10-K 1 c56783_10k.htm 3B2 EDGAR HTML -- c56783_10k.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

S ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2008
OR

£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from   to  
Commission file number 1-10804

XL CAPITAL LTD
(Exact name of registrant as specified in its charter)

 

 

 

Cayman Islands
(State or other jurisdiction of
incorporation or organization)

 

98-0191089
(I.R.S. Employer Identification No.)

XL House, One Bermudiana Road
Hamilton, Bermuda HM 11

(Address of principal executive offices and zip code)

 

(441) 292-8515
(Registrant’s telephone number, including area code)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

 

 

Title of each class

 

Name of each exchange
on which registered

Class A Ordinary Shares, Par Value $0.01 per Share

 

New York Stock Exchange

10.75% Equity Security Units

 

New York Stock Exchange

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes S  No £

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes £  No S

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 for 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
S  No £

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  S  Accelerated filer  £  Non-accelerated filer  £  Smaller reporting company  £  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes
£  No S

The aggregate market value of the voting common equity of the registrant held by non-affiliates of the registrant on June 30, 2008 was approximately $3.7 billion computed upon the basis of the closing sales price of the Class A Ordinary Shares on June 30, 2008. For purposes of this computation, ordinary shares held by directors and officers of the registrant have been excluded. Such exclusion is not intended, nor shall it be deemed, to be an admission that such persons are affiliates of the registrant.

As of February 25, 2009, there were outstanding 342,210,169 Class A Ordinary Shares, $0.01 par value per share, of the registrant.

Documents Incorporated by Reference

The Registrant’s Definitive Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report relating to the annual meeting of ordinary shareholders to be held on April 24, 2009 is incorporated by reference into Part III of this Form 10-K.




XL CAPITAL LTD
TABLE OF CONTENTS

 

 

 

 

 

 

 

 

 

Page

 

 

 

   

PART I

Item 1.

 

Business

 

 

 

1

 

Item 1A.

 

Risk Factors.

 

 

 

30

 

Item 1B.

 

Unresolved Staff Comments

 

 

 

49

 

Item 2.

 

Properties

 

 

 

49

 

Item 3.

 

Legal Proceedings

 

 

 

49

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

 

 

51

 

PART II

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

 

 

54

 

Item 6.

 

Selected Financial Data

 

 

 

56

 

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

58

 

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

 

129

 

Item 8.

 

Financial Statements and Supplementary Data

 

 

 

140

 

Item 9.

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

 

 

 

231

 

Item 9A.

 

Controls and Procedures

 

 

 

231

 

Item 9B.

 

Other Information.

 

 

 

231

 

PART III

Item 10.

 

Directors, Executive Officers and Corporate Governance

 

 

 

232

 

Item 11.

 

Executive Compensation

 

 

 

232

 

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

 

 

232

 

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

 

 

 

232

 

Item 14.

 

Principal Accounting Fees and Services

 

 

 

232

 

PART IV

Item 15.

 

Exhibits, Financial Statement Schedules.

 

 

 

233

 

This Annual Report on Form 10-K contains “Forward-Looking Statements” as defined in the Private Securities Litigation Reform Act of 1995. A non-exclusive list of the important factors that could cause actual results to differ materially from those in such Forward-Looking Statements is set forth herein under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Cautionary Note Regarding Forward-Looking Statements.”


PART I

 

 

 

 

 

 

ITEM 1.

 

BUSINESS

 

 

 

History

XL Capital Ltd, through its subsidiaries (the “Company” or “XL”), is a leading provider of global insurance and reinsurance coverages to industrial, commercial and professional service firms, insurance companies and other enterprises on a worldwide basis. XL Capital Ltd was incorporated with limited liability under the Cayman Islands Companies Act on March 16, 1998, as EXEL Merger Company. XL Capital Ltd was formed as a result of the merger of EXEL Limited and Mid Ocean Limited on August 7, 1998, and the Company was named EXEL Limited on that date.

EXEL Limited and Mid Ocean Limited are companies that were incorporated in the Cayman Islands in 1986 and 1992, respectively. At a special general meeting held on February 1, 1999, the shareholders of the Company approved a resolution changing the name of the Company to XL Capital Ltd.

On June 18, 1999, XL Capital Ltd merged with NAC Re Corp. (“NAC”), a Delaware corporation organized in 1985, in a stock merger. This merger was accounted for as a pooling of interests under U.S. generally accepted accounting principles (“GAAP”). Following the merger, the Company changed its fiscal year end from November 30 to December 31 as a conforming pooling adjustment.

On July 25, 2001, the Company acquired certain Winterthur International insurance operations (“Winterthur International”) to extend its predominantly North American-based large corporate insurance business globally. Results of operations of Winterthur International have been included from July 1, 2001, the date from which the economic interest was transferred to the Company.

Effective January 1, 2002, the Company increased its shareholding in Le Mans Ré from 49% to 67% in order to expand its international reinsurance operations. On September 3, 2003, the Company exercised its option to buy the remaining 33% from MMA and changed the name of Le Mans Ré to XL Re Europe S.A. On October 18, 2006, the Company received approval to form a new European company, XL Re Europe Ltd, based in Dublin, Ireland, which is licensed to write all classes of reinsurance business. XL Re Europe Ltd is the headquarters of the Company’s European reinsurance platform with branch offices in France and the U.K.

On August 4, 2006, the Company completed the sale of approximately 37% of its then financial guarantee reinsurance and insurance businesses through an initial public offering (“IPO”) of 23.4 million common shares of Syncora Holdings Ltd. (“Syncora”) (formerly Security Capital Assurance Ltd. or “SCA”). On June 6, 2007, the Company completed the sale of a portion of Syncora’s common shares still owned by the Company through a secondary offering and thereby reduced its ownership of Syncora’s outstanding common shares further from approximately 63% to approximately 46%. On August 5, 2008, the Company closed an agreement (the “Master Agreement”) with Syncora and its subsidiaries, as well as certain counterparties to credit default swap agreements, in connection with the termination of certain reinsurance and other agreements. As part of the Master Agreement, the Company transferred all of the shares it owned in Syncora to a trust and as a result has no further ownership interest in the company. For further details relating to the Master Agreement, see Item 8, Note 4 to the Consolidated Financial Statements, “Syncora Holdings Ltd.”

See further information under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Segments

The Company is organized into four operating segments: Insurance, Reinsurance, Life Operations, and Other Financial Lines – in addition to a Corporate segment that includes the general investment and financing operations of the Company.

The Company evaluates the performance for both the Insurance and Reinsurance segments based on underwriting profit and evaluates the contribution from each of the Life Operations and Other Financial Lines segments. Other items of revenue and expenditure of the Company are not evaluated at the segment level for reporting purposes. In addition, the Company does not allocate investment assets by segment for

1


its property and casualty (“P&C”) operations. Investment assets related to (i) the Company’s Life Operations and Other Financial Lines segments and (ii) certain structured products included in the Insurance and Reinsurance segments are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each of these segments.

The following table sets forth an analysis of gross premiums written by segment for the years ended December 31, 2008, 2007 and 2006. Additional financial information about the Company’s segments, including financial information about geographic areas, is included in Item 8, Note 6 to the Consolidated Financial Statements, “Segment Information.”

 

 

 

 

 

 

 

 

 

 

 

Year ended December 31
(U.S. dollars in thousands)

 

2008
Gross
Premiums
Written

 

Percentage
Change

 

2007
Gross
Premiums
Written

 

Percentage
Change

 

2006
Gross
Premiums
Written

Insurance

 

 

$

 

5,308,914

   

 

 

(2.3

)%

 

 

 

$

 

5,434,266

   

 

 

(3.4

)%

 

 

 

$

 

5,627,293

 

Reinsurance

 

 

 

2,260,477

   

 

 

(15.1

)%

 

 

 

 

2,663,494

   

 

 

(13.1

)%

 

 

 

 

3,066,138

 

Life Operations

 

 

 

690,915

   

 

 

(7.0

)%

 

 

 

 

743,220

   

 

 

8.2

%

 

 

 

 

686,906

 

Syncora (1)

 

 

 

   

 

 

(100.0

)%

 

 

 

 

156,983

   

 

 

(61.3

)%

 

 

 

 

405,910

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

 

8,260,306

   

 

 

(8.2

)%

 

 

 

$

 

8,997,963

   

 

 

(8.1

)%

 

 

 

$

 

9,786,247

 

 

 

 

 

 

 

 

 

 

 

 


 

 

(1)

 

 

 

Gross premiums written relating to Syncora in 2007 are for the period from January 1, 2007 through June 6, 2007, the date on which the Company completed the sale of a portion of Syncora’s common shares then owned by the Company, through a secondary offering and thereby reduced its ownership of Syncora’s outstanding common shares from approximately 63% to approximately 46%. From June 6, 2007 until the execution of the Master Agreement, the Company accounted for its remaining investment in Syncora using the equity method of accounting. Subsequent to August 5, 2008, the Company has no further ownership interest in Syncora.

Insurance Segment

General

The Company’s Insurance segment provides commercial property and casualty insurance products on a global basis. Products generally provide tailored coverages for complex corporate risks and include the following lines of business: property, casualty, professional liability, environmental liability, aviation and satellite, marine and offshore energy, equine, fine art and specie, excess and surplus lines and other insurance coverages including program business. However, given the changing economic environment that has been experienced throughout 2008 and early 2009 during the global economic and financial crises and following the significant impacts to the Company during 2008, including the downgrade of the financial strength ratings of the Company’s core insurance and reinsurance subsidiaries by leading rating agencies, the Company plans to focus on those lines of business within its insurance operations that provide the best return on capital over the pricing cycle. For the Insurance segment, this will include the non-renewal of certain insurance programs, as well as a continued reduction in long-term agreements in order to capture the benefit of hardening markets.

Property and casualty products are typically written as global insurance programs for large multinational companies and institutions and include umbrella liability, product recall property catastrophe, U.S. workers’ compensation, and primary master property and liability coverages. Property and casualty products generally provide large capacity on a primary, quota share or excess of loss basis. Global insurance programs are targeted to large worldwide companies in major industry groups including aerospace, automotive, consumer products, pharmaceutical, pulp and paper, high technology, telecommunications, transportation and basic metals. In North America, the casualty business written includes primary, umbrella and high layer excess business. The primary casualty programs (including workers’ compensation) generally require customers to take large deductibles or self-insured retentions. For the umbrella and excess business written, the Company’s liability attaches after large deductibles, including self insurance or insurance from other companies. Outside of North America, casualty business is generally written on a primary basis. Policies are written on an occurrence, claims-made and occurrence reported basis. The Company’s property business written, which also includes construction projects, is short-tail by nature and written on both a primary and excess of loss basis. Property business written includes exposures to man-made and natural disasters, and generally, loss experience is characterized as low frequency and high severity. This may result in volatility in the Company’s results of operations, financial condition and

2


liquidity. In addition to the property and casualty products noted above, in 2008 the Company launched underwriting capabilities for the Upper Middle Markets (“UMM”) in the U.S., U.K. and Continental Europe. These units are focused on providing underwriting expertise and tailored insurance solutions for the UMM customers through focused distribution channels of select regional retail brokers. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, for further information.

Professional liability insurance includes directors’ and officers’ liability, errors and omissions liability and employment practices liability coverages. Policies are written on both a primary and excess of loss basis. Directors’ and officers’ coverage includes primary and excess directors’ and officers’ liability, employment practices liability, company securities and private company directors’ and officers’ liability. Products are targeted at a variety of different sized companies, with a heavy concentration on small to medium-sized firms when written on a primary basis. Employment practices liability is written primarily for very large corporations and covers those firms for legal liability in regard to the treatment of employees. Errors and omissions coverage is written on a primary and excess basis. Errors and omissions insurance written on a primary basis is targeted to small at medium-sized firms and coverage is provided for various professional exposures, including, but not limited to, insurance brokers, consultants, architects and engineers, lawyers, public entities and real estate agents.

Environmental liability products include pollution and remediation legal liability, general and project-specific pollution and professional liability, commercial general property redevelopment and contractor’s pollution liability. Business is written for both single and multiple years on a primary or excess of loss, claims-made or, less frequently, occurrence basis. Targeted industries include environmental service firms, contractors, healthcare facilities, manufacturing facilities, real estate redevelopment, transportation and construction. The Company also offers commercial general liability and automobile liability insurance to environmental businesses.

Aviation and satellite products include comprehensive airline hull and liability, airport liability, aviation manufacturers’ product liability, aviation ground handler liability, large aircraft hull and liability, corporate non-owned aircraft liability, space third party liability and satellite risk including damage or malfunction during ascent to orbit and continual operation, and aviation war. Aviation liability and physical damage coverage is offered for large aviation risks on a proportional basis, while smaller general aviation risks are offered on a primary basis. Satellite risks are generally written on a proportional basis. The target markets for aviation and satellite products include airlines, aviation product manufacturers, aircraft service firms, general aviation operators and telecommunications firms.

Marine and offshore energy, equine and fine art and specie insurance are also provided by the Company. Marine and energy coverage includes marine hull and machinery, marine war, marine excess liability, cargo and offshore energy insurance. Equine products specialize in providing bloodstock, livestock and aquaculture insurance. Fine art and specie coverages include fine art, jewelers block, cash in transit and related coverages for financial institutions.

Excess and surplus lines products include both general liability and property coverages. For general liability, most Insurance Services Office, Inc. products are written. For property, limits are relatively low and coverages exclude flood, earthquake and difference in conditions.

The Company’s program business specializes in insurance coverages for distinct market segments in North America, including program administrators and managing general agents who operate in a specialized market niche and have unique industry backgrounds or specialized underwriting capabilities. Products encompass automobile extended warranty and other property and casualty coverage. The Company implemented an exit strategy for its small commercial property catastrophe coverage program in 2006 and has decided to exit the automobile extended warranty business in 2009.

Certain structured indemnity products, previously structured by XL Financial Solutions (“XLFS”), are included within the results of the Insurance segment covering a range of insurance risks including property and casualty insurance, certain types of residual exposures and other market risk management products. In August 2008, the Company ceased certain operations that included the closure of the XLFS business unit and reassignment of responsibility for existing structured indemnity business to either the insurance or reinsurance segment depending on the underlying nature of the transactions.

3


Also included as part of the Insurance segment is XL GAPS, a loss prevention consulting service which offers individually tailored risk management solutions to risk managers, insurance brokers and insurance company clients operating on a global basis.

The excess nature of many of the Company’s insurance products, coupled with historically large policy limits, results in a book of business that can have losses characterized as low frequency and high severity. As a result, large losses, though infrequent, can have a significant impact on the Company’s results of operations, financial condition and liquidity. The Company attempts to mitigate this risk by, among other things, using strict underwriting guidelines, effective risk management practices (e.g., monitoring of aggregate exposures) and various reinsurance arrangements, discussed below.

U.S. Terrorism

The U.S. Terrorism Risk Insurance Act of 2002 (“TRIA”), as amended, established the Terrorism Risk Insurance Program (“TRIP”) which became effective on November 26, 2002 and was a three-year federal program effective through 2005. On December 22, 2005, President George Bush signed a bill extending TRIA (“TRIAE”) for two more years, continuing TRIP through 2007. On December 26, 2007, President George Bush signed the Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”) which further extended TRIP for 7 years until December 31, 2014 and also eliminated the distinction between foreign and domestic acts of terrorism.

The Company had, prior to the passage of TRIP and the related legislation, underwritten exposures under certain insurance policies that included coverage for terrorism. The passage of TRIP and the related legislation, has required the Company to make a mandatory offer of “Certified” terrorism coverage with respect to relevant covered insurance policies as specified under the related legislation.

Non-U.S. Terrorism

The Company provides coverage for terrorism under casualty policies on a case-by-case basis. The Company generally does not provide significant limits of coverage for terrorism under first party property policies outside of the U.S. unless required to do so by local law, or as required to comply with any national terrorism risk pool which may be available. Various countries have enacted legislation to provide insurance coverage for terrorism occurring within their borders, to protect registered property, and to protect citizens traveling abroad. The legislation typically requires registered direct insurers to provide terrorism coverage for specified coverage lines and then permits them to cede the risk to a national risk pool. The Company has subsidiaries that participate in terrorism risk pools in various jurisdictions, including Australia, France, Spain, the Netherlands and the United Kingdom.

Underwriting

The Company underwrites and prices most risks individually following a review of the exposure and in accordance with the Company’s underwriting guidelines. Most of the Company’s insurance operations have underwriting guidelines that are industry-specific. The Company seeks to control its exposure on individual insurance contracts through terms and conditions, policy limits and sublimits, attachment points, and facultative and treaty reinsurance arrangements on certain types of risks.

The Company’s underwriters generally evaluate each industry category and subgroups within each category. Premiums are set and adjusted for an insured based, in large part, on the industry group in which the insured is placed and the insured’s perceived risk relative to the other risks in that group. Rates may vary significantly according to the industry group of the insured as well as the insured’s risk relative to the group. The Company’s rating methodology for individual insureds seeks to set premiums in accordance with claims potential as measured by past experience and future expectations, the attachment point and amount of underlying insurance, the nature and scope of the insured’s operations, including the industry group in which the insured operates, exposures to loss, natural hazard exposures, risk management quality and other specific risk factors relevant in the judgment of the Company’s underwriters to the type of business being written.

4


Underwriting and loss experience is reviewed regularly for, among other things, loss trends, emerging exposures, changes in the regulatory or legal environment as well as the efficacy of policy terms and conditions.

As the Company’s insurance products are primarily specialized coverages, underwriting guidelines and policy forms differ by product offering as well as by legal jurisdiction. Liability insurance is written on both a primary and excess of loss basis, on occurrence, occurrence reported and claims-made policy forms. Occurrence reported policies typically cover occurrences causing unexpected and unintended personal injury or property damage to third parties arising from events or conditions that commence at or subsequent to an inception date, or retroactive date, if applicable, and prior to the expiration of the policy provided that proper notice is given during the term of the policy or the discovery period. Traditional occurrence coverage is also available for restricted classes of risk and is generally written on a follow-form basis where the policy adopts the terms, conditions and exclusions of the underlying policy. Property insurance risks are written on a lead or follow-form basis that usually provides coverage for all risks of physical damage and business interruption. Maximum limits are generally subject to sublimits for coverage in critical earthquake and flood zones, where the Company seeks to limit its liability in these areas.

Reinsurance Ceded

In certain cases, the risks assumed by the Company in the Insurance segment are partially reinsured with third party reinsurers. Reinsurance ceded varies by location and line of business based on a number of factors, including market conditions. The benefits of ceding risks to third party reinsurers include reducing exposure on individual risks, protecting against catastrophic risks, maintaining acceptable capital ratios and enabling the writing of additional business. Reinsurance ceded does not legally discharge the Company from its liabilities to the original policyholder in respect of the risk being reinsured.

The Company uses reinsurance to support the underwriting and retention guidelines of each of its subsidiaries as well as to control the aggregate exposure of the Company to a particular risk or class of risks. Reinsurance is purchased at several levels ranging from reinsurance of risks assumed on individual contracts to reinsurance covering the aggregate exposure on a portfolio of policies issued by groups of companies. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, for further information.

Premiums

Premium rates and underwriting terms and conditions for all lines of business written vary by jurisdiction principally due to local market conditions, competitor product offerings and legal requirements.

The following table is an analysis of the Insurance segment’s gross premiums written, net premiums written and net premiums earned, by line of business for the year ended December 31, 2008:

 

 

 

 

 

 

 

(U.S. dollars in thousands)

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

Casualty – professional lines

 

 

$

 

1,472,874

   

 

$

 

1,351,237

   

 

$

 

1,369,668

 

Casualty – other lines

 

 

 

1,273,016

   

 

 

793,512

   

 

 

822,252

 

Property catastrophe

 

 

 

(65

)

 

 

 

 

(2,177

)

 

 

 

 

270

 

Other property

 

 

 

886,483

   

 

 

505,564

   

 

 

471,013

 

Marine, energy, aviation and satellite

 

 

 

747,311

   

 

 

604,786

   

 

 

621,774

 

Other specialty lines (1)

 

 

 

850,404

   

 

 

712,307

   

 

 

660,322

 

Other (2)

 

 

 

22,736

   

 

 

(22,908

)

 

 

 

 

(11,055

)

 

Structured indemnity

 

 

 

56,155

   

 

 

42,505

   

 

 

62,801

 

 

 

 

 

 

 

 

Total

 

 

$

 

5,308,914

   

 

$

 

3,984,826

   

 

$

 

3,997,045

 

 

 

 

 

 

 

 


 

 

(1)

 

 

 

Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, specie, middle markets and excess and surplus lines.

 

(2)

 

 

 

Other includes credit and surety and other lines.

5


Competition

The Company competes globally in the property and casualty insurance markets. Its competitors include the following companies and their affiliates: The ACE Group of Companies (“ACE”); Allianz Aktiengesellschaft (“Allianz”); American International Group, Inc. (“AIG”); Factory Mutual Global (“FMG”) for property only; Hartford Financial Services (“Hartford”); Lloyd’s of London Syndicates (“Lloyd’s”); The Chubb Corporation (“Chubb”); The Travelers Companies (“Travelers”); and Zurich Financial Services Group (“Zurich”).

The Company’s major geographical markets for its property and casualty insurance operations are North America, Europe and Bermuda. The Company’s main competitors in each of these markets include the following:

North America – AIG, ACE, Chubb, FMG, Zurich, Travelers, CNA Financial Corporation, Hartford, FMG, Liberty Mutual Group and Lloyd’s.

Europe – Allianz, AIG, FMG, Zurich, AXA, ACE, Lloyd’s, Assicurazioni Generali and HDI-Gerling Industrie Versicherung AG.

Bermuda – ACE, Allied World Assurance Company, Axis Capital Group, Max Re Ltd., Endurance Specialty Insurance Ltd and Arch Capital Group Ltd.

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Executive Overview” for further discussion.

Marketing and Distribution

The majority of Insurance Segment business originates via a large number of international, national and regional producers, acting as the agents and representatives of current and prospective policyholders. A portion of Insurance Segment business is marketed and underwritten by general agents and independent agents acting on behalf of the Company. Typically, all such producers, general agents, and independent agents receive commission payments from the Company for their services, which payments are calculated as a percentage of gross premium paid by the policyholder on an account-by-account basis. A certain portion of business originating from producers is submitted on a fee basis under which the producer is compensated by a fee paid to it by its policyholder client. With regard to fee only business, the Company has considered requests from certain producers to provide commissions in addition to fees paid to such producers. After evaluation, such fees are paid, on a case by case basis, with disclosure by the producer to the policyholder-client.

In the past, the Company has also entered into contingent commission arrangements with some producers that provided for the payment of additional commissions based on such variables as production of new and renewal business or the retention of business. Going forward, the Company intends to entertain requests for additional commission arrangements only where such additional commissions are based upon the volume of bound business originating from a specific broker during a prior calendar year. Such arrangements are distinct from program business where additional commissions are generally based on profitability of business submitted to and bound by the Company.

With regard to excess and surplus lines business, the Company receives submissions from licensed wholesale surplus lines brokers.

The Company has no implied or explicit commitments to accept business from any particular broker, and neither producers nor any other third party have the authority to bind the Company, except in the case where underwriting authority may be delegated contractually to selected general agents. Such general agents are subject to a financial and operational due diligence review prior to any such delegation of authority and ongoing reviews and audits are carried out as deemed necessary by the Company with the goal of assuring the continuing integrity of underwriting and related business operations. See Item 8, Note 20(a) to the Consolidated Financial Statements for information on the Company’s major producers, “Commitments and Contingencies – Concentrations of Credit Risk.”

6


Claims Administration

Claims management for the insurance operations includes the review of initial loss reports, administration of claims databases, generation of appropriate responses to claims reports, identification and handling of coverage issues, determination of whether further investigation is required and, where appropriate, retention of claims counsel, establishment of case reserves, payment of claims and notification to reinsurers. With respect to the establishment of case reserves, when the Company is notified of insured losses, claims personnel record a case reserve as appropriate for the estimated amount of the exposure at that time. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process.

Claims in respect of business written by the Company’s Lloyd’s syndicates are primarily notified by various central market bureaus. Where a syndicate is a “leading” syndicate on a Lloyd’s policy, its underwriters and claims adjusters will deal with the broker or insured on behalf of itself and the following market for any particular claim. This may involve appointing attorneys or loss adjusters. The claims bureau and the leading syndicate advise movement in loss reserves to all syndicates participating on the risk. The Company’s claims department may adjust the case reserves it records from those advised by the bureau as deemed necessary.

Certain of the Company’s product lines have arrangements with third party administrators (“TPAs”) to provide claims handling services to the Company in respect of such product lines. These agreements set forth the duties of the TPA, limits of authority, protective indemnification language and various procedures that are required to meet statutory compliance. These arrangements are also subject to audit review by the Company’s claim department.

Reinsurance Segment

General

The Company’s Reinsurance segment provides casualty, property risk (including energy and engineering), property catastrophe, marine, aviation, and other specialty reinsurance on a global basis with business being written on both a proportional and non-proportional basis. As noted above, given the changing economic environment that has been experienced throughout 2008 and early 2009 during the global economic and financial crises and following the significant impacts to the Company during 2008, including the downgrade of the financial strength ratings of the Company’s leading insurance and reinsurance subsidiaries by leading rating agencies, the Company plans to focus on those lines of business within its reinsurance operations that provide the best return on capital. For the Company’s Reinsurance segment in 2009, this will in certain instances, result in a greater emphasis being placed on short-tail lines of business.

Business written on a non-proportional basis generally provides for an indemnification by the Company to the ceding company for a portion of losses both individually and in the aggregate, on policies with limits in excess of a specified individual or aggregate loss deductible. For business written on a proportional bases including “quota share” or “surplus” basis, the Company receives an agreed percentage of the premium and is liable for the same percentage of each and all incurred loss. For proportional business, the ceding company normally receives a ceding commission for the premiums ceded and may also, under certain circumstances, receive a profit commission. Occasionally this commission could be on a sliding scale depending on the loss ratio performance in which case there is generally no profit commission. Reinsurance may be written on a portfolio/treaty basis or on an individual risk/facultative basis. The treaty business is mainly underwritten using reinsurance intermediaries while the individual risk business is generally underwritten directly with the ceding companies, especially for business written in the U.S.

The Company’s casualty reinsurance includes general liability, professional liability, automobile and workers’ compensation. Professional liability includes directors’ and officers’, employment practices, medical malpractice, and environmental liability. Casualty lines are written as treaties, programs as well as on an individual risk basis and on both a proportional and a non-proportional basis. The treaty business

7


includes clash programs which cover a number of underlying policies involved in one occurrence or a judgment above an underlying policy’s limit, before suffering a loss.

The Company’s property business, primarily short-tail in nature, is written on both a portfolio/treaty and individual/facultative basis and includes property catastrophe, property risk excess of loss and property proportional. A significant portion of the property business underwritten consists of large aggregate exposures to man-made and natural disasters and, generally, loss experience is characterized as low frequency and high severity. This may result in volatility in the Company’s results of operations, financial condition and liquidity. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The Company seeks to manage its reinsurance exposures to catastrophic events by limiting the amount of exposure written in each geographic or peril zone worldwide, underwriting in excess of varying attachment points and requiring that contracts exposed to catastrophe loss include aggregate limits. The Company also seeks to protect its total aggregate exposures by peril and zone through the purchase of reinsurance programs.

The Company’s property catastrophe reinsurance account is generally “all risk” in nature. As a result, the Company is exposed to losses from sources as diverse as hurricanes and other windstorms, earthquakes, freezing, riots, floods, industrial explosions, fires, and many other potential natural or man-made disasters. In accordance with market practice, the Company’s policies generally exclude certain risks such as war, nuclear contamination or radiation. Following the terrorist attacks at the World Trade Center in New York City, in Washington, D.C. and in Pennsylvania on September 11, 2001 (collectively, “the September 11 event”), terrorism cover, including NBRC, has been restricted or excluded in many territories and classes. Some U.S. States make it mandatory to provide some cover for “Fire Following” terrorism and some countries make terrorism coverage mandatory. The Company’s predominant exposure under such coverage is to property damage.

The Company had, prior to the passing of TRIA, underwritten reinsurance exposures in the U.S. that included terrorism coverage. Since the passage of TRIA in the U.S., together with the TRIEA and TRIPRA extensions noted above, the Company has underwritten a very limited number of stand-alone terrorism coverage policies in addition to coverage included within non-stand-alone policies. In the U.S., in addition to NBRC acts, the Company generally excludes coverage included under TRIA from the main catastrophe exposed policies. In other cases, both within and outside the U.S., the Company generally relies on either a terrorism exclusion clause, which does not include personal lines, excluding NBRC, or a similar clause that excludes terrorism completely. There are a limited number of classes underwritten where no terrorism exclusion exists.

Property catastrophe reinsurance provides coverage on an excess of loss basis when aggregate losses and loss adjustment expenses from a single occurrence of a covered event exceed the attachment point specified in the policy. Some of the Company’s property catastrophe contracts limit coverage to one occurrence in any single policy year, but most contracts generally enable at least one reinstatement to be purchased by the reinsured.

The Company also writes property risk excess of loss reinsurance. Property risk excess of loss reinsurance covers a loss to the reinsured on a single risk of the type reinsured rather than to aggregate losses for all covered risks on a specific peril, as is the case with catastrophe reinsurance. The Company’s property proportional account includes reinsurance of direct property insurance. The Company seeks to limit the catastrophe exposure from its proportional and per risk excess business through extensive use of occurrence and cession limits.

Other specialty reinsurance products include energy, marine, aviation, space, engineering, fidelity, trade credit, and political risk.

The Company underwrites a small portfolio of contracts covering political risk and trade credit. Exposure is assumed from a limited number of trade credit contracts and through Lloyd’s quota shares. In addition, there are runoff exposures from discontinued writings in the Company’s marine portfolio.

The results of certain transactions previously structured by XLFS that were generally written on an aggregrate stop loss or excess of loss basis are included within the results of the Reinsurance segment. In August 2008, the Company ceased certain operations that included the closure of the XLFS business unit

8


and reassignment of responsibility for existing structured indemnity business to either the Insurance segment or Reinsurance segment depending on the underlying nature of the transactions.

Underwriting

Underwriting risks for the reinsurance property and casualty business are evaluated using a number of factors including, but not limited to, the type and layer of risk to be assumed, the actuarial evaluation of premium adequacy, the cedant’s underwriting and claims experience, the cedant’s financial condition and claims paying rating, the exposure and/or experience with the cedant, and the line of business to be reinsured.

Other factors assessed by the Company include the reputation of the proposed cedant, the geographic area in which the cedant does business and its market share, a detailed evaluation of catastrophe and risk exposures, and historical loss data for the cedant where available and for the industry as a whole in the relevant regions, in order to compare the cedant’s historical loss experience to industry averages. On-site underwriting reviews are performed where it is deemed necessary to determine the quality of a current or prospective cedant’s underwriting operations, with particular emphasis on proportional and working excess of loss placements.

For property catastrophe reinsurance business, the Company’s underwriting guidelines generally limit the amount of exposure it will directly underwrite for any one reinsured and the amount of the aggregate exposure to catastrophic losses in any one geographic zone. The Company believes that it has defined geographic and peril zones such that a single occurrence, for example an earthquake or hurricane, should not affect more than one peril zone. While the exposure to multiple zones is considered remote for events such as a hurricane, the Company does manage its aggregate exposures for such a scenario where the Company considers it appropriate to do so. The definition of the Company’s peril zones is subject to periodic review. The Company also generally seeks an attachment point for its property catastrophe reinsurance at a level that is high enough to produce a low frequency of loss. The Company seeks to limit its aggregate exposure in the proportional business through extensive use of occurrence and cession limits.

Reinsurance Retroceded

The Company uses third party reinsurance to support the underwriting and retention guidelines of each reinsurance subsidiary as well as seeking to limit the aggregate exposure of the Company to a particular risk or class of risks. Reinsurance is purchased at several levels ranging from reinsurance of risks assumed on individual contracts to reinsurance covering the aggregate exposures. The benefits of ceding risks to other reinsurers include reducing exposure on individual risks, protecting against catastrophic risks, maintaining acceptable capital ratios and enabling the writing of additional business. Reinsurance ceded does not legally discharge the Company from its liabilities in respect of the risk being reinsured. Reinsurance ceded varies by location and line of business based on factors including, among others, market conditions and the credit worthiness of the counterparty.

Upon expiration of the Company’s quota share reinsurance treaty with Cyrus Re which reduced the Company’s catastrophe exposures, the Company, effective January 1, 2008, entered into a quota share reinsurance treaty with a newly-formed Bermuda reinsurance company, Cyrus Re II. Pursuant to the terms of the quota share reinsurance treaty, Cyrus Re II assumed a 10% cession of certain lines of property catastrophe reinsurance and retrocession business underwritten by certain operating subsidiaries of the Company for business that incepted between January 1, 2008 and July 1, 2008. In connection with such cessions, the Company paid Cyrus Re II reinsurance premium less a ceding commission, which included a reimbursement of direct acquisition expenses incurred by the Company as well as a commission to the Company for generating the business. The quota share reinsurance treaty also provided for a profit commission payable to the Company. Following the Company’s evaluation of its exposures and the current market conditions, Cyrus Re II was canceled and not renewed at December 31, 2008.

The traditional catastrophe retrocession program was renewed in June 2008 to cover certain of the Company’s exposures net of Cyrus Re II cessions. These protections, in various layers and in excess of varying attachment points according to the territory exposed, assist in managing the Company’s net retention to an acceptable level. The Company has co-reinsurance retentions within this program. The

9


Company renewed additional structures with a restricted territorial scope for 12 months at July 2008. The Company continued to buy additional protection for the Company’s marine and offshore energy exposures. These covers provide protection in various layers and excess of varying attachment points according to the scope of cover provided. The Company has co-reinsurance participations within this program.

The Company continues to buy specific reinsurances on its credit and bond, motor third party liability, property and aviation portfolios to manage its net exposures in these classes.

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 13 to the Consolidated Financial Statements “Reinsurance” for further information.

Premiums

The following table is an analysis of the Reinsurance segment’s gross premiums written, net premiums written and net premiums earned, by line of business for the year ended December 31, 2008:

 

 

 

 

 

 

 

(U.S. dollars in thousands)

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

Casualty – professional lines

 

 

$

 

213,519

   

 

$

 

213,498

   

 

$

 

247,979

 

Casualty – other lines

 

 

 

356,723

   

 

 

347,849

   

 

 

425,541

 

Property catastrophe

 

 

 

401,740

   

 

 

290,443

   

 

 

305,690

 

Other property

 

 

 

947,899

   

 

 

602,423

   

 

 

678,504

 

Marine, energy, aviation and satellite

 

 

 

119,593

   

 

 

104,346

   

 

 

126,761

 

Other (1)

 

 

 

220,332

   

 

 

194,237

   

 

 

205,433

 

Structured indemnity

 

 

 

671

   

 

 

671

   

 

 

3,298

 

 

 

 

 

 

 

 

Total

 

 

$

 

2,260,477

   

 

$

 

1,753,467

   

 

$

 

1,993,206

 

 

 

 

 

 

 

 


 

 

(1)

 

 

 

Other includes credit and surety, whole account contracts and other lines.

