UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
S QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2008
OR
£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-10804
XL CAPITAL LTD
(Exact name of registrant as specified in its charter)
|
|
|
CAYMAN ISLANDS |
98-0191089 |
XL House, One Bermudiana Road, Hamilton, Bermuda HM 11
(Address of principal executive offices and zip code)
(441) 292-8515
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes S No £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer S Accelerated filer £ Non-accelerated filer £ Smaller reporting company £
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No S
As of May 5, 2008, there were 179,038,908 outstanding Class A Ordinary Shares, $0.01 par value per share, of the registrant.
XL CAPITAL LTD INDEX TO FORM 10-Q Page No Item 1. Consolidated Balance Sheets as at March 31, 2008 (Unaudited) and
December 31, 2007 3 4 5 Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 2008 and 2007 (Unaudited) 6 7 Item 2. Management’s Discussion and Analysis of Financial Condition and
Results of Operations 31 Item 3. 58 Item 4. 63 Item 1. 64 Item 1A. 67 Item 2. 67 Item 6. 68 69 2
XL CAPITAL LTD
(Unaudited)
December 31, ASSETS Investments: Fixed maturities, at fair value (amortized cost: 2008, $32,121,326; 2007, $34,233,816)
$
30,442,521
$
33,607,790 Equity securities, at fair value (cost: 2008, $548,744; 2007, $664,213)
665,848
854,815 Short-term investments, at fair value (amortized cost: 2008, $1,111,582; 2007, $1,814,445)
1,113,018
1,803,198 Total investments available for sale
32,221,387
36,265,803 Investments in affiliates
2,508,796
2,611,149 Other investments (cost: 2008, $580,299; 2007, $614,848)
686,340
708,476 Total investments
35,416,523
39,585,428 Cash and cash equivalents
3,904,966
3,880,030 Accrued investment income
391,641
447,660 Deferred acquisition costs
862,046
756,854 Prepaid reinsurance premiums
1,135,257
972,516 Premiums receivable
4,546,961
3,637,452 Reinsurance balances receivable
854,797
817,931 Unpaid losses and loss expenses recoverable
4,664,039
4,697,471 Goodwill and other intangible assets
1,842,158
1,841,591 Deferred tax asset, net
421,131
370,419 Other assets
761,556
754,912 Total assets
$
54,801,075
$
57,762,264 LIABILITIES AND SHAREHOLDERS’ EQUITY Liabilities: Unpaid losses and loss expenses
$
23,365,213
$
23,207,694 Future policy benefit reserves
6,907,053
6,772,042 Deposit liabilities
3,888,731
7,920,085 Notes payable and debt
2,868,980
2,868,731 Reinsurance balances payable
1,255,597
843,511 Net payable for investments purchased
317,297
191,472 Unearned premiums
5,531,248
4,681,989 Other liabilities
1,410,021
1,326,179 Total liabilities
$
45,544,140
$
47,811,703 Commitments and Contingencies Minority interest in equity of consolidated subsidiaries
$
1,584
$
2,419 Shareholders’ Equity: Series E preference ordinary shares, 1,000,000 authorized, par value $0.01 Issued and outstanding: (2008 and 2007, 1,000,000)
10
10 Class A ordinary shares, 999,990,000 authorized, par value $0.01 Issued and outstanding: (2008, 179,033,752; 2007, 177,910,151)
1,790
1,779 Additional paid in capital
7,368,796
7,358,801 Accumulated other comprehensive (loss) income
(837,579
)
9,159 Retained earnings
2,722,334
2,578,393 Total shareholders’ equity
$
9,255,351
$
9,948,142 Total liabilities and shareholders’ equity
$
54,801,075
$
57,762,264 See accompanying Notes to Unaudited Consolidated Financial Statements 3
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share amounts)
March 31,
2008
2007
XL CAPITAL LTD
(Unaudited)
2008
2007 Revenues: Net premiums earned
$
1,712,362
$
1,791,044 Net investment income
499,229
553,092 Net realized (losses) gains on investments
(102,251
)
9,292 Net realized and unrealized gains on derivative instruments
44,682
7,741 Net income from investment fund affiliates
11,799
118,936 Fee income and other
8,291
3,337 Total revenues
$
2,174,112
$
2,483,442 Expenses: Net losses and loss expenses incurred
$
1,000,893
$
994,787 Claims and policy benefits
196,299
188,343 Acquisition costs
266,297
259,951 Operating expenses
263,824
280,503 Exchange losses
67,745
23,569 Interest expense
124,112
142,791 Amortization of intangible assets
420
420 Total expenses
$
1,919,590
$
1,890,364 Income before minority interest, income tax and net income from operating affiliates
$
254,522
$
593,078 Minority interest in net income of subsidiaries
—
14,898 Provision for income tax
30,702
72,755 Net (income) from operating affiliates
(20,553
)
(57,082
) Net income
244,373
562,507 Preference share dividends
(32,500
)
(12,789
) Net income available to ordinary shareholders
$
211,873
$
549,718 Net income
$
244,373
$
562,507 Change in net unrealized (losses) on investments, net of tax
(1,075,587
)
(102,568
) Additional pension liability
(44
)
(188
) Change in value of cash flow hedge
109
4,231 Foreign currency translation adjustments
230,472
29,829 Change in net unrealized (loss) on future policy benefit reserves
(1,688
)
(460
) Minority interest share in change in accumulated other comprehensive loss in SCA
—
(2,355
) Comprehensive (loss) income
$
(602,365
)
$
490,996 Weighted average ordinary shares and ordinary share equivalents outstanding — basic
176,336
178,772 Weighted average ordinary shares and ordinary share equivalents outstanding — diluted
176,827
179,601 Earnings per ordinary share and ordinary share equivalent — basic
$
1.20
$
3.07 Earnings per ordinary share and ordinary share equivalent — diluted
$
1.20
$
3.06 See accompanying Notes to Unaudited Consolidated Financial Statements 4
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(U.S. dollars in thousands, except per share amounts)
Three Months Ended
March 31,
XL CAPITAL LTD
(Unaudited)
2008
2007 Series A, B and E Preference Ordinary Shares: Balance — beginning of year
$
10
$
207 Issuance of Series E preference ordinary shares
—
10 Balance — end of period
$
10
$
217 Class A Ordinary Shares: Balance — beginning of year
$
1,779
$
1,810 Issuance of Class A ordinary shares
12
5 Exercise of stock options
—
1 Repurchase of shares
(1
)
(33
) Balance — end of period
$
1,790
$
1,783 Additional Paid in Capital: Balance — beginning of year
$
7,358,801
$
6,451,569 Issuance of Class A ordinary shares
47,800
48,941 Issuance of Series E preference ordinary shares
—
983,786 Repurchase of Class A ordinary shares
(3,879
)
(110,531
) Stock option expense
3,261
4,399 Exercise of stock options
—
4,485 Net change in deferred compensation
(37,187
)
(38,238
) Balance — end of period
$
7,368,796
$
7,344,411 Accumulated Other Comprehensive Income: Balance — beginning
of year
$
9,159
$
411,405 Net change in unrealized (losses) on investment portfolio, net of tax
(1,087,999
)
(119,231
) Net change in unrealized gains on affiliate and other investments, net of tax
12,412
16,663 Change in value of cash flow hedge
109
4,231 Change in net unrealized (loss) on future policy benefit reserves
(1,688
)
(460
) Foreign currency translation adjustments
230,472
29,829 Minority interest share in change in accumulated other comprehensive loss in SCA
—
(2,355
) Additional pension liability
(44
)
(188
) Balance — end of period
$
(837,579
)
$
339,894 Retained Earnings: Balance — beginning of year
$
2,578,393
$
3,266,175 Net
income
244,373
562,507 Dividends on Series A, B and E preference ordinary shares
(32,500
)
(12,789
) Dividends
on Class A ordinary shares
(67,932
)
(68,381
) Repurchase of Class A ordinary shares
—
(121,270
) Balance — end
of period
$
2,722,334
$
3,626,242 Total Shareholders’ Equity
$
9,255,351
$
11,312,547 See accompanying Notes to Unaudited Consolidated Financial Statements 5
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)
Three Months Ended
March 31,
XL CAPITAL LTD
(Unaudited)
2008
2007 Cash flows provided by operating activities: Net income
$
244,373
$
562,507 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Net realized losses (gains) on sales of investments
102,251
(9,292
) Net realized and unrealized (gains) on derivative instruments
(44,682
)
(7,741
) Amortization of (discounts) on fixed maturities
(13,202
)
(16,649
) Net (income) from investment and operating affiliates
(32,352
)
(176,018
) Amortization of deferred compensation
10,584
12,017 Accretion of convertible debt
249
239 Accretion of deposit liabilities
76,551
94,883 Unpaid losses and loss expenses
(233,902
)
(128,954
) Future policy benefit reserves
16,635
8,963 Unearned premiums
762,366
982,002 Premiums receivable
(818,399
)
(787,438
) Unpaid losses and loss expenses recoverable
154,597
156,706 Prepaid reinsurance premiums
(147,583
)
(108,049
) Reinsurance balances receivable
(15,061
)
89,864 Deferred acquisition costs
(93,985
)
(128,634
) Reinsurance balances payable
387,284
90,000 Deferred tax asset
(16,700
)
(14,279
) Other
133,989
(72,731
) Total adjustments
$
228,640
$
(15,111
) Net cash provided by operating activities
$
473,013
$
547,396 Cash flows provided by (used in) investing activities: Proceeds from sale of fixed maturities and short-term investments
$
5,813,296
$
7,072,176 Proceeds from redemption of fixed maturities and short-term investments
829,515
380,106 Proceeds from sale of equity securities
270,641
236,162 Purchases of fixed maturities and short-term investments
(3,341,779
)
(7,553,727
) Purchases of equity securities
(163,874
)
(221,797
) Net acquisitions less dispositions of affiliates
60,990
(75,535
) Other investments
(68
)
(75,129
) Net cash provided by (used in) investing activities
$
3,468,721
$
(237,744
) Cash flows (used in) provided by financing activities: Proceeds from exercise of stock options and issuance of Class A ordinary shares
—
4,486 Proceeds from issuance of Series E preference ordinary shares
—
983,796 Repurchase of Class A ordinary shares
(3,880
)
(231,834
) Dividends paid on Class A ordinary shares
(67,013
)
(68,381
) Dividends paid on preference ordinary shares
—
(10,081
) Deposit liabilities
(4,108,428
)
76,052 Net cash flow on securities lending
167,671
97,003 Dividends paid to minority shareholders of SCA
—
(16,130
) Net cash (used in) provided by financing activities
$
(4,011,650
)
$
834,911 Effects of exchange rate changes on foreign currency cash
94,852
2,488 Increase in cash and cash equivalents
24,936
1,147,051 Cash and cash equivalents — beginning of period
3,880,030
2,223,748 Cash and cash equivalents — end of period
$
3,904,966
$
3,370,799 See accompanying Notes to Unaudited Consolidated Financial Statements 6
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)
Three Months Ended
March 31,
XL CAPITAL LTD 1. Basis of Preparation and Consolidation These unaudited consolidated financial statements include the accounts of the Company and all of its subsidiaries and have been prepared in accordance with accounting principles generally
accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all
of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, these unaudited financial statements reflect all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation of financial position and results of operations as at the end of and for the periods presented. The results of operations for any interim
period are not necessarily indicative of the results for a full year. All significant inter-company accounts and transactions have been eliminated. The preparation of financial statements in conformity
with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from these estimates. To facilitate period-to-period comparisons, certain reclassifications have been made to prior period consolidated financial statement amounts to conform to current period presentation. There was
no effect on net income from this change in presentation. Unless the context otherwise indicates, references herein to the “Company” include XL Capital Ltd and its consolidated subsidiaries. 2. Significant Accounting Policies (a) Fair Value Measurements Financial Instruments subject to Fair Value Measurements In September 2006, the FASB issued FAS 157, “Fair Value Measurements” (“FAS 157”). FAS 157 clarifies that fair value is an exit price, representing the amount that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between market participants. Under FAS 157, fair value measurements are not adjusted for transaction costs. FAS 157 nullifies the
guidance included in EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management
Activities,” that prohibited the recognition of a day one gain or loss on derivative contracts (and hybrid financial instruments measured at fair value under FAS 155) where a company was unable to
verify all of the significant model inputs to observable market data and/or verify the model to market transactions. However, FAS 157 requires that a fair value measurement reflect the assumptions
market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing
model) and/or the risks inherent in the inputs to the model. In addition, FAS 157 prohibits the recognition of “block discounts” for large holdings of unrestricted financial instruments where quoted prices are readily and regularly available for an identical
asset or liability in an active market. The provisions of FAS 157 are to be applied prospectively, except changes in fair value measurements that result from the initial application of FAS 157 to
existing derivative financial instruments measured under EITF Issue No. 02-3, existing hybrid financial instruments measured at fair value and block discounts, all of which are to be recorded as an
adjustment to beginning retained earnings in the year of adoption. The Company adopted FAS 157 as of January 1, 2008. There was no transition adjustment required to opening retained earnings as a result of the adoption of this standard. As noted above, the
fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
(the exit price). Instruments that the Company owns (long positions) are marked to bid prices, and instruments that the Company has sold, but not yet purchased (short positions) are marked to offer
prices. Fair value measurements are not adjusted for transaction costs. 7
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (a) Fair Value Measurements (continued) In February 2008, the FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP FAS 157-2”), which permits a one-year deferral of the application of FAS 157 for all
non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). FSP FAS 157-2 is
effective in conjunction with FAS 157 for interim and annual financial statements issued after January 1, 2008. Accordingly, the provisions of FAS 157 have not been applied to goodwill and other
intangible assets held by the Company which are measured annually for impairment testing purposes only. Basis of Fair Value Measurement FAS 157 also establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices
in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under
FAS 157 are described further below:
•
Level 1 — Quoted prices in active markets for identical assets/liabilities (unadjusted); no blockage factors. • Level 2 — Other observable inputs — include quoted prices for similar assets/liabilities (adjusted) and market corroborated inputs. • Level 3 — Unobservable inputs. An asset or a liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Details on assets and liabilities that have been included under the requirements of FAS 157 to illustrate the bases for determining the fair values of the assets and liabilities held by the Company
are detailed in the accounting policy sections that follow. (b) Cash and Cash Equivalents Cash equivalents include fixed interest deposits placed with a maturity of under 90 days when purchased. Bank deposits are not considered to be fair value measurements and as such are not
subject to FAS 157 disclosures. Money market funds are classified as Level 1 as these instruments are considered actively traded, however, certificates of deposit are classified as Level 2. (c) Total Investments Investments Available For Sale Investments that are considered available for sale are carried at fair value. The fair values for all investments available for sale are sourced from third parties. The fair value of fixed maturity
securities is based upon quoted market values where available, “evaluated bid” prices provided by third party pricing services (“pricing services”) where quoted market values are not available, or by
reference to broker or underwriter bid indications where pricing services do not provide coverage for a particular security. The pricing services use market approaches to valuations using primarily
Level 2 inputs in the vast majority of valuations, or some form of discounted cash flow analysis to obtain investment values for a small percentage of fixed maturity securities for which they provide a
price. Pricing services indicate that they will only produce an estimate of fair value if there is objectively verifiable information available to produce a valuation. Standard inputs to the valuations
provided by the pricing services listed in approximate order of priority for use when available include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets,
benchmark securities, bids, offers, and reference data. The pricing services may prioritize inputs differently on any given day for any security, and not all inputs listed are available for use in the
evaluation process on any given day for each security evaluation; however, the pricing services also 8
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (c) Total Investments (continued) monitor market indicators, industry and economic events. Information of this nature is a trigger to acquire further corroborating market data. When these inputs are not available, they identify
“buckets” of similar securities (allocated by asset class types, sectors, sub-sectors, contractual cash flows/structure, and credit rating characteristics) and apply some form of matrix or other modeled
pricing to determine an appropriate security value which represents their best estimate as to what a buyer in the marketplace would pay for a security in a current sale. While the Company receives
values for the majority of the investment securities it holds from one or more pricing services, it is ultimately management’s responsibility to determine whether the values received and recorded in
the financial statements are representative of appropriate fair value measurements. It is common industry practice to utilize pricing services as a source for determining the fair values of investments
where the pricing services are able to obtain sufficient market corroborating information to allow them to produce a valuation at a reporting date. In addition, in the majority of cases although a
value may be obtained from a particular pricing service for a security or class of similar securities, these values are corroborated against values provided by other pricing services. Broker quotations are used to value fixed maturities where prices are unavailable from pricing services due to factors specific to the security such as limited liquidity, lack of current transactions,
or trades only taking place in privately negotiated transactions. These are considered Level 3 valuations as significant inputs utilized by brokers may be difficult to corroborate with observable market
data, or sufficient information regarding the specific inputs utilized by the broker was not obtained to support a Level 2 classification. 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 remaining maturity of less than one year and are valued by the same external sources and in the same manner as fixed maturity securities. Equity securities include investments in open end mutual funds and shares of publicly traded alternative funds. The fair value of equity securities are based upon quoted market values (Level 1),
or monthly net asset value statements provided by the investment managers upon which subscriptions and redemptions can be executed (Level 2). 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. For mortgage-backed securities, and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Prepayment fees
or call premiums that are only payable to the Company when a security is called prior to its maturity are earned when received and reflected in net investment income. Investment in affiliates Investments in which the Company has significant influence over the operating and financial policies of the investee are classified as investments in affiliates on the Company’s balance sheet and
are accounted for 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 as well
as its portion of movements in certain of the investee shareholders’ equity balances. When financial statements of the affiliate are not available on a timely basis to record the Company’s share of
income or loss for the same reporting periods as the Company, the most recently available financial statements are used. This lag in reporting is applied consistently until timely information becomes 9
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (c) Total Investments (continued) available. Significant influence is deemed to exist where the Company has an investment of 20% or more in the common stock of a corporation or an investment of 3% or greater in closed end
funds, limited partnerships, LLC’s or similar investment vehicles. The Company records its alternative and private fund affiliates on a one month and three month lag, respectively, and its operating
affiliates on a three month lag. Significant influence is considered for other strategic investments on a case-by-case basis. Investments in affiliates are not subject to FAS 157 as they are not fair value
measurements. However, impairments associated with investments in affiliates that are deemed to be other-than-temporary are calculated in accordance with FAS 157 and appropriate disclosures
included within the financial statements during the period the losses are recorded. Other investments Contained within this asset class are investments including direct equity investments, investment funds, limited partnerships, equity tranches of collateralized loan participations and certain
structured project finance transactions. The Company accounts for its other investments that do not have readily determinable market values at estimated fair value as it has no significant influence
over these entities. Fair values for other investments, principally other direct equity investments, investment funds and limited partnerships, are primarily based on the net asset value provided by the investment
manager or the respective entity, recent financial information, available market data, and in certain cases management judgment may be required. These entities generally carry their trading positions
and investments, the majority of which have underlying securities valued using Level 1 or Level 2 inputs, at fair value as determined by their respective investment managers, accordingly, these
investments are generally classified as Level 2. Private equity investments are classified as Level 3. 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. Income on unrated tranches of collateralized loan obligations is reflected only to the extent the Company’s principal has been fully recovered. This is not considered to be a fair value
measurement under FAS 157 and accordingly these investments have been excluded from FAS 157 disclosures. The carrying value of these investments held by the Company at March 31, 2008 and
December 31, 2007 was $18.7 million and $22.7 million, respectively. In addition, the Company participates in structured transactions in project finance related areas under which the Company provides a cash loan supporting a trade finance transaction. These
transactions are accounted for in accordance with SOP 01-6, “Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others” under
which the loans are considered held for investment as the Company has the intent and ability to hold for the foreseeable future or until maturity or payoff. Accordingly, these funded loan
participations are reported in the balance sheet at outstanding principal adjusted for any allowance for loan losses as considered necessary by management. These investments are not considered to be
fair value measurements under FAS 157 and accordingly they have been excluded from the FAS 157 disclosures. The carrying value of these investments held by the Company at March 31, 2008 and
December 31, 2007 was $82.7 million and $125.1 million, respectively. Securities lending The Company engages in a securities lending program whereby certain securities from the Company’s portfolio are loaned to other institutions for short periods of time. The market value of the
loaned securities is monitored on a daily basis, with additional collateral obtained or refunded as 10
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (c) Total Investments (continued) the market value of the loaned securities changes. The Company’s policy is to require initial cash collateral equal to between 102% and 105% of the fair value of the loaned securities depending on
the class of assets loaned. The Company retains all economic interest in the securities it lends and receives a fee from the borrower for the temporary use of the securities. In addition, the Company
shares a portion of the interest earned on the collateral with the lending agent. The securities lending collateral is included in cash and cash equivalents with a corresponding liability related to the
Company’s obligation to return the collateral plus interest included in net payable for investments purchased. Other Than Temporary Declines in Investments The Company reviews the fair value of its investment portfolio on a periodic basis to identify declines in fair value below the carrying value that are other than temporary. This review involves
consideration of several factors including (i) the time period during which there has been a significant decline in fair value below carrying 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, (v) expected
future interest rate movements, and (vi) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company concludes that declines
in fair values are other than temporary, the cost of the security is written down to fair value below carrying 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. (d) Derivative Instruments The Company recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value. The changes in fair value of derivatives are shown in the
consolidated statement of income as “net realized and unrealized gains and losses on derivative instruments” unless the derivatives are designated as hedging instruments. The accounting for
derivatives which are designated as hedging instruments is discussed below. Changes in fair value of derivatives may create volatility in the Company’s results of operations from period to period. The Company conducts its derivative activities in three main areas: investment related derivatives, weather and energy derivatives and credit derivatives written by SCA and reinsured by the
Company. The Company’s direct use of investment related derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, reference rates or a
combination of these factors. The Company uses investment derivatives to manage duration, credit and foreign currency exposure for its investment portfolio as well as to add value to the investment
portfolio through replicating permitted investments, provided the use of such investments is incorporated into the overall portfolio evaluation. All derivatives are recorded at fair value. On the date the derivative contract is entered into, the Company may designate the derivative as a hedge of the fair value of a recognized asset or
liability (“fair value” hedge); a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset or liability (“cash flow” hedge); a
hedge of a net investment in a foreign operation; or the Company may not designate any hedging relationship for a derivative contract. 11
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (d) Derivative Instruments (continued) Derivative contracts can be exchange-traded or over-the-counter (OTC). Exchange-traded derivatives (futures and options) typically fall within Level 1 of the fair value hierarchy depending on
whether they are deemed to be actively traded or not. OTC derivatives are valued using market transactions and other market evidence whenever possible, including market-based inputs to models, model calibration to market clearing transactions,
broker or dealer quotations or alternative pricing sources where an understanding of the inputs utilized in arriving at the valuations is obtained. Where models are used, the selection of a particular
model to value an OTC derivative depends upon the contractual terms and specific risks inherent in the instrument as well as the availability of pricing information in the market. The Company
generally uses similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility,
prepayment rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, interest rate swaps and options, model inputs can generally be verified
and model selection does not involve significant management judgment. Such instruments comprise the majority of derivatives held by the Company and are typically classified within Level 2 of the
fair value hierarchy. Certain OTC derivatives trade in less liquid markets with limited pricing information, or required model inputs which are not directly market corroboratable which causes the determination of
fair value for these derivatives to be inherently more subjective. Accordingly, such derivatives are classified within Level 3 of the fair value hierarchy. The valuations of less standard or liquid OTC
derivatives are typically based on Level 1 and/or Level 2 inputs that can be observed in the market, as well as unobservable Level 3 inputs. Level 1 and Level 2 inputs are regularly updated to reflect
observable market changes, with resulting gains and losses reflected within Level 3. Level 3 inputs are only changed when corroborated by evidence such as similar market transactions, pricing
services and/or broker or dealer quotations. The Company also has investment related derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount
equal to the estimated present value of the excess of guaranteed minimum income benefit (“GMIB”) over the account balance upon the policyholder’s election to take the income benefit. The fair
value of this derivative is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide
for a return based on a portfolio of fixed income securities; as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated and recorded at fair value with changes in
fair value recognized in earnings. (e) Fair Values of Other Financial Instruments The fair values of financial instruments not disclosed elsewhere in the financial statements approximate their carrying value due to their short-term nature or because they earn or attract interest
at market rates. Certain financial instruments, particularly insurance contracts, are excluded from fair value disclosure requirements of FAS 107, “Disclosures about Fair Value of Financial
Instruments.” The fair value of the Company’s notes payable and debt outstanding as at March 31, 2008 and December 31, 2007, is estimated to be $2.2 billion and $2.6 billion, respectively, and is
based on quoted prices. (f) Recent Accounting Pronouncements In October 2006, the FASB issued proposed FASB Staff Position EITF 03-6-a, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.”
