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UNITED STATES FORM 10-Q S QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF XL CAPITAL LTD
CAYMAN ISLANDS
98-0191089 XL House, One Bermudiana Road, Hamilton, Bermuda HM 11 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, a non-accelerated filer or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. Large accelerated filer S Accelerated filer £ Non-accelerated filer £ Smaller reporting company £ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No S As of October 28, 2008, there were 330,787,685 outstanding Class A Ordinary Shares, $0.01 par value per share, of the registrant.
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(Address of principal executive offices and zip code)
(441) 292-8515
(Registrants telephone number, including area code)
XL CAPITAL LTD INDEX TO FORM 10-Q Page No Item 1. Consolidated Balance Sheets as at September 30, 2008 (Unaudited) and
December 31, 2007 3 4 5 6 7 8 Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations 43 Item 3. 89 Item 4. 97 Item 1. 98 Item 1A. 101 Item 2. 102 Item 6. 103 104 2
XL CAPITAL LTD
(Unaudited)
December 31, ASSETS Investments: Fixed maturities, at fair value (amortized cost: 2008, $29,561,258; 2007, $34,233,816)
$
26,501,478
$
33,607,790 Equity securities, at fair value (cost: 2008, $479,767; 2007, $664,213)
471,705
854,815 Short-term investments, at fair value (amortized cost: 2008, $1,647,249; 2007, $1,814,445)
1,633,654
1,803,198 Total investments available for sale
28,606,837
36,265,803 Investments in affiliates
2,325,505
2,611,149 Other investments (cost: 2008, $513,439; 2007, $614,848)
586,664
708,476 Total investments
31,519,006
39,585,428 Cash and cash equivalents
5,610,003
3,880,030 Accrued investment income
387,192
447,660 Deferred acquisition costs
815,429
756,854 Prepaid reinsurance premiums
1,194,100
972,516 Premiums receivable
3,650,464
3,637,452 Reinsurance balances receivable
659,940
817,931 Unpaid losses and loss expenses recoverable
4,083,021
4,697,471 Goodwill and other intangible assets
1,816,885
1,841,591 Deferred tax asset, net
343,748
370,419 Other assets
700,886
754,912 Total assets
$
50,780,674
$
57,762,264 LIABILITIES AND SHAREHOLDERS EQUITY Liabilities: Unpaid losses and loss expenses
$
22,178,777
$
23,207,694 Future policy benefit reserves
6,222,282
6,772,042 Deposit liabilities
2,769,682
7,920,085 Notes payable and debt
3,189,482
2,868,731 Reinsurance balances payable
929,879
843,511 Net payable for investments purchased
770,640
191,472 Unearned premiums
4,998,530
4,681,989 Other liabilities
1,059,262
1,326,179 Total liabilities
$
42,118,534
$
47,811,703 Commitments and Contingencies: Minority interest in equity of consolidated subsidiaries
$
1,597
$
2,419 Shareholders Equity: Series C preference ordinary shares, 20,000,000 authorized, par value $0.01 Issued and outstanding: (2008, 20,000,000; 2007, nil)
200
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, 330,788,403; 2007, 177,910,151)
3,308
1,779 Additional paid in capital
10,276,532
7,358,801 Accumulated other comprehensive (loss) income
(2,799,939
)
9,159 Retained earnings
1,180,432
2,578,393 Total shareholders equity
$
8,660,543
$
9,948,142 Total liabilities and shareholders equity
$
50,780,674
$
57,762,264 See accompanying Notes to Unaudited Consolidated Financial Statements 3
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share amounts)
September 30,
2008
2007
XL CAPITAL LTD
(Unaudited)
(Unaudited)
2008
2007
2008
2007 Revenues: Net premiums earned
$
1,694,631
$
1,730,582
$
5,088,715
$
5,451,931 Net investment income
436,281
567,987
1,375,862
1,688,294 Net realized (losses) on investments
(292,903
)
(160,208
)
(393,114
)
(132,620
) Net realized and unrealized (losses) on derivative instruments
(58,454
)
(58,162
)
(5,648
)
(41,233
) Net (loss) income from investment fund affiliates
(54,886
)
69,435
(63,522
)
255,414 Fee income and other
19,132
3,653
40,219
11,639 Total revenues
$
1,743,801
$
2,153,287
$
6,042,512
$
7,233,425 Expenses: Net losses and loss expenses incurred
$
1,209,565
$
920,564
$
3,149,043
$
2,857,299 Claims and policy benefits
199,861
195,440
605,885
662,883 Acquisition costs
216,879
253,077
729,413
811,049 Operating expenses
319,432
270,540
881,554
857,595 Exchange (gains) losses
(139,467
)
(26,204
)
(63,786
)
19,965 Extinguishment of debt
22,527
22,527
Interest expense
78,000
151,018
267,553
458,504 Amortization of intangible assets
1,386
420
2,226
1,260 Total expenses
$
1,908,183
$
1,764,855
$
5,594,415
$
5,668,555 (Loss) income before minority interest, income tax and net (loss) income from operating affiliates
$
(164,382
)
$
388,432
$
448,097
$
1,564,870 Minority interest in net income of subsidiary
23,994 Income tax
47,843
58,715
129,750
192,758 Net (loss) income from operating affiliates
(1,404,299
)
41,919
(1,452,647
)
140,640 Net (loss) income
(1,616,524
)
371,636
(1,134,300
)
1,488,758 Preference share dividends
(32,500
)
(43,661
)
(65,000
)
(66,530
) Net (loss) income available to ordinary shareholders
$
(1,649,024
)
$
327,975
$
(1,199,300
)
$
1,422,228 Weighted average ordinary shares and ordinary share equivalents outstanding basic
270,844
178,788
208,437
178,886 Weighted average ordinary shares and ordinary share equivalents outstanding diluted
270,844
179,781
208,437
180,340 (Loss) earnings per ordinary share and ordinary share equivalent basic
$
(6.09
)
$
1.83
$
(5.75
)
$
7.95 (Loss) earnings per ordinary share and ordinary share equivalent diluted
$
(6.09
)
$
1.82
$
(5.75
)
$
7.89 See accompanying Notes to Unaudited Consolidated Financial Statements 4
CONSOLIDATED STATEMENTS OF INCOME
(U.S. dollars in thousands, except per share amounts)
Three Months Ended
September 30,
Nine Months Ended
September 30,
XL CAPITAL LTD
(Unaudited)
(Unaudited)
2008
2007
2008
2007 Net (loss) income
$
(1,616,524
)
$
371,636
$
(1,134,300
)
$
1,488,758 Change in net unrealized (losses) on investments, net of tax
(825,288
)
(142,221
)
(2,587,155
)
(867,605
) Change in value of cash flow hedge
111
110
329
4,227 Foreign currency translation adjustments, net
(457,384
)
177,691
(219,966
)
272,975 Net unrealized (loss) gain on future policy benefit reserves
(872
)
2,092
(2,560
)
1,819 Realization of accumulated other comprehensive loss on sale of Syncora
4,953 Additional pension liability
319
(175
)
254
(363
) Comprehensive (loss) income
$
(2,899,638
)
$
409,133
$
(3,943,398
)
$
904,764 See accompanying Notes to Unaudited Consolidated Financial Statements 5
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(U.S. dollars in thousands)
Three Months Ended
September 30,
Nine Months Ended
September 30,
XL CAPITAL LTD
(Unaudited)
2008
2007 Series A, B, C and E Preference Ordinary Shares: Balance beginning of year
$
10
$
207 Issuance of Series C preference ordinary shares
200
Issuance of Series E preference ordinary shares
10 Redemption of Series A preference ordinary shares
(92
) Balance end of period
$
210
$
125 Class A Ordinary Shares: Balance beginning of year
$
1,779
$
1,810 Issuance of Class A ordinary shares
1,530
112 Exercise of stock options
8 Repurchase of Class A ordinary shares
(1
)
(133
) Balance end of period
$
3,308
$
1,797 Additional Paid in Capital: Balance beginning of year
$
7,358,801
$
6,451,569 Issuance of Class A ordinary shares
2,389,558
869,102 Issuance of Series C preference ordinary shares
499,800
Issuance of Series E preference ordinary shares
983,786 Repurchase of Class A ordinary shares
(4,834
)
(451,312
) Redemption of Series A preference ordinary shares
(229,908
) Fair value of purchase contracts associated with equity security units
(37,860