Additional discussion and financial information about the Reinsurance segment is set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 6 to the Consolidated Financial Statements, “Segment Information.”

Competition

The Company competes globally in the property and casualty markets.

The Company’s major geographical markets for its property and casualty reinsurance operations are North America, Europe, Bermuda and Emerging Markets (covering Asia/Pacific and South America). The main competitors in each of these markets include the following:

North America – Berkshire Hathaway, Munich Re Corporation, Swiss Re America Corporation, Transatlantic Re, Everest Re Group Ltd, Hannover Re, and PartnerRe Ltd.

Europe – Munich Re, Swiss Re, Lloyd’s, SCOR Reinsurance Company, and PartnerRe Ltd.

Bermuda – ACE Tempest Reinsurance Ltd, AXIS Specialty Limited, Arch Reinsurance Limited, Renaissance Reinsurance Limited, Montpelier Reinsurance Ltd, Platinum Underwriters Bermuda Ltd and PartnerRe Ltd.

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Executive Overview” for further discussion.

Marketing and Distribution

See Insurance Segment – “Marketing and Distribution” and Item 8, Note 20(a) to the Consolidated Financial Statements, “Commitments and Contingencies – Concentrations of Credit Risk”, for information in the Company’s marketing and distribution procedures and information on the Company’s major brokers.

10


Structure of Reinsurance Operations

The Company’s reinsurance operations are structured geographically into Bermuda operations, North American operations, European operations and Emerging Markets operations (covering Asia/Pacific and South America).

Claims Administration

Claims management for the reinsurance operations includes the receipt of loss notifications, review and approval of claims through a claims approval process, establishment of loss reserves and approval of loss payments. Case reserves for reported claims are generally established based on reports received from ceding companies with additional case reserves being established when deemed appropriate. Additionally, claims audits are conducted for specific claims and claims procedures at the offices of selected ceding companies, particularly in the U.S. and the U.K.

Life Operations Segment

In August 2008, the Company announced its intention to review strategic opportunities relating to its Life reinsurance business. In relation to this initiative, the Company sold the renewal rights to its Continental European short-term life, accident and health business in late 2008, a relatively small block managed by a team in France that also transferred to the purchaser as part of the transaction. The Company continues to explore various strategic options for the remainder of its Life Operations business.

The Life Operations segment provides life reinsurance on business written by life insurance companies, principally to help them manage mortality, morbidity, survivorship, investment and lapse risks.

Products offered include a broad range of underlying lines of life insurance business, including term assurances, group life, critical illness cover, immediate annuities and disability income. In addition, prior to selling the renewal rights, the products offered included short-term life, accident and health business. The segment also covers a range of geographic markets, with an emphasis on the U.K., U.S., and Continental Europe.

The portfolio has three particularly significant components:

1) The portfolio includes a small number of large contracts relating to closed blocks of U.K. and Irish fixed annuities in payment. In relation to certain of these contracts, the Company receives cash and investment assets at the inception of the reinsurance contract, relating to the future policy benefit reserves assumed. These contracts are long-term in nature, and the expected claims payout period can span up to 30 or 40 years with average duration of around 10 years. The Company is exposed to investment and survivorship risk over the life of these arrangements.

2) The second component of the portfolio relates to life risks (in the U.S. and U.K.) and critical illness risks (in the U.K.) where the Company is exposed to the mortality, morbidity and lapse experience from the underlying business, over the medium to long-term.

3) The third component relates to the annually renewable business covering life, accident and health risks written in Continental Europe. These contracts are short-term in nature and include both proportional and non-proportional reinsurance structures. While the renewal rights for this business have been sold, the existing business remains with the Company.

Underwriting & Claims Administration

Life reinsurance transactions fall into two distinct forms. The first relates to the reinsurance of an existing and closed block of risks (“in-force deal”), where the nature of the underlying exposure is known at the date of execution. The second relates to the reinsurance of liabilities which are yet to be written by the ceding company (“new business treaty”) where, provided the subsequent risks are within the agreed treaty parameters, these risks may be added to the portfolio.

The underwriting of an in-force deal is highly actuarial in nature, requiring detailed analytical appraisal of the key parameters which drive the ultimate profitability of the deal. This includes analysis of historic experience (claims, lapses, etc.) as well as the projection of these assumptions into the future.

11


For a new business treaty, in addition to the actuarial analysis required to set the terms, there is also a requirement to establish medical underwriting criteria which will apply to the new risks which may be added to the treaty. Once a treaty is accepted, there is then an ongoing need to monitor the risk selection by the medical underwriters at the ceding company and to ensure that the criteria are being met.

The team includes many members with specialized actuarial and medical underwriting knowledge. Claims administration also relies on experience and specific medical expertise.

The Company maintains comprehensive “terms of trade” guidelines for all core product lines, which are regularly monitored and refined. These guidelines describe the approach to be taken in assessing and underwriting opportunities, including the approach to be taken to the setting of core parameters and to the determination of appropriate pricing levels. The “terms of trade” are overseen by a separate team from the new business underwriters.

In addition, the Company maintains a medical underwriting manual which sets out the approach to be taken to underwriting specific medical impairments when setting terms for a new business treaty.

Reinsurance Retroceded

The Company purchases limited retrocession capacity on a “per-life” basis in the U.S. and Continental Europe in order to cap the maximum claim arising from the death of a single individual. Cover is purchased from professional retrocessionaires which meet the Company’s criteria for counterparty exposures. Limited retrocession of fixed annuity business has also been used to manage aggregate longevity capacity on specific deals.

Premiums

The following table is an analysis of the Life operations gross premiums written, net premiums written and net premiums earned for the year ended December 31, 2008:

 

 

 

 

 

 

 

(U.S. dollars in thousands)

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

Other Life

 

 

$

 

498,387

   

 

$

 

492,346

   

 

$

 

492,353

 

Annuity

 

 

 

192,528

   

 

 

157,498

   

 

 

157,498

 

 

 

 

 

 

 

 

Total

 

 

$

 

690,915

   

 

$

 

649,844

   

 

$

 

649,851

 

 

 

 

 

 

 

 

Additional discussion and financial information about the life operations is set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 6 to the Consolidated Financial Statements, “Segment Information.”

Competition

In regards to Life Operations business, the core activity is in the U.S., U.K. and Continental Europe.

Within the “new business treaty” area, competition includes amongst others: Reinsurance Group of America; Transamerica Re; Munich Re; Swiss Re; General Re and Hannover Re.

For the fixed annuity business, competition has historically come from less traditional reinsurance entities, e.g. insurance entities such as Canada Life and Prudential (U.K.) or recently established entities such as Paternoster, Synesis, and PIC. However, recently, more traditional reinsurance players, in particular Swiss Re, have entered or re-entered this market.

Marketing and Distribution

The Company predominantly markets its long-term products directly to clients, with a smaller element sourced through reinsurance intermediaries. For these products, the marketing hinges on relationships developed by the Company with client companies – particularly through professional contacts within the actuarial and underwriting communities.

12


The Company primarily marketed the short-term life, accident and health business through reinsurance intermediaries. Following the sale of the renewal rights, the Company has ceased to market these product lines.

The Company maintains good relations with the broking community as well as with a wide range of professional advisory firms (actuarial and accounting) from whom opportunities may be referred.

The Company’s distribution strategy has been to avoid any undue concentration on any single client or market. For treaties relating to new business, there is an effort to target ceding companies which are themselves strong and growing in their target segments. This prioritization of potential clients is based on analysis of public, market information.

Other Financial Lines Segment

The Other Financial Lines segment is comprised of remaining contracts associated with the funding agreement (“FA”) business and previously included the guaranteed investment contract (“GIC”) business. GICs and FAs provide users guaranteed rates of interest on amounts previously invested with the Company. FAs are very similar to GICs in that they have known cash flows. FAs were sold to institutional investors, typically through medium term note programs. As at December 31, 2007, the Company had approximately $4.0 billion of deposit liabilities associated with GICs which were correspondingly matched with invested assets. Based on the terms and conditions of the underlying GICs, upon the downgrade of Syncora Guarantee below certain ratings levels, all or portions of outstanding principal balances on such GICs would come due. Throughout 2008, several rating agencies downgraded Syncora and its subsidiaries and, as a result, the Company settled, in 2008 all of the GIC liabilities. In addition, certain funding agreement contracts matured, resulting in the settlement of the underlying principal and accrued interest. At December 31, 2008, the remaining balance of funding agreements, excluding accrued interest of $6.6 million, was $600.0 million, with settlements scheduled as follows: $150.0 million in October 2009 and $450.0 million in August 2010.

Unpaid Losses and Loss Expenses

Loss reserves are established due to the significant periods of time that may lapse between the occurrence, reporting and payment of a loss. To recognize liabilities for unpaid losses and loss expenses, the Company estimates future amounts needed to pay claims and related expenses with respect to insured events. The Company’s reserving practices and the establishment of any particular reserve reflects management’s judgment concerning sound financial practice and do not represent any admission of liability with respect to any claim. Unpaid losses and loss expense reserves are established for reported claims (“case reserves”) and incurred but not reported (“IBNR”) claims.

The nature of the Company’s high excess of loss liability and catastrophe business can result in loss payments that are both irregular and significant. Similarly, adjustments to reserves for individual years can be irregular and significant. Such adjustments are part of the normal course of business for the Company. Certain aspects of the Company’s business have loss experience characterized as low frequency and high severity. This may result in volatility in the Company’s results of operations, financial condition and liquidity.

The tables below present the development of the Company’s unpaid losses and loss expense reserves on both a net and gross basis. The cumulative redundancy (deficiency) calculated on a net basis differs from that calculated on a gross basis. As different reinsurance programs cover different underwriting years, net and gross loss experience will not develop proportionately. The top line of the tables shows the estimated liability, net of reinsurance recoveries, as at the year end balance sheet date for each of the indicated years. This represents the estimated amounts of losses and loss expenses, including IBNR, arising in the current and all prior years that are unpaid at the year end balance sheet date of the indicated year. The tables show the re-estimated amount of the previously recorded reserve liability based on experience as of the year end balance sheet date of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The cumulative redundancy (deficiency) represents the aggregate change with respect to that liability originally estimated. The lower portion of the first table also reflects the cumulative paid losses relating to these reserves. Conditions and

13


trends that have affected development of liabilities in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate redundancies or deficiencies into the future, based on the tables below. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Cautionary Note Regarding Forward-Looking Statements.”

Analysis of Losses and Loss Expense Reserve Development
Net of Reinsurance Recoveries

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(U.S. dollars in millions)

 

1998

 

1999

 

2000

 

2001

 

2002

 

2003

 

2004

 

2005

 

2006

 

2007 (1)

 

2008

ESTIMATED LIABILITY FOR UNPAID LOSSES AND LOSS EXPENSES, NET OF REINSURANCE RECOVERABLES

 

 

$

 

4,303

   

 

$

 

4,537

   

 

$

 

4,207

   

 

$

 

7,004

   

 

$

 

8,313

   

 

$

 

10,532

   

 

$

 

12,671

   

 

$

 

17,201

   

 

$

 

17,900

   

 

$

 

18,191

   

 

$

 

17,685

 

LIABILITY RE-ESTIMATED AS OF:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One year later

 

 

 

4,016

   

 

 

4,142

   

 

 

4,382

   

 

 

7,404

   

 

 

9,250

   

 

 

10,800

   

 

 

13,785

   

 

 

17,090

   

 

 

17,475

   

 

 

17,580

 

 

 

Two years later

 

 

 

3,564

   

 

 

4,085

   

 

 

4,345

   

 

 

8,423

   

 

 

9,717

   

 

 

11,842

   

 

 

13,675

   

 

 

16,828

   

 

 

16,631

 

 

 

 

 

Three years later

 

 

 

3,580

   

 

 

4,120

   

 

 

5,118

   

 

 

8,653

   

 

 

10,723

   

 

 

11,849

   

 

 

13,607

   

 

 

16,155

 

 

 

 

 

 

 

Four years later

 

 

 

3,461

   

 

 

4,624

   

 

 

5,294

   

 

 

9,727

   

 

 

10,738

   

 

 

11,860

   

 

 

13,258

 

 

 

 

 

 

 

 

 

Five years later

 

 

 

3,742

   

 

 

4,747

   

 

 

5,435

   

 

 

9,674

   

 

 

10,710

   

 

 

11,680

 

 

 

 

 

 

 

 

 

 

 

Six years later

 

 

 

3,774

   

 

 

4,858

   

 

 

5,419

   

 

 

9,718

   

 

 

10,642

 

 

 

 

 

 

 

 

 

 

 

 

 

Seven years later

 

 

 

3,872

   

 

 

4,872

   

 

 

5,508

   

 

 

9,680

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Eight years later

 

 

 

3,833

   

 

 

4,927

   

 

 

5,496

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine years later

 

 

 

3,868

   

 

 

4,926

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ten years later

 

 

 

3,878

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

CUMULATIVE REDUNDANCY (DEFICIENCY) (1)

 

 

 

425

   

 

 

(389

)

 

 

 

 

(1,289

)

 

 

 

 

(2,676

)

 

 

 

 

(2,329

)

 

 

 

 

(1,148

)

 

 

 

 

(587

)

 

 

 

 

1,046

   

 

 

1,269

   

 

 

611

 

 

 

CUMULATIVE PAID LOSSES, NET OF REINSURANCE RECOVERIES, AS OF:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One year later

 

 

$

 

812

   

 

$

 

1,252

   

 

$

 

1,184

   

 

$

 

2,011

   

 

$

 

2,521

   

 

$

 

1,985

   

 

$

 

2,008

   

 

$

 

3,437

   

 

$

 

3,188

   

 

$

 

3,207

 

 

 

Two years later

 

 

 

1,594

   

 

 

1,828

   

 

 

1,920

   

 

 

3,984

   

 

 

3,800

   

 

 

2,867

   

 

 

3,884

   

 

 

5,759

   

 

 

5,620

 

 

 

 

 

Three years later

 

 

 

1,928

   

 

 

2,306

   

 

 

2,683

   

 

 

4,703

   

 

 

4,163

   

 

 

4,380

   

 

 

5,181

   

 

 

7,590

 

 

 

 

 

 

 

Four years later

 

 

 

2,249

   

 

 

2,824

   

 

 

3,038

   

 

 

4,641

   

 

 

5,365

   

 

 

5,286

   

 

 

6,392

 

 

 

 

 

 

 

 

 

Five years later

 

 

 

2,555

   

 

 

3,035

   

 

 

3,290

   

 

 

5,526

   

 

 

6,018

   

 

 

6,225

 

 

 

 

 

 

 

 

 

 

 

Six years later

 

 

 

2,741

   

 

 

2,807

   

 

 

3,774

   

 

 

5,969

   

 

 

6,764

 

 

 

 

 

 

 

 

 

 

 

 

 

Seven years later

 

 

 

2,856

   

 

 

3,110

   

 

 

3,985

   

 

 

6,514

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Eight years later

 

 

 

3,059

   

 

 

3,240

   

 

 

4,351

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine years later

 

 

 

3,029

   

 

 

3,482

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ten years later

 

 

 

3,350

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

Analysis of Property and Casualty Losses and Loss Expense Reserve Development
Gross of Reinsurance Recoverables

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(U.S. dollars in millions)

 

1998

 

1999

 

2000

 

2001

 

2002

 

2003

 

2004

 

2005

 

2006

 

2007 (1)

 

2008

ESTIMATED GROSS LIABILITY FOR UNPAID LOSSES AND LOSS EXPENSES

 

 

$

 

4,897

   

 

$

 

5,369

   

 

$

 

5,668

   

 

$

 

11,807

   

 

$

 

13,333

   

 

$

 

16,553

   

 

$

 

19,616

   

 

$

 

23,598

   

 

$

 

22,895

   

 

$

 

22,857

   

 

$

 

21,650

 

LIABILITY RE-ESTIMATED AS OF:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One year later

 

 

$

 

4,735

   

 

$

 

5,266

   

 

$

 

6,118

   

 

$

 

12,352

   

 

$

 

15,204

   

 

$

 

18,189

   

 

$

 

19,987

   

 

$

 

23,209

   

 

$

 

22,458

   

 

$

 

21,803

 

 

 

Two years later

 

 

 

4,352

   

 

 

5,147

   

 

 

6,105

   

 

 

14,003

   

 

 

16,994

   

 

 

18,520

   

 

 

19,533

   

 

 

22,937

   

 

 

21,337

 

 

 

 

 

Three years later

 

 

 

4,316

   

 

 

5,176

   

 

 

6,909

   

 

 

15,377

   

 

 

17,210

   

 

 

18,324

   

 

 

19,525

   

 

 

22,139

 

 

 

 

 

 

 

Four years later

 

 

 

4,232

   

 

 

5,663

   

 

 

7,086

   

 

 

15,441

   

 

 

17,048

   

 

 

18,362

   

 

 

19,153

 

 

 

 

 

 

 

 

 

Five years later

 

 

 

4,508

   

 

 

5,798

   

 

 

7,240

   

 

 

15,267

   

 

 

17,106

   

 

 

18,236

 

 

 

 

 

 

 

 

 

 

 

Six years later

 

 

 

4,568

   

 

 

5,890

   

 

 

7,223

   

 

 

15,401

   

 

 

17,051

 

 

 

 

 

 

 

 

 

 

 

 

 

Seven years later

 

 

 

4,658

   

 

 

5,881

   

 

 

7,317

   

 

 

15,381

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Eight years later

 

 

 

4,629

   

 

 

5,957

   

 

 

7,370

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine years later

 

 

 

4,681

   

 

 

5,960

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ten years later

 

 

 

4,682

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

CUMULATIVE REDUNDANCY (DEFICIENCY)

 

 

 

215

   

 

 

(591

)

 

 

 

 

(1,702

)

 

 

 

 

(3,574

)

 

 

 

 

(3,718

)

 

 

 

 

(1,683

)

 

 

 

 

463

   

 

 

1,459

   

 

 

1,558

   

 

 

1,054

 

 

 


 

 

(1)

 

 

  Excludes $351.0 million of financial guarantee reserves previously related to reinsurance agreements with Syncora.

14


The following table presents an analysis of the Company’s paid, unpaid and incurred losses and loss expenses and a reconciliation of beginning and ending unpaid losses and loss expenses for the years indicated:

Reconciliation of Unpaid Losses and Loss Expenses

 

 

 

 

 

 

 

(U.S. dollars in thousands)

 

2008

 

2007

 

2006

Unpaid losses and loss expenses at beginning of year

 

 

$

 

23,207,694

   

 

$

 

22,895,021

   

 

$

 

23,597,815

 

Unpaid losses and loss expenses recoverable

 

 

 

4,665,615

   

 

 

4,995,373

   

 

 

6,396,984

 

Financial guarantee reserves related to previous reinsurance agreements with Syncora that were recorded within “Net loss from operating affiliates”

 

 

 

(350,988

)

 

 

 

 

   

 

 

 

 

 

 

 

 

 

 

Net unpaid losses and loss expenses at beginning of year

 

 

 

18,191,091

   

 

 

17,899,648

   

 

 

17,200,831

 

Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in:

 

 

 

 

 

 

Current year

 

 

 

4,573,562

   

 

 

4,266,444

   

 

 

4,311,798

 

Prior years

 

 

 

(610,664

)

 

 

 

 

(425,441

)

 

 

 

 

(110,604

)

 

 

 

 

 

 

 

 

Total net incurred losses and loss expenses

 

 

 

3,962,898

   

 

 

3,841,003

   

 

 

4,201,194

 

Exchange rate effects and other adjustments

 

 

 

(677,664

)

 

 

 

 

421,575

   

 

 

355,500

 

Net loss reserves (disposed) acquired (1)

 

 

 

   

 

 

(155,259

)

 

 

 

 

40,184

 

Less net losses and loss expenses paid in respect of losses occurring in:

 

 

 

 

 

 

Current year

 

 

 

584,120

   

 

 

627,748

   

 

 

460,853

 

Prior years

 

 

 

3,206,726

   

 

 

3,188,128

   

 

 

3,437,208

 

 

 

 

 

 

 

 

Total net paid losses

 

 

 

3,790,846

   

 

 

3,815,876

   

 

 

3,898,061

 

Net unpaid losses and loss expenses at end of year

 

 

 

17,685,479

   

 

 

18,191,091

   

 

 

17,899,648

 

Financial guarantee reserves related to reinsurance agreements that existed at December 31, 2007 with Syncora that were recorded within “Net loss from operating affiliates”

 

 

 

   

 

 

350,988

   

 

 

 

Unpaid losses and loss expenses recoverable

 

 

 

3,964,836

   

 

 

4,665,615

   

 

 

4,995,373

 

 

 

 

 

 

 

 

Unpaid losses and loss expenses at end of year

 

 

$

 

21,650,315

   

 

$

 

23,207,694

   

 

$

 

22,895,021

 

 

 

 

 

 

 

 

The Company’s net unpaid losses and losses expenses (excluding in 2007, financial guarantee reserves previously related to reinsurance agreements with Syncora that were recorded within “Net loss from operating affiliates”) relating to the Company’s operating segments at December 31, 2008 and 2007 were as follows:

 

 

 

 

 

(U.S. dollars in millions)

 

December 31, 2008

 

December 31, 2007

Insurance

 

 

$

 

11,126

   

 

$

 

11,138

 

Reinsurance

 

 

 

6,559

   

 

 

7,053

 

 

 

 

 

 

Net unpaid loss and loss expense reserves

 

 

$

 

17,685

   

 

$

 

18,191

 

 

 

 

 

 

Current year net losses incurred

Net losses incurred increased by $307.1 million in 2008 as compared to 2007, mainly as a result, of the current year loss ratio increasing by 10.0 loss percentage points during the same period, primarily due to an increase in attritional and catastrophe-related property losses, an increase in professional lines loss ratio and the impact of a softening rate environment. Business volume reduced as net premiums earned related to the Company’s P&C operations decreased by 6.7% over this period. Overall, windstorm activity in the Atlantic and Gulf regions increased in 2008 as compared to 2007 and included the impacts of Hurricanes Gustav and Ike, which both made landfall in the U.S. in the third quarter of 2008. Hurricane Ike was estimated to have caused the third largest ever insured loss in the U.S. from a wind storm. Combined, Hurricanes Gustav and Ike had a significant impact on the results of the Company for the year ended December 31, 2008. Based on reports and estimates of loss and damage as at December 31, 2008, the

15


Company estimated losses incurred, net of reinsurance recoveries and reinstatement premiums, of $22.5 million and $210.0 million related to Hurricanes Gustav and Ike, respectively.

Net losses incurred for 2007 (excluding financial guarantee reserves previously related to reinsurance agreements with Syncora that were recorded within “Net loss from operating affiliates”) decreased from 2006 due to a reduction in business volume as the Company’s net premiums earned decreased by 4.6% from 2006 to 2007. However, the current year loss ratio increased by 2.4 loss percentage points from 2006 to 2007 as a result of an increase in attritional and catastrophe-related property experience as well as the impact of a softening rate environment. In 2007, six hurricanes formed in the Atlantic region including two Category 5 hurricanes, one of which, Hurricane Dean, resulted in a limited amount of insured damage to areas of Mexico affected by the hurricane. Other natural catastrophes in 2007 included European windstorms Kyrill and Per/Hanno, California wildfires, floods in the U.K. and Mexico, the Peruvian earthquake and five hurricanes in the Eastern Pacific region. In 2006, there were only five hurricanes in the Atlantic region and more importantly there was no significant insured damage for those hurricanes that did make landfall.

Prior year net losses incurred

The following tables present the development of the Company’s gross and net, losses and loss expense reserves, excluding, for 2007, financial guarantee reserves related to previous reinsurance agreements with Syncora that were recorded within “Net loss from operating affiliates.” The tables also show the estimated reserves at the beginning of each fiscal year and the favorable or adverse development (prior year development) of those reserves during such fiscal year.

 

 

 

 

 

 

 

Gross
(U.S. dollars in millions)

 

2008

 

2007

 

2006

Unpaid losses and loss expense reserves at the beginning of the year

 

 

$

 

22,857

   

 

$

 

22,895

   

 

$

 

23,598

 

Net (favorable) adverse development of those reserves during the year

 

 

 

(1,054

)

 

 

 

 

(437

)

 

 

 

 

(389

)

 

 

 

 

 

 

 

 

Unpaid losses and loss expense reserves re-estimated one year later

 

 

$

 

21,803

   

 

$

 

22,458

   

 

$

 

23,209

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net
(U.S. dollars in millions)

 

2008

 

2007

 

2006

Unpaid losses and loss expense reserves at the beginning of the year

 

 

$

 

18,191

   

 

$

 

17,900

   

 

$

 

17,201

 

Net (favorable) adverse development of those reserves during the year

 

 

 

(611

)

 

 

 

 

(425

)

 

 

 

 

(111

)

 

 

 

 

 

 

 

 

Unpaid losses and loss expense reserves re-estimated one year later

 

 

$

 

17,580

   

 

$

 

17,475

   

 

$

 

17,090

 

 

 

 

 

 

 

 

As different reinsurance programs cover different underwriting years, contracts and lines of business, net and gross loss experience do not develop proportionately. In 2008, gross prior year favorable development exceeded net prior year favorable development in both the Reinsurance and Insurance segments. Within the Reinsurance segment, the gross impact of favorable loss experience related to a large crop program was mostly offset by the impact of retrocessional protection related to this program. In the Insurance segment, the impact of reductions in gross reported losses on older years in certain casualty lines was mostly offset by the impact of the reinsurance recoverable component on such losses, while the impact of gross reserve releases in professional and specialty lines was mostly offset by the impact of a reduction in estimated ceded IBNR following a reserve review in these lines.

The following table presents the net (favorable) adverse prior year loss development of the Company’s loss and loss expense reserves by operating segment for each of the years indicated:

 

 

 

 

 

 

 

(U.S. dollars in millions)

 

2008

 

2007

 

2006

Insurance segment

 

 

$

 

(305.5

)

 

 

 

$

 

(158.1

)

 

 

 

$

 

(13.2

)

 

Reinsurance segment

 

 

 

(305.2

)

 

 

 

 

(267.3

)

 

 

 

 

(97.4

)

 

 

 

 

 

 

 

 

Total

 

 

$

 

(610.7

)

 

 

 

$

 

(425.4

)

 

 

 

$

 

(110.6

)

 

 

 

 

 

 

 

 

During 2008, net favorable prior year development totaled $610.7 million in the Company’s property and casualty operations and included net favorable development in the Insurance and Reinsurance segments of $305.5 million and $305.2 million, respectively. Within the Reinsurance segment, net favorable prior year reserve development included casualty and other lines reserve releases in both European and U.S.

16


casualty and professional portfolios as well as reserve releases associated with the reinsurance-to-close relating to the 2005 year of account on certain Lloyd’s sourced business. In the same period, property and other short-tail lines net favorable development was attributable to most business units globally. The Insurance segment net favorable prior year reserve development was due to reserve releases in global property lines of business as a result of favorable claim development as well as reserve releases in certain casualty lines primarily in 2003 to 2006 accident years due to lower than expected reported loss activity. In addition, net reserve releases of approximately $80.9 million resulted from a favorable settlement in the fourth quarter of 2008 in regards to certain reinsurance recoverable balances relating to casualty lines and to a lesser extent, certain property lines of business. Offsetting this favorable development was modest reserve strengthening within environmental lines as well as strengthening associated with certain structured indemnity contracts. Within the professional lines, reserve releases in the 2003 to 2006 accident years were largely offset by strengthening of reserves in the 2007 year.

During 2007, the Company had net favorable prior year reserve development in property and casualty operations of $425.4 million. Reinsurance net favorable development accounted for $267.3 million of the release in 2007, while net favorable development within the Insurance segment totaled $158.1 million for the same period. The corresponding prior year development on a gross basis was $259.7 million for the Reinsurance segment and $177.6 million for the Insurance segment. Within the Reinsurance segment, reserve releases of $188.7 million in property and other short-tail lines of business and $87.4 million in casualty and other lines, were partially offset by adverse prior year development of $8.8 million within the structured indemnity line of business. The Insurance segment net prior year reserve releases consisted of $95.0 million in property and $162.1 million in casualty lines of business, partially offset by net adverse development of $23.0 million, $7.0 million and $69.0 million in certain professional, marine and other lines of business, respectively.

During 2006, the Company had net favorable prior year reserve development in property and casualty operations of $110.6 million. Within the Insurance segment, net overall favorable prior year reserve development for the year ended December 31, 2006, was $13.2 million, while net favorable development within the Reinsurance segment during the same period was $97.4 million.

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 12 to the Consolidated Financial Statements, “Losses and Loss Expenses”, for further information regarding the developments in prior year loss reserve estimates for each of the years indicated within each of the Company’s operating segments.

Net loss reserves (disposed) acquired

The Company did not dispose of or acquire net loss reserves in 2008.

Net losses disposed in the amount of $155.3 million in 2007 represent reserves associated with the de-consolidation of Syncora following the secondary offering on June 6, 2007 of $181.4 million, partially offset by net losses acquired of $26.2 million related to a reinsurance to close loss portfolio transfer.

During 2006, the Company acquired $40.2 million in losses through a loss portfolio transfer contract structured by XLFS.

Exchange rate effects

Exchange rate effects on net loss reserves in each of the three years ended December 31, 2008 related to the global operations of the Company primarily where reporting units have a functional currency that is not the U.S. dollar. The increase in the value of the U.S. dollar in 2008 combined with the decrease in the value of the U.S. dollar in 2007 and 2006 mainly compared to the Swiss franc, U.K. Sterling and the Euro, gave rise to translation and revaluation exchange movements related to carried loss reserve balances of $(677.7) million, $421.6 million and $355.5 million in 2008, 2007 and 2006, respectively.

17


Net paid losses

Total net paid losses were $3.8 billion in each of 2008 and 2007, and $3.9 billion and 2006, respectively. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for further information.

Other loss related information

The Company’s net incurred losses and loss expenses include actual and estimates of potential non-recoveries from reinsurers. As at December 31, 2008 and 2007, the reserve for potential non-recoveries from reinsurers was $187.6 million and $193.1 million, respectively. For further information, see Note 13 to the Consolidated Financial Statements, “Reinsurance.”

Except for certain workers’ compensation and certain financial guarantee liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation unpaid losses that are considered fixed and determinable, and discounted such losses using an interest rate of 5% in 2008 (2007: 5%). In addition, the Company has also used a rate of approximately 5% to discount financial guarantee liabilities. The tabular reserving methodology associated with workers’ compensation liabilities results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2008 and 2007 were $755.8 million and $813.7 million, respectively. The related discounted unpaid losses and loss expenses were $346.0 million and $377.0 million as of December 31, 2008 and 2007, respectively. Financial guarantee case reserves at December 31, 2008 and 2007 were $14.5 million and $427.4 million, respectively.

Investments

Investment structure and strategy

The Company’s investment operations are managed centrally by the Company’s investment department. The Finance and Risk Oversight Committee of the Board of Directors of the Company approves the investment policy and guidelines, and reviews the implementation of the investment strategies on a regular basis.

The primary objectives of the investment strategy are to support the liabilities arising from the operations of the Company, generate stable investment income and build book value for the Company over the longer term. However, recent turmoil in the global markets in late 2007 and throughout 2008 has resulted in an increase in realized and unrealized losses as well as lower net investment income yields and losses on investment fund affiliates. Following the Company’s announcement that will see it focus on its P&C operations, the Company announced its intention to reposition the Company’ investment portfolio to one that supports a more focused P&C operation. The Company began repositioning the portfolio in 2008 so that a) future book value volatility particularly related to credit spreads arising from the portfolio is reduced, b) a reduction in lower rated corporate securities and financial issuers is achieved, c) exposure to CMBS securities is reduced and d) a reduction in asset classes such as subprime, Alt-A and Core CDO’s previously supporting Other Financial Lines activities is achieved. Realignment will be achieved primarily through cash generated from bond maturities and coupon reinvestment, cash flow from business operations as well as certain opportunistic sales.

Consistent with this strategy, management continued the process of reducing risk in the investment portfolio during the latter part of 2008. Fannie Mae and Freddie Mac preferred positions were sold as well as securities of a number of regional banks. Most of this was accomplished prior to the bankruptcy of Lehman Brothers Holdings Inc. (“Lehman”) in September 2008 when credit markets became even more disrupted. In addition, management reduced the aggregate sub-prime, Alt A, CMBS and CDO portfolio holdings significantly, through maturities and turnover in the ordinary course of business and certain

18


opportunistic sales, in particular $1.6 billion in the CMBS portfolio, as well as reduced the aggregate corporate portfolios by $1.2 billion.

In addition, in the fourth quarter of 2008, management recorded a charge for other-than-temporary impairments (“OTTI”) of $400.0 million for which it could no longer assert its intent to hold until recovery. Although management believes these securities are likely to recover to their current amortized cost, it determined that these securities were at-risk for further mark-to-market declines, and potentially real economic losses, to the extent that economic conditions were to deteriorate further than present estimates and the Company’s allocation to these asset classes is overweight relative to a traditional P&C portfolio. Accordingly, in conjunction with its risk reduction exercise, management is likely to pursue targeted sales of these assets over the course of 2009. The assets are concentrated in certain holdings within the Company’s BBB and lower corporate, CMBS, equity and consumer ABS portfolios.

The Company reduced its risk exposure to alternative investments by approximately $0.8 billion during 2008 in response to adverse market conditions and in regards to the risk reduction exercise ongoing within its investment portfolio. Management further reduced interest rate risk exposure in 2008 by shortening the duration of the portfolio supporting the U.S. property and casualty operations by 0.6 years. Cash and government agency holdings were increased by approximately $2.4 billion to approximately $13.2 billion representing approximately 41.2% of the fixed income portfolio at December 31, 2008. Following the risk reduction steps executed to date, the credit spread of the fixed income portfolio duration has been reduced to 3.1 years as at December 31, 2008.

While the Company seeks to reduce the overall risk within its investment portfolio, it will continue to attempt to balance investment returns against market and credit risks taken. Market risk may arise due to interest rate variability and exposure to foreign denominated currencies, which the Company seeks to manage through asset/liability management, and due to the allocation to risk assets, including global equity securities and alternative investments, which the Company seeks to manage through diversification. Credit risk arises from investments in fixed income securities and is managed with aggregate and portfolio limits and by establishing minimum credit quality guidelines. The Company guidelines require a minimum Aa3/AA– weighted-average rating for its fixed income portfolio.

The Company’s investment portfolio consists of exposures to fixed income securities, equities, alternative investments, derivatives, business and other investments and cash. These securities and investments are denominated in both U.S. dollar and foreign currencies. The Company’s direct use of investment derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, reference rates or a combination of these factors. When investment guidelines allow for the use of derivatives, these can generally only be used for the purpose of managing interest rate risk, foreign exchange rate risk, credit risk and replicating permitted investments, provided the use of such instruments is incorporated in the overall portfolio evaluation. The direct use of derivatives is generally not permitted to economically leverage the portfolio outside of the stated guidelines. Derivatives may also be used to add value to the investment portfolio where market inefficiencies are perceived to exist, to equitize cash holdings through the purchase of equity-indexed derivatives, to adjust the duration of a portfolio of fixed income securities to match the duration of related deposit liabilities and as part of duration management activities on the P&C portfolio.

