ITEM 1. BUSINESS
History
XL Capital Ltd, together with its subsidiaries (the “Company” or “XL”), is a leading provider of insurance and reinsurance coverages and financial products and services 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 was renamed EXEL Limited on that date.
EXEL Limited and Mid Ocean are companies that were incorporated in the Cayman Islands in 1986 and 1992, respectively. At a special general meeting held on February 1, 1999, the shareholders of the Company approved a resolution changing the name of the Company to XL Capital Ltd.
On June 18, 1999, XL Capital Ltd merged with NAC Re Corp (“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”). Accordingly, all financial information for the 1998 and 1999 fiscal years, contained in this document includes the results of NAC as though it had always been a part of the Company. 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 completed the acquisition of certain Winterthur International insurance operations (“Winterthur International”) to extend its predominantly North American based large corporate insurance business globally. This was an all-cash transaction preliminarily valued at approximately $405.6 million. The preliminary purchase price of the acquisition was based on audited financial statements as at December 31, 2000 for the business being acquired, and is subject to adjustment based on the audited June 30, 2001 financial statements of Winterthur International, which are expected to be completed in 2003. Results of operations of Winterthur International have been included from July 1, 2001, the date from which the economic interest was transferred to the Company. In 2003, the Company rebranded the acquired Winterthur International operations “XL Global Risk”. See further information under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
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. Le Mans Ré underwrites a worldwide portfolio comprising most classes of property and casualty reinsurance business, together with a selective portfolio of life reinsurance business. The remaining 33% ownership is held by Les Mutuelles du Mans Assurances Group (“MMA”). The Company has an option to buy the remaining shares from MMA for approximately $138.5 million in cash on December 13, 2003. The Company currently intends to exercise its option. Due to certain contractual arrangements between the Company and MMA, MMA does not have any economic interest in the earnings of Le Mans Ré with effect from January 1, 2002 and accordingly, no minority interest was recorded in 2002. See further information under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 6 (a) to the Consolidated Financial Statements.
Insurance Operations
General
The Company provides commercial property and casualty insurance products on a global basis. Products generally provide tailored coverages for complex corporate risks and are divided into two categories: risk management products and specialty products.
Risk management products comprise global property and casualty insurance programs for large multinational companies including umbrella liability, products recall, integrated risk and primary master
property and liability coverages. Risk management products generally provide large capacity on a primary, quota share and excess of loss basis. In North America, casualty business written is generally long tail, umbrella and high layer excess business meaning that the Company’s liability is after large deductibles, including self insurance or insurance from sources other than the Company. Internationally, casualty business is also written on a primary basis. Policies are written on both an occurrence and claims made basis. The Company’s property business written is primarily short tail in nature and written on both a primary and excess of loss basis. Risk management products 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.
Specialty lines products include directors and officers liability insurance, environmental liability insurance, political risk insurance, professional liability insurance, aviation and satellite insurance, employment practices liability insurance, surety, marine and energy insurance, specie, bloodstock and other insurance covers including program business.
Directors and officers coverage includes primary and excess directors and officers liability, employment practices liability, company securities, and private company directors and officers liability. Policies are written on both a primary and excess claims-made basis, and professional liability errors and omissions risks are generally written on an excess basis. Products are targeted to Fortune International 1000 companies and medium sized firms.
Environmental liability products include contractor’s pollution liability, pollution and remediation legal liability, general and project-specific pollution and professional liability, commercial general liability for chemical risk and commercial property redevelopment. Business is written for both single and multiple years on a primary and excess claims-made basis. Targeted industries include chemical facilities, construction, environmental service firms, healthcare facilities, manufacturing facilities, real estate, transportation, and architects and engineers.
Political risk insurance generally covers risks arising from expropriation, currency inconvertibility and war or political violence. Political risk insurance is typically provided to financial institutions, equity investors, export credit agencies and multilateral agencies in connection with direct and other types of investments in emerging market countries.
Aviation and satellite products include comprehensive airline hull and liabilities, 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. 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 airports, airlines, corporate jet fleets and telecommunication firms.
Marine and offshore energy, specie and bloodstock insurance is provided by the Company. Marine and energy coverage includes marine hull and machinery, marine liability, cargo and offshore energy insurance. Specie products are highly specialized classes of insurance for the protection of fine arts and other high value items. Bloodstock products specialize in providing equine/livestock insurance.
The Company’s program business specializes in insurance coverages for distinct market segments in the North American region. The program business manages program administrators and managing general agents who operate in a specialized market niche and have unique industry backgrounds or specialized underwriting needs. Products encompass automobile warranty, intellectual property and trademark infringement and property and casualty coverages.
Business is also written on a broad range of surety products and services throughout North America, with a focus on contract, commercial and international trade surety bonds, targeting all segments of the construction marketplace. Surety products include bid, performance, payment, maintenance and supply bonds, commercial surety bonds, U.S. customs and international trade surety bonds, license, permit bonds, court bonds, public official bonds and other miscellaneous bonds.
The Terrorism Risk Insurance Act of 2002 (“TRIA”) became effective on November 26, 2002 and is a three-year federal program effective through 2005. TRIA voided in force terrorism exclusions as of November 26, 2002 for certified terrorism acts (i.e. those arising from international, not domestic, acts) on all TRIA specified property and casualty business. TRIA requires covered insurers to make coverage available for certified acts of terrorism on all new and renewal policies issued after TRIA was enacted. TRIA allows the Company to assess a premium charge for terrorism coverage and, if the policyholder declines the coverage or fails to pay the buy-back premium, certified acts of terrorism may then be excluded from the policy, subject, however, to state specific requirements such as mandatory coverage for fire losses in statutory fire policy states. Subject to a premium-based deductible, and provided
the Company has otherwise complied with all the requirements as specified in TRIA, the Company is eligible for reimbursement by the Federal Government for 90% in 2003 of its covered terrorism related losses arising from a certified terrorist attack, with such reimbursement ending once the aggregated insured losses for the entire insurance industry exceed $100 billion in a single program year. Once this $100 billion loss threshold has been reached for any program year, any insurer covered under TRIA that has met its deductible will not be responsible for any further loss payments in that program year.
The Company had, prior to the passage of the TRIA, underwritten exposures under certain insurance policies that included coverage for terrorism. The passage of TRIA has required the Company to make a mandatory offer of “Certified” terrorism coverage with respect to all of its TRIA covered insurance companies. In addition, the Company underwrites a limited number of policies providing terrorism coverage that would not be subject to TRIA.
The excess nature of many of the Company’s insurance products, coupled with historically large policy limits, creates a book of business that is classified 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 using strict underwriting guidelines and various reinsurance arrangements, discussed below.
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 an individual insurance contract through terms and conditions, policy limits and sub-limits, attachment points, and facultative and treaty reinsurance arrangements on certain types of risks.
Underwriters generally evaluate each industry category and sub-groups 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.
Underwriting and loss experience is reviewed regularly for 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 an excess and a primary basis, typically on occurrence-reported or claims-made policy forms. Policies typically cover occurrences causing unexpected and unintended personal injury or property damage to third parties arising from events or conditions which commence at or subsequent to an inception date, or retroactive date, if applicable (but not prior to January 1, 1986), 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 sub-limits for coverage in critical earthquake zones.
Reinsurance Ceded
In certain cases, the risks assumed by the Company are partially reinsured with third party reinsurers. Reinsurance ceded varies by location and line of business based on factors including, among others, market conditions. The benefits of ceding risks to other reinsurers include reducing exposure on individual risks, protecting against catastrophic risks and maintaining acceptable capital ratios. Reinsurance ceded does not legally discharge the Company from its liabilities in respect of the risk being reinsured.
The Company uses reinsurance to support the underwriting and retention guidelines of each entity 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 of groups of companies. See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operation”.
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 from general operations, by line of business for the year ended December 31, 2002:
(U.S. dollars in thousands)
______________
(1) In 2002, the Company exited certain European accident and health and employee benefits books of business as these lines were not in line with the Company’s overall strategy.
(2) Other insurance premiums written and earned include political risk, surety, bonding, warranty and other lines.
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 3 to the Consolidated Financial Statements.
Competition
The Company competes globally in the property and casualty markets. Its competitors include
the following companies and their affiliates: ACE Limited (“ACE”); American International Group, Inc. (“AIG”); Hartford Financial Services; Lloyd’s of London Syndicates (“Lloyd’s”); Munchener Ruckversicherungs-Gesellschaft Aktiengesellschaft (“Munich Re”); Swiss Reinsurance Company (“Swiss Re”); The Chubb Corporation (“Chubb”); The St. Paul Companies, Inc. (“St. Paul”) and Zurich Financial Services Group.
The Company’s major geographical markets for its property and casualty insurance operations are North America and Europe. The Company’s main competitors in each of these markets include the following:
North America - AIG, ACE, Chubb, Zurich Financial Services Group, Travelers Property Casualty Corp., St. Paul; CNA Financial Corporation, Hartford Financial Services, Factory Mutual Insurance Company and Lloyd’s.
Europe - Allianz Aktiengesellschaft, AIG, Zurich Financial Services Group, AXA, Munich Re, The ACE Group of Companies, Lloyd’s, and Swiss Re.
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Current Outlook” for further discussion of current market conditions.
Marketing and Distribution
Clients are referred to the Company through a large number of brokers and captive managers who receive from the insured or ceding company a set fee or brokerage commission usually equal to a percentage of gross premiums.
In addition, the Company enters into contingent commission arrangements with some intermediaries that provides for the payment of additional commissions based on such variables as production of new and renewal business or the retention of business.
In general, the Company is not committed to accept business from any particular broker, and brokers do not have the authority to bind the Company, except in the case where underwriting authority may be delegated to selected administrators. These administrators are subject to a due diligence financial and operational review prior to any delegation of authority and ongoing reviews are carried out as deemed necessary. See Item 8, Note 18(a) to the Consolidated Financial Statements for information on the Company’s major brokers.
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 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 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 bureaus and the leading syndicate advise movement in loss reserves to all syndicates participating on the risk. A claims department may adjust the case reserves it records from those advised by the bureaus as deemed necessary.
Reinsurance Operations
General
The Company provides casualty, property, accident and health, other specialty reinsurance, and life products on a global basis with business being written on both a proportional and excess of loss basis. This reinsurance may be written on a treaty or facultative basis.
The Company’s casualty reinsurance includes general liability, professional liability, automobile and workers’ compensation. Other specialty reinsurance products include marine and energy, aviation and fidelity, surety and political risk. Business written on an excess of loss basis generally indemnifies a ceding company for a portion of the losses on policies in excess of a specified loss amount. For business written on a proportional basis, the Company receives an agreed percentage of the premium and is liable for the same percentage of the incurred losses of the ceding company as specified in the treaty of each risk of the reinsured class. The ceding company receives a commission based upon premiums ceded and may also, under certain circumstances, receive a profit commission.
The Company’s property business is primarily short-tail in nature and includes property catastrophe, property excess of loss and property proportional. A significant portion of 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 and 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 exposures to catastrophic events by limiting the amount of exposure in each geographic zone worldwide and requiring that its property catastrophe contracts provide for aggregate limits and include varying attachment points. The Company also seeks to protect its aggregate exposures by peril and zone through the purchase of reinsurance programs. See “-Risk Management” for further information.
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 windstorms, earthquakes, freezing, riots, floods, industrial explosions, fires, and many other potential disasters. In accordance with market practice, the Company’s policies generally exclude certain risks such as war, nuclear contamination or radiation and, following the September 11 event, terrorism cover is also excluded in many territories and classes. The Company’s predominant exposure under such coverage is to property damage.
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 one reinstatement to be purchased by the reinsured.
The Company also writes property risk excess of loss reinsurance. Risk excess of loss reinsurance covers a loss of 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 business through extensive use of occurrence and cession limits.
The Company had, prior to the passing of the TRIA, underwritten reinsurance exposures in the U.S. that include terrorism coverage. Since the passage of the TRIA in the U.S., 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., the Company excludes coverage included under the TRIA in addition to nuclear, biological and chemical (“NBC”) acts 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 NBC, or a similar clause that excludes terrorism completely.
The Company’s accident and health products include accidental death, medical, hospital indemnity and income protection coverages.
The Company underwrites a small portfolio of contracts covering political risk and trade credit with much of the exposure being derived from one cedant. Additional exposure is assumed from a limited number of trade credit contracts (which focus on OECD economies and may include some political risk exposures) and through Lloyd’s quota shares. In addition, there are run off exposures from discontinued writings in the Company’s marine portfolio.
The Company’s reinsurance segment also writes life reinsurance which is primarily European life reinsurance. This includes term assurances, group life, critical illness cover, immediate annuities and disability income business. The majority of the business written is on a proportional basis, meaning the Company receives a specified percentage of the premiums and risks assumed for each contract. The Company has also written a few significant contracts of portfolios of closed blocks of U.K. and European annuities. In certain of these contracts, the Company receives cash and investment assets at the inception of the contract relating to future policy benefit reserves assumed. These contracts are long term in nature where the expected claims payout period can span thirty to forty years.
Underwriting
Underwriting risks for the general and life reinsurance business are evaluated using a number of factors including the type and layer of risk to be assumed, the actuarial evaluation of premium adequacy, the cedent’s underwriting and claims experience, the cedent’s financial condition and claims paying rating, the exposure and or experience with the cedent, and the line of business to be underwritten.
In addition, the Company assesses a variety of other factors, including the reputation of the proposed cedent, the geographic area in which the cedent does business and its market share, a detailed assessment of catastrophe and risk exposures, and historical loss data for the cedent and, where available, for the industry as a whole in the relevant regions, in order to compare the cedent’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 cedent’s underwriting operations.
For the 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 zones such that a single occurrence, for example an earthquake or hurricane, generally should not affect more than one peril zone. While the exposure to multiple zones is considered remote for the peril of hurricane, the Company does manage its aggregates for such a scenario. The definition of the Company’s peril zones is subject to periodic review and change. 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 Ceded
In certain cases, the risks assumed by the Company are partially reinsured with third party reinsurers. Reinsurance ceded varies by location and line of business based on factors including, among others, market conditions. The benefits of ceding risks to other reinsurers include reducing exposure on individual risks, protecting against catastrophic risks and maintaining acceptable capital ratios. Reinsurance ceded does not legally discharge the Company from its liabilities in respect of the risk being reinsured.
The Company uses reinsurance to support the underwriting and retention guidelines of each reinsurance subsidiary as well as to seek 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.
A corporate multi-year program is purchased for a significant portion of the Company’s global property exposures. This protection gives total limits in various layers and excess of varying attachment points according to territorial exposure. The Company has co-reinsurance retentions within this program. In addition, the balance of property exposures are protected by a traditional excess of loss program. The Company’s casualty reinsurance program covers multiple claims arising from two or more risks from a single occurrence or event. In addition, the Company had coverage from 1997 through 2002 in the event that the accident year loss and loss expense ratio (primarily for its North American business) exceeded a pre-determined amount, with coverage up to specified limits. The Company also buys specific reinsurance on its marine and aviation portfolios to manage its net exposures in these classes. For the
Company’s life
reinsurance operations, business is essentially written within prescribed retention limits where minimal use is made of reinsurance. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 11 to the Consolidated Financial Statements 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 from general and life operations, by line of business for the year ended December 31, 2002:
(U.S. dollars in thousands)
______________
(1) Other reinsurance premiums written and earned include political risk, surety, bonding, warranty and other lines.
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 3 to the Consolidated Financial Statements.
Competition
The Company competes globally in the property and casualty markets. Its competitors include the following companies and their affiliates: ACE; AIG; Chubb; Hartford Financial Services; Lloyd’s; Munich Re; St. Paul; Swiss Re; and Zurich Financial Services Group.
The Company’s major geographical markets for its property and casualty general reinsurance operations are North America and Europe. The main competitors in each of these markets include the following:
North America - General Re Corporation, American Re Corporation, Employers Reinsurance Corporation, Swiss Re, America Corporation, Transatlantic Reinsurance Company, Everest Re Group Ltd, GE Reinsurance Corp., Munich Re, Hartford Financial Services, ERC Frankona Rueckverischerungs Aktien Gesellschaft (“ERC Frankona”), Lloyd’s and PartnerRe Ltd.
Europe - Munich Re, Swiss Re, Lloyd’s, General Cologne Re, SCOR Reinsurance Company, PartnerRe Ltd and ERC Frankona.
The Company’s major geographical market for its life reinsurance operations is Europe and the main competitors in this market include the Reinsurance Group of America, Inc., Munich Re, ERC Frankona, General Cologne Re, Swiss Re and Hannover Life Re.
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Current Outlook” for further discussion of current market conditions.
Marketing and Distribution
See “Marketing and Distribution” under Insurance Operations and Item 8, Note 18 (a) to the Consolidated Financial Statements. In addition, for life reinsurance operations, the majority of business is written directly with the ceding company rather than a broker.
Claims Administration
Claims management for the reinsurance operations includes the receipt of loss notifications, the establishment of loss reserves and approval of loss payments. Case reserves for reported claims are generally established based on reports received from ceding companies. Additionally, claims audits are conducted for specific claims and claims procedures at the offices of selected ceding companies.
Financial Products and Services Operations
General
The Company provides insurance, reinsurance, and derivative solutions for complex financial risks including financial guaranty insurance and reinsurance, weather and energy risk management products and institutional life products. Each of these transactions is unique and tailored to the specific needs of the insured or user. With the exception of certain weather and energy risk management business, these are typically multi-year transactions. Products may be sold in insurance or derivative form.
Financial guaranty insurance and reinsurance generally guarantees payments of interest and principal on an issuer’s obligations when due. Obligations guaranteed or enhanced by the Company range in duration and premiums are received either on an installment basis or up front. Guaranties written in credit default swap form provide coverage for losses upon the occurrence of specified credit events set forth in the swap documentation.
The Company classifies the financial guaranty policies underwritten in three categories: asset-backed obligations, municipal obligations and structured single risk obligations. Each category contains risks and structures that are unique to the underlying obligation. Asset-backed obligations insured or reinsured by the Company are generally issued in structured transactions backed by pools of assets of specified types, such as residential mortgages, auto loans and other consumer receivables, equipment leases and corporate debt obligations, having an ascertainable cash flow or market value. Municipal obligations insured or reinsured consist mainly of general or special obligations of state and local governments, supported by the issuer’s ability to charge fees for specified services or projects. Structured single risk obligations underwritten by the Company include essential infrastructure projects, such as
bridges, toll roads, airports and power plants, and obligations backed by receivables from the future sales of commodities or the processing of payments received by financial institutions.
The Company’s weather and energy risk management products are customized solutions designed to assist corporate customers, primarily energy companies and utilities, to manage their financial exposure to variations in underlying weather conditions. Weather risk management solutions generally average one season (five months) in duration. The Company attempts to hedge a significant portion of these risks written within the capital markets. Beginning in 2003, the Company intends to broaden the scope of the products it offers to include dual commodity or dual trigger products such as weather contingent gas and other energy risk management products such as outage and load shaping.
In 2002, the Company substantially completed the establishment of its institutional life platform and began to write municipal reinvestment contracts. See Item 8, Note 12 to the Consolidated Financial Statements. The Company expect to write business owned and life contracts and funding agreements in 2003. Also, in the fourth quarter of 2002, the Company assumed, through novation, certain blocks of U.S. based term life mortality reinsurance business from one of the Company’s insurance affiliates. In connection with this transaction, the Company received cash and investments equal to the amount of the future policy benefit reserves acquired. See Item 8, Note 27 to the Consolidated Financial Statements. This business is
managed separately from the life business written in the reinsurance segment in terms of the nature of the business and location of the risk.
Underwriting
The Company has underwriting guidelines for the various products and asset classes comprising the credit enhancement business, which include single and aggregate risk limitations on specified exposures. A credit committee provides final underwriting approval. The Company’s underwriting policy is to credit enhance obligations and exposures that would otherwise be rated in the lower investment grade categories, but also underwrites high non-investment grade risks. For the weather and energy business, the Company has both daily and seasonal value at risk (“VaR”) limits for weather exposures and daily VaR limits for natural gas exposures.
Municipal guaranteed reinvestment contracts are customized financial products that offer an investment return to the purchaser. The Company underwrites the cash flow risks associated with each contract and continually monitors each contract’s performance. The Company utilizes underwriting guidelines to assess risks and internal cash flow and asset liability models to price each contract. The Company focuses on reinvestment opportunities associated with municipal bond issuers in this segment.
Reinsurance Ceded
Similar to the Company as a whole, the financial products and services operations utilize outwards reinsurance for single risk and portfolio management purposes, particularly in its financial guaranty and life operations. The Company has retroceded risks on a facultative basis to third-party reinsurers to provide greater flexibility to manage large single risks and reduce concentrations in specific bond sectors or geographic regions. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 11 to the Consolidated Financial Statements for further information. For the weather and energy risk management business, the Company typically uses derivatives to hedge or mitigate its primary exposure.
Premiums
The following table is an analysis of the Financial Products and Services segment’s gross premiums written, net premiums written and net premiums earned from general and life operations for the year ended December 31, 2002:
(U.S. dollars in thousands)
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 3 to the Consolidated Financial Statements.
Competition
The principal competitors in the municipal and asset-backed insured markets include other AAA/Aaa rated and, to a lesser extent, AA/Aa rated monoline financial guarantors and multiline insurance companies and banks. These include MBIA Inc., Ambac Financial Group, Inc. (“Ambac”), and Financial Security Assurance Holdings Ltd (“FSA”). There are also many means by which issuers may borrow money without using third party credit enhancement. For example, structured financings may be executed by issuing senior and subordinated tranches of debt that effectively substitutes for third party enhancement. Additionally,
issuers may raise debt financing by issuing corporate debt or by borrowing from banks. Such alternatives effectively constitute a form of competition for financial guarantor insurance companies.
With respect to the Company’s municipal guaranteed reinvestment contract business, competitors includes financial institutions in the banking, investment banking, life insurance and financial guaranty industries. These include Aegon, AIG, Ambac, Bayerische Landesbank (BLB), Caisse des Depots et Consignations, FSA and MBIA Inc.
With respect to the Company’s weather and energy risk management business, competition is encountered in both the U.S. and on a worldwide basis from companies within the energy, insurance and, to an increasing extent, the financial services sector. Among the principal competitive factors affecting the Company’s weather and energy business are its financial strength ratings, its capability in originating, marketing and executing innovative products and services, its relative pricing, and its ability and willingness to hedge all or a portion of such risks.
Marketing and Distribution
Marketing of the Company’s financial guaranty business is targeted based on the type and stage of completion of the transaction. Targeted parties include investment bankers, issuers of and investors in credit-enhanced transactions and concessionaires in certain transactions. Other financial guaranty insurers or reinsurers or other counterparties may also be a source of new business.
With respect to the Company’s weather and energy risk management business, new clients are acquired through direct marketing but may also be referred through a number of brokers who receive a fee that is a function of the size of the transaction. The Company’s main clients have been in the energy and financial services sector. Guaranteed investment or municipal reinvestment contract business is mainly originated through specialized brokers.
See Item 8, Note 18 (a) to the Consolidated Financial Statements for further information.
Claims Administration
Claims management includes the identification of potential claims through systematic surveillance of the insured portfolio, the establishment of reserves for losses that are both probable and estimable, the accounting for loss adjustment expenses, the receipt of claims, the approval of claim payments and the notification to reinsurers. Surveillance also involves proactive efforts to prevent or mitigate potential claims once they are identified. If a claim is paid, recoveries will be sought based on the security pledged under the policy.
XL Financial Solutions
XL Financial Solutions (“XLFS”) functions as an internal joint venture among the Company’s three operating segments, and provides a wide range of financial products and finite transactions, including finite property and casualty insurance and reinsurance coverages, structured deposits and derivatives. Most transactions originated through XLFS are multi-year in nature, with many transactions having durations in excess of ten years. Generally, the underlying nature of the transaction determines the business segment in which the business it is written. Up to and including 2002, property and casualty business written is included in the reinsurance segment or the insurance segment, depending upon whether the customer is a reinsurance company or other type of entity, respectively. In 2003, XLFS expects to write non-property and casualty risks, including financial market and transactions that may be structured in derivative form, which will be included in the financial products and services segment.
Risk Management
The Company seeks to identify, assess, monitor and manage its market, credit, operational and legal risks in accordance with defined policies and procedures. The Company’s senior management takes an active role in the risk management process and has developed and implemented policies and procedures that require specific administrative and business functions to assist in the identification, assessment and control of various risks pertaining to the Company’s businesses. The Company recently formed a risk
management committee. This committee was established to, among other things, implement and track risk aggregates by category and class including credit, country, and region, analyze operational risks and recommend capacity allocations for the Company as a whole. Due to the changing nature of the global marketplace, the Company’s risk management policies, procedures and methodologies are constantly evolving and are subject to ongoing review and modification. See Item 7A, “Quantitative and Qualitative Disclosure About Market Risk” for further discussion.
Aggregate exposures to potential catastrophic losses are monitored at an entity level and also at the corporate level. In addition to internal controls designed to mitigate the Company’s exposure to a specific client, class of business or geographic exposure, the Company maintains various reinsurance programs that seek to protect the Company against foreseeable catastrophic and other types of risks.
Under its reinsurance security policy, the Company seeks to cede business to reinsurers generally rated A or better by Standard & Poor’s (“S&P”) or, in the case of Lloyd’s syndicates, S&P “Four Bells” and/or B+ from Moody’s Investor Service, Inc. (“Moody’s”). The Company’s Chief Credit Officer considers reinsurers that are not rated or do not fall within the above rating categories and may grant exceptions to the Company's general policy on a case-by-case basis. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 11 to the Consolidated Financial Statements for further information.
As part of risk management, the Company also has several credit committees that meet regularly to review the terms and conditions of proposed new transactions.
Unpaid Losses and Loss Expenses
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 and liquidity.
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 reflect 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 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. Conditions and trends that have affected development of liabilities in the past may not necessarily occur in the future. Accordingly, it is inappropriate to extrapolate future redundancies or deficiencies based upon historical experience. See generally Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Cautionary Note Regarding Forward-Looking Statements”.
The tables below present the development of unpaid loss and loss expense reserves related to the Company’s general operations 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 show the estimated liability, net of reinsurance recoveries, as at the 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 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 end of each succeeding year. The estimate changes as more in formation 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 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 CONSOLIDATED LOSS AND LOSS EXPENSE RESERVE DEVELOPMENT
NET OF REINSURANCE RECOVERIES
(U.S. dollars in millions)
______________
(1) See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion.
