SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002
COMMISSION FILE NUMBER 1-10804
XL CAPITAL LTD
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CAYMAN ISLANDS 98-0191089
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
XL HOUSE, ONE BERMUDIANA ROAD, HAMILTON, BERMUDA HM11
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES AND ZIP CODE)
(441) 292-8515
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]
As of August 2, 2002, there were 135,780,655 outstanding Class A Ordinary
Shares, $0.01 par value per share, of the registrant.
XL CAPITAL LTD
INDEX TO FORM 10-Q
Page No
------------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets as at June 30, 2002 and
December 31, 2001 (Unaudited) ............................. 3
Consolidated Statements of Income and Comprehensive
Income for the Three Months Ended June 30, 2002 and
2001 (Unaudited) and the Six Months Ended June 30, 2002
and 2001 (Unaudited) ...................................... 4
Consolidated Statements of Shareholders' Equity for the
Six Months Ended June 30, 2002 and 2001 (Unaudited) ....... 5
Consolidated Statements of Cash Flows for the Six
Months Ended June 30, 2002 and 2001 (Unaudited) ........... 6
Notes to Unaudited Consolidated Financial Statements ...... 7
Item 2. Management's Discussion and Analysis of Results of
Operations and Financial Condition ........................ 19
Item 3. Quantitative and Qualitative Disclosure about Market
Risk ...................................................... 36
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ......................................... 39
Item 4. Submission of Matters to a Vote of Shareholders ........... 39
Item 6. Exhibits and Reports on Form 8-K .......................... 39
Signatures
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
XL CAPITAL LTD
CONSOLIDATED BALANCE SHEETS
(U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
(UNAUDITED)
--------------------------
JUNE 30, DECEMBER 31,
2002 2001
------------ ------------
A S S E T S
Investments:
Fixed maturities at fair value
(amortized cost: 2002, $12,009,617;
2001, $10,945,568) ............................ $11,922,363 $10,831,927
Equity securities, at fair value
(cost: 2002, $715,702; 2001, $575,090) ........ 662,138 547,805
Short-term investments, at fair value
(amortized cost: 2002, $891,485;
2001, $1,050,015) ............................. 881,819 1,050,113
----------- -----------
Total investments available for sale ... 13,466,320 12,429,845
Investments in affiliates ....................... 1,234,174 1,037,344
Other investments ............................... 223,059 273,528
----------- -----------
Total investments ...................... 14,923,553 13,740,717
Cash and cash equivalents ......................... 2,278,754 1,863,861
Accrued investment income ......................... 196,990 180,305
Deferred acquisition costs ........................ 631,977 394,258
Prepaid reinsurance premiums ...................... 1,023,610 846,081
Premiums receivable ............................... 3,397,482 2,182,348
Reinsurance balances receivable ................... 1,448,156 1,246,106
Unpaid losses and loss expenses recoverable ....... 4,727,297 5,033,952
Goodwill and other intangible assets .............. 1,648,475 1,616,943
Deferred tax asset, net ........................... 389,675 419,222
Other assets ...................................... 523,296 439,282
----------- -----------
Total assets ........................... $31,189,265 $27,963,075
=========== ===========
L I A B I L I T I E S A N D S H A R E H O L D E R S' E Q U I T Y
Liabilities:
Unpaid losses and loss expenses ................... $12,396,503 $11,825,680
Deposit liabilities and policy benefit reserves ... 2,828,755 2,374,164
Unearned premiums ................................. 4,145,201 2,682,089
Notes payable and debt ........................... 1,863,816 1,604,877
Reinsurance balances payable ...................... 2,027,837 1,672,122
Net payable for investments purchased ............. 1,453,400 1,247,027
Other liabilities ................................. 1,045,000 1,071,402
Minority interest ................................. 53,222 48,530
----------- -----------
Total liabilities ...................... $25,813,734 $22,525,891
----------- -----------
Commitments and Contingencies
Shareholders' Equity:
Authorized, 999,990,000 Class A ordinary shares,
par value $0.01 Issued and outstanding:
(2002, 135,755,752; 2001, 134,734,491) ........ $ 1,358 $ 1,347
Contributed surplus ............................... 3,439,868 3,378,549
Accumulated other comprehensive loss .............. (193,051) (213,013)
Deferred compensation ............................. (38,038) (27,177)
Retained earnings ................................. 2,165,394 2,297,478
----------- -----------
Total shareholders' equity ............. $ 5,375,531 $ 5,437,184
----------- -----------
Total liabilities and
shareholders' equity ................. $31,189,265 $27,963,075
=========== ===========
See accompanying Notes to Consolidated Financial Statements
3
XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(U.S. DOLLARS AND SHARES IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED) (UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------------ -------------------------
2002 2001 2002 2001
----------- --------- ----------- ----------
Revenues:
Net premiums earned - general operations ......................... $ 1,068,160 $ 640,984 $ 2,101,113 $1,183,138
Net premiums earned - life operations ............................ 10,497 -- 49,690 --
Net investment income ............................................ 174,743 151,168 345,870 294,264
Net realized (losses) gains on investments ....................... (110,002) (36,098) (216,022) 26,437
Net realized and unrealized (losses) gains on derivative
instruments ................................................... (6,713) 5,026 (19,913) 2,662
Equity in net income of investment affiliates .................... 7,931 23,196 40,116 43,570
Fee income and other ............................................. 23,452 11,493 32,320 18,562
----------- --------- ----------- ----------
Total revenues ................................................ $ 1,168,068 $ 795,769 $ 2,333,174 $1,568,633
----------- --------- ----------- ----------
Expenses:
Net losses and loss expenses incurred - general operations ....... $ 844,627 $ 386,951 $ 1,491,551 $ 717,155
Claims and policy benefit reserves - life operations ............. 18,816 -- 66,579 --
Acquisition costs ................................................ 174,260 143,202 359,992 269,074
Operating expenses ............................................... 180,906 81,898 326,051 154,956
Exchange (gains) losses .......................................... (23,206) 7,608 (31,570) 6,438
Interest expense ................................................. 40,139 26,168 81,761 47,425
Amortization of intangible assets ................................ 11 14,703 625 29,171
----------- --------- ----------- ----------
Total expenses ................................................. $ 1,235,553 $ 660,530 $ 2,294,989 $1,224,219
----------- --------- ----------- ----------
(Loss) income before minority interest, income tax expense
and equity in net income of insurance and operating affiliates ... $ (67,485) $ 135,239 $ 38,185 $ 344,414
Minority interest in net income of subsidiary .................. 1,779 (652) 4,034 517
Income tax expense ............................................. 22,900 13,603 36,854 10,694
Equity in net income of insurance and operating affiliates ..... (416) (6,318) (448) (14,332)
----------- --------- ----------- ----------
Net (loss) income .................................................. $ (91,748) $ 128,606 $ (2,255) $ 347,535
----------- --------- ----------- ----------
Change in net unrealized depreciation of investments ............... $ 68,848 $ (59,299) $ (35,466) $ (109,706)
Foreign currency translation adjustments ........................... (1,649) (7,360) 55,428 (33,482)
----------- --------- ----------- ----------
Comprehensive (loss) income ........................................ $ (24,549) $ 61,947 $ 17,707 $ 204,347
=========== ========= =========== ==========
Weighted average ordinary shares and ordinary share
equivalents outstanding - basic .................................. 135,662 125,396 135,431 125,312
=========== ========= =========== ==========
Weighted average ordinary shares and ordinary share
equivalents outstanding - diluted ................................ 135,662 127,765 135,431 127,546
=========== ========= =========== ==========
Earnings per ordinary share and ordinary share
equivalent - basic ............................................... $ (0.68) $ 1.03 $ (0.02) $ 2.77
=========== ========= =========== ==========
Earnings per ordinary share and ordinary share
equivalent - diluted ............................................. $ (0.68) $ 1.01 $ (0.02) $ 2.72
=========== ========= =========== ==========
See accompanying Notes to Consolidated Financial Statements
4
XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(U.S. DOLLARS IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
----------------------------
2002 2001
----------- -----------
ORDINARY SHARES:
Balance-beginning of year .................. $ 1,347 $ 1,250
Issue of shares ............................ 2 --
Exercise of stock options .................. 9 8
Repurchase of shares ....................... -- (2)
----------- -----------
Balance-end of period .................. $ 1,358 $ 1,256
----------- -----------
CONTRIBUTED SURPLUS:
Balance-beginning of year .................. $ 3,378,549 $ 2,497,416
Issue of shares ............................ 18,219 15,993
Exercise of stock options .................. 43,100 28,633
Repurchase of shares ....................... -- (4,607)
----------- -----------
Balance-end of period .................. $ 3,439,868 $ 2,537,435
----------- -----------
ACCUMULATED OTHER COMPREHENSIVE LOSS:
Balance-beginning of year .................. $ (213,013) $ (104,712)
Net change in unrealized losses on
investment portfolio, net of tax ......... (34,309) (110,470)
Net change in unrealized gains on
investment portfolio of affiliate ........ (1,157) 764
Currency translation adjustments ........... 55,428 (33,482)
----------- -----------
Balance-end of period .................. $ (193,051) $ (247,900)
----------- -----------
DEFERRED COMPENSATION:
Balance-beginning of year ................. $ (27,177) $ (17,727)
Issue of restricted shares ................ (17,736) (15,103)
Amortization .............................. 6,875 4,775
----------- -----------
Balance-end of period .................. $ (38,038) $ (28,055)
----------- -----------
RETAINED EARNINGS:
Balance-beginning of year .................. $ 2,297,478 $ 3,197,441
Net (loss) income .......................... (2,255) 347,535
Cash dividends paid ........................ (128,255) (116,944)
Repurchase of shares ....................... (1,574) (11,454)
----------- -----------
Balance-end of period .................. $ 2,165,394 $ 3,416,578
----------- -----------
TOTAL SHAREHOLDERS' EQUITY ................... $ 5,375,531 $ 5,679,314
=========== ===========
See accompanying Notes to Consolidated Financial Statements
5
XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. DOLLARS IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
--------------------------
2002 2001
----------- -----------
CASH FLOWS PROVIDED BY (USED IN)
OPERATING ACTIVITIES:
Net (loss) income .............................. $ (2,255) $ 347,535
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Net realized losses (gains) on investments ..... 216,022 (26,437)
Net realized and unrealized losses on
derivative instruments ....................... 19,913 (2,662)
Amortization of discounts on fixed maturities .. (13,872) (21,517)
Equity in net income of investment and
insurance and operating affiliates ........... (40,564) (57,902)
Amortization of deferred compensation .......... 6,875 4,775
Amortization of intangible assets ........... 625 29,171
Accretion of deposit liabilities ............ 28,395 39,639
Unpaid losses and loss expenses ................ 32,438 373,453
Unearned premiums .............................. 1,393,714 446,861
Premiums receivable ............................ (1,142,645) (367,968)
Unpaid losses and loss expenses recoverable .... 390,789 (293,327)
Prepaid reinsurance premiums ................... (169,155) (79,489)
Reinsurance balances receivable ................ (139,317) (86,229)
Deferred acquisition costs ..................... (237,219) (69,323)
Reinsurance balances payable ................... 286,548 106,038
Deferred tax asset ............................. 33,111 (10,571)
Other .......................................... (98,767) 102,515
----------- -----------
Total adjustments ...................... 566,891 87,027
----------- -----------
Net cash provided by operating activities ...... 564,636 434,562
----------- -----------
CASH FLOWS PROVIDED BY (USED IN)
INVESTING ACTIVITIES:
Proceeds from sale of fixed maturities and
short-term investments ....................... 22,304,489 13,857,761
Proceeds from redemption of fixed maturities
and short-term investments ................... 1,601,993 345,521
Proceeds from sale of equity securities ........ (478,070) 515,591
Purchases of fixed maturities and
short-term investments ....................... (23,478,748) (14,506,336)
Purchases of equity securities ................. (281,549) (475,660)
Investments in affiliates, net of
dividends received ........................... (284,315) (66,974)
Acquisition of subsidiaries, net of
cash acquired ................................ (32,197) (20,586)
Other investments .............................. 14,492 (76,145)
Fixed assets and other ......................... (1,252) (14,599)
----------- -----------
Net cash used in investing activities .......... (635,157) (441,427)
CASH FLOWS PROVIDED BY (USED IN)
FINANCING ACTIVITIES:
Proceeds from exercise of stock options ........ 43,109 28,640
Repurchase of shares ........................... (1,575) (16,063)
Dividends paid ................................. (128,255) (116,944)
Proceeds from notes payable and debt ........... 596,814 891,500
Repayment of notes payable and debt ............ (350,000) (50,000)
Deposit liabilities ............................ 324,877 16,699
----------- -----------
Net cash provided by financing activities ........ 484,970 753,832
Effects of exchange rate changes on foreign
currency cash .................................. 444 (455)
----------- -----------
Increase in cash and cash equivalents ............ 414,893 746,512
CASH AND CASH EQUIVALENTS - BEGINNING OF YEAR .... $ 1,863,861 $ 930,469
----------- -----------
CASH AND CASH EQUIVALENTS - END OF YEAR .......... $ 2,278,754 $ 1,676,981
=========== ===========
See accompanying Notes to Consolidated Financial Statements
6
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(U.S. DOLLARS IN THOUSANDS)
1. BASIS OF PREPARATION AND CONSOLIDATION
These unaudited consolidated financial statements include the accounts of
XL Capital Ltd and all of its subsidiaries (collectively referred to as the
"Company") and have been prepared in accordance with U.S. generally accepted
accounting principles ("GAAP") for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by GAAP for complete
financial statements. In the opinion of management, these unaudited financial
statements reflect all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation of financial position and results
of operations as at the end of and for the periods presented. The results of
operations for any interim period are not necessarily indicative of the results
for a full year. All significant intercompany accounts and transactions have
been eliminated. The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from these estimates.