The Company’s investment portfolio is structured to take into account a number of variables including local regulatory requirements, business needs, collateral management and risk tolerance. At December 31, 2008 and 2007, total investments, cash and cash equivalents and accrued investment income, less net receivable (payable) for investments sold (purchased), were $34.3 billion and $43.7 billion, respectively.

Functionally, the Company’s investment portfolio is divided into three principal components:

1) Asset/Liability Portfolio: The largest component is the asset/liability portfolio which is intended to support the liabilities arising from the property and casualty as well as the life operations of the Company.

From a functional perspective, the asset/liability portfolio is allocated into two sub portfolios: a) the P&C general account portfolio and b) the structured and spread product portfolio.

The P&C general account portfolio is the largest component of the Company’s investment portfolio and primarily supports the property and casualty liabilities of the Company as well as provides liquidity to settle claims arising from the Company’s property and casualty operations. The P&C general account

19


portfolio is made up entirely of investment grade fixed income securities and its primary strategy focuses on diversification of asset maturities relative to the expected cash flows of the property and casualty operation. The P&C general portfolio holds Topical (representing subprime, Alt-A, 2nd Lien and ABS CDOs) and Core CDO assets with a fair value of approximately $1.4 billion which supported the previously written GIC and funding agreement contracts. The Company has announced its intention to reduce its exposure to such asset classes over time as part of its long-term strategic portfolio alignment activities. The P&C general account portfolio was approximately $23.1 billion and $24.1 billion at December 31, 2008 and 2007, respectively. As at December 31, 2008, the general account portfolio was approximately 67.3% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net receivable (payable) for investments sold (purchased)) as compared to approximately 55.3% as at December 31, 2007.

The structured and spread product portfolio consists of highly structured, actively managed investment portfolios that support specific transactions within the Company’s Insurance, Reinsurance, Life Operations and Other Financial Lines segments. These represent structured indemnity, annuity products, funding agreement transactions, and previously GIC transactions. As a result of the long duration of assets supporting the Life business, there has been a significant decline in the fair value of these securities as they are more sensitive to prevailing government interest rates and credit spreads. The Company also continues to explore strategic alternatives with respect to the Life Operations segment.

Liquidations necessary to fund the settlement of the remaining GIC liabilities of approximately $4.0 billion throughout 2008 following the downgrade of Syncora Guarantee and the maturity of $1.2 billion funding agreements were funded through the sale of assets in the Other Financial Lines segment investment portfolio as well as the general investment portfolio. Management’s approach was to avoid sale of assets where current market prices did not reflect intrinsic values or where transaction costs for liquidation were excessive. As a result, the Company continues to hold in its general portfolio a significant portion of the assets which previously supported the structured and spread products including GICs, in exchange for those assets that were liquidated.

Assets supporting remaining structured and spread business were approximately $8.0 billion and $14.8 billion at December 31, 2008 and 2007, respectively. As at December 31, 2008, the structured and spread portfolio was approximately 23.4% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net receivable (payable) for investments sold (purchased)) as compared to approximately 33.8% as at December 31, 2007.

2) The second component of the investment portfolio is the risk asset portfolio, which was approximately $2.8 billion and $4.4 billion at December 31, 2008 and 2007, respectively. The risk asset portfolio is that portion of the Company’s capital that is invested in risk assets to generate growth in the Company’s book value over the longer term with the efficient utilization of risk. The Company utilizes a risk budgeting framework for the dynamic risk and asset allocation of the risk asset portfolio. The fundamental premise of the risk budgeting methodology for the risk asset portfolio is to maximize expected returns for a given level of risk. The risk asset portfolio includes four core strategy portfolios including: (i) the alternative investment portfolio; (ii) the high yield portfolio; (iii) the public equity portfolio; and (iv) the private investment portfolio.

As part of the overall risk asset portfolio, the Company sets specific constraints during the risk allocation process that reflect the Company’s overall tolerance for risk, including guidelines on the level of Value at Risk (“VaR”) of the risk asset portfolio, stress testing and a maximum drawdown level attributable to the alternative investment portfolio. These levels are approved by the Finance and Risk Oversight Committee of the Company’s Board of Directors annually. In addition, each of the core risk asset portfolios is subject to specific investment guidelines that are also approved by the Finance and Risk Oversight Committee of the Company’s Board of Directors. These guidelines address the investment parameters and risk associated with each portfolio. The Company monitors the total risk and return of the risk asset portfolio to ensure compliance with the risk target guidelines as approved.

The alternative investment portfolio is a diversified portfolio of investments in limited partnerships and similar investment vehicles, with each fund generally pursuing absolute return investment mandates. These funds are typically investing in one or more of the traditional asset classes including equities, fixed income, credit, currency and commodity markets. For the majority of the portfolio, the Company owns minority

20


investment interests that are accounted for under the equity method and are included in the Consolidated Balance Sheet under “Investments in affiliates.” The objective of the alternative investment portfolio is to attain an attractive risk-adjusted total return while maintaining a moderate to low level of sensitivity to the movements in traditional asset classes and realizing a low volatility.

Within the alternative investment portfolio, various strategies can be pursued and the Company classifies each fund allocation into four general style categories as follows: (i) Event driven, which includes strategies that pursue merger arbitrage, distressed and special situations opportunities; (ii) Directional/tactical, which includes strategies that pursue long/short equity, managed futures and macro opportunities; (iii) Arbitrage, which includes strategies that pursue equity market neutral, fixed income arbitrage and convertible arbitrage opportunities; and (iv) Multi-strategy, which includes strategies incorporating several aspects of the above.

The alternative investment portfolio had more than 85 separate investments in different funds at December 31, 2008 with a total exposure of $1.1 billion, making up approximately 3.2% of the investment portfolio (including cash and cash equivalents, accrued investment income and net payable for investments purchased) as compared to December 31, 2007 where the Company had approximately 80 separate fund investments with a total exposure of $2.3 billion representing approximately 5.2% of the investment portfolio.

At December 31, 2008, the alternative investment portfolio allocation was 34% in Directional/tactical strategies, 33% in Arbitrage strategies, 23% in Event driven strategies and 10% in Multi-strategy strategies. At December 31, 2007, the alternative investment portfolio allocation was 47% in Directional/tactical strategies, 25% in Arbitrage strategies, 21% in Event driven strategies and 7% in Multi-strategy strategies.

The high yield portfolio is invested in a diversified portfolio of below investment grade securities, including downgraded securities of predominantly corporate structured credit issuers. The high yield portfolio was approximately $0.8 billion and $0.9 billion at December 31, 2008 and 2007, respectively. As at December 31, 2008 and 2007, the Company’s allocation to high yield securities was approximately 2.2% and 2.1%, respectively, of the total investment portfolio (including cash and cash equivalents, accrued investment income and net receivable (payable) for investments sold (purchased)).

The equity portfolio is invested in a diversified portfolio of publicly traded equity securities. As at December 31, 2008, the Company’s equity portfolio was $0.3 billion as compared to $0.8 billion as at December 31, 2007. This excludes $32.0 million of fixed income fund investments and publicly traded alternative funds that generally do not have the risk characteristics of equity investments. As at December 31, 2008, the Company’s allocation to equity securities was approximately 1.0% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net receivable (payable) for investments sold (purchased)) as compared to approximately 1.7% as at December 31, 2007.

The private investment portfolio is invested in a selection of less liquid private investments that include venture capital, leveraged buy-outs, mezzanine and distressed debt, opportunistic real estate and equity tranches of collateralized debt obligations. As at December 31, 2008 and 2007, the Company’s exposure to private investments was approximately $0.4 billion. Included in private investments, at December 31, 2008, are $14.7 million representing equity tranches in unrated pools of collateralized debt obligations. As at December 31, 2008, the Company’s exposure to private investments consisted of approximately 1.2% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net receivable (payable) for investments sold (purchased)), compared to approximately 1.0% as at December 31, 2007.

3) The third component of the Company’s total investment portfolio, valued at $0.4 billion at December 31, 2008 and 2007, is related to insurance and financial affiliates and investments in investment management companies. As at December 31, 2008, the Company’s allocation to insurance and financial affiliates and investments in investment management companies’ securities was approximately 1.1% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net receivable (payable) for investments sold (purchased)) as compared to approximately 0.9% as at December 31, 2007. At December 31, 2008, the Company’s investment in insurance affiliates included investments in ARX Holding Corporation and ITAÚ XL Seguros Corporativos S.A., representing operations in the U.S. homeowners insurance and Brazilian commercial insurance markets, respectively. At December 31, 2008, the Company owned minority stakes in nine independent investment management companies. The Company

21


sought to develop relationships with specialty investment management organizations, generally acquiring an equity interest in the business. In these investments, the Company seeks to achieve strong returns on capital while accessing the investment expertise of professionals to help manage portions of the Company’s investment assets. In addition, the Company is active in the relationships with these managers, seeking to benefit from the intellectual capital in ways that will enhance the Company’s overall financial performance and achieve broader strategic goals.

Where the Company maintains significant influence over the decisions of the investment management organization, through board representation or through certain voting and/or consent rights, the Company’s proportionate share of the income or loss from these companies is reported as net income from operating affiliates. The Company’s existing managers manage or sponsor a broad range of investment products, providing institutional and high net worth investor’s access to a wide array of asset classes and investment strategies. See Item 8, Note 9 to the Consolidated Financial Statements, “Investments.”

Implementation of investment strategy

Although the Company’s management is responsible for implementation of the investment strategy, the day-to-day management of the investment portfolio is outsourced to investment management service providers in accordance with detailed investment guidelines provided and monitored by the Company. This allows the Company an active management of its investment portfolio with flexible access to top talents specializing in various investment products and markets. Managers are selected directly by the Company on the basis of various criteria including investment style, track record, performance, internal controls, operational risk, and diversification implications. Well-established, large institutional investment professionals manage the vast majority of the Company’s investment portfolio. Each investment manager may manage one or more portfolios, each of which is governed by a detailed set of investment guidelines, including overall objectives, risk parameters, and diversification requirements that fall within the Company’s overall investment policies and guidelines, including but not limited to exposures to eligible securities, prohibited investments/transactions, credit quality and general concentrations limits.

Investment performance

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for discussion of the Company’s investment performance.

Portfolio credit ratings, duration and maturity profile

It is the Company’s policy to operate the aggregate fixed income portfolio with a minimum weighted average credit rating of Aa3/AA–. The aggregate credit rating is determined based on the weighted average rating of securities, where the average credit rating, where available, from Standard & Poor’s (“S&P”), Moody’s Investors Service (“Moody’s”) and Fitch Ratings (“Fitch”) is allocated to each security. The weighted average credit rating of the fixed income portfolio was AA at December 31, 2008 and 2007.

The Company did not have an aggregate direct investment in a single entity, other than government and sovereign investments, representing debt holdings of the U.S., French and United Kingdom governments, or agency securities representing debt of, excluding mortgages backed by, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, in excess of 10% of shareholders’ equity at December 31, 2008 or 2007.

The aggregate duration and currency of the fixed income portfolio is managed relative to liabilities. Duration measures bond price volatility and is an indicator of the sensitivity of the price of a bond (or a portfolio of bonds) to changes in interest rates, assuming a parallel change in all global yield curves reflecting the percentage change in price for a 100 basis point change in yield. Management believes that the duration of the fixed income portfolio is the best single measure of interest rate risk and the table below summarizes the weighted average duration in years and currency of the main components of the fixed income portfolio at December 31, 2008 and 2007:

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Investment Portfolio Weighted Average Duration in Years

 

December 31,
2008

 

December 31,
2007

Fixed income portfolio by Liability Type:

 

 

 

 

Property and Casualty – General Account

 

 

 

3.2

   

 

 

3.8

 

Structured and Spread:

 

 

 

 

– Property and Casualty Structured

 

 

 

4.2

   

 

 

3.3

 

– Other Financial Lines

 

 

 

0.4

   

 

 

0.4

 

– Life Operations

 

 

 

8.9

   

 

 

9.2

 

Total Fixed income portfolio

 

 

 

4.2

   

 

 

4.3

 

 

 

 

 

 

Fixed income portfolio by Liability Currency:

 

 

 

 

U.S. Dollar

 

 

 

3.1

   

 

 

3.1

 

U.K. Sterling

 

 

 

7.6

   

 

 

7.9

 

Euro

 

 

 

6.3

   

 

 

5.9

 

Other

 

 

 

3.4

   

 

 

3.7

 

Total Fixed income portfolio

 

 

 

4.2

   

 

 

4.3

 

 

 

 

 

 

The maturity profile of the fixed income portfolio is a function of the maturity profile of liabilities, the expected operating cash flows of the Company and, to a lesser extent, the maturity profile of common fixed income benchmarks. For further information on the maturity profile of the fixed income portfolio see Item 8, Note 9 to the Consolidated Financial Statements, “Investments.”

Ratings

The Company’s ability to underwrite business is dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company is downgraded, its ability to write business as well as its financial condition and/or results of operations, could be materially adversely affected.

A downgrade below “A–” of the Company’s principal insurance and reinsurance subsidiaries by either S&P or A.M. Best Company, Inc. (“A.M. Best”), which is two notches below the current S&P financial strength rating of “A” (Negative) and the A.M. Best financial strength rating of “A” (Stable) of these subsidiaries, may trigger termination provisions in a significant amount of the Company’s assumed reinsurance agreements and may potentially require the Company to return unearned premiums to cedants. In addition, due to collateral posting requirements under the Company’s letter of credit and revolving credit facilities, such a downgrade may require the posting of cash collateral in support of certain “in use” portions of these facilities (see “Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources,” below). Specifically, a downgrade below “A–” by A.M. Best would trigger such collateral requirements for the Company’s two largest credit facilities. In certain limited instances, such downgrades may require the Company to return cash or assets to counterparties or to settle derivative and/or other transactions with the respective counterparties. See Item 1A, Risk Factors, “A downgrade or potential downgrade in our financial strength and credit ratings by one or more rating agencies could materially and negatively impact our business, financial condition, results of operations, and/or liquidity.”

Throughout 2008, various rating agency actions were taken that resulted in downgrades of the financial strength ratings of the Company’s leading property and casualty operating companies. During the 2008, the following rating agency actions were taken:

 

 

 

 

A.M. Best revised the financial strength rating of the Company’s lending property and casualty operating companies to “A” from “A+” and affirmed them with a stable outlook.

 

 

 

 

S&P revised the financial strength rating for the Company’s leading property and casualty operating companies to “A” (Negative) from “A+” (Negative).

 

 

 

 

Moody’s Investor Services, Inc. revised the financial strength rating of the Company’s principal insurance and reinsurance subsidiaries to “A2” (Negative) from “A1” (On Review for Possible Downgrade).

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Fitch revised the financial strength rating of the Company’s leading insurance and reinsurance subsidiaries to “A” (Rating Watch Negative) from “A+” (Rating Watch Negative).

In their public rating action announcements, the rating agencies expressed concerns regarding, among other things, the Company’s reduced financial flexibility as a result of significant unrealized losses in the Company’s investment portfolio, anticipated weakness in the profitability over the medium term and the belief that the Company’s prospective competitive position and resulting underwriting performance have diminished mainly as a result of material earnings and capital charges over the past several years. Notwithstanding these concerns rating agency comments indicate that they are comfortable with the Company’s capital position and the quality of the Company’s core insurance and reinsurance business.

In addition, during 2008, A.M. Best downgraded the financial strength rating to “A–” (Stable) from “A” (Stable) and issuer credit rating (ICR) to “a–” (Stable) from “a” (Stable) of XL Life Ltd.

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The following table summarizes the financial strength and claims paying ratings, as noted above, from internationally recognized rating agencies in relation to the Company’s principal insurance and reinsurance subsidiaries and pools as at February 27, 2009:

 

 

 

 

 

 

 

 

 

Rating agency

 

Agency’s description
of rating

 

Rating

 

Agency’s rating
definition

 

Ranking of Rating

A.M. Best

 

“An opinion of an insurer’s financial strength and ability to meet ongoing obligations to policyholders.”

 

“A” (Stable)

 

“Excellent” ability to meet its ongoing obligations to policyholders.

 

The “A” grouping is the third highest ratings category out of fifteen. It is assigned to companies that have, in A.M. Best’s opinion, an excellent ability to meet their ongoing obligations to policyholders.

S&P

 

“A current opinion of the financial security characteristics of an insurance organization with respect to its ability to pay under its insurance policies and contracts in accordance with their terms.”

 

“A” (Negative)

 

“Strong” financial security characteristics.

 

The “A” grouping is the third highest out of nine main ratings. Main ratings from “AA” to “CCC are subdivided into three subcategories: “+” indicating the high end of the main rating; no modifier, indicating the mid range of the main rating; and “–” indicating the lower end of the main rating.

Moody’s

 

An opinion of “the ability of insurance companies to repay punctually senior policyholder claims and obligations.”

 

“A2” (Negative)

 

“Good” financial security.

 

The “A” grouping is the third highest out of nine rating categories. Each rating category is subdivided into three subcategories. Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating classification from “Aa” through “Caa”. Numeric modifiers are used to refer to the ranking within a group – with 1 being the highest and 3 being the lowest.

Fitch

 

“An assessment of the financial strength of an insurance organization, and its capacity to meet senior obligations to policyholders and contract holders on a timely basis.”

 

“A” (Rating Watch Negative)

 

“Strong” capacity to meet policyholder and contract obligations.

 

The “A” rating is the third highest out of twelve ratings categories. “A” rated insurers are viewed as possessing strong capacity to meet policyholder and contract obligations. “+”or “–” may be appended to a rating to indicate the relative position of a credit within the rating category.

In addition, as at February 27, 2009, XL Capital Ltd currently had the following long-term debt ratings: ‘bbb’ (Stable) from A.M. Best, ‘BBB+’ (Negative) from S&P, ‘Baa2’ (Negative) from Moody’s and ‘BBB+’ (Rating Watch Negative) from Fitch.

The Company believes that the primary users of ratings include commercial and investment banks, policyholders, brokers, ceding companies and investors.

Tax Matters

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 25 to the Consolidated Financial Statements, “Taxation.”

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Regulation

The Company’s operations are subject to regulation and supervision in each of the jurisdictions where they are domiciled and licensed to conduct business. Generally, regulatory authorities can have broad supervisory and administrative powers over such matters as licenses, fitness of management, standards of solvency, material transactions between affiliates, premium rates, policy forms, investments, security deposits, methods of accounting, form and content of financial statements, reserves for unpaid losses and loss adjustment expenses, reinsurance, minimum capital and surplus requirements and/or risk based capital standards, dividends and other distributions to shareholders, periodic examinations and annual and other report filings. In general, such regulation is for the protection of policyholders rather than shareholders.

Bermuda Operations

The Insurance Act 1978 of Bermuda and related regulations, as amended (the “Act”), regulates the Company’s (re)insurance operating subsidiaries in Bermuda, and it provides that no person may carry on any insurance business in or from within Bermuda unless registered as an insurer by the Bermuda Monetary Authority (the “BMA”) under the Act. Insurance as well as reinsurance is regulated under the Act.

The Act imposes on Bermuda insurance companies, solvency and liquidity standards, certain restrictions on the declaration and payment of dividends and distributions, certain restrictions on the reduction of statutory capital, auditing and reporting requirements, and grants the Authority powers to supervise, investigate and intervene in the affairs of insurance companies. Significant requirements include the appointment of an independent auditor, the appointment of a loss reserve specialist and the filing of the Annual Statutory Financial Return with the BMA. The Supervisor of Insurance is the chief administrative officer under the Act.

In early July 2008, the Insurance Amendment Act of 2008 was passed, which introduced a number of changes to the Act, such as allowing the BMA to prescribe standards for an enhanced capital requirement and a capital and solvency return that insurers and reinsurers must comply with. The Bermuda Solvency Capital Requirement (“BSCR”) employs a standard mathematical model that can relate more accurately the risks taken on by (re)insurers to the capital that is dedicated to their business. (Re)insurers may adopt the BSCR model or, where an insurer or reinsurer believes that its own internal model better reflects the inherent risk of its business, an in-house model approved by the BMA. Class 4 (re)insurers, such as the Company, were required to implement the new capital requirements under the BSCR model beginning with fiscal years ending on or after December 31, 2008.

Under the Bermuda Companies Act 1981, as amended, a Bermuda company may not declare or pay a dividend or make a distribution out of contributed surplus if there are reasonable grounds for believing that: (a) the company is, or would after the payment be, unable to pay its liabilities as they become due; or (b) the realizable value of the company’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. For further information see Item 8, Note 26 to the Consolidated Financial Statements, “Statutory Financial Data.”

United States

Within the United States, the Company’s insurance and reinsurance subsidiaries are subject to regulation and supervision by their respective states of incorporation and by other jurisdictions in which they do business. The methods of regulation vary, but in general have their source in statutes that delegate regulatory and supervisory powers to an insurance official. The regulation and supervision relate primarily to approval of policy forms and rates, the standards of solvency that must be met and maintained, including risk-based capital standards, material transactions between an insurer and its affiliates, the licensing of insurers, agents and brokers, restrictions on insurance policy terminations, the nature of and limitations on the amount of certain investments, limitations on the net amount of insurance of a single risk compared to the insurer’s surplus, deposits of securities for the benefit of policyholders, methods of accounting, periodic examinations of the financial condition and market conduct of insurance companies, the form and content of reports of financial condition required to be filed, and reserves for unearned premiums, losses, expenses and other obligations. All transactions between or among the insurance and reinsurance company subsidiaries must be fair and equitable. In general, such regulation is for the protection of policyholders rather than shareholders.

26


Regulations generally require insurance and reinsurance companies to furnish information to their domestic state insurance department concerning activities that may materially affect the operations, management or financial condition and solvency of the company. Regulations vary from state to state but generally require that each primary insurance company obtain a license from the department of insurance of a state to conduct business in that state. A reinsurance company is not generally required to have an insurance license to reinsure a U.S. ceding company from outside the U.S. However, for a U.S. ceding company to obtain financial statement credit for reinsurance ceded, the reinsurer must obtain an insurance license or accredited status from the cedant’s state of domicile or another U.S. state with equivalent insurance regulation or must post collateral to support the liabilities ceded. In addition, regulations for reinsurers vary somewhat from primary insurers in that the form and rate of reinsurance contracts and the market conduct of reinsurers are not subject to regulator approval.

The Company’s U.S. insurance subsidiaries are required to file detailed annual and, in most states, quarterly reports with state insurance regulators in each of the states in which they are licensed. Such annual and quarterly reports are required to be prepared on a calendar year basis. In addition, the U.S. insurance subsidiaries’ operations and accounts are subject to financial condition and market conduct examination at regular intervals by state regulators.

Statutory surplus is an important measure utilized by the regulators and rating agencies to assess the Company’s U.S. insurance subsidiaries’ ability to support business operations and provide dividend capacity. The Company’s U.S. insurance subsidiaries are subject to various state statutory and regulatory restrictions that limit the amount of dividends that may be paid, within any twelve month period, from earned surplus without prior approval from regulatory authorities. These restrictions differ by state, but are generally based on a calculation of the lesser of 10% of statutory surplus or 100% of ‘adjusted net investment income’ to the extent that it has not previously been distributed.

Most states have implemented laws that establish standards for current, as well as continued, state licensing or accreditation. In addition, the National Association of Insurance Commissioners (the “NAIC”) promulgated, and all states have adopted, Risk-Based Capital (“RBC”) standards for property and casualty companies and life insurance companies as a means of monitoring certain aspects affecting the overall financial condition of insurance companies. RBC is designed to measure the adequacy of an insurer’s statutory surplus in relation to the risks inherent in its business. The NAIC’s RBC Model Law provides for four incremental levels of regulatory attention for insurers whose surplus is below the calculated RBC target. These levels of attention range in severity from requiring the insurer to submit a plan for corrective action to actually placing the insurer under regulatory control. The Company’s current RBC ratios for its U.S. subsidiaries are satisfactory and such ratios are not expected to result in any adverse regulatory action. The Company is not aware of any such actions relative to it.

While the federal government does not directly regulate the insurance business in the U.S. (other than for flood, nuclear and reinsurance of losses from terrorism), federal legislation and administrative policies can affect the insurance industry. The federal government has also undertaken initiatives in several areas that may impact the insurance industry including tort reform, corporate governance and the taxation of insurance companies. In addition, legislation has been introduced from time to time in recent years that, if enacted, could result in the federal government assuming a more direct role in the regulation of the insurance industry, primarily as respects federal licensing in lieu of state licensing.

International Operations

A substantial portion of the Company’s property and casualty insurance business and a majority of its life reinsurance business is carried on in countries other than Bermuda and the U.S. The degree of regulation in foreign jurisdictions can vary. Generally, the Company’s subsidiaries must satisfy local regulatory requirements. Licenses issued by foreign authorities to subsidiaries of the Company are subject to modification or revocation for cause by such authorities. The Company’s subsidiaries could be prevented, for cause, from conducting business in certain of the jurisdictions where they currently operate. While each country imposes licensing, solvency, auditing and financial reporting requirements, the type and extent of the requirements differ substantially. Key areas where countries may differ include: (i) the type of financial reports to be filed; (ii) a requirement to use local intermediaries; (iii) the amount of reinsurance

27


permissible; (iv) the scope of any regulation of policy forms and rates; and (v) the type and frequency of regulatory examinations.

In addition to these requirements, the Company’s foreign operations are also regulated in various jurisdictions with respect to currency, amount and type of security deposits, amount and type of reserves, amount and type of local investment and limitations on the share of profits to be returned to policyholders on participating policies. For further information see Item 8, Note 26 to the Consolidated Financial Statements, “Statutory Financial Data.”

European Union

Financial services including insurance, reinsurance, securities and Lloyd’s in the United Kingdom are regulated by the Financial Services Authority (“FSA”). The FSA’s Handbook of Rules and Guidance (the “FSA Rules”) covers all aspects of regulation including capital adequacy, financial and non-financial reporting and certain activities of U.K.-regulated firms. The Company’s subsidiaries carrying out regulated activities in the U.K. comply with the FSA Rules. The Company’s Lloyd’s managing agency, its managed syndicates and its associated corporate capital vehicles are subject to additional Lloyd’s requirements.

FSA regulations also impact the Company as “controller” (an FSA defined term) of its U.K.-regulated subsidiaries. Through the FSA’s Approved Persons regime, certain employees and Directors are subject to regulation by the FSA of their fitness and certain employees are individually registered at Lloyd’s.

The Company’s network of offices in the European Union consists mainly of branches of U.K. as well as Irish (regulated by the Irish Financial Services Regulatory Authority “ISFRA”) companies that are principally regulated under European Directives from their home states, the U.K. and Ireland, rather than by each individual jurisdiction.

Employees

At December 31, 2008, the Company had approximately 4,000 employees. At that date, 394 of the Company’s employees were represented by workers’ councils and 412 of the Company’s employees were subject to collective bargaining agreements. Subsequent to December 31, 2008, the Company announced a restructuring initiative which will result in the Company’s workforce decreasing by approximately 10% during 2009.

Available Information

The public can read and copy any materials the Company files with the U.S. Securities and Exchange Commission (“SEC”) at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public can obtain information on the operation of the Public Reference Room by calling the SEC at 1-800- SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers, including the Company, that file electronically with the SEC. The address of the SEC’s website is http://www.sec.gov.

The Company’s Internet website address is http://www.xlcapital.com. The information contained on the Company’s website is not incorporated by reference into this Annual Report on Form 10-K or any other of the Company’s documents filed with or furnished to the SEC.

The Company makes available free of charge, including through the Company’s Internet website, the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.

The Company adopted Corporate Governance Guidelines, as well as written charters for each of the Audit Committee, the Compensation Committee, the Finance and Risk Oversight Committee, the Nominating and Governance Committee, the Public Affairs Committee as well as a Code of Ethics for Senior Financial Officers, a Code of Business Conduct & Ethics for employees and a related Compliance Program. Each of these documents is posted on the Company’s web-site at http://www.xlcapital.com, and

28


each is available in print to any shareholder who requests it by writing to the Company at Investor Relations Department, XL Capital Ltd, XL House, One Bermudiana Road, Hamilton HM 11, Bermuda.

The required Section 303A Certification of the Chief Executive Officer of Xl Capital Ltd has been submitted to the New York Stock Exchange, and the certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 and required by Rules 13a-14(a) of the Securities Exchange Act of 1934, has been filed with the U.S. Securities and Exchange Commission as exhibits to this Annual Report.

The Company intends to post on its website at http://www.xlcapital.com any amendment to, or waiver of, a provision of its Code of Business Conduct & Ethics that applies to its Chief Executive Officer, Chief Financial Officer and Controller or persons performing similar functions and that relates to any element of the code of ethics definition set forth in Item 406 of Regulation S-K of the Securities Act of 1933, as amended.

29


 

 

 

 

 

 

ITEM 1A.

 

RISK FACTORS

 

 

 

Any of the following risk factors could have a significant or material adverse effect on our business, financial condition, results of operations and/or liquidity, in addition to the other information contained in this report. Additional risks not presently known to us or that we currently deem immaterial may also impair our business, financial condition and results of operations.

Risks Related to the Company

A downgrade or potential downgrade in our financial strength and credit ratings by one or more rating agencies could materially and negatively impact our business, financial condition, results of operations and/or liquidity.

As our ability to underwrite business is dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies, a further downgrade by any of these institutions could cause our competitive position in the insurance and reinsurance industry to suffer and make it more difficult for us to market our products. As well, the majority of our assumed reinsurance contracts contain provisions that would allow our clients to terminate the contract in the event of a downgrade in our ratings below specified levels by one or more rating agencies. Based on premium value, approximately 65% of our reinsurance contracts that incepted at January 1, 2008 contained provisions allowing clients to terminate those contracts upon a decline in our ratings. A downgrade could also result in a substantial loss of business for us as ceding companies and brokers that place such business may move to other insurers and reinsurers with higher ratings and the loss of key employees.

A downgrade below “A–” of our principal insurance and reinsurance subsidiaries by either Standard & Poor’s (“S&P”) or A.M. Best Company (“A.M. Best”), which is two notches below the current S&P financial strength rating of “A” (Negative) and two notches below the current A.M. Best financial strength rating of “A” (Stable) of these subsidiaries, may trigger termination provisions in a significant amount of our assumed reinsurance agreements and may potentially require us to return unearned premium to cedants. Whether a client would exercise its termination rights after such a downgrade would likely depend on, among other things, the reasons for the downgrade, the extent of the downgrade, prevailing market conditions, the degree of unexpired coverage, and the pricing and availability of replacement reinsurance coverage. In the event of such a downgrade, we cannot predict whether or how many of our clients would actually exercise such termination rights or the extent to which any such terminations would have a material adverse effect on our financial condition, results of operations or future prospects and could have a significant adverse effect on the market price for our securities. In addition, due to collateral posting requirements under our letter of credit and revolving credit facility agreements, such a downgrade may require the posting of cash collateral in support of certain “in use” portions of these facilities (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” under Part II, Item 7 of this report). Specifically, a downgrade below “A–” by A.M. Best would trigger such collateral requirements for the Company’s two largest credit facilities. In certain limited instances, such downgrades may require us to return cash or assets to counterparties or to settle derivative and/or other transactions with the respective counterparties.

In addition to the financial strength ratings of our principal insurance and reinsurance subsidiaries, various rating agencies also publish credit ratings for XL Capital Ltd. Credit ratings are indicators of a debt issuer’s ability to meet the terms of debt obligations in a timely manner are part of our overall funding profile and affect our ability to access certain types of liquidity. Downgrades in our credit ratings could have a material adverse effect on our financial condition and results of operations in a number of ways, including adversely limiting our access to capital markets, potentially increasing the cost of debt or requiring us to post collateral.

In December 2008, S&P lowered counterparty credit and financial strength ratings on XL Capital Ltd’s core operating companies to “A” (negative) from “A+” (negative). At the same time, Standard & Poor’s lowered its counterparty credit rating on XL Capital Ltd to “BBB+” (negative) from “A–” (negative). In addition, during the same period, Moody’s revised the financial strength rating of the Company’s principal insurance and reinsurance subsidiaries to “A2” (Negative) from “A1” (On Review for Possible Downgrade) and also revised the counterparty credit rating on XL Capital Ltd to “Baa2” (Negative) from “Baa1” (On

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Review for Possible Downgrade). As well, in December 2008, Fitch revised the financial strength rating of the Company’s leading insurance and reinsurance subsidiaries to “A” (Rating Watch Negative) from “A+” (Rating Watch Negative) and also revised the counterparty credit rating on XL Capital Ltd to “BBB+” (Rating Watch Negative) from “A” (Stable).

We may require additional capital in the future, which may not be available to us on satisfactory terms, on a timely basis or at all.

Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover our losses. To the extent that the funds generated by our ongoing operations are insufficient to fund future operating requirements and cover claim payments, or that our capital position is adversely impacted by mark-to-market movements on the investment portfolio, catastrophe events or otherwise, we may need to raise additional funds through financings or curtail our growth and reduce our assets. As a result of the current severe economic conditions that persist in the capital markets, any future financing may not be available on terms that are favorable to us, if at all. In addition, any future equity financings could be dilutive to our existing shareholders or could result in the issuance of securities that have rights, preferences and privileges that are senior to those of our other securities. Our inability to obtain adequate capital could have a material adverse effect on our business, financial condition and results of operations.

Our holding company structure and certain regulatory and other constraints affect our ability to pay dividends, make payments on our debt securities and make other payments.

As a holding company with no direct operations or significant assets other than the capital stock of our subsidiaries, we rely on investment income, cash dividends, loans and other permitted payments from our subsidiaries to make principal and interest payments on our debt, to pay operating expenses and common and preferred shareholder dividends, to make capital investments in our subsidiaries and to pay certain of our other obligations that may arise from time to time. We expect future investment income, dividends and other permitted payments from these subsidiaries to be our principal source of funds to pay such expenses, preferred and common stock dividends and obligations. The payment of dividends to us by our insurance and reinsurance subsidiaries is regulated under the laws of various jurisdictions including Bermuda, the U.K., Ireland, and Switzerland and certain insurance statutes of various states in the United States in which our insurance and reinsurance subsidiaries are licensed to transact business and the other jurisdictions where we have regulated subsidiaries. For further information regarding regulatory restrictions governing the payment of dividends by the Company’s significant property and casualty subsidiaries in Bermuda and the U.S., see Note 26 to the Consolidated Financial Statements “Statutory Financial Data.”

XL Capital Ltd is subject to certain regulatory constraints that affect its ability to pay dividends on its ordinary shares and preferred shares. Under Cayman Islands law, XL Capital Ltd may not declare or pay a dividend if there are reasonable grounds for believing that XL Capital Ltd is, or would after the payment be, unable to pay its liabilities as they become due in the ordinary course of business. Also, the terms of our preferred shares prohibit declaring or paying dividends on our ordinary shares unless full dividends have been declared and paid on our outstanding preferred shares. In addition, our ability to declare and pay dividends may be restricted by covenants in our letters of credit and revolving credit facilities.

We are exposed to significant capital markets risk related to changes in interest rates, credit spreads, equity prices and foreign exchange rates as well as other investment risks, which may adversely affect our results of operations, financial condition or cash flows.

