
| Bank One Corp (3) | | | | 0.58% | |
| Washington Mutual Inc | | | | 0.56% |
|
|
| |
| |
| | | (1) | | Including fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased. | |
| | | (2) | | Corporate holdings include parent and affiliated companies that issue fixed income securities. In some cases a portion of the market value may be invested in bonds that are securitized or have sufficient credit enhancement that provides a long-term credit rating that is higher than the rating of the unsecured debt of the parent company. | |
| | | (3) | | Effective July 1, 2004 JPMorgan Chase & Co and Bank One Corp have merged. | |
The Company’s fixed income portfolio is exposed to interest rate risk. Interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. The hypothetical case of an immediate 100 basis point adverse parallel shift in global bond curves as at June 30, 2004 would decrease the fair value of the Company’s fixed income portfolio by approximately 4.5% or $1.1 billion as compared to approximately 5.0% or $0.8 billion as at June 30,
55
2003. Based on historical observations, it is unlikely that all global yield curves would shift in the same direction, by the same amount and at the same time.
Equity Portfolio
As at June 30, 2004, the Company’s equity portfolio was $651.0 million as compared to $550.0 million as at June 30, 2003. As at June 30, 2004, the Company’s allocation to equity securities was approximately 2.3% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net payable for investments purchased) as compared to approximately 2.4% as at June 30, 2003.
As at June 30, 2004, approximately 56.8% of the equity portfolio was invested in U.S. companies as compared to approximately 35.0% as at June 30, 2003. As at June 30, 2004, the top ten equity holdings represented approximately 7.8% of the Company’s total equity portfolio as compared to approximately 7.6% as at June 30, 2003.
The Company’s equity portfolio is exposed to price risk. Equity price risk is the potential loss arising from decreases in the market value of equities. An immediate hypothetical 10% change in the value of each equity position would affect the fair value of the portfolio by approximately $65.1 million as at June 30, 2004 as compared to $55.0 million as at June 30, 2003.
Alternative Investment Portfolio
The Company’s alternative investment portfolio (included in investments in affiliates or other investments) had approximately 100 separate investments in different funds at June 30, 2004 with a total portfolio of $1.6 billion representing approximately 5.5% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net payable for investments purchased) as compared to June 30, 2003 where the Company had approximately 100 separate fund investments with a total exposure of $1.4 billion representing approximately 6.0% of the total investment portfolio.
As at June 30, 2004, the alternative investment style allocation was 24.0% in arbitrage strategies, 42.0% in directional/tactical strategies, 25.0% in event driven strategies and 9.0% in multi-strategy strategies.
Private Investment Portfolio
As at June 30, 2004, the Company’s exposure to private investments was approximately $195.8 million compared to $191.2 million as at June 30, 2003. As at June 30, 2004, the Company’s exposure to private investments consisted of approximately 0.7% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net payable for investments purchased), as compared to 0.8% as at June 30, 2003.
Bond and Stock Index Futures Exposure
As at June 30, 2004, bond and stock index futures outstanding were $41.6 million with underlying investments having a market value of $265.3 million. A 10% appreciation or depreciation of these derivative instruments would have resulted in realized gains and realized losses of $4.1 million respectively. The Company reduces its exposure to these futures through offsetting transactions, including options and forwards.
Foreign Currency Exchange Risk
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of its foreign currency fixed maturities and certain of its foreign currency equity investments. These contracts are not designated as specific hedges for financial reporting purposes and, therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of three months or less. At June 30, 2004 and 2003, forward foreign exchange contracts with notional principal amounts totaling $271.0 million and $62.0 million, respectively, were outstanding. The fair value of these contracts as at June 30, 2004 and 2003 was $266.0 million and $59.4 million, respectively, with an unrealized gain of $5.0 million in 2004 and an unrealized gain of $2.6 million in 2003. For the six months ended June 30, 2004 and 2003, realized losses of $3.0 million and realized gains of $1.6 million, respectively, and unrealized gains of $1.3 million and of $3.8 million, respectively, were recorded in net realized and unrealized gains and losses on derivative instruments.