This FASB Staff Position (FSP) addresses whether instruments granted in share-based payment transactions may be participating securities prior to vesting and, therefore, need to be included in 12
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (f) Recent Accounting Pronouncements (continued) the earnings allocation in computing basic earnings per share (EPS) pursuant to the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, “Earnings per Share.” A share-
based payment award that contains a non-forfeitable right to receive cash when dividends are paid to common shareholders irrespective of whether that award ultimately vests or remains unvested
shall be considered a participating security as these rights to dividends provide a non-contingent transfer of value to the holder of the share-based payment award. Accordingly, these awards should be
included in the computation of basic EPS pursuant to the two-class method. The guidance in this proposed FSP would be effective in the first reporting period beginning after the FASB posts the
final FSP to its website. All prior period EPS data will have to be adjusted retrospectively to reflect the provisions of the FSP. Under the terms of the Company’s restricted stock awards, grantees are
entitled to the right to receive dividends on the unvested portions of their awards. There is no requirement to return these dividends in the event the unvested awards are forfeited in the future.
Accordingly, this FSP will have an impact on the Company’s EPS calculations should the FASB issue the proposed guidance as final during 2008. The Company will continue to evaluate the potential
impact of this guidance. During February 2007, the FASB issued FAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”), which permits entities to choose to measure many financial
instruments and certain other items at fair value. A company must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent
reporting date. The fair value option may be applied on an instrument by instrument basis, with a few exceptions. The fair value option is irrevocable (unless a new election date occurs) and the fair
value option may be applied only to entire instruments and not to portions of instruments. FAS 159 is effective for interim and annual financial statements issued after January 1, 2008. The Company
did not elect to apply the Fair Value option to any existing assets or liabilities as of January 1, 2008. The Company is aware of the SEC’s review of the loss reserving practices of the financial guarantee industry. The Company recognizes that there is diversity in practice among financial
guarantee insurers and reinsurers with respect to their accounting policies. Current accounting literature, specifically FASB Statement of Financial Accounting Standards No. 60 “Accounting and
Reporting by Insurance Enterprises” (“FAS 60”) does not specifically address the unique characteristics of financial guarantee insurance contracts. Consequently, the accounting principles applied by
the industry have evolved over time and incorporate the concepts of both short-duration and long-duration contracts accounting under the provisions of FAS 60 and other accounting literature such as
FAS 5 and EITF 85-20. On April 18, 2007, the FASB issued its anticipated exposure draft, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FAS 60”, which provides
guidance for the accounting for financial guarantee insurance contracts under which it considers claims liability recognition, premium recognition, and the related amortization of deferred policy
acquisition costs. This exposure draft was issued with a comment deadline of June 18, 2007 and the FASB concluded redeliberations of the exposure draft during January 2008. The Company has
reviewed the exposure draft and will continue its loss reserving methodology as noted in Note 2 (k) of the Company’s Annual Report on Form 10-K, until the final guidance is issued by the FASB.
The final guidance is expected to be effective for fiscal years beginning after December 15, 2008, and for interim periods within those fiscal years. The Company had reserves for financial guarantee
insurance contracts of $432.7 million and $427.4 million at March 31, 2008 and December 31, 2007, respectively. In December 2007, the FASB issued FAS 141(R), “Business Combinations” (“FAS 141(R)”). This statement retains the purchase method of accounting for acquisitions, and requires that an acquirer
recognize and measure in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their fair values as of the acquisition date. 13
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (f) Recent Accounting Pronouncements (continued) FAS 141(R) changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the expensing of acquisition-related costs as incurred, and establishes a framework
for recognizing and measuring goodwill or a gain from a bargain purchase at the acquisition date. FAS 141(R) also establishes disclosure requirements to enable the evaluation of the nature and
financial effects of the business combination. FAS 141(R) will be effective for interim and annual financial statements issued after January 1, 2009 and applies prospectively to business combinations
for which the acquisition date is subsequent to January 1, 2009. Earlier adoption is prohibited. The Company is currently evaluating the potential impact of this guidance, which will apply only in the
event of a future business combination; however, this standard will not have an impact on the Company’s financial condition or results of operations during the current year. In December 2007, the FASB issued FAS 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“FAS 160”), to establish accounting and reporting
standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. FAS 160 requires a company to clearly identify and present ownership interests in subsidiaries held
by parties other than the company in the consolidated financial statements within the equity section but separate from the company’s equity. It also requires the amount of consolidated net income
attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; requires any changes in ownership interest of the
subsidiary be accounted for as equity transactions; and requires that when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary and the gain or loss on
the deconsolidation of the subsidiary be measured at fair value. FAS 160 will be effective for interim and annual financial statements issued after January 1, 2009. FAS 160 must be applied
prospectively as of January 1, 2009; however, the presentation and disclosure standards must be applied retrospectively to all periods presented. Earlier adoption is prohibited. The Company is
currently evaluating the potential impact of this guidance, however, this standard will not have an impact on the Company’s financial condition or results of operations during the current year. In February 2008, the FASB issued FSP FAS 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” (“FSP 140-3”) FSP 140-3 requires an initial transfer of
a financial asset and a repurchase financing that was entered into contemporaneously or in contemplation of the initial transfer to be evaluated as a linked transaction under FAS 140 unless certain
criteria are met, including that the transferred asset must be readily obtainable in the marketplace. FSP 140-3 is effective for fiscal years beginning after November 15, 2008, and will be applied to
new transactions entered into after the date of adoption. Early adoption is prohibited. The Company is currently evaluating the impact of adopting FSP 140-3 on its financial condition and results of
operations, however, it is not expected to have an impact on the Company’s financial condition and results of operations. In March 2008, the FASB issued FAS 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133.” FAS 161 requires enhanced
disclosures about an entity’s derivative and hedging activities, and is effective for financial statements issued for fiscal years beginning after November 15, 2008, with early application encouraged. The
Company will adopt the standard as of January 1, 2009. FAS 161 requires only additional disclosures concerning derivatives and hedging activities, and therefore the adoption of FAS 161 will not
have an impact on the Company’s financial condition and results of operations. 3. Fair Value Measurements Effective January 1, 2008, the Company adopted FAS 157, which requires disclosures about the Company’s assets and liabilities that are carried at fair value. As required by FAS 157, financial 14
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 3. Fair Value Measurements (continued) assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The following tables set forth the Company’s assets and liabilities that were accounted for at fair value as of March 31, 2008 by level within the fair value hierarchy (see Note 2 for further
information on the fair value hierarchy):
(U.S. dollars in thousands)
Quoted Prices in
Significant Other
Significant
Counterparty
Balance Assets Fixed maturities, at fair value
$
—
$
29,220,755
$
1,221,766
$
—
$
30,442,521 Equity securities, at fair value
504,764
161,084
—
—
665,848 Short-term investments, at fair value
—
1,103,449
9,569
—
1,113,018 Total investments available for sale
504,764
30,485,288
1,231,335
—
32,221,387 Cash equivalents (1)
1,832,727
855,858
—
—
2,688,585 Other investments (2)
—
532,635
52,338
—
584,973 Other assets (3)(5)
—
173,816
89,585
(7,144
)
256,257 Total assets accounted for at fair value
$
2,337,491
$
32,047,597
$
1,373,258
$
(7,144
)
$
35,751,202 Liabilities Financial instruments sold, but not yet purchased (6)
$
—
$
37,947
$
—
$
—
$
37,947 Other liabilities (4) (5)
—
48,305
37,139
(7,144
)
78,300 Total liabilities accounted for at fair value
$
—
$
86,252
$
37,139
$
(7,144
)
$
116,247
(1)
Cash equivalents balances subject to fair value measurements include certificates of deposit and money market funds. Operating cash balances are not subject to FAS 157. (2) The other investments balance excludes certain unrated tranches of collateralized loan obligations which are carried under the cost recovery method given the uncertainty of future cash flows, as well as certain investments in project finance
transactions which are carried at amortized cost. See Note 2 for further details. (3) Other assets include derivative instruments. (4) Other liabilities include derivative instruments. (5) The derivative balances included in each category above are reported on a gross basis by level with a netting adjustment presented separately in the “Counterparty Netting” column. The Company often enters into different types of derivative
contracts with a single counterparty and these contracts are covered under an ISDA master netting agreement. The fair value of the individual derivative contracts are reported gross in their respective levels based on the fair value hierarchy. (6) Financial instruments sold, but not purchased are included within “Net payable for investments purchased” on the balance sheet. Level 3 Gains and Losses The table below presents additional information about assets and liabilities measured at fair value on a recurring basis and for which significant Level 3 inputs were utilized to determine fair
value. The table reflects gains and losses for the three month period ended March 31, 2008 for all financial assets and liabilities categorized as Level 3 as of March 31, 2008. The table does not
include gains or losses that were reported in Level 3 in prior periods for assets that were transferred 15
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Active Markets for
Identical Assets
(Level 1)
Observable
Inputs
(Level 2)
Unobservable
Inputs
(Level 3)
Netting
as of
March 31,
2008
XL CAPITAL LTD 3. Fair Value Measurements (continued) out of Level 3 prior to March 31, 2008. Gains and losses for assets and liabilities classified within Level 3 in the table below may include changes in fair value that are attributable to both observable
inputs (Levels 1 and 2) and unobservable inputs (Level 3). Further, it should be noted that the following table does not take into consideration the effect of offsetting Level 1 and 2 financial
instruments entered into by the Company that are either economically hedged by certain exposures to the Level 3 positions or that hedge the exposures in Level 3 positions.
(U.S. dollars in thousands)
Fixed
Level 3 Assets and
Liabilities
Derivative
Short-term
Other Balance, beginning of year
$
1,385,601
$
15,606
$
40,354
$
12,283 Realized (losses) gains
(84,337
)
(5,947
)
—
2,081 Movement in unrealized (losses) gains
(180,666
)
(90
)
665
34,734 Purchases, issuances and settlements
101,168
—
11,319
3,348 Transfers in and/or out of Level 3
—
—
—
— Balance, end of period
$
1,221,766
$
9,569
$
52,338
$
52,446 Movement in total (losses) gains above relating to instruments still held at the reporting date
$
(174,895
)
$
(78
)
$
665
$
34,734 The vast majority of Level 3 assets are made up of securities for which the values were obtained from brokers where either significant inputs were utilized in determining the value that were
difficult to corroborate with observable market data, or sufficient information regarding the specific inputs utilized by the broker was not available to support a Level 2 classification. Fixed maturities and short term investments In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments as is currently the case for certain U.S. CMOs, ABSs, CMBSs, collateralized debt
obligations (CDOs), and other topical assets which include certain securities with underlying sub-prime and related residential mortgage exposures (such as sub-prime first liens and Alt-A asset backed
securities) for which sufficient information, such as cash flows or other security structure or market information, is not available to enable a pricing service to provide a price. However, increased
market illiquidity in the first quarter of 2008 did not result in the reclassification of securities into Level 3 due to unavailable Level 2 pricing. Fixed maturities and short term investments classified
within Level 3 are made up of those securities for which the values were obtained from brokers where either significant inputs were utilized in determining the value that were difficult to corroborate
with observable market data, or sufficient information regarding the specific inputs utilized by the broker was not obtained to support a Level 2 classification. The fair values of the majority of the
Company’s holdings in securities exposed to sub-prime mortgages are generally not based on quoted prices for identical securities, however, where they are based on model-derived valuations from
pricing sources in which all significant inputs and significant value drivers are considered to be observable in active markets, these securities continue to be classified within Level 2. Other investments Included within the Other Investments component of the Company’s Level 3 valuations are private equity investments where the Company is not deemed to have significant influence over the
investee. The fair value of these investments is based upon net asset values received from the investment manager. The nature of the underlying investments held by the investee which form the basis
of the net asset value include assets such as private business ventures and are such that 16
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Maturities
Three Months Ended
March 31, 2008
Contracts — Net
Investments
Investments
XL CAPITAL LTD 3. Fair Value Measurements (continued) significant Level 3 inputs are utilized in the determination of the individual underlying holding values and accordingly the fair value of the Company’s investment in each entity is classified within
Level 3. The Company also incorporates factors such as the most recent financial information received, the values at which capital transactions with the investee take place, and management’s
judgment regarding whether any adjustments should be made to the net asset value in recording the fair value of each position. Derivative instruments Derivative instruments classified within Level 3 include: (i) certain interest rate swaps where the duration of the contract the Company holds exceeds that of the longest term on a market
observable input, (ii) weather and energy derivatives, (iii) credit derivatives written by SCA and embedded in reinsurance provided by the Company, (iv) GMIB derivatives embedded within a certain
reinsurance contract and (v) put options included within contingent capital facilities. The majority of inputs utilized in the valuations of these types of derivative contracts are considered Level 1 or
Level 2, however, each valuation includes at least one Level 3 input that was significant to the valuation and accordingly the values are disclosed within Level 3. In addition, see Note 2 for a general discussion of types of assets and liabilities that are classified within Level 3 of the fair value hierarchy as well as the Company’s valuation policies for such
instruments. 4. Security Capital Assurance Ltd (“SCA”) On August 4, 2006, the Company completed the sale of approximately 37% of its then financial guarantee reinsurance and insurance businesses through an initial public offering (“IPO”) of
23.4 million common shares of SCA for proceeds of approximately $446.9 million. On June 6, 2007, the Company completed the sale of a portion of SCA’s common shares still owned by the
Company through a secondary offering and thereby reduced its ownership of SCA’s outstanding common shares further from approximately 63% to approximately 46%. Accordingly, SCA is no
longer a consolidated subsidiary or operating segment of the Company and the Company accounts for its remaining investment in SCA using the equity method of accounting. Management has done extensive analysis of SCA’s underlying financial guarantee portfolio to evaluate the exposures and underlying possible losses as at December 31, 2007 and continues to
attempt to monitor and evaluate any information made available to the Company related to its relationship with SCA. Given management’s view of the risk exposure along with the uncertainty facing
the entire financial guarantee industry, the Company reduced the reported value of its investment in SCA to nil at December 31, 2007. Market developments with respect to the monoline industry
continue to be largely negative. During the three months ended March 31, 2008, SCA was downgraded by several rating agencies, which has significantly limited SCA’s ability to write new business.
In addition, the Company’s shares in SCA are unregistered and thus illiquid. Based on the nature of the Company’s investment in SCA and the resultant limitations on any future business models,
management continues to believe that the fair value of the Company’s investment in SCA is less than the traded market value at March 31, 2008, of $0.52 per share. Management believes this decline
in value is other than temporary. Concurrent with the initial public offering (“IPO”) of SCA and subsequently, the Company has entered into certain service, reinsurance and guarantee arrangements with SCA and its
subsidiaries, to govern certain aspects of the Company’s relationship with SCA. Prior to the sale of SCA shares through the secondary offering on June 6, 2007, the effect of these arrangements has
been eliminated upon consolidation of the Company’s results. The income statement impacts of all transactions with SCA have been included in “Net (loss) income from operating affiliates.” 17
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 4. Security Capital Assurance Ltd (“SCA”) (continued) As at December 31, 2007, SCA had total assets of $3.6 billion, total liabilities of $3.1 billion, outstanding preferred share equity of $246.6 million, and common shareholders’ equity of
$180.5 million. During the fourth quarter of 2007 SCA had net earned premiums of $57.0 million, total revenues of $(430.0) million, and a net loss to common shareholders before minority interest of
$1,197.1 million. Service agreements The Company has entered into a series of service agreements under which subsidiaries of the Company provided services to SCA and its subsidiaries or received certain services from SCA
subsidiaries for a period of time after the IPO. For the quarter ended March 31, 2008, the Company reported net fee income under the aforementioned agreements aggregating to approximately $0.6
million. Reinsurance agreements The Company also provides certain reinsurance protections with respect to adverse development on certain transactions as well as indemnification under specific facultative and excess of loss
coverages for subsidiaries of SCA: XL Financial Assurance (“XLFA”) and XL Capital Assurance, Inc. (“XLCA”). The adverse development cover relates to a specific project financing transaction
while the facultative covers generally reinsure certain policies up to the amount necessary for XLCA and XLFA to comply with certain regulatory and risk limits. The excess of loss reinsurance
provides indemnification for the portion of any individual paid loss covered by XLFA in excess of 10% of XLFA’s surplus, up to an aggregate amount of $500 million, and excludes coverage for
liabilities arising other than pursuant to the terms of the underlying policies. With regards to the excess of loss cover, in 2007 the Company reported unpaid losses and loss expenses of $300.0 million which represented the discounted value of a $500 million full limit loss
on this contract. With regards to the facultative reinsurance agreement, the Company reported unpaid losses and loss expenses as at December 31, 2007 of $51.0 million and $17.9 million in mark-to-
market losses related to those underlying contracts written in derivative form. These losses were based on the Company’s examination of exposures under these agreements and have been recorded
within “Net loss from operating affiliates.” These amounts represent the discounted value of expected losses net of related premiums and are discounted at approximately 5%. During the three
months ended March 31, 2008, the Company has not received any information from SCA or otherwise that has indicated that a change in the notional value of the underlying reserves is necessary
and as such the only losses recorded during the first quarter of 2008 represent the unwind of the discount on the established reserves at December 31, 2007 and totaled $4.8 million. As at March 31,
2008, the Company carried a net receivable of approximately $8.1 million, net unearned premiums of $35.0 million, net unpaid losses and loss expenses of $430.9 million and net derivative liabilities
of $17.9 million in relation to these agreements. As at March 31, 2008 and December 31, 2007, the Company’s total net exposure under its facultative agreements with SCA subsidiaries was approximately $6.9 billion and $7.7 billion,
respectively, of net par outstanding. Of the total net par outstanding at March 31, 2008, approximately $126.6 million and $766.8 million was related to RMBS and ABS CDOs, with greater than 50%
RMBS collateral, respectively. Of the total net par outstanding under the facultative agreements at December 31, 2007, approximately $138.0 million and $769.0 million of net par outstanding was
related to RMBS and ABS CDOs, with greater than 50% collateral, respectively. Of the RMBS exposures at March 31, 2008, 100% were rated ‘BBB’. Of the related ABS CDO exposures at March
31, 2008, 26.4% were ‘AAA’ rated, 16.4% were rated ‘A’, 40.9% were ‘BBB’ and 16.3% were rated below investment grade. At December 31, 2007, 100% of the RMBS exposures were rated ‘BBB’
while all related ABS CDO exposures were rated ‘AAA’. 18
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 4. Security Capital Assurance Ltd (“SCA”) (continued) The following tables present the net par outstanding related to the facultative reinsurance and the adverse development facultative reinsurance noted above at March 31, 2008 by credit quality
and broad sector allocation:
(U.S. dollars in millions)
As at March 31, 2008
Net Par
% of Total Credit Quality: AAA
$
697.7
10.1
% AA
136.6
2.0
% A
1,144.8
16.6
% BBB
4,253.3
61.6
% BB and below
667.5
9.7
% Total*
$
6,899.9
100.0
%
(U.S. dollars in millions)
As at March 31, 2008
Net Par
% of Total International Finance
$
3,953.4
57.3
% Public Finance
568.2
8.2
% Structured Finance
2,378.3
34.5
% Total*
$
6,899.9
100.0
%
*
As at March 31, 2008, $1.3 billion of the total $6.9 billion in net par outstanding was originally written by SCA in derivative form.