ANALYSIS OF CONSOLIDATED LOSS AND LOSS EXPENSE RESERVE DEVELOPMENT
GROSS OF REINSURANCE RECOVERABLES
(U.S. dollars in millions)
The following table presents an analysis of paid, unpaid and incurred losses and loss expenses for the Company’s general operations 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)
Current year net losses incurred
Current year net losses incurred in 2002 were $2.9 billion as compared to $2.7 billion in 2001. Current year net losses incurred in 2002 increased over 2001 primarily due to the inclusion of a full year of Winterthur International results (that had current year losses of $349.7 million), Le Mans Ré, consolidated with effect from January 1, 2002 (that had net losses incurred of approximately $167.0 million), and general growth of the Company’s operations. Partially offsetting these increases was a lower level of catastrophic and other loss events in 2002 as compared to 2001.
In 2001, current year net losses incurred included $760.0 million relating to the September 11 event, losses of $241.2 million relating to the Winterthur International operations (acquired with effect from July 1, 2001), catastrophic and other loss events, including the bankruptcy of Enron Corp., several satellite losses, the Toulouse, France petrochemical plant explosion, Tropical Storm Allison, the Petrobras oil rig loss in Brazil and several other European property losses, and other growth of the Company’s operations related to new business assumed.
Current year net losses incurred for 2000 included net reserve adjustments of $114.0 million to several unprofitable lines of insurance business that the Company exited, including trucking, inland energy and certain classes of aviation.
Prior year net losses incurred
The following tables present the development of the Company’s gross loss and loss expense reserves and loss and loss expense reserves net of reinsurance for its general operations. 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.
(U.S. dollars in millions)
As different reinsurance programs cover different underwriting years, contracts and lines of business, net and gross loss experience do not develop proportionately.
The following table presents the net adverse (favorable) prior year loss development of the Company’s loss and loss expense reserves for its general operations by each operating segment for each of the years indicated:
(U.S. dollars in millions)
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 10 to the Consolidated Financial Statements for further information regarding the significant developments in prior year loss reserve estimates for each of the years indicated within each of the Company’s operating segments.
Net loss reserves acquired
Net loss reserves acquired in 2002 related primarily to Le Mans Ré of $376.2 million consolidated as a subsidiary with effect from January 1, 2002. This was partially offset by the return by the Company of the accident and health business related to the Winterthur International acquisition back to the seller in June 2002 of approximately $190.0 million. Net loss reserves acquired in 2001 related primarily to the acquisition of Winterthur International. The Company has contractual post-closing protection with respect to adverse development of reserves, including unearned premium reserves, resulting from Winterthur International business written prior to July 1, 2001. Business in force at June 30, 2001 carries a maximum exposure to a combined ratio of 105%. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies” and Item 8, Note 6 (c) to the Consolidated Financial Statements for further information.
Exchange rate effects
Exchange rate effects on net loss reserves in 2002 and 2001 also related primarily to Winterthur International which has several operations where the functional currency is not the U.S. dollar. The reduction in the value of the U.S. dollar during 2002 and 2001 mainly compared to the Swiss Franc and Euro has given rise to translation and revaluation exchange movements of $552.2 million and $60.6 million in 2002 and 2001, respectively.
Net paid losses
Total net paid losses increased $1.0 billion to $2.8 billion in 2002. This increase is due to the inclusion of a full year of Winterthur International, which had approximately $786.0 million of net paid losses, the consolidation of Le Mans Ré and growth of the Company’s other operations. The increase in paid losses, related primarily to prior years, is due mainly to payments relating to loss reserves associated with the Winterthur International acquisition. At December 31, 2002, the Company had paid approximately 25% of its estimated ultimate losses relating to the September 11 event. This relatively low percentage is due to the size and complexity of the claims and the fact that approximately 60% of the Company’s ultimate incurred losses related to the reinsurance segment where there is an inherent lag between the timing of a loss event and when it is reported by the ceding company to the Company. See Item 8, Note 4 to the Consolidated Financial Statements.
The amount of paid losses increased in 2001 over 2000 due mainly to an increase in current year loss events and the inclusion of Winterthur International business from July 1, 2001.
Other loss related information
The Company’s net incurred losses and loss expenses included actual and estimates of potential non-recoveries from reinsurers. As at December 31, 2002 and 2001, the reserve for potential non-recoveries from reinsurers was $47.3 million and $49.7 million, respectively.
Except for certain workers’ compensation and long-term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation and long-term disability unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 7%. The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2002 and 2001 were $374.5 million and $231.0 million, respectively. The related discounted unpaid losses and loss expenses were $151.7 million and $98.0 million as of December 31, 2002 and 2001, respectively. The amount of the discount credit included in net losses and loss expenses incurred was $22.6 million and $9.1 million in 2002 and 2001, respectively.
Investments
Investment structure and strategy
The Company’s investment operations are managed centrally by the Company’s investment department which also provides certain investment advice and support for the rest of the Company’s operations. The Finance Committee of the Board of Directors approves the Company’s overall investment policy and guidelines and reviews the implementation of the investment strategy on a regular basis.
The primary goal of the investment strategy is to maximize investment returns taking into account market and credit risk in light of the Company’s business objectives of stable earnings growth and growth in long-term book value. Market risk is principally due to interest rate variability which the Company seeks to control through asset/ liability management and to a lesser extent due to the allocation to risk assets which the Company seeks to control through diversification. Credit risk arises from investments in corporate fixed income securities and is managed with aggregate and portfolio limits.
The Company’s overall investment portfolio is structured to take into account a number of variables including local regulatory requirements, business needs, collateral management and risk management. At December 31, 2002 and 2001, total investments and cash, less payable for investments purchased, managed by the investment department, were $20.0 billion and $14.4 billion, respectively.
Functionally, the Company’s investment portfolio is divided into three components. The largest component is the asset/liability portfolio supporting property and casualty and financial guaranty liabilities, which was approximately $11.9 billion and $9.6 billion at December 31, 2002 and 2001, respectively. The key focus for this component is asset and liability management and it is used to provide liquidity to settle claims arising from the Company’s property and casualty underwriting and financial products and services general operations. The asset/liability portfolio is made up entirely of investment grade fixed income securities comprising (i) deposits and regulatory holdings and (ii) actively managed portfolios.
The second component of the investment portfolio is the structured product portfolio, which was approximately $4.5 billion and $1.9 billion at December 31, 2002 and 2001, respectively. This portfolio consists of highly structured investment portfolios that support specific insurance and reinsurance transactions, e.g., deposit liability and future policy benefit reserves. Many of these transactions have underlying liabilities that pay out over the long term. As a result, asset and liability management is also a key focus for this portfolio. The structured product portfolio consists of actively managed investment grade fixed income securities that have a longer duration than the asset/liability portfolio discussed above.
The third component of the investment portfolio is the risk asset portfolio which was approximately $3.6 billion and $2.9 billion at December 31, 2002 and 2001, respectively. This portfolio is comprised of alternative investments, high yield fixed income, equity (public, private and collateralized debt obligations) and certain corporate investments. The risk asset portfolio is managed with a total return focus with an efficient utilization of risk and is intended to increase the Company’s book value over the long term.
The alternative investment portfolio, part of the risk asset portfolio, is a highly diversified portfolio of investments in limited partnerships and similar investment vehicles. For the vast majority of the portfolio, the Company owns minority investment interests that are accounted for under the equity method and included in the Consolidated Balance Sheet under “Investments in affiliates”. This portfolio was $1.3 billion and $0.8 billion at December 31, 2002 and 2001, respectively. See Item 8, Note 8 to the Consolidated Financial Statements.
Implementation of investment strategy
Although the Company’s investment department is responsible for implementation of the investment strategy, the day to day management of the investment portfolio is outsourced to investment management service providers. External investment managers are selected and monitored using a disciplined due diligence process, including input from external consultants. Each investment manager may manage one or more portfolios and is governed by a detailed set of investment guidelines including overall objectives, risk
parameters, and diversification requirements that fall within the overall guidelines discussed above. Compliance with investment guidelines is monitored on a regular basis by the investment department.
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.
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 market value weighted average using a linear credit rating scale similar to that used by Moody’s Investors Service, Inc. The highest credit rated fixed income securities are held within the asset/liability and structured product portfolios. Sub-investment grade (high yield) fixed income is held within the risk asset portfolio. The weighted average credit rating of the fixed income portfolio was Aa2/AA at December 31, 2002 and 2001.
The Company did not have an aggregate investment in a single entity, other than the U.S. Government, in excess of 10% of shareholders’ equity at December 31, 2002 or 2001.
The aggregate duration 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 the yield curve reflecting the percentage change in price for a 100 basis point change in yield. Management believes that the duration of the portfolio is the best single measure of interest rate risk and the table below summarizes the weighted average duration in years of the main components of the fixed income portfolio at December 31, 2002 and 2001:
The maturity profile of the fixed income portfolio is a function of the maturity profile of liabilities and, to a lesser extent, the maturity profile of common fixed income benchmarks. See Item 8, Note 7 to the Consolidated Financial Statements.
Geographic Areas
See Item 8, Notes 3 and 25 to the Consolidated Financial Statements.
Ratings
The Company’s ability to underwrite business is largely dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent agencies. The following are the financial strength ratings from internationally recognized rating agencies as at December 31, 2002 in relation to the Company’s principal insurance and reinsurance subsidiaries and pools:
Rating
agency Agency’s description
of rating Rating Agency’s rating
definition Ranking of Rating
Standard and
Poor’s “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.” AA “Very strong” capacity to meet its financial commitments. This is the second 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.
A.M. Best “An opinion of an insurer’s financial strength and ability to meet ongoing obligations to policyholders.” A+ “Superior.” This is the second highest out of fifteen ratings.
Moody’s
Investors
Service An opinion of “the ability of insurance companies to repay punctually senior policyholder claims and obligations.” Aa2 “Excellent.” This is the second highest out of nine main ratings. Each main rating is subdivided into three subcategories: “1”, indicating the high end of the main rating; “2” indicating the mid-range of the main rating; and “3”, indicating the lower end of the main rating.
The following are the financial strength ratings from internationally recognized rating agencies as of December 31, 2002 in relation to the Company’s principal financial guaranty insurance and reinsurance subsidiaries:
Rating
agency Agency’s description
of rating Rating Agency’s rating
definition Ratings’
Ranking
Standard and
Poor’s “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.” AAA “Extremely strong” capacity to meet its financial commitments. This is the highest out of nine main ratings.
Moody’s
Investors
Service An opinion of “the ability of insurance companies to repay punctually senior policyholder claims and obligation.” Aaa “Exceptional.” This is the highest out of nine main ratings.
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.” AAA “Exceptionally strong.” This is the highest out of eight main ratings.
The Company believes that the primary users of ratings include commercial and investment banks, policyholders, ceding companies and investors. There can be no assurance that any such ratings will be retained for any period of time or that they will not be qualified, suspended, revised downward or withdrawn entirely by such rating agencies.
Tax Matters
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Note 24 to the Consolidated Financial Statements.
Regulation
See Item 8, Note 25 to the Consolidated Financial Statements.
Employees
At December 31, 2002, the Company employed approximately 3,100 employees. At that date, approximately 130 of the Company’s employees were represented by unions or workers’ councils and approximately 40 of the Company’s employees were subject to collective bargaining agreements. The Company believes that it has a good relationship with its employees.
Available Information
The public may read and copy any materials the Company files with the Securities and Exchange Commission (“SEC”) at the SEC’s Public Reference Room at 450 Fifth Street, NW., Washington, DC 20549. The public may 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 that file electronically with the SEC (such as the Company) and the address of that site is (http://www.sec.gov).
The Company’s Internet website address is http://www.xlcapital.com.
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 Exchange Act as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.
ITEM 2.
ITEM 2. PROPERTIES
The Company operates in the United States, Bermuda, Europe and various other locations around the world. In 1997, the Company acquired commercial real estate in 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 addition, the Company owns XL House in London, England, acquired as part of the Winterthur International acquisition and the fair value of this property at the time of acquisition was approximately $56.4 million. 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, 2002, 2001 and 2000 was approximately $30.4 million, $18.9 million and $18.3 million, respectively. The increase in rent expense for 2002 is due primarily to the acquisition of Winterthur International. See Item 8, Note 18 (d) to the Consolidated Financial Statements for discussion of the Company’s lease commitments for real property.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company, in common with the property and casualty insurance and reinsurance industry in general, is subject to litigation and arbitration in the normal course of its business. Such legal proceedings are considered in connection with the Company's loss and loss expense reserves. As of December 31, 2002, the Company was not a party to any material litigation or arbitration other than in the ordinary course of its business in relation to claims activity.
ITEM 4.
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 for the year ended December 31, 2002:
______________
* Retired on March 31, 2002.
Brian M. O’Hara has been President and Chief Executive Officer of the Company since 1994 and a Director of the Company since 1986, having previously served as Vice Chairman of the Company from 1987. He is Chairman of XL Insurance (Bermuda) Ltd and XL Re Ltd and was Chief Executive Officer of XL Insurance (Bermuda) Ltd until 1998, having previously served as Chairman, President and Chief Executive Officer from 1994, President and Chief Executive Officer from 1992, and as President and Chief Operating Officer from 1986.
Fiona E. Luck has been Executive Vice President of Group Operations of the Company since July 1999 and Assistant Secretary since January 2002. Ms. Luck was previously employed at ACE Bermuda as Executive Vice President from 1998, and Senior Vice President from 1997. From 1992 to 1997, Ms. Luck was the Managing Director of the Marsh & McLennan Global Broking office in Bermuda.
Jerry M. de St. Paer has been Executive Vice President and Chief Financial Officer of the Company since February 2001. Mr. de St. Paer was appointed Treasurer and Assistant Secretary of the Company in January 2002. Mr. de St. Paer was previously Managing Director of Hudson International Advisors in New York. Prior to forming Hudson International in 1998, he served as Managing Director, Insurance at J.P. Morgan & Company, Inc. Mr. de St. Paer was previously employed at The Equitable (now AXA Financial Advisors), from 1986 until 1997, serving most recently as Senior Executive Vice President and Chief Financial Officer of The Equitable and as Executive Vice President of Strategic Studies and Development of the AXA Groupe.
Paul S. Giordano has been Executive Vice President and General Counsel of the Company since June 1999. Mr. Giordano served as Senior Vice President since January 1997 and was appointed Secretary of the Company on December 31, 1997. Mr. Giordano was associated with Cleary, Gottlieb, Steen & Hamilton and Clifford Chance in New York and London prior to joining the Company.
Christopher V. Greetham has been Executive Vice President of the Company since December 1998 and has served as Chief Investment Officer of the Company since 1996. Prior to joining the Company, Mr. Greetham served as Senior Vice President and Chief Financial Officer of OIL Insurance Ltd from 1982 to 1996 and as Vice President of Bankers Trust Company from 1975 to 1982.
Nicholas M. Brown, Jr. has been Executive Vice President of the Company since July 1999 and Chief Executive of Insurance operations since July 2000. He was President and Chief Executive Officer of NAC Re Corp, (now known as XL America) from January 1999, having previously served as President and Chief Operating Officer of NAC Re Corp and President and Chief Executive Officer of NAC Re (now known as XL Re America) from 1996. Prior to joining XL Re America, Mr. Brown served as Executive Vice President and
Chief Operating Officer of St. Paul Fire and Marine Insurance Company from 1994 to 1996 and as President of St. Paul Specialty from 1993 to 1994. From 1976 through 1993, he served in various positions at Aetna Life and Casualty Companies.
Henry C.V. Keeling has been Executive Vice President of the Company and Chief Executive of XL Re since August 1998. He was appointed Chief Executive Officer of Reinsurance operations in July 2000. Mr. Keeling was President and Chief Operating and Underwriting Officer of Mid Ocean Re (now known as XL Re Ltd) from 1992 to 1998. He previously served as a director of Taylor Clayton (Underwriting Agencies) Ltd and deputy underwriter for syndicate 51 at Lloyd’s from 1984 through 1992.
Robert R. Lusardi has been Executive Vice President of the Company since February 1998, and Chief Executive Officer of Financial Products and Services Operations since July 2000. Mr. Lusardi served as Chief Financial Officer of the Company from 1998 through February 2001. Prior to joining the Company, Mr. Lusardi was a Managing Director at Lehman Brothers, where he was employed from 1980 to 1998.
K. Bruce Connell served as Executive Vice President and Group Underwriting Officer until his retirement on March 31, 2002. He had been Executive Vice President of the Company until March 1998 and Group Underwriting Officer since July 2000. Mr Connell previously served as President and Chief Operating Officer of XL Global Re from November 1997 to August 1998, President of XL Global Re since December 1995 and Senior Vice President of XL Insurance (Bermuda) Ltd from 1990 to 1995.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) The Company’s Class A ordinary shares, $0.01 par value, are listed on the New York Stock Exchange 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.
Each Class A ordinary share has one vote, except that 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 Articles of Association. “Controlled Shares” includes, among other things, all Class A ordinary shares for 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).
(b) The number of record holders of Class A ordinary shares as of December 31, 2002 was 804. This figure does not represent the actual number of beneficial owners of the Company’s ordinary shares because shares are frequently held in “street name” by securities dealers and others for the benefit of individual owners who may vote the shares.
(c) In 2002, four regular quarterly dividends were paid at $0.47 per share to all ordinary shareholders of record as of February 4, May 28, August 5 and December 2. In 2001, four regular quarterly dividends were paid at $0.46 per share to all ordinary shareholders of record as of February 15, May 25, August 15 and November 15.
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 United States, 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 25 to the Consolidated Financial Statements for further discussion.
(d) Rights to purchase Class A ordinary shares (“the Rights”) were distributed as a dividend at the rate of one Right for each Class A ordinary share held of record as of the close of business on October 31, 1998. Each Right entitles holders of Class A ordinary shares to buy one ordinary share at an exercise price of $350.
The Rights would be exercisable, and would detach from the Class A ordinary shares, only if a person or group were to acquire 20% or more of the Company’s outstanding Class A ordinary shares, or were to announce a tender or exchange offer that, if consummated, would result in a person or group beneficially owning 20% or more of Class A ordinary shares. Upon a person or group without prior approval of the Board acquiring 20% or more of Class A ordinary shares, each Right would entitle the holder (other than such an acquiring person or group) to purchase Class A ordinary shares (or, in certain circumstances, Class A ordinary shares of the acquiring person) with a value of twice the Rights exercise price upon payment of the Rights exercise price. The Company will be entitled to redeem the Rights at $0.01 per Right at any time until the close of business on the tenth day after the Rights become exercisable. The Rights will expire at the close of business on September 30, 2008, and
do not initially have a fair value. The Company has initially reserved 119,073,878 Class A ordinary shares being authorized and unissued for issue upon exercise of Rights.
ITEM 6.
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.
______________
See Notes on next page.
______________
(1) Results for all periods subsequent to July 1, 2001 include the results of Winterthur International, which was acquired with effect from this date. The results also include the consolidation of Le Mans Ré, which is accounted for as a subsidiary with effect from January 1, 2002. In the years ended December 31, 2001, 2000 and 1999, the Company’s share of net income of Le Mans Ré was included in equity in net income of insurance and operating affiliates. The Company’s net income for the year ended December 31, 2002 and 2001 was reduced significantly by the September 11 event. See Item 8, Note 4 to the Consolidated Financial Statements. The effect of all of these items should be considered when making period to period comparisons of the Company’s results of operations and financial condition and liquidity. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis.
(2) Information includes the results of NAC as though it had always been a part of the Company.
(3) Net income per ordinary share is based on the basic and diluted weighted average number of ordinary shares and ordinary share equivalents outstanding for each period. Net loss per ordinary share is based on the basic weighted average number of ordinary shares outstanding.
(4) Cash dividends per ordinary share for 1999 and prior years have not been adjusted for the pooling effect of NAC.
(5) Fully diluted book value per ordinary share is a non-GAAP measure. It is calculated by adding to Shareholders’ equity the exercise proceeds of all vested “in the money” Company stock options and dividing the balance by the sum of total Class A ordinary shares outstanding and total vested “in the money” stock options.
(6) The loss and loss expense ratio is calculated by dividing the losses and loss expenses incurred by the net premiums earned for general insurance and reinsurance operations.
(7) The underwriting expense ratio is the sum of acquisition expenses and operating expenses for general insurance and reinsurance operations divided by net premiums earned for general insurance and reinsurance operations. See Item 8, Note 3 to the Consolidated Financial Statements for further information.
(8) The combined ratio 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.
(9) Certain reclassifications to prior period information have been made to conform to current year presentation.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
The following is a discussion of the Company’s financial condition and results of operations. 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.
The Company’s results for all periods subsequent to July 1, 2001 include the results of Winterthur International. See Critical Accounting Policies and Item 8, Note 6 (c) to the Consolidated Financial Statements for futher information.
The Company’s results for 2002 and 2001 also include the effects of 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”). This should be considered when making period to period comparisons. See Item 8, Note 4 to the Consolidated Financial Statements for further information.
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.
Critical Accounting Policies
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 and financial condition and liquidity. These critical accounting policies have been discussed by management with the Company’s Audit Committee of the 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.
1) Unpaid Losses and Loss Expenses and Unpaid Loss and Loss Expenses Recoverable
Unpaid losses and loss expenses includes reserves for unpaid reported losses and loss expenses and for losses incurred but not reported ("IBNR"). The reserve for unpaid reported losses and loss expenses for the Company’s general operations is established by management based on amounts reported from insureds or ceding companies and consultation with legal counsel, and represents 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 claims personnel record 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 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. In the Company’s Lloyd’s operations within the insurance segment, where the Company is not a lead underwriter, claim reserves are established based upon notifications from a central market bureau.
With respect to the Company’s reinsurance general operations, case reserves for reported claims are generally established based on reports received from ceding companies.
With respect to the Company’s financial products and services general operations, financial guaranty claims written on an insurance basis are established consistent with the Company’s insurance operations and financial guaranty claims written on a reinsurance basis are established consistent with the Company’s reinsurance operations.
At December 31, 2002, the Company’s total gross reserves for unpaid losses and loss expenses was $13.2 billion, of which $7.7 billion related to reserves for reported claims and $5.5 billion for IBNR reserves. Most of the Company’s IBNR loss reserves are established with respect to its insurance and reinsurance casualty business. Casualty business generally has a longer tail (meaning a longer period of time between receipt of the premium and the ultimate settlement of the claim) than the Company’s other lines of business. IBNR reserves are calculated by the Company’s actuaries using several standard actuarial methodologies including paid and incurred loss development, the Bornhuetter-Ferguson incurred loss method and frequency and severity approaches.
Loss and loss expenses are charged to income as they are incurred. This includes loss and loss expense payments and any changes in reported 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.
Claims relating to property catastrophe and property risk excess treaties are generally reported within approximately twenty four months from the date of occurrence.
The Company’s net unpaid loss and loss expense reserves broken down by operating segment at December 31, 2002 was as follows:
(U.S. dollars in millions)
The following table shows the net unpaid loss and loss expense reserves for the Company at December 31, 2002 by line of business:
(U.S. dollars in millions)
______________
(1) Consists of several products, including accident and health, financial guarantee, political risk, surety and bonding.
The total net unpaid loss and loss expense reserves includes both reported and IBNR reserves. IBNR reserves are calculated by the Company’s actuaries using standard actuarial methodologies as discussed above. The outcomes of the Company’s actuarial reviews, consistent with historical practice, will either provide (i) a single point estimate that is management’s best estimate or (ii) a range of reserve estimates. The Company considers a ‘best estimate’ to be one that has an equal likelihood of developing a redundancy or deficiency as the loss experience matures. For the majority of the Company’s actuarial reviews, a single point reserve representing management’s best estimate is recorded. The Company’s actuaries utilize one set of assumptions in determining its single point estimate. These assumptions include loss development factors, loss ratios, reported claim frequency and severity. These 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. In all other instances, a range of reserve estimates is calculated. At December 31, 2002, in those instances in which a range was calculated, the Company’s loss reserve estimates were at the mid-point of those ranges.
The following table shows the recorded estimate and the high and low ends of the range of reserves for each of the lines of business noted above for which a range of estimates was provided at December 31, 2002, as well as the recorded estimate of reserves for those lines of business for which a point estimate was established:
(U.S. dollars in millions)
As at December 31, 2002, the Company’s total net unpaid loss and loss expense reserve was the sum of the single point estimates and the mid-point of the range for those lines in which a range was provided. The Company does not have a range for its total net unpaid loss and loss expense reserves. Moreover, it would not be appropriate to add the ranges for each line of business to obtain a range around the Company’s total reserves because this would not reflect the diversification effects across the Company’s various lines of business. The diversification effects result from the fact that losses across the Company’s different lines of business are not completely correlated.
Certain aspects of the Company’s casualty operations complicate the actuarial process for establishing reserves. Casualty business written by the Company’s insurance operations is high layer excess casualty business, meaning that the Company’s liability is 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 of the Company has increased. As a result, the Company has obtained a larger statistical base to assist in establishing reserves for these excess casualty insurance claims.
Reinsurance operations by their nature add further complications to the reserving process 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. This period can be as long as thirty years for casualty reinsurance business written. As a result, more judgment is used to establish reserves for ultimate claims in the Company’s reinsurance operations.
See further discussion within the Company’s operating segments for prior year development of loss reserves.
The Company’s three types of 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.
High layer excess casualty 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. 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.
Set forth below is information regarding the numbers and amounts of claims for high layer excess casualty insurance for December 31, 1999 through December 31, 2002:
Number of claims reported as of December 31, 1999
Number of claims reported during 2000
Number of claims reported during 2001
Number of claims reported during 2002
Number of claims reported as of December 31, 2002
(U.S. dollars in millions)
Cumulative claims paid as of December 31, 1999 $
1,711
Amount of claims paid during 2000 $
Cumulative claims paid as of December 31, 2000 $
2,186
Amount of claims paid during 2001 $
Cumulative claims paid as of December 31, 2001 $
2,312
Amount of claims paid during 2002 $
Cumulative claims paid as of December 31, 2002 $
2,851
As at December 31, 2002, the Company’s reported claims for its high layer excess casualty business were 32 shock losses, 50 non-shock losses and 63 professional liability losses.
With respect to casualty reinsurance, the reserving methods 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, detailed claim information for this line of business is not available.
With respect to discontinued asbestos and long-tail environment business, see Item 8, Note 10 to the Consolidated Financial Statements. This business had been previously written by NAC prior to its acquisition by the Company.