Our assets are invested by a number of professional investment advisory management firms under the direction of our management team in accordance, in general, with detailed investment guidelines set by us. Although our investment policies stress diversification of risks, conservation of principal and liquidity, our investments are subject to market-wide risks, as noted below, and fluctuations, as well as to risks inherent in particular securities.

Our assets are invested by a number of professional investment advisory management firms under the direction of our management team in accordance, in general, with detailed investment guidelines set by us. Although our investment policies stress diversification of risks, conservation of principal and liquidity, our investments are subject to market-wide risks, as noted below, and fluctuations, as well as to risks inherent

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in particular securities. We are exposed to significant capital markets risk related to changes in interest rates, credit spreads and defaults, market liquidity, equity prices and foreign currency exchange rates. Throughout 2008, financial market conditions continued to be extremely challenging as the global credit crisis that began in July 2007 continued to adversely impact global fixed income markets. Credit spreads on both corporate and structured credit assets widened throughout 2008 and remained wide as at December 31, 2008 as compared to December 31, 2007, resulting in continuing depressed pricing on fixed income securities and other credit products. If significant, continued volatility, changes in interest rates, changes in credit spreads and defaults, a lack of pricing transparency, market liquidity, declines in equity prices, and the strengthening or weakening of foreign currencies against the U.S. dollar, individually or in tandem, could have a material adverse effect on our consolidated results of operations, financial condition or cash flows through realized losses, impairments, and changes in unrealized positions. Levels of write-down or impairment are impacted by our assessment of the intent and ability to hold securities which have declined in value until recovery as well as actual losses as a result of defaults or cash-flow deterioration. We periodically review our investment portfolio structure and strategy. If, as a result of such review, we determine to reposition or realign portions of the portfolio where we determine not to hold certain securities in an unrealized loss position to recovery, then we will incur an other than temporary impairment charge. Such charges may have a material adverse effect on our results of operations and business.

During 2008, the prolonged and severe disruptions in the public debt and equity markets, including among other things, widening of credit spreads, bankruptcies and government intervention in a number of large financial institutions, have resulted in significant realized and unrealized losses in our investment portfolio. For the year ended December 31, 2008, we incurred substantial realized and unrealized investment losses, as described in Management’s Discussion and Analysis of Financial Condition and Results of Operations under Part II, Item 7 of this report. We continue to closely monitor current market conditions and evaluate the long term impact of this recent market volatility on all of our investment holdings. Depending on market conditions, we could incur additional realized and unrealized losses in future periods, which could have a material adverse effect on the Company’s results of operations, financial condition and business.

Our exposure to interest rate risk relates primarily to the market price and cash flow variability associated with changes in interest rates. Our investment portfolio contains interest rate sensitive instruments, such as fixed income securities, which have been and may continue to be adversely affected by changes in interest rates from governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. A rise in interest rates would increase the net unrealized loss position of our investment portfolio, offset by our ability to earn higher rates of return on funds reinvested. Conversely, a decline in interest rates would decrease the net unrealized loss position of our investment portfolio, offset by lower rates of return on funds reinvested. Our mitigation efforts with respect to interest rate risk are primarily focused towards maintaining an investment portfolio with diversified maturities that has a weighted average duration that is approximately equal to the duration of our estimated liability cash flow profile. However, our estimate of the liability cash flow profile may be inaccurate and we may be forced to liquidate investments prior to maturity at a loss in order to cover liabilities. Although we take measures to manage the economic risks of investing in a changing interest rate environment, we may not be able to mitigate the interest rate risk of our assets relative to our liabilities.

A portion of our risk asset portfolio consists of below investment-grade high yield fixed income securities, a portion of which are non-investment grade as a result of recent credit downgrades. These securities have a higher degree of credit or default risk. Certain sectors within the investment and below investment grade fixed income market, such as structured and corporate credit, may be less liquid in times of economic weakness or market disruptions. While we have put in place procedures to monitor the credit risk and liquidity of our invested assets, in general and those impacted by recent credit market issues specifically, it is possible that, in periods of economic weakness or periods of turmoil in capital markets, we may experience default losses in both our investment-grade and below investment-grade corporate and structured credit holdings. This may result in a material reduction of net income, capital and cash flows. Beginning in the latter half of 2007 and continuing throughout 2008, increasing delinquencies in U.S. residential collateral in various securitized products has led to increased volatility and decreased liquidity across financial markets as a whole. Decreases in market liquidity have increased the difficulty and

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volatility in pricing across credit exposed markets. Such illiquidity, volatility and related uncertainty may persist or even worsen in the future.

We invest a portion of our portfolio in common stock or equity-related securities, including in hedge funds and private equity funds. The value of these assets fluctuates, along with other factors, with equity and credit markets. In times of economic weakness, the market value and liquidity of these assets may decline, and may impact net income, capital and cash flows. In addition, certain of the products offered by our Life Operations segment offer guaranteed benefits which increase our potential benefit exposure should debt and equity markets continue to decline. In addition, the amount of earnings from alternative funds and private investment funds are not earned evenly across the year, or even from year to year. As a result, the amount of earnings that that we record from these investments may vary substantially from quarter to quarter. The timing of distributions from such private investment funds depends on particular events relating to the underlying investments. The ability of a alternative fund to satisfy any redemption request from its investors depends on the underlying liquidity of the alternative fund’s investments. As a result, earnings, distributions and redemptions from these two asset classes may be more difficult to predict.

Our functional currencies of our principal insurance and reinsurance subsidiaries include the U.S. dollar, U.K. sterling, the Euro, the Swiss Franc, and the Canadian dollar. Exchange rate fluctuations relative to the functional currencies may materially impact our financial position and results of operations. Many of our non- U.S. subsidiaries maintain both assets and liabilities in currencies different than their functional currency, which exposes us to changes in currency exchange rates.

In addition, locally-required capital levels are invested in local currencies in order to satisfy regulatory requirements and to support local insurance operations regardless of currency fluctuations. Foreign exchange rate risk is reviewed as part of our risk management process. While we utilize derivative instruments such as futures, options and foreign currency forward contracts to, among other things, manage our foreign currency exposure, it is possible that these instruments will not effectively mitigate all or a substantial portion of our foreign exchange rate risk.

Certain of our investments may be illiquid and are in asset classes that have been experiencing significant market valuation fluctuations.

We hold certain investments that may lack liquidity or of which the observability of prices or inputs may be reduced in periods of market dislocation, such as sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures. Even some of our high quality assets have been more illiquid as a result of the recent challenging market conditions. Generally, securities classified as Level 3 pursuant to the fair value hierarchy set forth in FAS 157 may be less liquid, more difficult to value and require significant judgment, and more likely to result in sales materially different than fair values determined by management.

If we require significant amounts of cash on short notice in excess of normal cash requirements or are required to post or return collateral in connection with certain of our reinsurance contracts, credit agreements, derivative transactions or our invested portfolio, we may have difficulty selling these investments in a timely manner, be forced to sell them for less than we otherwise would have been able to realize, or both.

The reported value of our relatively illiquid types of investments and, in certain circumstances, our high quality, generally liquid asset classes, do not necessarily reflect the lowest current market bid price for the asset. If we were forced to sell certain of our assets in the current market, there can be no assurance that we will be able to sell them for the prices at which we have recorded them and we may be forced to sell them at significantly lower prices, particularly at times of extreme market illiquidity.

Changes to U.S. GAAP with respect to whether unrealized losses on hybrid securities are other than temporary impairments may result in additional impairment charges

Recent correspondence between the SEC and FASB indicates that the application of the impairment model specified for debt securities remains the appropriate basis for analyzing investment grade hybrid securities for other than temporary impairments. However, should accounting standards require the application of the model specified for equity securities, where the primary determinant of charges for other than temporary impairments is the duration of impairments, we would be required to re-evaluate our

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assertion that unrealized losses on such hybrid securities are considered temporary, which could materially and negatively impact future results.

There can be no assurance as to the effect that governmental and regulatory actions will have on financial markets generally or on us in particular

In response to the financial crises affecting the banking system and financial markets and going concern threats to financial institutions, there have been numerous regulatory and governmental actions. Within the United States, the Federal Reserve has taken action through reduced federal funds rates and expansion of acceptable collateral to provide additional liquidity. Fannie Mae and Freddie Mac have been placed under conservatorship along with having received capital injections and enhanced liquidity, and numerous financial institutions have received capital both in the form of emergency loans and the Emergency Economic Stabilization Act of 2008 which made available $700 billion of capital through direct Treasury equity investments, In early 2009, the American Recovery and Reinvestment Act of 2009 was enacted to provide further stimulus to institutions that have received or will receive financial assistance under the Troubled Asset Relief Program. Certain of our competitors, such as companies that engage in both life and property insurance lines of business, are participating, or may in the future, in some or all of these government programs.

There are other pending initiatives, including but not limited to, “cram-down” legislation specifically relating to mortgage-backed securities. In certain residential mortgages, the losses from such a cramdown may be shared across all tranches of the security on a prorated basis. The Company may absorb additional losses should any such investments that it holds become subject to any such cram-down provisions. At the present time, there is no clarity on how the rating agencies will react to such a development, and we may experience significant numbers of downgrades on our RMBS holdings.

Within the United Kingdom and Euro-zone, similar actions included interest rate cuts and nationalization of certain financial institutions has been undertaken.

We own a number of Tier 1 and 2 hybrid securities issued by financial institutions including those based in the U.S. and U.K. There is a risk that if markets continue to deteriorate, that further government intervention, particularly nationalization of such institutions, could occur. There is also a risk of regulatorily imposed deferral of coupons. This may result in losses on the hybrid securities we hold.

There can be no assurance as to the effect that any such governmental actions or future regulatory initiatives may have on certain investment instruments in our investment portfolio, or on our competitive position, business and financial position.

If actual claims exceed our loss reserves, our financial results could be adversely affected.

Our results of operations and financial condition depend upon our ability to assess accurately the potential losses associated with the risks that we insure and reinsure. We establish reserves for unpaid losses and loss adjustment expense (“LAE”) liabilities, which are estimates of future payments of reported and unreported claims for losses and related expenses with respect to insured events that have occurred. The process of establishing reserves for property and casualty claims can be complex and is subject to considerable variability as it requires the use of informed estimates and judgments. Actuarial estimates of unpaid loss and LAE liabilities are subject to potential errors of estimation, which could be significant, due to the fact that the ultimate disposition of claims incurred prior to the date of such estimation, whether reported or not, is subject to the outcome of events that have not yet occurred. Examples of these events include the accuracy of the factual information on which the estimates were based, especially as this develops, jury decisions, court interpretations, legislative changes, changes in the medical condition of claimants, public attitudes, and economic conditions such as inflation. Any estimate of future costs is subject to the inherent limitation on the ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of loss and LAE liabilities will vary, perhaps materially, from any estimate.

Similarly, the actual emergence of claims for life business may vary from the assumptions underlying the policy benefit reserves, in particular, the future assumed mortality improvements on the blocks of in-payment annuities.

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In relation to previously written financial guarantee business and related exposures, we establish reserves for losses and LAE on such business based on management’s best estimate of the ultimate expected incurred losses. Our estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. Establishment of such reserves requires the use and exercise of significant judgment by management, including with respect to estimates regarding the occurrence and amount of a loss on an insured or reinsured obligation. Estimates of losses may differ from actual results and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred. Examples of these events include changes in the level of interest rates, credit deterioration of insured and reinsured obligations, and changes in the value of specific assets supporting insured and reinsured obligations. In general, guarantees in credit default swap form previously written are exposed to the same risks as noted above, except in events of default by the guarantor. Credit default swaps, however, do not qualify for the financial guarantee scope exception under FAS 133, and, therefore are reported at fair value with changes in the fair value included in earnings. Fair value for such swaps are determined based on methodologies further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates” under Item II, Part 7 of this report. Any estimate of future costs is subject to the inherent limitation on our ability to predict the aggregate course of future events. It should therefore be expected that the actual emergence of losses and LAE will vary, perhaps materially, from any estimate.

We have an actuarial staff in each of our operating segments and a Chief Actuary that regularly evaluates the levels of loss reserves, taking into consideration factors that may impact the ultimate losses incurred. Any such evaluation could result in future changes in estimates of losses or reinsurance recoverable and would be reflected in our results of operations in the period in which the estimates are changed. Losses and LAE, to the extent that they exceed the applicable reserves, are charged to income as incurred. The reserve for unpaid losses and LAE represents the estimated ultimate losses and LAE less paid losses and LAE, and comprises case reserves and incurred but not reported loss reserves (“IBNR”). During the loss settlement period, which can span many years in duration for casualty business, additional facts regarding individual claims and trends often will become known and case reserves may be adjusted by allocation from IBNR without any change in the overall reserve. In addition, application of statistical and actuarial methods may require the adjustment of the overall reserves upward or downward from time to time. Accordingly, the ultimate settlement of losses may be significantly greater than or less than reported loss and loss expense reserves.

The effects of emerging claim and coverage issues on our business are uncertain.

As industry practices and legal, judicial, social and other environmental conditions change, unexpected issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims, such as the effects that recent disruptions in the credit markets could have on the number and size of reported claims under D&O and professional liability insurance lines of business. In some instances, these changes may not become apparent until some time after we have issued the insurance or reinsurance contracts that are affected by the changes. As well, our actual losses may vary materially from our current estimate of the loss based on a number of factors, including receipt of additional information from insureds or brokers, the attribution of losses to coverages that had not previously been considered as exposed and inflation in repair costs due to additional demand for labor and materials. As a result, the full extent of liability under an insurance or reinsurance contract may not be known for many years after such contract is issued and a loss occurs.

The occurrence of disasters could adversely affect our financial condition.

We have substantial exposure to losses resulting from natural and man-made disasters and other catastrophic events. Catastrophes can be caused by various events, including hurricanes, earthquakes, floods, hailstorms, explosions, severe weather, fires, war and acts of terrorism. The incidence and severity of catastrophes are inherently unpredictable, and it is difficult to predict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate.

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The occurrence of claims from catastrophic events is likely to result in substantial volatility in our financial condition and results of operations for the fiscal quarter or year in which a catastrophic event occurs, as well as subsequent fiscal periods, and could have a material adverse effect on our financial condition and results of operations and our ability to write new business. This risk is exacerbated due to accounting principles and rules that do not permit (re)insurers to reserve for such catastrophic events until they occur. We expect that future possible increases in the values and concentrations of insured property, the effects of inflation and changes in cyclical weather patterns may increase the severity of catastrophic events in the future. Although we attempt to manage our exposure to catastrophic events, a single catastrophic event could affect multiple geographic zones and lines of business and the frequency or severity of catastrophic events could exceed our estimates, in each case potentially having a material adverse effect on our financial condition and results of operations. In addition, while we may, depending on market conditions, purchase catastrophe reinsurance and retrocessional protection, the occurrence of one or more major catastrophes in any given period could result in losses that exceed such reinsurance and retrocessional protection. This could have a material adverse effect on our financial condition and results of operations and may result in substantial liquidation of investments, possibly at a loss, and outflows of cash as losses are paid.

The failure of any of the underwriting risk management strategies that we employ could have a material adverse effect on our financial condition, results of operations and/or liquidity.

We seek to limit our loss exposure by, among other things, writing a number of our reinsurance or retrocession contracts on an excess of loss basis, adhering to maximum limitations on reinsurance written in defined geographical zones, limiting program size for each client and prudently underwriting each program written. In addition, in the case of proportional treaties, we generally seek to use per occurrence limitations or loss ratio caps to limit the impact of losses from any one event. We cannot be sure that all of these loss limitation methods will have the precise risk management impact intended. For instance, although we also seek to limit our loss exposure by geographic diversification, geographic zone limitations involve significant underwriting judgments, including the determination of the area of the zones and the inclusion of a particular policy within a particular zone’s limits. Underwriting involves the exercise of considerable judgment and the making of important assumptions about matters that are inherently unpredictable and beyond our control, and for which historical experience and probability analysis may not provide sufficient guidance. The failure of any of the underwriting risk management strategies that we employ could have a material adverse effect on our financial condition and results of operations. Also, we cannot provide assurance that various provisions of our policies, such as limitations or exclusions from coverage or choice of forum, will be enforceable in the manner that we intend and disputes relating to coverage and choice of legal forum may arise, which could materially adversely affect our financial condition and results of operations.

The loss of one or more key executives or the inability to attract, motivate and retain qualified personnel could adversely affect our ability to conduct business.

Our success depends on our ability to attract new highly skilled individuals and to motivate and retain our existing key executives and qualified personnel. The loss of the services of any of our key executives or the inability to attract, motivate and retain other highly skilled individuals in the future could adversely affect our ability to conduct our business. In addition, we do not maintain key man life insurance policies with respect to our employees.

In fiscal 2008, the market price of our Class A ordinary shares declined very significantly during the year. A substantial portion of our annual compensation paid to our senior employees has, in recent years, been paid in the form of equity-based awards. In addition, we reduced the number of employees across nearly all of our locations in August 2008 as well as in February 2009. The combination of these events could adversely affect our ability to hire, motivate and retain qualified employees.

In addition, many of our senior executives working in Bermuda are not Bermudian and our success may depend in part on the continued services of key employees in Bermuda. Under Bermuda law, non-Bermudians (other than spouses of Bermudians and holders of permanent resident certificates) may not engage in any gainful occupation in Bermuda without an appropriate governmental work permit. A work permit may be granted or renewed by the Bermuda government for a specific period of time, upon showing

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that, after proper public advertisement, no Bermudian (or spouse of a Bermudian or holder of a permanent resident certificate) is available who meets the minimum standards reasonably required by an employer with respect to a certain position. The government of Bermuda places a six-year term limit on individuals with work permits, subject to certain exemptions for key employees. No assurances can be given that any work permit will be issued or, if issued, renewed upon the expiration of the relevant term or that key employee status will be granted or revoked.

A decrease in the fair value of our reporting units may result in future goodwill impairments.

Following the goodwill impairment charge of $990.0 million recorded during the fourth quarter of 2008, the goodwill balance at December 31, 2008 was $813.3 million. When we acquire an entity, the excess of the purchase price over the net identifiable assets acquired is allocated to goodwill. We conduct impairment tests on our reported goodwill at least annually or more frequently if impairment indicators exist. In performing a goodwill impairment test, we use various methods and make various assumptions to determine the fair value of our reporting units, including the determination of expected future cash flows and/or profitability of such reporting units, and we take into account market value multiples and/or cash flows of entities that we deem to be comparable in nature, scope or size to our reporting units. However, expected future cash flows and/or profitability may be materially and negatively impacted as a result of, among other things, a decrease in renewal activity and new business opportunities, retaining our underwriting teams, lower-than-expected yields and/or cash flows from our investment portfolio, higher-than-expected claims activity and magnitude of incurred losses and general economic factors that impact the reporting unit. In addition, previously determined market value multiples and/or cash flows may no longer be relevant as a result of these potential factors. As a result of these potential changes, the estimated fair value of one or more of our reporting units may decrease, causing the carrying value of the net assets assigned to the reporting unit to exceed the fair value of such net assets. If we determine an impairment exists, we adjust the carrying value of goodwill to its implied fair value. The impairment charge is recorded in our income statement in the period in which the impairment is determined. If we are required in the future to write down additional goodwill, our financial condition and results of operations would be negatively affected. In connection with fair value measurements and the accounting for goodwill, the use of generally accepted accounting principles requires management to make certain estimates and assumptions. Significant judgment is required in making these estimates and assumptions, and actual results may ultimately be materially different from such estimates and assumptions.

Lawsuits, including putative class action lawsuits, have been filed against us by policyholders and security holders the ultimate outcome of which could have a material adverse effect on our consolidated financial condition, future operating results and/or liquidity

We are subject to lawsuits and arbitrations in the regular course of our business. In addition, lawsuits have been filed against us as detailed in Item 8, Note 20(g) to the Consolidated Financial Statements, “Commitments and Contingencies – Claims and Other Litigation.” We believe that we have substantial defenses to all outstanding litigation and intend to pursue our defenses vigorously, although an adverse resolution of one or more of these items could have a material adverse effect on our results of operations in a particular fiscal quarter or year.

There is a possibility that the Master Agreement and the related commutations and releases could be challenged or that we could be subject to litigation as a result of the Master Agreement. Any such challenge could have a material adverse effect on our financial condition, results of operations, liquidity or the market price of our securities.

We provided certain reinsurance protections (the “Reinsurance Agreements”) with respect to adverse development on certain transactions as well as indemnification under specific facultative and excess of loss coverages for subsidiaries of Syncora: Syncora Guarantee Re and Syncora Guarantee. As at June 30, 2008, our total net exposure under facultative agreements with Syncora subsidiaries was approximately $6.4 billion of net par value outstanding. Pursuant to the closing of the Master Agreement, all of these Reinsurance Agreements were commuted.

In addition, through one or more of our subsidiaries, we entered into certain agreements with subsidiaries of Syncora pursuant to which we guaranteed certain obligations of Syncora Guarantee Re and Syncora Guarantee under specific agreements (the “Guarantee Agreements”). As at June 30, 2008, the total

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net par value outstanding of business written by subsidiaries of Syncora which fell under the Guarantee Agreements was approximately $60 billion. Pursuant to the terms of, and required conditions under, the Master Agreement, Syncora Guarantee Re’s facultative quota share reinsurance agreement with Syncora Guarantee, and all individual risk cessions thereunder, and the Financial Security Master Facultative Agreement, and all individual risk cessions thereunder, will be commuted, thereby rendering the Syncora Guarantee Re guarantee and Financial Security guarantee of no further force and effect.

Following the closing of the Master Agreement, Syncora and its applicable subsidiaries are required to use commercially reasonable efforts to commute the underlying financial guarantees that are the subject of the EIB Guarantees. There can be no assurances that such commutation will ultimately occur and that our $955.4 million exposure (as of December 31, 2008) under the EIB Guarantees will be eliminated.

As further described in Note 4 to the Consolidated Financial Statements, “Syncora Holdings Ltd. (“Syncora”)”, while the NYID and the BMA approved the Master Agreement and related agreements and transactions, including the commutation of the agreements described above, and the Delaware Insurance Department (“DID”) approved the Master Agreement and the commutation of the Syncora Guarantee Re/Syncora Guarantee Quota Share, and although we believe the effect of the Master Agreement will be to relieve us of all of our obligations under the Reinsurance Agreements and the Guarantee Agreements (other than as noted above with respect to the EIB Guarantee, if such Guarantee remains in place post-closing), no assurance can be given that the enforceability of the Master Agreement, the agreements relating thereto and the transactions contemplated thereunder will not be challenged, including under applicable fraudulent transfer laws (described in the following paragraph) and/or by asserting any number of other theories for recovery, including third-party beneficiary rights, or that other litigation will not be commenced against us as a result of the Master Agreement and such related agreements and transactions. We believe that we would have significant defenses to any such challenges and would vigorously defend against any such claims. However, we cannot assure you that any such claims would not be made or, that any such claims would not ultimately be successful.

Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws (including those applicable in any state insurance insolvency proceeding) Syncora’s commutation and release of our obligations pursuant to the Master Agreement and related agreements would constitute a voidable fraudulent transfer if it was determined that Syncora or any applicable subsidiary thereto, at the time it entered into the Master Agreement or such related agreement:

 

 

 

 

intended to hinder, delay or defraud its creditors; or

 

 

 

 

received less than “reasonably equivalent value” or “fair consideration” for such release; and either

 

 

 

 

was insolvent or rendered insolvent by reason of such incurrence; or

 

 

 

 

was engaged in a business or transaction for which its remaining assets constituted unreasonably small capital; or

 

 

 

 

intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature.

Among other regulatory approvals obtained in connection with the Master Agreement, the NYID issued an approval letter to Syncora Guarantee under Section 1505 of the New York Insurance Law and the DID issued an approval letter to Syncora Guarantee Re under Section 5005(a) of the Delaware Insurance Code (effective upon Syncora Guarantee Re’s redomestication to Delaware) (both of which require that the terms of a transaction between an issuer and one or more of its affiliates be fair and equitable) stating, in the case of NYID, that the terms of the Master Agreement and each of the commutations are fair and equitable to Syncora Guarantee and do not adversely affect policyholders of Syncora Guarantee and, in the case of the DID, stating that the terms of the Master Agreement and the commutation of the Syncora Guarantee Re/Syncora Guarantee Quota Share were fair and equitable to Syncora Guarantee. The BMA (the domiciliary regulator of Syncora Guarantee Re) also issued an approval letter approving the Master Agreement and each commutation to which Syncora Guarantee Re is a party, including the Syncora Guarantee Re/Syncora Guarantee Quota Share. There can be no assurance that a court would agree with our, the NYID’s, the DID’s, the BMA’s or Syncora’s conclusions, or as to what law or standard a court would ultimately apply in making any such determination or as to how such court would ultimately rule. Additionally, in the event of any liquidation or rehabilitation or similar proceeding of any insurance

38


subsidiary of Syncora, there can be no assurance that any insurance regulator or regulators responsible for such proceedings, in their capacity as liquidator or rehabilitator, would respect the insurance regulatory approvals obtained in connection with the Master Agreement.

If any such challenge were successful, we could be required to honor our original obligations under the Reinsurance Agreements and Guarantee Agreements or be subject to other remedies. Any challenge could have a material adverse effect on the market price for our securities and on our business and, if successful, could also have a material adverse effect on our financial condition, results of operations and liquidity.

Since the closing of the Master Agreement, Syncora has stated in its quarterly reports on Form 10-Q for the quarters ended June 30, 2008 and September 30, 2008, that substantial doubt exists as to their ability to continue as a going concern. In addition, Syncora was delisted from the New York Stock Exchange (the “NYSE”) as a result of its common shares no longer meeting the NYSE continued listing standards.

Current legal and regulatory activities relating to insurance brokers and agents, contingent commissions, the municipal guaranteed investment contract market could adversely affect our business, financial condition and results of operations.

In 2004 contingent commission arrangements became a focus of investigations by various regulatory agencies, including certain state Attorneys General and insurance departments. Due to various governmental investigations into contingent commission practices, various market participants have modified or eliminated acquisition expenses formerly arising from placement service agreements and related arrangements. As a result, it is possible that policy commissions or brokerage that we pay may increase in the future and/or that different forms of broker or prodcer compensation arrangements will develop in the future. Any such additional expense that may result could have a material adverse effect on our financial conditions or results.

One of our subsidiaries that had been a provider of municipal guaranteed investment contracts (“GICs”) received a grand jury subpoena in November 2006 from the Antitrust Division of the U.S. Department of Justice (the “DOJ”) and a subpoena from the SEC seeking documents pursuant to respective investigations into municipal GICs and related products sold in connection with municipal bond offerings. Our subsidiary is fully cooperating with these federal industry-wide investigations. In June 2008, subsidiaries of ours also received a subpoena from the Office of the Connecticut Attorney General and an Antitrust Civil Investigative Demand from the Office of the Florida Attorney General in connection with a coordinated multi-state Attorneys General investigation into the matters referenced in the DOJ and SEC subpoenas. We are fully cooperating with these investigations.

At this time, we are unable to predict the potential effects, if any, that these investigations may have upon us, the insurance and reinsurance markets in general or industry and reinsurance business practices or what changes, if any, may be made to laws and regulations regarding the industry. Any of the foregoing could also result in litigation or otherwise adversely affect our business, financial condition, or results of operations.

We may be unable to purchase reinsurance and, even if we are able to successfully purchase reinsurance, we are subject to the possibility of uncollectability. The impairment of other financial institutions also could adversely affect us.

We purchase reinsurance for our own account in order to mitigate the volatility that losses impose on our financial condition. Our clients purchase reinsurance from us to cover part of the risk originally written by them. Retrocessional reinsurance involves a reinsurer ceding to another reinsurer, the retrocessionaire, all or part of the reinsurance that the first reinsurer has assumed. Reinsurance, including retrocessional reinsurance, does not legally discharge the ceding company from its liability with respect to its obligations to its insureds or reinsureds. A reinsurer’s or retrocessionaire’s insolvency, inability or refusal to make timely payments under the terms of its agreements with us, therefore, could have a material adverse effect on us because we remain liable to our insureds and reinsureds. At December 31, 2008, we had approximately $4.6 billion of reinsurance recoverables and reinsurance balances receivable, net of reserves for uncollectible recoverables. For further information regarding our reinsurance exposure, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, under Part II, Item 7 of this report.

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From time to time, market conditions may limit or prevent us from obtaining the types and amounts of reinsurance that we consider adequate for our business needs such that we may not be able to obtain reinsurance or retrocessional reinsurance from entities with satisfactory creditworthiness in amounts that we deem desirable or on terms that we deem appropriate or acceptable.

We also have exposure to counterparties in various industries, including banks, alternatives and other investment vehicles, and in transactions in addition to reinsurance agreements, including derivative transactions. Many of these transactions expose us to credit risk in the event our counterparty fails to perform its obligations. Even if we are entitled to collateral when a counterparty defaults, such collateral may be illiquid or proceeds from such collateral when liquidated may not be sufficient to recover the full amount of the obligation. We also have exposure to financial institutions in the form of secured and unsecured debt instruments and equity securities.

Operational risks, including human or systems failures, are inherent in our business.

Operational risk and losses can result from, among other things, fraud, errors, failure to document transactions properly or to obtain proper internal authorization, failure to comply with regulatory requirements, information technology failures, or external events.

We believe that our modeling, underwriting and information technology and application systems are critical to our business. Moreover, our information technology and application systems have been an important part of our underwriting process and our ability to compete successfully. We have also licensed certain systems and data from third parties. We cannot be certain that we will have access to these, or comparable, service providers, or that our information technology or application systems will continue to operate as intended. A major defect or failure in our internal controls or information technology and application systems could result in management distraction, harm to our reputation or increased expense.

In particular, we have outsourced the day-to-day management, custody and record-keeping of our investment portfolio to third-party managers and custodians that we believe to be reputable. A major defect in those investment managers’ investment management strategy, information and technology systems, internal controls or decision-making could result in management distraction and/or significant financial loss. A major defect in custodian internal controls or information and technology systems could result in management distraction or significant financial loss.

We believe appropriate controls and mitigation procedures are in place to prevent significant risk of defect in our internal controls, information technology, application systems, investment management and custody and record-keeping, but internal controls provide only reasonable, not absolute, assurance as to the absence of errors or irregularities and any ineffectiveness of such controls and procedures could have a material adverse effect on our business.

Since we depend on a few brokers for a large portion of our revenues, loss of business provided by any one of them could adversely affect us.

We market our insurance and reinsurance products worldwide primarily through insurance and reinsurance brokers. Marsh & McLennan Companies and AON Corporation and their respective subsidiaries each provided approximately 17%, of our gross written premiums for property and casualty operations for the year ended December 31, 2008. Loss of all or a substantial portion of the business provided by one or more of these brokers could have a material adverse effect on our business.

Our reliance on brokers subjects us to credit risk.

In certain jurisdictions, when an insured or ceding insurer pays premiums for policies of insurance or contracts of reinsurance to brokers for further payment to us, such premiums might be considered to have been paid and the insured or ceding insurer will no longer be liable to us for such amounts, whether or not we have actually received the premiums from the broker. In addition, in accordance with industry practice, we generally pay amounts owed on claims under our reinsurance contracts to brokers, and these brokers, in turn, pay these amounts over to the clients that have purchased reinsurance from us. Although the law is unsettled and depends upon the facts and circumstances of the particular case, in some jurisdictions, if a broker fails to make such a claims payment to the insured or ceding insurer, we might remain liable to the insured or ceding insurer for that non-payment. Consequently, we assume a degree of credit risk associated with the brokers with whom we transact business. Due to the unsettled and fact-specific nature of the law

40


governing these types of scenarios, we are unable to quantify our exposure to this risk. To date, we have not experienced any material losses related to such credit risks.

Risks Related to the Insurance and Reinsurance Industries

The insurance and reinsurance industries are historically cyclical and we may experience periods with excess underwriting capacity and unfavorable premium rates.

The insurance and reinsurance industries have historically been cyclical, characterized by periods of intense price competition due to excess underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. An increase in premium levels is often offset by an increasing supply of insurance and reinsurance capacity, either by capital provided by new entrants or by the commitment of additional capital by existing insurers or reinsurers, which may cause prices to decrease. Either of these factors could lead to a significant reduction in premium rates, less favorable policy terms and conditions and fewer submissions for our underwriting services. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance and reinsurance industries significantly. Throughout most of 2008, both the insurance and reinsurance industries experienced soft market conditions, including decreases in premium rates across most lines of business, increased competitive pressures and increased retention by insureds and/or cedants. While pricing relative to risks in such markets began to improve in late 2008 and early 2009, there is no assurance that such improvements in rates and conditions will continue.

Competition in the insurance and reinsurance industries could reduce our operating margins.

The insurance and reinsurance industries are highly competitive. We compete on an international and regional basis with major U.S., Bermudian, European and other international insurers and reinsurers and with underwriting syndicates, some of which have greater financial and management resources and higher ratings than we do. We also compete with new companies that continue to be formed to enter the insurance and reinsurance markets. In addition, capital market participants have recently created alternative products that are intended to compete with reinsurance products. Increased competition could result in fewer submissions, lower premium rates and less favorable policy terms and conditions, which could reduce our margins.

Unanticipated losses from terrorism and uncertainty surrounding the future of the TRIPRA could have a material adverse effect on our financial condition and results of operations.

In response to the tightening of supply in certain insurance and reinsurance markets resulting from, among other things, the September 11 event, the Terrorism Risk Insurance Program (“TRIP”) was created upon the enactment of the U.S. Terrorism Risk Insurance Act of 2002 (“TRIA”) to ensure the availability of commercial insurance coverage for certain terrorist acts in the U.S. This law established a federal assistance program through the end of 2005 to help the commercial property and casualty insurance industry cover claims related to future terrorism-related losses and required that coverage for terrorist acts be offered by insurers. TRIA was originally scheduled to expire at the end of 2005, but was extended in December 2005 for an additional two years. On December 26, 2007, President George Bush approved the Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”), extending TRIP through December 31, 2014 and also eliminated the distinction between foreign and domestic acts of terrorism.

TRIA voided in force terrorism exclusions as of November 26, 2002 for certified terrorism on all TRIA specified property and casualty business. TRIA required covered insurers to make coverage available for certified acts of terrorism on all new and renewal policies issued after TRIA was enacted. TRIA along with further extensions to TRIP, as noted above, allows us to assess a premium charge for terrorism coverage and, if the policyholder declines the coverage or fails to pay the buy-back premium, certified acts of terrorism may then be excluded from the policy, subject, however, to state specific requirements. Terrorism coverage cannot be excluded from workers’ compensation policies. Subject to a premium-based deductible and provided that we have otherwise complied with all the requirements as specified under TRIPRA, we are eligible for reimbursement by the Federal Government for up to 85% of our covered terrorism-related losses arising from a certified terrorist attack. Such payment by the government will, in effect, provide reinsurance protection on a quota share basis. The maximum liability during a program year,

41


including both the Federal Government’s and insurers’ shares, is capped on an aggregated basis at $100 billion. While regulations have been promulgated by the Department of the Treasury (“Treasury”) requiring that Treasury advise participating insurers, such as the Company, in advance of reaching the $100 billion aggregate limit that such aggregate limit could be reached during the program year, there is a risk that the Company will not be given adequate notice of the potential exhaustion of that aggregate limit. Accordingly, the Company could overpay with regard to such losses, and it is unlikely Treasury would reimburse the Company for such losses; moreover, it is unclear whether the Company, in the event of an overpayment, would be able to recover the amount of any such overpayment.