56
The Company attempts to manage the exchange volatility arising on certain costs denominated in foreign currencies. Throughout the year, forward contracts are entered into to acquire foreign currencies at an agreed rate in the future. At June 30, 2004, the Company had forward contracts outstanding for the purchase of the equivalent of $207.2 million in Euros and the equivalent of $99.8 million in GBP at fixed rates. The unrealized loss on these contracts at June 30, 2004 was $5.9 million and $1.4 million, respectively.
ITEM 4. CONTROLS AND PROCEDURES
The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of disclosure controls and procedures pursuant to Rules 13a-15 and 15d-15 promulgated under the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures are effective to provide reasonable assurance that all material information relating to the Company required to be filed in this report has been made known to them in a timely fashion. There have been no changes in internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
The Company’s management, including the Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls or its internal controls will prevent all errors and all fraud. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. As a result of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. As a result of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Accordingly, the Company’s disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the disclosure controls and procedures are met.
57
XL CAPITAL LTD
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On March 17, 2004, certain current and former directors and officers of the Company were named as defendants in a putative “shareholder derivative complaint” (Marilyn Clark, Derivatively on Behalf of XL Capital Ltd v. Brian O’Hara et al.) filed in Connecticut Superior Court by a California shareholder (the “Action”). The Company is named as a nominal defendant. The complaint alleges several causes of action including breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment during the time period “from November 2001 to the present” (the “Relevant Period”). The Action alleges that the Company maintained inadequate loss reserves for its NAC Re subsidiary (now known as XL Reinsurance America, Inc.) during the Relevant Period and that, as a consequence, the Company’s earnings and assets were materially overstated. The relief sought against certain of the defendants includes profits made on sales of the Company’s shares over a two year period. Defendants have filed a motion to dismiss the complaint on various grounds including lack of subject matter jurisdiction and that it has been filed in an incorrect forum. If the complaint is not dismissed, the defendants intend to vigorously defend the claims asserted against them. There has been no discovery in the Action.
On June 21, 2004, a consolidated and amended class action complaint (the “Amended Complaint”) was served on the Company and certain of its present and former directors and officers as defendants in a putative class action (Malin et al. v. XL Capital Ltd et al.) filed in United States District Court, District of Connecticut (the “Malin Action”). The Malin Action purports to be on behalf of purchasers of the Company’s common stock between November 1, 2001 and October 16, 2003, and alleges claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder (“Securities Laws”). The Amended Complaint alleges that the defendants violated the Securities Laws by, among other things, failing to disclose in various public and shareholder and investor reports and other communications the alleged inadequacy of the Company’s loss reserves for its NAC Re subsidiary (now known as XL Reinsurance America, Inc.) and that, as a consequence, the Company’s earnings and assets were materially overstated. The time for the Company and the individual defendants to respond to the Amended Complaint has not occurred and there has been no discovery in the Malin Action. The Company and the defendant present and former officers and directors intend to vigorously defend the claims asserted against them.
On June 17, 2004, William Kronenberg, III, Frank A. Piliero and David M. Rosenberg (together, the “Claimants”) commenced an arbitration against the Company before the American Arbitration Association (“AAA”) in New York, New York. The Claimants and the Company were parties to a stock purchase agreement dated June 1, 1999, pursuant to which the Company acquired the outstanding capital stock of ECS, Inc (the “Stock Purchase Agreement”). In their AAA arbitration demand, the Claimants assert claims of fraud and deceitful conduct, negligent misrepresentation, and breach of contract and a covenant of good faith and fair dealing, all relating to the allegation that the Company failed to make certain contingent payments allegedly due to Claimants under the Stock Purchase Agreement. Claimants seek $85 million (the maximum amount payable under the contingent payment provision at issue), plus punitive damages, interest, costs and attorneys’ fees. On July 30, 2004, the Company filed an Answering Statement and Motion to Stay or Dismiss the AAA arbitration. On April 13, 2004, the Company commenced a separate arbitration procedure, as provided in the Stock Purchase Agreement, but the Claimants have refused to participate in such procedure. On July 15, 2004, the Company filed a petition in the United States District Court for the Southern District of New York, seeking an order of the Court compelling the Claimants to arbitrate the dispute pursuant to those procedures and staying or dismissing the AAA arbitration. Oral argument for the petition is scheduled for August 10, 2004. The Company intends to vigorously defend against the Claimants’ claims.