Except for certain workers’ compensation and long term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation and long-term disability unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 7%. The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. A 1% reduction in the interest rate would increase unpaid loss and loss expense reserves and net incurred loss and loss expenses by approximately $22.0 million based on the current estimated amount and payout of the liabilities. See Item 8, Note 10 to the Consolidated Financial Statements.
The establishment of unpaid loss and loss expense reserves also includes the estimation of related reinsurance recoverables. Due to the size of the gross losses arising from the September 11 event and the effect on the reinsurance industry, the Company, in addition to its normal review process, further analyzed the recoverability of these assets. In addition to the potential effect of the non recoverability of these assets from reinsurers disputing claims, the reinsurance market in general has experienced significant capital erosion as a result of underwriting and investment losses. Accordingly, there is greater uncertainty regarding recoverability due to the reinsurers’ ability to pay. See “Financial Condition and Liquidity” and Item 8, Note 11 to the Consolidated Financial Statements for further information.
2) Future Policy Benefit Reserves
Future policy benefit reserves relate to the Company’s life operations and are estimated using assumptions for investment yields, mortality, expenses and provisions for adverse loss deviation. Uncertainties such as interest rate volatility and the accuracy of mortality tables make it difficult to estimate the ultimate benefit payments.
Most of the Company’s future policy benefit reserves relate to annuity portfolio reinsurance contracts under which the Company makes annuity payments throughout the term of the contract for a specified portfolio of policies. For certain of these contracts, a single premium is paid at inception of the contract by way of a transfer of cash and investments to the Company.
The reserving methodology for these annuity portfolio reinsurance contracts is described in Financial Accounting Standard (“FAS”) 60 as amended by FAS 97. These contracts subject the Company to risks arising from policyholder mortality over a period that extends beyond the periods in which premiums are collected. Liabilities for future policy benefit reserves are established in accordance with the provisions of FAS 60.
Claims and expenses for individual policies within these annuity reinsurance contracts are projected over the lifetime of the contract to calculate a net present value of future cash flows. Assumptions for each element of the basis (mortality, expenses and interest) are determined at the issue of the contract and these assumptions are locked-in throughout the term of the contract unless a premium deficiency exists. The assumptions are best estimate assumptions plus provisions for adverse deviations on the key risk elements (i.e. mortality and interest). Provisions for adverse deviation are sufficient to cover reasonable deviations from the best estimated outcome of the contract. As the experience on the contracts emerges, the assumptions are reviewed. This occurs at least annually and includes both an analysis of experience and review of likely future experience. If such review would produce reserves in excess
of those currently held then lock-in assumptions will be revised and a loss recognized. During the years ended December 31, 2002, 2001 and 2000, there were no adjustments to the locked-in assumptions for any of these contracts.
The future policy benefit reserves for these annuity portfolio reinsurance contracts amounted to $2.1 billion at December 31, 2002. The Company holds the investment assets backing these liabilities. These investments are primarily fixed income securities with maturities that closely match the expected claims settlement profile.
As stated above, the future policy benefit reserves include provisions for adverse deviation in excess of best estimate assumptions, that amounted to approximately $60.0 million at December 31, 2002. The future policy benefit reserves would only be increased if these provisions for adverse deviation became insufficient in the light of emerging claims experience. The present value of future claims would increase by approximately 0.3%-0.4% if mortality rates were to decrease by 1% in all future years, relative to the reserving assumptions.
3) Deposit Liabilities
The Company has entered into certain contracts with cedants that transfer insufficient risk to be accounted for as insurance or reinsurance transactions. The Company uses a conservative portfolio rate of return of equivalent duration to the liabilities in determining risk transfer. For these contracts, the initial deposit liability equals the cash received at inception. The Company has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the estimated ultimate liability. The Company establishes an initial accretion rate at inception of the contract. The deposit accretion rate is the rate of return required to fund expected future payment obligations (this is equivalent to the ‘best estimates’ of future cash flows), which are determined actuarially based upon the nature of the underlying indemnifiable losses. This is a function of the ultimate size of such losses, the impact of the contractual limits upon indemnification of such losses, and the underlying loss settlement process which determines the timing of payments. An increase in the ultimate claims cost or accelerated claims settlement would potentially lead to an increase in the deposit liability accretion rate or lead to incurred losses if significant. The Company has not had any significant change in these assumptions during the last three years ended December 31, 2002.
Interest expense of $65.9 million, $47.9 million and $38.4 million was recorded related to the accretion of the deposit liabilities for the years ended December 31, 2002, 2001 and 2000, respectively. For some of the Company’s deposit liabilities the accretion rate is recorded at its contractual limit. For all other contracts, a 1% increase in the average accretion rate would result in an increase in deposit liabilities and interest expense by $8.5 million on an annualized basis.
4) Derivative Instruments and Weather and Energy Derivatives
The Company records all derivative instruments and weather derivatives at fair value. Changes in fair value of derivatives may create volatility in the Company’s results of operations from period to period.
For further information regarding sensitivity analysis see Item 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company enters into derivatives and other financial instruments primarily for risk management purposes. The Company’s derivative transactions can expose the company to credit default swap risk, weather and energy risk, investment market risk, and foreign currency exchange rate risk. The Company attempts to manage these risks based on guidelines established by senior management. Derivative
instruments are carried at fair value with the resulting changes in fair value recognized in income in the period in which they occur.
The following risk management discussion and the estimated amounts generated from the sensitivity and value-at-risk (“VaR”) analyses presented in this document are forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these estimated results due to, among other things, actual developments in the global financial markets. The results of analysis used by the Company to assess and mitigate risk should not be considered projections of future events of losses. See “Management's Discussion and Analysis of Financial Condition and Results of Operations-Cautionary Note Regarding Forward-Looking Statements.”
Credit Default Swap Risk
The Company enters into swaps written under ISDA forms in its insurance and financial products and services segments as an extension of its financial guaranty business. The fair value is determined using models developed by the Company and is dependent upon a number of factors, including changes in interest rates, future default rates, changes in credit quality, future expected recovery rates and other market factors. Other elements of the change in fair value are based upon pricing established at the inception of the contract. A change in the interest, default and recovery rate assumptions would cause the fair value associated with credit default swaps to decrease as follows:
(U.S. dollars in thousands)
Weather and Energy Risk
The Company offers weather and energy risk management products in insurance or derivative form to end-users, while managing the risks in the over-the-counter and exchange traded derivatives markets. In addition to entering into transactions with end-users, (which represents the majority of the Company weather and energy derivative transactions) the Company also maintains a smaller weather and energy derivatives trading portfolio. As of the year ended December 31, 2002, a majority of the Company’s outstanding weather transactions were due to mature on or before December 31, 2003.
During 2002, the Company initiated a limited trading portfolio of listed natural gas futures and options and over-the-counter contracts with similar terms to support its anticipated offering of energy risk management products to end-users in 2003.
Fair value for the Company’s natural gas contracts are determined through the use of quoted market prices. As quoted market prices are not widely available in the weather derivative market, management uses available market data and internal pricing models based upon consistent statistical methodologies to estimate fair values. Estimating fair value of instruments which do not have quoted market prices requires management judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, realized and forecasted weather conditions, changes in interest rates and other market factors.
The following table summarizes the movement in the fair value of contracts outstanding during the year ended December 31, 2002:
(U.S. dollars in thousands)
The following table summarizes the maturity of contracts outstanding at December 31, 2002:
(U.S. dollars in thousands)
Market Risk
Market risk for the Company’s commodity portfolio relates to changes in underlying weather conditions (i.e., changes in climatic variables such as temperature and precipitation) and to a lesser extent, natural gas prices. The Company has underwritten risks in Asia, Australia, Europe, and North America, with its primary market risk reflected in temperature changes within the United States and Europe.
The Company manages its weather risk portfolio through the employment of a variety of strategies. These include geographical and directional diversification of risk exposures and direct hedging within the capital and reinsurance markets. Risk management is undertaken on a portfolio-wide basis, to maintain a portfolio that the Company believes is well diversified and which remains within the aggregate risk tolerance established by the Company’s senior management.
Value-At-Risk
A statistical technique known as VaR is one of the tools used by management to measure, monitor and review the market risk exposures of the Company’s weather risk and natural gas portfolios. VaR, as it relates to commodity risk, is at the 99% confidence level.
The Company estimates VaR based on the historical simulation of each of the seasonal books into which weather transactions are segregated. Currently, the Company’s VaR calculation does not exceed $60 million in any one season. The Company’s high, low and average aggregate seasonal VaR amounts assumed over all future seasons during 2002 were $201.3 million, $25.8 million and $102.7 million, respectively. The Company’s high, low and average aggregate seasonal VaR amounts during 2001 were $48.6 million, $4.7 million and $30.1 million, respectively. The summation of all future seasons equals the aggregate portfolio VaR, although this is not a statisitc utilized by management because current weather events and patterns are generally independent of, and have an immaterial effect on, expectations for future seasons (and once a season ends, the associated VaR is zero for the remainder of the fiscal year). Therefore, the Company could reduce or eliminate its VaR on futu re seasons by selling its positions prior to the beginning of a season.
Since VaR statistics are estimates based on simulations of historical market data, VaR should not be viewed as an absolute, prognostic measurement gauge of future financial performance or as a way for the Company to predict risk. There can be no assurance that the Company’s actual future losses will not exceed its VaR amounts. The Company also maintains VaR limits set by management for natural gas contracts, that had a daily VaR limit of $3.5 million during 2002.
Credit Risk
The Company is exposed to credit risk, or the risk that counterparties to weather and energy transactions will fail to perform their contractual obligations leading to possible losses. In order to control its risk exposures, the Company has implemented a credit risk control framework centered on a management credit committee, credit policies and credit limits developed, enhanced and maintained by a credit officer and a credit committee comprised of senior management. All credit-sensitive transactions are reviewed and approved by the Company’s risk management personnel and/or credit committee and exposures are reviewed with respect to authorized credit limits before the Company enters into weather derivative transactions. To address counterparty risk concerns and to support credit exposures in certain cases, the Company may require that a counterparty provide a guaranty or a letter of credit or post margin
or collateral. The Company monitors its credit exposures on a daily basis to ensure adherence to all policies and limits.
Operational Risk
Operational risk refers to the risk of loss resulting from the Company’s weather and energy risk trading operations, including, but not limited to, improper or unauthorized execution and processing of transactions, deficiencies in the Company’s operating systems, and inadequacies or breaches in the Company’s control procedures and processes. The Company relies on the ability of its employees and systems to process its
transactions, but in the event of a breakdown or improper operation of systems or improper action by employees, the Company could suffer, among other things, financial loss, regulatory sanctions, reputation damage or other material adverse consequences.
In order to mitigate and control its operational risk, the Company has developed and continues to enhance and audit specific policies and procedures that are designed to identify and manage operational risk at appropriate levels. For example, the Company has implemented procedures that require that all transactions are accurately recorded and properly reflected in the Company’s books and records, including reconciliation of trade entry and confirmation and regular crosschecks with counterparties. Critical IT systems are backed up on a daily basis. The Company also uses periodic self-assessments and internal audit reviews as a further check on operational risk. Moreover, trading position valuations and other trading processes and procedures are subject to periodic review.
Legal Risk
Legal risk is largely comprised of the risk that a derivative transaction will not be properly documented or executed. Proper documentation is critical to assure not only that a counterparty has the authority to enter into the transaction, but also that the transaction is enforceable as negotiated between parties and among other items, are excluded from preferential transfer provisions in the event of counterparty insolvency. As a result, the Company obtains an executed International Swap Dealers Association, Inc. (“ISDA”) Master Agreement or a form of confirmation which incorporates by reference the ISDA Master Agreement and certain elective provisions of the Schedule.
The ISDA Master Agreement Schedule adopted and periodically enhanced by the Company incorporates, among other provisions, the following contractual protections: the netting of transactions between the Company and the counterparty; a right of set-off for the Company; a representations and warranties provision; and a customized event of default and termination section (typically based upon credit ratings downgrades identified by the Company’s risk management department). Further contractual protections and legal documentation may be required when the Company enters into a derivative transaction with a non-U.S. counterparty.
The Company seeks to identify, assess, monitor and manage its market, credit, operational and legal risks in accordance with defined policies and procedures. The Company’s senior management takes an active role in the risk management process and has developed and implemented policies and procedures that require specific administrative and business functions to assist in the identification, assessment and control of the various risks within the business. Due to the changing nature of the global marketplace, the Company’s risk management policies, procedures and methodologies are constantly evolving and are subject to ongoing review and modification. Market, credit, operational, legal and other risks are inherent in the Company’s weather risk management business and cannot be wholly eliminated despite the Company’s risk management policies, procedures and methodologies.
The Company anticipates that further regulation of weather and energy derivative contracts is reasonably likely to occur based upon recent events and failures in the energy market. Based upon the evolving regulatory developments in energy trading, the Company will continue to monitor and enhance its market, credit, operational and legal procedures and processes to comply with future regulation.
Investment Market Risk
The Company’s investment portfolio is managed by external investment professionals under the direction of the Company’s management and in accordance with detailed investment guidelines provided and monitored by the Company on a frequent basis. 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. The vast majority of the Company’s investment portfolio is managed by well established, large institutional investment professionals.
The Company’s investment portfolio consists of exposures to fixed income securities, equities, alternative investments, derivatives, business and other investments, and cash. These securities and investments are denominated in both U.S. dollar and foreign currencies.
Through the structure of the Company’s investment portfolio, the Company’s earnings are directly affected by changes in the valuations of the securities and investments held in the investment portfolio. These valuation changes reflect changes in interest rates (e.g. changes in the level, slope and curvature of the yield curves, volatility of interest rates, mortgage prepayment speeds and credit spreads), credit quality, equity prices (e.g. changes in prices and volatilities of individual securities, equity baskets and equity indices) and foreign currency exchange rates (e.g. changes in spot prices, forward prices and volatilities of currency rates). Market risk therefore arises due to the uncertainty surrounding the future valuations of these different assets, the factors that impact their values and the impact that this could have on the Company’s earnings.
The Company seeks to manage the risks of the investment portfolio through a combination of asset class, country, industry and security level diversification and investment manager allocations. Further, individual security and issuer exposures are controlled and monitored at the investment portfolio level, via specific investment constraints outlined in investment guidelines and agreed with the external investment professionals. Additional constraints are agreed with the external investment professionals which may address exposures to eligible securities, prohibited investments/transactions, credit quality and general concentrations limits.
The Company’s direct use of investment derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, references rates or a combination of these factors. When investment guidelines allow for the use of derivatives, these can generally only be used for the purposes of managing interest rate risk, foreign exchange risk and credit risk, provided the use of such instruments are incorporated in the overall portfolio duration, spread, convexity and other relevant portfolio metrics. The direct use of derivatives is not permitted to economically leverage the portfolio outside of the stated guidelines. Derivatives may also be used to add value to the investment portfolio where market inefficiencies are perceived to exist, to utilize cash holdings to purchase equity indexed derivatives and to adjust the duration of a portfolio of fixed income securities to match the duration of related deposit liabilities.
Investment Value-At-Risk
Central to the Company’s market risk management framework is Value at Risk (VaR). VaR is a statistical risk measure, calculating the level of potential losses that could be expected to be exceeded, over a specified holding period and at a given level of confidence, in normal market conditions, due to adverse movements in the investment portfolio’s underlying securities and investments valuations.
The Company calculates the VaR of the investment portfolio using a 1-month time horizon and a 95% level of confidence. This means that, on average, the Company could expect losses greater than predicted by the VaR results 5% of the time, or once every 20 months. The calculation of VaR is performed monthly using a full valuation based on the Monte Carlo approach and it is expressed both in terms of U.S. dollars and as a percentage of the Company’s investment portfolio.
The modeling of the risk of any portfolio, as measured by VaR, involves a number of assumptions and approximations. While the Company believes that its assumptions and approximations are appropriate, there is no uniform industry methodology for calculating VaR. The Company notes that different VaR results can be produced for the same portfolio dependent, not only on the approach used but also on the assumptions employed when implementing the approach. However, in order to maintain meaningful and comparable VaR results over time, the Company has maintained the same assumptions and approximations in its methodology over the period.
The VaR approach uses historical data to determine the sensitivity of each of the underlying securities to the risk factors incorporated into the models that are employed in the Monte Carlo simulations. In calculating these sensitivities, greater importance is placed on the more recent data points and information. Since the VaR approach is based on historical positions and market data, VaR results should not be viewed
as an absolute and predictive gauge of future financial performance or as a way for the company to predict risk. There is no assurance that the Company’s actual future losses will not exceed its VaR and the Company expects that 5% of the time the VaR will be exceeded. Additionally, the Company acknowledges the fact that risks associated with abnormal market events can be significantly different to the VaR results and these are by definition not reflected or assessed in the VaR analysis.
The VaR of the investment portfolio at December 31, 2002 was approximately $236.0 million. The VaR of all investment related derivatives excluding investments in affiliates and other investments was $6.0 million.
In instances where the data or time series is insufficient to determine the risk factor sensitivities, the VaR approach uses proxy time series data available for similar instruments. As at December 31, 2002, approximately $5.2 billion (28% of the Company’s investment portfolio at market value) was proxied. Approximately $1.4 billion related to various fixed income portfolios, $1.3 billion to alternative investments and $780.0 million to various cash portfolios. Also there were 91 ($28.5 million) holdings not proxied and excluded from the VaR calculations because they could not be easily proxied because they could not be modeled. The Company reviews the proxies to ensure that an appropriate data and time series is being used in the calculations and that the proxies used are conservative.
The following two tables show the Company’s average, minimum and maximum VaR in percentage and dollar terms for the total investment portfolio during 2002, based upon the VaR at quarter end dates. They also include the Company’s VaR in percentage and dollar terms for the total investment portfolio as at December 31, 2002. The Company’s investment portfolio VaR as at December 31, 2002 is not necessarily indicative of future VaR levels.
(U.S dollars in millions):
______________
(1) Based on a 95% confidence level with a one month holding period and expressed as a percentage of the total investment portfolio.
(2) The majority of the Company’s alternative investment portfolio is accounted for as equity in affiliates. However, for purposes of monitoring and tracking the Company’s total investment market risk, the total alternative investment portfolio is included in these
calculations. The alternative investment portfolio is principally proxied to the public equity markets and fixed income markets in these VaR calculations. The actual annualized volatility of the Company’s alternatives portfolio during 2002 was 2.4% versus approximately 21% for the public equity markets and approximately 4% for the fixed income markets, as proxied by the S&P500 Index and Lehman Aggregate Bond Index, respectively.
(3) Total undiversified VaR is the summation of the individual VaRs for each of the separate asset classes and by construction ignores any and all correlations between the different asset classes. The total undiversified VaR therefore ignores diversification benefits that exist in between these different asset classes.
(4) Diversification VaR equals the difference between the investment portfolio’s total portfolio VaR and the total undiversified VaR. As the former explicitly accounts for the correlations and diversification benefits that exist between the actual asset classes and the latter explicitly does not, the difference in the two VaR results must be due to the ‘diversification benefits’. These diversification benefits arise due to the risk reduction that occurs when different assets, that are not perfectly correlated, are combined in a portfolio. It will vary over time dependent on: allocations changes; changes in the correlations between the different asset classes; and changes in the general asset class risks. The NA reflects the fact that since the minimum and maximum VaR for the six different asset class portfolios do not refer to the same point in time and therefore it is not meaningful to calculate the diversification VaR.
(5) Total investment portfolio VaR is the Company’s investment portfolio VaR based on the prescribed methodology that explicitly accounts for the diversification benefits that occur when each of the allocations to the individual asset classes are included in the investment portfolio.
(6) Based on a 95% confidence level with a one month holding period, expressed in millions of US$ Dollars.
The Company’s total investment portfolio VaR is driven by: the size of the overall investment portfolio; the size of the allocations to the different asset classes and securities in the asset classes; the risks associated with each of the asset classes and securities; and the correlations and diversification benefits between each of the asset classes and securities. Changes in any of these variables will have a direct impact on the Company’s VaR.
The Company’s total undiversified VaR, which ignores any correlation and diversification benefits, at December 31, 2002 was 2.52% compared to a maximum of 3.13% and a minimum of 1.98%. The Company’s average diversification VaR during 2002 resulted in an average reduction of the Company’s total undiversified VaR of 1.04% and as at December 31, 2002 was 1.28%.
The Company’s total investment portfolio VaR was on average 1.48% during 2002 and as at December 31, 2002, was 1.24%. The Company’s maximum and minimum total investment portfolio VaR during 2002 were 1.78% and 1.21%, respectively. The Company’s largest VaR exposure during 2002 was to fixed income. The average VaR for fixed income was 1.68%, compared to a maximum of 2.0% and a minimum of 1.29%. As at December 31, 2002, the fixed income VaR was 1.60%.
At December 31 2002, the ranking for the Company’s asset class risk, based on the individual asset class VaRs, was: fixed income; alternative investments; equity; business and other investments; cash equivalents and derivatives.
Stress Testing
VaR does not provide the means to estimate the magnitude of the loss in the 5% of occurrences that the Company expects the VaR level to be exceeded. To complement the VaR analysis based on normal market environments, the Company considers the impact on the investment portfolio in several different historical stress periods to analyse the effect of unusual market conditions. The Company establishes certain historical stress test scenarios which are applied to the actual investment portfolio. As these stress tests and estimated gains and losses are based on historical events, they will not necessarily reflect future stress events or gains and losses from such events. The results of the stress test scenarios are reviewed on a regular basis to ensure they reflect current shareholders equity, market conditions and the Company’s total risk profile.
The table below shows the maximum impact on the Company’s investment portfolio if all events stress tested were to repeat themselves, given the actual investment portfolio’s allocations at quarter end dates during 2002. The Company assumes that no action is taken during the stress period to either liquidate or rebalance the portfolio. The Company believes that this fairly reflects the potential decreased liquidity that is often associated with stressed market environments.
From the different scenarios that the Company analyses, the largest downside event risk exposure during 2002 was 7.6%, based on the investment portfolio as at March 31, 2002. The largest upside risk exposure during 2002 was 21.4% as at March 31 and June 30, 2002.
Given the investment portfolio allocations as at 31 December 2002, the Company would expect to lose approximately 4.7% of the portfolio if the most damaging event stress tested was repeated, all other things held equal. Given the investment portfolio allocations as at 31 December 2002, the Company would expect to gain approximately 14.9% of the portfolio if the most favorable event stress tested was repeated, all other things held equal.
Investment Credit Risk
The Company is exposed to credit risk through its portfolio of debt securities which has historically been a significant exposure in the investment portfolio.
The Company controls credit risk in the investment portfolio through the credit research performed by the external investment professionals and limitations on the investment portfolio’s exposure to individual credits, as set by the Company. Limits are set for each credit rating and are a function of the probability of default and the expected loss in the event of default. Limits ensure that losses from individual defaults should not exceed predetermined levels.
The Company reviews on a regular basis its corporate debt concentration, credit quality and compliance with credit limits. Any obligor over its credit limits or experiencing material credit quality deterioration is placed on a Watch List for closer monitoring. Where appropriate, holdings will be reduced.
As at December 31, 2002, the average credit quality of the Company’s total fixed income portfolio, which includes fixed maturities, short term investments, cash and cash equivalents and net payable for investments purchased, was AA.
The Company’s total fixed income portfolio credit quality breakdown as at December 31, 2002 is shown in the following table .
______________
(1) Portfolio includes fixed maturities, short term investments, cash and cash equivalents and net payable for investments purchased.
Individual corporate holdings in the portfolio are diversified, exceeding 900 separate issuer exposures. As at December 31, 2002, the top 10 corporate exposures represented approximately 5.1% of the total fixed income portfolio (excluding operating cash balances) and approximately 14% of the corporate holdings. The top 10 corporate holdings listed below utilizes a conservative approach to aggregation as it includes unsecured as well as securetized, credit enhanced and collateralized securities issued by parent companies and their affiliates.
______________
(1) Corporate exposures include parent and affiliated companies that issue fixed income securities. In some cases a portion of the market value may be invested in bonds that are securitized or have sufficient credit enhancement that provides a long-term credit rating that is higher than the rating of the unsecured debt of the parent company.
Interest Rate and Equity Price Risk
The Company believes that VaR is an appropriate indicator of the risk of the portfolio, however an immediate 100 basis point adverse shift in global treasury government bond curves would result in a decrease in total return of 5.2% or $754.0 million in the Company’s fixed income portfolio as of December 31, 2002. It is unlikely that all global yield curves would shift at the same time. In evaluating the impact of price changes in the equity portfolio, a 10% change in equity prices would affect total return by approximately $57.0 million at December 31, 2002.
At December 31, 2002, bond and stock index futures outstanding were $263.5 million with underlying investments having a market value of $831.9 million. Losses of $1.1 million were realized on these contracts for the year ended December 31, 2002. A 10% appreciation or depreciation of these derivative instruments would have resulted in realized gains and realized losses of $26.3 million respectively. The Company reduces its exposure to these futures through offsetting transactions, including options and forwards.
In addition, the Company has short-term debt and long-term debt outstanding. Interest rates on short-term debt are LIBOR based. Accordingly, any changes in interest rates will affect interest expense.
Foreign Currency Exchange Risk
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities and equity investments. These contracts are not designated as specific hedges for financial reporting purposes and therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of three months or less. At December 31, 2002, forward foreign exchange contracts with notional principal amounts totaling $30.2 million were outstanding. The fair value of these contracts as at December 31, 2002 was $28.6 million with unrealized losses of $1.6 million. For the year ended December 31, 2002, realized losses of $3.4 million and unrealized losses of $0.8 million were recorded in net realized and unrealized gains and losses on derivative instruments. Based on this value, a 10% appreciation or depreciation of the U.S. dollar as compared to the level of other currencies under contract at December 31, 2002 would have resulted in approximately $6.3 million of unrealized losses and $1.7 million in unrealized gains, respectively.
Credit Risk
The Company is exposed to credit risk in the event of non-performance by the other parties to the forward contracts, however the Company does not anticipate non-performance. The difference between the notional principal amounts and the associated market value is the Company’s maximum credit exposure.