)
Outstanding accrued contingent capital put premium
51,064
Stock option expense
16,499
11,084 Exercise of stock options
6,207
50,325 Net change in deferred compensation
(2,703
)
(6,210
) Balance end of period
$
10,276,532
$
7,678,436 Accumulated Other Comprehensive Income (Loss): Balance beginning of year
$
9,159
$
411,405 Net change in unrealized (losses) on investment portfolio, net of tax
(2,572,684
)
(865,687
) Net change in unrealized (losses) on affiliate and other investments, net of tax
(14,471
)
(1,918
) Change in value of cash flow hedge
329
4,227 Net unrealized (loss) gain on future policy benefit reserves
(2,560
)
1,819 Foreign currency translation adjustments
(219,966
)
272,975 Realization of accumulated other comprehensive loss on sale of Syncora
4,953 Additional pension liability
254
(363
) Balance end of period
$
(2,799,939
)
$
(172,589
) Retained Earnings: Balance beginning of year
$
2,578,393
$
3,266,175 Net (loss) income
(1,134,300
)
1,488,758 Dividends on Series A, B and E preference ordinary shares
(65,000
)
(66,530
) Dividends on Class A ordinary shares
(198,661
)
(206,492
) Repurchase of Class A ordinary shares
(557,889
) Balance end of period
$
1,180,432
$
3,924,022 Total Shareholders Equity
$
8,660,543
$
11,431,791 See accompanying Notes to Unaudited Consolidated Financial Statements 6
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
(U.S. dollars in thousands)
Nine Months Ended
September 30,
XL CAPITAL LTD
(Unaudited)
2008
2007 Cash flows (used in) provided by operating activities: Net (loss) income
$
(1,134,300
)
$
1,488,758 Adjustments to reconcile net income to net cash provided by operating activities: Net realized losses on investments
393,114
132,620 Net realized and unrealized losses on derivative instruments
5,648
41,233 Amortization of (discounts) on fixed maturities
(31,403
)
(63,545
) Net loss (income) from investment fund and operating affiliates
1,516,169
(396,054
) Cash paid to Syncora
(1,775,000
)
Amortization of deferred compensation
46,591
38,149 Accretion of convertible debt
751
1,013 Accretion of deposit liabilities
117,787
306,176 Unpaid losses and loss expenses
(478,748
)
(22,479
) Future policy benefit reserves
(3,285
)
69,921 Unearned premiums
434,674
471,198 Premiums receivable
(90,717
)
(234,234
) Unpaid losses and loss expenses recoverable
594,596
231,154 Prepaid reinsurance premiums
(242,118
)
(101,672
) Reinsurance balances receivable
152,100
274,570 Deferred acquisition costs
(99,415
)
(100,247
) Reinsurance balances payable
106,018
(6,602
) Deferred tax asset
94,224
6,626 Other
(270,617
)
(137,347
) Total adjustments
$
470,369
$
510,480 Net cash (used in) provided by operating activities
$
(663,931
)
$
1,999,238 Cash flows provided by (used in) investing activities: Proceeds from sale of fixed maturities and short-term investments
$
11,614,263
$
19,312,713 Proceeds from redemption of fixed maturities and short-term investments
2,403,975
1,473,034 Proceeds from sale of equity securities
720,928
655,665 Proceeds from sale of Syncora common shares, net of cash sold upon de-consolidation
(110,843
) Purchases of fixed maturities and short-term investments
(9,878,649
)
(22,513,672
) Purchases of equity securities
(507,426
)
(545,942
) Net dispositions of affiliates
302,671
250 Other investments
77,162
(186,625
) Net cash provided by (used in) investing activities
$
4,732,924
$
(1,915,420
) Cash flows (used in) provided by financing activities: Proceeds from issuance of Class A ordinary shares and exercise of stock options
$
2,231,000
$
875,333 Proceeds from issuance of Series C preference ordinary shares
500,000
Proceeds from issuance of Series E preference ordinary shares
983,796 Redemption of Series A preference ordinary shares
(230,000
) Repurchase of Class A ordinary shares
(4,835
)
(1,009,334
) Dividends paid
(230,886
)
(228,902
) Proceeds from issuance of debt
557,750
322,836 Repayment of debt
(255,000
)
(825,000
) Deposit liabilities
(5,267,966
)
517,958 Net cash flow on securities lending
149,850
196,736 Proceeds from issuance of Syncora Series A perpetual preference shares
247,248 Dividends paid to minority shareholders of Syncora
(16,130
) Net cash (used in) provided by financing activities
$
(2,320,087
)
$
834,541 Effects of exchange rate changes on foreign currency cash
(18,933
)
43,132 Increase in cash and cash equivalents
1,729,973
961,491 Cash and cash equivalents beginning of period
3,880,030
2,223,748 Cash and cash equivalents end of period
$
5,610,003
$
3,185,239 See accompanying Notes to Unaudited Consolidated Financial Statements 7
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)
Nine Months Ended
September 30,
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 addition, the year-end balance sheet data was derived from audited financial statements but does not include all disclosures
required by accounting principles generally accepted in the United States of America. 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. 8
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (a) Fair Value Measurements (continued) The Company adopted FAS 157 as of January 1, 2008, applying the provisions of the statement prospectively to assets and liabilities measured at fair value. 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. 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. In October 2008, the FASB issued FSP No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP FAS 157-3). This FSP clarifies the application of FAS 157 in a market that is not active and provides an example to illustrate key
considerations in the determination of the fair value of a financial asset when the market for that asset is not active. The key considerations illustrated in the FSP FAS 157-3 example include the use of an entitys own assumptions about future cash flows and appropriately risk-adjusted discount rates,
appropriate risk adjustments for nonperformance and liquidity risks, and the reliance that an entity should place on quotes that do not reflect the result of market transactions. FSP FAS 157-3 was preceded by a press release that was jointly issued by the Office of the Chief Accountant of the Securities
and Exchange Commission (SEC) and the FASB staff on September 30, 2008 which provided immediate clarification on fair value accounting based on the measurement guidance of FAS 157. FSP FAS 157-3 was effective upon issuance. FSP FAS 157-3 did not have an impact on the Companys
consolidated financial statements. Basis of Fair Value Measurement FAS 157 also establishes a fair value hierarchy that prioritizes the inputs to the respective 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). An assets or liabilitys classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. 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 or liabilities (unadjusted); no blockage factors. Level 2 Other observable inputs (quoted prices in markets that are not active or inputs that are observable either directly or indirectly)include quoted prices for similar assets/liabilities (adjusted) other than quoted prices in Level 1; quoted prices in markets that are not active; or other inputs
that are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities. 9
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (a) Fair Value Measurements (continued)
Level 3 Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the reporting entitys own assumptions about the assumptions that market participants would use in pricing the asset or
liability. Level 3 assets and liabilities include financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or
estimation.