Guarantee agreements The Company has also entered into certain guarantee agreements with subsidiaries of SCA. These guarantee agreements terminated with respect to any new business produced by SCA through
the underlying agreements after the effective date of SCA’s IPO, but the agreements remain in effect with respect to cessions or guarantees written under these agreements prior to the IPO. The
agreements unconditionally and irrevocably guarantee: (i) XLCA for the full and complete performance of XLFA’s obligations under its facultative quota share reinsurance agreement with XLCA, (ii)
the full and complete payments when due of XLCA’s obligations under certain financial guarantees issued by XLCA and arranged by XL Capital Assurance (U.K.) Limited and (iii) Financial
Security Assurance (“FSA”) for the full and complete performance of XLFA’s obligations under a FSA Master Facultative Agreement. The guarantees the Company has provided contain a dual
trigger, such that the guarantees respond only if two events occur. Firstly, the underlying guaranteed obligation must default on payments of interest and principal, and secondly, the relevant SCA
subsidiary must fail to meet its obligations under the applicable reinsurance or guarantee. As at March 31, 2008 and December 31, 2007, the Company’s total net par outstanding falling under these
guarantees was $69.6 billion and $75.2 billion, respectively. At March 31, 2008 and December 31, 2007, indirect consumer mortgage exposures related to these guarantee agreements totaled
approximately $2.8 billion and $2.9 billion, respectively, related to RMBS and $3.4 billion and $3.3 billion, respectively, related to ABS CDOs with greater than 50% RMBS collateral. Of the RMBS
exposures at March 31, 2008, 44.9% were rated ‘AAA’, 6.6% were rated ‘A’, 48.4% were rated ‘BBB’ and 0.1% were rated below investment grade. Of the related ABS CDO exposures at March 31,
2008, 44.6% were ‘AAA’ rated, 22.2% were rated ‘A’ and 33.2% were rated ‘BBB’. Of the RMBS exposures at December 31, 2007, 44.1% were rated ‘AAA’, 6.9% were rated ‘A’ and 49.0% were
rated ‘BBB’. All related ABS CDO exposures at December 31, 2007 were rated ‘AAA’. In addition to the evaluation of the overall SCA portfolio, management has also evaluated the exposure as at December 31, 2007 in the pre-IPO business subject to the guarantees and has
concluded that expected losses in that portion of the book are substantially less significant than 19
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Outstanding
Outstanding
XL CAPITAL LTD 4. Security Capital Assurance Ltd (“SCA”) (continued) those in the post IPO business as of such date. This is largely due to the fact that the most negatively impacted RMBS vintages were written in 2006 and 2007. As at December 31, 2007 SCA had
reported net case reserves subject to the guarantees of $12 million, which represented 1.9% of the total SCA net case reserves. Any analysis of probability of loss related to the guarantees is made
more complex by the fact that the timing of loss payments related to pre IPO versus post IPO exposures is not certain,
and as such it is uncertain where the current claims paying ability will apply. The Company’s analysis, however, indicated that the payout patterns of pre and post IPO exposures are largely consistent. SCA’s
audited financial statements as at December 31, 2007 reported shareholders
equity of $427 million and included not only SCA’s best estimate of
total losses but also a fair value assessment of derivative liabilities related
to those credit enhancement products sold in credit default swap form. Such
fair value assessment included risk margins necessary to transfer the related
liabilities to a hypothetical third party and not just the expected future
contractual cash flows. In addition, subsequent to December 31, 2007, nationally
recognized ratings agencies have published base and stressed loss scenarios
with respect to SCA, and have provided financial strength ratings on SCA.
While such ratings have been downgraded during the first quarter of 2008,
none indicate probable default. This further supports the Company’s
conclusion that no accrued liability in respect to the guarantees is necessary.
However, future developments could expose the Company to potential payments
in respect to the guarantees which could be material to the Company. For
further information relating to certain risks associated with the guarantees
refer to Item 1A. Risk Factors in the Company’s
Annual Report on Form 10-K for the year ended December 31, 2007. The following tables present the net par outstanding related to the guarantees provided by the Company to SCA at March 31, 2008 by credit quality and broad sector allocation:
(U.S. dollars in millions)
As at March 31, 2008
Net Par
% of Total Credit Quality: AAA
$
16,731.7
24.0
% AA
10,996.0
15.8
% A
22,877.0
32.9
% BBB
17,386.4
25.0
% BB and below
1,582.0
2.3
% Total
$
69,573.1
100.0
%
(U.S. dollars in millions)
As at March 31, 2008
Net Par
% of Total International Finance
$
11,330.5
16.3
% Public Finance
34,607.6
49.7
% Structured Finance
23,635.0
34.0
% Total
$
69,573.1
100.0
% Other agreements As at December 31, 2007, the Company had approximately $4.0 billion of deposit liabilities associated with guaranteed investment contracts (“GICs”) for which credit enhancement was provided
by XLCA. Based on the terms and conditions of the underlying GICs, upon the downgrade of XLCA below certain ratings levels, all or portions of the outstanding principal balances on such GICs
would come due. In January and February 2008, several rating agencies downgraded SCA and its subsidiaries and as a result, the Company settled, in March 2008, the majority of the GIC liabilities.
The resulting balance of deposit liabilities associated with GICs as at March 31, 2008 was $80.4 million. 20
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Outstanding
Outstanding
XL CAPITAL LTD 5. Segment Information Following the Company’s revised strategy implemented in the second quarter of 2007, the Company is organized into four operating segments: Insurance, Reinsurance, Life Operations, and Other
Financial Lines — in addition to a Corporate segment that includes the general investment and financing operations of the Company. The Company evaluates the performance for both the Insurance and Reinsurance segments based on underwriting profit and evaluates the contribution from each of the Life Operations and
Other Financial Lines segments. Other items of revenue and expenditure of the Company are not evaluated at the segment level for reporting purposes. In addition, the Company does not allocate
investment assets by segment for its property and casualty operations. Investment assets related to (i) the Company’s Life Operations and Other Financial Lines segments and (ii) certain structured
products included in the Insurance and Reinsurance segments, are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each
of these segments. 21
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 5. Segment Information (continued) Quarter ended March 31, 2008:
Insurance
Reinsurance
Total P&C
Life
Other Financial
Total Gross premiums written
$
1,628,349
$
1,072,545
$
2,700,894
$
234,958
$
—
$
2,935,852 Net premiums written
1,183,852
952,701
2,136,553
224,213
—
2,360,766 Net premiums earned
1,008,402
544,378
1,552,780
159,582
—
1,712,362 Fee income and other
7,464
763
8,227
64
—
8,291 Net losses and loss expenses
684,812
316,081
1,000,893
196,299
—
1,197,192 Acquisition costs
125,836
116,344
242,180
24,117
—
266,297 Operating expenses (1)
164,505
45,358
209,863
8,083
—
217,946 Underwriting profit (loss)
$
40,713
$
67,358
$
108,071
$
(68,853
)
$
—
$
39,218 Exchange losses
53,108
13,743
66,851
894
—
67,745 Net investment income
—
—
308,041
97,135
—
405,176 Net results from structured products (2)
(9,193
)
10,824
1,631
—
7,723
9,354 Contribution from P&C, Life Operations, Other Financial Lines
$
350,892
$
27,388
$
7,723
$
386,003 Corporate & other: Net realized & unrealized (losses) on investment & derivative instruments (3)
$
(57,569
) Net gain from investment and operating affiliates (4)
32,352 Corporate operating expenses
35,926 Interest expense (5)
49,365 Income taxes & other
31,122 Net Income
$
244,373 Ratios — P&C operations: (6) Loss and loss expense ratio
67.9
%
58.1
%
64.5
% Underwriting expense ratio
28.8
%
29.7
%
29.1
% Combined ratio
96.7
%
87.8
%
93.6
% Notes:
(1)
Operating expenses exclude corporate operating expenses, shown separately. (2) The net results from P&C structured products includes net investment income, interest expense and operating expenses of $34.1 million, $27.6 million, and $4.9 million, respectively. (3) This includes net realized losses on investments of $102.3 million, net realized and unrealized gains on investment and other derivatives of $44.7 million, but does not include unrealized losses on investments for which the decline was considered
temporary, which are included in accumulated other comprehensive income (loss). (4) Net gain from investment and operating affiliates includes losses recorded of $4.8 million during the first quarter of 2008 representing the unwind of the discount established reserves associated with reinsurance agreements with SCA. (5) Interest expense excludes interest expense related to deposit liabilities recorded in the Insurance, Reinsurance, and Other Financial Lines segments. (6) Ratios are based on net premiums earned from property and casualty operations. The underwriting expense ratio excludes exchange gains and losses. (7) The Other Financial Lines segment is comprised of the GIC and funding agreement (“FA”) businesses. The net results from these products include net investment income, interest expense and operating expenses of $59.9 million, $47.1 million,
and $5.1 million, respectively. While not reported within the contribution from the Other Financial Lines segment, it should be noted that approximately $78.9 million of the reported realized losses on investments during the first three months of
2008, primarily as a result of other-than-temporary impairments, related to portfolios associated with GICs and FAs. 22
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands, except ratios)
(Unaudited)
Operations
Lines (7)
XL CAPITAL LTD 5. Segment Information (continued) Quarter ended March 31, 2007:
Insurance (6)
Reinsurance (6)
Total P&C
Life
Other
SCA
Total Gross premiums written
$
1,579,406
$
1,374,886
$
2,954,292
$
213,275
$
—
$
104,958
$
3,272,525 Net premiums written
1,245,515
1,152,492
2,398,007
202,938
—
84,725
2,685,670 Net premiums earned
1,051,350
546,321
1,597,671
146,994
—
46,379
1,791,044 Fee income and other
3,092
171
3,263
74
—
—
3,337 Net losses and loss expenses
647,266
348,322
995,588
188,343
—
(801
)
1,183,130 Acquisition costs
126,223
109,491
235,714
20,267
—
3,970
259,951 Operating expenses (1)
164,134
45,068
209,202
8,490
—
24,070
241,762 Underwriting profit (loss)
$
116,819
$
43,611
$
160,430
$
(70,032
)
$
—
$
19,140
$
109,538 Exchange losses (gains)
7,335
16,524
23,859
(290
)
—
—
23,569 Net investment income
—
—
314,181
92,834
—
26,125
433,140 Net results from structured products (2)
2,529
9,823
12,352
—
9,161
—
21,513 Contribution from P&C, Life Operations, Other Financial Lines and SCA
$
463,104
$
23,092
$
9,161
$
45,265
$
540,622 Corporate & other: Net realized & unrealized (losses) gains on investment & derivative instruments (3)
$
(6,817
)
$
17,033 Net gain from investment and operating affiliates
—
176,018 Corporate operating expenses
—
32,479 Interest expense (4)
—
50,614 Minority interest
14,898
14,898 Income taxes & other
79
73,175 Net Income
$
23,471
$
562,507 Ratios — P&C operations: (5) Loss and loss expense ratio
61.6
%
63.8
%
62.3
% Underwriting expense ratio
27.6
%
28.2
%
27.9
% Combined ratio
89.2
%
92.0
%
90.2
% Notes:
(1)
Operating expenses exclude corporate operating expenses, shown separately. (2) The net results from P&C structured products includes net investment income, interest expense and operating expenses of $32.4 million, $16.1 million, and $3.9 million, respectively. (3) This includes net realized gains on investments of $9.3 million, net realized and unrealized gains on investment and other derivatives of $7.7 million, but does not include unrealized appreciation or depreciation on investments for which the
decline was considered temporary, which are included in accumulated other comprehensive income (loss). (4) Interest expense excludes interest expense related to deposit liabilities recorded in the Insurance, Reinsurance, and Other Financial Lines segments. (5) Ratios are based on net premiums earned from property and casualty operations. The underwriting expense ratio excludes exchange gains and losses. (6) Certain lines of business and transactions previously reported under the Financial Lines segment have been reclassified and reported under the Insurance, Reinsurance and Corporate (that includes the general investment and financing operations
of the Company) segments based on the nature of the underlying business. (7) The Other Financial Lines segment is comprised of the GIC and FA businesses. The net results from these products include net investment income, interest expense and operating expenses of $87.6 million, $76.1 million, and $2.3 million,
respectively. 23
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands, except ratios)
(Unaudited)
Operations
Financial
Lines (7)
XL CAPITAL LTD 5. Segment Information (continued) The following tables summarize the Company’s net premiums earned by line of business: Quarter ended March 31, 2008:
Insurance
Reinsurance
Life
Total P&C Operations: Casualty — professional lines
$
345,567
$
66,621
$
—
$
412,188 Casualty — other lines
219,268
117,889
—
337,157 Property catastrophe
766
93,149
—
93,915 Other property
131,014
179,601
—
310,615 Marine, energy, aviation and satellite
171,087
31,550
—
202,637 Other specialty lines (1)
163,176
—
—
163,176 Other (2)
(36,374
)
54,499
—
18,125 Structured indemnity
13,898
1,069
—
14,967 Total P&C Operations
$
1,008,402
$
544,378
$
—
$
1,552,780 Life Operations: Other Life
$
—
$
—
$
117,866
$
117,866 Annuity
—
—
41,716
41,716 Total Life Operations
$
—
$
—
$
159,582
$
159,582 Total
$
1,008,402
$
544,378
$
159,582
$
1,712,362 Quarter ended March 31, 2007:
Insurance
Reinsurance
Life
SCA
Total P&C Operations: Casualty — professional lines
$
360,535
$
52,564
$
—
$
—
$
413,099 Casualty — other lines
210,545
170,174
—
—
380,719 Property catastrophe
18,736
71,319
—
—
90,055 Other property
140,280
142,342
—
—
282,622 Marine, energy, aviation and satellite
171,070
31,234
—
—
202,304 Other specialty lines (1)
135,777
—
—
—
135,777 Other (2)
5,240
59,856
—
—
65,096 Structured indemnity
9,167
18,832
—
—
27,999 Total P&C Operations
$
1,051,350
$
546,321
$
—
$
—
$
1,597,671 Life Operations: Other Life
$
—
$
—
$
104,617
$
—
$
104,617 Annuity
—
—
42,377
—
42,377 Total Life Operations
$
—
$
—
$
146,994
$
—
$
146,994 SCA
$
—
$
—
$
—
$
46,379
$
46,379 Total
$
1,051,350
$
546,321
$
146,994
$
46,379
$
1,791,044
(1)
Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, and excess and surplus lines. (2) Other includes employers’ liability, surety, political risk and other lines 24
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands)
(Unaudited)
Operations
(U.S. dollars in thousands)
(Unaudited)
Operations
XL CAPITAL LTD 6. Investments The cost (amortized cost for fixed maturities and short-term investments), fair value, gross unrealized gains and gross unrealized (losses) of the Company’s investments at March 31, 2008 and
December 31, 2007 were as follows: March 31, 2008
Cost or
Gross
Gross
Fair Fixed maturities U.S. Government and Government agency
$
2,304,409
$
132,889
$
(1,827
)
$
2,435,471 Corporate
13,512,123
122,451
(1,151,483
)
12,483,091 Mortgage and asset-backed securities
12,621,973
96,864
(1,006,754
)
11,712,083 U.S. States and political subdivisions of the States
305,928
4,185
(4,798
)
305,315 Non-U.S. Sovereign Government
3,376,893
146,900
(17,232
)
3,506,561 Total fixed maturities
$
32,121,326
$
503,289
$
(2,182,094
)
$
30,442,521 Total short-term investments
$
1,111,582
$
10,585
$
(9,149
)
$
1,113,018 Total equity securities
$
548,744
$
142,325
$
(25,221
)
$
665,848 December 31, 2007
Cost or
Gross
Gross
Fair Fixed maturities U.S. Government and Government agency
$
2,585,336
$
102,135
$
(1,698
)
$
2,685,773 Corporate
13,407,142
104,967
(524,861
)
12,987,248 Mortgage and asset-backed securities
14,881,988
109,666
(497,777
)
14,493,877 U.S. States and political subdivisions of the States
252,818
2,803
(2,087
)
253,534 Non-U.S. Sovereign Government
3,106,532
100,207
(19,381
)
3,187,358 Total fixed maturities
$
34,233,816
$
419,778
$
(1,045,804
)
$
33,607,790 Total short-term investments
$
1,814,445
$
12,448
$
(23,695
)
$
1,803,198 Total equity securities
$
664,213
$
205,498
$
(14,896
)
$
854,815 The Company had gross unrealized losses totaling $2,216.4 million at March 31, 2008, which it considers to be temporary impairments. Individual security positions comprising this balance have
been evaluated by management, based on specified criteria, to determine if these impairments should be considered other than temporary. These criteria include an assessment of the severity and
length of time securities have been impaired, along with management’s ability and intent to hold the securities to recovery, among other factors included below. 25
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands)
(Unaudited)
Amortized
Cost
Unrealized
Gains
Unrealized
Losses
Value
(U.S. dollars in thousands)
Amortized
Cost
Unrealized
Gains
Unrealized
Losses
Value
XL CAPITAL LTD 6. Investments (continued) Factors considered in determining that additional other-than-temporary impairment charges were not warranted include; managements’ consideration of current and near term liquidity needs, an
evaluation of the factors and time necessary for recovery, and the results of on-going retrospective reviews of security sales and the basis for such sales. At March 31, 2008, there were $2,191.2 million of gross unrealized losses on fixed maturities and short-term investments, and $25.2 million of gross unrealized losses on equity securities. At
December 31, 2007, there were $1,069.5 million of gross unrealized losses on fixed maturities and short-term investments, and $14.9 million of gross unrealized losses on equity securities. At March 31,
2008 and December 31, 2007, approximately 2.6% and 2.3%, respectively, of the Company’s fixed income investment portfolio was invested in securities which were below investment grade or not
rated. Approximately 7.0% of the unrealized losses in the Company’s fixed income securities portfolio at March 31, 2008 related to securities that were below investment grade or not rated. The
information shown below about the unrealized losses on the Company’s investments at March 31, 2008 concerns the potential affect upon future earnings and financial position should management
later conclude that some of the current declines in the fair value of these investments are other than temporary declines. The following is an analysis of how long each of those securities at March 31, 2008 had been in a continual unrealized loss position: March 31, 2008
Less than 12 months
Equal to or greater
Fair
Gross
Fair
Gross Fixed maturities and short-term investments: U.S. Government and Government agency
$
131,737
$
1,200
$
35,819
$
636 Corporate
4,725,086
447,713
4,280,619
712,053 Mortgage and asset-backed securities
5,253,340
597,671
2,426,220
409,459 U.S. States and political subdivisions of the States
114,954
4,448
2,057
350 Non-U.S. Sovereign Government
353,734
4,881
394,556
12,832 Total fixed maturities and short-term investments
$
10,578,851
$
1,055,913
$
7,139,271
$
1,135,330 Total equity securities
$
259,344
$
25,221
$
—
$
— 26
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands)
(Unaudited)
than 12 months
Value
Unrealized
Losses
Value
Unrealized
Losses
XL CAPITAL LTD 6. Investments (continued) The following is an analysis of how long each of those securities at December 31, 2007 had been in a continual unrealized loss position: December 31, 2007
Less than 12 months
Equal to or greater
Fair
Gross
Fair
Gross Fixed maturities and short-term investments: U.S. Government and Government agency
$
122,199
$
552
$
31,795
$
1,166 Corporate
6,495,775
306,047
3,060,081
240,055 Mortgage and asset-backed securities
5,716,732
408,108
1,975,361
91,731 U.S. States and political subdivisions of the States
68,028
1,844
4,202
253 Non-U.S. Sovereign Government
454,992
5,354
531,052
14,389 Total fixed maturities and short-term investments
$
12,857,726
$
721,905
$
5,602,491
$
347,594 Total equity securities
$
195,703
$
14,896
$
—
$
— 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)
March 31, 2008
December 31, 2007
Amortized
Fair
Amortized
Fair Due after 1 through 5 years
$
6,156,910
$
6,010,608
$
5,980,146
$
5,946,528 Due after 5 through 10 years
6,406,880
6,314,903
6,559,877
6,536,884 Due after 10 years
6,935,563
6,404,927
6,811,805
6,630,501 Mortgage and asset-backed securities
12,621,973
11,712,083
14,881,988
14,493,877
$
32,121,326
$
30,442,521
$
34,233,816
$
33,607,790 At March 31, 2008 and December 31, 2007, approximately $305.7 million and $144.3 million, respectively, of securities included in investments available for sale were loaned to various counter-
parties through the Company’s securities lending program. At March 31, 2008 and December 31, 2007, approximately $313.9 million and $146.2 million, respectively, of cash collateral held in
connection with these loans, is included in cash and cash equivalents, with a corresponding liability reflected in net payable for investments purchased. Securities in an unrealized loss position were comprised of approximately 7,600 securities, of which 61% of the unrealized loss were securities with fair value to amortized cost ratios at or greater
than 90%. The majority of these securities are high quality investment grade fixed maturities depressed due to broad overall market widening of credit spreads seen in the third and fourth quarters of
2007 and the first quarter of 2008. 27
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands)
than 12 months
Value
Unrealized
Losses
Value
Unrealized
Losses
(Unaudited)
Cost
Value
Cost
Value
XL CAPITAL LTD 7. 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. The following table summarizes the net realized and unrealized gains (losses) on derivative instruments included in net income for the three months ended March 31, 2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
2008
2007 Credit derivatives (1)
$
2,170
$
(11,381
) Weather and energy derivatives.