To facilitate period to period comparisons, certain reclassifications have
been made to prior year consolidated financial statement amounts to conform to
current year presentation. There was no effect on net income from this change in
presentation.
2. ACCOUNTING PRONOUNCEMENTS
Effective January 1, 2002, the Company adopted Financial Accounting
Standard ("FAS") 142, "Goodwill and Other Intangible Assets". FAS 142 addresses
financial accounting and reporting for goodwill and other intangible assets both
upon acquisition and after these assets have initially been recognized in the
financial statements. Adoption of FAS 142 has resulted in the Company ceasing to
amortize goodwill. The Company has assessed the carrying value of goodwill in
accordance with FAS 142 and has determined that these assets are currently
unimpaired.
The following is the pro forma effect on net income and earnings per share
for the three month and six month periods ended June 30, 2001 had FAS 142 been
effective January 1, 2001 as compared to the actual net income and earnings per
share for the three month and six month periods ended June 30, 2002:
THREE MONTHS SIX MONTHS
ENDED JUNE 30 ENDED JUNE 30
------------------------ -------------------------
2002 2001 2002 2001
----------- --------- ----------- ----------
NET (LOSS) INCOME:
Reported net (loss) income ....................................... $ (91,748) $ 128,606 $ (2,255) $ 347,535
Goodwill amortization ............................................ -- 14,495 -- 28,599
----------- --------- ----------- ----------
Adjusted net (loss) income ....................................... $ (91,748) $ 143,101 $ (2,255) $ 376,134
----------- --------- ----------- ----------
BASIC EARNINGS PER SHARE:
Reported basic (loss) earnings per share ......................... $ (0.68) $ 1.03 $ (0.02) $ 2.77
Goodwill amortization ............................................ -- 0.11 -- 0.23
----------- --------- ----------- ----------
Adjusted basic (loss) earnings per share ......................... $ (0.68) $ 1.14 $ (0.02) $ 3.00
----------- --------- ----------- ----------
DILUTED EARNINGS PER SHARE:
Reported diluted (loss)earnings per share ........................ $ (0.68) $ 1.01 $ (0.02) $ 2.72
Goodwill amortization ............................................ -- 0.11 -- 0.23
----------- --------- ----------- ----------
Adjusted diluted (loss) earnings per share ....................... $ (0.68) $ 1.12 $ (0.02) $ 2.95
----------- --------- ----------- ----------
7
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
2. ACCOUNTING PRONOUNCEMENTS (CONTINUED)
The following is the pro forma effect on net income and earnings per share
for the years ended December 31, 2001, 2000 and 1999 had FAS 142 been effective
January 1, 1999 as compared to the reported net income and earnings per share
for the years ended December 31, 2001, 2000 and 1999:
YEAR ENDED DECEMBER 31
--------------------------------
2001 2000 1999
--------- --------- ---------
NET (LOSS) INCOME:
Reported net (loss) income .................. $(576,135) $ 506,352 $ 470,509
Goodwill amortization ....................... 57,426 57,579 49,141
--------- --------- ---------
Adjusted net (loss) income .................. $(518,709) $ 563,931 $ 519,650
--------- --------- ---------
BASIC EARNINGS PER SHARE:
Reported basic (loss) earnings per share .... $ (4.55) $ 4.07 $ 3.69
Goodwill amortization ....................... 0.46 0.46 0.38
--------- --------- ---------
Adjusted basic (loss) earnings per share .... $ (4.09) $ 4.53 $ 4.07
--------- --------- ---------
DILUTED EARNINGS PER SHARE:
Reported diluted (loss)earnings per share ... $ (4.55) $ 4.03 $ 3.62
Goodwill amortization ....................... 0.46 0.46 0.37
--------- --------- ---------
Adjusted diluted (loss) earnings per share .. $ (4.09) $ 4.49 $ 3.99
--------- --------- ---------
Goodwill comprises approximately 98% of the total goodwill and other
intangible assets at June 30, 2002. The remaining balance represents intangible
assets that are being amortized over their estimated useful lives of periods
between six and twenty years.
3. SEGMENT INFORMATION
The Company is organized into three operating segments - insurance,
reinsurance and financial products and services - in addition to a corporate
segment that includes the investment and financing activities of the Company.
General operations and life operations are disclosed separately within each
segment. There were no significant life operations in the first six months of
2001. General operations include property and casualty lines of business and
financial products and services. Effective January 1, 2002, the Company provides
100% of the capacity of its Lloyd's syndicates and these operations are included
in the insurance segment and are no longer shown separately.
The Company evaluates the performance of each segment based on
underwriting profit or loss. Other items of revenue and expenditure of the
Company are not evaluated at the segment level for general operations. In
addition, the Company does not allocate assets by segment for its general
operations. Investment assets related to the Company's life operations are held
in portfolios that are separately managed. Net investment income from these
assets is included in net income from life operations.
Certain lines of business within general operations written by the Company
have loss experience generally characterized as low frequency and high severity.
This may result in volatility in both the Company's and an individual segment's
results and operational cash flows.
8
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
3. SEGMENT INFORMATION (CONTINUED)
The following is an analysis of the underwriting profit or loss by
segment, together with a reconciliation of underwriting results to net income:
QUARTER ENDED JUNE 30, 2002:
TOTAL FINANCIAL
INSURANCE AND PRODUCTS
INSURANCE REINSURANCE REINSURANCE AND SERVICES TOTAL
--------- ----------- ------------- ------------ -----------
GENERAL OPERATIONS:
Net premiums earned $ 549,776 $ 495,300 $ 1,045,076 $23,084 $ 1,068,160
Fee income and other 10,886 8,506 19,392 4,060 23,452
Net losses and loss expenses (1) 410,397 427,561 837,958 6,669 844,627
Acquisition costs 67,644 100,295 167,939 5,045 172,984
Operating expenses (2) 111,241 31,021 142,262 12,312 154,574
Exchange gains 22,181 1,025 23,206 -- 23,206
--------- --------- ----------- ------- -----------
Underwriting (loss) profit $ (6,439) $ (54,046) $ (60,485) $ 3,118 $ (57,367)
--------- --------- ----------- ------- -----------
LIFE OPERATIONS:
Life premiums earned $ -- $ 10,497 $ 10,497 $ -- $ 10,497
Fee income and other -- -- -- -- --
Claims and policy benefit reserves -- 18,816 18,816 -- 18,816
Acquisition costs and operating expenses -- 2,467 2,467 -- 2,467
Net investment income -- 16,825 16,825 -- 16,825
--------- --------- ----------- ------- -----------
Net income from life operations $ -- $ 6,039 $ 6,039 $ -- $ 6,039
--------- --------- ----------- ------- -----------
Net investment income $ 157,918
Net realized and unrealized losses on
investments and derivative instruments (116,715)
Equity in net income of affiliates 8,347
Interest expense 40,139
Amortization of intangible assets 11
Corporate operating expenses (2) 25,141
Minority interest 1,779
Income tax expense 22,900
-----------
NET LOSS $ (91,748)
===========
GENERAL OPERATIONS:
Loss and loss expense ratio (3) 74.6% 86.3% 80.2%
Underwriting expense ratio (3) 32.6% 26.5% 29.7%
--------- --------- -----------
Combined ratio (3) 107.2% 112.8% 109.9%
========= ========= ===========
(1) Net losses and loss expenses include an increase to loss reserves of $73.0
million and $127.0 million in the insurance and reinsurance segments,
respectively, related to the September 11 event. See Note 4 for further
details.
(2) Operating expenses exclude corporate operating expenses, shown separately.
(3) Ratios are based on net premiums earned from general insurance and
reinsurance operations, excluding fee income and other. The underwriting
expense ratio excludes exchange gains.
9
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
3. SEGMENT INFORMATION (CONTINUED)
QUARTER ENDED JUNE 30, 2001:
TOTAL FINANCIAL
INSURANCE AND PRODUCTS
INSURANCE REINSURANCE REINSURANCE AND SERVICES TOTAL
--------- ----------- ------------- ------------ -----------
GENERAL OPERATIONS:
Net premiums earned $ 339,923 $ 292,407 $ 632,330 $ 8,654 $ 640,984
Fee income and other 413 714 1,127 10,366 11,493
Net losses and loss expenses 201,598 183,339 384,937 2,014 386,951
Acquisition costs 65,919 76,126 142,045 1,157 143,202
Operating expenses (1) 33,565 23,069 56,634 6,863 63,497
Exchange losses 2,783 4,825 7,608 -- 7,608
--------- --------- ----------- ------- -----------
Underwriting profit $ 36,471 $ 5,762 $ 42,233 $ 8,986 $ 51,219
--------- --------- ----------- ------- -----------
Net investment income $ 151,168
Net realized and unrealized losses on
investments and derivative instruments (31,072)
Equity in net income of affiliates 29,514
Interest expense 26,168
Amortization of intangible assets 14,703
Corporate operating expenses (1) 18,401
Minority interest (652)
Income tax expense 13,603
-----------
NET INCOME $ 128,606
===========
GENERAL OPERATIONS:
Loss and loss expense ratio (2) 59.3% 62.7% 60.9%
Underwriting expense ratio (2) 29.3% 33.9% 31.4%
--------- --------- -----------
Combined ratio (2) 88.6% 96.6% 92.3%
========= ========= ===========
(1) Operating expenses exclude corporate operating expenses, shown separately.
(2) Ratios are based on net premiums earned from general insurance and
reinsurance operations, excluding fee income and other. The underwriting
expense ratio excludes exchange losses.
10
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
3. SEGMENT INFORMATION (CONTINUED)
SIX MONTHS ENDED JUNE 30, 2002:
TOTAL FINANCIAL
INSURANCE AND PRODUCTS
INSURANCE REINSURANCE REINSURANCE AND SERVICES TOTAL
--------- ----------- ------------- ------------ -----------
GENERAL OPERATIONS:
Net premiums earned $1,142,432 $ 916,467 $ 2,058,899 $42,214 $ 2,101,113
Fee income and other 17,431 9,405 26,836 5,482 32,318
Net losses and loss expenses (1) 786,777 692,193 1,478,970 12,581 1,491,551
Acquisition costs 159,609 192,509 352,118 6,003 358,121
Operating expenses (2) 200,214 49,707 249,921 27,302 277,223
Exchange gains 24,293 7,277 31,570 -- 31,570
--------- --------- ----------- ------- -----------
Underwriting profit (loss) $ 37,556 $ (1,260) $ 36,296 $ 1,810 $ 38,106
--------- --------- ----------- ------- -----------
LIFE OPERATIONS:
Life premiums earned $ -- $ 49,690 $ 49,690 $ -- $ 49,690
Fee income and other -- 2 2 -- 2
Claims and policy benefit reserves -- 66,579 66,579 -- 66,579
Acquisition costs and operating expenses -- 4,145 4,145 -- 4,145
Net investment income -- 32,343 32,343 -- 32,343
--------- --------- ----------- ------- -----------
Net income from life operations $ -- $ 11,311 $ 11,311 $ -- $ 11,311
--------- --------- ----------- ------- -----------
Net investment income $ 313,527
Net realized and unrealized losses on
investments and derivative instruments (235,935)
Equity in net income of affiliates 40,564
Interest expense 81,761
Amortization of intangible assets 625
Corporate operating expenses (2) 46,554
Minority interest 4,034
Income tax expense 36,854
-----------
NET LOSS $ (2,255)
===========
GENERAL OPERATIONS:
Loss and loss expense ratio (3) 68.9% 75.5% 71.8%
Underwriting expense ratio (3) 31.5% 26.4% 29.2%
--------- --------- -----------
Combined ratio (3) 100.4% 101.9% 101.1%
========= ========= ===========
(1) Net losses and loss expenses include an increase to loss reserves of $73.0
million and $127.0 million in the insurance and reinsurance segments,
respectively, related to the September 11 event.
(2) Operating expenses exclude corporate operating expenses, shown separately.
(3) Ratios are based on net premiums earned from general insurance and
reinsurance operations, excluding fee income and other. The underwriting
expense ratio excludes exchange gains.