We believe that TRIP and the related legislation has been an effective mechanism to assist policyholders and industry participants with the extreme contingent losses that might be caused by acts of terrorism. We cannot assure you that TRIPRA will be extended beyond 2014, and its expiration or a significant change in terms could have an adverse effect on us, our clients or the insurance industry.

Potential government intervention in our industry as a result of recent events and instability in the marketplace for insurance products could hinder our flexibility and negatively affect the business opportunities that may be available to us in the market.

Government intervention and the possibility of future government intervention have created uncertainty in the insurance and reinsurance markets. Government regulators are generally concerned with the protection of policyholders to the exclusion of other constituencies, including shareholders of insurers and reinsurers. While we cannot predict the exact nature, timing or scope of possible governmental initiatives, such proposals could adversely affect our business by, among other things:

 

 

 

 

providing insurance and reinsurance capacity in markets and to consumers that we target, e.g., the creation or expansion of a state or federal catastrophe funds such as those in Florida;

 

 

 

 

requiring our participation in industry pools and guarantee associations;

 

 

 

 

expanding the scope of coverage under existing policies;

 

 

 

 

regulating the terms of insurance and reinsurance policies; or

 

 

 

 

disproportionately benefiting the companies of one country over those of another.

The insurance industry is also affected by political, judicial and legal developments that may create new and expanded theories of liability, which may result in unexpected claims frequency and severity and delays or cancellations of products and services by insureds, insurers and reinsurers which could adversely affect our business.

For further information regarding government regulation and/or intervention in response to the financial and credit crises, see risk factor entitled “There can be no assurance as to the effect that governmental actions will have on such markets generally or on us in particular,” above.

Consolidation in the insurance industry could adversely impact us.

Insurance industry participants may seek to consolidate through mergers and acquisitions. Continued consolidation within the insurance industry will further enhance the already competitive underwriting environment as we would likely experience more robust competition from larger, better capitalized competitors. These consolidated entities may use their enhanced market power and broader capital base to negotiate price reductions for our products and services, and reduce their use of reinsurance, and as such, we may experience rate declines and possibly write less business.

Risks Related to Regulation

The regulatory regimes under which we operate, and potential changes thereto, could have a material adverse effect on our business.

Our insurance and reinsurance subsidiaries operate in 28 countries around the world as well as in all 50 U.S. states. Our operations in each of these jurisdictions are subject to varying degrees of regulation and supervision. The laws and regulations of the jurisdictions in which our insurance and reinsurance subsidiaries are domiciled require, among other things, that these subsidiaries maintain minimum levels of statutory capital, surplus and liquidity, meet solvency standards, submit to periodic examinations of their

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financial condition and restrict payments of dividends and reductions of capital. Statutes, regulations and policies that our insurance and reinsurance subsidiaries are subject to may also restrict the ability of these subsidiaries to write insurance and reinsurance policies, make certain investments and distribute funds.

In recent years, the U.S. insurance regulatory framework has come under increased federal scrutiny. In addition, some state legislatures have considered or enacted laws that may alter or increase state regulation of insurance and reinsurance companies and holding companies. Moreover, the National Association of Insurance Commissioners, which is the organization of insurance regulators from the 50 U.S. states, the District of Columbia and the four U.S. territories, as well as state insurance regulators regularly reexamine existing laws and regulations.

We may not be able to comply fully with, or obtain desired exemptions from, revised statutes, regulations and policies that govern the conduct of our business. Failure to comply with, or to obtain desired authorizations and/or exemptions under, any applicable laws could result in restrictions on our ability to do business or undertake activities that are regulated in one or more of the jurisdictions in which we operate and could subject us to fines and other sanctions. In addition, changes in the laws or regulations to which our insurance and reinsurance subsidiaries are subject, or in the interpretations thereof by enforcement or regulatory agencies, could have a material adverse effect on our business.

If our Bermuda operating subsidiaries become subject to insurance statutes and regulations in jurisdictions other than Bermuda or if there is a change in Bermuda law or regulations or the application of Bermuda law or regulations, there could be a significant and negative impact on our business.

XL Insurance (Bermuda) Ltd and XL Re Ltd, two of our wholly-owned operating subsidiaries, are registered Bermuda Class 4 insurers. As such, they are subject to regulation and supervision in Bermuda. Bermuda insurance statutes and the regulations and policies of the Bermuda Monetary Authority require XL Insurance (Bermuda) Ltd and XL Re Ltd to, among other things:

 

 

 

 

maintain a minimum level of capital and surplus;

 

 

 

 

maintain solvency margins and liquidity ratios;

 

 

 

 

restrict dividends and distributions;

 

 

 

 

obtain prior approval regarding the ownership and transfer of shares;

 

 

 

 

maintain a principal office and appoint and maintain a principal representative in Bermuda;

 

 

 

 

file an annual statutory financial return;

 

 

 

 

file annual audited financial statements in accordance with applicable GAAP or International Financial Reporting Standards;

 

 

 

 

file annual Bermuda Solvency Capital Requirement (“BSCR”), a risk-based capital adequacy model, and capital and solvency return

 

 

 

 

allow for the performance of certain periodic examinations of XL Insurance (Bermuda) Ltd and XL Re Ltd and their respective financial conditions.

These statutes and regulations may restrict our ability to write insurance and reinsurance policies, distribute funds and pursue our investment strategy.

In 2008, the Bermuda Monetary Authority (“BMA”) introduced new risk-based capital standards for insurance companies as a tool to assist the BMA both in measuring risk and in determining appropriate levels of capitalization. The amended Bermuda insurance statutes or regulations pursuant to the new risk-based supervisory approach will require additional filings by insurers to be made to the BMA for the year ended December 31, 2008. The required statutory capital and surplus of our Bermuda-based operating subsidiaries increased under the BSCR. While our Bermuda-based operating subsidiaries currently have excess capital and surplus under these new requirements, there can be no assurance that such requirement or similar regulations, in their current form or as may be amended in the future, will not have a material adverse effect on our business, financial condition or results of operations.

The process of obtaining licenses is very time consuming and costly and XL Insurance (Bermuda) Ltd and XL Re Ltd may not be able to become licensed in jurisdictions other than Bermuda should we choose

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to do so. The modification of the conduct of our business that would result if we were required or chose to become licensed in certain jurisdictions could significantly and negatively affect our financial condition and results of operations. In addition, our inability to comply with insurance statutes and regulations could significantly and adversely affect our financial condition and results of operations by limiting our ability to conduct business as well as subjecting us to penalties and fines.

Because XL Insurance (Bermuda) Ltd and XL Re Ltd are Bermuda companies, they are subject to changes in Bermuda law and regulation that may have an adverse impact on our operations, including through the imposition of tax liability or increased regulatory supervision. In addition, XL Insurance (Bermuda) Ltd and XL Re Ltd will be exposed to any changes in the political environment in Bermuda, including, without limitation, changes as a result of the independence issues which have been discussed in Bermuda in recent years. While we cannot predict the future impact on our operations of changes in the laws and regulation to which we are or may become subject, any such changes could have a material adverse effect on our business, financial condition and results of operations.

Changes in current accounting practices and future pronouncements may materially impact our reported financial results.

Unanticipated developments in accounting practices may require us to incur considerable additional expenses to comply with such developments, particularly if we are required to prepare information relating to prior periods for comparative purposes or to apply the new requirements retroactively. The impact of changes in current accounting practices and future pronouncements cannot be predicted but may affect the calculation of net income, net equity and other relevant financial statement line items and the timing of when impairments and other charges are tested or taken. In particular, recent guidance and ongoing projects put in place by standard setters globally have indicated a possible move away from the current insurance accounting models toward more “fair value” based models which could introduce significant volatility in the earnings of insurance industry participants.

Risks Related to Taxation

We and our Bermuda insurance subsidiaries may become subject to U.S. tax, which may have a material adverse effect on our results of operations and your investment.

We take the position that neither we nor any of our Bermuda insurance subsidiaries are engaged in a U.S. trade or business through a U.S. permanent establishment. Accordingly, we take the position that none of our Bermuda insurance subsidiaries should be subject to U.S. tax (other than U.S. excise tax on insurance and reinsurance premium income attributable to insuring or reinsuring U.S. risks and U.S. withholding tax on some types of U.S. source investment income). However, because there is considerable uncertainty as to the activities that constitute being engaged in a trade or business within the United States, we cannot be certain that the U.S. Internal Revenue Service (the “IRS”) will not contend successfully that we or any of our Bermuda insurance subsidiaries are engaged in a trade or business in the United States. If we or any of our Bermuda insurance subsidiaries were considered to be engaged in a trade or business in the United States, any such entity could be subject to U.S. corporate income and additional branch profits taxes on the portion of its earnings effectively connected to such U.S. business, in which case our financial condition and results of operations could be materially adversely affected.

Changes in U.S. tax law might adversely affect an investment in our shares.

The tax treatment of non-U.S. companies and their U.S. and non-U.S. insurance subsidiaries has been the subject of Congressional discussion and legislative proposals. For example, one legislative proposal would impose additional limits on the deductibility of interest by foreign-owned U.S. corporations. Another legislative proposal would treat a non-U.S. corporation as a U.S. corporation for U.S. federal income tax purposes if it were considered to be primarily managed and controlled in the U.S. In addition, in 2008, legislation was proposed in the U.S. that would severely restrict the ability of a company to utilize affiliate reinsurance to manage its U.S. risks and capital position. In general, the legislation (the “Neal Bill” proposed in the House of Representatives and a Senate Finance Draft release) would permanently disallow the deduction for premiums ceded to affiliates, to the extent the reinsurance exceeded industry aggregate levels of unrelated party reinsurance, calculated on a statutory line of business basis. If enacted, any such

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law could have an adverse impact on us or our shareholders. It is possible that other legislative proposals could emerge in the future that could also have an adverse impact on us or our shareholders. We cannot assure you that future legislative action will not increase the amount of U.S. tax payable by us. If this happens, our financial condition and results of operations could be materially adversely affected.

Additionally, the U.S. federal income tax laws and interpretations, including those regarding whether a company is engaged in a trade or business (or has a permanent establishment) within the United States or is a PFIC, or whether U.S. holders would be required to include in their gross income “subpart F income” or the RPII of a CFC, are subject to change, possibly on a retroactive basis. There are currently no regulations regarding the application of the PFIC rules to insurance companies and the regulations regarding RPII are still in proposed form. New regulations or pronouncements interpreting or clarifying such rules may be forthcoming. We cannot be certain if, when or in what form such regulations or pronouncements may be provided and whether such guidance will have a retroactive effect.

There is U.S. income tax risk associated with reinsurance between U.S. insurance companies and their Bermuda affiliates.

Congress has periodically considered legislation intended to eliminate certain perceived tax advantages of Bermuda insurance companies and U.S. insurance companies with Bermuda affiliates, including perceived tax benefits resulting principally from reinsurance between or among U.S. insurance companies and their Bermuda affiliates. In this regard, section 845 of the Code was amended in 2004 to permit the IRS to reallocate, recharacterize or adjust items of income, deduction or certain other items related to a reinsurance agreement between related parties to reflect the proper “amount, source or character” for each item (in contrast to prior law, which only covered “source and character”). If the IRS were to successfully challenge our reinsurance arrangements under section 845, our financial condition and results of operations could be materially adversely affected and the price of our ordinary shares could be adversely affected.

The Organisation for Economic Co-operation and Development is considering measures that might change the manner in which we are taxed.

On July 17, 2008, the Organisation for Economic Co-operation and Development (the “OECD”) issued the final version of its “Report on the Attribution of Profits to Permanent Establishments” (the “Report”). The Report is the final report on the OECD’s project to establish a broad consensus regarding the interpretation and practical application of Article 7 of the OECD Model Tax Convention on Income and on Capital (“Article 7”). Article 7 sets forth international tax principles for attributing profits to a permanent establishment and forms the basis of an extensive network of bilateral income tax treaties between OECD member countries and between many OECD member and non-member countries. Part IV of the Report addresses the attribution of profits to a permanent establishment of an enterprise that conducts insurance activities.

The OECD has undertaken to implement the conclusions of the Report in two phases. First, to provide improved certainty for the interpretation of existing treaties based on the current text of Article 7, the OECD has revised the commentary to the current version of Article 7 to take into account the conclusions of the Report that do not conflict with the existing interpretation of Article 7 reflected in the previous commentary. Second, to reflect the full conclusions of the Report, the OECD intends to issue a new version of Article 7 and related commentary to be used in the negotiation of new treaties and amendments to existing treaties. A discussion draft of the new Article 7 and related commentary was released on July 7, 2008, and the final version of this new Article 7 is expected to be released in 2010. The final version of new Article 7 might include provisions that could change the manner in which we are taxed.

If an investor acquires 10% or more of our ordinary shares, it may be subject to taxation under the “controlled foreign corporation” (the “CFC”) rules.

Under certain circumstances, a U.S. person who owns 10% or more of the voting power of a foreign corporation that is a CFC (a foreign corporation in which 10% U.S. shareholders own more than 50% of the voting power of the foreign corporation or more than 25% of a foreign insurance company) for an uninterrupted period of 30 days or more during a taxable year must include in gross income for U.S. federal income tax purposes such “10% U.S. Shareholder’s” pro rata share of the CFC’s “subpart F income,” even if the subpart F income is not distributed to such 10% U.S. Shareholder, if such 10% U.S.

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Shareholder owns (directly or indirectly through foreign entities) any shares of the foreign corporation on the last day of the corporation’s taxable year. “Subpart F income” of a foreign insurance corporation typically includes foreign personal holding company income (such as interest, dividends and other types of passive income), as well as insurance and reinsurance income (including underwriting and investment income) attributable to the insurance of risks situated outside the CFC’s country of incorporation. Ownership of our equity security units by a U.S. person may cause such person to be treated for U.S. federal income tax purposes as the owner of our ordinary shares prior to the purchase contract settlement date. For purposes of interpreting the voting restrictions in our Articles of Association, we intend to treat the ordinary shares issuable upon settlement of a purchase contract underlying a unit as currently owned by the holder of that unit.

We believe that because of the dispersion of our share ownership, provisions in our organizational documents that limit voting power and other factors, no U.S. person or U.S. partnership that acquires our shares directly or indirectly through one or more foreign entities should be required to include its “subpart F income” in income under the CFC rules of the Internal Revenue Code of 1986, as amended (the “Code”). It is possible, however, that the IRS could challenge the effectiveness of these provisions and that a court could sustain such a challenge, in which case an investor’s investment could be materially adversely affected, if the investor is considered to own 10% or more of our shares.

U.S. Persons who hold shares will be subject to adverse tax consequences if we are considered to be a Passive Foreign Investment Company (a “PFIC”) for U.S. federal income tax purposes.

If we are considered a PFIC for U.S. federal income tax purposes, a U.S. person who owns any of our shares will be subject to adverse tax consequences, including a greater tax liability than might otherwise apply and tax on amounts in advance of when tax would otherwise be imposed, in which case an investor’s investment could be materially adversely affected. In addition, if we were considered a PFIC, upon the death of any U.S. individual owning shares, such individual’s heirs or estate would not be entitled to a “step-up” in the basis of the shares which might otherwise be available under U.S. federal income tax laws. We believe that we are not, have not been, and currently do not expect to become, a PFIC for U.S. federal income tax purposes. We cannot provide absolute assurance, however, that we will not be deemed a PFIC by the IRS. If we were considered a PFIC, it could have material adverse tax consequences for an investor that is subject to U.S. federal income taxation. There are currently no regulations regarding the application of the PFIC provisions to an insurance company. New regulations or pronouncements interpreting or clarifying these rules may be forthcoming. We cannot predict what impact, if any, such guidance would have on an investor that is subject to U.S. federal income taxation.

There are U.S. income tax risks associated with the related person insurance income of our non-U.S. insurance subsidiaries.

If (i) the related person insurance income, which we refer to as “RPII,” of any one of our non-U.S. insurance subsidiaries were to equal or exceed 20% of that subsidiary’s gross insurance income in any taxable year and (ii) U.S. persons were treated as owning 25% or more of the subsidiary’s stock (by vote or value), a U.S. person who owns any ordinary shares, directly or indirectly, on the last day of such taxable year on which the 25% threshold is met would be required to include in its income for U.S. federal income tax purposes that person’s ratable share of that subsidiary’s RPII for the taxable year, determined as if that RPII were distributed proportionately only to U.S. holders at that date, regardless of whether that income is distributed. The amount of RPII earned by a subsidiary (generally premium and related investment income from the direct or indirect insurance or reinsurance of any direct or indirect U.S. holder of shares of that subsidiary or any person related to that holder) would depend on a number of factors, including the identity of persons directly or indirectly insured or reinsured by that subsidiary. Although we do not believe that the 20% threshold will be met in respect of any of our non-U.S. insurance subsidiaries, some of the factors that may affect the result in any period may be beyond our control. Consequently, we cannot provide absolute assurance that we will not exceed the RPII threshold in any taxable year.

The RPII rules provide that if a holder who is a U.S. person disposes of shares in a non-U.S. insurance corporation that had RPII (even if the 20% gross income threshold was not met) and met the 25% ownership threshold at any time during the five-year period ending on the date of disposition, and the holder owned any stock at such time, any gain from the disposition will generally be treated as a dividend

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to the extent of the holder’s share (taking into account certain rules for determining a U.S. holder’s share of RPII) of the corporation’s undistributed earnings and profits that were accumulated during the period that the holder owned the shares (possibly whether or not those earnings and profits are attributable to RPII). In addition, such a shareholder will be required to comply with specified reporting requirements, regardless of the amount of shares owned. We believe that these rules should not apply to dispositions of our ordinary shares because XL Capital is not itself directly engaged in the insurance business. We cannot provide absolute assurance, however, that the IRS will not successfully assert that these rules apply to dispositions of our ordinary shares.

We and our Bermuda insurance subsidiaries may become subject to taxes in Bermuda after March 28, 2016, which may have a material adverse effect on our financial condition, results of operations and your investment.

We and our Bermuda insurance subsidiaries have received from the Ministry of Finance in Bermuda exemptions from any Bermuda taxes that might be imposed on profits, income or any capital asset, gain or appreciation until March 28, 2016. The exemptions are subject to the proviso that they are not construed so as to prevent the application of any tax or duty to such persons as are ordinarily resident in Bermuda (we and our Bermuda insurance subsidiaries are not so currently designated) and to prevent the application of any tax payable in accordance with the provisions of The Land Tax Act 1967 or otherwise payable in relation to the land leased to us and our Bermuda insurance subsidiaries. We, as a permit company under The Companies Act 1981 of Bermuda, have received similar exemptions, which are effective until March 28, 2016. Our Bermuda insurance subsidiaries are required to pay certain annual Bermuda government fees and certain business fees as an insurer under The Insurance Act 1978 of Bermuda. Currently there is no Bermuda withholding tax on dividends paid by our Bermuda insurance subsidiaries to us. Given the limited duration of the Ministry of Finance’s assurance, we cannot be certain that we or our Bermuda insurance subsidiaries will not be subject to any Bermuda tax after March 28, 2016. Such taxation could have a material adverse effect on our financial condition, results of operations and the price of our ordinary shares.

We may become subject to taxes in the Cayman Islands after June 2, 2018, which may have a material adverse effect on our results of operations and your investment.

Under current Cayman Islands law, we are not obligated to pay any taxes in the Cayman Islands on our income or gains. We have received an undertaking from the Governor-in-Council of the Cayman Islands pursuant to the provisions of the Tax Concessions Law, as amended, that until June 2, 2018, (i) no subsequently enacted law imposing any tax on profits, income, gains or appreciation shall apply to us and (ii) no such tax and no tax in the nature of an estate duty or an inheritance tax shall be payable on any of our ordinary shares, debentures or other obligations. Under current law, no tax will be payable on the transfer or other disposition of our ordinary shares. The Cayman Islands currently impose stamp duties on certain categories of documents; however, our current operations do not involve the payment of stamp duties in any material amount. The Cayman Islands also currently impose an annual corporate fee upon all exempted companies incorporated in the Cayman Islands. Given the limited duration of the undertaking from the Governor-in-Council of the Cayman Islands, we cannot be certain that we will not be subject to any Cayman Islands tax after June 2, 2018. Such taxation could have a material adverse effect on our financial condition, results of operations and your investment.

Risks Related to our Ordinary Shares

Provisions in our Articles of Association may reduce the voting rights of our ordinary shares.

Our Articles of Association generally provide that shareholders have one vote for each ordinary share held by them and are entitled to vote, on a non-cumulative basis, at all meetings of shareholders. However, the voting rights exercisable by a shareholder may be limited so that certain persons or groups are not deemed to hold 10% or more of the voting power conferred by our ordinary shares. Under these limitations, some shareholders may have less than one vote for each ordinary share held by them. Moreover, these limitations could have the effect of reducing the voting power of some shareholders who would not otherwise be subject to such limitations by virtue of their direct share ownership.

47


Provisions in our Articles of Association may restrict the ownership and transfer of our ordinary shares.

Our Articles of Association provide that our Board of Directors shall decline to register a transfer of shares if it appears to our Board of Directors, whether before or after such transfer, that the effect of such transfer would be to increase the number of shares owned or controlled by any person to 10% or more of any class of voting shares, the total issued shares of XL Capital Ltd or the voting power of XL Capital Ltd. In addition, our Articles of Association also provide that if, and for so long as, the votes conferred on any person by the ownership or control of our shares (including any preference ordinary shares) constitute 10% or more of the votes conferred by our issued shares, each such share held by such person shall confer only a fraction of the vote that would otherwise be conferred, as determined by the formula described in our Articles of Association, and such voting rights will continue to be readjusted until no shareholder’s voting rights exceed this limitation as a result of such reduction. Notwithstanding the foregoing, our Board of Directors may make such final adjustments to the aggregate number of votes conferred on any person by the ownership or control of shares that they consider fair and reasonable, in the light of all applicable circumstances, to ensure that such votes represent less than 10% of the aggregate voting power of the votes conferred by all our issued shares. For these purposes, references to ownership or control of our shares mean ownership within the meaning of Section 958 of the Code and Section 13(d)(3) of the Securities Exchange Act of 1934, as amended.

Certain provisions in our charter documents could, among other things, impede an attempt to replace our directors or to effect a change of control, which could diminish the value of our ordinary shares.

Our Articles of Association contain provisions that may make it more difficult for shareholders to replace directors and could delay or prevent a change of control that a shareholder may consider favorable. These provisions include a staggered board of directors, limitations on the ability of shareholders to remove directors, limitations on voting rights and certain transfer restrictions on our ordinary shares. See “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities,” under Part II, Item 5 of this report. In addition, insurance regulations in certain jurisdictions may also delay or prevent a change of control or limit the ability of a shareholder to acquire in excess of specified amounts of our ordinary shares.

It may be difficult to enforce judgments against XL Capital Ltd or its directors and executive officers.

XL Capital Ltd is incorporated pursuant to the laws of the Cayman Islands and our principal executive offices are in Bermuda. In addition, certain of our directors and officers reside outside the United States and a substantial portion of our assets and the assets of such directors and officers are located outside the United States. As such, it may be difficult or impossible to effect service of process within the United States upon those persons or to recover on judgments of U.S. courts against us or our directors and officers, including judgments predicated upon civil liability provisions of U.S. federal securities laws. We have been advised by our Cayman counsel that there is doubt as to whether the courts of the Cayman Islands would enforce:

 

 

 

 

judgments of U.S. courts based upon the civil liability provisions of U.S. federal securities laws obtained in actions against XL Capital Ltd or its directors and officers who reside outside the United States; or

 

 

 

 

original actions brought in the Cayman Islands against these persons or XL Capital Ltd predicated solely upon U.S. federal securities laws.

We have also been advised that there is no treaty in effect between the United States and the Cayman Islands providing for such enforcement and there are grounds upon which Cayman Islands courts may not enforce judgments of United States courts. Some remedies available under the laws of U.S. jurisdictions, including some remedies available under U.S. federal securities laws, may not be allowed in Cayman Islands courts as contrary to public policy.

U.S. persons who own our ordinary shares may have more difficulty protecting their interests than U.S. persons who are shareholders of a U.S. corporation.

The law applicable to companies established in the Cayman Islands, under which we are governed, differs in certain material respects from laws generally applicable to U.S. corporations and their shareholders. These differences include the manner in which directors must disclose transactions in which

48


they have an interest and their ability to vote notwithstanding a conflict of interest, the rights of shareholders to bring class action and derivative lawsuits and the scope of indemnification available to directors and officers.

Future sales of shares of our ordinary shares, including ordinary shares held by Syncora in connection with the Master Agreement, may depress the price of our ordinary shares.

Any sales of a substantial number of ordinary shares including ordinary shares held by Syncora in connection with the Master Agreement, or the perception that those sales might occur, may cause the market price of our ordinary shares to decline.

 

 

 

 

 

 

ITEM 1B.

 

UNRESOLVED STAFF COMMENTS

 

 

 

None.

 

 

 

 

 

 

ITEM 2.

 

PROPERTIES

 

 

 

The Company operates in Bermuda, the United States, Europe and various other locations around the world. In 1997, the Company acquired commercial real estate in Hamilton, Bermuda for the purpose of securing long-term office space for its worldwide headquarters. The development was completed in April 2001. The total cost of this development, including land, was approximately $126.6 million.

In July 2003, the Company acquired new offices at 70 Gracechurch Street, London, which have become the Company’s new London headquarters. The acquisition was made through a purchase, sale and leaseback transaction. The move to the new offices was completed in 2004 and consolidated the Company’s London businesses in one location. The capital lease asset and liability associated with this transaction totaled $129.3 million at December 31, 2008.

The majority of all other office facilities throughout the world that are occupied by the Company and its subsidiaries are leased.

Total rent expense for the years ended December 31, 2008, 2007 and 2006 was $35.4 million, $34.5 million and $35.8 million, respectively. See Item 8, Note 20(d) to the Consolidated Financial Statements, “Commitments and Contingencies – Properties,” for discussion of the Company’s lease commitments for real property.

 

 

 

 

 

 

ITEM 3.

 

LEGAL PROCEEDINGS

 

 

 

On September 21, 2004, a consolidated and amended class action complaint (the “Amended Complaint”) was served on the Company and certain of its present and former directors and officers as defendants in a putative class action (Malin et al. v. XL Capital Ltd et al.) filed in United States District Court, District of Connecticut (the “Malin Action”). The Malin Action purports to be on behalf of purchasers of the Company’s common stock between November 1, 2001 and October 16, 2003, and alleges claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder (the “Securities Laws”). The Amended Complaint alleged that the defendants violated the Securities Laws by, among other things, failing to disclose in various public statements, reports to shareholders and other communications the alleged inadequacy of the Company’s loss reserves for its NAC Re subsidiary (now known as XL Reinsurance America, Inc.) and that, as a consequence, the Company’s earnings and assets were materially overstated. On August 26, 2005, the Court dismissed the Amended Complaint owing to its failure adequately to allege that the lead plaintiffs had sustained a loss, but provided leave for the plaintiffs to file a further amended complaint. The plaintiffs thereafter filed another amended complaint (the “Second Amended Complaint”), which is similar to the Amended Complaint in its substantive allegations. By order dated July 21, 2007, the Judge granted defendants’ motion to dismiss the Second Amended Complaint and plaintiffs appealed the dismissal order. By order dated February 26, 2009, the U.S. Court of Appeals for the Second Circuit affirmed the decision of the District Court.

In November 2006, a subsidiary of the Company received a grand jury subpoena from the Antitrust Division of the U.S. Department of Justice (“DOJ”) and a subpoena from the SEC, both of which sought documents in connection with an investigation into the municipal guaranteed investment contract (“GIC”) market and related products. In June 2008, subsidiaries of the Company also received a subpoena from the Connecticut Attorney General and an Antitrust Civil Investigative Demand from the Office of the Florida

49


Attorney General in connection with a coordinated multi-state Attorneys General investigation into the matters referenced in the DOJ and SEC subpoenas. The Company is fully cooperating with these investigations.

Commencing in March 2008, the Company and two of its subsidiaries were named, along with approximately 20 other providers and insurers of municipal Guaranteed Investment Contracts and similar derivative products in the U.S. (“collectively Municipal Derivatives”) as well as fourteen brokers of such products, in several purported federal antitrust class actions. The Judicial Panel on Multidistrict Litigation ordered that these be consolidated for pretrial purposes and assigned them to the Southern District of New York. The consolidated amended complaint filed in August 2008 alleges that there was a conspiracy among the defendants during the period from January 1, 1992 to the present to rig bids and otherwise unlawfully decrease the yield for Municipal Derivative products. The purported class of plaintiffs consists of purchasers of Municipal Derivatives. On October 21, 2008 most of the defendants filed motions to dismiss the consolidated amended complaint, which motions were fully briefed as of January 21, 2009. In addition, the same two subsidiaries of the Company have been named in a number of similar actions filed by various municipalities in California state courts. The Defendants have removed those cases to federal court. The Plaintiffs have filed motions to remand, most of which have been denied but some of which remain pending. Certain of the cases originally filed in California state courts have been transferred to the Southern District of New York by the Judicial Panel on Multidistrict Litigation. The Company intends to vigorously defend these actions.

From time to time, the Company has also received and responded to additional requests from Attorneys General, state insurance regulators and federal regulators for information relating to the Company’s contingent commission arrangements with brokers and agents and/or the Company’s insurance and reinsurance practices in connection with certain finite-risk and loss mitigation products. Similarly, the Company’s affiliates outside the U.S. have, from time to time, received and responded to requests from regulators relating to the Company’s insurance and reinsurance practices regarding contingent commissions or finite-risk and loss mitigation products. The Company has fully cooperated with the regulators in these matters.

In August 2005, plaintiffs in a proposed class action (the “Class Action”) that was consolidated into a multidistrict litigation in the United States District Court for the District of New Jersey, captioned In re Insurance Brokerage Antitrust Litigation, MDL No. 1663, Civil Action No. 04-5184 (the “MDL”), filed a consolidated amended complaint (the “Amended Complaint”), which named as new defendants approximately 30 entities, including Greenwich Insurance Company, Indian Harbor Insurance Company and XL Capital Ltd. In the MDL, the Class Action plaintiffs asserted various claims purportedly on behalf of a class of commercial insureds against approximately 113 insurance companies and insurance brokers through which the named plaintiffs allegedly purchased insurance. The Amended Complaint alleged that the defendant insurance companies and insurance brokers conspired to manipulate bidding practices for insurance policies in certain insurance lines and failed to disclose certain commission arrangements and asserted statutory claims under the Sherman Act, various state antitrust laws and the Racketeer Influenced and Corrupt Organizations Act (“RICO”), as well as common law claims alleging breach of fiduciary duty, aiding and abetting a breach of fiduciary duty and unjust enrichment. By Opinion and Order dated August 31, 2007, the Court dismissed the Sherman Act claims with prejudice and, by Opinion and Order dated September 28, 2007, the Court dismissed the RICO claims with prejudice. The plaintiffs then appealed both orders to the U.S. Court of Appeals for the Third Circuit. Oral argument before the appellate court is expected in April 2009.

Various XL entities have been named as defendants in three of the many tag-along actions that have been consolidated into the MDL for pretrial purposes. These tag-along actions make allegations similar to the Amended Complaint but do not purport to be class actions. On April 4, 2006, a tag-along Complaint was filed in the U.S. District Court for the Northern District of Georgia on behalf of New Cingular Wireless Headquarters LLC and several other corporations against approximately 100 defendants, including Greenwich Insurance Company, XL Specialty Insurance Company, XL Insurance America, Inc., XL Insurance Company Limited, Lloyd’s syndicates 861, 588 and 1209 and XL Capital Ltd. (the “New Cingular Lawsuit”). On or about May 21, 2007, a tag-along Complaint was filed in the U.S. District Court for the District of New Jersey on behalf of Henley Management Company, Big Bear Properties, Inc., Northbrook Properties, Inc., RCK Properties, Inc., Kitchens, Inc., Aberfeldy LP and Payroll and Insurance

50


Group, Inc. against multiple defendants, including “XL Winterthur International” (the “Henley Lawsuit”). On October 12, 2007, a Complaint in a third tag-along action, captioned Sears Roebuck & Co. v. Marsh & McLennan Companies, Inc., et al., No. 1:07-CV-2535 (the “Sears Lawsuit”), was filed in the U.S. District Court for the Northern District of Georgia by Sears, Roebuck & Co., Sears Holdings Corporation, Kmart Corporation and Lands’ End Inc. Among the many named defendants are X.L. America, Inc., XL Insurance America, Inc., XL Specialty Insurance Company and XL Insurance (Bermuda) Ltd. The three tag-along actions are currently stayed.

Three purported class actions on behalf of shareholders of Syncora have been filed in the Southern District of New York against the Company and one of its subsidiaries (collectively “XL”), Syncora, four Syncora officers, and various underwriters of Syncora securities. The Judge ordered that these be consolidated. The consolidated amended complaint, filed in August 2008, alleges violations of the Securities Act of 1933 arising out of the secondary public offering of Syncora common shares held by XL on June 6, 2007 and sales/exchanges by Syncora of certain preferred shares as well as under the Securities Exchange Act of 1934 arising out of trading in Syncora securities during the asserted class period of March 15, 2007 to March 17, 2008. The principal allegations are that Syncora failed to appropriately and timely disclose its exposures under certain derivative contracts and insurance of tranches of structured securities. XL is named as a party that “controlled” Syncora during the relevant time period. On October 14, 2008, XL and other defendants filed motions to dismiss the consolidated amended complaint. Plaintiffs filed opposition briefs on December 22, 2008, and XL and the other defendants filed reply briefs on February 5, 2009. The Company intends to vigorously defend these actions.

In connection with the secondary offering of the Company’s Syncora shares, the Company and Syncora each agreed to indemnify the several underwriters of that offering against certain liabilities, including liabilities under the Securities Act of 1933 for payment of legal fees and expenses, settlements and judgments incurred with respect to litigation such as this. The Company and Syncora have agreed to each bear 50% of this indemnity obligation.

The Company is subject to litigation and arbitration in the normal course of its business. These lawsuits and arbitrations principally involve claims on policies of insurance and contracts of reinsurance and are typical for the Company and for the property and casualty insurance and reinsurance industry in general. Such legal proceedings are considered in connection with the Company’s loss and loss expense reserves. Reserves in varying amounts may or may not be established in respect of particular claims proceedings based on many factors, including the legal merits thereof. In addition to litigation relating to insurance and reinsurance claims, the Company and its subsidiaries are subject to lawsuits and regulatory actions in the normal course of business that do not arise from or directly relate to claims on insurance or reinsurance policies. This category of business litigation typically involves, amongst other things, allegations of underwriting errors or misconduct, employment claims, regulatory activity, shareholder disputes or disputes arising from business ventures. The status of these legal actions is actively monitored by management. If management believed, based on available information, that an adverse outcome upon resolution of a given legal action was probable and the amount of that adverse outcome was reasonable to estimate, a loss would be recognized and a related liability recorded. The Company believes that the expected ultimate outcome of all outstanding litigation and arbitration will not have a material adverse effect on its consolidated financial condition, operating results and/or liquidity, although an adverse resolution of one or more of these items could have a material adverse effect on the Company’s results of operations in a particular fiscal quarter or year.