Embedded Debt Derivatives
The puts and the interest rate adjustment features embedded in the CARZ and LYONs are considered derivatives and are subject to fair value. There is currently minimal fair value ascribed to (i) the puts, as the contingent events of these features are considered unlikely to occur or (ii) the interest rate adjustment feature due to the current trading value of the bonds.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
XL CAPITAL LTD
CONSOLIDATED BALANCE SHEETS AS AT DECEMBER 31, 2002 AND 2001
(U.S. dollars in thousands, except share amounts)
ASSETS
LIABILITIES AND SHAREHOLDERS’ EQUITY
XL CAPITAL LTD
CONSOLIDATED BALANCE SHEETS AS AT DECEMBER 31, 2002 AND 2001
(U.S. dollars in thousands, except share amounts)
See accompanying Notes to Consolidated Financial Statements
XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(U.S. dollars in thousands, except per share amounts)
See accompanying Notes to Consolidated Financial Statements
XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(U.S. dollars in thousands)
See accompanying Notes to Consolidated Financial Statements
XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(U.S. dollars in thousands)
XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(U.S. dollars in thousands
See accompanying Notes to Consolidated Financial Statements
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31 2002, 2001 AND 2000
1. History
XL Capital Ltd together with its subsidiaries (the “Company” or “XL”), is a holding company organized under the laws of the Cayman Islands. XL Capital Ltd was incorporated on March 16, 1998, as the successor to EXEL Limited, a Cayman Islands corporation organized in 1986, in connection with EXEL Limited’s merger with Mid Ocean Limited, a Cayman Islands corporation. XL Capital Ltd operated under the name EXEL Limited from completion of the merger until February 1, 1999, when its current name was approved by the requisite vote of the Company’s shareholders. The Company provides insurance and reinsurance coverages and financial products and services to industrial, commercial and professional service firms, insurance companies and other enterprises on a worldwide basis.
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. Le Mans Ré was formed in July 1999, when the Company signed a joint venture agreement with Les Mutuelles du Mans Assurances Group to form a new French reinsurance company. Le Mans Ré underwrites a worldwide portfolio comprising most classes of property and casualty reinsurance business, together with a selective portfolio of life reinsurance business. See Note 6 (a) for additional information.
On July 25, 2001, the Company completed the acquisition of certain Winterthur International insurance operations (“Winterthur International”) to extend its predominantly North American based large corporate business globally. Effective July 1, 2001, the Company’s results include Winterthur International. See Note 6 (c) for additional information. In 2003, the Winterthur International operations changed its name to “XL Global Risk”.
In 1999, XL Capital Ltd merged with NAC Re Corp (“NAC”), a Delaware corporation. NAC was organized in 1985 and writes property and casualty insurance and reinsurance in the U.S., Canada and Europe.
XL Re Ltd, formerly XL Mid Ocean Re, was organized under the laws of Bermuda in 1992 initially to write property catastrophe reinsurance following a reduction in market capacity due to the effects of severe hurricanes that struck the southeastern United States in the late 1980s and early 1990s.
XL London Market, formerly XL Brockbank which comprised both Brockbank and Denham Syndicate Management Limited, is organized under the laws of the U.K. and is a leading Lloyd’s managing agency that provides underwriting and similar services to four Lloyd’s syndicates. Effective January 1, 2002, the Company provides 100% of the capacity for these syndicates. These syndicates underwrite property, marine and energy, aviation, satellite, professional indemnity and other specialty lines of insurance and reinsurance to a global client base.
2. Significant Accounting Policies
(a) Basis of Preparation and Consolidation
These consolidated financial statements include the accounts of the Company and all of its subsidiaries and have been prepared in accordance with U.S. GAAP (“GAAP”). The results include the consolidation of Le Mans Re, accounted for as a subsidiary with effect from January 1, 2002. Effective July 1, 2001, the results also include the acquired Winterthur International operations under the purchase method of accounting, described in Note 6 (c). All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions include the
loss events of September 11, 2001, described in Note 4. Actual results could differ from these estimates.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
(a)
Basis of Preparation and Consolidation (continued)
Certain reclassifications have been made to prior year consolidated financial statement amounts to conform to current year presentation.
(b) Premiums and Acquisition Costs
Premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums written are recorded at the inception of the policy and are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. Financial guaranty installment premiums are recorded as premiums written when reported. Premiums are earned on a monthly pro-rata basis over the period the coverage is provided. Financial guaranty insurance premiums are earned over the life of the exposure. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of policies in force. Net premiums earned are presented after deductions for reinsurance ceded to other insurance companies.
Reinstatement premiums are written at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and are earned over the remaining risk period.
Premiums from long duration contracts that transfer significant mortality or morbidity risks are recognized as revenue and earned when due from policyholders. Premiums from long duration contracts that do not subject the Company to risks arising from policyholder mortality or morbidity are accounted for as deposit liabilities.
Acquisition costs, which vary with and are related to the acquisition of policies consisting primarily of commissions paid to brokers, are deferred and amortized over the period the premiums are earned. Future earned premiums, the anticipated losses, other costs (and in the case of a premium deficiency, investment income) related to those premiums, is also considered in determining the level of acquisition costs to be deferred.
(c)
Reinsurance
In the normal course of business, the Company seeks to reduce the loss that may arise from events that could cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurers or reinsurers. Reinsurance premiums ceded are expensed and any commissions recorded thereon are earned on a monthly pro-rata basis over the period the reinsurance coverage is provided. Prepaid reinsurance premiums represent the portion of premiums ceded applicable to the unexpired term of policies in force. Reinstatement premiums ceded are recognized at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and are expensed over the remaining risk period. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Provision is made for estimated unrecoverable reinsurance.
(d)
Fee Income and Other
Fee income and other includes fees earned for insurance related services provided and is earned over the service period of the contract. Any adjustments to fees earned or the service period are reflected in income in the period when determined.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
(e) Other Than Temporary Declines In Investments
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These factors include (i) the time period during which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized in the period such determination is made.
With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information, market conditions generally and assessing value relative to other comparable securities.
(f) Derivative Instruments and Weather Derivative Contracts
The Financial Accounting Standards Board (“FASB”) issued Financial Accounting Standards (“FAS”) No.133, “Accounting for Derivative Instruments and Hedging Activities” in June 1998. FAS 133 establishes accounting and reporting standards for derivative instruments including those embedded in other contracts (collectively referred to as derivatives), and for hedging activity. It requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. Non-exchange traded weather products are not covered by FAS 133, however they are also recorded at fair value. The Company adopted FAS 133, as amended, as of January 1, 2001. The Company conducts activities in three main types of instruments: credit default swap derivatives, weather and energy derivatives and investment related derivative instruments. There was no significant cumulative effect from the adoption of FAS 133.
In 2002, the Company amended the presentation of its derivative transactions in the consolidated statements of income to include the change in fair value of all of its derivative transactions in one line item under “net realized and unrealized gains and losses on derivative instruments”. Previously, certain components of the change in fair value were reported in “net premiums earned, net losses and loss expenses incurred and fee and other income”. There was no effect on net income for this change and prior period results have been reclassified to reflect this change.
Credit Default Swap Derivatives
Credit default swaps are recorded at fair value which is determined using models developed by the Company and is dependent upon a number of factors including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change resulting from movements in credit and quality spreads is unrealized as the credit default swaps are not traded to realize this value and are included in net realized and unrealized gains and losses on derivative instruments. Other elements of the change in fair value are based upon pricing established at the inception of the contract.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Weather and Energy Derivatives
Weather and energy derivatives are recorded at fair value with the changes in fair value included in “net realized and unrealized (losses) gains on derivative instruments”. Fair value for the Company’s energy contracts are determined through the use of quoted market prices. As quoted market prices are not widely available in the weather derivative market, management uses available market data and internal pricing models based upon consistent statistical methodologies to estimate fair values. Estimating the fair value of instruments which do not have quoted market prices requires management judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in interest rates and other market factors.
Investment Related Derivative Instruments
The Company uses investment derivatives to manage duration and currency exposure for its investment portfolio. Investment derivatives that are not designated as hedges are carried at fair value, with the corresponding realized and unrealized gains and losses included in net realized and unrealized gains and losses on derivative instruments.
The Company has used derivative instruments to manage the interest rate exposure of the Company’s guaranteed investment contracts (GICs). All interest rate swaps are recorded at fair value. Fair value is determined using fixed income analytical models and related commercially available software, and is dependent upon interest rate conditions and relationships among interest rates and indices. Changes in the value of fair value hedges are recorded as adjustments to the hedged items to the extent that the hedge is effective. Changes in the value of cash flow hedges are recorded in other comprehensive income to the extent that the hedge is effective. The ineffective portion of both fair value and cash flow hedges are recorded in the Statement of Income as realized gains and losses on derivative instruments.
(g) Total Investments
Investments Available For Sale
Investments that are considered available for sale are carried at fair value. The fair value of investments is based upon quoted market values where available or by reference to broker or underwriter bid indications. The net unrealized appreciation or depreciation on investments, net of tax, is included in accumulated other comprehensive income (loss). Any unrealized depreciation in value considered by management to be other than temporary is charged to income in the period that it is determined.
Short-term investments comprise investments with a maturity equal to or greater than 90 days but less than one year. Equity securities include investments in open end mutual funds.
All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of equities and fixed income investments are determined on the basis of average cost and amortized cost, respectively. Investment income is recognized when earned and includes interest and dividend income together with the amortization of premium and discount on fixed maturities and short-term investments.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
Investment In Affiliates
Investments in which the Company has significant influence over the operations are classified as investments in affiliates for accounting purposes and are carried under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss from such investments in its results for the period. Significant influence is deemed to exist where the Company has an investment of 3% or greater in closed end funds, limited partnerships or similar investment vehicles. Significant influence is considered for other strategic investments on a case-by-case basis. The determination of whether an entity is classified as an affiliate for accounting purposes may be different from the determination of whether such entity would constitute an affiliate for any other purposes, including regulatory purposes. The equity in net income of affiliates is shown separately between equity in net income of strategic insurance and operating affiliates and equity in net income of investment affiliates. Any decline in value considered by management to be other than temporary is charged to income in the period that it is determined.
Other investments
The Company accounts for its other investments at estimated fair value, as it has no significant influence over these entities. Income is recorded when received. Investments are written down to their estimated fair value where management considers there is an other than temporary decline in value, based on financial information received.
(h) Cash Equivalents
Cash equivalents include fixed interest deposits placed with a maturity of under 90 days when purchased.
(i) Foreign Currency Translation
Assets and liabilities of foreign operations whose functional currency is not the U.S. dollar are translated at year end exchange rates. Revenue and expenses of such foreign operations are translated at average exchange rates during the year. The effect of the translation adjustments for foreign operations, net of applicable deferred income taxes, is included in accumulated other comprehensive income (loss).
Other monetary assets and liabilities denominated in foreign currencies are revalued at the exchange rate in effect at the balance sheet date with the resulting foreign exchange gains and losses recognized in income. Revenue and expense transactions are translated at the average exchange rates prevailing during the year.
(j) Intangible Assets
Identifiable intangible assets with finite lives are amortized on a straight-line basis over their estimated useful lives. The Company evaluates the recoverability of its intangible assets whenever changes in circumstances warrant. If it is determined that an impairment exists, the excess of the unamortized balance over the fair value of the intangible asset will be charged to income at that time.
Effective January 1, 2002, the Company adopted Financial Accounting Standard (“FAS”) 142, “Goodwill and Other Intangible Assets”. FAS 142 address financial accounting and reporting for goodwill and other intangible assets both upon acquisition and after these assets have initially been recognized in the financial statements. Adoption of FAS 142 has resulted in the Company ceasing to amortize goodwill and identifiable intangible assets with indefinite lives. In accordance with FAS 142, the Company continues to review the carrying value of goodwill related to all of its investments for any impairment at least annually. If it is determined that an impairment exists, the Company adjusts the carrying value of goodwill to fair value. The impairment charge is recorded in income in the period in which it is determined. See Note 5 for further information.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
(k) Losses and Loss Expenses
Unpaid losses and loss expenses includes reserves for unpaid reported losses and loss expenses and for losses incurred but not reported. The reserve for unpaid reported losses and loss expenses for the Company’s general operations is established by management based on amounts reported from insureds or ceding companies and consultation with legal counsel, and represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company.
The reserve for losses incurred but not reported is estimated by management based on loss development patterns determined by reference to the Company’s underwriting practices, the policy form, type of insurance program and the experience of the relevant industries. The Company’s actuaries employ a variety of generally accepted methodologies to determine estimated ultimate loss reserves, including the Bornhuetter-Ferguson incurred loss method. The outcome of the actuarial review will either provide (i) a single point estimate that is management’s best estimate or (ii) a range of reserve estimates. The Company considers a ‘best estimate’ to be one that has an equal likelihood of developing a redundancy or deficiency as the loss experience matures.
Certain workers’ compensation and long term disability liabilities are considered fixed and determinable and are subject to tabular reserving. Reserves associated with these liabilities are discounted.
Management believes that the reserves for unpaid losses and loss expenses are sufficient to cover losses that fall within coverages assumed by the Company. However, there can be no assurance that losses will not exceed the Company’s total reserves. The methodology of estimating loss reserves is periodically reviewed to ensure that the assumptions made continue to be appropriate and any adjustments resulting therefrom are reflected in income of the year in which the adjustments are made.
(l) Deposit Liabilities
Contracts entered into by the Company with cedants which are not deemed to transfer significant underwriting and/or timing risk are accounted for as deposits, whereby liabilities are initially recorded at the same amount as assets received as defined under FAS 113. The Company uses a conservative portfolio rate of return of equivalent duration to the liabilities in determining risk transfer. An initial accretion rate is established based on actuarial estimates whereby the deposit liability is increased to the estimated amount payable over the term of the contract. The deposit accretion rate is the rate of return required to fund expected future payment obligations (this is equivalent to the ‘best estimates’ of future flows), which are determined actuarially based upon the nature of the underlying indemnifiable losses. Accretion of the liability is recorded as interest expense. The Company periodically
reassesses the estimated ultimate liability. Any changes to this liability are reflected as an adjustment to interest expense to reflect the cumulative effect of the period the contract has been in force, and by an adjustment to the future accretion rate of the liability over the remaining estimated contract term.
Guaranteed investment contracts whereby the Company receives deposits at a contractual interest rate are recorded at amortized cost. The company may enter into associated transactions in order to reduce the Company’s exposure to fluctuations in interest rates related to these contracts. For fair value hedges, changes in the fair value of the hedging instrument are recognized in income. The change in the fair value of the hedged item, attributable to the hedged risk, is recorded as an adjustment to the carrying amount of the hedged item and is recognized in income.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
(m) Future policy benefit reserves
The Company estimates the present value of future policy benefits related to long duration contracts using appropriate assumptions for investment yields, mortality, and expenses, including a provision for adverse deviation. The original assumptions are to determine changes in the liability for future policy benefits unless a premium deficiency exists. Any changes to this estimate that result from its periodic estimation will be reflected in income as an adjustment to life claims and policy benefits.
The assumptions used to determine the future policy benefit reserves are best estimate assumptions that are determined at the inception of the contracts and are locked-in throughout the life of the contract unless a premium deficiency exists. As the experience on the contracts emerges, the assumptions are reviewed. If such review would produce reserves in excess of those currently held then the lock-in assumptions will be revised and a loss recognized.
Certain annuity contracts provide the holder with a guarantee that the benefit received upon death will be no less than a minimum prescribed amount. To the extent the guaranteed minimum death benefit exceeds the current account value at the time of death, the Company incurs a cost that is recorded as “policy benefits” for the period in which the death occurs.
(n) Income Taxes
The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The deferral of tax losses is evaluated based upon management’s estimates of the future profitability of the Company’s taxable entities based on current forecasts and the period for which losses may be carried forward. A valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized.
(o) Stock Plans
The Company accounts for stock compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. Accordingly, compensation expense for stock option grants and stock appreciation rights is recognized to the extent that the fair value of the stock exceeds the exercise price of the option at the measurement date. See Note 2 (s).
(p) Per Share Data
Basic earnings per ordinary share is based on weighted average ordinary shares outstanding and excludes any dilutive effects of options and convertible securities. Diluted earnings per ordinary share assumes the conversion of dilutive convertible securities and the exercise of all dilutive stock options.
(q)
Variable Interest Entities
The accounting treatment for the Company’s investment in and relationships with variable interest entities is dependant upon whether the Company is considered to have effective control over the entity. The Company considers several factors to determine whether effective control exists. These factors include, but are not limited to, the initial equity investment made in the vehicle, the degree of exposure to the risks of the underlying assets and liabilities of the entity and the potential to benefit from the rewards. Those variable interest entities that the Company deems necessary to consolidate are accounted for in accordance with the accounting policy for subsidiaries in Note 2(a). Those which the Company does not deem it necessary to consolidate are accounted for in accordance with the terms of the transactions and contractual agreements in place. See Note 2 (s) for further information.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
(r) Fair Value of Financial Instruments
Fair values of investments and derivatives are based on published market values, if available, estimates of fair values, of similar issues estimates of fair values produced by the Company's fair value models. See notes 2 (e), 2 (f), 2 (g), 7 and 15 for further information.
(s) Recent Accounting Pronouncements
In December 2002, FASB issued FAS 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”. FAS 148, amends FAS 123, “Accounting for Stock-Based Compensation,” by providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, FAS 148 amends the disclosure requirements of FAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company plans to record stock option expense for options granted subsequent to January 1, 2003, in accordance with FAS 123, as amended by FAS 148. The Company expects that the effect of adoption of this statement will be a reduction in net income. However, the final determination of this cost is dependant upon a number of factors including but not limited to, the number of options granted and the volatility of the Company’s share price and their related effect on the Black-Scholes valuation.
In January 2003, FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities”, (“FIN 46”). The objective of FIN 46 is to improve financial reporting by companies involved with variable interest entities. This new model for consolidation applies to an entity which either (1) the powers or rights of the equity holders do not give them sufficient decision making powers or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN 46 apply immediately to variable i
nterest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The effect of adoption of this standard on the Company’s financial condition is currently being evaluated with a possible increase in both assets and liabilities of approximately $2.4 billion based on structures and contracts currently in place. Management is assessing alternatives with regards to restructuring these variable interest entities. See Note 16 for further information.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guaranties, Including Indirect Guaranties of Indebtedness of Others” (“FIN 45”). FIN 45 requires that upon issuance of certain types of guaranties, a guarantor must recognize a liability for the fair value of an obligation assumed under a guaranty. FIN 45 also requires additional disclosures by a guarantor in its interim and annual financial statements about the obligations associated with guaranties issued. The recognition provisions of FIN 45 are effective for any guaranties issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company has adopted the disclosure requirements for the year ended December 31, 2002. The Company is currently evaluating the effects of the initial recognition provisions of FIN 45; however the Company does not expect that the adoption of FIN 45 will have a material effect on the Company’s financial condition and results of operations.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. Significant Accounting Policies (continued)
The FASB is currently discussing the accounting related to certain modified coinsurance (“modco”) and funds withheld reinsurance agreements that provide for a total return on a portfolio of fixed income securities that contain embedded derivatives that would require bifurcation under FAS 133. Tentative guidance has been provided in Derivative Implementation Guidance issue No. B36, “Embedded Derivatives- Bifurcation of Embedded Credit”. If embedded derivative accounting for certain modco and funds withheld reinsurance agreements is eventually required, guidance will be applied prospectively for all existing contracts and future transactions in the quarter it becomes effective. The Company currently does not believe the application of the new guidance will have a material impact on its financial condition and results of operations.
3. Segment Information
The Company is organized into three underwriting segments-insurance, reinsurance, and financial products and services-in addition to a corporate segment that includes the investment and financing operations of the Company. General operations and life operations are disclosed separately within each segment. General operations include property and casualty lines of business and financial products and services. Effective January 1, 2002, the Company provides 100% of the capacity of its Lloyd’s syndicates. These operations are included in the insurance segment and are no longer shown separately.
The Company evaluates performance of each segment based on underwriting results for general operations and net income from life operations. Other items of revenue and expenditure of the Company are not evaluated at the segment level for general operations. In addition, the Company does not allocate assets by segment for its general operations. Investment assets related to the Company’s life operations are held in separately identified portfolios. Net investment income from these assets is included in net income from life operations.
Certain lines of business within general operations written by the Company have loss experience generally characterized as low frequency and high severity. This may result in volatility in both the Company’s results and operational cash flows.
Insurance Operations
Insurance business written includes general liability, other liability including directors and officers, professional and employment practices liability, environmental liability, property, program business, marine and energy, aviation and satellite, and other product lines including customs bonds, surety, political risk, and specialty lines.
Reinsurance Operations
Reinsurance business written includes treaty and facultative reinsurance to primary insurers of casualty and property risks, principally: general liability; professional liability; accident and health; automobile and workers compensation; commercial and personal property risks; specialty risks including fidelity and surety and ocean marine; property catastrophe; property excess of loss; property pro-rata; marine and energy; aviation and satellite; and various other reinsurance to insurers on a worldwide basis. The Company’s reinsurance operations also writes life reinsurance business, primarily European term assurances, group life, critical illness cover, immediate annuities in payment and disability income business.
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3. Segment Information (continued)
Financial Products and Services
Financial products and services business written includes insurance, reinsurance and derivative solutions for complex financial risks. These include financial guaranty insurance and reinsurance, credit enhancement swaps, other collateralized transactions and weather risk management products. While each of these is unique and is tailored for the specific needs of the insured or user, they are often multi-year contracts. Due to the nature of these types of contracts, premium volume as well as underwriting results can vary significantly from period to period. The financial products and services segment also assumes U.S. term life mortality reinsurance business from one of the Company’s insurance affiliates.
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3. Segment Information (continued)
The following is an analysis of the underwriting profit or loss by segment together with a reconciliation of underwriting profit or loss to net income or loss:
(U.S. dollars in thousands, except ratios)
______________
(1) Operating expenses exclude corporate operating expenses, shown separately.
(2) This includes net losses on credit default swaps of $16.2 million and $29.9 million related to the insurance and financial products and services segments, respectively, $16.6 million on net realized gains on weather risk management contracts in the financial products and services segment and net realized and unrealized losses of $22.2 million on investment derivatives.
(3) Ratios are based on net premiums earned from general insurance and reinsurance operations, excluding fee income and other. The underwriting expense ratio excludes exchange gains and losses.
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3. Segment Information (continued)
(U.S. dollars in thousands, except ratios)
______________
(1) Operating expenses exclude corporate operating expenses, shown separately.
(2) This includes net gains on credit default swaps of $8.1 million and net losses of $27.5 million related to the insurance and financial products and services segments, respectively, $16.6 million on net realized gains on weather risk management contracts in the financial products and services segment and net realized and unrealized gains of $14.6 million on investment derivatives.
(3) Corporate operating expenses include charges of $14.0 million related to the acquisition of Winterthur International.
(4) Ratios are based on net premiums earned from general insurance and reinsurance operations, excluding fee income and other. The underwriting expense ratio excludes exchange gains and losses.
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3. Segment Information (continued)
(U.S. dollars in thousands, except ratios)
______________
(1) Net losses and loss expenses for the insurance segment include, and the reinsurance segment exclude, $33.5 million relating to an intercompany stop loss arrangement. Total results are not affected. The loss and loss expense ratio would have been 67.3% and 75.1% and the underwriting results would have been a profit of $4.0 million and a loss of $125.0 million in the insurance and reinsurance segments, respectively, had this stop loss arrangement not been in place.
(2) Operating expenses exclude corporate operating expenses, shown separately.
(3) This includes net gains on credit default swaps of $15.9 million related to the financial products and services segment and net realized and unrealized gains of $5.5 million on investment derivatives.
(4) Ratios are based on net premiums earned for general insurance and reinsurance, excluding fee income and other. The underwriting expense ratio excludes exchange gains and losses.
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3. Segment Information (continued)
Supplemental Segment and Geographic Information
The following table is an analysis of the Company’s gross premiums written, net premiums written and net premiums earned from general operations, by line of business for the years ended December 31, 2002, 2001 and 2000:
Year Ended December 31, 2002:
(U.S. dollars in thousands)
Year Ended December 31, 2001:
(U.S. dollars in thousands)
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3. Segment Information (continued)
Year Ended December 31, 2000:
(U.S. dollars in thousands)
______________
(1) Other insurance and reinsurance premiums written and earned include political risk, surety, bonding, warranty and other lines.
The following table shows an analysis of the Company’s net premiums written for general operations by geographical location of subsidiary where the premium is written for the years ended December 31:
(U.S. dollars in thousands)
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4. The September 11 Event
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”) are estimated to have caused the largest ever man-made insured losses for the property and casualty insurance industry. The Company has exposure to this event with claims expected to arise mainly from its aviation, property, personal accident and business interruption insurance and reinsurance coverages.
The Company has performed a detailed analysis of contracts it believes are exposed to this event. The process varied between segments, due to the specific nature of each of their operations, and by line of business. For the insurance lines of business, the Company was able to identify a limited number of relevant contracts soon after the event. The process included identification of possible claims using underwriting systems to determine potential exposures on a case-by-case basis. The exposures were then analyzed to determine the exact location and magnitude of the potential loss.
This process was complicated in the reinsurance operations where the Company is not a direct insurer. Potential losses on certain business lines were easily estimated, such as aviation and direct property catastrophe. Estimates related to the retrocessional book of business were more difficult to ascertain due to the inherent nature of determining the effect from losses arising on the underlying contracts.
The amount of reinsurance recoveries was calculated in accordance with underlying reinsurance contract terms and management believes that the credit rating of the relevant reinsurers continues to provide confidence in ultimate recoverability of these balances.
The Company estimates losses incurred of approximately $996.0 million, net of reinsurance recoveries, based on reports and estimates of loss and damage. The following is an analysis of the impact on the Company’s segments and total results of operations from the September 11 event for the years ended December 31, 2002 and 2001:
Year Ended December 31, 2002:
(U.S. dollars in thousands)
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4. The September 11 Event (continued)
Year Ended December 31, 2001:
(U.S. dollars in thousands)
Premiums written, ceded and earned related to reinstatement and adjustment premiums that are typically received and paid when a catastrophic event occurs. The premium is paid to reinstate coverage for the remaining life of the contract.
Net losses and loss expenses comprise gross claims of $2.1 billion with estimated reinsurance recoveries of $1.2 billion, both excluding Winterthur International. Winterthur International incurred gross losses of $272.0 million related to the September 11 event, which the Company expects to recover from third-party reinsurers or under the net loss reserve seasoning mechanism in the Sale and Purchase Agreement (defined in Note 6 (c)), or a combination of the two. These losses related to business written by Winterthur International prior to July 1, 2001.
The Company has paid only approximately 25% of its estimated ultimated losses relating to the September 11 event as at December 31, 2002.