11
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
3. SEGMENT INFORMATION (CONTINUED)
SIX MONTHS ENDED JUNE 30, 2001:
TOTAL FINANCIAL
INSURANCE AND PRODUCTS
INSURANCE REINSURANCE REINSURANCE AND SERVICES TOTAL
--------- ----------- ------------- ------------ -----------
GENERAL OPERATIONS:
Net premiums earned $ 609,396 $ 559,267 $ 1,168,663 $14,475 $ 1,183,138
Fee income and other 3,038 151 3,189 15,373 18,562
Net losses and loss expenses 361,729 351,797 713,526 3,629 717,155
Acquisition costs 121,870 145,726 267,596 1,478 269,074
Operating expenses (1) 66,352 39,775 106,127 18,220 124,347
Exchange losses 1,401 5,037 6,438 -- 6,438
--------- --------- ----------- ------- -----------
Underwriting profit $ 61,082 $ 17,083 $ 78,165 $ 6,521 $ 84,686
--------- --------- ----------- ------- -----------
Net investment income $ 294,264
Net realized and unrealized gains on
investments and derivative instruments 29,099
Equity in net income of affiliates 57,902
Interest expense 47,425
Amortization of intangible assets 29,171
Corporate operating expenses (1) 30,609
Minority interest 517
Income tax expense 10,694
-----------
NET INCOME $ 347 535
===========
GENERAL OPERATIONS:
Loss and loss expense ratio (2) 59.4% 62.9% 61.1%
Underwriting expense ratio (2) 30.9% 33.2% 32.0%
--------- --------- -----------
Combined ratio (2) 90.3% 96.1% 93.1%
========= ========= ===========
(1) Operating expenses exclude corporate operating expenses, shown separately.
(2) Ratios are based on net premiums earned from general insurance and
reinsurance operations, excluding fee income and other. The underwriting
expense ratio excludes exchange losses.
12
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
3. SEGMENT INFORMATION (CONTINUED)
The following tables summarize the Company's gross premiums written, net
premiums written and net premiums earned by line of business:
QUARTER ENDED JUNE 30, 2002:
GROSS NET NET
PREMIUMS PREMIUMS PREMIUMS
WRITTEN WRITTEN EARNED
---------- ---------- ----------
GENERAL OPERATIONS
Casualty insurance ....................... $ 421,091 $ 274,306 $ 204,890
Casualty reinsurance ..................... 206,110 200,456 198,982
Property catastrophe ..................... 64,740 47,018 53,574
Other property ........................... 319,005 218,158 224,614
Marine, energy, aviation and satellite ... 178,046 120,475 119,256
Lloyd's syndicates (1) ................... 136,276 116,265 84,000
Accident and health (2) .................. (38,048) (40,073) 45,041
Financial products and services .......... 84,539 82,125 23,084
Other insurance (3) ...................... 123,364 97,184 92,947
Other reinsurance (3) .................... 31,857 19,908 21,772
---------- ---------- ----------
Total general operations ................. 1,526,980 1,135,822 1,068,160
LIFE OPERATIONS (4) ...................... 19,968 11,529 10,497
---------- ---------- ----------
TOTAL .................................... $1,546,948 $1,147,351 $1,078,657
========== ========== ==========
QUARTER ENDED JUNE 30, 2001:
GROSS NET NET
PREMIUMS PREMIUMS PREMIUMS
WRITTEN WRITTEN EARNED
---------- ---------- ----------
GENERAL OPERATIONS
Casualty insurance ....................... $ 250,039 $ 170,261 $ 113,502
Casualty reinsurance ..................... 118,932 81,271 92,391
Property catastrophe ..................... 50,892 44,726 41,035
Other property ........................... 175,535 128,075 124,787
Marine, energy, aviation and satellite ... 77,088 36,959 49,606
Lloyd's syndicates (1) ................... 162,242 145,042 118,387
Financial products and services .......... 29,214 28,994 8,654
Other insurance (3) ...................... 102,823 85,100 51,723
Other reinsurance (3) .................... 39,082 28,724 40,899
---------- ---------- ----------
TOTAL .................................... $1,005,847 $ 749,152 $ 640,984
========== ========== ==========
Footnotes appear on the following page.
13
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
3. SEGMENT INFORMATION (CONTINUED)
SIX MONTHS ENDED JUNE 30, 2002:
GROSS NET NET
PREMIUMS PREMIUMS PREMIUMS
WRITTEN WRITTEN EARNED
---------- ---------- ----------
GENERAL OPERATIONS
Casualty insurance ....................... $ 916,327 $ 639,782 $ 441,758
Casualty reinsurance ..................... 656,439 576,898 358,827
Property catastrophe ..................... 262,486 224,420 113,899
Other property ........................... 898,262 597,922 454,399
Marine, energy, aviation and satellite ... 475,916 346,732 223,043
Lloyd's syndicates (1) ................... 470,001 380,079 204,362
Accident and health (2) .................. 89,858 64,904 64,699
Financial products and services .......... 156,335 151,310 42,214
Other insurance (3) ...................... 248,962 195,924 150,006
Other reinsurance (3) .................... 164,065 125,259 47,906
---------- ---------- ----------
Total general operations ................. 4,338,651 3,303,230 2,101,113
LIFE OPERATIONS (4) ...................... 58,496 48,497 49,690
---------- ---------- ----------
TOTAL .................................... $4,397,147 $3,351,727 $2,150,803
========== ========== ==========
SIX MONTHS ENDED JUNE 30, 2001:
GROSS NET NET
PREMIUMS PREMIUMS PREMIUMS
WRITTEN WRITTEN EARNED
---------- ---------- ----------
GENERAL OPERATIONS
Casualty insurance ....................... $ 439,226 $ 281,970 $ 198,510
Casualty reinsurance ..................... 290,322 204,316 163,780
Property catastrophe ..................... 153,050 142,568 77,857
Other property ........................... 353,081 254,968 219,118
Marine, energy, aviation and satellite ... 254,665 152,367 111,428
Lloyd's syndicates (1) ................... 379,238 279,582 210,546
Financial products and services .......... 41,203 40,927 14,475
Other insurance (3) ...................... 169,510 127,754 85,302
Other reinsurance (3) .................... 76,397 76,954 102,122
---------- ---------- ----------
TOTAL .................................... $2,156,692 $1,561,406 $1,183,138
========== ========== ==========
(1) The Company's Lloyd's syndicates write a variety of coverages, primarily
marine, energy, aviation and satellite.
(2) Accident and health business originally included in the acquisition of
Winterthur International was written and earned commencing July 1, 2001.
During the three months ended June 30, 2002, the Company sold the
remaining unearned premium related to this business, totaling $49.0
million, back to Winterthur Swiss Insurance Company. This was accounted
for as a return premium. For more information on the acquisition of
Winterthur International, see Note 5(c). Accident and health business was
written by the Company's Lloyd's syndicates during the three and six month
periods ended June 30, 2001.
(3) Other insurance and reinsurance premiums written and earned include
political risk, surety, bonding, warranty and other lines.
(4) The Company did not write any significant life business during the three
month and six month periods ended June 30, 2001.
14
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
4. THE SEPTEMBER 11 EVENT
As part of the Company's ongoing reserve review process and as a result of
loss development information during the second quarter of 2002, the Company
believed it was necessary to increase its gross and net reserves for the
September 11 event by $200.0 million. This increase included $127.0 million
related to the reinsurance segment, primarily due to higher business
interruption losses and exposure to potential claims by the Lloyd's Central
Guarantee Fund under a reinsurance contract, as to which the Company has fully
reserved its rights. The remaining $73.0 million primarily comprised a loss in
the accident and health book of the Company's Lloyd's operations.
5. BUSINESS COMBINATIONS
(A) LE MANS RE
Effective January 1, 2002, the Company increased its shareholding in Le
Mans Re from 49% to 67% in order to expand its international reinsurance
operations. Le Mans Re underwrites a worldwide portfolio comprising most classes
of property and casualty reinsurance business, together with a portfolio of life
reinsurance business. The remaining 33% ownership is held by Les Mutuelles du
Mans Assurances Group ("MMA"). However, MMA does not have any economic interest
in the future earnings of Le Mans Re as a result of this ownership beginning
January 1, 2002 due to certain contractual arrangements between the Company and
MMA. Accordingly, no minority interest has been recorded. The Company has the
option to buy the remaining shares from MMA for approximately $119.0 million in
cash on December 13, 2003. The Company must provide notice of its intention to
exercise prior to June 13, 2003. The Company currently intends to exercise its
option prior to this date. In addition, MMA has the option to sell the remaining
shares to the Company on December 13, 2003, or earlier if specific events occur,
for approximately $119.0 million in cash. These events include, but are not
limited to, a reduction of the Standard & Poor's rating of Le Mans Re and a
change of control in either the Company or Le Mans Re. If the Company or MMA
have not exercised their options by December 13, 2003, the parties may agree to
extend the exercise period. The Company has accrued a liability for the purchase
of the remaining shares at approximately $119.0 million, included in other
liabilities, at June 30, 2002.
The cost of the acquisition of the increase in ownership, including the
liability discussed above, was approximately $171.1 million. Goodwill arising
from the acquisition was approximately $50.0 million. The Company expects to
complete the allocation of goodwill and intangible assets by the end of 2002.
Cash paid, net of cash acquired, was $45.5 million during the six months ended
June 30, 2002.
Pro forma financial information is not presented for the acquisition of Le
Mans Re as the results of their operations are not significant to the
consolidated results of operations of the Company.
(B) LYNDON LIFE INSURANCE COMPANY
In the first quarter of 2002, the Company acquired Lyndon Life Insurance
Company, a shell company licensed in forty nine U.S. states, for the purpose of
obtaining licenses for the Company's life operations. The cost of the
acquisition was $13.5 million, paid in April 2002, and intangible assets arising
from the acquisition were $3.5 million. No goodwill was recorded on this
acquisition.
15
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
5. BUSINESS COMBINATIONS (CONTINUED)
(C) WINTERTHUR INTERNATIONAL
Effective July 1, 2001, the Company acquired Winterthur International
primarily to extend its predominantly North American based large corporate
insurance business globally. Results of operations for Winterthur International
have been included effective July 1, 2001. The following unaudited pro forma
financial information for the three month and six month periods ended June 30,
2001 includes the unaudited financial information for Winterthur International
for the three month and six month periods ended June 30, 2001 as if the
acquisition of the Winterthur International operations occurred on January 1,
2001. Winterthur International's results of operations for the three month and
six month periods ended June 30, 2001, included in the pro forma financial
information, have not been adjusted for the contractual protection that the
Company has received from the seller with effect from July 1, 2001.
The pro forma financial information for the three month and six month
periods ended June 30, 2001 is based upon information currently available and
certain assumptions that the Company's management believes are reasonable. The
pro forma financial information does not purport to represent what the Company's
results of operations or financial condition would have been had the transaction
occurred on such dates or to project the Company's results of operations or
financial condition for any future period or date. As a result of the above, the
pro forma financial information should be reviewed with caution and undue
reliance should not be placed on such information.
QUARTER ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
------------------------ ------------------------
2002 2001 2002 2001
Actual Pro forma Actual Pro forma
---------- ---------- ---------- ----------
Total revenues ............ $1,168,068 $ 984,261 $2,333,174 $1,945,629
Net (loss) income(1) ...... $ (91,748) $ 66,495 $ (2,255) $ 223,140
(Loss) earnings
per ordinary share:
Basic ................. $ (0.68) $ 0.53 $ (0.02) $ 1.78
Diluted ............... $ (0.68) $ 0.52 $ (0.02) $ 1.75
(1) Net (loss) income is adjusted for the effect of goodwill amortization had
FAS 142 been adopted effective January 1, 2001.
As discussed in Note 3, the accident and health business was sold back to
Winterthur Swiss Insurance Company. As a result of the ongoing process to fair
value identifiable assets and liabilities, the excess of the selling price over
the carrying value of this business was accounted for by adjusting the original
purchase price of Winterthur International.
6. NOTES PAYABLE AND DEBT AND FINANCING ARRANGEMENTS
In January 2002, the Company issued $600.0 million par value Guaranteed
Senior Notes due January 2012. The Notes were issued at 99.469% of their face
amount and gross proceeds were $596.8 million. The Guaranteed Senior Notes have
a coupon of 6.5%. Related expenses of the offering amounted to $7.9 million.
Proceeds of the Notes were used to pay down without penalty $350.0 million of
outstanding revolving credit in February 2002 that would have expired in June
2002, and for general corporate purposes.
16
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
7. DERIVATIVE INSTRUMENTS
The Company enters into derivative instruments for risk management,
trading and investment purposes. The Company is exposed to potential loss from
various market risks, including changes in interest rates, foreign currency
exchange rates and commodity values. The commodity risk relates to the Company's
participation in the weather and energy risk management markets. The Company
manages its market risks based on guidelines established by management. These
derivative instruments are carried at fair value with the resulting gains and
losses recognized in income in the period in which they occur.