For further information in relation to legal proceedings, see Item 8, Note 20 (g) to the Consolidated Financial Statements, “Commitments and Contingencies – Claims and Other Litigation.”

 

 

 

 

 

 

ITEM 4.

 

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

 

 

No matters were submitted to a vote of ordinary shareholders during the fourth quarter of the fiscal year covered by this report.

Executive Officers of the Company

The table below sets forth the names, ages and titles of the persons who were the executive officers of the Company at December 31, 2008:

51


 

 

 

 

 

Name

 

Age

 

Position

Michael S. McGavick

 

 

 

51

   

Chief Executive Officer and Director

Brian W. Nocco

 

 

 

56

   

Executive Vice President and Chief Financial Officer

James H. Veghte

 

 

 

52

   

Executive Vice President and Chief Executive of Reinsurance Operations

David B. Duclos

 

 

 

51

   

Executive Vice President and Chief Executive of Insurance Operations

Sarah E. Street

 

 

 

46

   

Executive Vice President and Chief Investment Officer

Kirstin Romann Gould

 

 

 

42

   

Executive Vice President, General Counsel and Secretary

Susan L. Cross

 

 

 

48

   

Executive Vice President and Global Chief Actuary

Celia R. Brown

 

 

 

54

   

Executive Vice President, Head of Global Human Resources and Corporate Relations

Jacob D. Rosengarten

 

 

 

53

   

Executive Vice President and Chief Enterprise Risk Officer

Michael S. McGavick, was appointed as Director of the Company in April 2008 and shortly prior to his commencement as the Company’s Chief Executive Officer on May 1, 2008. Previously, Mr. McGavick was President, Chairman (2002-2005) & CEO of the Seattle-based Safeco Corporation from January 2001 to December 2005. Prior to joining Safeco, Mr. McGavick spent six years with the Chicago-based CNA Financial Corporation, where he held various senior executive positions before becoming President and Chief Operating Officer of the company’s largest commercial insurance operating unit. Mr. McGavick’s insurance industry experience also includes two years as Director of the American Insurance Association’s Superfund Improvement Project in Washington D.C. where he became the Association’s lead strategist in working to transform U.S. Superfund environmental laws.

Brian W. Nocco was appointed Executive Vice President, Chief Financial Officer in August 2007. Mr. Nocco was previously employed at Nationwide Insurance Group as Chief Risk Officer from 2006 to 2007, and Senior Vice President and Treasurer from 2001 to 2005. Prior to Nationwide, Mr. Nocco served as Executive Vice President, Corporate Development of Imperial Bank and Chief Financial Officer of two of its subsidiaries. From 1994 to 1998, Mr. Nocco served as Senior Vice President, Chief Compliance Officer with The Chubb Corporation.

James H. Veghte was appointed Executive Vice President, Chief Executive of Reinsurance Operations in January 2006. Mr. Veghte was Chief Executive Officer of XL Reinsurance America Inc. (XLRA) having previously served as Chief Operating Officer of the Company’s reinsurance operations and President, Chief Operating Officer & Chief Underwriting Officer of XL Re Ltd. Previously held roles with the Company include President of XL Re Latin America Ltd., Chief Operating Officer of Le Mans Re (now the French branch of XL Re Europe Ltd.), General Manager of XL Re Ltd’s London branch and Executive Vice President and Underwriter of XL Mid Ocean Reinsurance Ltd in Bermuda. Prior to joining XL, Mr. Veghte was Senior Vice President and Chief Underwriting Officer of Winterthur Reinsurance Corp of America.

David B. Duclos was appointed Executive Vice President, Chief Executive of Insurance Operations in April 2008. From 2006 to his appointment in April 2008, Mr. Duclos was the Chief Operating Officer of the Company’s Insurance Operations and was responsible for product line underwriting, regional management and sales, ceded reinsurance and risk management. From 2004 to 2006, Mr. Duclos served as Executive Vice President of global specialty lines within the Company’s Insurance Operations and in 2003, upon joining the Company, he served as Senior Vice President responsible for U.S. program operations. Prior to joining the Company, Mr. Duclos worked over three years at Kemper Insurance Company in various senior level positions. Mr. Duclos began his career with CIGNA Corporation where he spent 21 years in various regional and national management roles in the field and home office.

Sarah E. Street was appointed to the position of Executive Vice President and Chief Investment Officer in October 2006. Ms. Street is also the Chief Executive Officer of XL Capital Investment Partners. Prior to joining XL, Ms. Street held numerous leadership positions at JPMorganChase and its predecessor organizations, working in a number of corporate finance units as well as in the capital markets business of the bank.

Kirstin Romann Gould was appointed to the position of Executive Vice President, General Counsel in September 2007 and this position includes her prior responsibilities as General Counsel, Corporate Affairs and Corporate Secretary. Ms. Gould was previously Executive Vice President, General Counsel, Corporate

52


Affairs from July 2006 to September 2007 and has also served as Chief Corporate Legal Officer and Associate General Counsel. Prior to joining the Company, Ms. Gould was associated with the law firms of Clifford Chance and Dewey Ballantine in New York and London.

Susan L. Cross was appointed to the Company’s senior leadership team in August 2008, serving as Executive Vice President and Global Chief Actuary. Ms. Cross has served as Global Chief Actuary since 2006 and previously was Chief Actuary of the Company’s Reinsurance Operations from 2004 to 2006, Chief Actuary of XL Re Bermuda from 2002 to 2004 and also held various actuarial positions in the insurance and reinsurance operations of the Company from 1999 to 2002. Prior to joining the Company, Ms. Cross was Principal and Consulting Actuary at Tillinghast Towers Perrin.

Celia R. Brown was appointed to the Company’s senior leadership team in February 2008, serving as Executive Vice President, Head of Global Human Resources and Corporate Relations, where she is responsible for human relations, marketing, global communications, public relations and corporate social responsibility. Ms. Brown has served as Head of Global Human Resources and Corporate Relations since 2006 and previously was the lead for Global Human Resources Operations from 2004 to 2006. Ms. Brown has spent over twenty years with the Company and its subsidiaries, including its predecessor companies, in capacities including Associate General Counsel, Corporate Secretary and Head of Human Resources for NAC Re Corp and Chief Administrative Officer for X.L. America and for the Company’s Insurance Operations.

Jacob D. Rosengarten joined the Company’s senior leadership team and was appointed Executive Vice President, Chief Enterprise Risk Officer in September 2008. Prior to joining the Company, Mr. Rosengarten served as Managing Director of Risk Management and Analytics for Goldman Sachs Asset Management (“GSAM”) from 1998 to 2008. From 1993 to 1998, Mr. Rosengarten served as Director of Risk and Quantitative Analysis at Commodities Corporation (now GSAM’s Hedge Fund Strategy Unit).

53


PART II

 

 

 

 

 

 

ITEM 5.

 

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

 

 

The Company’s Class A ordinary shares, $0.01 par value per share, are listed on the NYSE under the symbol “XL.”

The following table sets forth the high, low and closing sales prices per share of the Company’s Class A ordinary shares per fiscal quarter, as reported on the New York Stock Exchange Composite Tape:

 

 

 

 

 

 

 

 

 

High

 

Low

 

Close

2008:

 

 

 

 

 

 

1st Quarter

 

 

$

 

52.26

   

 

$

 

27.73

   

 

$

 

29.55

 

2nd Quarter

 

 

 

38.30

   

 

 

20.33

   

 

 

20.56

 

3rd Quarter

 

 

 

23.60

   

 

 

13.50

   

 

 

17.94

 

4th Quarter

 

 

 

17.94

   

 

 

2.65

   

 

 

3.70

 

2007:

 

 

 

 

 

 

1st Quarter

 

 

$

 

74.40

   

 

$

 

66.93

   

 

$

 

69.96

 

2nd Quarter

 

 

 

84.91

   

 

 

69.44

   

 

 

84.29

 

3rd Quarter

 

 

 

85.67

   

 

 

70.47

   

 

 

79.20

 

4th Quarter

 

 

 

82.10

   

 

 

48.16

   

 

 

50.31

 

Each Class A ordinary share has one vote, except if, and so long as, the Controlled Shares (defined below) of any person constitute ten percent (10%) or more of the issued Class A ordinary shares, the voting rights with respect to the Controlled Shares owned by such person are limited, in the aggregate, to a voting power of approximately 10%, pursuant to a formula specified in the Company’s Articles of Association. “Controlled Shares” includes, among other things, all Class A ordinary shares which such person is deemed to beneficially own directly, indirectly or constructively (within the meaning of Section 13(d)(3) of the Securities Exchange Act of 1934, as amended, or Section 958 of the Internal Revenue Code of 1986, as amended).

The number of record holders of Class A ordinary shares as of December 31, 2008 was 373. This figure does not represent the actual number of beneficial owners of the Company’s Class A ordinary shares because such shares are frequently held in “street name” by securities dealers and others for the benefit of individual owners who may vote the shares.

In 2008, two quarterly dividends of $0.38 per share were paid to all ordinary shareholders of record as of March 14 and June 13 and two quarterly dividends of $0.19 per share were paid to all ordinary shareholders on record as of September 12 and December 9. In 2007, four quarterly dividends were paid at $0.38 per share to all ordinary shareholders of record as of March 15, June 11, September 10 and December 10.

In February 2009, the Board of Directors approved a reduction in the quarterly dividend payable on the Company’s Class A Ordinary Shares to $0.10 per ordinary share beginning with the quarterly dividend payable in March 2009. At December 31, 2008, the Company had a retained deficit of $315.5 million and as allowed under Cayman law, the Company will pay dividends in March 2009 from additional paid in capital.

The declaration and payment of future dividends by the Company will be at the discretion of the Board of Directors and will depend upon many factors, including the Company’s earnings, financial condition, business needs, capital and surplus requirements of the Company’s operating subsidiaries and regulatory and contractual restrictions.

As a holding company, the Company’s principal source of income is 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 that the Company operates in, including Bermuda, the U.S. and the U.K., and those of the Society of Lloyd’s, and certain contractual provisions. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Item 8, Note 26 to the Consolidated Financial Statements, “Statutory Financial Data,” for further discussion.

54


Information concerning securities authorized for issuance under equity compensation plans appears in Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

Recent Sales of Unregistered Securities

Unregistered issuances of the Company’s equity securities were previously disclosed in the Company’s Current Report on Form 8-K, filed on July 28, 2008.

Purchases of Equity Securities by the Issuer and Affiliate Purchases

The following table provides information about purchases by the Company during the quarter ended December 31, 2008 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act:

 

 

 

 

 

 

 

 

 

Period

 

Total Number
of Shares
Purchased

 

Average Price
Paid
per share

 

Total Number
of Shares
Purchased as
Part of
Publicly
Announced Plans
or Programs

 

Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Plans
or Programs (1)

October

 

 

 

4,615

   

 

$

 

12.03

   

 

 

   

 

$

 

375.5 million

 

November

 

 

 

835

   

 

 

9.70

   

 

 

   

 

$

 

375.5 million

 

December

 

 

 

18,217

   

 

 

4.10

   

 

 

   

 

$

 

375.5 million

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

23,667

   

 

$

 

5.85

   

 

 

 

   

 

$

 

375.5 million

 

 

 

 

 

 

 

 

 

 


 

 

(1)

 

 

 

All shares were purchased in connection with the vesting of restricted shares granted under the Company’s restricted stock plan. All of these purchases were made in connection with satisfying tax withholding obligations of those employees. These shares were not purchased as part of the Company’s share repurchase program noted below.

 

(2)

 

 

 

On September 24, 2007, the Board of Directors of the Company approved a share repurchase program, authorizing the Company to repurchase up to $500.0 million of its Class A ordinary shares. During the year ended December 31, 2008, no share repurchases were made under the share repurchase program. As at December 31, 2008, the Company could repurchase $375.5 million of its equity securities under the share repurchase program.

55


Class A Ordinary Share Performance Graph

Set forth below is a line graph comparing the yearly dollar change in the cumulative total shareholder return, with all dividends reinvested, over a five-year period on the Company’s Class A ordinary shares from December 31, 2003 through December 31, 2008 as compared to the cumulative total return of the Standard & Poor’s 500 Stock Index and the cumulative total return of the Standard & Poor’s Property & Casualty Insurance Index.

 

 

 

 

 

 

ITEM 6.

 

SELECTED FINANCIAL DATA

 

 

 

The selected consolidated financial data below is based upon the Company’s fiscal year end of December 31. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements and the Notes thereto presented under Item 8.

 

 

 

 

 

 

 

 

 

 

 

 

 

2008

 

2007

 

2006

 

2005

 

2004

 

 

(U.S. dollars in thousands, except per share amounts)

Income Statement Data:

 

 

 

 

 

 

 

 

 

 

Net premiums earned

 

 

$

 

6,640,102

   

 

$

 

7,205,356

   

 

$

 

7,569,518

   

 

$

 

9,365,495

   

 

$

 

8,582,014

 

Net investment income

 

 

 

1,768,977

   

 

 

2,248,807

   

 

 

1,978,184

   

 

 

1,475,039

   

 

 

1,035,012

 

Net realized (losses) gains on investments

 

 

 

(962,054

)

 

 

 

 

(603,268

)

 

 

 

 

(116,458

)

 

 

 

 

241,882

   

 

 

246,547

 

Net realized and unrealized (losses) gains on derivative instruments

 

 

 

(73,368

)

 

 

 

 

(55,451

)

 

 

 

 

101,183

   

 

 

28,858

   

 

 

73,493

 

Net (loss) income from investment fund affiliates (1)

 

 

 

(277,696

)

 

 

 

 

326,007

   

 

 

269,036

   

 

 

154,844

   

 

 

124,008

 

Fee income and other

 

 

 

52,158

   

 

 

14,271

   

 

 

31,732

   

 

 

19,297

   

 

 

35,317

 

Net losses and loss expenses incurred (2)

 

 

 

3,962,898

   

 

 

3,841,003

   

 

 

4,201,194

   

 

 

7,434,336

   

 

 

4,865,102

 

Claims and policy benefits – life operations

 

 

 

769,004

   

 

 

888,658

   

 

 

807,255

   

 

 

2,510,029

   

 

 

1,526,921

 

Acquisition costs, operating expenses and foreign exchange gains and losses

 

 

 

1,921,940

   

 

 

2,188,889

   

 

 

2,374,358

   

 

 

2,188,357

   

 

 

2,277,321

 

Interest expense

 

 

 

351,800

   

 

 

621,905

   

 

 

552,275

   

 

 

403,849

   

 

 

292,234

 

Extinguishment of debt

 

 

 

22,527

   

 

 

   

 

 

   

 

 

   

 

 

 

Impairment of goodwill

 

 

 

989,971

   

 

 

   

 

 

   

 

 

   

 

 

 

Amortization of intangible assets

 

 

 

2,968

   

 

 

1,680

   

 

 

2,355

   

 

 

10,752

   

 

 

15,827

 

(Loss) income before minority interests, net income from operating affiliates and income tax expense

 

 

 

(872,989

)

 

 

 

 

1,593,587

   

 

 

1,895,758

   

 

 

(1,261,908

)

 

 

 

 

1,118,986

 

(Loss) income from operating affiliates (1)(2)

 

 

 

(1,458,246

)

 

 

 

 

(1,059,848

)

 

 

 

 

111,670

   

 

 

67,426

   

 

 

143,357

 

Preference share dividends

 

 

 

78,645

   

 

 

69,514

   

 

 

40,322

   

 

 

40,322

   

 

 

40,321

 

56


 

 

 

 

 

 

 

 

 

 

 

 

 

2008

 

2007

 

2006

 

2005

 

2004

 

 

(U.S. dollars in thousands, except per share amounts)

Net (loss) income available to ordinary shareholders

 

 

$

 

(2,632,458

)

 

 

 

$

 

206,375

   

 

$

 

1,722,445

   

 

$

 

(1,292,298

)

 

 

 

$

 

1,126,292

 

Per Share Data:

 

 

 

 

 

 

 

 

 

 

Net (loss) income per ordinary share – basic (3)

 

 

$

 

(11.02

)

 

 

 

$

 

1.16

   

 

$

 

9.63

   

 

$

 

(9.14

)

 

 

 

$

 

8.17

 

Net (loss) income per ordinary share – diluted (3)

 

 

$

 

(11.02

)

 

 

 

$

 

1.15

   

 

$

 

9.60

   

 

$

 

(9.14

)

 

 

 

$

 

8.13

 

Weighted average ordinary shares outstanding – diluted (3)

 

 

 

238,862

   

 

 

179,693

   

 

 

179,450

   

 

 

141,406

   

 

 

138,582

 

Cash dividends per ordinary share

 

 

$

 

1.14

   

 

$

 

1.52

   

 

$

 

1.52

   

 

$

 

2.00

   

 

$

 

1.96

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

Total investments available for sale

 

 

$

 

27,464,510

   

 

$

 

36,265,803

   

 

$

 

39,350,983

   

 

$

 

35,724,439

   

 

$

 

27,823,828

 

Cash and cash equivalents

 

 

 

4,353,826

   

 

 

3,880,030

   

 

 

2,223,748

   

 

 

3,693,475

   

 

 

2,203,726

 

Investments in affiliates.

 

 

 

1,552,789

   

 

 

2,611,149

   

 

 

2,308,781

   

 

 

2,046,721

   

 

 

1,936,852

 

Unpaid losses and loss expenses recoverable

 

 

 

3,997,722

   

 

 

4,697,471

   

 

 

5,027,772

   

 

 

6,441,522

   

 

 

6,971,356

 

Premiums receivable

 

 

 

3,377,016

   

 

 

3,637,452

   

 

 

3,591,238

   

 

 

3,799,041

   

 

 

3,838,228

 

Total assets

 

 

 

45,682,005

   

 

 

57,762,264

   

 

 

59,308,870

   

 

 

58,454,901

   

 

 

49,245,469

 

Unpaid losses and loss expenses

 

 

 

21,650,315

   

 

 

23,207,694

   

 

 

22,895,021

   

 

 

23,597,815

   

 

 

19,615,773

 

Future policy benefit reserves

 

 

 

5,452,865

   

 

 

6,772,042

   

 

 

6,476,057

   

 

 

5,776,318

   

 

 

4,556,952

 

Unearned premiums

 

 

 

4,217,931

   

 

 

4,681,989

   

 

 

5,652,897

   

 

 

5,388,996

   

 

 

5,191,368

 

Notes payable and debt

 

 

 

3,189,734

   

 

 

2,868,731

   

 

 

3,368,376

   

 

 

3,412,698

   

 

 

2,721,431

 

Redeemable preference ordinary shares

 

 

 

500,000

   

 

 

   

 

 

   

 

 

   

 

 

 

Shareholders’ equity

 

 

 

6,115,233

   

 

 

9,948,142

   

 

 

10,131,166

   

 

 

8,471,811

   

 

 

7,738,695

 

Book value per ordinary share

 

 

$

 

15.46

   

 

$

 

50.30

   

 

$

 

53.12

   

 

$

 

44.31

   

 

$

 

51.98

 

Operating Ratios:

 

 

 

 

 

 

 

 

 

 

Loss and loss expense ratio (4)

 

 

 

66.1

%

 

 

 

 

59.8

%

 

 

 

 

62.2

%

 

 

 

 

107.4

%

 

 

 

 

68.8

%

 

Underwriting expense ratio (5)

 

 

 

29.6

%

 

 

 

 

29.0

%

 

 

 

 

27.3

%

 

 

 

 

25.6

%

 

 

 

 

27.3

%

 

Combined ratio (6)

 

 

 

95.7

%

 

 

 

 

88.8

%

 

 

 

 

89.5

%

 

 

 

 

133.0

%

 

 

 

 

96.1

%

 


 

 

(1)

 

 

 

The Company generally records the income related to alternative fund affiliates on a one month lag and the private investment fund affiliates on a three month lag in order for the Company to meet the accelerated filing deadlines. The Company generally records the income related to operating affiliates on a three month lag.

 

(2)

 

 

 

In 2008, net loss from operating affiliates includes losses totaling approximately $1.4 billion related to the closing of the Master Agreement as well as losses recorded throughout 2008 and up until the closing of the Master Agreement that were associated with previous reinsurance and guarantee agreements with Syncora. In 2007, $351.0 million of financial guarantee reserves related to reinsurance agreements with Syncora were recorded within net loss from operating affiliates.

 

(3)

 

 

 

Net income per ordinary share is based on the basic and diluted weighted average number of Class A ordinary shares and share equivalents outstanding for each period. Net loss per ordinary share is based on the basic weighted average number of ordinary shares outstanding.

 

(4)

 

 

 

The loss and loss expense ratio related to the property and casualty operations is calculated by dividing the losses and loss expenses incurred by the net premiums earned for the Insurance and Reinsurance segments.

 

(5)

 

 

 

The underwriting expense ratio related to the property and casualty operations is the sum of acquisition expenses and operating expenses for the Insurance and Reinsurance segments divided by net premiums earned for the Insurance and Reinsurance segments. See Item 8, Note 6 to the Consolidated Financial Statements, “Segment Information,” for further information.

 

(6)

 

 

 

The combined ratio related to the property and casualty operations is the sum of the loss and loss expense ratio and the underwriting expense ratio. A combined ratio under 100% represents an underwriting profit and over 100% represents an underwriting loss.

57


 

 

 

 

 

 

ITEM 7.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 

 

This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” 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 expectations. Actual results may differ materially from those projected in such forward-looking statements, and therefore undue reliance should not be placed on them. See “Cautionary Note Regarding Forward-Looking Statements,” for a list of additional 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 audited Consolidated Financial Statements and Notes thereto presented under Item 8.

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 results of operations and financial condition.

Index

 

 

 

Executive Overview

 

 

 

59

 

Financial Measures

 

 

 

63

 

Results of Operations

 

 

 

65

 

Other Key Focuses of Management

 

 

 

73

 

Critical Accounting Policies and Estimates

 

 

 

76

 

Segments

 

 

 

93

 

Income Statement Analysis

 

 

 

93

 

Insurance

 

 

 

93

 

Reinsurance

 

 

 

96

 

Life Operations

 

 

 

99

 

Other Financial Lines

 

 

 

101

 

Syncora

 

 

 

101

 

Investment Activities

 

 

 

102

 

Investment Performance

 

 

 

102

 

Net realized gains and losses on investments and other than temporary declines in the value of investments

 

 

 

103

 

Net realized and unrealized gains and losses on derivative instruments

 

 

 

104

 

Other Revenues and Expenses

 

 

 

105

 

Balances Sheet Analysis

 

 

 

107

 

Investments

 

 

 

107

 

Net unrealized gains and losses on investments

 

 

 

108

 

Unpaid Losses and Loss Expenses

 

 

 

112

 

Unpaid Losses and Loss Expenses Recoverable and Reinsurance Balances Receivable

 

 

 

113

 

Liquidity and Capital Resources

 

 

 

117

 

Cross-Default and Other Provisions in Debt Instruments

 

 

 

126

 

Long-Term Contractual Obligations

 

 

 

127

 

Variable Interest Entities and Other Off-Balance Sheet Arrangements

 

 

 

128

 

Recent Accounting Pronouncements

 

 

 

128

 

Cautionary Note Regarding Forward-Looking Statements

 

 

 

128

 

58


Executive Overview

Background

The Company operates on a global basis and is a leading provider of insurance and reinsurance coverages to industrial, commercial and professional service firms, insurance companies and other enterprises, typically the global equivalent of the Fortune 2000. The Company operates in markets where it believes its underwriting expertise and financial strength represent a relative advantage.

The Company has grown through acquisitions and development of new business opportunities. Acquisitions included Global Capital Re in 1997, Mid Ocean Limited in 1998, ECS, Inc. and NAC Re Corp. in 1999, Winterthur International in 2001 and Le Mans Re in 2002. All acquisitions were entered into in order to further support the Company’s strategic plan to develop a global platform in insurance and reinsurance. The Company competes as an integrated global business and at December 31, 2008 employed approximately 4,000 employees in 28 countries. Subsequent to December 31, 2008, the Company announced a restructuring initiative which will result in the Company’s workforce decreasing by approximately 10% during 2009.

Underwriting Environment

The Company earns its revenue primarily from net premiums written and earned. The property and casualty insurance as reinsurance markets have historically been cyclical, meaning that based on market conditions, there have been periods where premium rates are high and policy terms and conditions are more favorable to the Company (a “hard market”) and there have been periods where premium rates decline and policy terms and conditions are less favorable to the Company (a “soft market”). Market conditions are driven primarily by competition in the marketplace, the supply of capital in the industry, investment yields and the frequency and severity of loss events. Management’s goal is to build long-term shareholder value by capitalizing on current opportunities and managing through any cyclical downturns by reducing its property and casualty book of business and exposures if and when rates deteriorate to unprofitable levels.

Insurance

Throughout 2008, the Company’s Insurance segment continued to experience soft property and casualty market conditions as premium rates across most lines of business as compared to the prior year, decreased by approximately 6% in the aggregate and competitive pressures continued. Throughout 2008, property renewals reflected decreases in premium rates of approximately 12% on average, while certain casualty lines experienced premium rate reductions averaging approximately 9%. In addition, premium rates within certain specialty lines of business decreased by up to 5%. Offsetting these premium rate decreases was strong pricing in the U.S. professional Directors and Officers (“Directors and Officers”) book of business, specifically with regards to financial institutions, and more recently on the offshore energy book as a result of market losses from Hurricanes Gustav and Ike.

In addition, during 2008, new business writings were impacted by market conditions as competitors continued to focus on retaining business in all lines and markets. However, during this period, the Company wrote approximately $900 million in new business (excluding program business and long-term agreements). This was largely a result of successes in the Company’s organic growth strategies which include E&S, private D&O as well as construction and upper middle market. Renewal ratios for core property, casualty and professional lines were approximately 83%. However, following the rating agency actions taken in December 2008 (see “Ratings”, above), the Company experienced a slight decline in renewal activity and new business opportunities in certain lines of business. For further information on recent rate and renewal activity, see “2009 Underwriting Outlook” below for further information.

59


The following table provides an analysis of gross premiums written, net premiums written and net premiums earned for the Insurance segment for the last three years ended December 31:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(U.S. dollars in thousands)

 

2008

 

2007 (3)

 

2006 (3)

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

Casualty – professional lines

 

 

 

1,472,874

   

 

 

1,351,237

   

 

 

1,369,668

   

 

$

 

1,516,412

   

 

$

 

1,376,819

   

 

$

 

1,404,567

   

 

$

 

1,558,746

   

 

$

 

1,490,896

   

 

$

 

1,483,518

 

Casualty – other lines

 

 

 

1,273,016

   

 

 

793,512

   

 

 

822,252

   

 

 

1,342,817

   

 

 

848,919

   

 

 

819,687

   

 

 

1,304,245

   

 

 

799,957

   

 

 

847,834

 

Property catastrophe

 

 

 

(65

)

 

 

 

 

(2,177

)

 

 

 

 

270

   

 

 

15,312

   

 

 

(7,460

)

 

 

 

 

52,541

   

 

 

149,436

   

 

 

68,847

   

 

 

56,714

 

Other property

 

 

 

886,483

   

 

 

505,564

   

 

 

471,013

   

 

 

871,009

   

 

 

599,668

   

 

 

535,322

   

 

 

830,367

   

 

 

490,858

   

 

 

500,956

 

Marine, energy, aviation, and satellite

 

 

 

747,311

   

 

 

604,786

   

 

 

621,774

   

 

 

809,073

   

 

 

623,085

   

 

 

638,162

   

 

 

942,974

   

 

 

695,391

   

 

 

676,009

 

Other specialty lines (1)

 

 

 

850,404

   

 

 

712,307

   

 

 

660,322

   

 

 

786,074

   

 

 

666,208

   

 

 

582,565

   

 

 

785,340

   

 

 

594,247

   

 

 

500,159

 

Other (2)

 

 

 

22,736

   

 

 

(22,908

)

 

 

 

 

(11,055

)

 

 

 

 

36,698

   

 

 

27,439

   

 

 

33,416

   

 

 

10,167

   

 

 

5,776

   

 

 

60,784

 

Structured indemnity

 

 

 

56,155

   

 

 

42,505

   

 

 

62,801

   

 

 

56,871

   

 

 

52,177

   

 

 

50,328

   

 

 

46,018

   

 

 

39,400

   

 

 

33,349

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

5,308,914

   

 

 

3,984,826

   

 

 

3,997,045

   

 

$

 

5,434,266

   

 

$

 

4,186,855

   

 

$

 

4,116,588

   

 

$

 

5,627,293

   

 

$

 

4,185,372

   

 

$

 

4,159,323

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

 

(1)

 

 

 

Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, specie, middle markets and excess and surplus lines.

 

(2)

 

 

 

Other includes credit and surety and other lines.

 

(3)

 

 

 

Certain reclassifications have been made to conform to current year presentation.

Reinsurance

In the Reinsurance segment, the year ended December 31, 2008 reflected a decline in premium rates across most major lines of business, as market conditions continued to soften and the reinsurance industry continued to experience pricing erosion, increased competitive pressures and increased retentions by cedants. Renewals and new business in 2008 continued to be assessed against internal hurdle rates with a continued focus on underwriting discipline. U.S. and non-U.S. catastrophe exposed property lines experienced rate declines of approximately 10% while other property lines of business saw rates decrease by 10% to 15%. Ocean marine pricing rates remained flat to down 5%, while rates within the aviation market decreased by up to 10%. Casualty pricing trends in the reinsurance market experienced deterioration in rates of up to 15%, however, rate changes on business actually bound in this line of business decreased between 10 to 15%. However, with increased hurricane and other loss activity during the latter half of 2008, taken together with the distressed state of the financial markets, rate declines across all lines of business began to slow in the latter half of 2008.

The following table provides an analysis of gross premiums written, net premiums written and net premiums earned for the Reinsurance segment for the last three years ended December 31:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(U.S. dollars in thousands)

 

2008

 

2007

 

2006

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

 

Gross
Premiums
Written

 

Net
Premiums
Written

 

Net
Premiums
Earned

Casualty – professional lines

 

 

$

 

213,519

   

 

$

 

213,498

   

 

$

 

247,979

   

 

$

 

256,280

   

 

$

 

256,327

   

 

$

 

273,494

   

 

$

 

297,962

   

 

$

 

296,221

   

 

$

 

346,870

 

Casualty – other lines

 

 

 

356,723

   

 

 

347,849

   

 

 

425,541

   

 

 

543,251

   

 

 

527,860

   

 

 

602,452

   

 

 

660,455

   

 

 

613,056

   

 

 

723,854

 

Property catastrophe.

 

 

 

401,740

   

 

 

290,443

   

 

 

305,690

   

 

 

475,540

   

 

 

286,866

   

 

 

264,666

   

 

 

449,347

   

 

 

234,724

   

 

 

234,965

 

Other property

 

 

 

947,899

   

 

 

602,423

   

 

 

678,504

   

 

 

970,196

   

 

 

677,764

   

 

 

753,278

   

 

 

1,044,316

   

 

 

730,445

   

 

 

749,714

 

Marine, energy, aviation, and satellite

 

 

 

119,593

   

 

 

104,346

   

 

 

126,761

   

 

 

150,548

   

 

 

128,942

   

 

 

141,619

   

 

 

176,928

   

 

 

139,748

   

 

 

154,313

 

Other (1)

 

 

 

220,332

   

 

 

194,237

   

 

 

205,433

   

 

 

239,418

   

 

 

204,845

   

 

 

240,049

   

 

 

365,844

   

 

 

298,860

   

 

 

294,532

 

Structured indemnity

 

 

 

671

   

 

 

671

   

 

 

3,298

   

 

 

28,261

   

 

 

28,261

   

 

 

26,481

   

 

 

71,286

   

 

 

71,286

   

 

 

66,711

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

$

 

2,260,477

   

 

$

 

1,753,467

   

 

$

 

1,993,206

   

 

$

 

2,663,494

   

 

$

 

2,110,865

   

 

$

 

2,302,039

   

 

$

 

3,066,138

   

 

$

 

2,384,340

   

 

$

 

2,570,959

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

 

(1)

 

 

 

Other includes credit and surety, whole account contracts and other lines.

60


The following sets forth potential trends relevant to the Company’s property and casualty operations in 2009:

2009 Underwriting Outlook

Given the changing economic environment that has been experienced throughout 2008 and early 2009 due to the global economic and financial crises and following the significant impacts to the Company during 2008, including the downgrade of the financial strength ratings of the Company’s core insurance and reinsurance subsidiaries by leading rating agencies, the Company plans to focus on those lines of business within its insurance and reinsurance operations that provide the best return on capital over the pricing cycle. As such, the Company will be highly selective on new business, emphasize short-tail lines, where applicable, in the Company’s reinsurance operations, exit other businesses (e.g., Casualty facultative business), non-renew certain insurance programs, as well as continue to reduce long-term agreements (within the insurance operations) in order to capture the benefit of improving pricing. While certain of these decisions as well as any lost business as a result of rating agency downgrades will result in a reduction to both gross and net premiums written in 2009, the Company expects such negative impacts to be partially offset by the positive impact of hardening rates across most lines of business as described below.

Throughout 2007 and the majority of 2008, the property and casualty insurance and reinsurance markets experienced soft market conditions across most, if not all lines of business, as evidenced by decreases in market pricing and a weakening of policy terms and conditions. However, following catastrophe activity throughout 2008, most notably, losses resulting from Hurricanes Ike and Gustav, and more importantly, following severe economic conditions and the impacts of the financial crisis, which reduced the available capital of many property and casualty (re)insurers, market capacity decreased and in conjunction, market pricing across most insurance and reinsurance lines of business began to improve and is expected to continue improving throughout 2009. The following is a summary of the January 2009 rate indications and recent renewal activity for each of the Insurance and Reinsurance segments of the Company:

Insurance

With regards to market conditions within the core lines of business within the Insurance segment, fourth quarter 2008 renewals reflected modest improvement in market conditions as premium rates improved across all line of business and certain lines experienced rate increases. Overall, December 2008 renewals reflected an aggregate price increase of 1% for the entire book. More specifically, December premium rates increased approximately 5% in professional lines, 10% in offshore energy and well over 10% in the Company’s specie book. Rates in both property and casualty were down in the low single digits. Initial indications based on January 2009 renewals reflect continued rate improvement with positive rate movement in property, professional and some specialty lines. Rates within the Company’s casualty lines were down slightly by approximately 3%, which represents a significant improvement as compared to rate declines experienced in 2008.

While the Insurance segment’s gross and net premiums written will be impacted by its decision to focus on those lines of business that provide the best return on capital as described above, as well as from a certain level of lost renewals or business opportunities as a result of rating agency actions taken throughout 2008, indications from recent underwriting activity highlight that retention rates remain strong and broadly in line with management’s expectations.