10,457
14,470 Other non-investment derivatives
(58
)
3,840 Investment derivatives (2)
32,113
812 Net realized and unrealized gains on derivative instruments
$
44,682
$
7,741
(1)
Excludes credit derivative swaps entered into within the investment portfolio. (2) Includes derivatives entered into by the Company’s external investment portfolio managers on the Company’s behalf, including certain credit derivative swaps used to hedge credit exposures. Credit derivatives have been entered into through both the Company’s investment portfolio and SCA and have been recorded at fair value. Following the secondary sale of SCA common shares,
the Company retained some credit derivative exposures written by SCA through reinsurance agreements that have certain of these derivatives exposures embedded within them. Valuation of
investment related credit derivatives is provided by pricing services. Subsequent to June 6, 2007, the Company has received SCA related derivative fair values from SCA management and has
reviewed the methodology applied in developing those estimates. SCA estimates fair value for investment grade exposures by monitoring changes in credit quality and selecting appropriate market
indices to determine credit spread movements over the life of the contracts. The determination of the credit spread movements is the basis for calculating the fair value when appropriate active
market indices are available. For credit derivatives where no appropriate market indices are readily available, the Company uses an alternative fair value methodology. Under this methodology, the
fair value is determined using a model which 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. In addition, judgment is applied to factors necessary to determine the rates of return and levels of subordination required by a market participant to assume
the risks. Where relevant, recent transactions or contract discussions related to similar risks are considered. In general, SCA holds credit derivatives to maturity. Accordingly, changes in the fair value
of such credit derivatives are unrealized. Subsequent to June 6, 2007, the change in value of the embedded derivative portion of the financial guarantee reinsurance agreements the Company has with
SCA are included in “Net (loss) income from operating affiliates.” 8. XL Capital Finance (Europe) plc XL Capital Finance (Europe) plc (“XLFE”) is a wholly owned finance subsidiary of the Company. In January 2002, XLFE issued $600.0 million par value 6.5% Guaranteed Senior Notes due
January 2012. These Notes are fully and unconditionally guaranteed by the Company. XL Capital Ltd’s ability to obtain funds from its subsidiaries is subject to certain contractual restrictions, 28
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Three Months Ended
March 31,
XL CAPITAL LTD 8. XL Capital Finance (Europe) plc (continued) applicable laws and statutory requirements of the various countries in which the Company operates including Bermuda, the U.S. and the U.K., among others. Required statutory capital and surplus
for the principal operating subsidiaries of the Company was $5.3 billion as of December 31, 2007. 9. Related Party Transactions For detailed information regarding the Company’s transactions with SCA see Note 4 “Security Capital Assurance Ltd.” At March 31, 2008 and 2007, the Company owned minority stakes in nine and eleven independent investment management companies (“Investment Manager Affiliates”), respectively. These
ownership stakes are part of the Company’s asset management strategy, pursuant to which the Company seeks to develop relationships with specialty investment management organizations, generally
acquiring an equity interest in the business. The Company also invests in certain of the funds and limited partnerships and other legal entities managed by these affiliates and through these funds and
partnerships pay management and performance fees to the Company’s Investment Manager Affiliates. In the normal course of business, the Company enters into certain quota share reinsurance contracts with a subsidiary of one of its other strategic affiliates, ARX Holding Corporation. During
the quarter ended March 31, 2008, these contracts resulted in reported net premiums of $21.5 million, net paid claims of $6.2 million and reported acquisition costs of $10.0 million. During the same
period in 2007, these contracts resulted in reported net premiums of $39.6 million, net paid claims of $4.7 million and reported acquisition costs of $19.7 million. Management believes that these
transactions are conducted at market rates consistent with negotiated arms-length contracts. In the normal course of business, the Company enters into cost sharing and service level agreement transactions with certain other strategic affiliates, which management believes to be conducted
consistent with arms-length rates. Such transactions, individually and in the aggregate, are not material to the Company’s financial condition, results of operations and cash flows. 10. Deposit Liabilities Deposit liabilities include GICs and FAs as well as reinsurance and insurance deposits. As at December 31, 2007, the Company had approximately $4.0 billion of deposit liabilities associated with
GICs for which credit enhancement was provided by XLCA. Based on the terms and conditions of the underlying GICs, upon the downgrade of XLCA below certain ratings levels, all or portions of
outstanding principal balances on such GICs would come due. In January and February 2008, several rating agencies downgraded SCA and its subsidiaries and as a result, the Company settled, in
March 2008, the majority of the GIC liabilities. The resulting balance of deposit liabilities associated with GICs as at March 31, 2008 was $80.4 million. In addition, at March 31, 2008, the balance of
deposit liabilities associated with FAs was $1.8 billion. The Company expects the balance of deposit liabilities associated with GICs and FAs to continue to decrease throughout 2008 as the contracts
associated with GICs and FAs mature and the associated deposit liabilities are settled. Management does not expect any significant impact on the Company’s results of operations or liquidity as a
result of the maturity of these contracts. 29
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 11. Computation of Earnings Per Ordinary Share and Ordinary Share Equivalent
(Unaudited)
2008
2007 Basic earnings per ordinary share: Net income
$
244,373
$
562,507 Less: preference share dividends
(32,500
)
(12,789
) Net income available to ordinary shareholders
$
211,873
$
549,718 Weighted average ordinary shares outstanding
176,336
178,772 Basic earnings per ordinary share
$
1.20
$
3.07 Diluted earnings per ordinary share: Net income
$
244,373
$
562,507 Less: preference share dividends
(32,500
)
(12,789
) Net income available to ordinary shareholders
$
211,873
$
549,718 Weighted average ordinary shares outstanding — basic..
176,336
178,772 Average stock options outstanding (1)..
491
829 Weighted average ordinary shares outstanding — diluted
176,827
179,601 Diluted earnings per ordinary share
$
1.20
$
3.06 Dividends per ordinary share
$
0.38
$
0.38
(1) 30
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Three Months Ended
March 31,
Net of shares repurchased under the treasury stock method.
ITEM 2. 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 liquidity 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 and an individual segment’s results of operations and financial condition. This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements that involve inherent risks and uncertainties. Statements that
are not historical facts, including statements about the Company’s beliefs and expectations, are forward-looking statements. These statements are based upon current plans, estimates and projections.
Actual results may differ materially from those included in such forward-looking statements, and therefore undue reliance should not be placed on them. See “Cautionary Note Regarding Forward-
Looking Statements” below for a list of factors that could cause actual results to differ materially from those contained in any forward-looking statement. This discussion and analysis should be read in conjunction with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and the audited Consolidated
Financial Statements and notes thereto, presented under Item 7 and Item 8, respectively, of the Company’s Form 10-K for the year ended December 31, 2007. Executive Overview See “Executive Overview” in Item 7 of the Company’s Form 10-K for the year ended December 31, 2007. Results of Operations The following table presents an analysis of the Company’s net income available to ordinary shareholders and other financial measures (described below) for the three months ended March 31,
2008 and 2007: (U.S. dollars and shares in thousands, except per share amounts)
(Unaudited)
2008
2007 Net income available to ordinary shareholders
$
211,873
$
549,718 Earnings per ordinary share — basic
$
1.20
$
3.07 Earnings per ordinary share — diluted
$
1.20
$
3.06 Weighted average number of ordinary shares and ordinary share equivalents — basic
176,336
178,772 Weighted average number of ordinary shares and ordinary share equivalents — diluted
176,827
179,601 The Company’s net income and other financial measures as shown below for the three months ended March 31, 2008 have been affected, among other things, by the following significant items: 1) Impact of credit market movements on the Company’s investment portfolio In the first quarter of 2008, financial market conditions continued to be extremely challenging as the global credit crisis that begun in July 2007 continued to adversely impact global fixed income
markets. Continuing challenges included continued weakness in the U.S. housing market and increased mortgage delinquencies, investor anxiety over the U.S. economy, rating agency downgrades of
various structured products, unresolved issues with structured investment vehicles and monolines, deleveraging of financial institutions and hedge funds and a serious dislocation in the interbank
market. All of these elements led to continued declines in mortgage and structured credit prices in the first quarter of 2008 as well as significant spread widening and price erosion in corporate fixed
income, particularly within the financial sector. Increasing deleveraging of financial institutions led to substantial amounts of forced liquidations which triggered negative pricing pressures. Continued
declines in government rates did little to alleviate the concerns in either residential mortgage markets or the short-term funding market during the first quarter of 2008. These elements were the 31
Three Months Ended
March 31,
primary drivers behind the increase of $1.1 billion in net unrealized losses and $102.3 million in net realized losses on investments reported for the quarter ended March 31, 2008. Realized losses and impairments totaled $53.8 million during the quarter ended March 31, 2008 in the Company’s holdings of sub-prime non-agency securities, second liens, ABS CDOs with sub-
prime collateral as well as Alt-A mortgage exposures (“Topical Assets”). These losses and impairments continued to be principally concentrated in 2005, 2006, and 2007 vintage securities. In addition,
realized losses in the first quarter of 2008 were positively impacted, although not significantly, as the Company realized net gains from the sale of assets associated with the settlement of the majority
of the GIC portfolio that took place during the first three months of 2008. Liquidations necessary to fund the repayment of the GIC liabilities following the downgrade of XLCA, were funded
through sales of assets in the Other Financial Lines segment investment portfolios as well as the general investment portfolios. Management’s approach was to avoid the sale of assets where current
market prices did not reflect intrinsic values or where transaction costs for liquidation were excessive. As a result, the Company continues to hold a number of the Topical Assets and these have been
transferred to the general portfolio in exchange for those assets that were liquidated. The following table details the current exposures to Topical Assets within the Company’s fixed income portfolio as well as the current net unrealized gain (loss) position as at March 31, 2008 and
December 31, 2007: (U.S. dollars in thousands)
As at
As at
Holding at
Percent
Net
Holding at
Percent
Net Topical Assets: Sub-prime first lien mortgages
$
796,341
2.2
%
$
(203,660
)
$
995,947
2.5
%
$
(145,785
) Alt-A mortgages
729,814
2.1
%
(138,498
)
924,783
2.3
%
(40,145
) Second lien mortgages (including sub-prime second lien mortgages)
82,244
0.2
%
1,965
97,647
0.3
%
788 ABS CDOs with sub-prime collateral
29,123
0.1
%
2,484
39,317
0.1
%
101 Total exposure to Topical Assets
$
1,637,522
4.6
%
$
(337,709
)
$
2,057,694
5.2
%
$
(185,041
) The following table provides the earnings and comprehensive earnings impact related to the Topical Assets in the first quarter of 2008: (U.S. dollars in thousands)
Three Months Ended
Realized
Change Topical Assets: Sub-prime first lien mortgages
$
(31,798
)
$
(57,875
) Alt-A mortgages
(14,087
)
(98,353
) Second lien mortgages (including sub-prime second lien mortgages)
(4,648
)
1,177 ABS CDOs with sub-prime collateral
(3,265
)
2,383 Total
$
(53,798
)
$
(152,668
) The Company’s sub-prime and Alt-A exposures remain primarily highly rated, have strong underlying loan characteristics and are supported by adequate subordination levels. During the quarter,
the Company had approximately $145 million of topical investments downgraded by rating agencies. Of the total Topical Asset exposure as at March 31, 2008 and December 31, 2007 of $1.6 billion and $2.0 billion, respectively, approximately $66.6 million and $76.8 million, respectively, of the 32
March 31, 2008
December 31, 2007
Fair Value
of Fixed
Income
Portfolio
Unrealized
(Loss) Gain
Fair Value
of Fixed
Income
Portfolio
Unrealized
(Loss) Gain
March 31, 2008
(Loss) and
(Impairments)
in Net
Unrealized
(Loss) Gain
related securities had ratings dependent on guarantees issued by third party guarantors (i.e. monoline insurers). Decreases in the ratings of such third party guarantors would typically decrease the fair
value of guaranteed securities; however, at March 31, 2008, in the event of non-performance on the part of these third party guarantors, the Company estimates that the average credit quality of this
portfolio would be ‘A’ and that approximately 94.9% would remain investment grade. In addition, of the total portfolio of fixed maturity securities at March 31, 2008 and December 31, 2007, of $30.4
billion and $33.6 billion, respectively, less than 2% were guaranteed by such third parties with no individual third party representing more than 1%. As noted above, the remaining changes in net unrealized losses were primarily as a result of spread widening in both corporate credit, particularly financials, and CMBS assets. The Company
believes these losses are a result of technical spread widening, as a result of the market events noted above, rather than any fundamental deterioration or other-than-temporary impairment. Net realized and unrealized gains on investment derivatives for the quarter ended March 31, 2008 resulted primarily from corporate credit deterioration and the resulting appreciation of certain
credit derivative swaps held in the investment portfolio. Net income from investment fund affiliates was only slightly positive in the first quarter of 2008 as the markets, during the quarter, were particularly challenging for strategies employed by the
Company’s alternative investment managers given the extreme volatility and overall pull back of credit availability. As at March 31, 2008, approximately 13.9% of the asset and mortgage-backed holdings were classified as part of the Company’s exposure to Topical Assets. This represented approximately 4.6%
of the total fixed income portfolio and 21.6% of the total net unrealized loss position. Of the Topical Asset securities, approximately 97% were rated as investment grade. All portfolio holdings,
including those with sub-prime exposure, are reviewed as part of the ongoing other-than-temporary-impairment monitoring process. The Company continues to actively monitor its exposures, and to
the extent market disruptions continue, including but not limited to disruptions in the residential mortgage market, the Company’s financial position could be negatively impacted. 2) Continuing competitive underwriting environment Insurance In the Insurance segment, January 2008 renewals reflected increasing soft market conditions as premium rates across most lines of business decreased within the market. In addition, competitive
pressures continued to make new business more difficult to win. Overall, January 2008 renewals reflected decreases in premium rates of approximately 5 to 20%, while certain casualty lines
experienced premium rate reductions of approximately 5 to 15%. In addition, premium rates within certain specialty lines and the U.S. Excess and Surplus line of business decreased by up to 10%.
While market competition continued to increase in most lines of business in early 2008, desired retentions were broadly maintained. However, as a result of rating agency downgrades in late January
2008, it may be more difficult for the Company, going forward, to attract new business and/or retain previously written business, particularly within certain casualty and professional lines of business.
However, broad reactions from customers and brokers continue to indicate that the impact of these downgrades is likely to be limited. 33
The following table provides an analysis of gross premiums written, net premiums written and net premiums earned for the Insurance segment for the three month periods ended March 31, 2008
and 2007: (U.S. dollars in thousands)
(Unaudited)
(Unaudited)
Gross
Net
Net
Gross
Net
Net Casualty — professional lines
$
304,386
$
267,862
$
345,567
$
317,918
$
282,149
$
360,535 Casualty — other lines
490,735
335,571
219,268
481,448
361,316
210,545 Property catastrophe
(30
)
(1,105
)
766
16,710
2,216
18,736 Other property
334,915
225,682
131,014
293,323
238,631
140,280 Marine, energy, aviation, and satellite
234,491
186,732
171,087
233,228
165,425
171,070 Other specialty lines (1)
239,146
188,802
163,176
209,991
171,549
135,777 Other (2)
4,669
(37,079
)
(36,374
)
11,531
10,214
5,240 Structured indemnity
20,037
17,387
13,898
15,257
14,015
9,167 Total
$
1,628,349
$
1,183,852
$
1,008,402
$
1,579,406
$
1,245,515
$
1,051,350
(1)
Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, and excess and surplus lines. (2) Other includes employers’ liability, surety, political risk and other lines. Reinsurance In the Reinsurance segment, January 1, 2008 renewals pointed to a decline in premium rates across most major lines of business, as market conditions continued to soften and the reinsurance
industry continued to experience pricing erosion, increased competitive pressures and increased retentions by cedants. Renewals and new business in 2008 continued to be assessed against internal
hurdle rates with a continued focus on underwriting discipline. U.S. catastrophe exposed property lines experienced rate declines of approximately 10% to 15%, while rates for non-U.S. catastrophe
exposed property lines of business dropped by up to 10%. Other property lines of business saw rates decrease by 10% to 15%. Ocean marine pricing rates remained flat to down 5%, while rates
within the aviation market decreased by up to 10%. Casualty pricing trends in the reinsurance market experienced deterioration in rates of up to 15%. However, rate changes on business actually
bound in this line of business decreased between 10 to 15%. The following table provides an analysis of gross premiums written, net premiums written and net premiums earned for the Reinsurance segment for the three month periods ended March 31,
2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
(Unaudited)
Gross
Net
Net
Gross
Net
Net Casualty — professional lines
$
82,910
$
82,908
$
66,621
$
104,061
$
108,249
$
52,564 Casualty — other lines
176,942
171,459
117,889
295,315
274,908
170,174 Property catastrophe
244,060
216,206
93,149
287,739
188,632
71,319 Other property
289,455
226,935
179,601
349,023
276,047
142,342 Marine, energy, aviation, and satellite
68,919
66,317
31,550
80,524
72,667
31,234 Other (1)
206,385
185,002
54,499
240,124
213,889
59,856 Structured indemnity
3,874
3,874
1,069
18,100
18,100
18,832 Total
$
1,072,545
$
952,701
$
544,378
$
1,374,886
$
1,152,492
$
546,321
(1)
Other includes employers’ liability, surety, political risk and other lines.
34
Three Months Ended
March 31, 2008
Three Months Ended
March 31, 2007
Premiums
Written
Premiums
Written
Premiums
Earned
Premiums
Written
Premiums
Written
Premiums
Earned
Three Months Ended
March 31, 2008
Three Months Ended
March 31, 2007
Premiums
Written
Premiums
Written
Premiums
Earned
Premiums
Written
Premiums
Written
Premiums
Earned
3) Favorable prior year reserve development During the first three months of 2008, the Company incurred net favorable prior year reserve development in property and casualty operations of $67.0 million compared to $64.7 million for the
same period in 2007. Reinsurance favorable development accounted for $49.7 million of the release in 2008, with the balance coming from the Insurance segment. For further details see the segment
results in the Income Statement Analysis below. Financial Measures The following are some of the financial measures management considers important in evaluating the Company’s operating performance:
(U.S. dollars and shares in thousands, except ratios and per share amounts)
(Unaudited)
2008
2007 (3) Underwriting profit — property and casualty operations
$
108,071
$
160,430 Combined ratio — property and casualty operations
93.6
%
90.2
% Net investment income — property and casualty operations (1)
$
308,041
$
314,181 Annualized return on average shareholders’ equity
9.9
%
22.7
%
(Unaudited)
December 31, Book value per ordinary share
$
46.11
$
50.30 Fully diluted book value per ordinary share (2)
$
46.11
$
50.29
(1)
Net investment income relating to property and casualty operations does not include the net investment income related to the net results from structured products. (2) Fully diluted book value per ordinary share represents book value per ordinary share combined with the impact from dilution of share based compensation including in-the-money stock options at any period end. The Company believes that fully
diluted book value per ordinary share is a financial measure important to investors and other interested parties who benefit from having a consistent basis for comparison with other companies within the industry. However, this measure may not
be comparable to similarly titled measures used by companies either outside or inside of the insurance industry. (3) Certain lines of business and transactions previously reported under the Financial Lines segment were reclassified and reported under the Insurance, Reinsurance and Corporate (that includes the general investment and financing operations of
the Company) segments based on the nature of the underlying business. Underwriting profit — property and casualty operations One way that the Company evaluates the performance of its insurance and reinsurance operations is the underwriting profit or loss. The Company does not measure performance based on the
amount of gross premiums written. Underwriting profit or loss is calculated from premiums earned and fee income, less net losses incurred and expenses related to underwriting activities, plus
unrealized foreign exchange gains and losses on underwriting balances. Underwriting profit in the three month period ended March 31, 2008 is primarily reflective of the combined ratio discussed
below. Combined ratio — property and casualty operations The combined ratio for property and casualty operations is used by the Company and many other insurance and reinsurance companies as another measure of underwriting profitability. The
combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company’s insurance and reinsurance operations. A combined ratio
of less than 100% indicates an underwriting profit and greater than 100% reflects an underwriting loss. The Company’s combined ratio for the three months ended March 31, 2008, is higher than the
same period in the previous year, primarily as a result of an increase in both the loss and loss expense ratio as well as the underwriting expense ratio. The higher loss and loss expense ratio resulted
from 35
Three Months Ended
March 31,
March 31,
2008
2007
higher current year attritional losses, primarily in property lines, as well as lower net premium earned in the first quarter of 2008 as compared to the same period in 2007 as a result of the continuing
competitive underwriting environment noted above. The increased underwriting expense ratio has been driven largely by continued pricing pressures that resulted in less premium earned as well as
increased acquisition costs. Net investment income — property and casualty operations Net investment income related to property and casualty operations is an important measure that affects the Company’s overall profitability. The largest liability of the Company relates to its
unpaid loss reserves, and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due, and thus a significant part of the portfolio is in fixed
income securities. Net investment income is influenced by a number of factors, including the amounts and timing of inward and outward cash flows, the level of interest rates and credit spreads and
changes in overall asset allocation. Net investment income related to property and casualty operations decreased by $6.1 million during the first quarter of 2008 as compared to same period in the
prior year. Overall, portfolio yields have decreased as yields earned on investment of cash flows and reinvestment of maturing or sold securities are generally lower than on securities previously held,
as prevailing market interest rates, particularly in the U.S., have decreased over the last year. As well, the portfolio mix has changed as a result of the settlement of the Muni GIC liabilities, as the
property and casualty operations assumed a number of the floating rate securities previously held in the Company’s Other Financial Lines segment. The average size of the property and casualty investment portfolio during the three months ended March 31, 2008, decreased as compared to the same period in 2007, mainly due to an increase
in unrealized losses as a result of widening credit spreads on corporate and structured credit assets, partially offset by declining U.S. and Euro government interest rates. Book value per ordinary share Management also views the change in the Company’s book value per ordinary share as an additional measure of the Company’s performance. Book value per share is calculated by dividing
ordinary shareholders’ equity by the number of outstanding ordinary shares at any period end. Book value per ordinary share is affected primarily by the Company’s net income (loss), by any changes
in the net unrealized gains and losses on its investment portfolio, currency translation adjustments and also the impact of any share repurchase or issuance activity. Book value per ordinary share
decreased by $4.19 in the first three months of 2008 as compared to an increase of $1.83 in the first three months of 2007. The decrease is primarily as a result of an increase in unrealized losses on
investments of approximately $1.1 billion, net of tax, as a result of widening credit spreads on corporate and structured credit assets and the negative impact of the weakening U.S. dollar, partially
offset by declining U.S. and Euro government interest rates in the first quarter of 2008. Partially offsetting the decrease in book value per ordinary share was $211.9 million in net income for the
three months ended March 31, 2008 and positive currency translation gains which increased book value. Annualized return on average ordinary shareholders’ equity Annualized return on average ordinary shareholder’s equity (“ROE”) is another financial measure that management considers important in evaluating the Company’s operating performance. ROE
is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholders’ equity. The Company establishes minimum target ROEs for its total
operations, segments and lines of business. If the Company’s minimum ROE targets over the longer term are not met with respect to any line of business, the Company seeks to modify and/or exit
these lines. In addition, the Company’s compensation of its senior officers is significantly dependent on the achievement of the Company’s performance goals to enhance shareholder value as
measured by ROE (adjusted for certain items considered to be ‘non-operating’ in nature). In the first quarter 36
of 2008, ROE was 9.9%, 12.8 percentage points lower than the prior year as a result of losses recorded in the Company’s investment portfolio in the first quarter of 2008 in relation to adverse credit
market conditions and lower net income associated with the Company’s investment fund and operating affiliates. In addition, as noted above, the Company’s underwriting profit decreased in the first
quarter of 2008 as compared to the same period in 2007. Partially offsetting these decreases was lower levels of shareholders equity resulting from increases in unrealized losses on investments. In the
first quarter of 2007, ROE was 22.7% due to solid underwriting results throughout its property and casualty operations combined with strong investment fund affiliate income. Other Key Focuses of Management See the discussion of the Other Key Focuses of Management in Item 7 of the Company’s Form 10-K for the year ended December 31, 2007. That discussion is updated with the disclosures set
forth below. The Company’s investment in and relationships with SCA The Company has multiple relationships with SCA as a result of SCA’s initial origins as a wholly-owned subsidiary and its subsequent IPO. These relationships are detailed in Note 4 to the
Consolidated Financial Statements, “Security Capital Assurance Ltd”, and include, most significantly, a 46.9% investment along with certain guarantees and reinsurance arrangements. The Company is
not a primary originator or insurer of mortgages, nor does it guarantee mortgages other than indirectly through the activities of SCA, and as such the impact to the Company with respect to credit
enhancement activities is largely limited to the SCA investment and related reinsurance agreements and guarantees. At December 31, 2007, the Company wrote down its investment in SCA to zero. The write down of SCA to zero in the fourth quarter of 2007 was based, in part, on the losses SCA recorded in
the fourth quarter of 2007 and as such no equity earnings related to SCA have been recorded in the first quarter of 2008. The Company continues to review all opportunities available to it regarding
its relationship with SCA. See
Note 4 to the Consolidated Financial Statements, “Security Capital Assurance
Ltd” for further information relating to the exposures associated with
the reinsurance and guarantee agreements with SCA as well as the impact to
the Company during the first quarter of 2008 as a result of these agreements.