The following table summarizes these instruments and the effect on net
income in the three months and six months ended June 30, 2002 and 2001:
THREE MONTHS THREE MONTHS SIX MONTHS SIX MONTHS
ENDED ENDED ENDED ENDED
JUNE 30, 2002 JUNE 30, 2001 JUNE 30, 2002 JUNE 30, 2001
------------- ------------- ------------- -------------
CREDIT DEFAULT SWAPS:
Net premiums earned ....................................... $ 21,116 $ -- $ 28,547 $ --
Losses and loss expenses .................................. (22,530) -- (27,156) --
Net unrealized losses on derivative instruments ........... (8,710) -- (10,159) --
Fee income and other ...................................... -- 5,317 -- 8,661
----------- --------- ----------- ----------
Total $ (10,124) $ 5,317 $ (8,768) $ 8,661
----------- --------- ----------- ----------
WEATHER AND ENERGY RISK MANAGEMENT PRODUCTS:
Fee income and other ...................................... $ 2,993 $ 4,099 $ 3,912 $ 4,786
INVESTMENT DERIVATIVES:
Net realized gains (losses) on derivative instruments .... $ 6,097 $ 9,592 $ 7,404 $ (3,091)
Net unrealized (losses) gains on derivative instruments ... (4,100) (4,566) (17,158) 5,753
----------- --------- ----------- ----------
Total $ 1,997 $ 5,026 $ (9,754) $ 2,662
----------- --------- ----------- ----------
EFFECT ON NET INCOME $ (5,134) $ 14,442 $ (14,610) $ 16,109
=========== ========= =========== ==========
The Company holds warrants in conjunction with certain of its other
investments. These warrants are recorded at fair value based on quoted market
prices. For the three month and six month periods ended June 30, 2002, the
Company recorded an unrealized loss of $0.8 million and $14.2 million,
respectively, related to the change in fair value of these warrants, included in
net unrealized (losses) gains on derivative instruments. The loss for the six
months ended June 30, 2002 related primarily to a decrease in the value of
warrants of Mutual Risk Management in the first quarter of 2002.
17
XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(U.S. DOLLARS IN THOUSANDS)
8. COMPUTATION OF EARNINGS PER ORDINARY SHARE AND ORDINARY SHARE EQUIVALENT
THREE MONTHS ENDED SIX MONTHS ENDED
June 30 JUNE 30
---------------------- ----------------------
2002 2001 2002 2001
--------- --------- --------- ---------
BASIC (LOSS) EARNINGS PER SHARE:
Net (loss) income ...................................... $ (91,748) $ 128,606 $ (2,255) $ 347,535
Weighted average ordinary shares outstanding ........... 135,662 125,396 135,431 125,312
Basic (loss) earnings per share ........................ $ (0.68) $ 1.03 $ (0.02) $ 2.77
========= ========= ========= =========
DILUTED (LOSS) EARNINGS PER SHARE:
Net (loss) income ...................................... $ (91,748) $ 128,606 $ (2,255) $ 347,535
Weighted average ordinary shares outstanding-basic ..... 135,662 125,396 135,431 125,312
Average stock options outstanding (1) .................. -- 2,369 -- 2,234
--------- --------- --------- ---------
Weighted average ordinary shares outstanding-diluted ... 135,662 127,765 135,431 127,546
--------- --------- --------- ---------
Diluted (loss) earnings per share ...................... $ (0.68) $ 1.01 $ (0.02) $ 2.72
========= ========= ========= =========
DIVIDENDS PER SHARE .................................... $ 0.47 $ 0.46 $ 0.94 $ 0.92
========= ========= ========= =========
(1) Net of shares repurchased under the treasury stock method. Basic shares
outstanding are used to calculate net loss per share.
Future weighted average number of shares outstanding may be affected by
the convertible debt issued during 2001. Due to the contingent nature of the
conversion features of the debt, there is no effect on diluted earnings per
share for the three months or six months ended June 30, 2002.
9. COMMITMENTS AND CONTINGENCIES
The decline in the Company's ordinary share price subsequent to June 30,
2002 could result in an additional interest cost to the Company in respect of
the Liquid Yield Option Notes(TM) ("LYONs") issued by the Company. Such
additional cost is contingent on the share price performance during a 30-day
trading period prior to the first "put" date of September 7, 2002. Should the
share price relative to the accreted conversion price of the LYONs be equal to
or less than 69% for 20 days within the 30 day trading period, contingent
additional principal will accrue for one year. As the LYONs is a zero coupon
note, additional principal represents interest expense. It is not yet known if
such additional expense, estimated at $1.9 million, will be incurred for the
twelve month period from September 7, 2002 to September 6, 2003. Alternatively,
the Noteholders have the right to require the Company to repurchase the Notes on
September 7, 2002. The Company cannot predict whether Noteholders will exercise
such right but currently plans to satisfy any such obligation in cash from
general operations should this occur. The amount of such repurchase obligation
would be $295.8 million.
18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2002
COMPARED TO THE THREE MONTHS ENDED JUNE 30, 2001
(U.S. DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
GENERAL
The following is a discussion of the Company's results of operations and
financial condition and liquidity. Certain aspects of the Company's business
have loss experience characterized as low frequency and high severity. This may
result in volatility in both the Company's and an individual segment's results
of operations and financial condition.
The Company's results for the three months ended June 30, 2002 include the
results of Winterthur International, acquired by the Company with effect from
July 1, 2001. They also include the results of Le Mans Re, accounted for as a
subsidiary with effect from January 1, 2002 following the Company's acquisition
of majority ownership. Previously, the Company's share of Le Mans Re's net
income was included in equity in net income of insurance and operating
affiliates. As a result of these two transactions, period to period comparisons
of the Company's results of operations and financial condition and liquidity may
not be meaningful.
This "Management's Discussion and Analysis of Results of Operations and
Financial Condition" contains forward-looking statements which involve inherent
risks and uncertainties. Statements that are not historical facts, including
statements about the Company's beliefs and expectations, are forward-looking
statements. These statements are based upon current plans, estimates and
projections. Actual results may differ materially from those projected in such
forward-looking statements, and therefore undue reliance should not be placed on
them. See Item 3, "--Cautionary Note Regarding Forward-Looking Statements", for
a list of factors that could cause actual results to differ materially from
those contained in any forward-looking statement.
This discussion and analysis should be read in conjunction with the
"Management's Discussion and Analysis of Results of Operations and Financial
Condition", and the audited Consolidated Financial Statements and notes thereto
presented under Item 7 and Item 8, respectively, of the Company's Form 10-K for
the year ended December 31, 2001.
CRITICAL ACCOUNTING POLICIES
The Company's critical accounting policies should be read in conjunction
with Item 7 of the Company's Form 10-K for the year ended December 31, 2001.
RESULTS OF OPERATIONS
The following table presents an after-tax analysis of the Company's net
(loss) income and (loss) earnings per share for the three months ended June 30,
2002 and 2001:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
------------------------
2002 2001
--------- ---------
Net operating income (1) .......................... $ 25,018 $ 160,062
Net realized (losses) gains on investments ........ (110,053) 36,482
Net realized and unrealized (loss) gains
on derivative instruments ....................... (6,713) 5,026
--------- ---------
Net (loss) income ................................. $ (91,748) $ 128,606
========= =========
(Loss) earnings per share - basic ................. $ (0.68) $ 1.03
========= =========
(Loss) earnings per share - diluted ............... $ (0.68) $ 1.01
========= =========
19
(1) Net operating income excludes after-tax net realized gains and losses on
investments and net realized and unrealized losses on derivative
instruments.
Net operating income decreased in the second quarter of 2002 compared to
the first quarter of 2001 primarily due to an increase in loss reserves of
$200.0 million related to the September 11 event. Due principally to the
complexity of the claims and inherent lag in reporting from insureds and
cedants, management believed it was necessary to increase the estimate for
ultimate losses related to this event. This increase in net loss reserves
included $73.0 million in the insurance segment and $127.0 million in the
reinsurance segment, discussed more fully in each of the segments below.
Net income was significantly reduced by an increase in net realized
investment losses in the second quarter of 2002. Net realized losses on
investments included a loss of $92.5 million related to certain
telecommunication fixed income securities, including WorldCom and Adelphia. Net
income in 2001 included net realized gains.
SEGMENTS
INSURANCE OPERATIONS
General insurance business written includes general liability, other
liability including directors and officers, professional and employment
practices liability, environmental liability, property, program business,
marine, aviation, satellite and other product lines including customs bonds,
surety, political risk and specialty lines. No life insurance business has been
written in this segment.
The following table summarizes the underwriting results for this segment:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
--------- ---------
2002 2001 % CHANGE
--------- --------- ---------
Net premiums earned ...................... $ 549,776 $ 339,923 61.73%
Fee income and other ..................... 10,886 413 NM
Net losses and loss expenses ............. 410,397 201,598 103.6%
Acquisition costs ........................ 67,644 65,919 2.6%
Operating expenses ....................... 111,241 33,565 231.4%
Exchange (gains) losses .................. (22,181) 2,783 NM
--------- --------- ---------
Underwriting (loss) profit ............... $ (6,439) $ 36,471 NM
========= ========= =========
Net unrealized losses on credit
default swaps .......................... $ (3,964) $ -- NM
========= ========= =========
* NM - Not Meaningful
In the quarter ended June 30, 2002, the insurance segment included the
results of Winterthur International, acquired effective July 1, 2001. As a
result, each of the above line items for the quarter ended June 30, 2002
experienced growth. Further, some business previously written by the Company's
insurance operations is now written by Winterthur International. Consequently,
period to period comparisons may not be meaningful.
Net premiums earned included $183.9 million from Winterthur International
in the quarter ended June 30, 2002. Excluding Winterthur International, net
premiums earned increased in the quarter ended June 30, 2002 compared to the
quarter ended June 30, 2001 by approximately $26.0 million due to growth in new
business written and significant pricing increases on business written in the
first six months of 2002. Pricing increases were experienced across all lines of
business as a result of a market correction following five years of poor
underwriting performance throughout the property and casualty industry caused by
a highly competitive environment. These price increases were further compounded
by the September 11 event. The increase in net premiums earned in the quarter
ended June 30, 2002 was partially offset by a reduction in net premiums earned
by the Company's Lloyd's syndicates following the exit of certain lines of
business.
20
The increase in fee income and other for the second quarter of 2002 as
compared to the second quarter of 2001 related primarily to consulting and
administration services provided by Winterthur International for employee
benefit plans of unrelated companies. These services will be discontinued in
2003. In addition, in the quarter ended June 30, 2001, managing agency expenses
were offset against fee income earned by the managing agency from Lloyd's
syndicates not owned by the Company. As the Company now owns 100% of the
syndicate capacity of its Lloyd's operations effective January 1, 2002, these
expenses are now included in operating expenses.
Exchange gains of $22.2 million in the quarter ended June 30, 2002 related
to the decline in value of the U.S. dollar against other currencies, primarily
the U.K. sterling and Swiss franc where the value of certain monetary net assets
denominated in these currencies increased. The exchange loss in the quarter
ended June 30, 2001 was due primarily to an increase in the value of the U.S.
dollar against the U.K. sterling.
In 2001, the insurance operations began to write credit default swaps at
primary layers in this segment. During the quarter ended June 30, 2002, an
unrealized loss of $4.0 million was recognized related to the fair value
adjustment for these credit default swaps.
The following table presents the ratios for this segment:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
--------------------
2002 2001
------ -----
Loss and loss expense ratio .......... 74.6% 59.3%
Underwriting expense ratio ........... 32.6% 29.3%
------ -----
Combined ratio ....................... 107.2% 88.6%
====== =====
The loss ratio increased in the quarter ended June 30, 2002 compared to
the same period of 2001 primarily due to an increase in net losses incurred
related to the September 11 event of $73.0 million. This was mainly attributable
to additional loss reserves in the accident and health business as a result of
the Company's ongoing reserve review process and additional information received
during the quarter.
Excluding this increase in net losses incurred, the loss ratio would have
been 61.4% in the quarter ended June 30, 2002. The quarter ended June 30, 2001
included favorable development of loss reserves related to certain casualty
business written in prior underwriting years, partially offset by a net incurred
loss related to Tropical Storm Allison. There were no significant catastrophe
events during the quarter ended June 30, 2002.
It is uncertain at this time whether the ongoing political and economic
crisis in Argentina may result in losses under political risk insurance and
reinsurance coverages provided by the Company, and if so, to what extent. The
Company believes both the possibility and magnitude of such losses are more
likely to increase the longer the crisis remains unresolved, potentially
increasing this segment's loss ratio in future quarters.
The underwriting expense ratio in the quarter ended June 30, 2002 included
acquisition and operating expenses for Winterthur International of $9.2 million
and $54.4 million, respectively. These expenses were reduced by the effect of
purchase accounting treatment on the deferred acquisition costs of $9.6 million.