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) Investments Investments Available For Sale Investments that are considered available for sale (comprised of the Companys fixed maturities, equity securities and short-term investments) are carried at fair value. The fair values for all available for sale investments 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 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 managements 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 10
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (c) Investments (continued) 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 sources. 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. Prices provided by independent pricing services and independent broker quotes can vary widely even for the same security. The use of different methodologies and assumptions may have a material effect on the estimated fair value amounts. During periods of market disruption including periods of
significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, such as the market disruption experienced during the quarter ended September 30, 2008, it may be difficult to value certain of the Companys securities, for example Alt-A and sub-prime mortgage backed securities, if
trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes that were in active markets with significant observable data that become illiquid due to the current financial environment. In such cases, more securities may fall to Level 3 and thus require more
subjectivity and management judgment. As such, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods which are more sophisticated or require greater estimation thereby resulting in values which may be less than the value at
which the investments may be ultimately sold. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within the Companys consolidated financial statements and the period-to-period changes in value could vary
significantly. Decreases in value may have a material adverse effect on the Companys results of operations and financial condition. The net unrealized gain or loss 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 using the same external factors 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 is 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 11
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (c) Investments (continued) 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 Companys 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 Companys 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 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, LLCs 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 considered to be fair value measurements under FAS 157. 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 (as defined above) 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, the general partner 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 gain or loss on investments, net of tax, is included in Accumulated other comprehensive income (loss). Any unrealized loss 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 Companys 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. These
investments are carried under the cost recovery method given the uncertainty of future cash flows. The carrying value of these investments held by the Company at September 30, 2008 and December 31, 2007 was $17.1 million and $22.7 million, respectively. 12
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (c) Investments (continued) In addition, the Company historically participated 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 September 30, 2008 and December 31, 2007 was $81.8 million and $125.1 million, respectively. Securities lending The Company participates in a securities lending program operated by a third party banking institution, whereby certain assets are loaned out and for which the Company earns an incremental return. For securities on loan, the lending agent receives cash collateral generally worth 102 to 105% of the
loaned securities which must be returned to the borrower upon return of the securities and which in the meantime is invested in a collateral pool managed by the banking institution. The collateral pool is subject to written investment guidelines with key objectives which includes safeguard of principal
and adequate liquidity to meet anticipated needs with a maximum weighted average maturity of ninety days. At September 30, 2008 and December 31, 2007, $290.3 million and $144.3 million, respectively, of securities included in investments available for sale were loaned to various counter parties
through the securities lending program. The cash collateral received as at September 30, 2008 and December 31, 2007 was $296.0 million and $146.6 million respectively. At September 30, 2008 and December 31, 2007, the value of the Companys share of the collateral pool held was $289.0 million and
$146.2 million, respectively, in connection with these loans, and is included in cash and cash equivalents, with a corresponding liability reflected in net payable for investments purchased. During the quarter ended September 30, 2008, the Company capped its maximum participation in the securities
lending program at $300 million. 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 Companys 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 securitys 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. 13
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (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 Companys results of operations from period to period. Credit derivatives are purchased within the Companys investment portfolio, have been sold through a limited number of contracts written as part of the Companys previous XL Financial Solutions business, and were previously entered into through the Companys prior reinsurance agreements with
Syncora Holdings Ltd. (Syncora) (formerly Security Capital Assurance Ltd. or SCA), as described below. From time to time, the Company may purchase credit default swaps to hedge an existing position or concentration of holdings. The credit derivatives are recorded at fair value. Following the
secondary sale of Syncora common shares, the Company retained some credit derivative exposures written by Syncora and certain of its subsidiaries through reinsurance agreements that had certain derivatives exposures embedded within them. Subsequent to June 6, 2007, the Company received Syncora
related derivative fair values from Syncora management and reviewed the methodology applied in developing those estimates. In addition, the change in value of the derivative portion of the financial guarantee reinsurance agreements the Company had with Syncora was included in Net (loss) income
from operating affiliates. Following the closing of the Master Agreement which terminated certain reinsurance and other agreements, these credit derivative exposures were eliminated by virtue of the commutation of the relevant reinsurance agreements. As of September 30, 2008, the remaining credit
derivative exposure outside of the Companys investment portfolio consisted of 25 contracts written by the Company that provide credit protection on senior tranches of structured finance transactions with total net par values outstanding of $661.1 million, a weighted average contractual term to maturity
of 5.9 years, and a total liability recorded of $19.7 million. The Companys 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 and complies with the Companys investment guidelines. 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. 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 14
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (d) Derivative Instruments (continued) 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 corroborated, 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 policyholders 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 Companys notes payable and debt outstanding as at September 30, 2008 and December 31, 2007, is estimated to be $1.9 billion and $2.6 billion, respectively, and is based on quoted prices. (f) Recent Accounting Pronouncements 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 15
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (f) Recent Accounting Pronouncements (continued) 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. 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 entitys 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
Companys financial condition and results of operations. In April 2008, the FASB issued FASB Staff Position 142-3, Determination of the Useful Lives of Intangible Assets, which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of an intangible asset. This interpretation will be
effective for the Company beginning January 1, 2009 and must also be applied to interim periods within 2009. The Company is currently evaluating the potential impact of this guidance; however, it is not expected to have a significant impact on the Companys financial condition and results of operations. In May 2008, the FASB issued FAS 162, The Hierarchy of Generally Accepted Principles (FAS 162) which outlines the order of authority for the sources of accounting principles. FAS 162 will be effective 60 days following the SECs approval of the Public Company Accounting Oversight Board
amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company does not expect FAS 162 to have an impact on its financial condition and results of operations. In May 2008, the FASB issued FAS 163, Accounting for Financial Guarantee Insurance Contracts, an interpretation of FAS 60 (FAS 163) to address current diversity in practice with respect to accounting for financial guarantee insurance contracts by insurance enterprises under FAS 60,
Accounting and Reporting by Insurance Enterprises (FAS 60). That diversity results in inconsistencies in the recognition and measurement of claim liabilities because of differing views regarding when a loss has been incurred under FAS 5, Accounting for Contingencies. FAS 163 requires that an
insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. FAS 163 also clarifies how FAS 60 applies to financial guarantee insurance contracts, including the recognition and
measurement to be used to account for premium revenue and claim liabilities. Those clarifications will increase comparability in financial reporting of financial guarantee insurance contracts by insurance enterprises. FAS 163 also requires expanded disclosures about financial guarantee insurance contracts.