5. Goodwill and Intangible Assets
FASB issued FAS 141, “Business Combinations,” and FAS 142, “Goodwill and Other Intangible Assets,” in July 2001. The Company has adopted these standards for the acquisition of Winterthur International. FAS 141 addresses financial accounting and reporting for the acquisition of other companies and is applicable for new transactions effective after June 30, 2001. For previous transactions, this standard is effective for fiscal years beginning after December 15, 2001. FAS 142 addresses financial accounting and reporting for goodwill and other intangible assets both upon acquisition and after these assets have initially been recognized in the financial statements.
Adoption of FAS 142 has resulted in the Company ceasing to amortize goodwill and certain intangible assets.
The Company assessed the carrying value of goodwill as of June 30, 2002 in accordance with FAS 142 and at that time, determined that goodwill assets were unimpaired. The Company continues to review the carrying value of goodwill related to all of its investments. As further information becomes available, the Company will adjust the carrying value of goodwill as appropriate.
The following is the pro forma effect on net income available to ordinary shareholders and earnings per ordinary share for the years ended December 31, 2001, and 2000 had FAS 142 been effective January 1, 2000 as compared to the reported net income and earnings per ordinary share for the years ended December 31, 2001 and 2000:
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5. Goodwill and Intangible Assets (continued)
(U.S. dollars in thousands, except per share amounts)
The following table shows an analysis of intangible assets broken down between goodwill, intangible assets with an indefinite life and intangible assets with a definite life for the years ended December 31, 2002 and 2001:
(U.S. dollars in thousands)
As at December 31, 2002 goodwill related to the insurance segment was $279.0 million, the reinsurance segment was $1.4 billion and the financial products and services segment was $4.6 million.
6. Business Combinations
(a) Le Mans Ré
Effective January 1, 2002, the Company consolidated its investment in Le Mans Ré after increasing its ownership from 49% to 67% in order to expand its international reinsurance operations. Le Mans Ré underwrites a worldwide portfolio comprising most classes of property and casualty reinsurance business, together with a selective portfolio of life reinsurance business. The remaining 33% ownership is held by Les Mutuelles du Mans Assurances Group (“MMA”). The Company has the option to buy the remaining shares from MMA for approximately $138.5 million in cash on December 13, 2003. The Company must provide
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6. Business Combinations (continued)
notice of its intention to exercise prior to June 13, 2003. The Company currently intends to exercise its option prior to this date. In addition, MMA has the option to sell the remaining shares to the Company on December 13, 2003, or earlier if specific events occur, for approximately $138.5 million in cash. These events include, but are not limited to, a reduction of the Standard & Poor’s rating of Le Mans Ré and a change of control in either the Company or Le Mans Ré. The purchase price for the remaining 33% ownership is fixed and the Company has recorded a liability for the purchase price for the remaining shares. Due to certain contractual arrangements between the company and MMA, MMA does not have any economic interest in the earnings of Le Man Ré with effect from January 1, 2002 and accordingly, no minority interest was recorded in 2002.
The cost of the acquisition for the increase in ownership from 49% to 67%, including the liability discussed above, was approximately $188.5 million. Goodwill arising from the acquisition was approximately $52.6 million. The Company recoginzed goodwill in excess of the fair value of Le Mans Ré's net assets to increase its European franchise for its reinsurance operations. Cash paid, net of cash acquired, was $45.5 million during the year ended December 31, 2002.
Pro forma financial information and condensed balance sheet information are not presented for the acquisition of Le Mans Ré as the results of Le Mans Ré’s operations are not significant to the consolidated balance sheet or consolidated results of operations of the Company.
(b) Lyndon Life Insurance Company
In the first quarter of 2002, the Company acquired Lyndon Life Insurance Company, a shell company licensed to conduct life insurance business in forty-nine U.S. states, for the purpose of obtaining licenses for the Company’s life operations. The cost of the acquisition was $13.5 million, paid in cash in April 2002, and intangible assets arising from the acquisition were $3.5 million. No goodwill was recorded on this acquisition. Lyndon Life Insurance Company has been renamed XL Life Insurance and Annuity Company.
(c) Winterthur International
On July 25, 2001, the Company completed the acquisition of certain Winterthur International insurance operations (“Winterthur International”) primarily to extend its predominantly North American based large corporate insurance business globally. In connection with its acquisition of Winterthur International in July 2001, in all cash transaction, the Company has recorded a recoverable from Winterthur Swiss Insurance Company (the “Seller”) of $645.7 million at December 31, 2002 based on provisions of the sale and purchase agreement between the parties (“SPA”).
The Company paid to the Seller $405.6 million at closing for Winterthur International based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at December 31, 2000 and the price is subject to final determination based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at June 30, 2001 (the “Completion Financials”). By the terms of the SPA, the Seller is required to deliver the Completion Financials to the Company but has not done so to date. The Company expects the Seller to deliver the Completion Financials later in 2003 or to agree with the Seller an alternative method for determining the final purchase price.
The SPA provides the Company with post-closing protection with respect to adverse development of loss and unearned premium reserves relating to the acquired Winterthur International operations. This protection is based upon actual net loss experience and development over a three year post-closing seasoning period based on loss development experience, collectible reinsurance, reinsurance recoveries and certain other factors set forth in the SPA.
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6. Business Combinations (continued)
(c) Winterthur International (continued)
The SPA provides for arbitration should the Seller and the Company disagree on the final amounts due thereunder. In the event such arbitration is commenced in the future, the Company may recognize an impairment if the amount determined to be due to the Company in such arbitration was less than the carrying value of the SPA recovery balance deemed due from the Seller. Under the terms of the SPA, the Company’s exposure to a deficiency in the net reserves and the run-off of expiring business of the acquired Winterthur International operations, including by reason of uncollectible reinsurance, is limited to $61.0 million. Certain Winterthur International businesses and product lines were not purchased, primarily asbestos, certain insurance liabilities in respect of 1985 and prior years, certain captive management, alternative risk and life insurance business.
The acquisition has been accounted for under the purchase method of accounting and, therefore, the identifiable assets and liabilities of Winterthur International were recorded at their estimated fair value on June 30, 2001 based on the unaudited financial statements prepared by the seller and provided to the Company at that time. The process of determining the fair value of such assets and liabilities acquired, as required under purchase accounting, included management’s estimates and independent valuations. The purchase price was preliminarily allocated to the acquired assets and liabilities based upon their estimated fair value at June 30, 2001. The excess of the purchase price over acquired tangible net assets was then applied to intangible assets with finite and indefinite lives. The remaining purchase price excess over fair value of net assets was allocated to goodwill. The Company’s estimate of
the fair value of loss reserves is approximately $5.0 million less than the carrying value recorded by the seller at July 1, 2001. This difference will be charged to income over the next five years. The Company has included $61.0 million of exposure in establishing its risk premium adjustment inherent in the fair value of loss reserves.
The fair value adjustment estimate consists of two components: (i) discounting the net loss reserves and unearned premium reserves to present value using a risk-free rate of return, net of deferred taxes, and (ii) developing an expense, profit and risk margin for the acquired reserves based on management’s estimate of current market pricing and the terms in the Sale and Purchase Agreement.
The expected payment patterns for the gross loss reserves and the associated reinsurance recoverable amounts are derived by developing separate payment patterns for the gross loss reserves using historical Winterthur International data by line of business and for the associated reinsurance recoverable amounts by lagging the gross payout patterns. In addition, management has estimated a 5% risk and profit margin within these reserves. This margin is based on current pricing quotes expected from a prospective reinsurer or other third party assuming the same risks and takes into account the reserve seasoning protection provided by the seller to the Company. Determination of a fair value for the net unearned premium reserve follows a similar approach to that applied to the loss reserves but with some minor adjustments.
The fair value of significant assets and liabilities acquired by the Company include $200.0 million of cash, $1.2 billion of invested assets, $1.1 billion of premiums receivable, $1.3 billion of unpaid losses and loss expenses recoverable, $2.6 billion of unpaid losses and loss expenses, $513.0 million of unearned premiums and $391.9 million of reinsurance balances payable. The contractual post-closing protection is considered in these fair value estimates.
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6. Business Combinations (continued)
(c) Winterthur International (continued)
Allocation of the purchase price is as follows:
(U.S. dollars in thousands)
The Company recognized goodwill in excess of the fair value of the net assets of Winterthur International operations to increase its global platform for its insurance operations.
The decrease in purchase price to $274.7 million as compared to the preliminary purchase price of $405.6 million at December 31, 2000 reflects the decline in the net asset value of Winterthur International as presented in the unaudited financial statements as at June 30, 2001. The difference of $130.9 million is included in other assets at December 31, 2002 and 2001 and is subject to final adjustment upon determination of the final purchase price and is expected to be recoverable from the Seller when the final audited U.S. GAAP financial statements at June 30, 2001 are delivered to the Company by the Seller. Although to date the Company has recognized a decline of $130.9 million in the purchase price paid for Winterthur International, the Company believes that the actual amount of reduction in the purchase price could be significantly greater when the purchase price is finally determined in accordance with the terms of the SPA.
Accident and health business originally included in the acquisition of Winterthur International was written and earned commencing July 1, 2001. During the quarter ended June 30, 2002, the Company sold the remaining unearned premium related to this business back to Winterthur Swiss Insurance Company (the seller). This was accounted for as a return premium. As a result of the ongoing process to fair value identifiable assets and liabilities, the excess of the selling price over the carrying value of this business of $27.0 million, was accounted for by adjusting the original purchase price of Winterthur International.
The Company has made an estimate of the value of intangible assets acquired and estimates that $14.7 million relates to insurance licenses and sales force, which have an indefinite life and are not therefore subject to amortization. The remaining $15.1 million relates to the value of business in force, which is estimated to have a finite life of up to five years and is being amortized over that period.
(d) The London Assurance Company of America, Inc.
In the first quarter of 2001, the Company acquired The London Assurance Company of America, Inc., a shell company licensed in forty-five U.S. states, for the purpose of obtaining licenses for the financial guaranty operations of the Company. The cost of the acquisition less cash acquired was $16.5 million. The intangible assets related to the licences was $11.2 million.
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7. Investments
Net investment income is derived from the following sources:
(U.S. dollars in thousands)
The following represents an analysis of net realized gains (losses) and the change in unrealized appreciation on investments:
(U.S. dollars in thousands)
The net realized losses in 2002 and 2001 included a loss of $251.5 million and $115.5 million, respectively, relating to certain fixed income, equity securities and other investments where the Company determined that there was an other than temporary decline in the value of those investments. The total amount of an other than temporary decline in value in 2002 related to $144.3 million on fixed income securities, $77.8 million on equity securities and $29.4 million on other investments. Of the decline in value of fixed income and equity securities considered to be other than temporary in 2002, approximately 44% was due to investments in the communications sector. The total amount of an other than temporary decline in value in 2001 related to $66.4 million on fixed income and equity investments and $49.1 million on other investments.
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7. Investments (continued)
The cost (amortized cost for fixed maturities and short-term investments), market value and related unrealized gains (losses) of investments are as follows:
(U.S. dollars in thousands)
(U.S. dollars in thousands)
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7. Investments (continued)
The contractual maturities of fixed maturity securities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(U.S. dollars in thousands)
At December 31, 2002 and 2001, approximately $242.1 million and $328.3 million, respectively, of securities were on deposit with various U.S. state or government insurance departments in order to comply with relevant insurance regulations. The decrease in 2002 from 2001 related primarily to a decrease in required reserves as claim payments relating to the September 11 event have continued to be paid in 2002. As such, the deposits for regulatory requirements decreased.
The Company has two facilities available for the issue of letters of credit collateralized against the Company’s investment portfolio with a value of $243.9 million at December 31, 2002 and $169.0 million at December 31, 2001. At December 31, 2002 and 2001, approximately $160.0 million and $120.0 million, respectively, of letters of credit were issued and outstanding under these facilities.
During 2001, $14.8 million of bonds were held in an escrow account in accordance with Internal Revenue Service regulations. During 2002 there was no longer a tax requirement to hold such funds in an escrow account and the funds were released.
8. Investments in Affiliates
The Company’s investment in affiliates and equity in net income from such affiliates are summarized below:
(U.S. dollars in thousands)
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8. Investments in Affiliates (continued)
The Company has made minority investments ranging from 20% to 30% in several investment fund managers for which the Company paid a total of $142.0 million. The significant investments include Highfields Capital Management LP, a global equity investment firm, Pareto Partners L.P., a currency overlay and fixed income manager, MKP Capital Management, a fixed income investment manager specializing in mortgage-backed securities, FrontPoint Partners LLC, an integrated alternative asset firm and Stanfield Capital Partners, a credit based asset management firm. The Company has invested in certain closed end funds, certain limited partnerships and similar investment vehicles, including funds managed by these investment fund managers, all of which are included in investment management companies and related investment funds above.
The Company’s significant insurance affiliate investments at December 31, 2002 included Annuity and Life Re Holdings Ltd., Sovereign Risk Insurance, Primus Guaranty, Ltd, American Strategic Holdings, and FSA International Ltd, with ownership in those entities at 12%, 49%, 43%, 35%, and 20%. The investment in Primus was not held in 2001.
In certain investments, the carrying value is different from the underlying share of the investee’s net assets. The difference represents goodwill on acquisition. Adoption of FAS 142 with effect from January 1, 2002 has resulted in the Company ceasing to amortize goodwill and certain intangible assets. See Note 18(c) for further information.
The equity in net loss of insurance and operating affiliates in 2002 includes a write down of the goodwill component of $13.3 million in the fourth quarter of 2002 due to a significant decline in the book value of Annuity and Life Re Holdings Ltd. (“Annuity and Life Re”). While the market value of Annuity and Life Re’s ordinary shares is lower than its book value, the Company believes its carrying value of $43.2 million is appropriate at December 31, 2002, as supported by a discounted cashflow analysis of its underlying contracts performed in conjunction with the U.S. term life contracts novated to the Company from Annuity and Life Re. See Note 27 for further information. The Company believes the discounted cash flow analysis is more reliable than the market value as the Company currently has no plans to sell its investment. However, future losses by Annuity and Life Re may cause the Company to recognize additional losses. The market value of the Company's holding of Annuity and Life Re at December 31, 2002 was $7.3 million.
9. Other Investments
Other investments include strategic investments over which the Company does not have significant influence and whose fair value is generally unquoted. This includes investments in limited partnerships where the Company does not participate in the management of the partnerships, and investments in collateralized debt/equity instruments. Income from other investments was $0.04 million and $5.8 million for the year ended December 31, 2002 and 2001, respectively. See Note 18(b) for further information.
The Company regularly reviews the performance of these other investments.
The Company recorded losses of $29.4 million and $49.1 million in the years ended December 31, 2002 and 2001, respectively, due to other than temporary declines in values of these investments.
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10. Losses and Loss Expenses
Unpaid losses and loss expenses for the Company’s general operations are comprised of:
(U.S. dollars in thousands)
Net losses and loss expenses incurred are comprised of:
(U.S. dollars in thousands)
The following table represents an analysis of paid and unpaid losses and loss expenses and a reconciliation of the beginning and ending unpaid losses and loss expenses for the years indicated:
(U.S. dollars in thousands)
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10. Losses and Loss Expenses (continued)
Prior year net losses incurred
The following table presents the net adverse (favorable) development of reserves analyzed by each of the Company’s operating segments :
(U.S. dollars in millions)
The significant developments in prior loss reserve year estimates for each the years indicated within each of the Company’s operating segments is discussed below.
Insurance Segment
During 2002, the Company’s net adverse development of $28 million was comprised of an increase in loss reserves of $73 million relating to the September 11 event that was partially offset by a net decrease in the other reserves of $45 million.
The increase in 2002 in the estimate of the ultimate losses relating to the September 11 event of $73 million related primarily to the accident and health business written in the Company’s Lloyd’s operations. The Company had originally recorded ultimate losses for the September 11 event in the insurance segment of $318 million in 2001 based on management’s best estimate at that time. This best estimate was based on an analysis which had been performed to attempt to identify all possible claims and to analyze the magnitude of the potential loss. However, the September 11 event was estimated to have caused the largest man-made insured event in the history of the insurance industry, which made such estimation inherently difficult. In addition, because the timing of the event was relatively close to the end of the year, much of the information received by the Company at that date was preliminary. The
increase in the loss reserves occurred in the second quarter of 2002 after the Company received additional information from policyholders with regard to claims relating to their insured employee casualties, including estimates of benefits payable under U.S. workers’ compensation statutes. Following receipt of this information, the Company completed an additional review of the reserves for this line of business. As a result of this review, management increased the ultimate loss reserves for this loss event.
The unpaid loss and loss expense reserves for the other insurance reserves at the beginning of 2002 was $4.4 billion. During 2002, the Company decreased the estimate of these reserves by a net amount of $45 million, consisting of a decrease in reserves relating to the excess casualty insurance business of $114 million partially offset by increases in prior year reserves for satellite lines of $30 million and other casualty insurance lines of $39 million. Estimated ultimate loss reserves were reduced for excess casualty insurance based upon lower than expected actual reported loss experience for business written in years 1997 and prior. A lack of available industry data resulted in more actuarial judgment being involved in establishing IBNR loss reserves for this line of business in the earlier years. Estimated loss reserves are then regularly updated to take into account actual claims reported. The adverse development experienced in the satellite lines was due to several satellite malfunctions that caused an increase in actual reported loss activity that was greater than expected. The adverse development for the other casualty lines was for business written in 1999 through 2001. In these years, premium rates for casualty business had declined due to competitive market pressures and in 2002 there was an increase in the size of claims reported that was higher than expected.
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10. Losses and Loss Expenses (continued)
The Company did not change its methodology or key assumptions used in 2002 to determine ultimate loss reserves for this or any other line of insurance business written.
During 2001 and 2000, the net favorable prior year loss development of $78 million and $456 million, respectively, related principally to the Company’s excess casualty insurance business written. 2001 favorable development related to business written in 1994 through 1997. Favorable development in 2000 related to business written in 1993 through 1998. Similar to 2002, favorable development was due primarily to the judgment required in establishing reserves for this line of business due to the lack of industry data available as described above. The Company did not change its methodology or key assumptions for this business in either 2001 or 2000.
While the Company has experienced favorable development in the high layer excess casualty lines for the last several years, there is no assurance that conditions and trends that have affected the development of liabilities in the past will continue. Accordingly, it may not be appropriate to extrapolate future redundancies based on the Company’s historical results.
Reinsurance Segment
During 2002, the Company’s prior year estimate of the year-end 2001 net reserve increased by $385 million. This increase was comprised of an increase of $127 million related to the September 11 event and an increase of $258 million for all other reinsurance reserves.
The increase in estimate for the September 11 event of $127 million related primarily to higher than originally estimated business interruption losses and exposure to potential claims by the Lloyd’s Central Guaranty Fund. The increase in estimate was recorded in the second quarter of 2002 following an analysis of additional new information received from the Company’s ceding companies with regard to their increased estimates of claims relating to their exposures to the September 11 event. During 2001, the Company had recorded incurred losses for the September 11 event for its reinsurance operations of $442 million. Due to the size and complexity of the loss and the time lag in ceding companies reporting the information to the Company, establishing reserves for this loss within a short time period was difficult.
The increase in estimate for all other reinsurance reserves in 2002 of $258 million related principally to losses on business written in 1997 through (and including) 2000 in the Company’s U.S. casualty reinsurance business and for asbestos losses in years prior to 1985. This increase was partially offset by decreases in estimates for losses related to business written in 1985 through 1996 in these same lines of business. The reporting and settlement period for reinsurance casualty business is relatively long and, in some cases, can be up to 30 years or more from the inception date. Moreover, reporting and settlement patterns can vary significantly from year to year. During the years 1998 through 2000, competitive market pressures on pricing caused premium rates for excess casualty business to decline industry wide. For these calendar years, there has been an increase in the number and size of claims report
ed in 2002. This increase has caused the Company to increase its estimated ultimate reserves for this business. The Company did not change its methodology or key assumptions for determining ultimate loss reserves in 2002.
The Company updated its assumptions for asbestos loss reserves in 2002 to take account of an increase in 2002 in the number and size of the ultimate asbestos claims that the Company anticipates on the policies underwritten during the years 1977 through 1985. These changes were based on recent increases in court filings and settlements on behalf of asbestos claimants. The Company’s increase of $30 million in 2002 increased its total net reserves for asbestos and environmental exposures to $66 million, which was less than 1% of the Company’s total unpaid loss and loss expenses at December 31, 2002. See further discussion below.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. Losses and Loss Expenses (continued)
During 2001 and 2000, the Company’s prior estimate of the year-end net reserves increased by $253 million and $61 million, respectively. The increase in 2001 related principally to loss estimates for losses occurring in 1998 through (and including) 2000. The increase in 2000 related principally to loss estimates for losses occurring in 1997 through (and including) 1999. Both years’ increases related to the Company’s casualty reinsurance business. The reasons were the same as those explained above. The Company did not change its methodology or key assumptions in 2001 or 2000. This adverse development was due to an increase in the size and frequency of the reported claims for these lines that was greater than previously expected in the underlying loss reporting patterns used to estimate ultimate losses.
The Company has experienced adverse development in the casualty reinsurance business for the last several years and there can be no assurance that conditions and trends that have affected the development of liabilities in the past will not continue.
Financial Products and Services Segment
During 2002 the Company’s prior estimate of the year-end 2001 net reserve of $26 million decreased by $13 million to $13 million as at December 31, 2002. This change in estimate was due entirely to the financial guaranty business written within this segment for losses related to business written in 1998 through and including 2001.
The Company commenced writing financial guaranty business in 1998 and had relied entirely upon industry data to establish reserves until the end of 2001. In 2002, the Company refined its assumptions to take into account its actual historical loss experience and revised its estimated claim reporting pattern for the IBNR losses that the Company records during each loss year. The Company uses this expected loss reporting pattern, combined with changes in reported losses, to determine the prior year development amount. Since reported losses for this business have been less than expected, the refinement in assumptions resulted in a decrease in the estimate of reserves for prior years.
Other loss information
In 2001 and 2000, the Company did not change its prior year loss reserves because it did not have sufficient Company-specific loss experience data available to justify amending the Company’s initial assumptions.
The Company’s net incurred losses and loss expenses included estimates of actual and potential non-recoveries from reinsurers. As at December 31, 2002 and 2001, the reserve for potential non-recoveries from reinsurers was $47.3 million and $49.7 million, respectively.
Except for certain workers compensation and long term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers compensation unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 7%. The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2002 and 2001 were $374.5 million and $231.0 million, respectively. The related discounted unpaid losses and loss expenses were
$151.7 million and $98.0 million as of December 31, 2002 and 2001, respectively. The amount of the discount credit included as a deduction in net losses and loss expenses incurred was $22.6 million and $9.1 million in 2002 and 2001, respectively.
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
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. Losses and Loss Expenses (continued)
irregular and significant. Such adjustments are part of the normal course of business for the Company. Conditions and trends that have affected development of liability in the past may not continue in the future. Accordingly, it is inappropriate to extrapolate future redundancies or deficiencies based upon historical experience.
Asbestos and Environmental Related Claims
The Company’s reserving process includes a continuing evaluation of the potential impact on unpaid liabilities from exposure to asbestos and environmental claims, including related loss adjustment expenses. Liabilities are established to cover both known and incurred but not reported claims.
A reconciliation of the opening and closing unpaid losses and loss expenses related to asbestos and environmental exposure claims related to business written prior to 1986 for the years indicated is as follows:
(U.S. dollars in thousands)
Incurred but not reported losses, net of reinsurance, included in the above table was $33.1 million in 2002, $8.0 million in 2001 and $14.0 million in 2000. Unpaid losses recoverable are net of potential uncollectible amounts.
The Company utilizes industry standard asbestos and environmental claims models to estimate its ultimate liability for these exposures.
As of December 31, 2002, the Company had approximately 537 open claim files for potential asbestos exposures and 515 open claim files for potential environmental exposures on business written prior to 1986. Approximately 44% of the open claim files for both 2002 and 2001 and 45% for 2000 are due to precautionary claim notices. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to receive coverage under the reinsurance contract. Such notices do not contain an incurred loss amount to the Company. The development of the number of open claim files for potential asbestos and environmental claims is as follows:
Asbestos
Claims
Environmental
Claims
Total number of claims outstanding at December 31, 2000
New claims reported in 2001
Claims resolved in 2001
Total number of claims outstanding at December 31, 2001
New claims reported in 2002
Claims resolved in 2002
Total number of claims outstanding at December 31, 2002
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. Losses and Loss Expenses (continued)
The Company’s exposure to asbestos and environmental claims arise from policies written, both on a proportional and excess basis, after 1972. The company discontinued writing policies with these exposures in 1985. Business written was across many different policies each with a relatively small contract limit. The Company’s recently reported asbestos claims related to both traditional products and premises and operations coverage.
The estimation of loss and loss expense liabilities for asbestos and environmental exposures is subject to much greater uncertainty than is normally associated with the establishment of liabilities for certain other exposures due to several factors, including: i) uncertain legal interpretation and application of insurance and reinsurance coverage and liability; ii) the lack of reliability of available historical claims data as an indicator of future claims development; iii) an uncertain political climate which may impact, among other areas, the nature and amount of costs for remediating waste sites; and iv) the potential of insurers and reinsurers to reach agreements in order to avoid further significant legal costs. Due to the potential significance of these uncertainties, the Company believes that no meaningful range of loss and loss expense liabilities beyond recorded reserves can be established. As the Company’s net unpaid loss and loss expense reserves related to asbestos and environmental exposures is less than 1% of the total net reserves at December 31, 2002, further adverse development is not expected to be material to the Company’s overall net loss reserves.
11. Reinsurance
The Company utilizes reinsurance and retrocession agreements principally to increase aggregate capacity and to reduce the risk of loss on business assumed. The Company’s reinsurance and retrocession agreements provide for recovery of a portion of losses and loss expenses from reinsurers and reinsurance recoverables and are recorded as assets. The Company is liable if the reinsurers are unable to satisfy their obligations under the agreements. Under the Company’s reinsurance security policy, reinsurers are generally required to be rated A or better by Standard & Poor’s (“S&P”) or, in the case of Lloyd’s syndicates, S&P “Four Bells” and/or B+ from Moody’s Investor Service. The Company will consider reinsurers that are not rated or do not fall within the above rating categories on a case-by-case basis.