For further information relating to certain risks associated with the guarantees
refer to Item 1A. Risk Factors in the Company’s Annual Report on Form
10-K for the year ended December 31, 2007. Management Changes In late October 2007, the Company announced that Mr. Brian M. O’Hara, President and Chief Executive Officer (“CEO”) of the Company, had informed the Company’s Board of Directors of
his decision to retire as President and CEO in mid-2008. Accordingly, the Board of Directors implemented a CEO succession plan including the authorization of a Succession Committee to lead the
new CEO selection process. On March 17, 2008, the Company announced that Mr. Michael S. McGavick will replace Mr. O’Hara as the Company’s CEO and effective May 1, 2008, Mr. McGavick
assumed the role of CEO. To provide continuity during the transition, Mr. O’Hara, who is currently serving as Acting Chairman of the Company’s Board of Directors, will serve as Chairman during
the final year of his current term on the Board which expires in April 2009. Ratings and Capital Management 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 rating agencies. As a result, in
the event that the Company’s financial strength rating is downgraded, its ability to write business may 37
be adversely affected. In January 2008, A.M. Best Company, Inc. (“A.M. Best”) revised the financial strength rating of the Company’s leading property and casualty operating subsidiaries to “A”
from “A+” and affirmed them with a ‘stable’ outlook. The downgrade by A.M. Best was primarily due to their concerns regarding the Company’s historic earnings volatility. In addition, both Fitch
and Moody’s downgraded the financial strength rating of the Company’s leading property and casualty operating subsidiaries to “A+” from “AA–” and to “A1” from “A3”, respectively. The Company
has continued to work closely with the various rating agencies in 2008 in order to manage and evaluate its capital needs to support the volume of business written in order to maintain its claims
paying and financial strength ratings. In 2006, in order to maximize the benefit from the new market environment, while limiting the Company’s net risk appetite, the Company utilized capacity available from a reinsurance vehicle
Cyrus Reinsurance Limited (“Cyrus Re”), to which the Company ceded approximately 35% of its property catastrophe risks. In so doing, the Company was able to reduce its net retained risk and
shared in the profitability of the reinsurance business ceded to this new vehicle in the form of market based profit commissions and other commissions for business ceded by the Company to this
facility. Business was ceded to this facility on a risks attaching basis up to July 1, 2007, which includes the inception date of the majority of the Company’s property catastrophe business. Effective
January 1, 2008, the Company entered into a quota share reinsurance treaty with a newly-formed Bermuda reinsurance company, Cyrus Reinsurance II Limited (“Cyrus Re II”). Pursuant to the terms
of the quota share reinsurance treaty, Cyrus Re II assumes a 10% cession of certain lines of property catastrophe reinsurance and retrocession business underwritten by certain operating subsidiaries
of the Company for the 2008 underwriting year. In connection with such cessions, the Company pays Cyrus Re II reinsurance premium less a ceding commission, which includes a reimbursement of
direct acquisition expenses incurred by the Company as well as a commission to the Company for generating the business. The quota share reinsurance treaty also provides for a profit commission
payable to the Company. Establishment of Reinsurance Operations in Brazil In response to the liberalization of the Brazilian reinsurance market in mid-April 2008, the Company’s Reinsurance Segment launched a new initiative to serve Brazil through the establishment of
both a locally domiciled and admitted foreign reinsurer. Upon receipt of the required regulatory approvals, together these two platforms should provide, the Company with access to the entire
Brazilian reinsurance market. Critical Accounting Policies and Estimates See the discussion of the Company’s Critical Accounting Policies and Estimates in Item 7 of the Company’s Form 10-K for the year ended December 31, 2007. Variable Interest Entities and Other Off-Balance Sheet Arrangements In February 2003, the Company entered into an aggregate of $300.0 million of commercial paper-based credit facilities (the “Credit Facilities”). These facilities were increased to $500.0 million in
June 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 inter-company quota
share reinsurance agreement. The issued securities and the Company’s repayment obligations were recorded as a net balance on the Company’s balance sheet because the Company had a contractual
legal right of offset. In February 2008, the Company terminated this arrangement, resulting in a repayment of $500.0 million and termination of the Trust. For further information, see the discussion of the Company’s variable interest entities and other off-balance sheet arrangements in Item 7 of the Company’s Form 10-K for the year ended
December 31, 2007. 38
Segment Results for the three months ended March 31, 2008 compared to the three months ended March 31, 2007 The Company is organized into four operating segments: Insurance, Reinsurance, Life Operations and Financial Lines — in addition to a corporate segment that includes the general investment and
financing operations of the Company. The Company evaluates the performance for both the Insurance and Reinsurance segments based on underwriting profit and evaluates the contribution from each of the Life Operations and
Other Financial Lines segments. Other items of revenue and expenditure of the Company are not evaluated at the segment level for reporting purposes. In addition, the Company does not allocate
investment assets by segment for its property and casualty operations. Investment assets related to (i) the Company’s Life Operations and Other Financial Lines segments and (ii) certain structured
products included in the Insurance and Reinsurance segments, are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each
of these segments. Income Statement Analysis Insurance General insurance business written includes risk management and specialty lines. Risk management products are comprised of global property and casualty insurance programs for large
multinational companies, including umbrella liability, integrated risk and primary master property and liability coverages. Specialty lines products include directors’ and officers’ liability, environmental
liability, professional liability, aviation and satellite, employment practices liability, marine, equine and certain other insurance coverages including program business. In addition, certain structured
indemnity products structured by XLFS are included within the results of the Insurance segment covering a range of insurance risks including property and casualty insurance, certain types of residual
value exposures and other market risk management products. A large part of the Company’s casualty insurance business written has loss experience that is 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. The following table summarizes the underwriting results for this segment: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 (1) Gross premiums written
$
1,628,349
$
1,579,406
3.1
% Net premiums written
1,183,852
1,245,515
(5.0
)% Net premiums earned
1,008,402
1,051,350
(4.1
)% Fee income and other
7,464
3,092
141.4
% Net losses and loss expenses
684,812
647,266
5.8
% Acquisition costs
125,836
126,223
(0.3
)% Operating expenses
164,505
164,134
0.2
% Underwriting profit
$
40,713
$
116,819
(65.1
)% Exchange losses
$
53,108
$
7,335
NM
* Net results — structured products
$
(9,193
)
$
2,529
NM
*
(1)
Certain lines of business and transactions previously reported under the Financial Lines segment have been reclassified and reported under the Insurance, Reinsurance and Corporate (that includes the general investment and financing operations
of the Company) segments based on the nature of the underlying business. * NM – Not meaningful 39
Three Months Ended
March 31,
Gross premiums written increased by 3.1% during the three months ended March 31, 2008 compared with the three months ended March 31, 2007, primarily as a result of higher levels of long-
term agreements of $87.0 million, favorable premium estimate adjustments recorded in the first quarter of 2008 associated with the global risk property book of business and U.K. based London
market business, as well as favorable foreign exchange rate movements of $66.1 million. Premium adjustments were as a result of revisions to premium estimates based on updates of insured
exposures within these lines of business. Partially offsetting these increases were continued decreases in premium rates as market conditions continued to soften, selective non-renewals in certain
property and marine lines of business and the runoff of certain property catastrophe program exposures. Net premiums written decreased by 5.0% during the first quarter of 2008 as compared to
same period in 2007, primarily as a result of an increase in ceded premiums written related to the purchase of an adverse development cover associated with a Company owned Lloyd’s syndicate and
reinstatement premiums relating to certain environmental lines of business, partially offset by the factors noted above related to gross premiums written. Net premiums earned decreased by 4.1% in the three month period ended March 31, 2008 compared with the three month period ended March 31, 2007. The decrease primarily resulted from the
earn-out of overall lower net premiums written in the past twelve months combined with the impact of the adverse development cover noted above. Fee income increased in the first quarter of 2008 as compared to the first quarter of 2007 mainly as a result of higher engineering fee revenue associated with GAPS, a loss prevention consulting
service provider acquired in late 2007. The following table presents the ratios for this segment:
(Unaudited)
2008
2007 Loss and loss expense ratio
67.9
%
61.6
% Underwriting expense ratio
28.8
%
27.6
% Combined ratio
96.7
%
89.2
% The loss and loss expense ratio includes net losses incurred for both the current year and any favorable or adverse prior year development of loss and loss expense reserves held at the beginning
of the year. The loss ratio for the three months ended March 31, 2008 increased compared with the three months ended March 31, 2007, primarily due to reduced premium rate levels, an increase in
catastrophe related losses as a result of U.S. windstorms and Australian floods that occurred in the first quarter of 2008 as well as an anticipated increase in notice activity relating to standard
professional lines of business. In addition, net favorable prior year development decreased from $20.2 million in the first three months of 2007 to $17.3 million during the first three months of 2008.
The following table summarizes the net (favorable) adverse prior year development relating to the Insurance segment for the three month periods ended March 31, 2008 and 2007: (U.S. dollars in millions)
(Unaudited)
2008
2007 Property
$
(11.1
)
$
(13.5
) Casualty and professional
(3.9
)
(37.5
) Specialty and other
(2.3
)
30.8 Total
$
(17.3
)
$
(20.2
) Loss and loss expense ratio excluding prior year development
69.6
%
63.5
% 40
Three Months Ended
March 31,
Three Months Ended
March 31,
Net prior period reserve releases in the three months ended March 31, 2008 were due primarily to favorable reserve development in global property lines of business as well as the release of a
portion of a previously established provision against reinsurance recoverable balances. Net prior period reserve releases in the three months ended March 31, 2007 were in certain property and
casualty lines of business and offset by adverse development within specialty and other lines. Excluding prior year development, the loss ratio for the three months ended March 31, 2008 increased by
6.1 loss percentage points as compared to the same period in 2007 due primarily to the reasons noted above impacting the loss ratio for the quarter. The increase in the underwriting expense ratio in the three months ended March 31, 2008, compared to the same period in 2007 was due to an increase in the operating expense ratio of 0.7
points (16.3% as compared to 15.6%) as well as an increase in the acquisition expense ratio of 0.5 points (12.5% as compared to 12.0%). The increase in the operating expense ratio was primarily as
a result of costs associated with the acquisition of GAPS, as well as the continued weakening of the U.S. dollar and its impact on operating expenses in both U.K. and European based operations.
The increase in the acquisition expense ratio was driven primarily by cessions associated with the purchase of an adverse development cover associated with a Company owned Lloyd’s syndicate noted
above, as well as a decrease in income associated with broker sharing agreements. Foreign exchange losses in the three months ended March 31, 2008 and 2007 were due primarily to the change in the value of the U.S. dollar against certain European currencies including the
Swiss Franc and Swedish Krona on certain inter-company balances. Net results from structured insurance products include certain structured indemnity contracts that are accounted for as deposit contracts. Net results from these contracts for the three months
ended March 31, 2008, have decreased compared to the same period in 2007 mainly due to higher interest expense associated with an accretion adjustment recorded in the first quarter of 2008 based
on changes in expected cash flows on a structured indemnity contract. Reinsurance Reinsurance business written includes casualty, property, marine, aviation and other specialty reinsurance on a global basis. The Company’s reinsurance property business generally has loss
experience characterized as low frequency and high severity, which can have a negative impact on the Company’s results of operations, financial condition and liquidity. The Company endeavors to
manage its exposures to catastrophic events by limiting the amount of its exposure in each geographic or peril zone worldwide and requiring that its property catastrophe contracts provide for
aggregate limits and varying attachment points. The following table summarizes the underwriting results for this segment: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 (1) Gross premiums written
$
1,072,545
$
1,374,886
(22.0
)% Net premiums written
952,701
1,152,492
(17.3
)% Net premiums earned
544,378
546,321
(0.4
)% Fee income and other
763
171
NM
* Net losses and loss expenses
316,081
348,322
(9.3
)% Acquisition costs
116,344
109,491
6.3
% Operating expenses
45,358
45,068
0.6
% Underwriting profit
$
67,358
$
43,611
54.5
% Exchange losses
$
13,743
$
16,524
(16.8
)% Net results — structured products
$
10,824
$
9,823
10.2
%
(1)
Certain lines of business and transactions previously reported under the Financial Lines segment have been reclassified and reported under the Insurance, Reinsurance and Corporate (that includes the general investment and financing operations
of the Company) segments based on the nature of the underlying business. * NM – Not meaningful 41
Three Months Ended
March 31,
Gross and net premiums written decreased by 22.0% and 17.3%, respectively, in the first quarter of 2008 as compared to the first quarter in 2007. These decreases resulted from the Company
declining business due to competitive pressures continuing to drive certain rates below the Company’s acceptable underwriting return levels together with increased client retentions. For the three
months ended March 31, 2008, premium rate decreases were most significant in certain casualty and non-U.S. property lines of business. There was a positive impact on gross premiums written of
favorable foreign exchange rate movements of $50.0 million as well as favorable premium adjustments of $22.7 million recorded in the first quarter of 2008 relating to the Company’s Latin American
reinsurance operations and these were partially offset by timing differences on contracts written in the first quarter of last year and expected to be written in the second quarter of 2008. The decrease
in net premiums written reflect the above changes in gross premiums written, combined with a reduction in ceded premiums in the first three months of 2008 as compared to the same period in 2007,
mainly as a result of a reduction in property catastrophe cessions to Cyrus Re II of 10% as compared to a 35% cession to Cyrus Re throughout 2007. Net premiums earned in the first quarter of 2008 decreased slightly by 0.4% as compared to the first quarter of 2007. The slight decrease was a reflection of the overall reduction of net
premiums written over the last 24 months, however, this increase was mostly offset by a reduction in ceded earned premiums of $31.8 million as a result of a reduction in property catastrophe
cessions to Cyrus Re II as noted above, as well as the impact on net premiums earned of favorable foreign exchange rate movements and favorable premium adjustments recorded in the first quarter
of 2008. Fee income increased in the first quarter of 2008 as compared to the first quarter of 2007 mainly as a result of the timing of the receipt of fees associated with certain structured indemnity
contracts in each respective period. The following table presents the ratios for this segment:
(Unaudited)
2008
2007 Loss and loss expense ratio
58.1
%
63.8
% Underwriting expense ratio
29.7
%
28.2
% Combined ratio
87.8
%
92.0
% The loss and loss expense ratio includes net losses incurred for both the current year and any favorable or adverse prior year development of loss and loss expense reserves held at the beginning
of the year. The loss ratio for the three months ended March 31, 2008 decreased compared with the three months ended March 31, 2007, primarily due to the impact of Windstorm Kyrill that
occurred in the first quarter of 2007 and higher net favorable prior year development of $49.7 million in the first quarter of 2008 as compared to net favorable prior year development of $44.5 million
in the same period of the prior year. The favorable impact of these items was partially offset by the impact of Storm Emma and property losses in the Company’s Latin American and Asia
operations during the first quarter 2008. The following table summarizes the net (favorable) adverse prior year development relating to the Reinsurance segment for the three month periods ended
March 31, 2008 and 2007: (U.S. dollars in millions)
(Unaudited)
2008
2007 Property and other short-tail lines
$
(16.6
)
$
(46.7
) Casualty and other
(31.7
)
(6.9
) Structured indemnity
(1.4
)
9.1 Total
$
(49.7
)
$
(44.5
) Loss and loss expense ratio excluding prior year development
67.2
%
71.9
% 42
Three Months Ended
March 31,
Three Months Ended
March 31,
For the three months ended March 31, 2008, casualty reserve releases were primarily within European casualty lines, while property and other short-tail lines reserve releases were attributable to
Bermuda and North American operations, partially offset by unfavorable reserve development in Latin America operations. In the same period in 2007, reserve releases were largely within certain
U.S. and non-U.S. property and other short-tail lines. Excluding prior year development, the loss ratio for the three months ended March 31, 2008 decreased by 4.7 loss percentage points as compared
to the same period in 2007 mainly as a result of the impact of Windstorm Kyrill and other smaller natural catastrophes that occurred in the first quarter of 2007. The increase in the underwriting expense ratio in the three months ended March 31, 2008, as compared with the three months ended March 31, 2007, was due to an increase in both acquisition
expense and operating expense ratios to 21.4% and 8.3%, respectively, as compared with 20.0% and 8.2%, respectively, in the first quarter of 2007. The increase in acquisition expenses was primarily
due to an increase in both sliding scale and profit commissions recorded in the first quarter of 2008 and partially offset by an adjustment in the first quarter of 2007 related to the earning of
acquisition expenses within the individual risk portfolio in the U.S. The operating expense ratio increased slightly as a result of higher professional and annual fees against lower net premiums earned,
partially offset by lower compensation expenses. Foreign exchange losses in the three months ended March 31, 2008 and 2007 were due primarily to the change in the value of the U.S. dollar against certain European currencies including the
U.K. Sterling and Euro on certain inter-company balances. Net results from structured reinsurance products include certain structured indemnity contracts that are accounted for as deposit contracts. Results from these products for the three months ended
March 31, 2008, increased compared to the same period in 2007 mainly due to higher net investment income relating to a change in the effective yield and cash flow stream of certain invested assets
associated with a structured indemnity contract. Life Operations Business written by the Life Operations segment is primarily European life reinsurance. This includes term assurances, group life, critical illness cover, immediate annuities, disability income
cover, and short-term life, accident and health business. Due to the nature of these contracts, premium volume may vary significantly from period to period. The following summarizes contribution from this segment: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Gross premiums written
$
234,958
$
213,275
10.2
% Net premiums written
224,213
202,938
10.5
% Net premiums earned
159,582
146,994
8.6
% Fee income and other
64
74
(13.5
)% Claims and policy benefits.
196,299
188,343
4.2
% Acquisition costs
24,117
20,267
19.0
% Operating expenses.
8,083
8,490
(4.8
)% Exchange losses (gains).