The standard is effective for the Company beginning January 1, 2009, and must be applied to all interim periods within 2009, except for certain disclosures about the Companys risk management activities which are required to be included in the Companys quarterly report on Form 10-Q for the current
period ended September 30, 2008. Except for those disclosures, earlier application is not permitted. The Company had reserves for financial guarantee insurance contracts of $14.2 million and $427.4 million, respectively, recorded within Unpaid Losses and Loss Expenses, at September 30, 2008 and
December 31, 2007, respectively. At December 31, 2007 the most significant financial guarantee exposures were related to the Companys reinsurance agreements with Syncora and its subsidiaries. Following the closing of the Master Agreement, the Companys 16
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (f) Recent Accounting Pronouncements (continued) financial guarantee exposures associated with Syncora were eliminated, with the exception of the guarantee of Syncoras obligations under certain policies with European Investment Bank which are not subject to FAS 163. For further details on this guarantee see Note 4, Syncora Holdings Ltd.
(Syncora). As of September 30, 2008, the Companys outstanding financial guarantee contracts that were subject to FAS 163 included the reinsurance of 48 financial guarantee contracts with total insured contractual payments outstanding of $1.0 billion ($164.9 million of interest and $854.2 million of principal)
with a remaining weighted-average contract period of 8.2 years. The total gross claim liability and unearned premiums recorded at September 30, 2008 were $14.2 million and $3.5 million, respectively. Of the contractual exposure existing at September 30, 2008, the Company has reinsured $441.9 million
with a third party. There are no gross claim liabilities or recoverables recorded relating to this exposure. Surveillance procedures to track and monitor credit deteriorations in the insured financial obligations are performed by the primary obligors for each transaction on the Companys behalf. Information
regarding the performance status and updated exposure values is provided to the Company on a quarterly basis and evaluated by management in recording claims reserves. Of the 48 contracts noted above, 5 contracts with total insured contractual payments outstanding of $18.7 million had experienced an
event of default and were considered by the Company to be non-performing at September 30, 2008, while the remaining 43 contracts were considered to be performing at such date. In May 2008, the FASB issued FSP APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement), which clarifies that convertible debt instruments that may be settled in cash upon conversion (including partial cash
settlement) are not addressed by paragraph 12 of APB Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants. Additionally, this FSP specifies that issuers of such instruments should separately account for the liability and equity components in a manner that
will reflect the entitys non-convertible debt borrowing rate when interest cost is recognized in subsequent periods. This FSP will be effective for the Company as of January 1, 2009 and will have to be applied retrospectively to all periods presented. The Company will evaluate the impact of the adoption
in the event any instruments that would be subject to this guidance are being considered in the future, however, it is not expected to have any impact on the Companys financial condition and results of operations upon adoption as the Company does not have any instruments issued and outstanding that
will be subject to this guidance. In June 2008, the FASB issued EITF No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entitys Own Stock (EITF 07-5). EITF 07-5 addresses the determination of whether an instrument (or an embedded feature) is indexed to an entitys own stock for the
purposes of determining whether an instrument is a derivative. To the extent a derivative instrument or embedded derivative feature is deemed indexed to an entitys own stock, it may be exempt from the requirements of FAS No. 133, Accounting for Derivative Instruments and Hedging Activities
(FAS 133). EITF 07-5 concluded that an entity should determine whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock first by evaluating the instruments contingent exercise provisions, if any, and then by evaluating the instruments settlement provisions. EITF
07-5 will be effective for financial statements issued for the Companys fiscal year beginning on January 1, 2009, and interim periods within the 2009 year. Earlier application is prohibited. EITF 07-5 must be applied to outstanding instruments as of January 1, 2009. This guidance is not expected to have
an impact on the Companys financial condition and results of operations. 17
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 2. Significant Accounting Policies (continued) (f) Recent Accounting Pronouncements (continued) In June 2008, the FASB issued FASB Staff Position EITF 03-6-1, 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 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 FSP is effective for the Company for the fiscal year beginning January 1, 2009 and all interim periods within 2009. All prior period EPS data
presented will have to be adjusted retrospectively to conform to the provisions of the FSP. Under the terms of the Companys 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 Companys EPS calculations. The Company is currently evaluating the impact of this guidance. In August 2008, the SEC announced that it will issue for comment a proposed roadmap regarding the potential use of International Financial Reporting Standards (IFRS) for the preparation of financial statements by U.S. registrants. IFRS are standards and interpretations adopted by the
International Accounting Standards Board. Under the proposed roadmap, the Company would be required to prepare financial statements in accordance with IFRS in fiscal 2014, including comparative information also prepared under IFRS for fiscal year 2013 and fiscal 2012. The Company is currently
assessing the potential impact of IFRS on its financial statements and will continue to follow the proposed roadmap for future developments. In September 2008, the FASB issued FSP FAS No. 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161. FSP FAS No.
133-1 and FIN 45-4 requires enhanced disclosures about credit derivatives and guarantees and amends FIN 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others to exclude derivative instruments accounted for at fair value
under FAS 133. The FSP is effective for financial statements issued for reporting periods ending after November 15, 2008. Since FSP FAS No. 133-1 and FIN 45-4 only requires additional disclosures concerning credit derivatives and guarantees, adoption of FSP FAS No. 133-1 and FIN 45-4 will not
impact the Companys financial condition or results of operations. The federal government, under the Emergency Economic Stabilization Act of 2008, will conduct an investigation of fair value accounting during the fourth quarter of 2008 and has granted the SEC the authority to suspend fair value accounting for any registrant or group of registrants at its discretion.