The effect of reinsurance and retrocessional activity on premiums written and earned from general operations is shown below:
(U.S. dollars in thousands)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. Reinsurance (continued)
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $1.4 billion, $3.0 billion and $1.1 billion for the years ended December 31, 2002, 2001 and 2000, respectively. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $1.6 billion at December 31, 2002, collateralizing reinsurance recoverables with respect to certain reinsurers.
The following table presents an analysis of total unpaid losses and loss expenses recoverable between general and life operations for the year ended December 31, 2002:
(U.S. dollars in thousands)
Included in unpaid loss and loss expenses recoverable at December 31, 2002 from general operations is an unsecured reinsurance recoverable from Winterthur Swiss Insurance Company (currently rated A by Standard and Poor's) of $514.8 million related to the acquisition of Winterthur International. In addition, approximately $1.8 billion related to reinsurance recoverables for Winterthur International are also guaranteed by Winterthur Swiss Insurance Company.
12. Deposit Liabilities
The Company has entered into certain contracts with cedants that transfer insufficient risk to be accounted for as insurance or reinsurance transactions. These contracts have been recorded as deposit liabilities and are matched by an equivalent amount of investments. The Company has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the estimated ultimate liability. The Company establishes an initial accretion rate at inception of the contract, which is reviewed and adjusted periodically based on claims activity and current investment yields.
Guaranteed investment contracts, whereby the Company receives deposits at a contractual interest rate, are recorded at amortized cost. The Company also has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the estimated ultimate liability. The Company establishes an initial accretion rate at inception of the contract, which is reviewed and adjusted periodically based on claims activity and current investment yields.
Total deposit liabilities are comprised of the following:
(U.S. dollars in thousands)
Interest expense of $65.9 million, $47.9 million and $38.4 million was recorded related to the accretion of reinsurance and insurance deposit liabilities for the years ended December 31, 2002, 2001 and 2000, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
13. Future Policy Benefit Reserves
During 2002, the Company entered into long duration contracts that subject the Company to mortality and morbidity risks and which were accounted for as life premiums earned. Future policy benefit reserves were established using appropriate assumptions for investment yields, mortality, and expenses, including a provision for adverse deviation. The average interest rate used for the determination of the future policy benefits for these contracts was 5.1% per annum at December 31, 2002 and 2001. Total future policy benefit reserves for the year ended December 31, 2002 and 2001 were $2.5 billion and $1.2 billion, respectively. Substantially all of these reserves relate to closed blocks of annuities.
14. Notes Payable and Debt and Financing Arrangements
As at December 31, 2002, the Company had bank, letter of credit and loan facilities available from a variety of sources, including commercial banks, totaling $4.6 billion, (2001: $4.4 billion) of which $1.9 billion (2001: $1.6 billion) of debt was outstanding. In addition, $2.5 billion (2001: $2.0 billion) of letters of credit were outstanding as at December 31, 2002, 6.5%, (2001: 5%) of which were collateralized by the Company’s investment portfolio, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates capital requirements.
The financing structure at December 31, 2002 was as follows:
(U.S. dollars in thousands)
(1) “Commitment” and “In Use” data represent December 31, 2002 accreted values.
The financing structure at December 31, 2001 was as follows:
(U.S. dollars in thousands)
(1) “Commitment” and “In Use” data represent December 31, 2001 accreted values.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. Notes Payable and Debt and Financing Arrangements (continued)
During 2002 and 2001, borrowings under these facilities were $846.8 million and $1.2 billion, respectively, and repayments under the facilities were $600.0 million and $50.0 million, respectively. Borrowings in 2002 were used to pay down two 5-year revolvers and for general corporate purposes. Borrowings in 2001 were used to repurchase $66.4 million of the Company’s shares and for general corporate purposes. The total pre-tax interest expense on notes and debt outstanding during the years ended December 31, 2002 and 2001 was $102.2 million and $65.4 million, respectively. Associated with the Company’s bank and loan commitments are various loan covenants with which the Company was in compliance throughout the year ended December 31, 2002. These facilities contain various cross default provisions and covenants, including a minimum rating requirement, as further described under “Cross Defaults and O
ther Provisions In Debt Documents”.
The Company issued $100.0 million of 7.15% Senior Notes due November 15, 2005 through a public offering at a price of $99.9 million in 1995.
In April 2001, the Company issued at par $255.0 million of 6.58% Guaranteed Senior Notes due April 2011 through a private placement to institutional investors. Proceeds of the debt were used for general corporate purposes.
In May 2001, the Company issued $1,010.8 million principal amount at maturity (subject to adjustment in the event there is an upward interest adjustment) of Zero Coupon Convertible Debentures (“CARZ”) at $593.57 per bond and, unless converted or repaid before their due date of May 2021, they will be repaid in May 2021 at $1,000 per bond, at a total cost of $1.01 billion. The accretion rate is 2.625% per annum on a semi-annual basis or 2.6422% per annum on an annual basis.
In September 2001, the Company also issued $508.8 million principal amount at maturity (subsequently increased to $511.4 million under the provisions of the upward interest adjustment described below) of Liquid Yield Option NotesTM (“LYONs”) at an initial price of $565.01 per bond. The LYONs will also be repaid at $1,004.93 each (originally $1,000.00 each but subsequently increased as a result of the accretion rate adjustment described below), unless converted or repaid before their due date of September 2021, at a total cost of $511.4 million. The accretion rate on the LYONs was originally 2.875% per annum on a semi-annual basis or 2.89566% per annum on an annual basis. The accretion rate for the year to September 7, 2003, was increased by 0.5% per annum on a semi-annual basis to a 3.37% on a semi-annual basis and 3.403% per annum on an annual basis as a result of the of the Company’s ordinary share price in the 30-day period leading up to the first put date in September 2002. The accretion rates will revert to their original rates in September 2003 unless the contingent additional accretion feature is once again triggered by the Company’s ordinary share price performance in a 30-day period leading up to the second put date.
In January 2002, the Company issued $600.0 million par value 6.50% Guaranteed Senior Notes due January 2012. The notes were issued at $99.469 and gross proceeds were $596.8 million. Related expenses of the offering amounted to $7.9 million. Proceeds of the notes were used to pay down two 5-year revolvers of $350.0 million and for general corporate purposes. These credit facilities were subsequently cancelled.
On June 27, 2002, the Company renewed its principal U.S. 364-day letter of credit and credit facility. The combined capacity of the new facility is $2.0 billion of which up to $500.0 million is available in the form of revolving credit. On July 24, 2002, the Company replaced letters of credit provided by the previous owner of the Winterthur International operations with letters of credit issued from its 364-day facility. During September 2002, the Company canceled a secured $150.0 million letter of credit facility that had been unutilized. In November 2002, the Company renewed its unsecured syndicated letter of credit facility that supports its operations at Lloyd’s. The renewed facility is denominated in U.K. sterling and was approximately $500.0 million at December 31, 2002.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. Notes Payable and Debt and Financing Arrangements (continued)
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are utilized to support non-admitted insurance and reinsurance operations in the U.S. and capital requirements at Lloyd’s. All of the commercial facilities are scheduled for renewal during 2003. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedents with statutory relief required under state insurance regulation in the U.S. It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedents. This could take the form of additional insurance trusts supported by the Company’s investment
portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business.
Although both the CARZ and LYONs are due to be repaid in 2021, there are several features that may result in the bonds being repaid or converted into the Company’s Class A Ordinary Shares before the redemption date. As these features include market-driven features and options available to the Company and bondholders, it is not possible to determine if the bonds will remain outstanding until their scheduled maturity in 2021.
Each of the CARZ and LYONs provide the bondholders the right to require the Company to repurchase the bonds on predetermined dates (“put” dates) at predetermined values as set forth in the relevant indenture. The remaining put dates for the CARZ occur on May 23 of 2004, 2006, 2008, 2011 and 2016. The remaining put dates for the LYONs occur on September 7 of 2003, 2004, 2006, 2008, 2011 and 2016. The Company may, at its option, pay the repurchase price in cash or Class A ordinary shares or a combination thereof.
In addition, each of the CARZ and LYONs provide for a contingent conversion feature that gives the bondholders the right to convert the bonds into the Company’s shares at other times during the life of the bonds if the market price of the Company’s shares is at certain levels. Accordingly, if the Company’s ordinary share price is at least 110% of the accreted conversion price for at least twenty of the thirty days during the relevant conversion period, the bondholders would have the right to convert the bonds into ordinary Shares. If converted for ordinary shares, each CARZ would be converted into 5.9467 ordinary shares and each holder of a LYONs would receive 5.277 ordinary shares. The accreted values would be determined by applying the accretion rate to the initial issue price. In the example of CARZ, the accreted price on May 23, 2003 will be $625.36 determined by adding two year’s accret
ion of 2.6422% per annum on an annual basis to the original issue price of $593.57.
The holders of each of the CARZ and LYONs also have the right to convert the bonds for ordinary shares in the event that the trading price of the bonds for a predetermined period falls below 95% of the value of the equivalent number of ordinary shares, provided however, if the ordinary shares are trading at a predetermined premium to the accreted price of the bonds, holders may receive cash, ordinary shares or a combination thereof in lieu of ordinary shares upon conversion.
These bonds also provide for interest rates to be adjusted in the event that the Company’s ordinary share price falls below levels specified in the relevant indenture relative to the conversion price.
In addition, in the event that the credit ratings assigned to the bonds by S&P fall below BBB+, the bonds would be convertible into ordinary shares at 5.9467 ordinary shares per CARZ and 5.277 ordinary shares per LYONs. The rating assigned to the bonds at the time of issue was A+. Some corporate transactions, such as a change of control of the Company, would give the bondholders the right to require the Company to repurchase the bonds at the accreted value of the bonds at that time.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. Notes Payable and Debt and Financing Arrangements (continued)
The bonds become immediately due if an event of default occurs and 25% or more of the bondholders demand repayment of the accreted value at the time of such event. Such an event of default would include failure to pay amounts due on the notes, an event of default occurring under the Company’s other credit facilities, or certain other events such as bankruptcy or insolvency of the Company. Further descriptions of the events of defaults are contained in the indentures and consequences to the Company are described under “Cross Default and Other Provisions in Debt Documents”.
The bonds are also callable as the Company has the right to redeem the bonds for cash, in full or in part, at their accreted value at any time after May 23, 2004, in the case of the CARZ, and September 7, 2004, in the case of the LYONs.
The puts and the interest rate adjustment features embedded in the CARZ and LYONs are considered derivatives and are subject to fair value. There is currently minimal value ascribed to the puts, as the contingent events of these features are considered unlikely to occur or to the interest rate adjustment feature due to the current trading value of the bonds. Due to the contingent nature of the conversion features of these debt securities, there is no impact on fully diluted earnings (loss) per ordinary share at this time.
Total pre-tax interest expense on the borrowings described above was $102.2 million, $65.4 million and $32.1 million for the years ended December 31, 2002, 2001 and 2000, respectively. Associated with the Company’s bank and loan commitments are various covenants that include, among other things, the requirement to maintain a minimum credit and financial strength rating and a minimum amount of consolidated shareholders’ equity. The Company was in compliance with these covenants throughout the three years ended December 31, 2002.
Cross-Default and Other Provisions in Debt Documents
In general, all of the Company’s bank facilities, indentures and other documents relating to the Company’s outstanding indebtedness (collectively, the “Company’s Debt Documents”), as described above, contain cross default provisions to each other and the Company’s Debt Documents (other than the LYONs, CARZ and 6.5% Guaranteed Senior Notes indentures) contain affirmative covenants. These covenants provide for, among other things, minimum required ratings of the Company’s insurance and reinsurance operating subsidiaries (other than its AAA financial guaranty companies) and the level of secured indebtedness in the future. In addition, generally each of the Company’s Debt Documents provide for an event of default in the event of a change of control of the Company or some events involving bankruptcy, insolvency or reorganization of the Company. The Company’s credit facilities and the 6.58% Guaranteed Senior Notes also contain minimum consolidated net worth covenants.
Under the Company’s 364-day facility, five-year credit facilities and ten-year private placement notes described above, in the event that the Company fails to maintain a claims paying rating of at least A from A.M. Best or the Company’s insurance and reinsurance rated operating subsidiaries (other than its AAA financial guaranty companies) fail to maintain a rating of at least A from S&P, an event of default would occur.
Each of the LYONs, CARZ and 6.5% Guaranteed Senior Notes indentures contains a cross default provision. In general, in the event that the Company defaults in the payment of indebtedness in the amount of $50.0 million or more, an event of default would be triggered under both the LYONs and 6.5% Guaranteed Senior Notes indentures. Under the CARZ indenture, in the event that the Company defaults in the payment of indebtedness in the amount of $100.0 million or more, an event of default would be triggered.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. Notes Payable and Debt and Financing Arrangements (continued)
Given that all of the Company’s Debt Documents contain cross default provisions, this may result in all holders declaring such debt due and payable and an acceleration of all debt due under those documents. If this were to occur, the Company may not have funds sufficient at that time to repay any or all of such indebtedness.
In addition, the Company’s unsecured Lloyd’s letter of credit facility provides that, in the event that the Company’s insurance and reinsurance rated operating subsidiaries fall below A (as generally measured by the lower of the financial strength rating from A.M. Best or S&P at any time), the facility would then be required to be fully secured by the Company, at which time the Company would be required to either (i) provide an amount in cash to cover an amount equal to the aggregate letters of credit outstanding at that time or (ii) deposit assets in trust securing 105% of the aggregate letters of credit outstanding at that time. If this were to occur, the Company may not be able to provide the collateral required in order to maintain this facility.
15. Derivative Instruments
The Company enters into derivative instruments for both risk management and trading purposes. The Company is exposed to potential loss from various market risks, and manages its market risks based on guidelines established by management. These derivative instruments are carried at fair value with the resulting gains and losses recognized in income in the period in which they occur.
In 2002, the Company amended the presentation of its derivative transactions in the consolidated statements of income to include the change in fair value of all of its derivative transactions in one line item under “net realized and unrealized (losses) gains on derivative instruments”. Previously, certain components of the change in fair value were included in “net premiums earned, net losses and loss expenses incurred and fee and other income”. There was no effect on net income for this change and prior period results have been reclassified to reflect this change.
The following table summarizes these instruments and the effect on net income in the years ended December 31, 2002, 2001 and 2000:
(U.S. dollars in thousands)
(a) Credit Default Swaps
Credit default swaps issued by the Company meet the definition of a derivative under FAS 133. Effective January 1, 2001, the Company has recorded these products at fair value, modeled on prevailing market conditions and certain other factors relating to the structure of the transaction. The Company considers credit default swaps to be, in substance, financial guaranty contracts as the Company has the intent to hold them to maturity. In 2001 and 2000, the change in fair value was split between net premiums earned, net losses and loss expenses incurred and net realized and unrealized (losses) gains on derivative instruments. In 2002, the change in fair value is all included in net realized gains and losses on derivatives. Prior period results have been reclassified to reflect this change.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
15. Derivative Instruments (continued) Credit default swaps generally cover a portfolio of securities. The credit ratings of the underlying securities vary and a single rating is calculated for the portfolio at the inception of the transaction by an independent agency. In order to effectively price and market the transaction, different tranches are modeled for the purpose of assigning credit ratings based upon the level of subordination. Generally, a primary layer is created to enable the originator of the transaction to participate in the risks. The Company generally participates in senior or higher quality rated tranches of a risk, but may participate in the primary layer in very limited instances.
The Company fair values transactions related to the primary layers of credit default swaps using a model that calculates the net present value of the premiums and expected losses based on assumptions regarding interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change in fair value recorded for transactions pertaining to primary layers for the year ended December 31, 2002 and 2001 was a loss of $16.2 million and a gain of $8.1 million, respectively.
Credit default swaps where the Company participates in the higher quality rated tranches are considered, in substance, financial guaranty transactions as the Company intends to hold them to maturity. Since the Company underwrites all financial guaranty transactions in the expectation of not incurring a loss, the net present value method described above is not considered appropriate. The rated tranches are therefore fair valued using changes in credit spreads to reflect current market conditions. The Company will also consider the characteristics and credit ratings of the underlying portfolio. The change in fair value recorded for the rated tranches was a loss of $29.9 million and $27.5 million for the years ended December 31, 2002 and 2001 respectively, and a gain of $15.9 million in the year ended December 31, 2000. In accordance with FAS 133, the Company recorded a transition adjustment to recognize the difference between the carrying values and the fair values of the credit default swaps at January 1, 2001. This adjustment was not significant.
(b) Weather and Energy Derivatives
Weather and energy derivatives are recorded at fair value with the changes in fair value included in “net realized and unrealized (losses) gains on derivative instruments”. Fair value is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair values are estimated using available market data and internal pricing models based upon consistent statistical methodologies. Estimating fair value of instruments which do not have quoted market prices requires management judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in interest rates and other market factors.
The change in fair value recorded for the weather and energy derivatives was a gain of $16.6 million and $16.6 million for the year ended December 31, 2002 and 2001, respectively.
(c ) Investment Derivatives, Including Embedded Derivatives
Foreign Currency Exposure Management
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities and equity investments. These contracts are not designated as specific hedges for financial reporting purposes and therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of three months or less. In addition, where the Company’s investment managers believe potential gains exist in a particular currency, a forward contract may not be entered into. At December 31, 2002 and 2001, forward foreign exchange contracts with notional
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
15. Derivative Instruments (continued)
principal amounts totaling $30.2 million and $45.5 million, respectively were outstanding. The fair value of these contracts as at December 31, 2002 and 2001 was $28.6 million and $45.7 million, respectively, with unrealized losses $1.6 million in 2002 and $0.1 million in 2001. For the years ended December 31, 2002 and 2001, realized losses of $3.4 million and a gain of $5.3 million, respectively, and unrealized losses of $0.8 million and $2.3 million, respectively, were recorded in net realized and unrealized gains and losses on derivative instruments.
Derivative Financial Instruments - Hedges
The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments, primarily to reduce its exposure to interest rate risks associated with guaranteed investment contracts. The Company uses interest rate swaps to convert certain liabilities from a fixed rate to a variable rate of interest (fair value hedge), and to convert a variable rate of interest from one basis to another (cash flow hedge). The Company formally documents all relationships between the hedging instruments and hedged items and links the hedge to specific liabilities. The Company assesses the effectiveness of the hedge, both at inception and on an on-going basis and determines whether the hedge is highly effective in offsetting changes in fair value or cash flows of the linked hedged item.
At December 31, 2002, contracts with a notional amount of $259.0 million were in a $1.1 million net unrealized gain position. As a result of the fair value hedges, deposit liabilities were reduced by $0.74 million at December 31, 2002. The ineffective portion of the hedge amounted to $0.06 million and the reduction in interest expense as a result of the hedges amounted to $0.18 million for the year ended December 31, 2002.
The Company is exposed to credit risk in the event of non-performance by the other parties to the forward contracts. The difference between the notional principal amounts and the associated market value is the Company’s maximum credit exposure.
Financial Market Exposure
The Company also uses bond and stock index futures to add value to the portfolio where market inefficiencies are believed to exist, to equitize cash holdings of equity managers and to adjust the duration of a portfolio of fixed income securities to match the duration of related deposit liabilities. These instruments are marked to market on a daily basis and changes in fair values are recorded through net realized and unrealized gains and losses on derivative instruments. The Company measures potential losses in fair values using various statistical techniques.
Other Investment Derivatives
The Company holds warrants in conjunction with certain of its other investments. These warrants are recorded at fair value based on quoted market prices. At December 31, 2002, the Company recorded a loss of $16.7 million, and a gain of $13.6 million for 2001. This related to the change in fair value of these warrants. The primary reason for the loss in 2002 was the decline in fair value of the Mutual Risk Management Ltd warrants of $11.6 million in 2002.
In 2002, the Company entered into a treasury rate lock agreement with the underwriters of the 6.50% Guaranteed Senior Notes due 2012, (2001: 6.58% Guaranteed Senior Notes due 2011). The Notes were priced using a margin over the yield of a U.S. Treasury note with a similar maturity. The treasury rate lock agreement was designed to eliminate underlying pricing risk of the Company’s debt that would have resulted from an increase in the yield of the comparable U.S. Treasury issue between the initiation of the transaction and the pricing of the transaction. The total cost of the hedge was $4.2 million. In 2001, a loss of $5.6 million was recorded in net realized and unrealized gains and losses related to the cancellation of the treasury lock agreement due to the September 11, 2002 event.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
16. Variable Interest Entities
The Company utilizes variable interest entities (as defined in FIN 46) both indirectly and directly in the ordinary course of the Company’s business. At the transactional level, the Company provides various forms of credit enhancement including financial guaranty insurance and reinsurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and structured single risk based obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through variable interest entities. In synthetic transactions, the Company guarantees payment obligations of counterparties including special purpose vehicles under credit default swaps referencing asset portfolios. The Company only provides financial guaranty insurance or enters into a credit default swap of the senior interests that would otherwise be rated investment grade. The Company does not hold any equity positions or subordinated debt in these arrangements. Accordingly, the Company does not consider its participation to be a significant variable interest in the entity and therefore these variable interest entities are not expected to be consolidated.
In February 2003, the Company entered into an aggregate of $300.0 million of commercial paper-based credit facilities (the “Credit Facilities”) and expects to increase these facilities to $500.0 million later in 2003. The proceeds of advances under the Credit Facilities were used to fund a trust account (“Trust”) to collateralize the reinsurance obligations of the Company under an intercompany quota share reinsurance agreement. The issued securities and the Company’s repayment obligations will be recorded as a net balance on the Company’s balance sheet because the Company has a contractual legal right of offset. In the event that in the future the Company were to not have the right to offset such assets (as, for example, would be the case if the assets in the Trust were withdrawn in order to satisfy the Company’s reinsurance obligations or if lender-issued securities could not be held in the Trust because they did not qualify as permitted assets under the trust agreement), then all or a portion of the assets in the Trust and the Company’s repayment obligations under the Credit Facilities would be required to be included as assets and liabilities on a gross basis, respectively, on the Company’s balance sheet.
Effective July 1, 2003 the Company may be required to consolidate up to $2.4 billion of assets and liabilities relating to the following variable interest entities due to its level of variable interest retained by the company and its related parties. Management is assessing alternatives with regards to restructuring these entities in order to mitigate this result and any impact on its financial covenants.
The Company has an investment in an asset backed commercial paper conduit that invests funds provided through a commercial paper and a Euro Medium Term Note program. The assets of this company are guaranteed by an unrelated third party, subject to a $25.0 million deductible. The Company has invested in a $30.0 million subordinate note which is the Company’s maximum exposure to loss as a result of its involvement with this variable interest entity. The Company could experience a loss in the event that the assets of the underlying commercial paper conduit do not perform as expected. The investment company has assets and liabilities of approximately $950.0 million at December 31, 2002 and 2001.
The Company provides insurance, reinsurance and a liquidity facility to a variable interest entity domiciled in the Cayman Islands of which the Company has 23% of the share capital. The variable interest entity was established primarily as a pass-through vehicle associated with a Medium Term Note program backed by a portfolio of investment grade bank perpetual securities and zero coupon notes. The variable interest entity had assets of approximately $715.0 million as at December 31, 2002. The Company’s maximum exposure to loss as a result of its insurance and reinsurance agreements with this variable interest entity was $544.1 million of policy limits as of December 31, 2002. The Company could experience a loss in the event that the underlying assets do not perform as expected.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
16. Variable Interest Entities (continued)
The Company has a residual interest in an asset backed securities collateralized bond obligation (“CBO”). The CBO has assets of $304.9 million and liabilities of $289.4 million as of December 31, 2002. Through the Company’s investment in the CBO’s preferred shares, the Company’s maximum exposure to loss as a result of its investment in this variable interest entity was $3.3 million as at December 31, 2002. The Company also has indirect exposure to loss through its investment in affiliates. The Company could experience a loss in the event that the cash flows relating to the underlying assets are not collected as expected.
The Company has an investment in the junior notes of a collateralized debt obligation (“CDO”). The Company also issued financial guaranties for the senior notes of the CDO. As of December 31, 2002, the CDO had assets of $452.7 million and liabilities of $395.6 million and the Company’s maximum exposure to loss as a result of its investment in this variable interest entity was approximately $425.0 million. The Company could experience a loss in the event that the cash flows relating to the underlying assets are not collected as expected.
17. Exposures Under Guaranties
The Company provides and reinsures financial guaranties issued to support public and private borrowing arrangements. Financial guaranties are conditional commitments that guarantee the performance of an obligor to a third party, typically the timely repayment of principal and interest. The Company’s potential liability in the event of non- payment by the issuer of the insured obligation is represented by its proportionate share of the aggregate outstanding principal and interest payable (“insurance in force”) on such insured obligation. In synthetic transactions, the Company guarantees payment obligations of counterparties under credit default swaps. The unearned premium reserve balance for such guarantees totaled approximately $215.4 million and $100.6 million at December 31, 2002 and 2001 respectively. The range of maturity of the insured obligations is one to thirty five years. The Company do
es not record a carrying value for future installment premiums as they are recognized over the term of the contract.
The Company manages its exposures to underwriting risk on these transactions through a structured process which includes but is not limited to detailed credit analysis, review of and adherence to underwriting guidelines and the use of reinsurance. The Company has also implemented surveillance policies and procedures to monitor its exposure throughout the life of the transactions. In addition, the structures of the transactions are such that the insured obligation is backed by a stream of cash flows, pools of assets or some other form of collateral. This collateral would typically become the Company’s upon the payment of a claim by the Company.
The following table presents financial guaranty aggregate insured portfolios at December 31, 2002 where the net par outstanding was $36.4 billion, which includes credit default swap exposures of $8.7 billion. The liability for these credit default swaps has a carrying value of $160.3 million.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
17. Exposures Under Guaranties (continued)
(1) Other includes Canada, France, Germany, Korea, Chile, Australia, Japan, Portugal, El Salvador, Jamaica, Panama, Costa Rica, Qatar, New Zealand and Spain.
18. Commitments and Contingencies
(a)
Concentrations of Credit Risk
The creditworthiness of a counterparty is evaluated by the Company, taking into account credit ratings assigned by rating agencies. The credit approval process involves an assessment of factors including, among others, the counterparty, country and industry credit exposure limits. Collateral may be required, at the discretion of the Company, on certain transactions based on the creditworthiness of the counterparty.