On July 15, 2003, the Company and Messrs. Esposito and O’Hara were named in a Consolidated Amended Class Action Complaint (the “Amended Complaint”) filed by certain shareholders of Annuity and Life Re (Holdings), Ltd. (“ANR”) against ANR and certain present and former officers and directors of ANR in the United States District Court for the District of Connecticut seeking unspecified money damages on behalf of purchasers of ANR stock. Schnall v. Annuity and Life Re (Holdings), Ltd., Civil Action No. 02-CV-2133 (GLG) (the “Schnall Action”). The plaintiffs claim that the defendants violated certain provisions of the United States securities laws by making (or being responsible as alleged controlling persons for) various alleged material misstatements and omissions in public filings and press releases of ANR. On July 19, 2004, an agreement in principle was reached with plaintiffs to settle the Schnall Action. The settlement is without any admission of liability or wrongdoing and would include a nominal cash payment by the Company. The settlement is subject to certain approvals, full documentation, notice to the class,
58
court approval and certain other steps required to consummate a class action settlement.
The Company is also subject to litigation and arbitration in the normal course of its business. These lawsuits and arbitrations principally involve claims on policies and are typical for the Company and for the property and casualty insurance and reinsurance industry in general. Such legal proceedings are considered in connection with the Company’s loss and loss expense reserves. Reserves in varying amounts may or may not be established in respect of particular claims proceedings based on many factors, including the legal merits thereof and other factors. In addition to claims litigation, the Company and its subsidiaries are subject to lawsuits in the normal course of business that do not arise from or directly relate to claims on insurance or reinsurance policies.
The Company believes that the ultimate outcomes of all outstanding litigation and arbitration will not have a material adverse effect on its consolidated financial condition, future operating results and/or liquidity, although an adverse resolution of a number of these items could have a material adverse effect on the Company’s results of operations in a particular fiscal quarter or year.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
The following table provides information about purchases by the Company during the quarter ended June 30, 2004 of equity securities that are registered by the company pursuant to Section 12 of the Exchange Act:
ISSUER PURCHASES OF EQUITY SECURITIES
| | | | | | | | | Total Number | | Approximate Dollar | |
| | | | | | | | | of Shares | | Value of Shares | |
| | | | | | | | | Purchased as | | that May Yet Be | |
| | | | | | | | | Part of | | Purchased Under | |
| | | | | Total Number | | Average Price | | Publicly | | the Plans | |
| | | | | of Shares | | Paid | | Announced Plans | | or Programs | |
| Period | | | | Purchased (1) | | per Share (2) | | or Programs | | (3) | |
|
| April 1-30, 2004 | | | | 34,879 | $ | 76.71 | | — | | $ | 135.4 million | |
| May 1-31, 2004 | | | | — | | — | | — | | $ | 135.4 million | |
| June 1-30, 2004 | | | | — | | — | | — | | $ | 135.4 million | |
| Total | | | | 34,879 | $ | 76.71 | | — | | $ | 135.4 million |
| |
|
| |
| |
| | | (1) | | All of the shares included in each period were purchased in connection with the vesting of restricted shares granted under the Company’s restricted stock plan. All of these purchases were made in connection with satisfying tax withholding obligations of those employees. These shares were not purchased as part of the Company’s publicly announced share repurchase program. | |
| | | (2) | | The price paid per share is the closing price of the shares on the vesting date. | |
| | | (3) | | On January 9, 2000, the Board of Directors previously authorized a $500.0 million share repurchase program. The Company did not repurchase any equity securities under the program during the three or six months ended June 30, 2004. As of June 30, 2004, the Company could repurchase up to approximately $135.4 million of our equity securities under the Company’s share repurchase program. | |