The impact of such actions on registrants who apply fair value accounting cannot be readily determined at this time. 18
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 3. Fair Value Measurements Effective January 1, 2008, the Company adopted FAS 157, which requires disclosures about the Companys assets and liabilities that are carried at fair value. As required by FAS 157, financial 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 Companys assets and liabilities that were accounted for at fair value as of September 30, 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
$
$
25,595,848
$
905,630
$
$
26,501,478 Equity securities, at fair value
354,569
117,136
471,705 Short-term investments, at fair value
1,630,855
2,799
1,633,654 Total investments available for sale
$
354,569
$
27,343,839
$
908,429
$
$
28,606,837 Cash equivalents (1)
1,843,487
2,600,360
4,443,847 Other investments (2)
423,025
64,801
487,826 Other assets (3)(5)
88,555
105,509
(6,428
)
187,636 Total assets accounted for at fair value
$
2,198,056
$
30,455,779
$
1,078,739
$
(6,428
)
$
33,726,146 Liabilities Financial instruments sold, but not yet purchased (6)
$
$
37,573
$
$
$
37,573 Other liabilities (4)(5)
47,051
32,722
(6,428
)
73,345 Total liabilities accounted for at fair value
$
$
84,624
$
32,722
$
(6,428
)
$
110,918
(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 (c) 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 Level 3 inputs were utilized to determine fair value. The table reflects gains and losses for the three and nine month periods ended September 30, 2008 for all financial
assets and liabilities categorized as Level 3 as of September 30, 2008. The table does not include gains or losses that were reported in Level 3 in prior periods for assets that were transferred out of Level 3 prior to September 30, 2008. Gains and losses for assets and liabilities classified 19
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
September 30,
2008
XL CAPITAL LTD 3. Fair Value Measurements (continued) 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
Derivative
Short-term
Other Balance, beginning of period
$
1,527,740
$
8,443
$
61,593
$
55,351 Realized (losses) gains
(32,779
)
113 Movement in unrealized (losses) gains
(126,358
)
(29
)
228
12,543 Purchases, issuances and settlements
29,309
(5,615
)
2,980
4,780 Transfers in and/or out of Level 3
(492,282
)
Balance, end of period
$
905,630
$
2,799
$
64,801
$
72,787 Movement in total (losses) gains above relating to instruments still held at the reporting date
$
(112,147
)
$
82
$
228
$
12,543
(U.S. dollars in thousands)
Fixed
Level 3 Assets and
Derivative
Short-term
Other Balance, beginning of period
$
1,385,601
$
15,606
$
40,354
$
12,283 Realized (losses) gains
(170,905
)
(46
)
26,956 Movement in unrealized (losses) gains
(246,929
)
2
(3,266
)
18,732 Purchases, issuances and settlements
111,183
(11,873
)
27,713
14,816 Transfers in and/or out of Level 3
(173,320
)
(890
)
Balance, end of period
$
905,630
$
2,799
$
64,801
$
72,787 Movement in total (losses) gains above relating to instruments still held at the reporting date
$
(238,451
)
$
$
(3,266
)
$
18,732 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. collateralized mortgage obligations (CMOs), asset backed securities (ABSs), commercial mortgage backed securities (CMBSs), collateralized debt
obligations (CDOs), and other Topical Assets (which the Company defines as sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures) for which sufficient information, such as cash flows or other security structure or market information,
is not available to enable a model derived price to be determined. Generally, securities that are less liquid are more difficult to value and/or dispose of. Fixed maturities and short term investments classified within Level 3 are made up of those securities for which the values were 20
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Maturities
Liabilities
Three Months Ended
September 30, 2008
Contracts Net
Investments
Investments
(Unaudited)
Maturities
Liabilities
Nine Months Ended
September 30, 2008
Contracts Net
Investments
Investments
XL CAPITAL LTD 3. Fair Value Measurements (continued) 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 Companys 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 services 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. In certain instances, given the current market dislocation, the Company had elected to utilize Level 3 broker valuations over available pricing service valuations during the prior quarter; however, during the current
quarter certain fixed maturity investments were recorded based upon pricing service valuations where available resulting in transfers being recorded from Level 3 to Level 2. If the Company were forced to sell certain of its assets in a period of market disruption, there can be no assurance that the
Company will be able to sell them for the prices at which the Company has recorded them. Other investments Included within the Other Investments component of the Companys 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 or general partner of the respective entity. 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 significant Level 3 inputs are utilized in the determination of the individual
underlying holding values and accordingly the fair value of the Companys 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
managements 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) GMIB derivatives embedded within a certain
reinsurance contract, (iv) put options included within contingent capital facilities and (v) credit derivatives sold providing protection on senior tranches of structured finance transactions where the value is obtained directly from the investment bank counterparty for which sufficient information regarding
the inputs utilized in the valuation was not obtained to support a Level 2 classification. In addition, prior to the closing of the Master Agreement (as described below), derivative instruments classified as Level 3 included credit derivatives written by Syncora and embedded in reinsurance provided by the
Company. Subsequent to the closing of the Master Agreement, these credit derivative exposures were eliminated by virtue of the commutation of the relevant reinsurance agreements. For further details relating to the Master Agreement, see Note 4 to the Consolidated Financial Statements, Syncora
Holdings Ltd. (Syncora). 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 Companys valuation policies for such instruments. 21
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 4. Syncora Holdings Ltd. (Syncora) On August 4, 2006, the Company completed the sale of approximately 37% of its then financial guarantee reinsurance and insurance businesses through an initial public offering (IPO) of 23.4 million common shares of Syncora for proceeds of approximately $446.9 million. On June 6, 2007, the
Company completed the sale of a portion of Syncoras common shares still owned by the Company through a secondary offering and thereby reduced its ownership of Syncoras outstanding common shares further from approximately 63% to approximately 46%. Accordingly, subsequent to June 6, 2007,
the Company accounted for its remaining investment in Syncora using the equity method of accounting. Given managements 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 Syncora to nil at December 31, 2007. The Companys shares in Syncora were unregistered and thus illiquid. Market
developments with respect to the monoline industry continued to be largely negative throughout 2008 and during the nine months ended September 30, 2008, Syncora was downgraded by several rating agencies. Accordingly, throughout 2008 and up until the closing of the Master Agreement with Syncora
which resulted in the transfer by the Company of all of the shares it owned in Syncora, the Company reported its investment in Syncora at nil and less than the traded market value during this time, as it was believed the decline in value was other than temporary. As described below, concurrent with the IPO of Syncora and subsequently, the Company entered into certain service, reinsurance and guarantee arrangements with Syncora and its subsidiaries, to govern certain aspects of the Companys relationship with Syncora. Prior to the sale of Syncora shares
through the secondary offering on June 6, 2007, the effect of these arrangements was eliminated upon consolidation of the Companys results. The income statement impacts of all transactions with Syncora subsequent to June 6, 2007, including the impact of the closing of the transactions subject to the
Master Agreement on August 5, 2008, have been included in Net (loss) income from operating affiliates. As at June 30, 2008, Syncora had total assets of $3.7 billion, total liabilities of $3.8 billion, outstanding preferred share equity of $246.6 million, and common shareholders deficit of $428.7 million. During the three months and six months ended June 30, 2008, Syncora had net earned premiums of
$121.0 million and $179.4 million, total revenues of $23.1 million and $15.8 million, and a net loss to common shareholders before minority interest of $490.1 million and $585.4 million, respectively. Service agreements Previously, the Company had entered into a series of service agreements under which subsidiaries of the Company provided services to Syncora and its subsidiaries or received certain services from Syncora subsidiaries for a period of time after the IPO. As detailed below, subsequent to June 30, 2008
the Company executed the Master Agreement in connection with, among other things, the termination of these service agreements. Reinsurance agreements As noted above, the Company previously provided 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 Syncora: Syncora Guarantee Re Inc. (Syncora Guarantee
Re) (formerly XL Financial Assurance Ltd. or XLFA) and Syncora Guarantee Inc. (Syncora Guarantee) (formerly XL Capital Assurance Inc. or XLCA). The adverse development cover related to a specific project financing transaction while the facultative covers generally 22
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 4. Syncora Holdings Ltd. (Syncora) (continued) reinsured certain policies up to the amount necessary for Syncora Guarantee and Syncora Guarantee Re to comply with certain regulatory and risk limits. The excess of loss reinsurance provided indemnification for the portion of any individual paid loss covered by Syncora Guarantee Re in excess of 10%
of Syncora Guarantee Res surplus, up to an aggregate amount of $500 million, and excluded coverage for liabilities arising other than pursuant to the terms of the underlying policies. As detailed below, subsequent to June 30, 2008 the Company executed the Master Agreement in connection with, among
other things, the termination of these reinsurance agreements. As at June 30, 2008 and December 31, 2007, the Companys total net exposure under its facultative agreements with Syncora subsidiaries was approximately $6.4 billion and $7.7 billion, respectively, of net par outstanding. Guarantee agreements Previously, the Company also entered into certain guarantee agreements with subsidiaries of Syncora. These guarantee agreements terminated with respect to any new business written by Syncora through the underlying agreements after the effective date of Syncoras IPO, but the agreements