The areas where significant concentrations of credit risk may exist include unpaid losses and loss expenses recoverable and reinsurance balances receivable (collectively “reinsurance assets”), investments and cash and cash equivalent balances. The Company’s reinsurance assets at December 31, 2002 amounted to $6.3 billion and resulted from reinsurance arrangements in the course of its operations. A credit exposure exists with respect to reinsurance assets as they may be uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound, and if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
18. Commitments and Contingencies (continued)
(a)
Concentrations of Credit Risk (continued)
In addition, the Company underwrites a significant amount of its general insurance and reinsurance business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances to the Company. During 2002, 2001 and 2000, approximately 23%, 23% and 22%, respectively, of the Company’s consolidated gross written premiums from general operations were generated from or placed by Marsh & McLennan Companies. During 2002, 2001 and 2000, approximately 17% 16% and 16%, respectively, of the Company’s consolidated gross written premiums from general operations were generated from or placed by AON Corporation and its subsidiaries. Both of these companies are large, well established companies and there are no indications that either of them is financially troubled. No other broker and no one ins
ured or reinsured accounted for more than 10% of gross premiums written from general operations in each of the three years ended December 31, 2002.
The Company’s available for sale investment portfolio is managed by external managers in accordance with guidelines that have been tailored to meet specific investment strategies, including standards of diversification, which limit the allowable holdings of any single issue. The Company did not have an aggregate investment in a single entity, other than the U.S. government, in excess of 10% of the Company’s shareholders’ equity at December 31, 2002 and 2001.
In connection with its acquisition of Winterthur International in July 2001, in an all cash transaction, the Company has recorded a total recoverable from Winterthur Swiss Insurance Company (the “Seller”) of $645.7 million at December 31, 2002 based on provisions of the sale and purchase agreement between the parties (“SPA”).
The Company paid to the Seller $405.6 million at closing for Winterthur International based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at December 31, 2000 and the price is subject to final determination based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at June 30, 2001 (the “Completion Financials”). By the terms of the SPA, the Seller is required to deliver the Completion Financials to the Company but has not done so to date. The Company expects the Seller to deliver the Completion Financials later in 2003 or to agree with the Seller to an alternative method for determining the final purchase price.
The SPA provides the Company with post-closing protection with respect to adverse development of loss and unearned premium reserves relating to the acquired Winterthur International operations. This protection is based upon actual net loss experience and development over a three year post-closing seasoning period based on loss development experience, collectible reinsurance, reinsurance recoveries and certain other factors set forth in the SPA. The SPA provides for arbitration should the Seller and the Company disagree on the final amounts due thereunder. In the event such arbitration is commenced in the future, the Company may recognize an impairment if the amount determined to be due to the Company in such arbitration was less than the carrying value of the SPA recovery balance deemed due from the Seller. An impairment also may result in the event that the Company and the Seller agree on an amount that is less than the amount shown as a recovery in the Company’s financial statements or to the extent that any amount proves to be uncollectible from the Seller for any reason.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
18. Commitments and Contingencies (continued)
(b) Other Investments
The Company has commited to invest in several limited partnerships and collateralized debt/equity investments as part of its overall corporate strategy. The Company has commitments which include potential additional add-on clauses, to invest a further $21.0 million over the next five years.
(c) Investments in Affiliates
The Company owns a minority interest in certain closed-end funds, certain limited partnerships and similar investment vehicles, including funds managed by those companies. The Company has commitments, which include potential additional add-on clauses, to invest a further $203.1 million over the next five years.
(d) Properties
The Company rents space for its offices under leases that expire up to 2017. Total rent expense for the years ended December 31, 2002, 2001 and 2000 was approximately $30.4 million, $18.9 million and $18.3 million, respectively. Future minimum rental commitments under existing leases are expected to be as follows:
(U.S. dollars in thousands)
(e) Tax Matters
The Company is a Cayman Islands corporation and, except as described below, neither it nor its non-U.S. subsidiaries have paid United States corporate income taxes (other than withholding taxes on dividend income) on the basis that they are not engaged in a trade or business or otherwise subject to taxation in the United States. However, because definitive identification of activities which constitute being engaged in trade or business in the United States is not provided by the Internal Revenue Code of 1986, regulations or court decisions, there can be no assurance that the Internal Revenue Service will not contend that the Company or its non-U.S. subsidiaries are engaged in trade or business or otherwise subject to taxation in the United States. If the Company or its non-U.S. subsidiaries were considered to be engaged in trade or business in the United States (and, if the Company or such subsidiaries w
ere to qualify for the benefits under the income tax treaty between the United States and Bermuda or Ireland, such businesses were attributable to a “permanent establishment” in the United States), the Company or such subsidiaries could be subject to U.S. tax at regular tax rates on its taxable income that is effectively connected with its U.S. trade or business plus an additional 30% “branch profits” tax on such income remaining after the regular tax, in which case there could be a significant adverse effect on the Company’s results of operations and financial condition.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
19. Share Capital
(a) Authorized and Issued
The authorized share capital is 999,990,000 ordinary shares of a par value of $0.01 each. Holders of Class A ordinary shares are entitled to one vote for each share. In June 2000, the Company’s Class B ordinary shares were converted into Class A ordinary shares on a one-for-one basis. All shares in issue at December 31, 2002 are Class A ordinary shares.
The following table is a summary of Class A ordinary shares issued and outstanding (in thousands):
The Company issued 9.2 million shares during November 2001 at a price of $89.00 per share to support capital requirements subsequent to the September 11 event. Net proceeds received were $787.7 million.
In August 2002, the Company issued 9.2 million 8.00% Series A Preference Ordinary Shares at $25 per share. Gross proceeds were $230.0 million and related expenses were $7.2 million. Upon dissolution of the Company, the holders of the Preference Shares would be entitled to receive a liquidation preference of $25 per share, plus accrued and unpaid dividends. Dividends on the Preference Shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Preference Shares on or after August 14, 2007, at a redemption price of $25 per share. The Company may, under certain circumstances, redeem the Preference Shares before August 14, 2007 at specified redemption prices, plus accrued and unpaid dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Preference Shares are entitled to a class vote
($26 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Preference Shares ($25 per share redemption price). The proceeds were used for general corporate purposes.
In November 2002, the Company issued 11.5 million 7.625% Series B Preference Ordinary Shares at $25 per share. Gross proceeds were $287.5 million and related expenses were $9.1 million. Upon dissolution of the Company, the holders of the Preference Shares would be entitled to receive a liquidation preference of $25 per share, plus accrued and unpaid dividends. Dividends on the Preference Shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Preference Shares on or after November 18, 2007, at a redemption price of $25 per share. The Company may, under certain circumstances, redeem the Preference Shares before November 18, 2007 at
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
19. Share Capital (continued)
specified redemption prices, plus accrued and unpaid dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Preference Shares are entitled to a class vote ($26 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Preference Shares ($25 per share redemption price). The proceeds were used for general corporate purposes.
(b) Share Repurchases
The Company has had several stock repurchase plans as part of its capital management program. On January 9, 2000, the Board of Directors authorized the repurchase of shares up to $500.0 million. During 2001, the Company repurchased 1.5 million ordinary shares at a total cost of $116.9 million, or an average cost of $76.40 per ordinary share. During 2000, the Company repurchased 5.1 million ordinary shares at a total cost of $247.7 million, or an average cost of $48.82 per ordinary share. The Company has repurchased shares from employees and directors in relation to share swaps on option exercises and withholding tax on restricted stock.
(c) Stock Plans
The Company’s long term stock plan, the 1991 Performance Incentive Program, as amended and restated effective May 10, 2002, provides for grants of non-qualified or incentive stock options, restricted stock awards and stock appreciation rights (“SARs”). The plan is administered by the Company and the Compensation Committee of the Board of Directors. Stock options may be granted with or without SARs. Grant prices are established at the fair market value of the Company’s common stock at the date of grant. Options and SARs have a life of not longer than ten years and vest as set forth by the Compensation Committee at the time of grant. Options currently vest annually over three or four years from date of grant.
Restricted stock awards issued under the 1991 Performance Incentive Program plan vest over such periods as the Compensation Committee may approve. These shares contained certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability. As the shares are issued, deferred compensation equivalent to the fair market value on the date of the grant is charged to shareholders’ equity and subsequently amortized over the vesting period. Restricted stock issued under the plan totaled 225,960 shares, 227,795 shares and 77,472 shares in 2002, 2001 and 2000, respectively. Restricted stock awards granted by NAC prior to the merger amounted to 3,627 shares in 1999. Vesting for restricted stock awards generally occurs over a four to six year period.
All options granted to non-employee directors are granted under the 1991 Performance Incentive Program. All options vest immediately on the grant date. Directors may also make an irrevocable election preceding the beginning of each fiscal year to defer cash compensation that would otherwise be payable as his or her annual retainer in increments of $5,000. The deferred payments are credited in the form of ordinary shares calculated by dividing 110% of the deferred payment by the market value of the Company’s stock at the beginning of the fiscal year. These shares are distributed under the terms of the plan. Shares issued under the plan totaled 3,622, 4,240 and 8,179 in 2002, 2001 and 2000, respectively.
A second stock plan is provided for the directors that grants share units equal to their annual retainer divided by market price of the Company’s ordinary stock on January 1 of each year. These units receive dividends in the form of additional units equal to the cash value divided by the market price on the payment date. Stock units totaling 6,659, 7,318 and 12,903 were issued in 2002, 2001 and 2000, respectively. Total units are granted as shares upon retirement.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
19. Share Capital (continued)
Following the merger with NAC, new option plans were created in the Company to adopt the NAC plans. Options generally have a five or six year vesting schedule, with the majority expiring ten years from the date of grant; the remainder having no expiration. A stock plan is also maintained for non-employee directors. Options expire ten years from the date of grant and are fully exercisable six months after their grant date.
In 1999, the Company adopted the 1999 Performance Incentive Plan under which 1,250,000 options were available and issued to employees who were not directors or executive officers of the Company.
The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standard 123, “Accounting for Stock-Based Compensation.” Had the Company adopted the accounting provisions of FAS 123, compensation costs would have been determined based on the fair value of the stock option awards granted in 2002, 2001 and 2000, and net income and earnings per share would have been reduced to the pro-forma amounts indicated below:
(U.S. dollars in thousands, except per share amounts)
The Company plans to record stock option expense for options granted subsequent to January 1, 2003 in accordance with transition guidance provided by FAS 148.
Employee Share Purchase Plan
The Employee Share Purchase Plan (the “ESPP”) was approved by the shareholders of the Company on May 10, 2002. The ESPP is administered by a committee which consists of members of the Compensation Committee of the Company’s Board of Directors. The ESPP has two offering periods a year with the first period commencing on July 1, 2002. All employees are eligible to participate in the ESPP provided they have been employed by the Company at least one month prior to the start of the offering period and they do not hold more than 5% of the Company’s total stock, including stock acquired in the current period. Employees can invest up to 20% of their total monthly cash compensation towards the purchase of the Company’s shares up to a total market value of U.S. $25,000. The total number of shares purchased in any offering period cannot exceed 1,000 shares. Employees who enroll in the ESPP may pur
chase the Company’s shares at a 15% discount on the lesser of the market price at the beginning or at the end of the six months. Once purchased, employees can sell or transfer their shares to someone else’s name only during an Open Trading Window. Participants in the ESPP are eligible to receive dividends on the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
19. Share Capital (continued)
Company’s shares. A total of 1,255,000 ordinary shares may be issued under the ESPP. The number of share issued at December 31, 2002 was 47,399.
(d) FAS 123 Pro Forma Disclosure
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
Total stock based compensation expensed, which related to amortization of restricted stock, was $14.3 million, $10.4 million and $9.5 million in 2002, 2001 and 2000, respectively.
(e) Options
Following is a summary of stock options and related activity:
(U.S. dollars in thousands, except per share amounts)
______________
* Available for grant includes shares that may be granted as either stock options or restricted stock.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
19. Share Capital (continued)
The following table summarizes information about the Company’s stock options (including stock appreciation rights) for options outstanding as of December 31, 2002:
______________
(1) Includes 25,732 options outstanding and exercisable, with an average exercise price of $23.85 that have no expiration date. These options are not included in the calculation of the average remaining contractual life.
(2) Includes 22,779 options outstanding and exercisable, with an average exercise price of $37.23 that have no expiration date. These options are not included in the calculation of the average remaining contractual life.
(f) Voting
The Company’s Articles of Association restrict the voting power of any person to less than approximately 10% of total voting power.
(g) Share Rights Plan
Rights to purchase Class A ordinary shares (“the Rights”) were distributed as a dividend at the rate of one Right for each Class A ordinary share held of record as of the close of business on October 31, 1998. Each Right entitles holders of Class A ordinary shares to buy one ordinary share at an exercise price of $350. The Rights would be exercisable, and would detach from the Class A ordinary shares, only if a person or group were to acquire 20% or more of the Company’s outstanding Class A ordinary shares, or were to announce a tender or exchange offer that, if consummated, would result in a person or group beneficially owning 20% or more of Class A ordinary shares. Upon a person or group without prior approval of the Board acquiring 20% or more of Class A ordinary shares, each Right would entitle the holder (other than such an acquiring person or group) to purchase Class A ordinary shares (or,
in certain circumstances, Class A ordinary shares of the acquiring person) with a value of twice the Rights exercise price upon payment of the Rights exercise price. The Company will be entitled to redeem the Rights at $0.01 per Right at any time until the close of business on the tenth day after the Rights become exercisable. The Rights will expire at the close of business on September 30, 2008, and do not have a fair value. The Company has reserved 119,073,878 Class A ordinary shares being authorized and unissued for issue upon exercise of Rights.
20. Retirement Plans
The Company maintains both defined contribution and defined benefit retirement plans, which vary for each subsidiary. Plan assets are invested principally in equity securities and fixed maturities.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
20. Retirement Plans (continued)
The Company has a qualified defined contribution plan which is managed externally and whereby employees and the Company contribute a certain percentage of the employee’s gross salary into the plan each month. The Company’s contribution generally vests over 5 years. The Company’s expenses for its qualified contributory defined contribution retirement plans were $22.2 million, $9.7 million and $7.4 million in the years ended December 31, 2002, 2001 and 2000, respectively.
A qualified non-contributory defined benefit pension plan exists to cover substantially all its U.S. employees. This plan also includes a non-qualified supplemental defined benefit plan designed to compensate individuals to the extent their benefits under the Company’s qualified plan are curtailed due to Internal Revenue Code limitations. Benefits are based on years of service and compensation, as defined in the plan, during the highest consecutive three years of the employee’s last ten years of employment. Under these plans, the Company’s policy is to make annual contributions to the plan that are deductible for federal income tax purposes and that meet the minimum funding standards required by law. The contribution level is determined by utilizing the entry age cost method and different actuarial assumptions than those used for pension expense purposes. The projected benefit obligation, accumulated benefit obligation and fair value of the assets for this plan with accumulated benefit obligations in excess of plan assets were $20.3 million, $20.3 million and $11.6 million, respectively, as of December 31, 2002, and $24.9 million, $15.1 million and $12.4 million, respectively, as of December 31, 2001.
In the first quarter of 2002, the Company curtailed its qualified non-contributory defined benefit plan. Under the terms of the curtailment, eligible employees will not earn additional defined benefits for future services. However, future service may be counted toward vesting of benefits which accumulated based on past service. The Company recognized a benefit of $9.9 million associated with this curtailment gain.
Pension benefits and retirement plans in relation to the Winterthur International acquisition are subject to transition provisions in the Sale and Purchase Agreement. Under these plans, employees accrue benefits based on years of credited service, average compensation and age. The pension obligation under these arrangements will continue with the seller until contractual terms are satisfied and the liability under a GAAP basis has been quantified and agreed between the Company and the seller, at which point all Winterthur International employees will be covered under a Company plan. Definition of various contractual rights and obligations and valuation of the plans are expected to be completed in 2003. The seller will provide the assets to fund the pension liability. It is not believed that adoption of these plans will have a significant effect on the results of operations, financial position and liquidity of the Company.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
21. Accumulated Other Comprehensive Income (Loss)
The related tax effects allocated to each component of the change in accumulated other comprehensive income were as follows:
(U.S. dollars in thousands)
22. Contributed Surplus
Under the laws of the Cayman Islands, the use of the Company’s contributed surplus is restricted to the issue of fully paid shares (i.e. stock dividend or stock split) and the payment of any premium on the repurchase of ordinary shares.
23. Dividends
In 2002, four regular quarterly dividends were paid at $0.47 per share to ordinary shareholders of record as of February 4, May 28, August 5 and December 2.
In 2002, the Company paid dividends of $9.6 million to Series A and Series B preference shareholders.
In 2001, four regular quarterly dividends were paid at $0.46 per share to ordinary shareholders of record of February 15, May 25, August 15 and November 30.
In 2000, four regular quarterly dividends were paid at $0.45 per share to ordinary shareholders of record of February 15, May 25, August 15 and November 15.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
24. Taxation
The Company is not subject to any taxes in the Cayman Islands on either income or capital gains under current Cayman law. The Company has received an undertaking that the Company will be exempted from Cayman Islands income or capital gains taxes until June 2018 in the event of any such taxes being imposed.
The Company’s Bermuda subsidiaries are not subject to any income, withholding or capital gains taxes under current Bermuda law. In the event that there is a change such that these taxes are imposed, the Bermuda subsidiaries would be exempted from any such tax until March 2016 pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966, and Amended Act of 1987.
The Company’s U.S. subsidiaries are subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The provision for federal income taxes has been determined under the principles of the consolidated tax provisions of the Internal Revenue Code and Regulations thereunder. Should the U.S. subsidiaries pay a dividend to the Company, withholding taxes will apply.
The Company has operations in subsidiary and branch form in various other jurisdictions around the world, including but not limited to the U.K., Switzerland, Ireland, Germany, France and Luxembourg that are subject to relevant taxes in those jurisdictions.
The income tax provisions for the years ended December 31, 2002, 2001 and 2000 are as follows:
(U.S. dollars in thousands)
The weighted average expected tax provision has been calculated using the pre-tax accounting income (loss) in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years December 31, 2002 and 2001 is provided below:
(U.S. dollars in thousands)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
24. Taxation (continued)
Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2002 and 2001 were as follows:
(U.S. dollars in thousands)
The valuation allowance of $50.5 million at December 31, 2002 relates to net operating loss carry-forwards that may not be realized within a reasonable period. The valuation allowance of $39.7 million at December 31, 2001 relates to net operating loss carry-forwards that may not be realized within a reasonable period and foreign tax credits that may expire before being realized. The deferred tax asset and valuation allowance for the U.S. foreign tax credits which expired in 2002 were eliminated in the current year. Management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized. U.S. net operating loss carryforwards at December 31, 2002 were approximately $199.5 million and will expire in future years through 2021. As at December 31, 2002, net operating loss carryforwards in the U.K. were $570.0 million and have no expiration.
Shareholders’ equity at December 31, 2002 and 2001 reflected tax benefits of $3.7 million and $9.1 million, respectively, related to compensation expense deductions for stock options exercised for one of the Company’s U.S. subsidiaries.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
25. Statutory Financial Data
The Company’s ability to pay dividends is subject to certain regulatory restrictions on the payment of dividends by its subsidiaries. The payment of such dividends is limited by applicable laws and statutory requirements of the various countries the Company operates in, including Bermuda, the U.S. and the U.K., among others. Statutory capital and surplus as reported to relevant regulatory authorities for the principal operating subsidiaries of the Company was as follows:
(U.S. dollars in thousands)
The difference between statutory financial statements and statements prepared in accordance with GAAP vary by jurisdiction however the primary difference is that statutory financial statements do not reflect deferred policy acquisition costs, deferred income tax net assets, intangible assets, unrealized appreciation on investments and any unauthorized/authorized reinsurance charges.
Except as noted below, there are no statutory restrictions on the payment of dividends from retained earnings by any of the Company’s subsidiaries as applicable minimum levels of solvency and liquidity have been met and all regulatory requirements and licensing rules complied with. At December 31, 2002 and 2001, XL Re America, one of the Company’s subsidiaries, had a statutory earned deficit and is restricted from making a dividend distribution at this time by the New York Insurance Department. At December 31, 2002 and 2001, XL Insurance Company Limited (previously known as Winterthur International Insurance Company Limited) had a statutory earned deficit and is restricted from making a dividend distribution at this time under U.K. Company law.
26. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
(U.S. dollars in thousands, except per share amounts)
______________
(1) Net of shares repurchased under the treasury stock method.
(2) Average stock options of 2,007 outstanding for the year ended December 31, 2001 have been excluded where these were anti-dilutive to the loss per ordinary share.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
27. Related Party Transactions
On December 31, 2002, the Company entered into an agreement with Annuity and Life Reinsurance, Ltd.(“ALRE”), a subsidiary of Annuity and Life Re (Holdings), Ltd. (“ANR”), pursuant to which the Company assumed certain blocks of life reinsurance business. The Company has an investment in ANR that is accounted for as an affiliate. Under the agreement, the Company has assumed five blocks of life reinsurance business from ALRE and entered into a 50% quota share reinsurance contract with ALRE with respect to four of those blocks of business that the Company believes were all on “arm’s length” terms. As consideration for the novation of the five blocks of business from ALRE, the Company made a payment of approximately $44.0 million. As consideration for the 50% quota share reinsurance contract, the Company received a ceding commission of approximately $26.0 million. In connection with the transferred blocks of business, ALRE also transferred to the Company approximately $66.0 million in assets and related future policy benefit reserves. The 50% quota share reinsurance contract is structured as a modified coinsurance arrangement, as such, the Company recorded a liability for the funds withheld in reinsurance balances payable on the balance sheet in the amount of $25.0 million.
28. Subsequent Events
On February 25, 2003, the Company entered into $300.0 million of commercial paper based credit facilities. The proceeds of the advances were used to fund a trust account, collateralizing the Company’s reinsurance obligations of a subsidiary. The Company expects that it will increase these facilities to $500.0 million later in 2003.
The Company entered into a new $100 million letter of credit facility in January 2003.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
29. Unaudited Quarterly Financial Data
The following is a summary of the unaudited quarterly financial data for 2002 and 2001:
(U.S. dollars in thousands, except per share amounts)
______________
(1) Certain reclassifications have been made relating to the Company’s change in presentation of credit default swaps and weather and energy derivatives. There was no effect on net income from this change in presentation.
XL CAPITAL LTD
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
29. Unaudited Quarterly Financial Data (continued)
In the second quarter of 2002, the Company recorded net losses and loss expenses incurred of approximately $200.0 million related to the September 11 event. The Company also recorded net realized losses on investments of $110.0 million.
Results for the third quarter of 2002 included a large life contract consisting of a U.K. portfolio of annuities. This contract increased net premiums earned and claims and policy benefits by $762.7 million and $776.8 million respectively in the fourth quarter of 2002.
In the fourth quarter of 2002, the Company incurred adverse loss development of $215 million of its casualty reinsurance business written in 1997 through (and including) 2000 and asbestos losses for business written prior to 1985. This was partially offset by decreases in estimates for losses related to this business written in 1985 through 1996 and decreases in the Company’s high excess casualty lines.
In the third quarter of 2001, the Company recorded net losses of approximately $795.9 million after tax due to the September 11 event.
In the fourth quarter of 2001, the Company wrote a large contract of European annuities for $549.3 million of net premium earned and policy benefits. In addition, the Company incurred adverse loss development of its casualty reinsurance business written prior to 1999 of approximately $140.0 million after-tax, and losses related to certain other events, including the bankruptcy of Enron Corp., American Airlines Flight 587 and several large European property losses.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There have been no changes in or any disagreements with accountants regarding accounting and financial disclosure within the twenty-four months ending December 31, 2002.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
This item is omitted because a definitive proxy statement that involves the election of directors will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year pursuant to Regulation 14A, which proxy statement is incorporated by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
This item is omitted because a definitive proxy statement that involves the election of directors will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year pursuant to Regulation 14A, which proxy statement is incorporated by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
This item is omitted because a definitive proxy statement that involves the election of directors will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year pursuant to Regulation 14A, which proxy statement is incorporated by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
This item is omitted because a definitive proxy statement that involves the election of directors will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year pursuant to Regulation 14A, which proxy statement is incorporated by reference.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
Within the 90 days prior to the date of filing this Form 10-K, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Company’s Chief Executive Officer and the Company’s Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company required to be included in the Company’s periodic SEC filings.
There have been no significant changes in the Company’s internal controls or in other factors which could significantly affect internal controls subsequent to the date the Company carried out its evaluation.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Financial Statements, Financial Statement Schedules and Exhibits.
1. Financial Statements
Included in Part II-See Item 8 of this report.
2. Financial Statement Schedules
Included in Part IV of this report:
Other Schedules have been omitted as they are not applicable to the Company.
3. Exhibits
Exhibits
Descriptions
1.1
Underwriting Agreement, dated November 1, 2001, by and among XL Capital Ltd, Goldman, Sachs & Co., Morgan Stanley & Co. Incorporated, Banc of America Securities LLC, Credit Suisse First Boston Corporation, J.P. Morgan Securities Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated, incorporated by reference to the Company’s Current Report on Form 8-K filed January 11, 2002.
1.2
Pricing Agreement, dated November 1, 2001, by and among XL Capital Ltd, Goldman, Sachs & Co., Morgan Stanley & Co. Incorporated, Banc of America Securities LLC, Credit Suisse First Boston Corporation, J.P. Morgan Securities Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated, incorporated by reference to the Company’s Current Report on Form 8-K filed January 11, 2002.
1.3
Underwriting Agreement, dated January 7, 2002, by and among XL Capital Finance (Europe) plc, XL Capital Ltd, Salomon Smith Barney Inc., J.P. Morgan Securities Inc., Banc of America Securities LLC, Barclays Capital Inc. and Credit Lyonnais Securities (USA) Inc., incorporated by reference to the Company’s Current Report on Form 8-K filed January 11, 2002.
1.4
Pricing Agreement, dated January 7, 2002, by and among XL Capital Finance (Europe) plc, XL Capital Ltd, Salomon Smith Barney Inc., J.P. Morgan Securities Inc., Banc of America Securities LLC, Barclays Capital Inc. and Credit Lyonnais Securities (USA) Inc., incorporated by reference to the Company’s Current Report on Form 8-K filed January 11, 2002.
Exhibits
Descriptions
1.5
Underwriting Agreement, dated August 9, 2002, by and among XL Capital Ltd, and Merrill Lynch, Pierce, Fenner & Smith Incorporated, Salomon Smith Barney Inc. and the other underwriters named on Schedule I of the related Pricing Agreement dated the date thereof, incorporated by reference to the Company’s Current Report on Form 8-K, dated August 14, 2002.