No such purchase adjustments for Winterthur International are required in future
quarters. Had an historical level of deferred acquisition costs for Winterthur
International been amortized, the expense ratio for this segment would have been
34.3% in the quarter ended June 30, 2002. Historically, Winterthur International
has had a higher operational expense ratio than the Company's other insurance
operations and is currently incurring ongoing integration costs.
Excluding the effects of Winterthur International, the operating expenses
increased in the quarter ended June 30, 2002 as compared to the quarter ended
June 30, 2001 due to the growth of the U.S. based insurance operations, notably
the professional and environmental businesses. In addition, there was a higher
amount of allocated corporate expenses in the U.S. to this segment in the
quarter ended June 30, 2002.
21
REINSURANCE OPERATIONS
REINSURANCE - GENERAL OPERATIONS
General reinsurance business written includes treaty and facultative
reinsurance to primary insurers of casualty risks, principally: general
liability; professional liability; automobile and workers compensation;
commercial and personal property risks; specialty risks including fidelity and
surety and ocean marine; property catastrophe; property excess of loss; property
pro-rata; marine and energy; aviation and satellite; political risk and various
other reinsurance to insurers on a worldwide basis. The Company endeavors to
manage its exposures to catastrophic events by limiting the amount of its
exposure in each geographic zone worldwide and requiring that its property
catastrophe contracts provide for aggregate limits and varying attachment
points.
The following table summarizes the underwriting results for the general
operations of this segment:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
--------------------------
2002 2001 % CHANGE
--------- --------- --------
Net premiums earned ................ $ 495,300 $ 292,407 69.4%
Fee income and other ............... 8,506 714 NM
Net losses and loss expenses ....... 427,561 183,339 133.2%
Acquisition costs .................. 100,295 76,126 31.7%
Operating expenses ................. 31,021 23,069 34.5%
Exchange (gains) losses ............ (1,025) 4,825 NM
--------- --------- --------
Underwriting (loss) profit ......... $ (54,046) $ 5,762 NM
========= ========= ========
Net premiums earned in the second quarter of 2002 increased compared to
the second quarter of 2001 primarily due to strong growth and pricing increases
in business written in the first half of 2002 and the latter half of 2001. This
increase was experienced across most lines of business, notably casualty
reinsurance and property lines. Pricing increases primarily reflected a market
correction following five years of poor underwriting performance throughout the
property and casualty industry caused by a highly competitive environment. These
price increases were further compounded by the September 11 event. In addition,
the inclusion of Le Mans Re consolidated as a subsidiary effective January 1,
2002 contributed $70.5 million of additional net premiums earned in the second
quarter of 2002.
Fee income and other in the second quarter of 2002 primarily arose from
the recognition of unearned income related to a contract that was commuted in
the quarter.
The net exchange gain in the quarter ended June 30, 2002 is primarily due
to a decline in the value of the U.S. dollar against other currencies in those
operations that transact in multiple currencies.
The following table presents the ratios for this segment:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
-------------------
2002 2001
------ -----
Loss and loss expense ratio ........... 86.3% 62.7%
Underwriting expense ratio ............ 26.5% 33.9%
------ -----
Combined ratio ........................ 112.8% 96.6%
====== =====
The increase in the loss and loss expense ratio for the quarter ended June
30, 2002 over the same quarter of 2001 is due primarily to $127.0 million of
additional losses related to the September 11 event. These additional loss
reserves included $35.0 million related to reinsurance of the Lloyd's Central
Guarantee Fund, which notified its reinsurers in the second quarter of 2002.
Additional loss reserves of approximately $92.0 million were also recorded in
the Company's property and aviation lines due to an increase in the level of
reported losses.
22
Excluding additional loss reserves related to the September 11 event, the
loss ratio would have been 60.7% in the second quarter of 2002, reflecting
improved terms and conditions on business being written and earned. In the
quarter ended June 30, 2001, the Company had favorable loss development on
certain property business written in prior underwriting years that was partially
offset by net incurred losses of $20.0 million related to Tropical Storm
Allison.
It is uncertain at this time whether the ongoing political and economic
crisis in Argentina may result in losses under political risk insurance and
reinsurance coverages provided by the Company, and if so, to what extent. The
Company believes both the possibility and magnitude of such losses are more
likely to increase the longer the crisis remains unresolved, potentially
increasing this segment's loss ratio in future quarters.
The decrease in expense ratio in the second quarter of 2002 as compared to
the second quarter of 2001 reflected the high growth in net premiums earned
relative to a smaller increase in operating expenses, which generally do not
change in direct proportion to changes in net premiums earned. In addition, a
change in the mix of business included in net premium earned in the quarter
ended June 30, 2002 caused a relatively smaller growth in acquisition expenses,
where certain lines of business had lower commission rates.
REINSURANCE - LIFE OPERATIONS
Life business written by the reinsurance operations includes long duration
annuity contracts and traditional mortality risk reinsurance. No such contracts
were written in the second quarter of 2001. Due to the nature of some of these
contracts, premium volume may vary significantly from period to period.
The following summarizes net income from life operations:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
-----------------
2002 2001
------- ----
Net premiums earned .................................. $10,497 $ --
Claims and policy benefit reserves ................... 18,816 --
Acquisition costs .................................... 1,276 --
Operating expenses ................................... 1,191 --
Net investment income ................................ 16,825 --
------- ----
Net income from life operations $ 6,039 $ --
======= ====
Net investment income is included in net income from life operations as it
relates to income earned on portfolios of segregated life investment assets
received that are matched by the assumption of policy benefit reserves on
contracts written. The accretion of the policy benefit reserves is included in
claims and policy benefit reserves.
FINANCIAL PRODUCTS AND SERVICES OPERATIONS
Financial products and services business written includes insurance,
reinsurance and derivative solutions for complex financial risks. These include
financial guaranty insurance and reinsurance, credit enhancement swaps, other
collateralized transactions and weather and energy risk management products.
While these transactions are usually tailored for the specific needs of the
insured or user, they often involve the issuance of multi-year contracts. The
Company has also started an institutionally-oriented life business and acquired
a shell company licensed in forty-nine U.S. states for the purpose of obtaining
life licenses. Initial products offered will include municipal guaranteed
investment contracts, funding agreements and business-owned life insurance. Due
to the nature and variety of the business written in this segment, gross premium
volume as well as underwriting results may vary significantly from period to
period.
Financial guaranties are conditional commitments that guarantee the
performance of certain financial obligations by an obligor to a third party. The
Company's potential liability in the event of non-performance by the issuer of
the insured obligation is represented by its proportionate share of the
23
aggregate outstanding principal and interest payable ("insurance in force") on
such insured obligation. The Company also guarantees payment obligations of
counterparties under credit default swaps. The maturity of the insured
obligations ranges from one to thirty five years.
The following table summarizes the underwriting results for this segment:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
-----------------------
2002 2001 % CHANGE
-------- -------- --------
Net premiums earned ................... $ 23,084 $ 8,654 166.7%
Fee income and other .................. 4,060 10,366 (60.8%)
Net losses and loss expenses .......... 6,669 2,014 231.1%
Acquisition costs ..................... 5,045 1,157 336.0%
Operating expenses .................... 12,312 6,863 79.4%
Underwriting profit ................... $ 3,118 $ 8,986 NM
-------- -------- --------
Net unrealized (losses) on credit
default swaps ....................... $ (4,746) $ -- NM
======== ======== ========
Net premiums earned increased in the second quarter of 2002 as compared to
the second quarter of 2001 primarily due to significantly greater premiums
written on new financial guaranty business.
A component of the financial guaranty business is written in credit
default swap form. The Company fair values credit default swaps by modeling its
exposures and creating indices by using proxies of the spreads on similar
categories of exposures. For the second quarter of 2001, all adjustments to the
fair value of credit default swaps were included in fee income and other. For
the second quarter of 2002, the components of the fair value changes were
included in net premiums earned, net losses and loss expenses and in net
realized and unrealized gains and losses on derivative instruments. See Item 1,
Note 7 to the Unaudited Consolidated Financial Statements.
Fee and other income in 2002 included fees earned from weather and energy
risk management products provided in swap form, net of hedges purchased. All
such swaps and any unhedged positions in the Company's trading book are carried
at fair value.
Net losses and loss expenses increased in the quarter ended June 30, 2002
relative to the growth in net premiums earned. The Company's financial guaranty
operations write business with an initial expected loss ratio of approximately
25%. The increase in operating expenses is directly related to the increase in
financial guaranty premiums written, as well as the continued expansion of
operations in this segment including life business, which has not yet written
any contracts.
The financial guaranty business tracks embedded value that represents the
present value of unearned premium and installment premiums not yet recorded, net
of expected losses and acquisition costs. This value was approximately $400.0
million at June 30, 2002 and is expected to be earned over the life of the
exposures, that can be up to thirty years, and with an average duration of
approximately seven years.
INVESTMENT ACTIVITIES - GENERAL OPERATIONS
The following table illustrates the change in net investment income and
net realized and unrealized losses on investments and derivative instruments for
the quarters ended June 30, 2002 and 2001:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
--------- ---------
2002 2001 % CHANGE
--------- --------- --------
Net investment income .................... $ 157,918 $ 151,168 4.5%
Net realized losses on investments ....... (110,002) (36,098) 304.7%
Net realized and unrealized gains on
investment derivative instruments ...... 1,997 5,026 (60.3%)
24
Net investment income increased moderately in the second quarter of 2002
as compared to the second quarter of 2001 due primarily to a higher investment
base in 2002. The growth in the investment base included the receipt of funds
related to new debt and equity issued by the Company and the addition of assets
from Winterthur International and Le Mans Re. This was partially offset by a
decrease in interest rate levels for the three months ended June 30, 2002
compared to the three months ended June 30, 2001.
Interest earned on deposit liability assets is included in investment
income and the accretion of deposit liabilities is included in interest expense.
In the second quarter of 2001, the accretion charge of $10.4 million was
included in net investment income and has been reclassified for this change.
There was no effect on net income from this change in presentation.
Net realized losses on investments in the second quarter of 2002 included
a loss of approximately $92.5 million related to losses on certain fixed income
and equity telecommunication securities held, including WorldCom and Adelphia.
In addition, the Company wrote down $20.0 million of its investment in Mutual
Risk Management and approximately $12.5 million of certain of the Company's
fixed income and equity investments where the Company believed that there was an
other than temporary decline in the value of those investments. These investment
losses were offset by realized gains from sales of approximately $15.0 million
on the Company's investment portfolio during the quarter ended June 30, 2002.
The Company has investment guidelines in place to minimize concentrations
in any one industry sector or any one company. The Company also monitors credit
exposure but such controls cannot mitigate losses due to accounting
irregularities or other improprietaries of other organizations.
Net realized and unrealized losses on investment derivative instruments
resulted primarily from the mark to market of foreign exchange and forwards
contracts used for risk management purposes. See Item 3, "Quantitative and
Qualitative Disclosure About Market Risk", for a more detailed analysis.
OTHER REVENUES AND EXPENSES
The following table sets forth other revenues and expenses for the three
months ended June 30, 2002 and 2001:
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30
------------------
2002 2001 % CHANGE
------- ------- --------
Equity in net income of investment affiliates ... $ 7,931 $23,196 (65.8)%
Equity in net income of insurance and
operating affiliates .......................... 416 6,318 (93.4)%
Amortization of intangible assets ............... 11 14,703 (99.9)%
Corporate operating expenses .................... 25,141 18,401 36.6%
Interest expense ................................ 40,139 20,642 94.4%
Minority interest ............................... 1,779 (652) NM
Income tax expense .............................. 22,900 13,603 68.3%
Equity in net income of investment affiliates in the second quarter of
2002, although positive, showed a decreased return as compared to the second
quarter of 2001 due to lower comparative performance from the fund investments
as a result of the volatility in the financial markets. In addition, income from
the Company's investments in management companies was lower in the second
quarter of 2002 as compared to income in the second quarter of 2001 due to lower
levels of performance in their funds under management.
The decrease in equity in net income of insurance and operating affiliates
primarily resulted from the acquisition of a majority shareholding in Le Mans
Re, and its consolidation as a subsidiary of the Company effective January 1,
2002. The Company's share of Le Mans Re's net income in the quarter ended June
30, 2001 was $3.0 million. In addition, there was a decrease in the earnings of
25
the remaining insurance and operating affiliates of approximately $2.9 million
as compared to last year's second quarter. The Company made no provision for its
share of Annuity and Life Re's second quarter loss as its results have not yet
been finalized.
Amortization of intangible assets decreased in the second quarter of 2002
compared to the second quarter of 2001 due to the adoption of FAS 142, where the
Company is no longer required to amortize goodwill. Had FAS 142 been effective
January 1, 2001, the amortization expense would have been approximately $0.2
million in the quarter ended June 30, 2001. The Company has assessed the
carrying value of goodwill at June 30, 2002 in accordance with FAS 142 and has
determined that these assets are currently unimpaired.