894
(290
)
NM
* Net investment income
97,135
92,834
4.6
% Contribution from Life Operations
$
27,388
$
23,092
18.6
%
*
NM – Not meaningful
The following table is an analysis of the Life Operations gross premiums written, net premiums written and net premiums earned for the three month periods ended March 31, 2008 and 2007: 43
Three Months Ended
March 31,
(U.S. dollars in thousands)
(Unaudited)
(Unaudited)
Gross
Net
Net
Gross
Net
Net Other Life
$
183,735
$
182,497
$
117,866
$
161,408
$
160,561
$
104,617 Annuity
51,223
41,716
41,716
51,867
42,377
42,377 Total
$
234,958
$
224,213
$
159,582
$
213,275
$
202,938
$
146,994 Gross premiums written relating to other life business increased by $22.3 million in the three months ended March 31, 2008 as compared to the same period in 2007 mainly due to premium
growth in the core underlying book of term assurance and critical illness business of $13.2 million and favorable foreign exchange rate movements of $2.8 million. In addition, gross premiums written
related to short-term life, accident and health business increased by $11.0 million primarily as a result of favorable foreign exchange rate movements, while growth in gross premiums written related
to U.S. business totaled $3.9 million in the first quarter of 2008. Partially offsetting these increases in gross premiums written was a decrease related to the French long-term life business from a single
premium of $8.6 million written in the first quarter of 2007. Gross premiums written relating to annuity business decreased by $0.6 million in the three months ended March 31, 2008 mainly due to
the absence of adjustment premiums, partially offset by favorable foreign exchange rate movements. Ceded premium ratios remained roughly consistent with the prior year. Net premiums earned in the first quarter of 2008 increased 8.6% as compared to the first quarter of 2007. This increase was consistent with the increase in gross and net premiums written as
described above. Claims and policy benefit reserves increased by $8.0 million or 4.2% in the three months ended March 31, 2008 as compared to the three months ended March 31, 2007, primarily as a result of
unfavorable foreign exchange rate movements. Changes in claims and policy benefits include the movement in policy benefit reserves related to other contracts (such as immediate annuities) where
investment assets were acquired with the assumption of the policy benefit reserves at the inception of the contract. For the three months ended March 31, 2008, acquisition costs increased by 19.0% as compared to the same period in 2007, largely as a result of an increase in business written and foreign
exchange rate movements in the first quarter of 2008, as noted above. Operating expenses decreased by 4.8% in the first quarter of 2008 as compared to the same period in the prior year due mainly
to lower allocated costs associated with administering the short-term life, accident and health business and partially offset by increased compensation costs and unfavorable foreign exchange rate
movements in the first quarter of 2008. Net investment income is included in the calculation of contribution from Life Operations, as it relates to income earned on portfolios of separately identified and managed life investment assets
and other allocated assets. Net investment income increased by $4.3 million or 4.6% in the three months ended March 31, 2008, as compared to the same period in 2007, primarily as a result of a
favorable foreign exchange rate movements of $3.3 million and an increase in the average investment balances to $7.1 billion from $6.8 billion. Other Financial Lines The Other Financial Lines segment is comprised of the guaranteed investment contract (“GIC”) and funding agreement (“FA”) businesses. As at December 31, 2007, the Company had
approximately $4.0 billion of deposit liabilities associated with GICs which were correspondingly matched with invested assets. Based on the terms and conditions of the underlying GICs, upon the
downgrade of XLCA below certain ratings levels, all or portions of outstanding principal balances on such GICs would come due. In January and February 2008, several rating agencies downgraded 44
Three Months Ended
March 31, 2008
Three Months Ended
March 31, 2007
Premiums
Written
Premiums
Written
Premiums
Earned
Premiums
Written
Premiums
Written
Premiums
Earned
SCA and its subsidiaries and as a result, the Company settled, in March 2008, the majority of the GIC liabilities. The resulting balance of deposit liabilities associated with GICs as at March 31, 2008
was $80.4 million. In addition, at March 31, 2008, the balance of deposit liabilities associated with FAs was $1.8 billion. The Company expects the balance of deposit liabilities associated with GICs
and FAs to continue to decrease throughout 2008 as the FAs and remaining GIC contracts mature and the associated deposit liabilities are settled. Management does not expect any significant impact
on the Company’s results of operations or liquidity as a result of the maturity of these contracts. At December 31, 2007, a significant component of the investments held in the Company’s Other Financial Lines segment portfolios was comprised of Topical Assets. Liquidations necessary to
fund the repayment of the GIC liabilities following the downgrade of XLCA, were funded through sales of assets in these portfolios as well as the general investment portfolios. Management’s
approach was to avoid the sale of assets where current market prices did not reflect intrinsic values or where transaction costs for liquidation were excessive. As a result, the Company continues to
hold a number of the Topical Assets and these have been transferred to the general portfolio in exchange for those assets that were liquidated. For the quarter ended March 31, 2008, the net results from the structured products noted above were $7.7 million and included net investment income, interest expense and operating expenses of
$59.9 million, $47.1 million, and $5.1 million, respectively. For the quarter ended March 31, 2007, the net results from these structured products were $9.2 million and included net investment income,
interest expense and operating expenses of $87.6 million, $76.1 million, and $2.3 million, respectively. For the three months ended March 31, 2008, net investment income and interest expense both
decreased primarily as a result of a decrease in the average deposit liability balance as a result of the settlement of the majority of the GIC portfolio noted above. However, operating expenses
increased by $2.8 million primarily due to the write-off in the first quarter of 2008 of deferred acquisition expenses in relation to the settlement of certain GICs noted above. While not reported
within the contribution from the Other Financial Lines segment, it should be noted that approximately $78.9 million of the reported realized losses on investments during the first three months of
2008 related to portfolios associated with GICs and FAs. SCA Prior to the secondary offering of SCA common shares on June 6, 2007, net income from SCA was consolidated with the Company’s results and SCA was considered an operating segment of the
Company. Subsequent to June 6, 2007, SCA was no longer a consolidated subsidiary or an operating segment of the Company and its remaining investment in SCA was accounted for using the equity
method of accounting, recorded on a one quarter lag through equity earnings (loss) from financial operating affiliates. At December 31, 2007, the Company reduced its investment in SCA to zero.
The write down of SCA to zero in the fourth quarter of 2007 was based, in part, on the losses SCA recorded in the fourth quarter of 2007 and as such no equity earnings related to SCA have been
recorded in the first quarter of 2008. For further information on SCA, see “Results of Operations” and “Other Revenues and Expenses” within Management’s Discussion and Analysis of Financial
Condition and Results of Operations. In addition, see Note 4 to the Consolidated Financial Statements, “Security Capital Assurance Ltd”, for further information. Investment Activities The following table illustrates the change in net investment income from property and casualty operations, net income from investment fund affiliates, net realized (losses) gains on investments
and net realized and unrealized gains (losses) on investment derivative instruments for the three months ended March 31, 2008 and 2007: 45
(U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Net investment income — property and casualty perations (1)
$
308,041
$
314,181
(2.0
)% Net income from investment fund affiliates (2)
11,799
118,936
(90.1
)% Net realized (losses) gains on investments
(102,251
)
9,292
NM
* Net realized and unrealized gains on investment and other derivative instruments
44,682
7,741
NM
*
(1)
Net investment income relating to property and casualty operations does not include the net investment income related to the net results from structured products. (2) The Company records the income related to alternative fund affiliates on a one month lag and the private investment fund affiliates on a three month lag in order for the Company to meet the accelerated filing deadlines. * NM – Not meaningful Net investment income related to property and casualty operations decreased in the first quarter of 2008 as compared to the first quarter of 2007 due primarily to declining portfolio yields.
Portfolio yields decreased as yields earned on investment of cash flows and reinvestment of maturing or sold securities were generally lower than on securities previously held, as prevailing market
interest rates, particularly in the U.S., decreased over the last year. As well, the portfolio mix changed as a result of the settlement of the Muni GIC liabilities, as the property and casualty operations
assumed a number of the floating rate securities previously held in the Company’s Other Financial Lines segment. Net income from investment fund affiliates decreased in the first quarter of 2008 compared to the first quarter of 2007, due primarily to the results from the Company’s alternative funds, which
were slightly positive in the first three months of 2008 as compared to strong positive results in the same period of the prior year. These results reflect flat returns in the Company’s alternative
portfolio as the markets during the quarter were particularly challenging for strategies employed by the Company’s alternative investment managers given the extreme volatility and overall pull back
of credit availability. The Company manages its investment grade fixed income securities using an asset/liability management framework. Due to the unique nature of the underlying liabilities, customized benchmarks
are used to measure investment performance and comparison to standard market indices is not meaningful. Investment performance is not monitored for certain assets primarily consisting of operating
cash and special regulatory deposits. The following is a summary of the investment portfolio returns for the asset/liability portfolios and risk asset portfolios for the three months ended March 31,
2008 and 2007:
(Unaudited)
2008 (1)
2007 (1) Asset/Liability portfolios USD fixed income portfolio
(2.6
)%
1.3
% Non USD fixed income portfolio
(1.7
)%
0.0
% Risk Asset portfolios Alternative portfolio (2)
0.7
%
5.5
% Equity portfolio
(10.3
)%
2.9
% High-Yield fixed income portfolio
(5.4
)%
2.0
%
(1)
Portfolio returns are calculated by dividing the sum of net investment income or net income from investment affiliates, realized gains (losses) and unrealized gains (losses) by the average market value of each portfolio. Performance is measured
in either the underlying asset currency or the functional currency. (2) Performance on the alternative portfolio reflects the three months ended February 29, 2008 and February 28, 2007, respectively. 46
Three Months Ended
March 31,
Three Months Ended
March 31,
Net Realized Losses and Gains and Other than Temporary Declines in the Value of Investments Net realized losses on investments in the first quarter of 2008 included net realized losses of $114.8 million related to the write-down of certain of the Company’s fixed income, equity and other
investments where the Company determined that there was an other than temporary decline in the value of those investments as well as net realized gains of $12.5 million from sales of investments.
Included in the balances noted above are realized losses and impairments in Topical Assets totaling $53.8 million. Net realized gains on investments in the first quarter of 2007 included net realized losses of $25.6 million related to the write-down of certain of the Company’s fixed income, equity and other
investments where the Company determined that there was an other than temporary decline in the value of those investments as well as net realized gains of $34.9 million from sales of 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 primary 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; (v) expected future interest rate movements; and (vi) 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. Net realized and unrealized gains on investment derivatives for the three months ended March 31, 2008, as well as the losses for the corresponding period in 2007, resulted from the Company’s
investment strategy to manage interest rate risk, foreign exchange risk, credit risk and to replicate permitted investments. Other Revenues and Expenses The following table sets forth other revenues and expenses for the three months ended March 31, 2008 and 2007: (U.S. dollars in thousands)
% Change
(Unaudited)
2008
2007 Net income from operating affiliates (1)
$
20,553
$
57,082
(64.0
)% Amortization of intangible assets
420
420
0.0
% Corporate operating expenses
35,926
32,479
10.6
% Interest expense (2)
49,365
50,614
(2.5
)% Income tax expense
30,702
72,755
(57.8
)%
(1)
The Company generally records the income related to certain operating affiliates on a three month lag in order for the Company to meet accelerated filing deadlines. However, no equity earnings associated with SCA or Primus were recorded in
the first quarter of 2008. (2) Interest expense does not include interest expense related structured products as reported within the Insurance, Reinsurance and Other Financial Lines segments. 48
Three Months Ended
March 31,
The following table sets forth the net income (loss) from operating affiliates for the three months ended March 31, 2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Net (loss) income from financial operating affiliates
$
(4,271
)
$
11,889
NM
* Net income from investment manager affiliates
12,879
37,426
(65.6
)% Net income from other strategic operating affiliates
11,945
7,767
53.8
% Total
$
20,553
$
57,082
(64.0
)% In the first quarter of 2008, the net loss from financial operating affiliates was primarily as a result of $4.8 million related to the unwind of the discount on established reserves associated with
reinsurance agreements with SCA and partially offset by net income associated with other financial operating affiliates. At December 31, 2007, the Company wrote down its investment in both SCA
and Primus to zero. The write down of SCA to zero in the fourth quarter of 2007 was based, in part, on the losses SCA recorded in the fourth quarter of 2007 and as such no equity earnings related
to SCA have been recorded in the first quarter of 2008. In addition, no equity earnings were recorded in relation to the Company’s investment in Primus as the continued widening of market credit
spreads in the first quarter of 2008 increased Primus’ mark to market credit derivative liabilities and thus maintained Primus’ negative book value. Further details are included in “Results of
Operations.” In addition, see Note 4 to the Consolidated Financial Statements, “Security Capital Assurance Ltd”, for further information. Investment manager affiliate income decreased during the first quarter of 2008 as compared to the same period in the prior year primarily as a result of strong earnings from a global equity
investment manager affiliate recorded in the first quarter of 2007 combined with lower earnings from certain affiliates in the first quarter of 2008 as a result of recent volatility in both the credit and
equity markets. Income from other strategic operating affiliates increased in the first quarter of 2008 as compared to the first quarter of 2007 mainly due to strong earnings reported in the first quarter of 2008
relating to an insurance affiliate which writes largely direct U.S. homeowners insurance and the Company’s Brazilian joint venture ITAÚ XL Seguros Corporativos S.A. Corporate operating expenses in the three months ended March 31, 2008 increased compared to the three months ended March 31, 2007 primarily as a result of an increase in professional fees in
the first quarter of 2008, partially offset by lower compensation expenses as a result of performance based accruals recorded in the first quarter of 2007. Interest expense for the three months ended March 31, 2008 as compared to the same period in 2007 was lower as a result of the retirement of the 2009 Senior Notes in May 2007 and partially
offset by interest expense recorded in the first quarter of 2008 associated with the issuance of the 2027 Senior Notes in May 2007. For more information on the Company’s financial structure, see
“Liquidity and Capital Resources.” The decrease in the Company’s income taxes arose principally from the decrease in the profitability of the Company’s U.S. and European operations. Balance Sheet Analysis Investments The primary objectives of the investment strategy are to support the liabilities arising from the operations of the Company, generate stable investment income and to build book value for the 49
Three Months Ended
March 31,
Company over the longer term. The strategy strives to maximize investment returns while taking into account market and credit risk. 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 tolerance. At March 31, 2008 and December 31, 2007, total investments, cash and cash equivalents, accrued investment income and net payable for investments purchased were $39.4 billion and $43.7
billion, respectively. The decrease was primarily as a result of the settlement of the majority of the GIC portfolio during the first quarter of 2008. The following table summarizes the composition of
the Company’s invested assets at March 31, 2008 and December 31, 2007: (U.S. dollars in thousands)
(Unaudited)
Percent of
Fair Value at
Percent of Cash and cash equivalents
$
3,904,966
9.9
%
$
3,880,030
8.9
% Net payable for investments purchased
(317,297
)
(0.8
)%
(191,472
)
(0.4
)% Accrued investment income
391,641
1.0
%
447,660
1.0
% Short-term investments
1,113,018
2.8
%
1,803,198
4.1
% Fixed maturities: U.S. Government and Government agency
$
2,435,471
6.2
%
$
2,685,773
6.1
% Corporate
12,483,091
31.7
%
12,987,248
29.7
% Mortgage and asset-backed securities
11,712,083
29.7
%
14,493,877
33.1
% U.S. States and political subdivisions of the States
305,315
0.8
%
253,534
0.6
% Non-U.S. Sovereign Government
3,506,561
8.9
%
3,187,358
7.3
% Total fixed maturities.
$
30,442,521
77.3
%
$
33,607,790
76.8
% Equity securities
665,848
1.7
%
854,815
2.0
% Investments in affiliates
2,508,796
6.4
%
2,611,149
6.0
% Other investments
686,340
1.7
%
708,476
1.6
% Total investments and cash and cash equivalents
$
39,395,833
100.0
%
$
43,721,646
100.0
% The Company reviews on a regular basis its corporate debt concentration, credit quality and compliance with established guidelines. At March 31, 2008 and December 31, 2007, the average credit
quality of the Company’s total fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net payable for investment purchased) was “AA” and “AA”,
respectively. As at March 31, 2008, approximately 51.3% of the fixed income portfolio was rated “AAA” by one or more of the principal ratings agencies. Approximately 2.6% was below investment
grade or not rated. Refer to “Results of Operations” for further discussion surrounding the impact of credit market movements on the Company’s investment portfolio and exposure to sub-prime related assets. Net Unrealized Losses and Gains on Investments At March 31, 2008, the Company had net unrealized losses on fixed maturities and short-term investments of $1,677.4 million and net unrealized gains on equities of $117.1 million. Of these
amounts, gross unrealized losses on fixed maturities and short term investments and equities were $2,191.2 million and $25.2 million, respectively. The information presented below for the gross
unrealized losses on the Company’s investments at March 31, 2008, shows the potential effect upon future earnings and financial position should management later conclude that some of the current
declines in the fair value of these investments are other than temporary. The increase in unrealized losses on investments was primarily as a result of widening corporate credit spreads on corporate 50
Fair Value at
March 31,
2008
Total
December 31,
2007
Total
and structured credit assets, partially offset by declining U.S. and Euro government interest rates in the first quarter of 2008. At March 31, 2008, approximately 7,200 fixed income securities out of a total of approximately 14,000 securities were in an unrealized loss position. The largest single unrealized loss in the fixed
income portfolio was $16.5 million. Approximately 400 equity securities out of a total of approximately 800 securities were in an unrealized loss position at March 31, 2008, with the largest individual
loss being $0.9 million. The following is an analysis of how long each of those securities with an unrealized loss at March 31, 2008 had been in a continual unrealized loss position:
(U.S. dollars in thousands)
Type of Securities
Length of time in a continual
(Unaudited)
(Unaudited)
Fixed Maturities
and Short-Term
Investments
Less than six months
$
252,382
$
6,021,718
At least 6 months but less than
12 months
803,531
4,557,133
At least 12 months but less than 2 years
949,499
5,764,615
2 years and over
185,831
1,374,656
Total
$
2,191,243
$
17,718,122
Equities
Less than six months
$
18,525
$
234,503
At least 6 months but less than
12 months
6,696
24,841
Total
$
25,221
$
259,344 The following is the maturity profile of the fixed income securities that were in a gross unrealized loss position at March 31, 2008: (U.S. dollars in thousands)
Maturity profile in years of fixed
(Unaudited)
(Unaudited) Less than 1 year remaining
$
9,149
$
383,523 At least 1 year but less than 5 years remaining
258,061
2,583,538 At least 5 years but less than 10 years remaining
275,991
2,551,494 At least 10 years but less than 20 years remaining
127,533
1,309,451 At least 20 years or more remaining
513,755
3,213,038 Mortgage and asset-backed securities
1,006,754
7,677,078 Total
$
2,191,243
$
17,718,122 Unpaid Losses and Loss Expenses The Company establishes reserves to provide for estimated claims, the general expenses of administering the claims adjustment process and for losses incurred but not reported. These reserves
are calculated using actuarial and other reserving techniques to project the estimated ultimate net liability for losses and loss expenses. The Company’s reserving practices and the establishment of any
particular reserve reflects management’s judgment concerning sound financial practice and do not represent any admission of liability with respect to any claims made against the Company. Unpaid losses and loss expenses totaled $23.4 billion at March 31, 2008, and $23.2 billion at December 31, 2007. 51
unrealized loss position
Amount of
unrealized loss at
March 31, 2008
Fair Value of Securities in
an unrealized loss position
at March 31, 2008
maturities in a continual gross
unrealized loss position
Amount of
unrealized loss at
March 31, 2008
Fair value of securities in
an unrealized loss position
at March 31, 2008
The table below represents a reconciliation of the Company’s unpaid losses and loss expenses for the three months ended March 31, 2008: (U.S. dollars in thousands)
(Unaudited)
(Unaudited)
(Unaudited) Balance as at December 31, 2007
$
23,207,694
$
(4,665,615
)
$
18,542,079 Losses and loss expenses incurred (1)
1,209,747
(208,854
)
1,000,893 Losses and loss expenses paid/recovered
1,362,871
(262,351
)
1,100,520 Foreign exchange and other
305,872
(18,207
)
287,665 Unwind of discount on established reserves associated with reinsurance agreements with SCA
4,771
—
4,771 Balance as at March 31, 2008
$
23,365,213
$
(4,630,325
)
$
18,734,888 While the Company reviews the adequacy of established reserves for unpaid losses and loss expenses regularly, no assurance can be given that actual claims made and payments related thereto
will not be in excess of the amounts reserved. In the future, if such reserves develop adversely, such deficiency would have a negative impact on future results of operations. See “Unpaid Losses and
Loss Expenses” in Item 1, “Critical Accounting Policies and Estimates” in Item 7 and Item 8, Note 10 to the Consolidated Financial Statements, each in the Company’s Form 10-K for the year ended
December 31, 2007 for further discussion. Unpaid Losses and Loss Expenses Recoverable and Reinsurance Balances Receivable As a significant portion of the Company’s net premiums written incept in the first three months of the year, certain assets and liabilities have increased at March 31, 2008 compared to December 31,
2007. This includes deferred acquisition costs, unearned premiums, premiums receivable and prepaid reinsurance premiums. In the normal course of business, the Company seeks to reduce the potential amount of loss arising from claims events by reinsuring certain levels of risk assumed in various areas of exposure
with other insurers or reinsurers. While reinsurance agreements are designed to limit the Company’s losses from large exposures and permit recovery of a portion of direct unpaid losses, reinsurance
does not relieve the Company of its ultimate liability to its insureds. Accordingly, the loss and loss expense reserves on the balance sheet represent the Company’s total unpaid gross losses. Unpaid
losses and loss expenses recoverable relate to estimated reinsurance recoveries on the unpaid loss and loss expense reserves. Unpaid losses and loss expenses recoverables were $4.7 billion at both March 31, 2008 and December 31, 2007. The table below presents the Company’s net paid and unpaid losses and loss expenses recoverable and reinsurance balances receivable at March 31, 2008 and December 31, 2007. (U.S. dollars in thousands)
(Unaudited)
December 31, Reinsurance balances receivable
$
926,741
$
872,465 Reinsurance recoverable on future policy benefits
33,714
31,856 Unpaid losses and loss expenses recoverable
4,738,250
4,804,209 Bad debt reserve on unpaid losses and loss expenses recoverable and reinsurance balances receivable
(179,869
)
(193,128
) Net paid and unpaid losses and loss expenses recoverable and reinsurance balances receivable
$
5,518,836
$
5,515,402 52
Gross unpaid
losses and loss
expenses
Unpaid
losses and
loss expenses
recoverable
Net unpaid
losses
and loss
expenses
March 31,
2008
2007
Fair Value Measurements of Assets and Liabilities As disclosed in Note 3 to the Consolidated Financial Statements, “Fair Value Measurements”, effective January 1, 2008, the Company adopted FAS 157 has accordingly provided required
disclosures by level within the fair value hierarchy of the Company’s assets and liabilities that are carried at fair value. As defined in the hierarchy, those assets and liabilities categorized as Level 3
have valuations determined using unobservable inputs. Unobservable inputs and may include the entity’s own assumptions about market participant assumptions, applied to a modeled valuation,
however, this is not the case with respect to the Company’s Level 3 assets and liabilities. The vast majority of the assets and liabilities classified as Level 3 are made up of those securities for which
the values were obtained from brokers where either significant inputs were utilized in determining the value that were difficult to corroborate with observable market data, or sufficient information
regarding the specific inputs utilized by the broker was not obtained to support a Level 2 classification. A significant component of these assets represents either Core CDO’s, totaling $726.9 million,
or securities within the Company’s topical portfolio, totaling $120.5 million. Certain asset classes, primarily consisting of privately placed investments, did not have sufficient market corroborated
information available to allow a pricing service to provide a price and accordingly the valuation was determined by broker quotes. In addition, in certain instances given the current market
dislocation, the Company has elected to utilize Level 3 broker valuations over available pricing service valuations. In periods of market dislocation, the observability of prices and inputs may be
reduced for many instruments as is currently the case currently for certain U.S. CMOs, ABSs, CMBSs, collateralized debt obligations (CDOs), and other topical assets which include certain securities
with underlying sub-prime and related residential mortgage exposures (such as sub-prime first liens and Alt-A asset backed securities) for which sufficient information, such as cash flows or other
security structure or market information, is not available to enable a third party pricing service to provide a price and as such valuation is determined based on broker quotes. However, increased
market illiquidity in the first quarter of 2008 did not result in the reclassification of securities into Level 3 due to unavailable Level 2 pricing. While the remainder of the Company’s holdings in
securities exposed to sub-prime mortgages are generally not based on quoted prices for identical securities, they are based on model-derived valuations from pricing sources in which all significant
inputs and significant value drivers are considered to be observable in active markets, and these securities continue to be classified within Level 2. While a number of the Level 3 investments have been written down as a result of the Company’s impairment analysis, the Company continues to report gross unrealized losses totaling $327.1
million related to Level 3 available-for-sale investments. Management completed a detailed review, in conjunction with its external investment managers and third party advisors, of the Company’s
underlying sub-prime and related residential mortgage exposures, as well as a consideration of the broader structured credit market, and concluded that the unrealized gains and losses in these asset
classes are the result of a decrease in value due to technical spreads widening and broader market sentiment, rather than fundamental collateral deterioration and are temporary in nature. The remainder of the Level 3 assets relate to private equity investments where the nature of the underlying assets held by the investee include positions such as private business ventures and are
such that significant Level 3 inputs are utilized in the valuation, and certain derivative positions. Controls over Valuation of Financial Instruments The Company performs quarterly reviews of the prices received from its third party valuation sources to assess if the prices represent a reasonable estimate of the fair value. This process is
completed by investment and accounting personnel who are independent of the third parties responsible for providing the valuations. The approaches taken to gain comfort include, but are not
limited to, valuation comparisons between external sources, and completing recurring reviews of third party pricing services methodologies. As a result of this analysis, if the Company determines
there is a more appropriate fair value based upon available market data, the price received from 53
one third party may be substituted for another, or in limited circumstances management may determine that an adjustment is required to a third party value. In addition, similar valuation controls are
followed by external parties responsible for sourcing appropriate valuations from third parties on the Company’s behalf which provides additional comfort over the reasonableness of the fair values
recorded in its financial statements. Valuation Methodology of Level 3 Assets and Liabilities Refer to Notes 2 and 3 of the Consolidated Financial Statements, “Significant Accounting Policies” and “Fair Value Measurements” for a description of the valuation methodology utilized to
value Level 3 assets and liabilities, how the valuation methodology is validated as well as further details associated with various assets classified as Level 3. As at March 31, 2008, the Company did
not have any liabilities that were carried at fair value based on Level 3 inputs other than derivative instruments in a liability position at March 31, 2008. Fair Value of Level 3 Assets and Liabilities At March 31, 2008, the fair value of Level 3 assets and liabilities as a percentage of the Company’s total assets and liabilities that are carried at fair value was as follows:
(U.S. dollars in thousands)
Total Assets and
Fair Value of
Level 3 Assets Assets Fixed maturities, at fair value
$
30,442,521
$
1,221,766
4.0
% Equity securities, at fair value
665,848
—
0.0
% Short term investments, at fair value
1,113,018
9,569
0.9
% Total investments available for sale
$
32,221,387
$
1,231,335
3.8
% Cash equivalents (1)
2,688,585
—
0.0
% Other investments (2)
584,973
52,338
8.9
% Other assets (3) (4)
256,257
89,585
35.0
% Total assets carried at fair value
$
35,751,202
$
1,373,258
3.8
% Liabilities Financial instruments sold, but not yet purchased (5)
$
37,947
$
—
0.0
% Other liabilities (4) (6)
78,300
37,139
47.4
% Total liabilities carried at fair value
$
116,247
$
37,139
31.9
%
(1)
Cash equivalents balances subject to fair value measurements include certificates of deposit and money market funds. (2) The other investments balance excludes certain unrated tranches of collateralized loan obligations which are carried under the cost recovery method given the uncertainty of future cash flows, as well as certain investments in project finance
transactions which are carried at amortized cost. See Note 2 of the Consolidated Financial Statements for further details. (3) Other assets include derivative instruments. (4) The derivative balances included above are reported on a gross basis. (5) Financial instruments sold, but not yet purchased are included within “Net payable for investments purchased” on the balance sheet. (6) Other liabilities include derivative instruments. As at March 31, 2008, the balance of Level 3 assets as a percentage of the Company’s total assets that were carried at fair value was 3.8%. The comparable percentage at December 31, 2007 was
3.7%. The increase was primarily as a result of change in the mix of assets in the first quarter of 2008 due to the sale of investments associated with the settlement of the majority of the GIC
portfolio in March 2008. During the three months ended March 31, 2008, there were no material changes in Level 3 assets as a result of inputs the Company no longer considers observable or valid.