remained in effect with respect to cessions or guarantees written under these agreements prior to the IPO. The agreements unconditionally and irrevocably guaranteed: (i) Syncora Guarantee for the full and complete performance when due of all of Syncora Guarantee Res obligations under its facultative
quota share reinsurance agreement with Syncora Guarantee, (ii) the full and complete payment when due of Syncora Guarantees obligations under certain financial guarantees issued by Syncora Guarantee and arranged by Syncora Guarantee (U.K.) Limited for the benefit of the European Investment
Bank (EIB) and (iii) Financial Security Assurance (Financial Security) for the full and complete performance of Syncora Guarantee Res obligations under a Financial Security Master Facultative Agreement. The guarantees the Company provided contained a dual trigger, such that the guarantees
responded only if two events were to occur. First, the underlying guaranteed obligation must have defaulted on payments of interest and principal, and secondly, the relevant Syncora subsidiary must have failed to meet its obligations under the applicable reinsurance or guarantee. As detailed below,
subsequent to June 30, 2008 the Company executed the Master Agreement in connection with, among other things, the termination of reinsurance agreements with Syncora and its subsidiaries. As a result of the termination of these reinsurance agreements, the related guarantee agreements described
above, with the exception of certain exposures relating to the European Investment Bank as described below, no longer have any force or effect. As at June 30, 2008 and December 31, 2007, the Companys total net par outstanding falling under these guarantees was $59.2 billion and $75.2 billion,
respectively. 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 Syncora Guarantee. Based on the terms and conditions of the underlying GICs, upon the downgrade of
Syncora Guarantee below certain ratings levels, all or portions of the outstanding principal balances on such GICs would come due. Throughout 2008, several rating agencies downgraded Syncora and its subsidiaries and as a result, the Company settled all of the GIC liabilities in the first nine months of
2008. Agreement with Syncora with Respect to Pre-IPO Guarantee and Reinsurance Agreements and Service Agreements On July 28, 2008, the Company announced that it and certain of its subsidiaries had entered into an agreement (the Master Agreement) with Syncora and certain of its subsidiaries (sometimes collectively referred to herein as Syncora) as well as certain counterparties to credit default swap 23
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 4. Syncora Holdings Ltd. (Syncora) (continued) agreements (the Counterparties), in connection with the termination of certain reinsurance and other agreements as described below. The transactions and termination of certain reinsurance and other agreements under the Master Agreement closed on August 5, 2008. As part of the transaction, the
Counterparties provided full releases to the Company and Syncora. The Master Agreement provided for the payment by the Company to Syncora of $1.775 billion in cash, the issuance by the Company to Syncora of eight million of its Class A Ordinary Shares which were newly issued by the Company and the transfer by the Company of all of its voting, economic or
other rights in the shares it owned in Syncora (representing approximately 46% of Syncoras issued and outstanding shares) (the Syncora Shares) to an escrow agent in accordance with an escrow agreement between Syncora and the Counterparties. This consideration was made in exchange for, among
other things, the full and unconditional:
commutation of the Third Amended and Restated Facultative Quota Share Reinsurance Treaty, effective July 1, 2006, between Syncora Guarantee Re and Syncora Guarantee and all individual risk cessions thereunder, as a result of which the guarantee by XL Insurance (Bermuda) Ltd (XLIB)
of Syncora Guarantee Res obligations to Syncora Guarantee thereunder no longer has any force or effect; commutation of the Excess of Loss Reinsurance Agreement, executed on October 3, 2001, pursuant to which XLIB agreed to reinsure certain liabilities of Syncora Guarantee Re (the Excess of Loss Agreement); commutation of the Second Amended and Restated Facultative Master Certificate, effective March 1, 2007, pursuant to which XL Re America, Inc. (XLRA) agreed to reinsure certain liabilities of Syncora Guarantee, and all individual risk cessions thereunder; (the XLRA Master Facultative
Agreement); commutation of the Facultative Quota Share Reinsurance Agreement, effective August 17, 2001, as amended by Amendment No. 1 to such agreement, dated as of August 4, 2006, pursuant to which XLIB agreed to reinsure certain liabilities of Syncora Guarantee Re, and all individual risk
cessions thereunder; commutation of the Adverse Development Reinsurance Agreement, dated as of August 4, 2006, between Syncora Guarantee and XLRA, and the Indemnification Agreement, dated as of August 4, 2006, between Syncora Guarantee Re and XLIB; and termination of certain indemnification and services agreements between the Company and Syncora. The Company and Syncora obtained approval from the New York State Insurance Department for the Master Agreement and each of the commutations to which XLRA or Syncora Guarantee was a party. Syncora also complied with all applicable procedures of the Bermuda Monetary Authority, the
Delaware Insurance Department and other regulators. On August 5, 2008, and simultaneous with the closing of the Master Agreement, Syncora commuted the Amended and Restated Master Facultative Reinsurance Agreement, dated November 3, 1998, between Financial Security and Syncora Guarantee Re, and all individual risk cessions thereunder. As
a result of this commutation, the Companys guarantee of Syncora Guarantee Res obligations thereunder (the Financial Security Guarantee) no longer has any force or effect. 24
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 4. Syncora Holdings Ltd. (Syncora) (continued) After
the closing of the Master Agreement on August 5, 2008, approximately $64.6
billion of the Companys total net exposure (which was $65.7 billion
as at June 30, 2008) under reinsurance agreements and guarantees with Syncora
subsidiaries was eliminated. Pursuant to the terms of the Master Agreement,
Syncora is required to use commercially reasonable efforts to commute the
agreements that are the subject of the Companys guarantee of Syncora
Guarantees obligations under certain financial guarantees issued by
Syncora Guarantee to the European Investment Bank (the EIB Policies),
subject to certain limitations. These guarantees were provided for the benefit
of EIB and are made up of transportation and public building risk with an
average rating of BBB, written between 2001 and 2006 with anticipated maturities
ranging between 2027 and 2038. As at September 30, 2008, the Companys
exposures relating to the EIB Policies (which relate to project finance transactions)
was approximately $1.0 billion reduced from $1.1 billion at June 30, 2008
mainly due to the strengthening of the U.S. dollar against the currencies
of the underlying obligations. As of September 30, 2008, there have been
no reported events of default on the underlying obligations, accordingly,
no reserves have been recorded. The terms of the Master Agreement were determined in consideration of a number of commercial and economic factors associated with all existing relationships with Syncora, including, but not limited to, a valuation of the consideration for the commuted agreements and any potential future claims
thereunder and the impact of outstanding uncertainty on both the ratings and business operations of the Company. The total value of the consideration noted above of $1.775 billion as well as the eight million ordinary shares of the Company transferred to Syncora valued at $128.0 million, significantly
exceeded the carried net liabilities of approximately $490.7 million related to such reinsurances and guarantees. Management considers the execution of the Master Agreement as the event giving rise to the additional liability. As detailed in the table below, the Company recorded a loss of approximately
$1.4 billion in respect of the closing of the Master Agreement during the three month period ended September 30, 2008:
(U.S. dollars in millions) Carried liabilities in relation to reinsurance and guarantee agreements commuted under the Master Agreement as at June 30, 2008
$
490.7 Other accruals
(5.2
) Cash payment made to Syncora in August 2008
(1,775.0
) Value of XL common shares transferred under the Master Agreement
(128.0
) Net loss associated with Master Agreement recorded in the three months ended September 30, 2008
$
(1,417.5
) 5. Restructuring and Asset Impairment Charges Given the softening property and casualty market conditions, the Company implemented in the third quarter of 2008, an expense reduction initiative designed to reduce the Companys operating expenses. The goal of this initiative was to achieve enhanced efficiency and an overall reduction in
operating expenses by streamlining processes across all geographic locations, with a primary emphasis on corporate functions. To date, this has been achieved through redundancies, increased outsourcing and the cessation of certain projects and activities. Charges have been recognized and accrued as
restructuring and asset impairment charges and allocated to the Companys reportable segments in accordance with FAS 146, Accounting for Costs Associated with Exit or Disposal Activities and FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Other costs that do not meet
the criteria for accrual are being expensed as restructuring charges as they are incurred. In relation to this initiative, the Company recorded restructuring and asset impairment charges totaling $41.7 million during the three months ended September 30, 2008 and expects to record further charges of
approximately $12.0 million through to the expected completion date of 25
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 5. Restructuring and Asset Impairment Charges (continued) the activities under the expense reduction initiative in the second quarter of 2009. Restructuring charges relate mainly to employee termination benefits as well as costs associated with ceasing to use certain leased property accounted for as operating leases. Asset impairment charges relate primarily to the
write-off of certain IT system and equipment costs previously capitalized. The Company recognizes an asset impairment charge when net proceeds expected from disposition of an asset are less than the carrying value of the asset and reduces the carrying amount of the asset to its estimated fair value.