Corporate operating expenses in the second quarter ended June 30, 2002
increased compared to the three months ended June 30, 2001 due to the continued
worldwide expansion of the Company's operations. The Company is in the process
of developing a network of shared service organizations to support the Company's
operations in certain locations on a centralized basis to improve efficiency
over the longer term.
The increase in interest expense primarily reflected an increase in the
level of indebtedness from June 30, 2001 to June 30, 2002. In addition, interest
expense included a higher accretion charge on the deposit liabilities due to
growth in these reserves. For more information on the Company's financing
structure, see "--Financial Condition and Liquidity."
The Company reported a pre-tax net loss of $68.8 million caused by the
increase to loss reserves of $200.0 million related to the September 11 event
and realized investment losses of $110.0 million. Both of these items occurred
primarily within the Company's Bermuda operations. The September 11 event
reserve increase in the Company's Lloyd's operations had no associated tax
benefit as the Company has provided a full valuation allowance of approximately
$20.0 million against its deferred tax asset. The change in the income taxes of
the Company reflected an improvement in the profitability of its U.S.
operations, which were largely unaffected by these events.
RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2002
COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2001
(U.S. DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
RESULTS OF OPERATIONS
The following table presents an after-tax analysis of the Company's net
income and earnings per share for the six months ended June 30, 2002 and 2001:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
------------------------
2002 2001
--------- --------
Net operating income (1) ............................. $ 235,402 $316,796
Net realized (losses) gains on investments ........... (217,744) 28,077
Net realized and unrealized (losses) gains
on derivative instruments .......................... (19,913) 2,662
--------- --------
Net (loss) income .................................... $ (2,255) $347,535
========= ========
(Loss) earnings per share - basic .................... $ (0.02) $ 2.77
========= ========
(Loss) earnings per share - diluted .................. $ (0.02) $ 2.72
========= ========
(1) Net operating income excludes after-tax net realized gains and losses on
investments and net realized and unrealized losses on derivative
instruments.
Net operating income decreased in the first six months of 2002 compared to
the first six months of 2001 primarily due to an increase in net losses incurred
of $200.0 million related to the September 11 event during the second quarter
ended June 30, 2002.
Net income was significantly reduced by net realized investment losses in
the first six months of 2002 of $217.7 million compared to investment gains of
$28.1 million in the same prior year period. Included in net realized losses on
26
on investments for 2002 was a loss of $92.5 million related to certain fixed
income and equity telecommunications securities, including WorldCom and
Adelphia. In 2002, the Company also wrote down an additional $80.0 million of
certain other fixed income and equity investments in circumstances where the
Company believed that there was an other than temporary decline in the value of
those investments.
SEGMENTS
INSURANCE OPERATIONS
The following table summarizes the underwriting results for this segment:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
-------------------------
2002 2001 % CHANGE
---------- ---------- ----------
Net premiums earned .................. $1,142,432 $ 609,396 87.5%
Fee income and other ................. 17,431 3,038 473.8%
Net losses and loss expenses ......... 786,777 361,729 117.5%
Acquisition costs .................... 159,609 121,870 31.0%
Operating expenses ................... 200,214 66,352 201.7%
Exchange (gains) losses .............. (24,293) 1,401 NM
---------- ---------- ----------
Underwriting profit .................. $ 37,556 $ 61,082 (38.5)%
========== ========== ==========
Net unrealized (losses) on
credit default swaps ............... $ (10,712) $ -- NM
========== ========== ==========
* NM - Not Meaningful
In the six months ended June 30, 2002, the insurance segment included the
results of Winterthur International, acquired effective July 1, 2001. As a
result, each of the above line items experienced growth. Consequently, period to
period comparisons may not be meaningful.
Net premiums earned included $345.5 million from Winterthur International
in the six months ended June 30, 2002. Excluding Winterthur International, net
premiums earned increased in the six months ended June 30, 2002 compared to the
six months ended June 30, 2001 by approximately $187.5 million, primarily due to
growth in new business written and significant pricing increases across all
lines of business. Pricing increases were due to a market correction following
five years of poor underwriting performance throughout the property and casualty
industry caused by a highly competitive environment. These price increases were
further compounded by the September 11 event.
The increase in fee income and other for the first six months of 2002 over
the first six months of 2001 related primarily to consulting and administration
services provided by Winterthur International for employee benefit plans of
unrelated companies. These services will be discontinued in 2003.
Exchange gains of $24.3 million in the six months ended June 30, 2002 were
primarily due to a decline in the value of the U.S. dollar against the U.K.
sterling and Swiss franc in those operations that have net monetary assets
denominated in these foreign currencies.
In 2001, the insurance operations began to write credit default swaps at
primary layers in this segment. During the six months ended June 30, 2002 an
unrealized loss of $10.7 million was recorded in this segment related to the
fair value adjustment for these credit default swaps.
27
The following table presents the ratios for the insurance segment:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
-------------------
2002 2001
------ ------
Loss and loss expense ratio ........... 68.9% 59.4%
Underwriting expense ratio ............ 31.5% 30.9%
------ ------
Combined ratio 100.4% 90.3%
====== ======
The loss ratio increased in the six months ended June 30, 2002 compared to
the same period of 2001 due to additional incurred losses of $73.0 million
related to the September 11 event, discussed above in the results of insurance
operations for the second quarter of 2002. Excluding these additional net losses
incurred, the loss ratio would have been 62.1%. The loss ratio for the six
months ended June 30, 2001 reflected favorable loss development of certain
casualty business lines written in prior underwriting years, partially offset by
losses from Tropical Storm Allison. There were no catastrophe losses in the six
months ended June 30, 2002.
The Company's exposure to the ongoing political and economic crisis in
Argentina is discussed above in the results of operations for the three months
ended June 30, 2002.
The underwriting expense ratio in the six months ended June 30, 2002
included acquisition and operating expenses for Winterthur International of
$14.2 million and $96.8 million, respectively. These expenses were reduced by
the effect of purchase accounting treatment on the deferred acquisition costs of
$19.3 million. No such purchase adjustments are required in future quarters. Had
an historical level of deferred acquisition costs for Winterthur International
been amortized, the expense ratio for this segment would have been 33.2% in the
six months ended June 30, 2002 as compared to 30.9%. Historically, Winterthur
International has had a higher operational expense ratio than the Company's
other insurance operations, and is currently incurring ongoing integration
costs.
Excluding the effect of Winterthur International, the operating expenses
for the six months ended June 30, 2002 were higher than the six months ended
June 30, 2001 due to the growth of the U.S. based insurance operations, notably
the professional and environmental businesses. In addition, there was a higher
amount of allocated corporate expenses in the U.S. to this segment in the six
months ended June 30, 2002.
REINSURANCE OPERATIONS
REINSURANCE - GENERAL OPERATIONS
The following table summarizes the underwriting results for general
operations of this segment:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
-------------------------
2002 2001 % CHANGE
--------- --------- ---------
Net premiums earned ................. $ 916,467 $ 559,267 63.9%
Fee income and other ................ 9,405 151 NM
Net losses and loss expenses ........ 692,193 351,797 96.7%
Acquisition costs ................... 192,509 145,726 32.1%
Operating expenses .................. 49,707 39,775 25.0%
Exchange (gains) losses ............. (7,277) 5,037 NM
--------- --------- ---------
Underwriting (loss) profit .......... $ (1,260) $ 17,083 NM
========= ========= =========
Net premiums earned in the first six months of 2002 increased compared to
the first six months of 2001 primarily due to strong growth and pricing
increases in business written in 2002 and the latter half of 2001 across most
lines of business, notably casualty reinsurance and property lines. In addition,
the inclusion of Le Mans Re consolidated as a subsidiary effective January 1,
2002 contributed $134.1 million of additional net premiums earned for the first
28
six months of 2002. The increase in net premiums earned also reflected
significant price increases across all lines of business. Pricing increases were
due to a market correction following five years of poor underwriting performance
throughout the property and casualty industry caused by a highly competitive
environment. These price increases were further compounded by the September 11
event.
Fee income and other in the six months ended June 30, 2002 was increased
by the recognition of unearned income on a contract commuted during the second
quarter of 2002.
Exchange gains during the first six months of 2002 of $7.3 million were
mainly attributable to a decline in the value of the U.S. dollar against the
U.K. sterling and euro in those operations that transact in multiple currencies.
The following table presents the ratios for the reinsurance segment:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
--------------------
2002 2001
------ ------
Loss and loss expense ratio .......... 75.5% 62.9%
Underwriting expense ratio ........... 26.4% 33.2%
------ ------
Combined ratio ....................... 101.9 96.1%
====== ======
The increase in the loss and loss expense ratio during the first six
months of 2002 is due to additional net loss reserves of $127.0 million related
to the September 11 event, discussed above in the results of reinsurance
operations for the quarter ended June 30, 2002. Excluding these losses, the loss
ratio would have been 61.7% in the first six months of 2002. The loss ratio for
the six months of June 30, 2001 reflected losses from Tropical Storm Allison,
the Petrobras oil rig loss and the Seattle earthquake, which were mostly offset
by favorable loss development on certain property business written in prior
underwriting years. There were no significant catastrophe losses in the first
half of 2002.
The Company's exposure to the ongoing political and economic crisis in
Argentina is discussed above in the results of operations for the three months
ended June 30, 2002.
The underwriting expense ratio was lower in the six months ended June 30,
2002 as compared to the six months ended June 30, 2001 due to several factors.
First, the growth in net premiums earned was greater than the increase in
operating expenses, which generally do not change in direct proportion to
changes in net premiums earned. Price increases which cause an increase in net
premiums earned would result in a lower expense ratio. Second, this ratio was
reduced by the effect of the recognition of a curtailment gain of approximately
$8.0 million on a pension plan in the U.S. during the first six months of 2002.
Lastly, there was a change in the mix of business in net premiums earned where
certain lines of business had a lower rate of commission.
REINSURANCE - LIFE OPERATIONS
Life business written by the Company includes long duration annuity
contracts and traditional mortality risk reinsurance. No such contracts were
written in the first half of 2001. Due to the nature of some of these contracts,
premium volume may vary significantly from period to period.
29
The following summarizes net income from life operations:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
------------------------
2002 2001
------- -------
Net premiums earned ............................... $49,690 $ --
Fee income and other .............................. 2 --
Claims and policy benefit reserves ................ 66,579 --
Acquisition costs ................................. 1,871 --
Operating expenses ................................ 2,274 --
Net investment income ............................. 32,343 --
------- -------
Net income from life operations ................... $11,311 $ --
======= =======
Net investment income is included in net income from life operations as it
relates to income earned on portfolios of segregated life investment assets
received that are matched by the assumption of policy benefit reserves on
contracts written. The accretion of the policy benefit reserves is included in
claims and policy benefit reserves.
FINANCIAL PRODUCTS AND SERVICES OPERATIONS
The following table summarizes the underwriting results for this segment:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
------------------
2002 2001 % CHANGE
------- ------- --------
Net premiums earned ............................ $42,214 $14,475 191.6%
Fee income and other ........................... 5,482 15,373 (64.3)%
Net losses and loss expenses ................... 12,581 3,629 246.7%
Acquisition costs .............................. 6,003 1,478 306.2%
Operating expenses ............................. 27,302 18,220 49.8%
------- ------- -------
Underwriting profit ............................ $ 1,810 $ 6,521 (72.2)%
======= ======= =======
Net unrealized gains on credit default swaps ... $ 553 $ -- NM
======= ======= =======
Net premiums earned increased in the first half of 2002 as compared to the
first half of 2001 primarily due to significantly greater premiums written on
new business in the financial guaranty business. Net premiums earned in the
first half of 2002 also included approximately $2.1 million of weather related
risk management transactions written.
Some financial guaranty business is written in credit default swap form.
The Company fair values credit default swaps by modeling its exposures and
creating indices by using proxies of the spreads on similar categories of
exposures. For the first six months of 2001, all adjustments to the fair value
of credit default swaps were included in fee income and other. For the first six
months of 2002, the components of the fair value changes were included in net
premiums earned, net losses and loss expenses and in net realized and unrealized
gains and losses on derivative instruments. See Item 1, Note 7 to the Unaudited
Consolidated Financial Statements.
Net losses and loss expenses increased in the six months ended June 30,
2002 relative to the growth in net premiums earned. The Company's financial
guaranty operations write business with an initial expected loss ratio of
approximately 25%. The increase in operating expenses reflected the continued
expansion of operations in this segment, including life business, which has not
30
yet written any transactions. These expenses, relative to the segment's
revenues, have improved compared to the prior year's quarter as the growing
portfolio of aggregate insurance in force is earned.