The increase in the percentage of total invested assets that is made up of assets which are 54
(Unaudited)
Liabilities Carried
at Fair Value at
March 31, 2008
Level 3 Assets
and Liabilities
and Liabilities as
a Percentage of
Total Assets and
Liabilities
Carried at Fair
Value, by class
experiencing increased market illiquidity does reduce the overall liquidity of the Company’s capital resources, however, management do not believe that this change is significant given the many other
sources of liquid assets available. Level 3 liabilities at March 31, 2008 represent derivative instruments in a liability position. For further discussion of the company’s liquidity and available capital
resources see “Liquidity and Capital Resources”, below. Changes in the Fair Value of Level 3 Assets and Liabilities See Note 3 of the Consolidated Financial Statements, “Fair Value Measurements”, for an analysis of the change in fair value of Level 3 Assets and Liabilities. Based on the changes in the fair value of Level 3 assets and liabilities during the quarter ended March 31, 2008, the Company does not expect any significant impact on the Company’s results of
operations or liquidity. Liquidity and Capital Resources As a holding company, the Company’s assets consist primarily of its investments in subsidiaries, and the Company’s future cash flows depend on the availability of dividends or other statutorily
permissible payments from its subsidiaries. The ability to pay such dividends is limited by the applicable laws and regulations of the various countries the Company operates in including, among
others, Bermuda, the United States, Ireland, Switzerland and the United Kingdom, and those of the Society of Lloyd’s and certain contractual provisions. No assurance can be given that the Company
or its subsidiaries will be permitted to pay dividends in the future. The Company and its subsidiaries provide no guarantees or other commitments (express or implied) of financial support to the Company’s subsidiaries or affiliates, except for where such
guarantees are in writing. Liquidity Liquidity is a measure of the Company’s ability to generate sufficient cash flows to meet the short and long term cash requirements of the Company’s business operations. The Company’s operating subsidiaries provide liquidity in that premiums are generally received months or even years before losses are paid under the policies related to such premiums.
Historically, cash receipts from operations, consisting of premiums and investment income, have provided more than sufficient funds to pay losses, operating expenses and dividends to the Company. Cash flow from operations is generally derived from the receipt of investment income on the Company’s total investment portfolio as well as the net receipt of premiums less claims and expenses
related to its underwriting activities in its property and casualty operations as well as its Life Operations segment. Net cash from operations was $473.0 million in the first three months of 2008
compared with $547.4 million in the same period in 2007. As part of the recent financial market turbulence that persisted in the latter part of 2007 and has continued throughout 2008, increasingly thin market liquidity has persisted throughout the U.S.
and other financial markets. Despite this increase in illiquidity throughout the financial markets, the Company successfully raised approximately $4 billion of cash from its fixed income portfolio in
order to settle a majority of the GIC portfolio in the first quarter of 2008. The Company continues to manage its liquidity needs through changes in the mix of its investment portfolio as well as
through other available capital resources and lines of credit as noted below. 55
Capital Resources At March 31, 2008, the Company had total shareholders’ equity of $9.3 billion. In addition to ordinary and preferred share capital, the Company depends on external sources of financing such as
debt, credit facilities and contingent capital to support its underwriting activities. On September 24, 2007, the Board of Directors of the Company approved a share repurchase program, authorizing the Company to repurchase up to $500.0 million of its Class A ordinary shares.
Repurchases may be made from time to time in the open market or in privately negotiated transactions, and the Company expects that those repurchases will be funded from cash on-hand. The
timing and amount of the share repurchases under the program will depend on a variety of factors, including market conditions, legal requirements and other factors. As of March 31, 2008, the
Company had repurchased 1.8 million shares for $124.5 million under the share repurchase program. Debt The following table presents the Company’s indebtedness under outstanding debt securities and lenders’ commitments as at March 31, 2008:
Notes Payable and Debt
Commitment
In Use
Year of
Payments Due by Period
Less than
1 to 3
3 to 5
After 5 5-year revolvers (1)
$
1,000,000
$
—
2010/2012
$
—
$
—
$
—
$
— 5-year revolver
100,000
—
2010
—
—
—
— 5.25% Senior Notes.
745,000
745,000
2011
—
745,000
—
— 6.58% Guaranteed Senior Notes
255,000
255,000
2011
—
—
255,000
— 6.50% Guaranteed Senior Notes
598,792
598,792
2012
—
—
600,000
— 5.25% Senior Notes.
595,793
595,793
2014
—
—
—
600,000 6.375% Senior Notes.
350,000
350,000
2024
—
—
—
350,000 6.25% Senior Notes.
324,395
324,395
2027
—
—
—
325,000
$
3,968,980
$
2,868,980
$
—
$
745,000
$
855,000
$
1,275,000 “Commitment” and “In Use” data represent March 31, 2008 accreted values. “Payments Due by Period” data represent ultimate redemption values.
(1)
The 2010 and 2012 5-year revolving credit facilities share a $1.0 billion revolving credit sublimit.
Credit facilities, contingent capital and other sources of collateral At March 31, 2008, the Company had six letter of credit facilities in place with total availability of $7.3 billion, of which $4.5 billion was utilized.
Other Commercial
Commitment
In Use
Year of
Amount of Commitment
Less than
1 to 3
3 to 5
After 5 Letter of Credit Facility
$
200,000
$
154,928
Continuous
$
200,000
$
—
$
—
$
— Letter of Credit Facility (1)
2,250,000
370,358
2010
—
2,250,000
—
— Letter of Credit Facility (1)
4,000,000
3,269,641
2012
—
—
4,000,000
— Letter of Credit Facility
317
317
2008
317
—
—
— Letter of Credit Facility
158
158
2008
158
—
—
— Letter of Credit Facility
893,070
685,491
2009
—
893,070
—
— Six letter of credit facilities
$
7,343,545
$
4,480,893
$
200,475
$
3,143,070
$
4,000,000
$
—
(1)
Of the total letter of credit facilities above, $1 billion is also included in the revolvers under notes payable and debt.
56
(U.S. dollars in thousands)
Expiry
1 Year
Years
Years
Years
Commitments
(U.S. dollars in thousands)
Expiry
Expiration per period
1 Year
Years
Years
Years
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are principally utilized to support non-admitted insurance
and reinsurance operations in the United States and capital requirements at Lloyd’s. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedants with
statutory relief under state insurance regulations in the U.S. It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from
banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedants. This could take the form of additional
insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other things, loss
development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and loss experience of such business. In addition, the Company has entered into contingent capital transactions of which no up-front proceeds were received by the Company, however, in the event that the associated irrevocable put
and/or contingent put option agreements are exercised, proceeds previously raised from investors from the issuance of pass-through trust securities would be received in return for the issuance of
preferred shares by the Company as applicable. Ratings The Company’s ability to underwrite business is dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the
event that the Company is downgraded, its ability to write business may be adversely affected. The Company regularly evaluates its capital needs to support the volume of business written in order to
maintain its claims paying and financial strength ratings. The Company regularly provides financial information to rating agencies to both maintain and enhance existing ratings. The following are the current financial strength and claims paying ratings from internationally recognized rating agencies in relation to the Company’s principal insurance and reinsurance
subsidiaries and pools:
Rating agency
Rating Standard & Poor’s
A+
(Stable
) Fitch
A+
(Stable
) A.M. Best
A
(Stable
) Moody’s Investor Services
A1
(Stable
) In addition, XL Capital Ltd had the following long term debt ratings as at March 31, 2008: “bbb” (Stable) from A.M. Best, “A–” (Stable) from Standard and Poor’s, “Baa1” (Stable) from
Moody’s and “A” (Stable) from Fitch. Other For information regarding cross-default and certain other provisions in the Company’s debt and convertible securities documents, see Item 7 of the Company’s Form 10-K for the year ended
December 31, 2007. See Part II, Item 2 “Unregistered Sales of Equity Securities and Use of Proceeds,” below. CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. Any prospectus, prospectus supplement, the Company’s Annual Report
to ordinary shareholders, any proxy statement, any other Form 10-K, Form 10-Q or Form 8-K of the Company or any other written or oral statements made by or on behalf of the Company may
include forward-looking statements that reflect the Company’s current views with respect to future 57
events and financial performance. Such statements include forward-looking statements both with respect to the Company in general, and to the insurance and reinsurance sectors in particular (both as
to underwriting and investment matters). Statements that include the words “expect”, “intend”, “plan”, “believe”, “project”, “anticipate”, “will”, “may”, and similar statements of a future or forward-
looking nature identify forward-looking statements for purposes of the PSLRA or otherwise. All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause actual results to differ materially from
those indicated in such statements. The Company believes that these factors include, but are not limited to, the following: (i) changes to the size of the Company’s claims relating to natural
catastrophes; (ii) the timely and full recoverability of reinsurance placed by the Company with third parties, or other amounts due to the Company; (iii) the projected amount of ceded reinsurance
recoverables and the ratings and creditworthiness of reinsurers may change; (iv) the timing of claims payments being faster or the receipt of reinsurance recoverables being slower than anticipated by
the Company; (v) higher than expected defaults on relevant underlying obligations of SCA’s subsidiaries and the adequacy of the claims paying ability of those SCA subsidiaries; (vi) the potential for
larger than expected mark-to-market movements on credit derivatives originally written by SCA and reinsured by the Company; (vii) ineffectiveness or obsolescence of the Company’s business
strategy due to changes in current or future market conditions; (viii) increased competition on the basis of pricing, capacity, coverage terms or other factors; (ix) greater frequency or severity of claims
and loss activity, including as a result of natural or man-made catastrophic events, than the Company’s underwriting, reserving or investment practices anticipate based on historical experience or
industry data; (x) developments in the world’s financial and capital markets that adversely affect the performance of the Company’s investments and the Company’s access to such markets including,
but not limited to further market developments relating to sub-prime and residential mortgages (xi) the potential impact on the Company from government-mandated insurance coverage for acts of
terrorism; (xii) the potential impact of variable interest entities or other off-balance sheet arrangements on the Company; (xiii) developments in bankruptcy proceedings or other developments related
to bankruptcies of companies insofar as they affect property and casualty insurance and reinsurance coverages or claims that the Company may have as a counterparty; (xiv) availability of borrowings
and letters of credit under the Company’s credit facilities; (xv) changes in regulation or tax laws applicable to the Company or its subsidiaries, brokers or customers; (xvi) acceptance of the
Company’s products and services, including new products and services; (xvii) changes in the availability, cost or quality of reinsurance; (xviii) changes in the distribution or placement of risks due to
increased consolidation of insurance and reinsurance brokers; (xix) loss of key personnel; (xx) the effects of mergers, acquisitions and divestitures; (xxi) changes in ratings, rating agency policies or
practices; (xxii) changes in accounting policies or practices or the application thereof; (xxiii) legislative or regulatory developments; (xxiv) changes in general economic conditions, including inflation,
foreign currency exchange rates and other factors; (xxv) the effects of business disruption or economic contraction due to war, terrorism or other hostilities; and (xxvi) the other factors set forth in the
Company’s other documents on file with the United States Securities and Exchange Commission (the “SEC”). The foregoing review of important factors should not be construed as exhaustive and
should be read in conjunction with the other cautionary statements that are included herein or elsewhere. The Company undertakes no obligation to update publicly or revise any forward-looking
statement, whether as a result of new information, future developments or otherwise. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Except as described below, there have been no material changes in the Company’s market risk exposures or how those exposures are managed, since December 31, 2007. The following discussion
should be read in conjunction with “Quantitative and Qualitative Disclosures about Market Risk”, presented under Item 7A of the Company’s Form 10-K for the year ended December 31, 2007. Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The Company is principally exposed to the following market risks: interest rate risk; 58
foreign currency exchange rate risk; equity price risk; credit risk; weather and energy-related risk, and other related market risks. The Company’s investment market risk arises from its investment portfolio which consists of fixed income securities, alternative investments, public equities, private investments, derivatives, other
investments, and cash, denominated in both U.S. and foreign currencies, which are sensitive to changes in interest rates, credit spreads, equity prices, foreign currency exchange rates and other related
market risks. The Company’s fixed income and equity securities are classified as available-for-sale, and as such changes in interest rates, credit spreads on corporate and structured credit, equity
prices, foreign currency exchange rates or other related market instruments will have an immediate effect on comprehensive income and shareholders’ equity but will not ordinarily have an immediate
effect on net income. Nevertheless, changes in interest rates, credit spreads, equity prices and other related market instruments effect consolidated net income when, and if, a security is sold or
impaired. The Company enters into derivatives and other financial instruments primarily for risk management purposes. The Company conducts activities in three main types of derivative instruments:
credit derivatives, weather and energy derivatives and investment-related derivative instruments. From time to time, the Company also uses investment derivative instruments such as futures, options,
interest rate swaps, credit default swaps and foreign currency forward contracts to manage the duration of its investment portfolio and foreign currency exposures and also to obtain exposure to a
particular financial market. The Company’s derivative transactions can expose the Company to credit derivative risk, weather and energy risk, foreign currency exchange rate risk, etc. 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. This risk management discussion and the estimated amounts generated from the sensitivity and VaR analyses presented in this document are forward-looking statements of market risk assuming
certain adverse market conditions occur. Actual results in the future may differ materially from these estimated results due to, among other things, actual developments in the global financial markets
and changes in the composition of the Company’s investment portfolio. The results of analysis used by the Company to assess and mitigate risk should not be considered projections of future events
of losses. See generally “Cautionary Note Regarding Forward-Looking Statements” in Item 2. Interest Rate Risk The Company’s fixed income portfolio is exposed to interest rate risk. Interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. The Company manages
interest rate risk within the context of its overall asset liability management strategy by setting duration targets for its investment portfolio in line with the estimated duration of its liabilities, thus
mitigating the overall economic effect of interest rate risk. The Company remains nevertheless exposed to accounting interest rate risk since the assets are marked to market, thus subject to market
conditions, while liabilities are accrued at a static rate. The hypothetical case of an immediate 100 basis point adverse parallel shift in global bond curves as at March 31, 2008, would decrease the fair
value of the Company’s fixed income portfolio by approximately 4.5% or $1.6 billion. Foreign Currency Exchange Rate Risk Many of the Company’s non-U.S. subsidiaries maintain both assets and liabilities in local currencies. Foreign currency exchange rate gains and losses arise for accounting purposes where net
assets or liabilities are denominated in foreign currencies that differ from the functional currency of those subsidiaries. In addition, the Company’s shareholders equity is impacted by movements in
currency exchange rates through both the foreign exchange component of realized and unrealized gains and losses within the Company’s investment portfolio, and the cumulative translation
adjustments resulting from the translation of foreign subsidiary results. 59
The principal currencies creating foreign exchange risk for us are the British pound sterling, the Euro, the Swiss Franc, and the Canadian dollar. The Company’s net notional foreign currency
denominated exposure on foreign exchange contracts was $393.6 million and $341.7 million as at March 31, 2008 and December 31, 2007 respectively, with a net unrealized gain of $8.6 million and
$0.9 million as at March 31, 2008 and December 31, 2007, respectively. Equity Price Risk The Company’s equity portfolio as well as certain derivatives and certain affiliate investments are exposed to equity price risk. Equity price risk is the potential loss arising from changes in the
market value of equities. An immediate hypothetical 10% change in the value of each equity position in the Company’s equity portfolio would affect the fair value of the portfolio by approximately
$57.6 million as at March 31, 2008. This excludes exposures to equities in the Company’s affiliate investments. As at March 31, 2008, the Company’s equity portfolio was approximately $576 million as compared to $757 million as at December 31, 2007. This excludes fixed income fund investments and
publicly traded alternative funds that generally do not have the risk characteristics of equity investments. As at March 31, 2008, the Company’s allocation to equity securities was approximately 1.5%
of the total investment portfolio (including cash and cash equivalents, accrued investment income and net payable for investments purchased) as compared to approximately 1.7% as at December 31,
2007. As at March 31, 2008, approximately 28.7% of the equity holdings was invested in U.S. companies as compared to approximately 28.8% as at December 31, 2007. As at March 31, 2008, the top
ten equity holdings represented approximately 10.4% of the Company’s total equity portfolio as compared to approximately 11.5% as at December 31, 2007. Credit Risk The Company’s exposure to market movements related to credit risk is primarily due to its investment portfolio, credit derivatives embedded in financial guarantee reinsurance exposures,
receivable and ceded reinsurance balances. Within the investment portfolio, credit risk is the exposure to adverse change in the creditworthiness of individual investment holdings, issuers, groups of
issuers, industries or countries. In addition, credit risk pertains to adverse change in the creditworthiness of the Company’s reinsurers and retrocessionaires, and their ability to pay certain reinsurance
receivable and recoverable balances. The table below shows the Company’s fixed income portfolio by credit rating in percentage terms of the Company’s total fixed income exposure (including fixed maturities, short-term
investments, cash and cash equivalents, accrued investment income and net payable for investments purchased) as at March 31, 2008:
Total AAA
51.3
% AA
18.8
% A
17.7
% BBB
9.6
% BB & below
2.5
% NR
0.1
% Total.