Restructuring and asset impairment charges noted above have been recorded in the Companys income statement under Operating Expenses. Costs incurred through September 30, 2008 and total estimated costs the Company expects to incur in connection with the restructuring and asset impairment are as follows:
(U.S. dollars in millions)
Total
Costs Employee Termination Benefits
$
46.2
$
36.9 Lease Termination and Other Costs
4.5
4.4 Asset Impairment Charges
3.0
0.4 Total
$
53.7
$
41.7 These costs are allocated to the Companys segments as follows:
(U.S. dollars in millions)
Total
Costs Insurance (1)
$
29.1
$
24.2 Reinsurance (1)
4.1
3.1 Other Financial Lines
0.5
0.5 Corporate
20.0
13.9 Total
$
53.7
$
41.7
(1)
Includes allocated restructuring charges associated with eliminating the XL Financial Solutions business unit.
Activity related to restructuring and asset impairment charges for the three month period ended September 30, 2008 was as follows:
(U.S. dollars in millions)
Accrual at
Costs
Amounts Paid and
Balance of Liability Employee Termination Benefits
$
$
36.9
$
27.1
$
9.8 Lease Termination and Other Costs
4.4
4.4
Asset Impairment
0.4
0.4
Total
$
$
41.7
$
31.9
$
9.8 26
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Expected
Costs
Incurred
through
September
30, 2008
Expected
Costs
Incurred
through
September
30, 2008
June 30, 2008
Incurred
Assets Impaired
at September 30,
2008
XL CAPITAL LTD 6. Segment Information 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 Companys Insurance and Reinsurance segments are
sometimes collectively referred to as property and casualty or P&C operations. 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 Companys 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. 27
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 6. Segment Information (continued) Three months ended September 30, 2008:
Insurance
Reinsurance
Total P&C
Life
Other
Total Gross premiums written
$
1,213,991
$
685,984
$
1,899,975
$
156,148
$
$
2,056,123 Net premiums written
839,788
418,126
1,257,914
145,741
1,403,655 Net premiums earned
1,041,740
483,283
1,525,023
169,608
1,694,631 Fee income and other
11,451
7,606
19,057
75
19,132 Net losses and loss expenses
830,789
378,776
1,209,565
199,861
1,409,426 Acquisition costs
112,175
79,205
191,380
25,499
216,879 Operating expenses (1)
181,478
51,423
232,901
7,864
240,765 Underwriting (loss) profit
$
(71,251
)
$
(18,515
)
$
(89,766
)
$
(63,541
)
$
$
(153,307
) Exchange (gains) losses
(67,948
)
(73,030
)
(140,978
)
1,511
(139,467
) Net investment income
293,109
102,636
395,745 Net results from structured products (2)
(14,591
)
7,699
(6,892
)
3,694
(3,198
) Contribution from P&C, Life Operations, Other Financial Lines
$
337,429
$
37,584
$
3,694
$
378,707 Corporate & other: Net realized & unrealized (losses) on investment & derivative instruments (3)
(351,357
) Net (loss) from investment fund and operating affiliates (4)
(1,459,185
) Corporate operating expenses
61,656 Extinguishment of debt (5)
22,527 Interest expense (6)
51,277 Income taxes & other
49,229 Net (loss)
$
(1,616,524
) RatiosP&C operations: (7) Loss and loss expense ratio
79.8
%
78.4
%
79.3
% Underwriting expense ratio
28.1
%
27.0
%
27.8
% Combined ratio
107.9
%
105.4
%
107.1
%
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 $27.4 million, $19.3 million, and $15.0 million, respectively. (3) This includes net realized losses on investments of $292.9 million and net realized and unrealized losses on investment and other derivatives of $58.5 million, but does not include unrealized losses on investments for which the decline was considered temporary, which are included in accumulated other comprehensive (loss) income. (4) Net loss from investment fund and operating affiliates for the three months ended September 30, 2008 included losses totaling approximately $1.4 billion related to the closing of the Master Agreement. (5) Represents debt extinguishment costs associated with the early redemption of the 6.58% Notes. (6) Interest expense excludes interest expense related to deposit liabilities recorded in the Insurance, Reinsurance, and Other Financial Lines segments. (7) Ratios are based on net premiums earned from property and casualty operations. The underwriting expense ratio excludes exchange gains and losses. (8) The net results from Other Financial Lines include net investment income, interest expense and operating expenses of $13.1 million, $7.4 million, and $2.0 million, respectively. 28
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands, except ratios)
(Unaudited)
Operations
Financial
Lines (8)
XL CAPITAL LTD 6. Segment Information (continued) Three months ended September 30, 2007:
Insurance
Reinsurance
Total P&C
Life
Other
Total Gross premiums written
$
1,169,435
$
624,303
$
1,793,738
$
140,694
$
$
1,934,432 Net premiums written
818,185
437,933
1,256,118
129,353
1,385,471 Net premiums earned
1,012,145
571,198
1,583,343
147,239
1,730,582 Fee income and other
3,195
380
3,575
78
3,653 Net losses and loss expenses
634,872
285,692
920,564
195,440
1,116,004 Acquisition costs
105,650
126,687
232,337
20,740
253,077 Operating expenses (1)
145,121
52,008
197,129
7,195
204,324 Underwriting profit (loss)
$
129,697
$
107,191
$
236,888
$
(76,058
)
$
$
160,830 Exchange losses (gains)
10,277
(33,467
)
(23,190
)
(3,014
)
(26,204
) Net investment income
325,543
100,005
425,548 Net results from structured products (2)
1,244
13,392
14,636
16,470
31,106 Contribution from P&C, Life Operations and Other Financial Lines
$
600,257
$
26,961
$
16,470
$
643,688 Corporate & other: Net realized & unrealized (losses) gains on investment & derivative instruments (3)
(218,370
) Net income from investment and operating affiliates (4)
111,354 Corporate operating expenses
56,872 Interest expense (5)
49,029 Minority interest
Income taxes & other
59,135 Net Income
$
371,636 Ratios P&C operations: (6) Loss and loss expense ratio
62.7
%
50.0
%
58.1
% Underwriting expense ratio
24.7
%
31.3
%
27.2
% Combined ratio
87.4
%
81.3
%
85.3
%
Notes:
(1)
Operating expenses exclude corporate operating expenses, shown separately. (2) For the three month period ended September 30, 2007, the net results from P&C structured products includes net investment income, interest expense and operating expenses of $35.1 million, $15.1 million, and $5.4 million, respectively. (3) This includes net realized losses on investments of $160.2 million and net realized and unrealized losses on investment and other derivatives of $58.2 million, but does not include unrealized appreciation or depreciation on investments, which are included in accumulated other comprehensive income (loss). (4) Net income from investment and operating affiliates included the equity earnings from the Companys investment in Syncora reported on a one quarter lag. (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 net results from Other Financial Lines include net investment income, interest expense and operating expenses of $107.3 million, $86.9 million, and $3.9 million, respectively. 29