Reinsurance

Across the Reinsurance segment, initial indications, based on January 1, 2009 renewals, point to a moderate rise in premium rates across most major lines of business. Market conditions continue to harden as a result of the reduction in available reinsurer capital, due in part to the credit and liquidity crisis, causing a firming in market pricing across most lines of business. U.S. and non-U.S. catastrophe exposed property lines experienced rate increases of approximately 15% and 5% respectively, while other property lines in the U.S. were generally flat. While U.S. casualty rates, excluding D&O, were down slightly, casualty motor rates in Europe saw increases of up to 10% with rates in other casualty lines remaining flat. In addition, aviation and marine lines of business experienced rate increases of between 5 to 10%.

61


Initial indications of renewal activity have been positive, despite the expected impact of lost renewals and new business opportunities as a result of the rating agency actions taken in December 2008, most notably, the downgrade by S&P, especially in Europe. While some insurers chose not to renew their business with the Company, overall, the negative impact on gross and net premiums written based on such renewal activity has been partially offset by the increase in rates as noted above.

Investment Environment

The Company seeks to generate revenue from investment activities through returns on its investment portfolio. The Company’s current investment strategy seeks to support the liabilities arising from the operations of the Company, generate investment income and build book value over the longer term.

During the year ended December 31, 2008, financial market conditions continued to be extremely challenging as the global credit crisis that began in July 2007, continued to adversely impact global markets. This unprecedented market volatility directly and materially affected the Company’s results of operations and investment portfolio during the year ended December 31, 2008, resulting in decreased net investment income and increases in both realized and unrealized losses in the Company’s investment portfolio. The fixed income markets experienced a period of extreme volatility during 2008, negatively impacting market liquidity conditions. As a result, the market for fixed-income instruments experienced decreased liquidity, increased price volatility, credit downgrade events, and increased probability of default. Domestic and international equity markets also experienced heightened volatility and turmoil during this period.

During 2008, the Company reported significant decreases in both its structured credit and corporate portfolios as a result of the negative conditions described above. Within the structured credit portfolio, the market conditions particularly impacted the Company’s holdings in sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral and Alt-A mortgages (“Topical Assets”), core collateralized debt obligations (“CDOs”) and commercial mortgage-backed securities (“CMBS”). Within the corporate portfolio, the Company’s financial sector holdings were particularly affected as credit spreads, which widened across the entire rating spectrum impacted all spread assets classes, particularly financials following the bankruptcy of Lehman Brothers Holdings Inc. (“Lehman”) in September 2008 and the subsequent failure or near failure of other financial institutions. The impact of the credit spread widening was partially offset by the increase in the fixed income portfolio which resulted from declining government interest rates.

Claims Environment

The Company’s profitability in any given period is based upon its premium and investment revenues as noted above, less net losses incurred and expenses. Net losses incurred are based upon claims paid and changes to unpaid loss reserves. Unpaid loss reserves are estimated by the Company and include both reported loss reserves and reserves for losses incurred but not reported, or IBNR. The Company’s lower underwriting results for 2008 as compared to 2007 were largely a reflection of the increase in catastrophe and property risk losses experienced in 2008. However, offsetting the current year incurred losses was $610.7 million of net favorable prior year reserve development in various lines of business within the Company’s Insurance and Reinsurance segments. In contrast, the Company’s positive underwriting results for 2007 and 2006 were partly a result of the lack of significant catastrophe events occurring throughout these years as well as net favorable development of prior year reserves. However, consistent with 2006 and 2007, net favorable development was partially offset in 2008 by the continuing increase in current period loss ratios during this period. The increase in 2008 reflects the impact of the softening rate environment as well as higher levels of catastrophe and attritional losses as noted above. In addition, in 2008, claims activity within the D&O and Errors and Omissions (“E&O”) insurance markets overall, rose as a result of an increase in class action lawsuits filed against public companies due to market losses and related stock price depreciation associated with the sub-prime mortgage and credit crisis in the U.S. Management actively monitors its potential exposure to such events and gives due consideration to emerging claim trends in determining its loss reserve requirements at each quarter end. For further analysis of this exposure, see “– Results of Operations” below.

62


Financial Measures

The following are some of the financial measures management considers important in evaluating the Company’s operating performance in the Company’s property and casualty operations:

 

 

 

 

 

 

 

(U.S. dollars in thousands, except ratios and per share amounts)

 

2008

 

2007

 

2006

Underwriting profit – property and casualty operations

 

 

$

 

307,205

   

 

$

 

737,449

   

 

$

 

733,633

 

Combined ratio – property and casualty operations

 

 

 

95.7

%

 

 

 

 

88.8

%

 

 

 

 

89.5

%

 

Net investment income – property and casualty operations (1)

 

 

$

 

1,174,856

   

 

$

 

1,289,554

   

 

$

 

1,090,785

 

Book value per ordinary share

 

 

$

 

15.46

   

 

$

 

50.30

   

 

$

 

53.12

 

Fully diluted book value per ordinary share (2)

 

 

$

 

15.46

   

 

$

 

50.29

   

 

$

 

53.01

 

Return on average ordinary shareholders’ equity

 

 

 

NM

*

 

 

 

 

2.2

%

 

 

 

 

19.6

%

 


 

 

(1)

 

 

 

Net investment income relating to property and casualty operations does not include the net investment income related to the net results from structured products.

 

(2)

 

 

 

Fully diluted book value per ordinary share represents book value per ordinary share combined with the impact from dilution of share based compensation including in-the-money stock options at any period end. The Company believes that fully diluted book value per ordinary share is a financial measure important to investors and other interested parties who benefit from having a consistent basis for comparison with other companies within the industry. However, this measure may not be comparable to similarly titled measures used by companies either outside or inside of the insurance industry.

 

*

 

 

 

NM – Not Meaningful

Underwriting profit (loss) – property and casualty operations

One way that the Company evaluates the performance of its insurance and reinsurance operations is the underwriting profit or loss. The Company does not measure performance based on the amount of gross premiums written. Underwriting profit or loss is calculated from premiums earned and fee income, less net losses incurred and expenses related to underwriting activities, plus unrealized foreign exchange gains and losses on underwriting balances. The Company’s underwriting profit in the year ended December 31, 2008 was primarily reflective of the combined ratio discussed below. The Company’s strong property and casualty underwriting profit for 2007 and 2006 were partly a result of the lack of significant catastrophe events occuring throughout these years and net favorable prior year loss development. Any changes to loss reserves affect the calculation of underwriting profit or loss but most often do not directly affect the Company’s cash flow in the same period.

Combined ratio – property and casualty operations

The combined ratio for property and casualty operations is used by the Company and many other insurance and reinsurance companies as another measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company’s general insurance and reinsurance operations. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss.

The Company’s combined ratio for the year ended December 31, 2008, was higher than the previous year, primarily as a result of an increase in the loss and loss expense ratio as well as the underwriting expense ratio. The higher loss and loss expense ratio resulted from higher current year attritional and catastrophe losses, primarily in property lines, combined with lower net premiums earned in the year ended December 31, 2008, as compared to 2007, as a result of the continuing competitive underwriting environment and softening market conditions noted above. The higher 2008 loss ratio also results from a higher level of loss activity in professional lines due to the subprime and related credit crises. Partially offsetting the increase in incurred losses was higher favorable prior year reserve development during the year ended December 31, 2008. While acquisition expenses decreased during the year ended December 31, 2008 as compared to 2007, the increase in operating expenses combined with the impact from the lower level of net premiums earned caused an increase in the underwriting expense ratio.

The Company’s combined ratio for the year ended December 31, 2007 was lower than the previous year, primarily as a result of a lower loss and loss expenses ratio partially offset by a higher underwriting expense ratio. The lower loss and loss expense ratio has resulted mainly from higher net favorable prior year development in the year ended December 31, 2007 as compared to the same period in 2006, while the

63


increased underwriting expense ratio was driven largely by increased compensation costs and continued pricing pressures that have resulted in less premium earned.

Net investment income – property and casualty operations

Net investment income related to property and casualty operations is an important measure that affects the Company’s overall profitability. The largest liability of the Company relates to its unpaid loss reserves, and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due, and thus a significant part of the portfolio is in fixed income securities. Net investment income is influenced by a number of factors, including the amounts and timing of inward and outward cash flows, the level of interest rates and credit spreads and changes in overall asset allocation.

Net investment income related to property and casualty operations, excluding structured products, decreased by $114.7 million during the year ended December 31, 2008, as compared to 2007. Overall, portfolio yields decreased in 2008 as yields earned on investment of cash flows and reinvestment of maturing or sold securities were generally lower than on securities previously held, as prevailing market interest rates, particularly in the U.S., decreased overall during the last twelve months. The portfolio mix has also changed as a result of the settlement of the GIC and funding agreement liabilities, as the property and casualty operations assumed a number of the floating rate securities previously held in the Company’s Other Financial Lines segment and accordingly, net investment income is more sensitive to changes in short-term interest rates. The Company has also increased allocations to lower yielding cash, government and agency investments.

The increase in net investment income in 2007 was primarily due to several years of positive operating cash flows which resulted in a higher overall average invested asset base. In addition, during 2007, portfolio yields increased in the Company’s investment portfolio, due primarily to the full 2007 financial year impact of the higher interest rates experienced in the U.S., U.K. and Euro-zone, during the latter part of 2006 and the beginning part of 2007.

Book value per ordinary share

Management also views the change in the Company’s book value per ordinary share as an additional measure of the Company’s performance. Book value per share is calculated by dividing ordinary shareholders’ equity by the number of outstanding ordinary shares at any period end. Book value per ordinary share is affected primarily by the Company’s net income (loss), by any changes in the net unrealized gains and losses on its investment portfolio, currency translation adjustments and also the impact of any share repurchase or issuance activity.

Book value per ordinary share decreased by $34.84 in the year ended December 31, 2008 as compared to a decrease of $2.82 during 2007 as noted below. The decrease in 2008 was primarily as a result of the Company’s issuance of Class A ordinary shares issued at a discount to book value (as described below), the Company’s net loss of $2.6 billion during the year ended December 31, 2008 and the increase in net unrealized losses on investments of approximately $2.9 billion, net of tax, during the same period. In addition, book value per ordinary share decreased as a result of unfavorable foreign currency translation adjustments of $472.3 million during the year ended December 31, 2008. In August 2008, the Company issued 143.8 million Class A ordinary shares at a price of $16.00 per share, which was lower than the Company’s book value per ordinary share at the time and thus dilutive. The Company’s net loss of $2.6 billion was mainly due to the impact of the closing of the Master Agreement in August 2008 as described above, the goodwill impairment charge recorded in 2008 of $990.0 million, catastrophe and attritional losses, as well as from net realized losses on investments and losses from investment fund affiliates during the year ended December 31, 2008. The increase in net unrealized losses on investments of $2.9 billion, net of tax, during the year ended December 31, of 2008 was mainly as a result of widening credit spreads on corporate and structured credit assets, offset by declines in interest rates, while unfavorable foreign currency translation adjustments during the same period resulted from the increase in value of the U.S. dollar against most major currencies, predominately the Euro and U.K. Sterling.

Book value per ordinary share decreased by $2.82 during the year ended December 31, 2007 to $50.30 from $53.12. The decrease in book value per share in 2007 was primarily as a result of an increase in net

64


unrealized losses on investments of $743.0 million, net of tax, partially offset by net income of $206.4 million for the year ended December 31, 2007, which increased book value, together with an increase in currency translation adjustments due to the impact of the decline in the value of the U.S. dollar on the net assets of European-based subsidiaries. In addition, certain capital and financing activities impacted book value per ordinary share, including the Company’s share repurchase activity throughout 2007 which decreased book value per ordinary share, as the price paid for such shares was at a premium to book value; however, this was partially offset by the issuance of Class A ordinary shares upon maturity of the purchase contracts associated with the 6.5% Equity Security Units (the “6.5% Units”), as the ordinary shares were issued at a premium to book value.

As noted above, fully diluted book value per ordinary share represents book value per ordinary share combined with the impact from dilution of share based compensation including in-the-money stock options at any period end. Fully diluted book value per ordinary share decreased by $34.83 during the year ended December 31, 2008 as a result of the factors noted above and is consistent with the decrease in basic book value per ordinary share as there were no in-the-money stock options at December 31, 2008 as a result of the reduction in market price of the Company’s ordinary shares in 2008.

Return on average ordinary shareholders’ equity

Return on average ordinary shareholder’s equity (“ROE”) is another financial measure that management considers important in evaluating the Company’s operating performance. ROE is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholders’ equity. The Company establishes minimum target ROEs for its total operations, segments and lines of business. If the Company’s minimum ROE targets over the longer term are not met with respect to any line of business, the Company seeks to modify and/or exit these lines. In addition, the Company’s compensation of its senior officers is significantly dependent on the achievement of the Company’s performance goals to enhance shareholder value as measured by ROE (adjusted for certain items considered to be ‘non-operating’ in nature).

In 2008, ROE was negative, mainly as a result of the impact of the closing of the Master Agreement in August 2008 as described above, the goodwill impairment charge recorded in late 2008, as well as from catastrophe losses, net realized losses on investments and losses from the Company’s investment fund affiliates during the year ended December 31, 2008.

In 2007, ROE was 2.2%, 17.4 percentage points lower than the prior year, primarily as a result of losses recorded in the second half of 2007 in relation to adverse credit market conditions, including but not limited to, losses associated with the Company’s investment in and reinsurance agreements with Syncora and realized losses, including other than temporary impairment charges (“OTTI”), in the Company’s investment portfolio. For further details of these losses, see “ – Results of Operations” below. Partially offsetting these decreases were strong underwriting results in 2007 within the Company’s core property and casualty operations and lower levels of shareholders equity resulting from capital activity and increases in unrealized losses on investments.

Results of Operations

The following table presents an analysis of the Company’s net income (loss) available to ordinary shareholders and other financial measures (described below) for the years ended December 31, 2008, 2007 and 2006:

 

 

 

 

 

 

 

(U.S. dollars in thousands, except share and per share amounts)

 

2008

 

2007

 

2006

Net (loss) income available to ordinary shareholders

 

 

$

 

(2,632,458

)

 

 

 

$

 

206,375

   

 

$

 

1,722,445

 

(Loss) earnings per ordinary share – basic

 

 

$

 

(11.02

)

 

 

 

$

 

1.16

   

 

$

 

9.63

 

(Loss) earnings per ordinary share – diluted

 

 

$

 

(11.02

)

 

 

 

$

 

1.15

   

 

$

 

9.60

 

Weighted average number of ordinary shares and ordinary share equivalents – basic

 

 

 

238,862

   

 

 

178,500

   

 

 

178,793

 

Weighted average number of ordinary shares and ordinary share equivalents – diluted

 

 

 

238,862

   

 

 

179,693

   

 

 

179,450

 

65


The Company’s net income (loss) and other financial measures as shown above for the three years ended December 31 have been affected by among other things, the following significant items:

 

 

 

 

 

1

)

 

 

impact of the closing of the Master Agreement (defined below) in August 2008 and the impact in 2007 of the Company’s investment in and relationships with Syncora;

 

 

2

)

 

 

impact of credit market movements in 2008 and 2007 on the Company’s investment portfolio and investment fund affiliates;

 

 

3

)

 

 

continuing competitive underwriting environment;

 

 

4

)

 

 

net prior year favorable loss development;

 

 

5

)

 

 

impact of increased property risk and catastrophe activity 2008 and limited property risk catastrophe activity in 2007 and 2006; and

 

 

6

)

 

 

goodwill impairment charge recorded in 2008.

1. Impact of the closing of the Master Agreement in August 2008 and the impact in 2007 of the Company’s investment in and relationships with Syncora

On July 28, 2008, the Company announced that it and certain of its subsidiaries had entered into an agreement (the “Master Agreement”) with Syncora and certain of its subsidiaries (sometimes collectively referred to herein as “Syncora”) as well as certain counterparties to credit default swap agreements (the “Counterparties”), in connection with the termination of certain reinsurance and other agreements. The transactions and termination of certain reinsurance and other agreements under the Master Agreement closed on August 5, 2008. For a description of the Master Agreement, see Note 4 to the Consolidated Financial Statements, “Syncora Holdings Ltd. (“Syncora”).”

After the closing of the Master Agreement on August 5, 2008, approximately $64.6 billion of the Company’s total net exposure (which was $65.7 billion as at June 30, 2008) under reinsurance agreements and guarantees with Syncora subsidiaries was eliminated. Pursuant to the terms of the Master Agreement, Syncora is required to use commercially reasonable efforts to commute the agreements that are the subject of the Company’s guarantee of Syncora Guarantee’s obligations under certain financial guarantees issued by Syncora Guarantee to the European Investment Bank (the “EIB Policies”), subject to certain limitations. As at December 31, 2008, the Company’s exposures relating to the EIB Policies (which relate to project finance transactions) was approximately $955.4 million reduced from $1.1 billion at June 30, 2008 mainly due to the strengthening of the U.S. dollar against the currencies of the underlying obligations. As of December 31, 2008, there had been no reported events of default on the underlying obligations, accordingly, no reserves have been recorded.

The terms of the Master Agreement were determined in consideration of a number of commercial and economic factors associated with all existing relationships with Syncora, including, but not limited to, a valuation of the consideration for the commuted agreements and any potential future claims thereunder and the impact of outstanding uncertainty on both the ratings and business operations of the Company. The total value of the consideration noted above of $1.775 billion as well as the eight million ordinary shares of the Company transferred to Syncora valued at $128.0 million, significantly exceeded the carried net liabilities of approximately $490.7 million related to such reinsurances and guarantees. Management considers the execution of the Master Agreement as the event giving rise to the additional liability. As detailed in the table below, the Company recorded a loss of approximately $1.4 billion in respect of the closing of the Master Agreement during the year ended December 31, 2008:

 

 

 

(U.S. dollars in millions)

 

 

Carried liabilities in relation to reinsurance and guarantee agreements commuted under the Master Agreement

 

 

$

 

490.7

 

Other accruals

 

 

 

(5.2

)

 

Cash payment made to Syncora in August 2008

 

 

 

(1,775.0

)

 

Value of XL common shares transferred under the Master Agreement

 

 

 

(128.0

)

 

 

 

 

Net loss associated with Master Agreement recorded in the year ended
December 31, 2008

 

 

$

 

(1,417.5

)

 

 

 

 

66


Given management’s view of the risk exposure along with the uncertainty facing the entire financial guarantee industry in the latter part of 2007, the Company reduced the reported value of its investment in Syncora to nil at December 31, 2007, from the reported equity method value of $669.8 million as at September 30, 2007. In addition, net losses were recorded in 2007 within “loss from operating affiliates” with respect to the previous excess of loss and facultative reinsurance of Syncora subsidiaries in the amounts of $300.0 million and $51.0 million, respectively. In addition, during 2007, the Company incurred $17.9 million in additional mark-to-market losses related to those underlying contracts in credit default swap form subject to the provisions noted above.

2. Impact of credit market movements in 2008 and 2007 on the Company’s investment portfolio and investment fund affiliates

During the year ended December 31, 2008, financial market conditions continued to be extremely challenging as the global credit crisis that began in July 2007, continued to adversely impact global markets. This unprecedented market volatility directly and materially affected the Company’s results of operations and investment portfolio during the year ended December 31, 2008. The credit markets experienced a period of extreme deterioration during 2008, negatively impacting market liquidity conditions. As a result, the market for fixed-income instruments experienced decreased liquidity, increased price volatility, credit downgrade events, and increased probability of default. Domestic and international equity markets also experienced heightened volatility and turmoil during this period.

During 2008, the Company reported significant decreases in both its structured credit and corporate portfolios as a result of the negative conditions described above. Within the structured credit portfolio, the market conditions particularly impacted the Company’s holdings in Topical Assets, CDOs and CMBS. Within the corporate portfolio, the Company’s financial sector holdings were particularly affected as credit spreads, which widened across the entire rating spectrum impacted all spread assets classes, particularly financial institutions following the bankruptcy of Lehman in September 2008 and the subsequent failure or near failure of other financial institutions including Tier One and Upper Tier Two securities (representing committed term debt and hybrid instruments senior to the common and preferred equities of the financial institutions). The impact of the credit spread widening was partially offset by the increase in the fixed income portfolio which resulted from declining government interest rates.

The following table provides further detail regarding the extreme volatility in the global credit markets, as well as in government interest rates using some sample market indices:

 

 

 

 

 

 

 

Interest Rate Movement for the year
ended December 31, 2008 (1)
(‘-’represents decreases in interest rates)

 

Credit Spread Movement for the year
ended December 31, 2008 (2)
(‘+’ represents widening of credit spreads)

United States

 

-189 basis points (5 year treasury)

 

+ 439 basis points (US Corporate A rated)

 

 

 

 

+ 72 basis points (US Agency RMBS, AAA rated)

 

 

 

 

+ 753 basis points (US CMBS, AAA rated)

United Kingdom

 

-149 basis points (10 year Gilt)

 

+ 217 basis points (UK Corporate, AA rated)

Euro-zone

 

-180 basis points (5 year Bund)

 

+ 317 basis points (Europe Corporate, A rated)


 

 

(1)

 

 

 

Source: Bloomberg Finance L.P.

 

(2)

 

 

 

Source: Merrill Lynch Global Indices.

The net impact of the market conditions over the course of 2008 on the Company’s investment portfolio for the year ended December 31, 2008 resulted in net realized losses of $962.1 million and an increase in net unrealized losses on available-for-sale investments of $2.9 billion. This represents approximately a 12.2% deterioration on average assets for the year ended December 31, 2008. See Item 1A, “Risk Factors,” “Deterioration in the public debt and equity markets could lead to additional investment losses” and “We are exposed to significant capital markets risk related to changes in interest rates, credit spreads, equity prices and foreign exchange rates which may adversely affect our results of operations, financial condition or cash flows,” above. Since the time of the Company’s August 2008 public offering of ordinary shares and equity security units (See “ – Results of Operations – Other Key Focuses of Management – Capital Management,” below), the volatility and disruption in the global capital markets reached unprecedented levels and substantially increased during both the third and fourth quarters of 2008.

67


During the fourth quarter of 2008, the Company recorded a charge on its investment portfolio for OTTI of $400.0 million in relation to impaired assets that it could no longer assert its intent to hold until recovery. Management believes that these securities were at-risk for further mark-to-market declines, and potentially real economic losses, to the extent that economic conditions were to deteriorate further than present estimates and the Company’s allocation to these asset classes is overweight relative to traditional P&C portfolio. By taking the charge as noted above, the Company expects to be able to accelerate its investment portfolio risk reduction exercise during 2009. As a result of the charge noted above, management is likely to pursue targeted sales of these assets over the course of 2009, and expects to realize the associated losses on these securities. The assets are concentrated in certain holdings within the Company’s BBB and lower corporate, CMBS, equity and consumer ABS portfolios.

Corporate credit portfolio

The following table details the Company’s corporate credit exposures by certain asset classes as well as ratings levels within the Company’s fixed maturity portfolio and the current net unrealized (loss) position as at December 31, 2008:

 

 

 

 

 

 

 

 

 

 

 

 

 

(U.S. dollars in millions)

 

AAA

 

AA

 

A

 

BBB

 

BB & Below

 

Total

Financials

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

712.4

   

 

$

 

1,280.6

   

 

$

 

2,153.3

   

 

$

 

343.4

   

 

$

 

64.7

   

 

$

 

4,554.4

 

Net unrealized (loss)

 

 

$

 

(14.6

)

 

 

 

$

 

(145.4

)

 

 

 

$

 

(659.5

)

 

 

 

$

 

(158.2

)

 

 

 

$

 

(44.0

)

 

 

 

$

 

(1,021.7

)

 

Non-Financials

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

521.8

   

 

$

 

711.4

   

 

$

 

2,213.2

   

 

$

 

1,511.6

   

 

$

 

552.9

   

 

$

 

5,510.9

 

Net unrealized (loss)

 

 

$

 

(14.7

)

 

 

 

$

 

(22.6

)

 

 

 

$

 

(307.2

)

 

 

 

$

 

(306.9

)

 

 

 

$

 

(216.6

)

 

 

 

$

 

(868.0

)

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

1,234.2

   

 

$

 

1,992.0

   

 

$

 

4,366.5

   

 

$

 

1,855.0

   

 

$

 

617.6

   

 

$

 

10,065.3

 

Net unrealized (loss)

 

 

$

 

(29.3

)

 

 

 

$

 

(168.0

)

 

 

 

$

 

(966.7

)

 

 

 

$

 

(465.1

)

 

 

 

$

 

(260.6

)

 

 

 

$

 

(1,889.7

)

 

At December 31, 2008, approximately $1.7 billion of the Company’s $4.6 billion in corporate financial sector securities was held in the portfolios supporting the Company’s Life Reinsurance Operations. Management continues the strategic analysis of the Company’s life reinsurance business. The assets associated with that business are more heavily weighted towards longer term securities from financial institutions, including a significant portion of the Company’s Tier 1 and Upper Tier 2 securities, representing committed term debt and hybrid instruments senior to the common and preferred equity of the financial institutions. Financials held in Life portfolios accounted for $663.1 million of the Company’s net unrealized loss as at December 31, 2008. As at December 31, 2008 approximately 34.0% of the overall sensitivity to interest rate risk and 37.8% to credit risk was related to the life reinsurance portfolio, despite these portfolios accounting for only 17.6% of the fixed income portfolio.

68


Structured credit portfolio

The following table details the Company’s structured credit exposures by certain asset classes as well as ratings levels within the Company’s fixed maturity portfolio and the current net unrealized gain (loss) position as at December 31, 2008:

 

 

 

 

 

 

 

 

 

 

 

 

 

(U.S. dollars in millions)

 

AAA

 

AA

 

A

 

BBB

 

BB & Below

 

Total

CMBS

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

2,101.5

   

 

$

 

15.2

   

 

$

 

15.4

   

 

$

 

11.8

   

 

$

 

10.6

   

 

$

 

2,154.5

 

Net unrealized (loss)

 

 

$

 

(331.8

)

 

 

 

$

 

(5.1

)

 

 

 

$

 

(4.9

)

 

 

 

$

 

(7.7

)

 

 

 

$

 

(12.4

)

 

 

 

$

 

(361.9

)

 

Prime RMBS

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

2,862.4

   

 

$

 

132.1

   

 

$

 

57.1

   

 

$

 

14.6

   

 

$

 

36.3

   

 

$

 

3,102.5

 

Net unrealized (loss)

 

 

$

 

(155.7

)

 

 

 

$

 

(67.0

)

 

 

 

$

 

(45.5

)

 

 

 

$

 

(5.0

)

 

 

 

$

 

(13.0

)

 

 

 

$

 

(286.2

)

 

Topical Assets

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

558.3

   

 

$

 

183.7

   

 

$

 

98.9

   

 

$

 

48.0

   

 

$

 

74.6

   

 

$

 

963.5

 

Net unrealized (loss)

 

 

$

 

(312.5

)

 

 

 

$

 

(157.5

)

 

 

 

$

 

(63.4

)

 

 

 

$

 

(24.7

)

 

 

 

$

 

(36.5

)

 

 

 

$

 

(594.6

)

 

Core CDOs (1)

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

166.1

   

 

$

 

324.4

   

 

$

 

51.7

   

 

$

 

110.3

   

 

$

 

13.7

   

 

$

 

666.2

 

Net unrealized (loss)

 

 

$

 

(61.7

)

 

 

 

$

 

(173.9

)

 

 

 

$

 

(46.6

)

 

 

 

$

 

(163.7

)

 

 

 

$

 

(24.1

)

 

 

 

$

 

(470.0

)

 

Other Asset & Mortgage Backed Securities

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

1,253.3

   

 

$

 

108.1

   

 

$

 

267.6

   

 

$

 

61.7

   

 

$

 

28.2

   

 

$

 

1,718.9

 

Net unrealized (loss)

 

 

$

 

(57.3

)

 

 

 

$

 

(18.3

)

 

 

 

$

 

(74.1

)

 

 

 

$

 

(28.9

)

 

 

 

$

 

(2.3

)

 

 

 

$

 

(180.9

)

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

 

6,941.6

   

 

$

 

763.5

   

 

$

 

490.7

   

 

$

 

246.4

   

 

$

 

163.4

   

 

$

 

8,605.4

 

Net unrealized (loss)

 

 

$

 

(919.0

)

 

 

 

$

 

(421.8

)

 

 

 

$

 

(234.5

)

 

 

 

$

 

(230.0

)

 

 

 

$

 

(88.3

)

 

 

 

$

 

(1,893.6

)

 


 

 

(1)

 

 

 

The Company defines Core CDOs as investments in non-mortgage collateralized debt obligations, primarily consisting of collateralized loan obligations.

The following table details the current exposures to Topical Assets within the Company’s fixed income portfolio as well as the current net unrealized (loss) gain position as at December 31, 2008 and December 31, 2007:

 

 

 

 

 

 

 

 

 

 

 

 

 

(U.S. dollars in thousands)

 

As at December 31, 2008

 

As at December 31, 2007

 

Holding at
Fair Value

 

Percent
of Fixed
Income
Portfolio

 

Net
Unrealized
(Loss) Gain

 

Holding
at Fair
Value

 

Percent
of Fixed
Income
Portfolio

 

Net
Unrealized
(Loss) Gain

Topical Assets:

 

 

 

 

 

 

 

 

 

 

 

 

Sub-prime first lien mortgages

 

 

$

 

487,659

   

 

 

1.5

%

 

 

 

$

 

(311,435

)

 

 

 

$

 

995,947

   

 

 

2.5

%

 

 

 

$

 

(145,785

)

 

Alt-A mortgages

 

 

 

406,098

   

 

 

1.3

%

 

 

 

 

(270,486

)

 

 

 

 

924,783

   

 

 

2.3

%

 

 

 

 

(40,145

)

 

Second lien mortgages (including sub-prime second lien mortgages)

 

 

 

58,903

   

 

 

0.2

%

 

 

 

 

(5,313

)

 

 

 

 

97,647

   

 

 

0.3

%

 

 

 

 

788

 

ABS CDOs with sub-prime collateral

 

 

 

10,595

   

 

 

0.0

%

 

 

 

 

(7,308

)

 

 

 

 

39,317

   

 

 

0.1

%

 

 

 

 

101

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total exposure to Topical Assets

 

 

$

 

963,255

   

 

 

3.0

%

 

 

 

$

 

(594,542

)

 

 

 

$

 

2,057,694

   

 

 

5.2

%

 

 

 

$

 

(185,041

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Of the total Topical Assets with fair value exposure as at December 31, 2008 and December 31, 2007 of $1.0 billion and $2.0 billion, respectively, approximately $40.5 million and $76.8 million, respectively, of the related securities had ratings dependent on guarantees issued by third party guarantors (i.e., monoline insurers). Decreases in the ratings of such third party guarantors would typically decrease the fair value of guaranteed securities; however, at December 31, 2008, in the event of non-performance at such date on the part of these third party guarantors, the Company estimated that the average credit quality of this portfolio would be ‘A’ and that approximately 96.1% would have remained investment grade at such date. In addition, of the total fixed income portfolio as at December 31, 2008 and December 31, 2007, of $31.9 billion and $39.6 billion, respectively, less than 2% were guaranteed by such third parties with no individual third party representing more than 1%.

69


At December 31, 2008, the Company’s sub-prime and Alt-A exposures remained primarily highly rated, had adequate underlying loan characteristics and the Company believed at such date that they were supported by adequate subordination levels based on current expectations of house price declines, loss severities and default levels. The Company had approximately $523.1 million of Topical Assets downgraded during the year ended December 31, 2008. However, 92.2% of the Company’s holdings remain rated investment grade at December 31, 2008.

Liquidations necessary to fund the repayment of the GIC liabilities following the downgrade of Syncora Guarantee and the maturity of certain funding agreements were funded through sales of assets in the Other Financial Lines segment investment portfolios as well as the general investment portfolio. Management’s approach was to avoid the sale of assets where current market prices did not reflect intrinsic values or where transaction costs for liquidation were excessive. As a result, the Company continues to hold approximately $1.4 billion of Topical Assets and core CDOs and these have been transferred to the general portfolio in exchange for those assets that were liquidated.

Realized losses and other than temporary impairments

Net realized losses on investments in the twelve months ended December 31, 2008 included net realized losses of approximately $1,023.6 million related to the write-down of certain of the Company’s fixed income, equity and other investments, including Lehman, where the Company determined that there was an other than temporary decline in the value of those investments, including a charge of $400.0 million related to assets for which the Company could no longer assert its intent to hold to recovery. See below for further information. Included in net realized losses noted above are net realized gains of $98.8 million as related to the foreign exchange component of inter-company sales of assets.

During the year ended December 31, 2008, net realized losses of $400.0 million related to the write-down of certain of the Company’s fixed income and equity investments, where, although management’s analysis of the securities indicated that these assets were expected to pay out all expected cash flows, management can no longer assert that it intends to hold these securities until such time as they recover, as management intends to pursue sales of these securities in connection with its efforts to reduce the risk within the Company’s the investment portfolio.

Included in the impairment charge for the year ended December 31, 2008, was $121.4 million of related exposures to financial institutions, primarily related to Lehman. The remaining impairment during 2008 was spread across the portfolio including structured credit, equity and other fixed income investments, with $228.5 million related to securities with sub-prime and Alt- A collateral which are included in the table below. Consistent with prior quarters, management continues to evaluate the impairment of the portfolio and satisfy itself that the remaining gross unrealized losses are temporary in nature.

The following table provides the realized and unrealized impact related to the Topical Assets during the year ended December 31, 2008:

 

 

 

 

 

(U.S. dollars in thousands)

 

Year Ended December 31, 2008

 

Realized
(Loss) and
(Impairments)

 

Change
in Net
Unrealized
(Loss)

Topical Assets:

 

 

 

 

Sub-prime first lien mortgages

 

 

$

 

(124,518

)

 

 

 

$

 

(165,650

)

 

Alt-A mortgages

 

 

 

(118,318

)

 

 

 

 

(230,341

)

 

Second lien mortgages (including sub-prime second lien mortgages)

 

 

 

(15,664

)

 

 

 

 

(6,101

)

 

ABS CDOs with sub-prime collateral

 

 

 

(17,209

)

 

 

 

 

(7,409

)

 

 

 

 

 

 

Total

 

 

$

 

(275,709

)

 

 

 

$

 

(409,501

)

 

 

 

 

 

 

All portfolio holdings, including those with sub-prime exposure, are reviewed as part of the ongoing other than temporary impairment monitoring process. The Company continues to actively monitor its exposures, and to the extent market disruptions continue, including but not limited to disruptions in the residential mortgage market and the related impacts on the assumptions embedded in the Company’s impairment assessments and estimates of future cash flows, the Company’s financial position could be

70


negatively impacted. See Item 1A, “Risk Factors – Deterioration in the public debt and equity markets could lead to additional investment losses,” above.

Alternative investment portfolio

Net income from investment fund affiliates was negative in the year ended December 31, 2008. Broad-based market declines, combined with extreme volatility, a sharp pull-back in the availability of credit and short sale restrictions implemented by securities market regulators, proved highly challenging for the strategies employed by many of the Company’s alternative investment managers. The Company’s alternative investments are managed to maximize total-return on a risk-adjusted basis, and the results during 2008 as compared to 2007 were reflective of different market conditions and opportunities available over these periods.