INVESTMENT ACTIVITIES - GENERAL OPERATIONS
The following table illustrates the change in net investment income and
net realized and unrealized gains and losses on investments for the six months
ended June 30, 2002 and 2001:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
---------------------
2002 2001 % CHANGE
--------- --------- --------
Net investment income ........................ $ 313,527 $ 294,264 6.5%
Net realized (losses) gains on investments ... (216,022) 26,437 NM
Net realized and unrealized (losses) gains
on investment derivative instruments ....... (9,754) 2,662 NM
Net investment income increased in the first six months of 2002 as
compared to the first quarter of 2001 due primarily to a higher investment base
in 2002. The growth in the investment base included the receipt of funds related
to new debt and equity issued by the Company and the addition of assets from
Winterthur International and Le Mans Re. The effect of the higher investment
base was partially offset by decreases in interest rate levels for the six
months ended June 30, 2002 compared to the six months ended June 30, 2001.
Interest earned on deposit liability assets is included in investment
income and the accretion of deposit liabilities is included in interest expense.
In the six months ended June 30, 2001, the accretion charge of $24.1 million was
included in net investment income and has been reclassified for this change.
There was no effect on net income from this change in presentation.
The Company has investment guidelines in place to minimize concentrations
in any one industry sector or any one company. The Company also monitors credit
exposure but such controls cannot mitigate losses due to accounting
irregularities or other improprietaries of other organizations.
Net realized losses on investments in the first half of 2002 included a
loss of $92.5 million of certain fixed income and equity telecommunications
securities, including WorldCom and Adelphia, and a loss of $80.0 million of
certain fixed income and equity investments where the Company believed that
there was an other than temporary decline in the value of those investments.
Net realized and unrealized losses on investment derivative instruments
resulted primarily from the fair value of warrants held by the Company in
conjunction with certain of its other investments, based on quoted market
values. See Item 3, "Quantitative and Qualitative Disclosure About Market Risk",
for a more detailed analysis.
31
OTHER REVENUES AND EXPENSES
The following table sets forth other revenues and expenses for the six
months ended June 30, 2002 and 2001:
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
------------------
2002 2001 % CHANGE
------- ------- -------
Equity in net income of investment affiliates ... $40,116 $43,570 (7.9)%
Equity in net income of insurance and
operating affiliates .......................... 448 14,332 NM
Amortization of intangible assets ............... 625 29,171 NM
Corporate operating expenses .................... 46,554 30,609 52.1%
Interest expense ................................ 81,761 47,425 72.4%
Minority interest ............................... 4,034 517 NM
Income tax expense .............................. 36,854 10,694 244.6%
Equity in net income of investment affiliates decreased in the first six
months of 2002 over the first six months of 2001 due primarily to decreased
returns in the quarter ended June 30, 2002 on the Company's investments in
investment funds and the management companies that administer these investment
funds as a result of the volatility in the financial markets.
The decrease in equity in net income of insurance and operating affiliates
primarily resulted from the acquisition of a majority shareholding in Le Mans
Re, and its consolidation as a subsidiary of the Company effective January 1,
2002. The Company's share of Le Mans Re's net income for the six months ended
June 30, 2001 was $8.0 million. In addition, there was a decrease in the
earnings of the remaining insurance and operating affiliates as compared to last
year's second quarter.
Amortization of intangible assets decreased in the first half of 2002
compared to the first half of 2001 due to the adoption of FAS 142, where the
Company is no longer required to amortize goodwill. Had FAS 142 been effective
January 1, 2001, the amortization expense would have been approximately $0.6
million in the six months ended June 30, 2001. The Company has assessed the
carrying value of goodwill at June 30, 2002 in accordance with FAS 142 and has
determined that these assets are currently unimpaired.
Corporate operating expenses in the six months ended June 30, 2002 have
increased compared to the six months ended June 30, 2001 due to the continued
worldwide expansion of the Company's operations. The Company is in the process
of developing a network of shared service organizations to support the Company's
operations in certain locations on a centralized basis to improve efficiency
over the longer term.
The increase in interest expense primarily reflects an increase in the
level of indebtedness from June 30, 2001 to June 30, 2002. The Company's
financing structure is outlined in "--Financial Condition and Liquidity."
The Company reported a pre-tax net income of $34.6 which was negatively
affected by the increase to loss reserves of $200.0 million related to the
September 11 event and realized investment losses of $216.0 million. Both of
these items occurred primarily within the Company's Bermuda operations. The
September 11 event reserve increase in the Company's Lloyds operations had no
associated tax benefit as the Company has provided a full valuation allowance of
approximately $20.0 million against its deferred tax asset. The change in the
income taxes of the Company reflected an improvement in the profitability of its
U.S. operations that were largely unaffected by these events.
FINANCIAL CONDITION AND LIQUIDITY
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
32
Kingdom, and those of the Society of Lloyd's. No assurance can be given that the
Company or its subsidiaries will be permitted to pay dividends in the future.
The Company's ability to underwrite business is largely dependent upon the
quality of its claims paying and financial strength ratings as evaluated by
independent agencies. The Company regularly provides financial information to
these agencies to maintain existing ratings.
The Company's fixed income investments including short-term investments
and cash equivalents at June 30, 2002 represented approximately 90.0% of
invested assets and were managed by several outside investment management firms.
Approximately 93.5% of fixed income securities are investment grade, with 66.0%
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.
At June 30, 2002, total investments available for sale and cash, net of
unsettled investment trades, were $14.3 billion compared to $13.0 billion at
December 31, 2001. The net payable for investments purchased increased from $1.2
billion at December 31, 2001 to $1.5 billion at June 30, 2002. This increase in
investment assets related to the inclusion of Le Mans Re as a subsidiary, the
receipt of premiums and an additional $319.9 million received on deposit
liabilities.
For the six months ended June 30, 2002, currency translation adjustments
were $55.4 million. This is shown as part of accumulated other comprehensive
loss and primarily related to unrealized gains on foreign currency exchange rate
movement at Winterthur International and Le Mans Re, where most operations have
a functional currency that 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 does 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.
Inflation can, among other things, lead to increased damage awards and
potentially result in larger claims. The Company's underwriting philosophy is to
adjust premiums in response to inflation, although this may not always be
possible due to competitive pressures. Inflationary factors are considered in
determining the premium level on any multi-year policies at the time contracts
are written.
The Company's liquidity depends on operating, investing and financing cash
flows, discussed below.
Certain business written by the Company has loss experience generally
characterized as having low frequency and high severity. This may result in
volatility in both the Company's results and operational cash flows. Operational
cash flows during the first six months of 2002 increased from the same period of
2001 primarily due to the receipt of increased premiums written. In the six
months ended June 30, 2002 and 2001, the net amount of losses paid by the
Company was $1.2 billion and $614.5 million, respectively. The increase in 2002
is due to growth in operations and the inclusion of Winterthur International and
Le Mans Re.
The Company's cash flow has not yet been adversely affected by the
September 11 event, as approximately 90% of these losses remain unpaid at June
30, 2002. The Company has reviewed the anticipated cash flow from the September
11 event and believes it has sufficient liquidity to meet its obligations.
In the six months ended June 30, 2002, the Company made the following
significant investments:
33
(1) Effective January 2002, the Company completed the acquisition of a
67% majority shareholding in Le Mans Re, increasing its shareholding from 49% at
December 31, 2001. Cash paid, net of cash acquired, was $45.5 million.
(2) The Company invested a further $286.4 million in affiliates, the
majority of which related to investments in alternative investment managers and
related investment funds. This included a $75.0 million investment in Primus
Guaranty, Ltd., that specializes in providing credit risk protection through
credit default swaps. The mark to market effect on their derivative instruments
may potentially introduce some volatility to the equity earnings in affiliates
in future periods.
As at June 30, 2002, the Company had bank, letter of credit and loan
facilities available from a variety of sources including commercial banks
totaling $5.4 billion, of which $1.9 billion in debt was outstanding. In
addition, $2.0 billion of letters of credit were outstanding, 6% of which were
collateralized by the Company's investment portfolio, supporting U.S.
non-admitted business and the Company's Lloyd's capital requirements.
The following tables present the Company's indebtedness under outstanding
securities and lenders' commitments as at June 30, 2002:
-------------------------------------------------
PAYMENTS DUE BY PERIOD
-------------------------------------------------
YEAR OF LESS THAN 1 TO 3 4 TO 5 AFTER 6
NOTES PAYABLE AND DEBT COMMITMENT IN USE EXPIRY 1 YEAR YEARS YEARS YEARS
------------------------------------------------------------------------------------
364-day revolver ......................... $ 500,000 $ -- 2002 $ -- $ -- $ -- $ --
7.15% Senior Notes ....................... 100,000 99,976 2005 -- 100,000 -- --
6.58% GUARANTEED SENIOR NOTES ............ 255,000 255,000 2011 -- -- -- 255,000
6.50% Guaranteed Senior Notes ............ 600,000 596,963 2012 -- -- 600,000
Zero Coupon Convertible Debentures (1) ... 617,602 617,602 2021 -- -- -- 1,010,833
Liquid Yield Option Notes(TM) (1) ........ 294,275 294,275 2021 -- -- -- 508,842
------------------------ ------------------------------------------------
Total .................................... $2,366,877 $1,863,816 $ -- $100,000 $ -- $2,374,675
======================== ================================================
(1) "Commitment" and "In Use" data represent June 30, 2002 accreted values.
"After 6 years" data represent ultimate redemption values. The
convertibles may be "put" or converted by the bondholders at various times
prior to the 2021 redemption date. The next "put" date is September 7,
2002 for the Liquid Yield Option Notes(TM), as described below, and May
23, 2004 for the Zero Coupon Convertible Debentures. The Company may also
choose to "call" the debt from May and September 2004 onwards for the Zero
Coupon Convertible Debentures and Liquid Yield Option Notes(TM),
respectively.
In January 2002, the Company issued $600.0 million par value 6.50%
Guaranteed Senior Notes due January 2012. The notes were issued at $99.469 and
gross proceeds were $596.8 million. Related expenses of the offering amounted to
$7.9 million. Proceeds of the Notes were used to pay down two 5-year revolving
credit facilities of $350.0 million and for general corporate purposes. These
credit facilities were subsequently canceled.
The decline in the Company's ordinary share price subsequent to June 30,
2002 could result in an additional interest cost to the Company in respect of
the Liquid Yield Option Notes(TM) ("LYONs") issued by the Company. Such
additional cost is contingent on the share price performance during a 30-day
trading period prior to the first "put" date of September 7, 2002. Should the
share price relative to the accreted conversion price of the LYONs be equal to
or less than 69% for 20 days within the 30 day trading period, contingent
additional principal will accrue for one year. As the LYONs is a zero coupon
note, additional principal represents interest expense. It is not yet known if
such additional expense, estimated at $1.9 million, will be incurred for the
twelve month period from September 7, 2002 to September 6, 2003. Alternatively,
the Noteholders have the right to require the Company to repurchase the Notes on
September 7, 2002. The Company cannot predict whether Noteholders will exercise
such right but currently plans to satisfy any such obligation in cash from
general operations should this occur. The amount of such repurchase obligation
would be $295.8 million.
The total pre-tax interest expense on the borrowings described above was
$81.8 million and $47.4 million for the six months ended June 30, 2002 and 2001,
respectively.
34
AMOUNT OF COMMITMENT
EXPIRATION PER PERIOD
-------------------------------------------------
PAYMENTS DUE BY PERIOD
-------------------------------------------------
YEAR OF LESS THAN 1 TO 3 4 TO 5 AFTER 6
OTHER COMMERCIAL COMMITMENTS COMMITMENT IN USE EXPIRY 1 YEAR YEARS YEARS YEARS
------------------------------------------------------------------------------------
Letter of Credit Facilities ........ $1,490,000 $1,251,000 2002 $1,490,000 -- -- --
Letter of Credit Facilities ........ $1,500,000 $779,000 2003 $1,500,000
The Company renewed its 364-day revolving credit and letter of credit
facility that expired in June 2002. The combined facility amounts to $2.0
billion, previously $1.5 billion, of which up to $500.0 million is available as
revolving credit and is disclosed in "Notes payable and debt" above. The
remaining $1.5 billion is disclosed in "Other Commercial Commitments" above,
however the Company may choose to use the total $2.0 billion facility in letter
of credit form.
The Company has several letter of credit facilities provided on a
syndicated and bilateral basis from commercial banks. These facilities are
utilized to support non-admitted insurance and reinsurance operations in the
U.S. and capital requirements at Lloyd's. All of these commercial facilities are
scheduled for renewal during 2002 and 2003. 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 cedants. 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.
In addition, from July 1, 2001 until July 24, 2002, the Company had
additional letters of credit provided by the previous owner of the Winterthur
International operations. The Company replaced this facility with letters of
credit issued from its 364-day facility on July 24, 2002.
The letter of credit facilities also included a $150.0 million secured
letter of credit facility established in January 2002. This facility is
unutilized and will expire at the end of 2002. In addition, Le Mans Re has a
secured letter of credit facility, included in the table above, under which
letters of credit amounting to $42.0 million were issued.