59
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual General Meeting of Class A Shareholders held on April 30, 2004 at the Executive Offices of the Company, XL House, One Bermudiana Road, Hamilton HM 11, Bermuda, the ordinary shareholders approved the following:
1. The election of three Class III Directors to hold office until 2007:
| | | | | Votes in Favor | | Votes Withheld | |
|
| J. Loudon | | | | 115,929,345 | | 2,256,200 | |
| R.S. Parker | | | | 116,615,861 | | 1,569,684 | |
| A. Senter | | | | 116,403,266 | | 1,782,279 |
| |
2. The appointment of PricewaterhouseCoopers LLP, New York, New York, to act as the independent auditors of the Company for the fiscal year ending December 31, 2004:
| | Votes In Favor | | Votes Against | | Abstentions | |
|
| | 116,451,445 | | 1,152,617 | | 581,483 | |
|
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
| | 10.1 | | Amendment, dated as of May 10, 2004, to (i) the Revolving Credit and Security Agreement, dated as of February 25, 2003, among XL Re Ltd, as the borrower, CAFCO, LLC, CRC Funding, LLC, CHARTA, LLC, CIESCO, LLC, Citibank, N.A. and Citicorp North America, Inc., as agent, and (ii) the Control Agreement, dated as of February 25, 2003, among XL Re Ltd, as the borrower, Citibank North America, Inc., as Agent and Mellon Bank, N.A., as the securities intermediary. | |
| | | 10.2 | | 364-Day Credit Agreement, dated as of June 23, 2004, between XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd and XL Re Ltd, as Account Parties and Guarantors, the lenders party thereto, and JPMorgan Chase Bank, as Administrative Agent. |
| | | 10.3 | | Three-Year Credit Agreement, dated as of June 23, 2004, between XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd and XL Re Ltd, as Account Parties and Guarantors, the lenders party thereto, and JPMorgan Chase Bank, as Administrative Agent. |
| | | 10.4 | | Form of Non-Statutory Stock Option Agreement (One-Time Vesting). |
| | | 10.5 | | Form of Non-Statutory Stock Option Agreement (Incremental Vesting). |
| | | 10.6 | | Form of Incentive Stock Option Agreement. |
| | | 10.7 | | Form of Restricted Stock Agreement. |
| | | 10.8 | | Form of Non-Statutory Stock Option Agreement (Renewal Form). |
| | | 10.9 | | Form of Non-Statutory Stock Option Agreement (Non-Employee Director Renewal Form). |
| | | 10.10 | | Form of Directors Restricted Stock Agreement. |
| | | 10.11 | | Form of Performance Restricted Stock Agreement. |
| | | 10.12 | | Form of Performance Restricted Stock Unit Agreement. |
| | | 10.13 | | Form of Restricted Stock Unit Agreement. |
| | | 10.14 | | Form of Director Stock Option Agreement. |
| | | 10.15 | | Agreement, dated December 24, 2003, between Winterthur Swiss Insurance Company and XL Insurance (Bermuda) Ltd (including Schedule B thereto), relating to the Second Amended and Restated Agreement for the Sale and Purchase of Winterthur International, dated February 15, 2001. |
| | | 10.16 | | Amendment Agreement, dated July 27, 2004, between Winterthur Swiss Insurance Company and XL Insurance (Bermuda) Ltd, relating to the Second Amended and Restated Agreement for the Sale and Purchase of Winterthur International, dated February 15, 2001. |
60
| | 31 | Rule 13a-14(a)/15d-14(a) Certifications. |
| | | 32 | | Section 1350 Certification. | |
| | | 99.1 | | XL Capital Assurance Inc. condensed consolidated financial statements (unaudited) for the three and six month periods ended June 30, 2004 and 2003. | |
| | | 99.2 | | XL Financial Assurance Ltd. condensed financial statements (unaudited) for the three and six month periods ended June 30, 2004 and 2003. | |
(b) Reports on Form 8-K
Current Report on Form 8-K filed on May 19, 2004, under Item 5 and Item 7 thereof.
61
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
| | XL CAPITAL LTD |
| | (Registrant) |
| | |
| Dated: August 9, 2004 | /s/ BRIAN M. O’HARA |
| |
|
| | Brian M. O’Hara |
| | President and Chief Executive Officer |
| | |
| Dated: August 9, 2004 | /s/ JERRY DE ST. PAER |
| |
|
| | Jerry de St. Paer |
| | Executive Vice President and |
| | Chief Financial Officer |
62