3. Continuing competitive underwriting environment

Soft market conditions were experienced across most lines of business throughout 2007 and most of 2008, resulting in an overall decrease in gross and net premiums written. For further information in relation to the underwriting environment, including details relating to rates and retention, see “Executive Overview - Underwriting Environment”, above.

In addition, in the latter part of 2008, unprecedented economic conditions continued to impact the Company. These conditions, combined with the recent volatility in the Company’s share price, rating agency actions with respect to the Company and issues faced by some of the Company’s competitors, resulted in the creation of challenges as well as certain opportunities for the Company’s P&C operations.

4. Net prior year favorable loss development

Net prior year favorable loss development occurs when there is a decrease to loss reserves recorded at the beginning of the year, resulting from actual or reported loss development for prior years that is less than expected loss development. Net prior year adverse loss development occurs when there is an increase to loss reserves recorded at the beginning of the year, resulting from actual or reported loss development for prior years exceeding expected loss development.

The following table presents the net (favorable) adverse prior year loss development of the Company’s loss and loss expense reserves for its property and casualty operations which include the Insurance and Reinsurance segments for each of the years indicated:

 

 

 

 

 

 

 

(U.S. dollars in millions)

 

2008

 

2007

 

2006

Insurance segment

 

 

$

 

(305.5

)

 

 

 

$

 

(158.1

)

 

 

 

$

 

(13.2

)

 

Reinsurance segment

 

 

 

(305.2

)

 

 

 

 

(267.3

)

 

 

 

 

(97.4

)

 

 

 

 

 

 

 

 

Total

 

 

$

 

(610.7

)

 

 

 

$

 

(425.4

)

 

 

 

$

 

(110.6

)

 

 

 

 

 

 

 

 

During 2008, net favorable prior year development totaled $610.7 million in the Company’s property and casualty operations and included net favorable development in the Insurance and Reinsurance segments of $305.5 million and $305.2 million, respectively. Within the Reinsurance segment, net favorable prior year reserve development included casualty and other lines reserve releases in both European and U.S. casualty and professional portfolios as well as reserve releases associated with the RITC relating to the 2005 year of account on certain Lloyd’s sourced business. In the same period, property and other short-tail lines net favorable development was attributable to most business units globally. The Insurance segment net favorable prior year reserve development was due to reserve releases in global property lines of business as a result of favorable claim development as well as reserve releases in certain casualty lines primarily in accident years 2003 to 2006 years due to lower than expected reported loss activity. In addition, net reserve releases of approximately $80.9 million resulted from an agreement with Axa/Winterthur in the fourth quarter of 2008 in regards to certain reinsurance recoverable balances relating to casualty lines and to a lesser extent, certain property lines of business. Offsetting this favorable development was modest reserve strengthening within environmental lines as well as strengthening associated with certain structured indemnity contracts. Within the professional lines, reserve releases in the 2003 to 2006 accident years were largely offset by strengthening of reserves in the 2007 year.

71


During 2007, the Company had net favorable prior year reserve development in property and casualty operations of $425.4 million compared to $110.6 million for the same period in 2006. Reinsurance net favorable development accounted for $267.3 million of the release in 2007, while net favorable development within the Insurance segment totaled $158.1 million for the same period. The corresponding prior year development on a gross basis was $259.7 million for the Reinsurance segment and $177.6 million for the Insurance segment. Within the Reinsurance segment, reserve releases of $188.7 million in property and other short-tail lines of business and $87.4 million in casualty and other lines, were partially offset by adverse prior year development of $8.8 million within the structured indemnity line of business. The Insurance segment’s net prior year reserve releases consisted of $95.0 million in property and $162.1 million in casualty lines of business, partially offset by net adverse development of $23.0 million, $7.0 million and $69.0 million in certain professional, marine and other lines of business, respectively.

During 2006, the Company had net favorable prior year reserve development in property and casualty operations of $110.6 million. Within the Insurance segment, net overall favorable prior year reserve development for the year ended December 31, 2006, was $13.2 million, while net favorable development within the Reinsurance segment during the same period was $97.4 million.

See Item 8, Note 12 to the Consolidated Financial Statements and see further discussion under “Critical Accounting Policies and Estimates”.

5. Impact of increased property risk and catastrophe activity in 2008 and limited property risk and catastrophe activity in 2007 and 2006

As compared to 2006 and 2007, 2008 saw increases in property risk losses as well as catastrophe activity and resulting incurred losses, primarily related to U.S. windstorm activity. On September 1, 2008, Hurricane Gustav hit the Louisiana coast of the U.S. as a Category 2 hurricane, causing considerable damage to insured property and loss of life. On September 13, 2008, Hurricane Ike made landfall near Galveston, Texas as a strong Category 2 hurricane, causing significantly more damage and loss of life than Hurricane Gustav. Based on market estimates, Hurricane Ike is estimated to have caused the third largest ever insured loss in the U.S. from a wind storm. The Company has estimated losses incurred, net of reinsurance recoveries and reinstatement premiums, of $22.5 million and $210.0 million related to Hurricanes Gustav and Ike, respectively. Actual losses may vary from this estimate based on a number of factors, including receipt of additional information from insureds and brokers, the attribution of losses to coverages that had not previously been considered as exposed and inflation in repair costs due to additional demand for labor and materials. In addition to natural peril catastrophes, there was also an increase in large property risk losses globally during 2008 that contributed to higher loss ratios in both the Insurance and Reinsurance segments.

Overall, 2007 and 2006 experienced a lower number of natural catastrophes as compared to 2008, although 2007 did result in an increase in overall natural catastrophe activity and insured losses as compared to 2006. In 2007, six hurricanes formed in the Atlantic region including two Category 5 hurricanes, while other natural catastrophes in 2007 included European windstorms Kyrill and Per/Hanno, California wildfires, floods in the U.K. and Mexico, the Peruvian earthquake and five hurricanes in the Eastern Pacific region. In 2006, there were only five hurricanes in the Atlantic region and more importantly there was no significant insured damage for those hurricanes that did make landfall.

6. Goodwill impairment charge recorded in 2008

Due to the financial market and economic events that occurred in the fourth quarter of fiscal 2008, the Company performed an interim impairment test for goodwill subsequent to its annual testing date of June 30. The interim impairment test resulted in a non-cash goodwill impairment charge of $990.0 million. The charge relates primarily to certain reinsurance units’ goodwill associated with the merger of Mid Ocean Limited (“Mid Ocean”) in 1998. The fair value of the Mid Ocean reporting unit was calculated using the methodologies as described within “Critical Accounting Policies and Estimates” below, and by comparison with similar companies using their publicly traded price multiples as the basis for valuation. For further information, see Item 8, Note 7 to the Consolidated Financial Statements, “Goodwill and Other Intangible Assets” and see further discussion under “Critical Accounting Policies and Estimates”.

72


Other Key Focuses of Management

Throughout the latter part of 2008 and into early 2009, the Company remains focused on, among other things, simplifying the Company’s business model to focus on core property and casualty business and enhancing its enterprise risk management capabilities. Details relating to these initiatives are highlighted below.

Simplify the Company’s Business Model and Enhance Risk Management

In relation to this top management priority, certain initiatives that have taken place or are underway include the following:

 

 

 

 

Focus on P&C Businesses: In order to support the Company’s focus on its dual platform of Insurance and Reinsurance P&C businesses, the Company ceased certain operations that included the closure of the XLFS business unit and reassignment of responsibility for structured indemnity business to either the Insurance segment or Reinsurance segment depending on the underlying nature of the transactions. As noted above, going forward, the Company plans to focus on those lines of business within its insurance and reinsurance operations that provide the best return on capital. As such, the Company will be highly selective on new business, emphasize short-tail lines, where applicable, in the Company’s reinsurance operations, exit other businesses (e.g., Casualty facultative business), non-renew certain insurance programs, as well as continue to reduce long-term agreements (within the insurance operations) in order to capture the benefit of hardening markets. In addition, the Company announced its intention to review strategic opportunities relating to its Life reinsurance business which resulted in the Company selling the renewal rights to its ‘life, accident and health’ business, a relatively small block of business, in late 2008. The Company continues to explore various strategic options for its annuity book, the mortality and critical illness book and as well for its U.S. life reinsurance business.

 

 

 

 

Enterprise Risk Management: The Company is focused on enhancing its risk management capabilities throughout all facets of its operations. This initiative is led by the Company’s newly hired Chief Enterprise Risk Officer (“CERO”) as noted below. The CERO is supported by, among others, the Company’s Enterprise Risk Management Committee (the “ERM Committee”) comprised of the most senior risk takers and managers of the Company. The ERM Committee will continue to assist with the efficient identification, assessment, monitoring, and reporting of key risks across the Company. On September 15, 2008, Mr. Jacob D. Rosengarten joined the Company as Executive Vice President and CERO. Mr. Rosengarten reports directly to the Company’s Chief Executive Officer, Michael S. McGavick, and chairs the Company’s ERM Committee. In addition, the Board of Directors has created a special committee of the Board to oversee endeavours in this area.

 

 

 

 

Simplify Investment Portfolio Over Time: In order to reposition the Company’s investment portfolio to one that supports a P&C focused operation, the Company began repositioning the portfolio in 2008 so that a) book value volatility particularly related to credit spreads arising from the portfolio is reduced, b) a reduction in lower rated corporate securities and financial issuers is achieved, c) exposure to CMBS securities is reduced and d) a reduction in asset classes such as subprime, Alt-A and Core CDO’s previously supporting Other Financial Lines activities is achieved. Realignment will be achieved primarily through cash generated from bond maturities and coupon reinvestment, cash flow from business operations as well as certain opportunistic sales.

 

 

 

 

 

Consistent with this strategy, management continued the process of reducing risk in the investment portfolio during the latter part of 2008. Fannie Mae and Freddie Mac preferred positions were sold as well as securities of a number of regional banks and other financial institutions. Most of this was accomplished prior to the Lehman bankruptcy in September 2008 when credit markets became even more disrupted. In addition, management reduced the aggregate sub-prime, Alt A, CMBS and CDO portfolio holdings significantly, through natural cash flows and certain opportunistic sales.

 

 

 

 

 

Results of portfolio simplification efforts included a reduction in exposure of $1.6 billion in the CMBS portfolio, as well as reducing the aggregate corporate portfolios by $1.2 billion during 2008. The Company also reduced its risk exposure to alternative investments by approximately $0.8 billion during 2008 in response to adverse market conditions and ongoing efforts to reduce the risk within

73


 

 

 

 

its investment portfolio. As well, following the charge of $400.0 million recorded during the fourth quarter of 2008 relating to impaired assets that the Company could no longer assert its intent to hold to recovery, the Company expects to be able to accelerate its investment portfolio risk reduction exercise during 2009.

 

 

 

 

 

Management further reduced interest rate risk exposure during 2008 by shortening the duration of the portfolio supporting the U.S. property and casualty operations by 0.6 years. Cash and government agency holdings were increased by approximately $2.4 billion to approximately $13.2 billion representing approximately 41.2% of the fixed income portfolio at December 31, 2008.

 

 

 

 

Reduction of Expenses to Reflect Simplified Business: In light of the changes in business strategy noted above and in response to expense pressure from softening market conditions and other significant market events which impacted the Company throughout 2008, the Company implemented in the third quarter of 2008 and subsequently in the first quarter of 2009, expense reduction initiatives designed to streamline certain of its processes and functions and reduce the Company’s expense across all major geographic locations, with primary emphasis on corporate functions. The Company recorded restructuring charges totaling $50.8 million during the year ended December 31, 2008. In 2009, the Company expects to record an additional $1.9 million of restructuring charges associated with the restructuring efforts announced in the third quarter of 2008 and approximately $60 million to $80 million associated with the restructuring efforts announced in the first quarter of 2009. Restructuring charges relate mainly to employee termination benefits as well as certain asset writeoffs and ceasing to use certain leased property.

Capital Management

Fundamental to supporting the Company’s business model is its ability to underwrite business, which is largely dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company is further downgraded, its ability to write business as well as its financial condition and/or results of operations, could be materially adversely affected. See Item 1, “Business – Ratings” for further information regarding recent rating actions by the various rating agencies, as well as details regarding the Company’s financial strength and debt ratings.

In relation to the Company’s capital position, several activities occurred throughout 2008 and early 2009, including the following:

 

 

 

 

In order to fund payments under the Master Agreement described above, in August 2008, the Company raised approximately $2.8 billion of additional capital through an issuance of both ordinary shares and equity security units (the “ESUs”). The ESUs consist of: (i) forward purchase contracts to purchase, and the Company to issue, its ordinary shares and (ii) debt securities. For further details relating to the Master Agreement, see Note 4 to the Consolidated Financial Statements, “Syncora Holdings Ltd. (“Syncora”).”

 

 

 

 

In addition to the payments to Syncora, the Company used the net proceeds from the offerings for general corporate purposes, and the redemption of X.L. America, Inc.’s $255 million 6.58% Guaranteed Senior Notes due April 2011 (the “6.58% Notes”) and capital funding of certain of the Company’s subsidiaries.

 

 

 

 

Concurrent with the closing of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent capital facility entered into in July 2003 resulting in net proceeds to the Company of approximately $500.0 million in exchange for the issuance by the Company of 20,000,000 redeemable Series C Preference Ordinary Shares. On February 27, 2009, the Company initiated a cash tender offer for all of the outstanding Series C Preference Shares. See “ – Capital Resources” below for further details relating to the redeemable Series C Preference Ordinary Shares.

 

 

 

 

In July 2008, the Board of Directors approved a reduction in the quarterly dividend payable on the Company’s Class A Ordinary Shares to $0.19 per ordinary share beginning with the quarterly dividend paid in September 2008. In addition, in February 2009, the Board of Directors approved a further reduction in the quarterly dividend payable on the Company’s Class A Ordinary Shares to $0.10 per ordinary share beginning with the quarterly dividend payable in March 2009.

 

74


 

 

 

 

Following the settlement of the purchase contracts associated with the 7.0% Units in February 2009, the Company issued 11,461,080 Shares for net proceeds of approximately $743.1 million, which was used to retire the senior notes previously due February 2011 which had a fixed coupon of 5.25% (the “2011 Senior Notes”).

Other capital management initiatives undertaken in 2008 included the following:

 

 

 

 

Upon expiration of the Company’s quota share reinsurance treaty with Cyrus Re which reduced the Company’s catastrophe exposures, the Company, effective January 1, 2008, entered into a quota share reinsurance treaty with a newly-formed Bermuda reinsurance company, Cyrus Re II. Pursuant to the terms of the quota share reinsurance treaty, Cyrus Re II assumed a 10% cession of certain lines of property catastrophe reinsurance and retrocession business underwritten by certain operating subsidiaries of the Company for business that incepted between January 1, 2008 and July 1, 2008. In connection with such cessions, the Company paid Cyrus Re II reinsurance premium less a ceding commission, which included a reimbursement of direct acquisition expenses incurred by the Company as well as a commission to the Company for generating the business. The quota share reinsurance treaty also provided for a profit commission payable to the Company. Following the Company’s evaluation of its exposures and the current market conditions, Cyrus Re II was canceled and not renewed at December 31, 2008.

 

 

 

 

In the second quarter of 2008, the Company purchased additional reinsurance including several tranches of industry loss warranty contracts attaching at various levels. Such industry loss warranty contracts were short-term in nature and are not considered to be a permanent component of the Company’s long-term risk management strategy. In relation to catastrophe risk management, the Company considers the loss of capital due to a single large event and the loss of capital that would occur from multiple (but potentially smaller) events in any given year. The Company imposes a limit to catastrophe risk from any single loss in a given region/peril at a 1% exceedance probability. The Company manages its limits to a catastrophe risk from a single loss in a given peril/region at a 1% exceedance probability. Tier 1 limits which include natural catastrophes and other realistic disaster scenarios are targeted at a level not to exceed 15% of tangible shareholders equity, where Tier 2 limits, which include pandemic, longevity and country risk, are established at no more than half of Tier 1 limits. These target limits are established by a combination of commercially available models, internally developed probable maximum loss estimates and the judgment of management.

In addition to the above noted key priorities of the Company, other key focuses of management during the year ended December 31, 2008 included the following:

Operational Transformation Program

In 2008, the Company announced the commencement of a multiple year operational transformation program (the “Program”) within the Company’s Insurance segment that involved the planned transformation of numerous business processes and technology systems into a unified global architecture. However, in January 2009, following a review of this initiative and in light of the current economic climate, the Company refined the scope of the Program to focus on enhancing claims capabilities to strengthen and support the Insurance segment’s global claims operations.

Evaluation of the Impact of Credit Market Volatility on Core Underwriting Operations

In addition to the evaluation of the impact of the distressed credit and sub-prime markets on the Company’s investment portfolio, as discussed above, management has also completed detailed assessments of the exposure to these credit related issues in the core P&C insurance and reinsurance businesses, in particular the Insurance segment professional lines portfolio exposures through D&O and E&O policies. Actual policy notices as well as potential further notice activity that could arise from insureds that have been linked to sub-prime related matters are monitored on a monthly basis. Such notice activity is considered in establishing loss and loss expense reserves at each period end. In the Insurance segment, the Company has received a total of 56 policy notices associated with the 2007 report year and 71 policy notices associated with the 2008 report year. For 2007, 54% of gross limits are side-A and for 2008, 41% are side-A (direct coverage of directors and officers only).

75


During the reserve review process in the first quarter of 2008, the loss ratio for the 2008 reporting year was established to provide a provision for clash-type events such as the sub-prime crisis was increased by approximately 5 points over the 2007 clash loss ratio. This increase applied to standard professional lines including D&O, E&O and Fiduciary exposures where the sub-prime related notice activity has been concentrated. Notice activity during the remainder of 2008 was in line with expectations and no further adjustment was made to the loss ratio established in the first quarter. While loss reserves for professional lines in the 2007 and prior report years have developed favorably in the aggregate during 2008, it should be noted that included within this favorable development is strengthening of the 2007 report year reserves due to the uncertainty associated with sub-prime and credit-related notice activity.

Minor adjustments were made to the current year loss ratios and prior year reserves in the Reinsurance segment professional lines portfolio during the year ended December 31, 2008, reflecting updated claim activity. Such adjustments had less than a one point impact on the year-to-date loss ratio for the segment and the reserve strengthening in more recent underwriting years was more than offset by favorable development on older underwriting years within professional lines. Global credit events have also had an impact on the trade credit portfolio written in the European reinsurance operations and this is reflected in the 2008 loss ratios.

Foreign Exchange Exposure

In the normal course of business, the Company is exposed to foreign exchange fluctuations on various items on its financial statements, in particular investments, future policy benefit reserves and unpaid losses and loss expenses. This exposure also exists on certain inter-company balances, which are eliminated for consolidation purposes. The Company attempts to manage this economic exposure through matching foreign currency denominated liabilities with foreign currency denominated assets. While unrealized foreign exchange gains and losses on underwriting balances may be in certain instances reported in earnings, the offsetting unrealized gains and losses on invested assets are recorded as a separate component of shareholders’ equity, to the extent that the asset currency does not match that entity’s functional currency. This results in an accounting mismatch that will result in foreign exchange gains or loss in the consolidated statements of income depending on the movement in certain currencies. Management continues to focus on attempting to limit this type of exposure in the future.

Critical Accounting Policies and Estimates

The following are considered to be the Company’s critical accounting policies and estimates due to the judgments and uncertainties affecting the application of these policies and/or the likelihood that materially different amounts would be reported under different conditions or using different assumptions. If actual events differ significantly from the underlying assumptions or estimates applied for any or all of the accounting policies (either individually or in the aggregate), there could be a material adverse effect on the Company’s results of operations, financial condition and liquidity. These critical accounting policies have been discussed by management with the Audit Committee of the Company’s Board of Directors.

Other significant accounting policies are nevertheless important to an understanding of the Company’s Consolidated Financial Statements. Policies such as those related to revenue recognition, financial instruments and consolidation require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. See Item 8, Note 2 to the Consolidated Financial Statements, “Significant Accounting Policies.”

1) Unpaid Losses and Loss Expenses and Unpaid Loss and Loss Expenses Recoverable

As the Company earns premiums for the underwriting risks it assumes, it also establishes an estimate of the expected ultimate losses related to the premium. Loss reserves or unpaid losses and loss expenses are established due to the significant periods of time that may lapse between the occurrence, reporting and settlement of a loss. The process of establishing reserves for unpaid property and casualty claims can be complex and is subject to considerable variability, as it requires the use of informed estimates and judgments. These estimates and judgments are based on numerous factors, and may be revised as additional

76


experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. Loss reserves include:

 

(a)

 

 

 

Case reserves – reserves for reported losses and loss expenses that have not yet been settled; and

 

(b)

 

 

 

IBNR losses.

Case reserves for the Company’s property and casualty operations are established by management based on amounts reported from insureds or ceding companies and consultation with legal counsel, and represent the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company. The method of establishing case reserves for reported claims differs among the Company’s operations.

With respect to the Company’s insurance operations, the Company is notified of insured losses and records a case reserve for the estimated amount of the settlement, if any. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of legal counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. With respect to the Company’s reinsurance operations, case reserves for reported claims are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the estimated ultimate cost of a loss. The uncertainty in the reserving process for reinsurers is due, in part, to the time lags inherent in reporting from the original claimant to the primary insurer to the reinsurer. As a predominantly broker market reinsurer for both excess-of-loss and proportional contracts, the Company is subject to a potential additional time lag in the receipt of information as the primary insurer reports to the broker who in turn reports to the Company. As of December 31, 2008, the Company did not have any significant backlog related to its processing of assumed reinsurance information.

Since the Company relies on information regarding paid losses, case reserves and IBNR provided by ceding companies in order to assist it in estimating its liability for unpaid losses and LAE, the Company maintains certain procedures in order to help determine the completeness and accuracy of such information. Periodically, management assesses the reporting activities of these companies on the basis of qualitative and quantitative criteria. In addition to conferring with ceding companies or brokers on claims matters, the Company’s claims personnel conduct periodic audits of specific claims and the overall claims procedures of its ceding companies at their offices. The Company relies on its ability to effectively monitor the claims handling and claims reserving practices of ceding companies in order to help establish the proper reinsurance premium for reinsurance agreements and to establish proper loss reserves. Disputes with ceding companies have been rare and generally have been resolved through negotiation.

As noted above, case reserves for the Company’s reinsurance operations are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the Company’s estimated ultimate cost of a loss. In addition to information received from ceding companies on reported claims, the Company also utilizes information on the pattern of ceding company loss reporting and loss settlements from previous catastrophic events in order to estimate the Company’s ultimate liability related to these hurricane loss events. Commercial catastrophe model analyses and zonal aggregate exposures are utilized to assess potential client loss before and after an event. Initial cedant loss reports are generally obtained shortly after a catastrophic event, with subsequent updates received as new information becomes available. The Company actively requests loss updates from cedants periodically for the first year following an event. The Company’s claim settlement processes also incorporate an update to the total loss reserve at the time a claim payment is made to a ceding company.

While the reliance on loss reports from ceding companies may increase the level of uncertainty associated with the estimation of total loss reserves for property reinsurance relative to direct property insurance, there are several factors which serve to reduce the uncertainty in loss reserve estimates for property reinsurance. First, for large natural catastrophe events such as Hurricane Ike, aggregate limits in property catastrophe reinsurance contracts are generally fully exhausted by the loss reserve estimates. Second, as a reinsurer, the Company has access to information from a broad cross section of the insurance industry. The Company utilizes such information in order to perform consistency checks on the data provided by ceding companies and is able to identify trends in loss reporting and settlement activity and incorporate such information in its estimate of IBNR reserves. Finally, the Company also supplements the

77


loss information received from cedants with loss estimates developed by market share techniques and/or from third party catastrophe models applied to exposure data supplied by cedants.

With respect to the Company’s financial lines operations, financial guarantee claims incurred on policies written on an insurance basis are established consistent with the Company’s insurance operations and financial guarantee claims incurred on policies written on a reinsurance basis are established consistent with the Company’s reinsurance operations.

IBNR reserves represent management’s best estimate, at a given point in time, of the amount in excess of case reserves that is needed for the future settlement and loss adjustment costs associated with claims incurred. It is possible that the ultimate liability may differ materially from these estimates. Because the ultimate amount of unpaid losses and LAE is uncertain, the Company believes that quantitative techniques to estimate these amounts are enhanced by professional and managerial judgment. Management reviews the IBNR estimates produced by the Company’s actuaries and determines its best estimate of the liabilities to record in the Company’s financial statements. The Company considers this single point estimate to be one that has an equal likelihood of developing a redundancy or deficiency as the loss experience matures.

IBNR reserves are estimated by the Company’s actuaries using several standard actuarial methodologies including the loss ratio method, the loss development or chain ladder method, the Bornhuetter-Ferguson (“BF”) method and frequency and severity approaches. IBNR related to a specific event may be based on the Company’s estimated exposure to an industry loss and may include the use of catastrophe modeling software. On a quarterly basis, IBNR reserves are reviewed by the Company’s actuaries, and are adjusted as new information becomes available. Any such adjustments are accounted for as changes in estimates and are reflected in the results of operations in the period in which they are made.

The Company’s actuaries utilize one set of assumptions in determining its single point estimate, which includes actual loss data, loss development factors, loss ratios, reported claim frequency and severity. The actuarial reviews and documentation are completed in accordance with professional actuarial standards appropriate to the jurisdictions where the business is written. The selected assumptions reflect the actuary’s judgment based on historical data and experience combined with information concerning current underwriting, economic, judicial, regulatory and other influences on ultimate claim settlements.

When estimating IBNR reserves, each of the Company’s insurance and reinsurance business units segregate business into exposure classes (over 150 classes are reviewed in total). Within each class, the business is further segregated by either the year in which the contract incepted (“underwriting year”), the year in which the claim occurred (“accident year”), or the year in which the claim is reported (“report year”). The majority of the Insurance segment is reviewed on an accident year basis. Professional lines insurance business is reviewed on a report year basis due to the claims made nature of the underlying policies. The majority of the Reinsurance segment is reviewed on an underwriting year basis.

Generally, initial actuarial estimates of IBNR reserves not related to a specific event are based on the loss ratio method applied to each class of business. Actual paid losses and case reserves (“reported losses”) are subtracted from expected ultimate losses to determine IBNR reserves. The initial expected ultimate losses involve management judgment and are based on historical information for that class of business; which includes loss ratios, market conditions, changes in pricing and conditions, underwriting changes, changes in claims emergence, and other factors that may influence expected ultimate losses.

Over time, as a greater number of claims are reported, actuarial estimates of IBNR are based on the BF and loss development techniques. The BF method utilizes actual loss data and the expected patterns of loss emergence, combined with an initial expectation of ultimate losses to determine an estimate of ultimate losses. This method may be appropriate when there is limited actual loss data and a relatively less stable pattern of loss emergence. The chain ladder method utilizes actual loss and expected patterns of loss emergence to determine an estimate of ultimate losses that is independent of the initial expectation of ultimate losses. This method may be appropriate when there is a relatively stable pattern of loss emergence and a relatively larger number of reported claims. Multiple estimates of ultimate losses using a variety of actuarial methods are calculated for many, but not all, of the Company’s (150+) classes of business for each year of loss experience. The Company’s actuaries look at each class and determine the most appropriate point estimate based on the characteristics of the particular class and other relevant factors, such as historical ultimate loss ratios, the presence of individual large losses, and known occurrences that have

78


not yet resulted in reported losses. Once the Company’s actuaries make their determination of the most appropriate point estimate for each class, this information is aggregated and presented to management for review and approval.

The pattern of loss emergence is determined using actuarial analysis, including judgment, and is based on the historical patterns of the recording of paid and reported losses by the Company, as well as industry information. Information that may cause historical patterns to differ from future patterns is considered and reflected in expected patterns as appropriate. For property, marine and aviation insurance, losses are generally reported within 2 to 3 years from the beginning of the accident year. For casualty insurance, loss emergence patterns can vary from 3 years to over 20 years depending on the type of business. For other insurance, loss emergence patterns fall between the property and casualty insurance. For reinsurance business, loss reporting lags the corresponding insurance classes by at least one quarter due to the need for loss information to flow from the ceding companies to the Company generally via reinsurance intermediaries. Such lags in loss reporting are reflected in the actuary’s selections of loss reporting patterns used in establishing the Company’s reserves.

Such estimates are not precise because, among other things, they are based on predictions of future developments and estimates of future trends in claim severity, claim frequency, and other issues. In the process of estimating IBNR reserves, provisions for economic inflation and changes in the social and legal environment are considered, but involve considerable judgment. When estimating IBNR reserves, more judgement is typically required for lines of business with longer loss emergence patterns.

Due to the low frequency and high severity nature of some of the business underwritten by the Company, the Company’s reserve estimates are highly dependent on actuarial and management judgment and are therefore uncertain. In property classes, there can be additional uncertainty in loss estimation related to large catastrophe events. With wind events, such as hurricanes, the damage assessment process may take more than a year. The cost of claims is subject to volatility due to supply shortages for construction materials and labor. In the case of earthquakes, the damage assessment process may take several years as buildings are discovered to have structural weaknesses not initially detected. The uncertainty inherent in IBNR reserve estimates is particularly pronounced for casualty coverages, such as excess liability, professional liability coverages, and workers compensation, where information emerges relatively slowly over time.

The Company’s three types of property and casualty reserve exposure with the longest tails are:

 

(1)

 

 

 

high layer excess casualty insurance;

 

(2)

 

 

 

casualty reinsurance; and

 

(3)

 

 

 

discontinued asbestos and long-tail environmental business.

Certain aspects of the Company’s casualty operations complicate the actuarial process for establishing reserves. Certain casualty business written by the Company’s insurance operations is high layer excess casualty business, meaning that the Company’s liability attaches after large deductibles including self insurance or insurance from sources other than the Company. The Company commenced writing this type of business in 1986 and issued policies in forms that were different from traditional policies used by the industry at that time. Initially, there was a lack of industry data available for this type of business. Consequently, the basis for establishing loss reserves by the Company for this type of business was largely judgmental and based upon the Company’s own reported loss experience which was used as basis for determining ultimate losses, and therefore IBNR reserves. Over time, the amount of available historical loss experience data has increased. As a result, the Company has obtained a larger statistical base to assist in establishing reserves for these excess casualty insurance claims.

High layer excess casualty insurance claims typically involve claims relating to (i) a “shock loss” such as an explosion or transportation accident causing severe damage to persons and/or property over a short period of time, (ii) a “non-shock” loss where a large number of claimants are exposed to injurious conditions over a longer period of time, such as exposure to chemicals or pharmaceuticals or (iii) a professional liability loss such as a medical malpractice claim. In each case, these claims are ultimately settled following extensive negotiations and legal proceedings. This process can typically take 5 to 15 years following the date of loss.

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Reinsurance operations by their nature add further complications to the reserving process, particularly for casualty business written, in that there is an inherent lag in the timing and reporting of a loss event from an insured or ceding company to the reinsurer. This reporting lag creates an even longer period of time between the policy inception and when a claim is finally settled. As a result, more judgment is required to establish reserves for ultimate claims in the Company’s reinsurance operations.

In the Company’s reinsurance operations, case reserves for reported claims are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the Company’s estimated ultimate cost of a loss.

Casualty reinsurance business involves reserving methods that generally include historical aggregated claim information as reported by ceding companies, combined with the results of claims and underwriting reviews of a sample of the ceding company’s claims and underwriting files. Therefore, the Company does not always receive detailed claim information for this line of business.

Discontinued asbestos and long-tail environment business had been previously written by NAC Re Corp. (now known as XL Reinsurance America Inc.), prior to its acquisition by the Company. As at December 31, 2008, total gross unpaid losses and loss expenses in respect of this business represented less than 1% of unpaid losses and loss expenses.

Except for certain workers’ compensation liabilities (including long-term disability), the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation unpaid losses that are considered fixed and determinable. For further discussion see the Consolidated Financial Statements.

Loss and loss expenses are charged to income as they are incurred. These charges include loss and loss expense payments and any changes in case and IBNR reserves. During the loss settlement period, additional facts regarding claims are reported. As these additional facts are reported, it may be necessary to increase or decrease the unpaid losses and loss expense reserves. The actual final liability may be significantly different than prior estimates.

As noted above, management reviews the IBNR estimates produced by the Company’s actuaries and determines its best estimate of the liabilities to record in the Company’s financial statements. The Company considers this single point estimate to be one that has an equal likelihood of developing a redundancy or deficiency as the loss experience matures. Management believes that the actuarial methods utilized adequately provide for loss development.

Management does not build in a provision for uncertainty outside of the estimates prepared by the Company’s actuaries.

The Company’s net unpaid losses and losses expenses (excluding, in 2007, financial guarantee reserves related to reinsurance agreements with Syncora that are recorded within “Net loss from operating affiliates”) relating to the Company’s operating segments at December 31, 2008 and 2007 was as follows:

 

 

 

 

 

(U.S. dollars in millions)

 

December 31,
2008

 

December 31,
2007

Insurance

 

 

$

 

11,126

   

 

$

 

11,138

 

Reinsurance

 

 

 

6,559

   

 

 

7,053

 

 

 

 

 

 

Net unpaid loss and loss expense reserves

 

 

$

 

17,685

   

 

$

 

18,191

 

 

 

 

 

 

80


 

 

 

 

 

 

 

(U.S. dollars in millions)

 

Net Unpaid Losses and Loss Expenses
as at December 31, 2008

 

Case
Reserves

 

IBNR
Reserves

 

Total
Reserves

Insurance

 

 

 

 

 

 

Casualty – professional lines.

 

 

$

 

1,558

   

 

$

 

2,764

   

 

$

 

4,322

 

Casualty – other lines

 

 

 

1,551

   

 

 

2,190

   

 

 

3,741

 

Property catastrophe (1)

 

 

 

9

   

 

 

14

   

 

 

23

 

Other property

 

 

 

482

   

 

 

119

   

 

 

601

 

Marine, energy, aviation, and satellite

 

 

 

635

   

 

 

534

   

 

 

1,169

 

Other specialty lines (2)

 

 

 

341

   

 

 

500

   

 

 

841

 

Other (3)

 

 

 

233

   

 

 

146

   

 

 

379

 

Structured Indemnity

 

 

 

(7

)

 

 

 

 

57

   

 

 

50

 

 

 

 

 

 

 

 

Total

 

 

$

 

4,802

   

 

$

 

6,324

   

 

$

 

11,126

 

 

 

 

 

 

 

 

Reinsurance

 

 

 

 

 

 

Casualty (4)

 

 

$

 

1,715

   

 

$

 

2,427

   

 

$

 

4,142

 

Property catastrophe (1)

 

 

 

157

   

 

 

148

   

 

 

305

 

Other property

 

 

 

535

   

 

 

427

   

 

 

962

 

Marine, energy, aviation, and satellite

 

 

 

443

   

 

 

72

   

 

 

515

 

Other (3)

 

 

 

256

   

 

 

301

   

 

 

557

 

Structured Indemnity

 

 

 

   

 

 

78

   

 

 

78

 

 

 

 

 

 

 

 

Total

 

 

$

 

3,106

   

 

$

 

3,453

   

 

$

 

6,559