For information regarding cross-default and certain other provisions in
the Company's debt documents, see Item 7 of the Company's Form 10-K for the year
ended December 31, 2001.
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, 2002, no shares were repurchased in the open market but the
Company has repurchased shares from employees and directors in relation to share
swaps on option exercises and withholding tax on restricted stock.
CURRENT OUTLOOK
The Company continued to recognize strong levels of net premiums earned,
primarily due to increases in pricing across virtually all property and casualty
lines of insurance and reinsurance business, significant new business growth,
the acquisition of Winterthur International effective July 1, 2001 and the
acquisition of a majority ownership stake in Le Mans Re, effective January 1,
2002. Rate increases and favorable terms and conditions remained at least as
strong as earlier in the year, and the Company believes these market conditions
will prevail through 2002 for most lines of property and casualty business the
Company writes. These improvements are, however, tempered by, among other
things, a challenging investment income environment and potential unusual loss
events.
35
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
The Company is exposed to potential loss from various market risks,
including changes in interest rates, foreign currency exchange rates, equity
prices and commodity values (as it relates to the Company's participation in the
weather risk and energy management market). The Company manages its market risks
based on guidelines established by senior management. The Company enters into
derivatives and other financial instruments for trading and risk management
purposes. These derivative instruments are carried at fair market value with the
resulting gains and losses recognized in income in the period in which they
occur.
This risk management discussion and the estimated amounts generated from
the sensitivity and value-at-risk ("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."
WEATHER AND ENERGY RISK
The Company offers weather and energy risk management products in
insurance or derivative form to end-users, while hedging the risks in the
over-the-counter and exchange traded derivatives markets. In addition to
entering into transactions with end-users, the Company also maintains a weather
and energy derivatives trading portfolio, with the majority of contracts
outstanding for less than twelve months. The fair values of these transactions
are determined using quantitative analysis. The models used to determine these
fair values are consistent with the models used to estimate the Company's VaR
exposure to weather risk.
The Company's high, low and average aggregate seasonal VaR amounts during
the period ended June 30, 2002 were $101.6 million, $25.8 million and $55.4
million, respectively, calculated at a 99% confidence level. The Company
calculates its aggregate VaR by summing the VaR amounts for each of its seasonal
portfolio. Since VaR statistics are estimates based on historical position and
market data, VaR should not be viewed as an absolute, predictive gauge of future
financial performance or as a way for the Company to predict risk. There can be
no assurance that the Company's actual future losses will not exceed its VaR
amounts.
The following table summarizes the movement in the fair value of weather
and energy contracts outstanding during the six months ended June 30, 2002:
SIX MONTHS ENDED
JUNE 30, 2002
----------------
Fair value of contracts outstanding, beginning of the year ..... $ (1,104)
Contracts realized or otherwise settled ........................ (8,094)
Fair value of new contracts .................................... 15,360
Other changes in fair value .................................... 3,410
--------
Fair value of contracts outstanding, end of period ............. $ 9,572
========
The following table summarizes the maturity of contracts outstanding as at
June 30, 2002:
GREATER
LESS THAN THAN 5 TOTAL FAIR
SOURCE OF FAIR VALUE 1 YEAR 1-3 YEARS 4-5 YEARS YEARS VALUE
-------------------- ------ --------- --------- ----- -----
Prices actively quoted ............................... $ 800 $ -- $ -- $ -- $ 800
Prices based on models and other valuation methods ... 4,732 1,657 2,383 -- 8,772
------ ------ ------ ------ ------
Total fair value of contracts outstanding ............ $5,532 $1,657 $2,383 $ -- $9,572
====== ====== ====== ====== ======
36
In managing its weather and energy risk management business, the Company
seeks to identify, assess, monitor and manage, in accordance with defined
policies and procedures its market, credit, operational and legal risks. The
Company's senior management takes an active role in the risk management process
and has developed and implemented policies and procedures that require specific
administrative and business functions to assist in the identification,
assessment and control of various risks. Due to the changing nature of the
global marketplace, the Company's risk management policies, procedures and
methodologies are evolving and are subject to ongoing review and modification.
Market, credit, operational, legal and other risks are inherent in the Company's
weather risk management business and cannot be wholly eliminated or reduced
despite the Company's risk management policies, procedures and methodologies,
which are subject to limitations and assumptions.
INVESTMENT MARKET RISK
The Company's investment portfolio consists of fixed income and equity
securities, denominated in both U.S. and foreign currencies. Accordingly,
earnings will be affected by, among other things, changes in interest rates,
credit quality, equity prices and foreign currency exchange rates. External
investment professionals manage the Company's portfolio under the direction of
the Company's management in accordance with detailed investment guidelines
provided by the Company. These guidelines encompass investments in derivatives.
Derivatives can only be utilized for purposes of managing interest rate risk,
foreign exchange risk and credit risk, provided the use of such instruments are
incorporated in the overall portfolio duration, spread, convexity and other
relevant portfolio metrics. The use of derivatives is not permitted to
economically leverage the portfolio outside of the stated guidelines.
VaR is one of the tools used by management to measure 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
maximum loss that could occur over a defined period of time given a certain
probability. The VaR of the investment portfolio, including all investment
related derivatives, at June 30, 2002 was approximately $222.4 million.
The Company also uses derivative investments to add value to the
investment portfolio where market inefficiencies are believed to exist, to
equitize cash holdings of equity managers and to adjust the duration of a
portfolio of fixed income securities to match the duration of related deposit
liabilities.
At June 30, 2002, bond and stock index futures outstanding were $226.0
million with underlying investments having a market value of $2.2 billion. Gains
of $7.3 million were realized on these contracts for the three months ended June
30, 2002. The Company reduces its exposure to these futures through offsetting
transactions, including options and forwards. The VaR of all investment related
derivatives at June 30, 2002 was approximately $6.0 million.
The Company holds warrants in conjunction with certain of its other
investments. These warrants are recorded at fair value based on quoted market
prices. For the six months ended June 30, 2002, the Company recorded an
unrealized loss of $14.2 million for the change in fair value of these warrants,
relating primarily to the Company's investment in Mutual Risk Management.
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 Shareholders, any proxy statement,
any 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 the insurance,
reinsurance and financial products and services sectors in particular (both as
to underwriting and investment matters). Statements that are not historical
facts, including statements about the Company's beliefs and expectations, are
forwarded-looking statements. These Statements are based on current plans,
estimates and projections. 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.
37
All forward-looking statements address matters that involve inherent risks
and uncertainties. Accordingly, there are or will be important factors that
could cause actual results to differ materially from those indicated in such
forward-looking statements. The Company believes that these factors include, but
are not limited to, the following: (i) rate increases and improvements in terms
and conditions may not be as large or sustainable as the Company is currently
projecting; (ii) the size of the Company's claims may change due to the
preliminary nature of reports and estimates of loss and damage, or due to
adverse development over time, including in relation to the attacks in the
United States on September 11, 2001; (iii) the timely and full recoverability of
reinsurance placed by the Company with third parties; (iv) the projected amount
of ceded reinsurance recoverables and the ratings and creditworthiness of
reinsurers may change; (v) the timing of claims payments being faster or the
receipt of reinsurance recoverables being slower than anticipated by the
Company; (vi) ineffectiveness or obsolescence of the Company's business strategy
due to changes in current or future market conditions; (vii) increased
competition on the basis of pricing, capacity, coverage terms or other factors;
(viii) 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; (ix) 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; (x) the potential impact
of government-sponsored solutions to make available insurance coverage for acts
of terrorism; (xi) developments in the bankruptcy proceedings of Adelphia
Communications, Enron Corp. and WorldCom Inc. (or other companies that are
subject to bankruptcy or other similar proceedings) or other developments
related to such companies, in so far as they affect property and casualty
insurance and reinsurance coverages; (xii) availability and terms of borrowings
and letters of credit under the Company's credit facilities; (xiii) changes in
regulation or tax laws applicable to the Company and its subsidiaries, brokers
or customers; (xiv) acceptance of the Company's products and services, including
new products and services; (xv) changes in the availability, cost or quality of
reinsurance; (xvi) changes in the distribution or placement of risks due to
increased consolidation of insurance and reinsurance brokers; (xvii) loss of key
personnel; (xviii) the effects of mergers, acquisitions and divestitures,
including, without limitation, the Winterthur International acquisition; (xix)
changes in rating agency policies or practices that could adversely affect the
Company's financial, statutory and other statements and reports and the
Company's ability to engage in particular lines of business; (xx) changes in
accounting policies or practices that could adversely affect the Company's
financial statutory and other statements and reports; (xxi) legislative, tax or
regulatory developments that could adversely affect the Company or the ability
of customers or brokers to do business with the Company; (xxii) changes in
general economic conditions, including inflation, foreign currency exchange
rates and other factors; (xxiii) the effects of business disruption or economic
contraction due to terrorism or other hostilities; (xxiv) developments relating
to Argentina, including the impact of any potential International Monetary Fund
assistance or structural reforms within Argentina; and (xxv) the other factors
set forth in the Company's most recent report on Form 10-K and the Company's
other documents on file with the SEC. The foregoing review of important factors
should not be construed as exhaustive and should be read in conjunction with the
other cautionary statements that are included herein or elsewhere. The Company
undertakes no obligation to publicly update or revise any forward-looking
statement, whether as a result of new information, future developments or
otherwise.
38
XL CAPITAL LTD
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is a party to various legal proceedings, including
arbitrations, arising in the ordinary course of business. Such legal proceedings
generally relate to claims asserted by or against the Company's subsidiaries in
the ordinary course of their respective insurance, reinsurance and financial
products and services operations. The Company does not believe that the eventual
resolution of any of the legal proceedings to which it is a party will result in
a material adverse effect on its financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
At the Annual General Meeting of Class A Shareholders held on May 10, 2002
at the Executive Offices of the Company, XL House, One Bermudiana Road, Hamilton
HM 11, Bermuda, the shareholders approved the following:
1. The election of six Class I Directors to hold office until 2005:
Votes in Favor Votes Withheld
-------------- --------------
R. Bornhuetter 119,763,533 615,322
M.P. Esposito, Jr. 119,773,879 604,976
R.R. Glauber 119,277,648 1,101,207
P. Jeanbart 119,768,894 609,961
C. Rance 119,748,102 630,753
E.E. Thrower 119,767,251 611,604
2. The appointment of Pricewaterhouse Coopers LLP, New York, New York, to act
as the independent auditors of the Company for the fiscal year ending
December 31, 2002:
VOTES IN FAVOR VOTES WITHHELD ABSTENTIONS
-------------- -------------- -----------
117,984,399 2,006,289 388,167
3. The approval of the amendment and restatement of the Company's 1991
Performance Incentive Program and:
VOTES IN FAVOR VOTES WITHHELD ABSTENTIONS BROKER NON-VOTES
-------------- -------------- ----------- ----------------
57,510,480 55,477,129 583,566 6,807,680
4. The approval of the Company's Employee Share Purchase Plan:
VOTES IN FAVOR VOTES WITHHELD ABSTENTIONS BROKER NON-VOTES
-------------- -------------- ----------- ----------------
112,835,580 310,007 425,588 6,807,680
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
10.63 364-Day Credit Agreement, dated June 27, 2002, between XL Capital
Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd, XL Europe Ltd
and XL Re Ltd, as account parties and guarantors, the lenders party
thereto, and JP Morgan Chase Bank, as administrative agent.
99.9 XL Capital Assurance Inc. unaudited condensed financial statements
for the three month and six month periods ended June 30, 2002 and
2001.
99.10 XL Financial Assurance Ltd. unaudited condensed financial statements
for the three month and six month periods ended June 30, 2002 and
2001.
39
(B) REPORTS ON FORM 8-K
None
40
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 5, 2002 /s/ BRIAN M. O'HARA
- --------------------- ----------------------------------------------------
BRIAN M. O'HARA
PRESIDENT AND CHIEF EXECUTIVE OFFICER
/s/ JERRY DE ST. PAER
----------------------------------------------------
JERRY DE ST. PAER
EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER
41
CERTIFICATION
ACCOMPANYING FORM 10-Q REPORT
OF XL CAPITAL LTD
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
(CHAPTER 63, TITLE 18 U.S.C.SS.1350(A) AND (B))
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chapter 63,
Title 18 U.S.C. ss.1350(a) and (b)), each of the undersigned hereby certifies
that the Quarterly Report on Form 10-Q for the period ended June 30, 2002 of XL
Capital Ltd ("Company") fully complies with the requirements of Section 13(a) or
Section 15(d) of the Securities Exchange Act of 1934 and that the information
contained in such Report fairly presents, in all material respects, the
financial condition and results of operations of the Company.
Dated: August 5, 2002 /s/ Brian M. O'Hara
-------------------------------------
Brian M. O'Hara
President and Chief Executive Officer
XL Capital Ltd
Dated: August 5, 2002 /s/ Jerry de St. Paer
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Jerry de St. Paer
Executive Vice President and Chief
Financial Officer
XL Capital Ltd