100.0
% At March 31, 2008, the average credit quality of the Company’s total fixed income portfolio was “AA.” As at March 31, 2008, the top 10 corporate holdings, which exclude government guaranteed and government sponsored enterprises, represented approximately 5.0% of the total fixed income
portfolio and approximately 13.5% of all corporate holdings. The top 10 corporate holdings listed below represent the direct exposure to the corporations listed below, including their subsidiaries, and
excludes any securitized, credit enhanced and collateralized asset or mortgage backed securities, cash 60
and cash equivalents, pooled notes and any over-the-counter (“OTC”) derivative counterparty exposure, if applicable.
Top 10 Corporate Holdings
Percentage of Total General Electric Company
0.7
% HBOS plc
0.7
% Citigroup Inc
0.6
% The Goldman Sachs Group, Inc
0.6
% Bank of America Corporation
0.5
% HSBC Holdings plc
0.5
% Lloyds TSB Group plc
0.4
% Merrill Lynch & Co., Inc.
0.4
% Barclays plc
0.3
% The Royal Bank of Scotland Group plc
0.3
%
(1)
Including fixed maturities, short-term investments, cash and cash equivalents, accrued investment income and net payable for investments purchased.
The Company also has exposure to market movement related to credit risk associated with its mortgage-backed and asset-backed securities. The table below shows the breakdown of the $11.8
billion structured credit portfolio as at March 31, 2008, of which approximately 84% is AAA rated:
(U.S. dollars in millions)
Fair Value
Percent of Portfolio CMBS
$
3,554.1
30.1
% Agency
1,597.3
13.5
% Whole Loans
1,673.2
14.2
% Core CDO (non-ABS CDOs and CLOs)
931.0
7.9
% Other ABS: ABS — Auto
980.9
8.3
% ABS — Credit Cards
597.8
5.1
% ABS — Other
822.2
7.0
% Topical: Sub-prime first lien
796.3
6.8
% Alt-A
729.8
6.2
% Second lien (including sub-prime second lien mortgages)
83.2
0.7
% ABS CDO’s with sub-prime collateral
29.1
0.2
% Total
$
11,794.9
100.0
% For further discussion of the exposure to credit market movements in the Company’s investment portfolio see the Investment Value-at-Risk section below. The Company also has exposure to market movements as a result of credit risk exposures related to financial guarantee reinsurance of SCA. This exposure generally relates to certain specific
facultative and excess of loss reinsurance agreements which are not, in their entirety, required to be marked to market. For further details surrounding this exposure, see Item 2 “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” and Item 1, Note 4 to the Consolidated Financial Statements, “Security Capital Assurance Ltd.” A portion of the exposures
resulting from this business represent risks written by SCA in credit derivative form which are reinsured by the Company. These components of the overall exposure are required to be marked to fair
value. The fair value of such instruments is determined using models developed by SCA management. Although the Company reviews the validity of the overall methodology applied, it relies on SCA
management’s application of the model to individual exposures. With regards to unpaid losses and loss expenses recoverable and reinsurance balances receivable, the Company has credit risk should any of its reinsurers be unable or unwilling to 61
Fixed Income
Portfolio (1)
settlement amounts due to the Company, however, these exposures are not marked to market. For further information relating to reinsurer credit risk, see “Management’s Discussion and Analysis of
Financial Condition and Results of Operations — Unpaid Losses and Loss Expenses Recoverable and Reinsurance Balances Receivable.” The Company is exposed to credit risk in the event of non-performance by the other parties to its derivative instruments in general, 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. Weather and Energy Risk The Company offers weather and contingent 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 or through the use of quota share or excess of loss arrangements. Fair values for the Company’s portfolio of speculative natural gas derivative contracts are determined through the use of quoted market prices. As quoted market prices are not widely available
in the weather derivative market, management uses available market data and internal pricing models based upon consistent statistical methodologies to estimate fair values. Estimating fair value of
instruments that do not have quoted market prices, requires management’s judgment in determining amounts that could reasonably be expected to be received from, or paid to, a third party in
respect 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 Company manages its weather and energy 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. At present, the Company’s VaR related to these risks does not exceed $20.0 million in any one season. Other Market Risks The Company’s private investment portfolio is invested in limited partnerships and other entities which are not publicly traded. In addition to normal market risks, these positions may also be
exposed to liquidity risk, risks related to distressed investments, and risks specific to startup or small companies. As at March 31, 2008, the Company’s exposure to private investments was $441.0 million compared to $427.5 million as at December 31, 2007. At March 31, 2008, bond and stock index futures outstanding had a net long position of $15.4 million as compared to a net short position of $384.5 million at December 31, 2007. A 10%
appreciation or depreciation of the underlying exposure to these derivative instruments would have resulted in realized gains or realized losses of $1.5 million as at March 31, 2008 and $38.5 million
as at December 31, 2007, respectively. The Company may reduce its exposure to these futures through offsetting transactions, including options and forwards. Investment Value-at-Risk (VaR) The VaR of the investment portfolio at March 31, 2008, based on a 95% confidence level with a one month holding period was approximately $644 million as compared to $648 million at
December 31, 2007. The VaR of all investment related derivatives excluding investments in affiliates and other investments was approximately $24.2 million as compared to $19.1 million at December 31, 62
2007. The Company’s investment portfolio VaR as at March 31, 2008 is not necessarily indicative of future VaR levels. To complement the VaR analysis based on normal market environments, the Company considers the impact on the investment portfolio of several different historical stress periods to analyze the
effect of unusual market conditions. The Company establishes certain historical stress test scenarios which are applied to the actual investment portfolio. As these stress tests and estimated gains and
losses are based on historical events, they will not necessarily reflect future stress events or gains and losses from such events. The results of the stress test scenarios are reviewed on a regular basis to
ensure they are appropriate, based on current shareholders equity, market conditions and the Company’s total risk tolerance. Given the investment portfolio allocations as at March 31, 2008, the Company would expect to lose approximately 6.2% of the portfolio if the most damaging event stress tested was repeated, all
other things held equal, as compared to 6.0% at December 31, 2007. Given the investment portfolio allocations as at March 31, 2008, the Company would expect to gain approximately 18.9% of the
portfolio if the most favorable event stress tested was repeated, all other things held equal, as compared to 18.1% at December 31, 2007. 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. ITEM 4. CONTROLS AND PROCEDURES Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the
effectiveness of disclosure controls and procedures pursuant to Rules 13a-15 and 15d-15 promulgated under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by
this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures are effective to provide reasonable assurance that
all material information relating to the Company required to be filed in this report has been made known to them in a timely fashion. Changes in Internal Control Over Financial Reporting There have been no changes in internal control over financial reporting identified in connection with the Company’s evaluation required pursuant to Rules 13a-15 and 15d-15 promulgated under
the Securities Exchange Act of 1934, as amended, that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal
control over financial reporting. 63
On September 21, 2004, a consolidated and amended class action complaint (the “Amended Complaint”) was served on the Company and certain of its present and former directors and officers
as defendants in a putative class action (Malin et al. v. XL Capital Ltd et al.) filed in United States District Court, District of Connecticut (the “Malin Action”). The Malin Action purports to be on
behalf of purchasers of the Company’s common stock between November 1, 2001 and October 16, 2003, and alleges claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and
Rule 10b-5 promulgated thereunder (the “Securities Laws”). The Amended Complaint alleged that the defendants violated the Securities Laws by, among other things, failing to disclose in various
public statements, reports to shareholders and other communications the alleged inadequacy of the Company’s loss reserves for its NAC Re subsidiary (now known as XL Reinsurance America, Inc.)
and that, as a consequence, the Company’s earnings and assets were materially overstated. On August 26, 2005, the Court dismissed the Amended Complaint owing to its failure adequately to allege
that the lead plaintiffs had sustained a loss, but provided leave for the plaintiffs to file a further amended complaint. The plaintiffs thereafter filed another amended complaint (the “Second Amended
Complaint”), which is similar to the Amended Complaint in its substantive allegations. On December 31, 2005, the defendants filed a motion to dismiss the Second Amended Complaint. The plaintiffs
opposed the motion. In addition, the plaintiffs filed a motion to strike certain documents and exhibits that the XL defendants had proffered in support of the motion to dismiss. By Order dated
December 15, 2006, the Judge granted in part and denied in part plaintiffs’ motion to strike and allowed limited discovery through March 2, 2007. The Judge denied defendants’ motion to dismiss
without prejudice to its renewal at the conclusion of such discovery. On March 22, 2007, the defendants filed their renewed motion to dismiss the Second Amended Complaint. By order dated July
21, 2007, the Judge granted defendants’ renewed motion and dismissed the Second Amended Complaint. On August 30, 2007 plaintiffs filed a notice of appeal. Briefing on the Appeal is concluded
and argument will be scheduled in the coming months. The Company and the defendant present and former officers and directors will continue to vigorously defend the Malin Action. In November 2006, a subsidiary of the Company received a grand jury subpoena from the Antitrust Division of the U.S. Department of Justice and a subpoena from the SEC, both of which seek
documents in connection with an investigation into the municipal guaranteed investment contract (“GIC”) market and related products. The Company is fully cooperating with these investigations. In March 2008, two subsidiaries of the Company were named, along with 20 other providers and insurers of municipal Guaranteed Investment Contracts and similar derivative products
(“collectively Municipal Derivatives”) as well as fourteen brokers of such products, in two purported federal antitrust class actions filed in the federal courts in the District of Columbia and the
Southern District of New York. These complaints allege that there was a conspiracy among the defendants during the period from January 1, 1992 to the present to rig bids for Municipal Derivatives.
The purported class of plaintiffs consists of purchasers of Municipal Derivatives. In April 2008, another federal antitrust class action containing similar allegations was filed in the Northern District of
California against 39 defendants, including the same two subsidiaries of the Company, as well as XL Capital, Ltd. It is anticipated that the Judicial Panel on Multidistrict Litigation will soon
determine the venue for these actions. The plaintiffs are then expected to file a consolidated amended complaint, and defendants will then have 60 days to move or answer in response thereto. The
Company intends to vigorously defend these actions. From time to time, the Company has also received and responded to additional requests from Attorneys General, state insurance regulators and federal regulators for information relating to the
Company’s contingent commission arrangements with brokers and agents and/or the Company’s insurance and reinsurance practices in connection with certain finite-risk and loss mitigation products.
Similarly, the Company’s affiliates outside the United States have, from time to time, 64
received and responded to requests from regulators relating to the Company’s insurance and reinsurance practices regarding contingent commissions or finite-risk and loss mitigation products. The
Company has fully cooperated with the regulators in these matters. In August 2005, plaintiffs in a proposed class action (the “Class Action”) that was consolidated into a multidistrict litigation in the United States District Court for the District of New Jersey,
captioned In re Insurance Brokerage Antitrust Litigation, MDL No. 1663, Civil Action No. 04-5184 (the “MDL”), filed a consolidated amended complaint (the “Amended Complaint”), which named
as new defendants approximately 30 entities, including Greenwich Insurance Company, Indian Harbor Insurance Company and XL Capital Ltd. In the MDL, the Class Action plaintiffs asserted
various claims purportedly on behalf of a class of commercial insureds against approximately 113 insurance companies and insurance brokers through which the named plaintiffs allegedly purchased
insurance. The Amended Complaint alleged that the defendant insurance companies and insurance brokers conspired to manipulate bidding practices for insurance policies in certain insurance lines
and failed to disclose certain commission arrangements. The named plaintiffs asserted statutory claims under the Sherman Act, various state antitrust laws and the Racketeer Influenced and Corrupt
Organizations Act (“RICO”), as well as common law claims alleging breach of fiduciary duty, aiding and abetting a breach of fiduciary duty and unjust enrichment. Discovery in the MDL
commenced in the latter part of 2005. Defendants filed motions to dismiss the Amended Complaint in late November 2005. By Opinion and Order dated October 3, 2006, the Court ruled on
defendants’ motions to dismiss the Amended Complaint, holding that plaintiffs’ RICO and antitrust claims were deficient as pled and directing plaintiffs to file a supplemental RICO case statement
and a supplemental statement of particularity as to their Sherman Act claims. Plaintiffs filed their supplemental pleadings on October 25, 2006 and on November 30, 2006, defendants filed motions to
dismiss plaintiffs’ supplemental pleadings. By Orders dated April 5, 2007, the Court dismissed plaintiffs’ Sherman Act and RICO claims without prejudice to their filing final amended pleadings. By
Order dated April 11, 2007, the Court stayed all proceedings in the MDL, including discovery, pending the disposition of defendants’ motions to dismiss plaintiffs’ Second Amended Complaint, which
was filed on May 22, 2007 and contained allegations as to XL that were materially similar to those set forth in plaintiffs’ October 2006 pleadings, but also purported to add as new defendants three
other XL entities. On June 2007, XL (along with other defendants) filed motions to dismiss the Sherman Act and RICO claims alleged in the Second Amended Complaint and to strike the newly-
named parties. By Opinion and Order dated August 31, 2007, the Court dismissed the Class Action plaintiffs’ Sherman Act claims with prejudice and, by Opinion and Order dated September 28, 2007, the
Court dismissed the Class Action plaintiffs’ RICO claims with prejudice. In its September 28, 2007, Opinion and Order, the Court declined to exercise supplemental jurisdiction over the Class Action
plaintiffs’ state law claims. On October 10, 2007, the Class Action plaintiffs filed a Notice of Appeal, stating their intention to appeal to the U.S. Court of Appeals for the Third Circuit (the “Third
Circuit”) from the District Court’s October 3, 2006 Opinion and Order; April 5, 2007 Opinions and Order; August 31, 2007 Opinion and Order; and September 28, 2007 Opinion and Order. Plaintiffs’
opening appellate brief and defendants’ opposition appellate brief have been filed. The District Court has not yet advised the parties whether it intends to continue its April 11, 2007 stay of all
proceedings in the MDL pending a ruling on the appeal by the Third Circuit or set a schedule in connection with the various tag-along actions that have been consolidated into the MDL. Various XL entities have been named as defendants in three of the many tag-along actions that have been consolidated into the MDL for pretrial purposes. On April 4, 2006, a tag-along
Complaint was filed in the U.S. District Court for the Northern District of Georgia on behalf of New Cingular Wireless Headquarters LLC and several other corporations against approximately 100
defendants, including Greenwich Insurance Company, XL Specialty Insurance Company, XL Insurance America, Inc., XL Insurance Company Limited, Lloyd’s syndicates 861, 588 and 1209 and XL
Capital Ltd. (the “New Cingular Lawsuit”). The New Cingular Lawsuit is a tag-along action that does not purport to be a class action. The New Cingular Complaint, which made the same basic
allegations as 65
those alleged in the Class Action plaintiffs’ Second Amended Complaint, asserted statutory claims under the Sherman Act, the Racketeer Influenced and Corrupt Organizations Act, as well as
common law claims alleging breach of fiduciary duty, inducement to breach fiduciary duty, unjust enrichment and fraud. On January 5, 2007, the plaintiffs in the New Cingular Lawsuit filed an
Amended Complaint, a RICO Statement and a memorandum of law. In accordance with the Court’s April 11, 2007 Order, all proceedings in the New Cingular Lawsuit, including discovery and
motions by defendants to dismiss the New Cingular Amended Complaint, were stayed pending the Court’s disposition of defendants’ motions to dismiss the Second Amended Complaint filed in the
MDL. The parties are awaiting the District Court’s decision as to whether the New Cingular Lawsuit will continued to be stayed or be permitted to proceed pending the Third Circuit’s disposition of
the Class Action plaintiffs’ pending appeal. On or about May 21, 2007 a tag-along Complaint was filed in the United States District Court for the District of New Jersey on behalf of Henley Management Company, Big Bear Properties,
Inc., Northbrook Properties, Inc., RCK Properties, Inc., Kitchens, Inc., Aberfeldy LP and Payroll and Insurance Group, Inc. against multiple defendants, including “XL Winterthur International” (the
“Henley Lawsuit”). The Complaint in the Henley Lawsuit, which contains certain of the basic allegations that are contained in the Class Action plaintiffs’ Second Amended Complaint, alleges
violations of Section 1 of the Sherman Act against all defendants and various other claims that are alleged against only defendant Marsh. The Henley Lawsuit is a tag-along action that does not
purport to be a class action. By Order dated July 11, 2007, the Court ordered that the Henley Lawsuit be consolidated into the MDL, making the Henley Lawsuit subject to the Court’s April 11,
2007 stay Order. The parties are awaiting the District Court’s decision as to whether the Henley Lawsuit will continued to be stayed or be permitted to proceed pending the Third Circuit’s disposition
of the Class Action plaintiffs’ pending appeal. On October 12, 2007, a Complaint in a third tag-along action, captioned Sears Roebuck & Co. v. Marsh & McLennan Companies, Inc., et al., No. 1:07-CV-2535 (the “Sears Lawsuit”), was filed in
the United States District Court for the Northern District of Georgia by Sears, Roebuck & Co., Sears Holdings Corporation, Kmart Corporation and Lands’ End Inc. Among the many named
defendants are X.L. America, Inc., XL Insurance America, Inc., XL Specialty Insurance Company and XL Insurance (Bermuda) Ltd. The Complaint in the Sears Lawsuit, which contains many of the
basic allegations that were contained in the Class Action plaintiffs’ Second Amended Complaint, alleges violations of the Sherman Act and RICO, as well as claims alleging breach of fiduciary duty
against the broker defendants; inducement to breach fiduciary duty against the insurer defendants; breach of contract against the broker defendants; tortious interference with contract against the
insurer defendants; unjust enrichment; common law fraud against the broker defendants; aiding and abetting common law fraud against the insurer defendants; violation of state consumer fraud
statutes; and violation of state antitrust statutes. The Sears Lawsuit is a tag-along action that does not purport to be a class action. The parties are awaiting the District Court’s decision as to whether
the Sears Lawsuit will continued to be stayed or be permitted to proceed pending the Third Circuit’s disposition of the Class Action plaintiffs’ pending appeal. Three purported class actions were filed against “XL Insurance Ltd” (“XLI”) and others in the United States District Court, for the Southern District of New York on behalf of shareholders of
Security Capital Assurance, Inc. (“SCA”). The complaints, filed December 7, 2007, December 18, 2007 and January 8, 2008 named as defendants SCA, two SCA officers, (and in two of the cases)
Goldman Sachs & Co., J.P. Morgan Securities, Inc., and Merrill Lynch, Pierce Fenner & Smith, Inc. All allege violations of various U.S. Securities laws against the defendants arising from purchases of
SCA shares in the June 6, 2007 secondary offering and shortly before. The complaints allege, among other things, that the Registration Statement and other public disclosures made by SCA and
individual defendants contained untrue statements of material facts and omitted other necessary facts to make the statements not misleading. The complaints allege that the disclosures failed to
disclose that SCA was materially exposed to risky securities relating to sub-prime real estate mortgages. The allegations against XLI claim it is liable as a selling shareholder and
as a 66
party that “controlled” SCA during the relevant time period. In late April, the Judge issued an order consolidating the actions, appointing Employees’ Retirement System of the state of Rhode Island
as lead plaintiff, and approving its selection of lead counsel. The order further provides that the lead plaintiff shall file a Consolidated Amended Complaint. The matter is designated In Re Security
Capital Assurance Ltd. Securities Litigation. The Company is also subject to litigation and arbitration in the normal course of its business. These lawsuits and arbitrations principally involve claims on policies of insurance and contracts of
reinsurance and are typical for the Company and for the property and casualty insurance and reinsurance industry in general. Such legal proceedings are considered in connection with the Company’s
loss and loss expense reserves. Reserves in varying amounts may or may not be established in respect of particular claims proceedings based on many factors, including the legal merits thereof. In
addition to claims litigation, the Company and its subsidiaries are subject to lawsuits in the normal course of business that do not arise from or directly relate to claims on policies of insurance or
contracts of reinsurance. The Company believes that the ultimate outcome of all outstanding litigation and arbitration will not have a material adverse effect on its consolidated financial condition, operating results and/or
liquidity, although an adverse resolution of one or more of these items could have a material adverse effect on the Company’s results of operations in a particular fiscal quarter or year. Refer to Item 1A. Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 for further information. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS (c) Purchases of Equity Securities by the Issuer and Affiliate Purchasers The following table provides information about purchases by the Company during the three months ended March 31, 2008 of equity securities that are registered by the Company pursuant to
Section 12 of the Exchange Act:
Period
Total Number
Average Price
Total Number
Approximate Dollar January 1-31, 2008
3,951
50.31
—
$
375.5 million February 1-29, 2008
—
—
—
$
375.5 million March 1-31, 2008
113,652
33.83
—
$
375.5 million Total
117,603
34.38
—
$
375.5 million
(1)
All share purchased were purchased in connection with the vesting of restricted shares granted under the Company’s restricted stock plan. All of these purchases were made in connection with satisfying tax withholding obligations of those
employees. These shares were not purchased as part of the Company’s share repurchase program noted below. (2) On September 24, 2007, the Board of Directors of the Company approved a share repurchase program, authorizing the Company to repurchase up to $500.0 million of its Class A ordinary shares. As at March 31, 2008, the Company had
repurchased 1.8 million shares for $124.5 million under the share repurchase program. 67
of Shares
Purchased (1)
Paid
per Share
of Shares
Purchased as
Part of
Publicly
Announced Plans
or Programs
Value of Shares
that May Yet Be
Purchased Under
the Plans
or Programs (2)
10.1
Employment Agreement, dated as of March 14, 2008 by and between XL Capital Ltd and
Michael S. McGavick, incorporated by reference to Exhibit 10.1 to the Company’s
Current Report on Form 8-K filed on March 20, 2008.
31**
Rule 13a-14(a)/15d-14(a) Certifications.
32**
Section 1350 Certification.
** 68
Filed herewith
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
XL CAPITAL LTD
Date: May 7, 2008
/s/ MICHAEL S. MCGAVICK
Michael S. McGavick
Date: May 7, 2008
/s/ BRIAN W. NOCCO
Brian W. Nocco 69
(Registrant)
Chief Executive Officer
Executive Vice President and
Chief Financial Officer