1.6
Pricing Agreement, dated August 9, 2002, by and among XL Capital Ltd, and Merrill Lynch, Pierce, Fenner & Smith Incorporated, Salomon Smith Barney Inc. and the other underwriters named on Schedule I of the related Pricing Agreement dated the date thereof, incorporated by reference to the Company’s Current Report on Form 8-K, filed November 14, 2002.
1.7
Underwriting Agreement, dated November 13, 2002, by and among XL Capital Ltd, and Merrill Lynch, Pierce, Fenner & Smith Incorporated, Salomon Smith Barney Inc. and the other underwriters named on Schedule I of the related Pricing Agreement dated the date thereof, incorporated by reference to the Company’s Current Report on Form 8-K, filed November 14, 2002.
1.8
Pricing Agreement, dated November 13, 2002, by and among XL Capital Ltd, and Merrill Lynch, Pierce, Fenner & Smith Incorporated, Salomon Smith Barney Inc. and the other underwriters named on Schedule I of the related Pricing Agreement dated the date thereof, incorporated by reference to the Company’s Current Report on Form 8-K, filed November 14, 2002.
3.1
Memorandum of Association, incorporated by reference to Annex G to the Joint Proxy Statement of EXEL Limited and Mid Ocean limited dated July 2, 1998.
3.2
Articles of Association, incorporated by reference to Annex G to the Joint Proxy Statement of EXEL Limited and Mid Ocean Limited dated July 2, 1998.
4.1
Rights Agreement, dated September 11, 1998, between Exel Limited and Chase Mellon Shareholder Services, L.L.C., as Rights Agent, incorporated by reference to the Company’s Current Report on Form 8-K filed October 21, 1998.
4.2
Registration Rights Agreement, dated May 23, 2001, between XL Capital Ltd and Goldman, Sachs & Co., Deutsche Banc Alex. Brown, and Dresdner Kleinwort Wasserstein L.L.C., as initial purchasers, as incorporated by reference to the Company’s Registration Statement on Form S-3 (No. 333-66976).
4.3
Registration Rights Agreement, dated September 4, 2001, between XL Capital Ltd and Merrill Lynch, Pierce, Fenner & Smith Incorporated, incorporated by reference to Exhibit 4.51 to the Company’s quarterly report on Form 10-Q for the period ended September 30, 2001.
4.4
Indenture, dated January 10, 2002, by and among XL Capital Finance (Europe) plc, XL Capital Ltd and State Street Bank and Trust Company, incorporated by reference to the Company’s Current Report on Form 8-K filed January 14, 2002.
4.5
Form of XL Capital Finance (Europe) plc Debt Security, incorporated by reference to the Company’s Current Report on Form 8-K filed January 14, 2002.
4.6
Excerpts from the Authorizing Resolutions of the Board of Directors of XL Capital Finance (Europe) plc, dated January 7, 2002, incorporated by reference to the Company’s Current Report on Form 8-K filed January 14, 2002.
4.7
Indenture, dated September 4, 2001, between XL Capital Ltd and State Street Bank & Trust Company relating to the Liquid-Yield Option Notes due 2021, incorporated by reference to Exhibit 4.49 to the Company’s quarterly report on Form 10-Q for the period ended September 30, 2001.
Exhibits
Descriptions
4.8
Form of Liquid-Yield Option Note due 2021 (referred to in Exhibit 4.7 above) and incorporated by reference to Exhibit 4.50 to the Company’s quarterly report on Form 10-Q for the period ended September 30, 2001.
4.9
Indenture, dated May 23, 2001, between XL Capital Ltd and Goldman, Sachs & Co., Deutsche Banc Alex. Brown, and Dresdner Kleinwort Wasserstein L.L.C., as initial purchasers, incorporated by reference to Exhibit 4(a) to the Company’s Registration Statement on Form S-3 (No. 333-66976).
4.10
Form of Zero Coupon Convertible debenture, due May 23, 2021 (referred to in Exhibit 4.8 above) and incorporated by reference to Exhibit 10.14.41 to the Company’s quarterly report on Form 10-Q for the period ended June 30, 2001.
4.11
Form of Note Purchase Agreement, dated April 12, 2001, relating to 6.58% Guaranteed Senior Notes due April 12, 2011, incorporated by reference to Exhibit 10.14.43 to the Company’s quarterly report on Form 10-Q for the period ended June 30, 2001.
4.12
Form of Note Purchase Agreement, dated November 1995, relating to 7.15% senior notes due November 15, 2005, incorporated by reference to NAC Re Corporation’s Registration Statement on Form S-3 (No. 33-97878).
4.13
Excerpts from the Authorizing Resolutions of the Special Finance Committee of XL Capital Ltd, dated July 29, 2002, incorporated by reference to the Company’s Current Report on Form 8-K filed August 14, 2002.
4.14
Excerpts from the Authorizing Resolutions of the Special Finance Committee of XL Capital Ltd, dated November 6, 2002, incorporated by reference to the Company’s Current Report on Form 8-K filed November 14, 2002.
10.1
Money Accumulation Savings Program, incorporated by reference to Exhibit 10.15 to the Company’s Registration Statement on Form S-1 (No. 33-40533).
10.2
1991 Performance Incentive Plan, incorporated by reference to Exhibit 10.17 to the Company’s Registration Statement on Form S-1 (No. 33-40533).
10.3
First Amendment to the 1991 Performance Incentive Program, incorporated by reference to Exhibit 10.4 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1996.
10.4
1991 Performance Incentive Program as amended and restated, effective March 17, 2000, incorporated by reference to the Company’s Proxy Statement dated April 7, 2000.
10.5
Retirement Plan for Non-employee Directors of XL Capital Ltd, as amended, incorporated by reference to Exhibit 10.5 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1996.
10.6
XL Capital Ltd Directors Stock and Option Plan, as amended, incorporated by reference to Exhibit 10.6 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1996.
10.7
XL Capital Ltd Stock Plan for Non-employee Directors, incorporated by reference to Exhibit 10.6 to the Company’s Annual report on Form 10-K for the year ended November 30, 1996.
10.8
Fourth Amendment to EXEL Limited Directors Stock and Option Plan, incorporated by reference to Exhibit 10.6.2 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1998.
10.9
Mid Ocean Limited 1993 Long Term Incentive and Share Award Plan, incorporated by reference to Exhibit 10.9.1 to the Company’s Annual report on form 10-K for the year ended November 30, 1998.
Exhibits
Descriptions
10.10
Amendment to Mid Ocean Limited 1993 Long Term Incentive and Share Award Plan, incorporated by reference to Exhibit 10.9.2 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1998.
10.11
Mid Ocean Ltd. Stock & Deferred Compensation Plan for Non-employee Directors, incorporated by reference to Exhibit 10.10.1 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1998.
10.12
Form of Severance Contract between NAC Re Corporation and the executive officers of NAC Re Corporation, incorporated herein by reference to the Company’s Annual Report on Form 10-K of NAC Re Corporation for the year ended December 30, 1988.
10.13
1997 Incentive and Capital Accumulation Plan, incorporated by reference to Exhibit A to the NAC Re Corporation definitive Proxy Statement filed with the Securities and Exchange Commission.
10.14
Dividend Reinvestment and Share Purchase Plan, dated January 18, 2002, incorporated by reference to the Company’s Registration Statement on Form S-3 (No. 333-76988).
10.15
Mark E. Brockbank Consultancy Agreement, incorporated by reference to Exhibit 10.12.1 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1998.
10.16
Henry C. V. Keeling Employment Agreement, incorporated by reference to Exhibit 10.11.2 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1998.
10.17
Amendment to Henry C. V. Keeling Service Agreement, incorporated by reference to Exhibit 10.12.2 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1998.
10.18
Michael A. Butt Employment Agreement, incorporated by reference to Exhibit 10.11.5 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1998.
10.19
Amendment to Henry C. V. Keeling Service Agreement, incorporated by reference to Exhibit 10.12.2 to the Company’s Annual Report on Form 10-K for the year ended November 30, 1998.
10.20
Ronald L. Bornheutter Consulting Agreement, dated July 1, 1999, incorporated by reference to Exhibit 10.14.19 to the Company’s Annual Report on form 10-K for the year ended December 31, 1999.
10.21
Ronald L. Bornheutter Settlement Agreement, dated June 30, 1999, incorporated by reference to Exhibit 10.14.19 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1999.
10.22
Nicholas M. Brown, Jr. Employment Contract, dated June 30, 1998, incorporated herein by reference to NAC Re Corporation’s quarterly report on Form 10-Q for the period ended June 30, 1998.
10.23
Amended and Restated Employment Agreement with Nicholas M. Brown, Jr., dated June 18, 1999, incorporated by reference to Exhibit 10.14.19 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1999.
10.24
Nicholas M. Brown, Jr. Employment Agreement, dated April 1, 2002, incorporated by reference to Exhibit 10.58 to the Company’s quarterly report on Form 10-Q for the period ended March 31, 2002.
10.25
Nicholas M. Brown, Jr. Retirement Agreement, dated April 1, 2002, incorporated by reference to Exhibit 10.59 to the Company’s quarterly report on Form 10-Q for the period ended March 31, 2002.
10.26
Jerry de St. Paer Employment Agreement, dated March 1, 2001, incorporated by reference to Exhibit 10.14.37 to the Company’s quarterly report on Form 10-Q for the period ended June 30, 2001.
Exhibits
Descriptions
10.27
Letter of Credit Facility and Reimbursement Agreement, dated as of June 30, 1999, by and among XL Insurance (Bermuda) Ltd (formerly known as XL Insurance Ltd) XL Capital Ltd, XL Europe Ltd, XL Re Ltd (formerly known as Mid Ocean Reinsurance Ltd), The Brockbank Group plc, as account parties and XL Insurance (Bermuda) Ltd, XL Capital Ltd, XL Re Ltd, and XL Investments Ltd, as guarantors and Mellon Bank, N.A., as issuing bank and agent incorporated by reference to Exhibit 10.14.19 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1999.
10.28
First Amendment dated as of January 21, 2000, to Letter of Credit Facility and Reimbursement Agreement dated June 30, 1999, incorporated by reference to Exhibit 10.14.19 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1999.
10.29
Second Amendment dated as of November 28, 2000, to Letter of Credit Facility and Reimbursement Agreement dated June 30, 1999, incorporated by reference to Exhibit 10.14.34 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.
10.30
364-day Credit Agreement, dated as of July 5, 2000, between XL Capital Ltd, X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Mid Ocean Reinsurance Ltd, as borrowers and guarantors, the lenders named therein, The Chase Manhattan Bank, as administrative agent, Chase Securities Inc., as advisor, lead arranger and book manager, Deutsche Bank AG, as syndication agent, and Mellon Bank,N.A. and Citibank, N.A., as co-documentation agent, incorporated by reference to Exhibit 10.14.31 to the Company’s quarterly report on Form 10-Q for the period ended June 30, 2000.
10.31
Letter of Credit and Reimbursement Agreement, dated as of July 5, 2000, between XL Capital Ltd, X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Mid Ocean Reinsurance Ltd, as account parties and guarantors, the lenders party thereto, The Chase Manhattan Bank, as administrative agent, Chase Securities Inc., as advisor, lead arranger and book manager, Deutsche Bank AG, as syndication agent, and Mellon Bank, N.A. and Citibank, N.A., as co-documentation agents, incorporated by reference to Exhibit 10.14.32 to the Company’s quarterly report on Form 10-Q for the period ended June 30, 2000.
10.32
Letter of Credit and Reimbursement Agreement, dated November 3, 2000, between XL Capital Ltd, XL America Inc., XL Insurance (Bermuda) Ltd (formerly known as XL Insurance Ltd), XL Europe and XL Re Ltd (formerly known as XL Mid Ocean Reinsurance Ltd), the guarantors, the lenders named therein, Citibank International plc, as agent and security trustee and Solomon Brothers International Limited, as arranger, incorporated by reference to Exhibit 10.14.33 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.
10.33
Amendment No. 1, dated as of September 26, 2001, to the Letter of Credit and Reimbursement Agreement dated November 3, 2000 between XL Capital Ltd as account party and guarantor, and X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Re Ltd, as guarantors, and the lenders party thereto and Citibank International plc, as agent and security trustee for the lenders and Salomon Brothers International Limited, as arranger, incorporated by reference to Exhibit 10.49 to the Company’s quarterly report on Form 10-Q for the period ended September 30, 2001.
10.34
Letter of Credit Agreement (Secured), between XL Mid Ocean Reinsurance Ltd and Citibank International plc dated May 19, 1993 (as amended) incorporated by reference to the Company’s Prospectus Supplement dated November 3, 1998.
10.35
364-day Credit Agreement, dated as of June 29, 2001, between XL Capital Ltd, X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Re Ltd, as borrowers and guarantors, the lenders party thereto, and The Chase Manhattan Bank, as administrative agent, J.P. Morgan Securities Inc., as advisor, lead arranger and bookrunner and Mellon Bank, N.A. and Citibank, N.A., as co-syndication agents, incorporated by reference to Exhibit 10.14.38 to the Company’s quarterly report on Form 10-Q for the period ended June 30, 2001.
Exhibits
Descriptions
10.36
Amendment No. 1, dated as of September 26, 2001, to the 364-day Credit Agreement dated as of June 29, 2001 between XL Capital Ltd, X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Re Ltd, as borrowers and guarantors and the lenders party thereto and The Chase Manhattan Bank, as administrative agent, incorporated by reference to Exhibit 10.45 to the Company’s quarterly report on Form 10-Q for the period ended September 30, 2001.
10.37
Amendment No. 2, dated March 15, 2002, to the 364-Day Credit Agreement dated as of June 29, 2001 between XL Capital Ltd, X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Re Ltd, as borrowers and guarantors and the lenders party thereto and JPMorgan Chase Bank (formerly The Chase Manhattan Bank), as administrative agent, incorporated by reference to Exhibit 10.60 to the Company’s quarterly report on Form 10-Q for the period ended March 31, 2002.
10.38
Letter of Credit and Reimbursement Agreement, dated as of June 29, 2001, between XL Capital Ltd, X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Re Ltd, as account parties and guarantors, and The Chase Manhattan Bank, as administration agent, incorporated by reference to Exhibit 10.14.39 to the Company’s quarterly report on Form 10-Q for the period ended June 30, 2001.
10.39
Amendment No. 1, dated as of September 26, 2001, to the Letter of Credit and Reimbursement Agreement dated as of June 29, 2001 between XL Capital Ltd, X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Re Ltd, as account parties and guarantors, the lenders party thereto and JPMorgan Chase Bank (formerly The Chase Manhattan Bank), as administrative agent, incorporated by reference to Exhibit 10.48 to the Company’s quarterly report on Form 10-Q for the period ended September 30, 2001.
10.40
Amendment No. 2, dated March 15, 2002 to the Letter of Credit Facility and Reimbursement Agreement dated as of June 29, 2001 between XL Capital Ltd, X.L. America, Inc., XL Insurance Ltd, XL Europe Ltd and XL Re Ltd, as account parties and guarantors, the lenders party thereto and JPMorgan Chase Bank (formerly The Chase Manhattan Bank), as administrative agent, incorporated by reference to Exhibit 10.61 to the Company’s quarterly report on Form 10-Q for the period ended March 31, 2002.
10.41
Amended and Restated Credit Agreement, dated August 31, 2001, between XL Capital Ltd, XL Insurance Ltd, XL Re Ltd and Mid Ocean Limited, as borrowers and guarantors, and The Chase Manhattan Bank as administrative agent, incorporated by reference to Exhibit 10-49 to the Company’s Annual Report on From 10-K for the year ended December 31, 2001
10.42
Amendment No. 1, dated as of September 26, 2001, to the Amended and Restated Credit Agreement dated as of August 31, 2001 between XL Capital Ltd, XL Insurance Ltd, XL Re Ltd and Mid Ocean Limited, as borrowers and guarantors, the banks party thereto and The Chase Manhattan Bank, as administrative agent, incorporated by reference to Exhibit 10.44 to the Company’s quarterly report on Form 10-Q for the period ended September 30, 2001.
10.43
Second Amended and Restated Agreement for the Sale and Purchase of Winterthur International, dated February 15, 2001, incorporated by reference to the Company’s Current Report on Form 8-K dated July 25, 2001.
10.44
Letter of Credit Facility and Reimbursement Agreement, dated November 20, 2001, between XL Capital Ltd as account party and XL Capital Ltd, X.L. America, Inc., XL Europe Ltd, XL Insurance (Bermuda) Ltd and XL Re Ltd as guarantors and Citibank International Plc as agent and trustee for the lenders party thereto, incorporated by reference to Exhibit 10-52 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
10.45
Amendment No. 1 dated as of March 21, 2002 to the Letter of Credit Facility and Reimbursement Agreement dated November 20, 2001, between XL Capital Ltd X.L. America, Inc., XL Europe Ltd, XL Insurance (Bermuda) Ltd and XL Re Ltd as guarantors and Citibank International Plc as agent and trustee for the lenders party thereto, incorporated by reference to Exhibit 10.62 to the Company’s quarterly report on Form 10-Q for the period ended March 31, 2002.
Exhibits
Descriptions
10.46
Letter of Credit Facility and Reimbursement Agreement, dated as of December 31, 2001, between XL Capital Ltd, X.L. America Inc., XL Insurance (Bermuda) Ltd, XL Europe Ltd and XL Re Ltd, as account parties and guarantors and Mellon Bank, as issuing bank, agent and arranger, incorporated by reference to Exhibit 10-53 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
10.47
Pledge Agreement, dated as of December 18, 2001, made by XL Investments Ltd, XL Re Ltd, XL Insurance (Bermuda) Ltd and XL Europe Ltd as guarantors and in favor of Citibank, N.A. incorporated by reference to Exhibit 10.54 to the Company’s Annual Report on Form 10K for the year ended December 31, 2001.
10.48
Limited Liability Company Agreement of XL Capital Principal Partners I, L.L.C., dated June 26, 2001, incorporated by reference to Exhibit 10.55 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
10.49
Amended and Restated Agreement of Limited Partnership of XL Capital Partners I, L.P., dated May 31, 2001, incorporated by reference to Exhibit 10.56 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
10.50*
First Amendment, dated as of October 30, 2002, to the Amended and Restated Agreement of Limited Partnership of XL Capital Partners I, L.P., dated May 31, 2001.
10.51*
Second Amendment, dated as of March 6, 2003, to the Amended and Restated Agreement of Limited Partnership of XL Capital Partners I, L.P., dated May 31, 2001.
10.52
Amended and Restated Agreement of Limited Partnership of XL Principal Partners I, L.P., dated June 28, 2001 incorporated by reference to Exhibit 10.57 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
10.53*
First Amendment, dated as of October 30, 2002, to the Amended and Restated Agreement of Limited Partnership of XL Principal Partners I, L.P., dated June 28, 2001.
10.54*
Second Amendment, dated as of March 6, 2003, to the Amended and Restated Agreement of Limited Partnership of XL Principal Partners I, L.P., dated June 28, 2001.
10.55
364-day Credit Agreement dated as of June 27, 2002 between XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd, XL Europe Ltd and XL Re Ltd, the lenders party thereto and JP Morgan Chase Bank, as administrative agent, incorporated by reference to Exhibit 10.63 to the Company’s quarterly report on Form 10-Q for the period ended June 30, 2002.
10.56*
Amendment No. 1 dated as of July 19, 2002 to the 364-Day Credit Agreement dated June 27, 2002 between XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd, XL Europe Ltd and XL Re Ltd, the lenders party thereto and JP Morgan Chase Bank, as administrative agent.
10.57*
Letter of Credit Facility and Reimbursement Agreement dated November 18, 2002 between XL Capital Ltd as account party and XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd, XL Europe Ltd and XL Re Ltd, as guarantors and Citibank International plc, as agent and trustee for the lenders party thereto.
10.58*
Amendment Agreement dated July 19, 2002 between Winterthur Swiss International and XL Insurance (Bermuda) Ltd.
10.59*
Standby Letter of Credit Agreement, dated January 31, 2003 between XL Capital Ltd, XL America, Inc., XL Insurance (Bermuda) Ltd, XL Europe Ltd and XL Re Ltd, as the applicant and National Australia Bank Limited, New York Branch, as the bank.
10.60*
Revolving Credit and Security Agreement dated as of February 25, 2003 between XL Re Ltd as borrower, Corporate Asset Funding Company, Inc., Corporate Receivables Corporation, Charta Corporation, Ciesco, L.P., and Citibank, N.A., as lenders thereto and Citicorp North America, Inc. as agent.
______________
* Filed herewith
Exhibits
Descriptions
10.61*
Control Agreement dated as of February 25, 2003, between XL Re Ltd and Citicorp North America, Inc. as agent and Mellon Bank, N.A. as securities intermediary.
12.1*
Statement regarding computation of ratios.
21.1*
List of subsidiaries of the Registrant.
23.1*
Consent of PricewaterhouseCoopers LLP.
99.1*
XL Capital Assurance Inc. audited financial statements as at and for the years ended December 31, 2002, 2001 and 2000.
99.2*
XL Financial Assurance Ltd. audited financial statements as at and for the years ended December 31, 2002, 2001 and 2000.
99.3*
Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b)
Reports on Form 8-K
(1) Current Report on Form 8-K filed on November 12, 2002, under Item 5 thereof.
(2) Current Report on Form 8-K filed on November 13, 2002, under Item 5 thereof
(3) Current Report on Form 8-K filed on November 14, 2002, under Item 5 thereof.
______________
* Filed herewith
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Shareholders of XL Capital Ltd:
In our opinion, the accompanying consolidated balance sheets, the related consolidated statements of income and comprehensive income, of shareholders’ equity and of cash flows present fairly, in all material respects, the financial position of XL Capital Ltd and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in Item 15(a) of this Form 10-K present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management; our responsibility
is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 5 to the consolidated financial statements, the Company changed its method of accounting for goodwill and intangible assets in 2002, upon adoption of Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets as of the effective date of January 1, 2002.
PRICEWATERHOUSECOOPERS LLP
New York, New York
February 11, 2003
XL CAPITAL LTD
SUPPLEMENTAL SCHEDULE I
CONSOLIDATED SUMMARY OF INVESTMENTS-OTHER THAN
INVESTMENTS IN RELATED PARTIES
AS AT DECEMBER 31, 2002
(U.S dollars in thousands)
______________
(1) Investments in fixed maturities and short-term investments are shown at amortized cost.
XL CAPITAL LTD
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONDENSED BALANCE SHEETS-PARENT COMPANY ONLY
AS AT DECEMBER 31, 2002 AND 2001
(U.S. dollars in thousands)
XL CAPITAL LTD
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
STATEMENT OF INCOME AND COMPREHENSIVE INCOME-PARENT COMPANY ONLY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(U.S. dollars in thousands)
XL CAPITAL LTD
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
STATEMENT OF CASH FLOWS-PARENT COMPANY ONLY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(U.S. dollars in thousands)
XL CAPITAL LTD
SCHEDULE IV-REINSURANCE
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(U.S. dollars in thousands)
XL CAPITAL LTD
SCHEDULE VI
SUPPLEMENTARY INFORMATION
CONCERNING PROPERTY/CASUALTY INSURANCE OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(U.S. dollars in thousands)
______________
(1) The information presented above includes balances from the general operations of the Company’s Financial Products and Services segment. Life operations have been excluded.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
XL CAPITAL LTD
By: /s/ Brian M. O’Hara
Brian M. O’Hara
President and Chief Executive Officer
POWER OF ATTORNEY
We, the undersigned directors and executive officers of XL Capital Ltd, hereby severally constitute Michael P. Esposito, Jr., Brian M. O’Hara and Paul S. Giordano, and each of them singly, our true and lawful attorneys with full power to them and each of them to sign for us, and in our names in the capacities indicated below, any and all amendments to the Annual Report on Form 10-K filed with the Securities and Exchange Commission, hereby ratifying and confirming our signatures as they may be signed by our said attorneys to any and all amendments to said Annual Report on Form 10-K.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signatures
Title
Date
/s/ Brian O’Hara
President, Chief Executive
March 28, 2003
Officer and Director
Brian M. O’Hara
(Principal Executive Officer)
/s/ Jerry M. De St. Paer
Executive Vice President
March 28, 2003
(Principal Financial Officer and
Jerry M. de St Paer
Principal Accounting Officer)
/s/ Michael P. Esposito Jr.
Director and Chairman of the
March 28, 2003
Board of Directors
Michael P. Esposito, Jr.
/s/ Ronald L. Bornhuetter
Director
March 28, 2003
Ronald L. Bornhuetter
/s/ Dale Comey
Director
March 28, 2003
Dale Comey
Signatures
Title
Date
/s/ Sir F. Brian Corby
Director
March 28, 2003
Sir F. Brian Corby
/s/ Robert R. Glauber
Director
March 28, 2003
Robert R. Glauber
/s/ Paul E. Jeanbart
Director
March 28, 2003
Paul E. Jeanbart
/s/ John Loudon
Director
March 28, 2003
John Loudon
/s/ Robert S. Parker
Director
March 28, 2003
Robert S. Parker
/s/ Cyril E. Rance
Director
March 28, 2003
Cyril E. Rance
/s/ Alan Z. Senter
Director
March 28, 2003
Alan Z. Senter
/s/ John T. Thornton
Director
March 28, 2003
John T. Thornton
/s/ Ellen E. Thrower
Director
March 28, 2003
Ellen E. Thrower
/s/ John W. Weiser
Director
March 28, 2003
John W. Weiser
CERTIFICATION
OF CHIEF EXECUTIVE OFFICER
XL CAPITAL LTD
Pursuant to section 302 of the Sarbanes-Oxley Act of 2002
(Chapter 63, Title 18 U.S.C.SS.1350(A) and (B))
I, Brian M. O’Hara, certify that:
1. I have reviewed this annual report on Form 10-K of XL Capital Ltd;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Dated: March 28, 2003
Brian M. O’Hara
/s/ Brian M. O’Hara
President and Chief Executive Officer
CERTIFICATION
OF CHIEF FINANCIAL OFFICER
XL CAPITAL LTD
Pursuant to section 302 of the Sarbanes-Oxley Act of 2002
(Chapter 63, Title 18 U.S.C.SS.1350(A) and (B))
I, Jerry de St. Paer, certify that:
1. I have reviewed this annual report on Form 10-K of XL Capital Ltd;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Dated: March 28, 2003
Jerry de St. Paer
/s/ Jerry de St. Paer
Executive Vice President and Chief Financial Officer