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands, except ratios)
(Unaudited)
Operations
Financial
Lines (7)
XL CAPITAL LTD 6. Segment Information (continued) Nine months ended September 30, 2008:
Insurance
Reinsurance
Total P&C
Life
Other
Total Gross premiums written
$
4,231,111
$
2,155,989
$
6,387,100
$
552,357
$
$
6,939,457 Net premiums written
3,108,460
1,645,474
4,753,934
520,887
5,274,821 Net premiums earned
3,068,492
1,518,098
4,586,590
502,125
5,088,715 Fee income and other
31,104
8,840
39,944
275
40,219 Net losses and loss expenses
2,169,423
979,620
3,149,043
605,885
3,754,928 Acquisition costs
351,888
302,077
653,965
75,448
729,413 Operating expenses (1)
535,065
141,940
677,005
25,246
702,251 Underwriting profit (loss)
$
43,220
$
103,301
$
146,521
$
(204,179
)
$
$
(57,658
) Exchange (gains) losses
(8,746
)
(55,549
)
(64,295
)
509
(63,786
) Net investment income
899,278
297,829
1,197,107 Net results from structured products (2)
(11,418
)
21,102
9,684
17,620
27,304 Contribution from P&C, Life Operations, Other Financial Lines
$
1,119,778
$
93,141
$
17,620
$
1,230,539 Corporate & other: Net realized & unrealized (losses) on investment & derivative instruments (3)
(398,762
) Net (loss) from investment fund and operating affiliates (4)
(1,516,169
) Corporate operating expenses
144,686 Extinguishment of debt (5)
22,527 Interest expense (6)
150,719 Income taxes & other
131,976 Net (loss)
$
(1,134,300
) Ratios P&C operations: (7) Loss and loss expense ratio
70.7
%
64.5
%
68.7
% Underwriting expense ratio
28.9
%
29.3
%
29.0
% Combined ratio
99.6
%
93.8
%
97.7
%
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 $86.6 million, $50.7 million, and $26.2 million, respectively. (3) This includes net realized losses on investments of $393.1 million, net realized and unrealized losses on investment and other derivatives of $5.7 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 loss from investment fund and operating affiliates for the nine months ended September 30, 2008 included losses totaling approximately $1.4 billion related to the closing of the Master Agreement as well as losses recorded throughout 2008 and up until the closing of the Master Agreement that were associated with previous reinsurance and guarantee agreements with
Syncora. (5) Represents debt extinguishment costs associated with the early redemption of the 6.58% Notes. (6) Interest expense excludes interest expense related to deposit liabilities recorded in the Insurance, Reinsurance, and Other Financial Lines segments. (7) Ratios are based on net premiums earned from property and casualty operations. The underwriting expense ratio excludes exchange gains and losses. (8) The net results from Other Financial Lines include net investment income, interest expense and operating expenses of $92.2 million, $66.2 million, and $8.4 million, respectively. While not reported within the contribution from the Other Financial Lines segment, it should be noted that approximately $73.4 million of the reported realized losses on investments during the nine
months ended September 30, 2008, primarily as a result of other-than-temporary impairments, related to portfolios associated with funding agreements and GICs. 30
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands, except ratios)
(Unaudited)
Operations
Financial
Lines (8)
XL CAPITAL LTD 6. Segment Information (continued)
Nine months ended September 30, 2007:
Insurance
Reinsurance
Total P&C
Life
Other
Syncora
Total Gross premiums written
$
4,166,709
$
2,525,507
$
6,692,216
$
588,930
$
$
156,983
$
7,438,129 Net premiums written
3,168,942
1,989,716
5,158,658
556,778
130,445
5,845,881 Net premiums earned
3,116,195
1,715,968
4,832,163
534,086
85,682
5,451,931 Fee income and other
10,480
869
11,349
227
63
11,639 Net losses and loss expenses
1,941,559
914,313
2,855,872
662,883
1,427
3,520,182 Acquisition costs
361,804
377,871
739,675
64,622
6,752
811,049 Operating expenses (1)
474,558
144,078
618,636
25,867
43,546
688,049 Underwriting profit (loss)
$
348,754
$
280,575
$
629,329
$
(219,059
)
$
$
34,020
$
444,290 Exchange losses (gains)
25,429
(514
)
24,915
(4,989
)
39
19,965 Net investment income
962,721
288,788
48,468
1,299,977 Net results from structured products (2)
3,038
28,802
31,840
32,422
(61
)
64,201 Contribution from P&C, Life Operations, Other Financial Lines and Syncora
$
1,598,975
$
74,718
$
32,422
$
82,388
$
1,788,503 Corporate & other: Net realized & unrealized (losses) gains on investment & derivative
(20,482
)
(173,853
) Net income from investment and operating affiliates (4)
396,054 Corporate operating expenses
144,875 Interest expense (5)
159,059 Minority interest
23,994
23,994 Income taxes & other
73
194,018 Net Income
$
37,839
$
1,488,758 Ratios P&C operations: (6) Loss and loss expense ratio
62.3
%
53.3
%
59.1
% Underwriting expense ratio
26.8
%
30.4
%
28.1
% Combined ratio
89.1
%
83.7
%
87.2
% Notes:
(1)
Operating expenses exclude corporate operating expenses, shown separately. (2) For the nine month period ended September 30, 2007, the net results from P&C structured products includes net investment income, interest expense and operating expenses of $98.5 million, $52.1 million, and $14.6 million, respectively. (3) This includes net realized losses on investments of $132.6 million and net realized and unrealized losses on investment and other derivatives of $41.2 million, but does not include unrealized appreciation or depreciation on investments, which are included in accumulated other comprehensive income (loss). (4) Earnings from the Companys investment in Syncora were recorded as net income from operating affiliates following the secondary sale of shares on June 6, 2007. (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 net results from Other Financial Lines include net investment income, interest expense and operating expenses of $289.8 million, $247.3 million, and $10.1 million, respectively. (8) Net income from Syncora represented consolidated earnings for the period from January 1, 2007 through to June 6, 2007, and prior to a secondary offering of Syncoras common shares owned by the Company, which had the effect of reducing its ownership of Syncoras outstanding common shares from approximately 63% to approximately 46%. Subsequent to June 6, 2007,
the Company accounted for its remaining investment in Syncora using the equity method of accounting. 31
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands)
(Unaudited)
Operations
Financial
Lines (7)
(8)
instruments (3)
XL CAPITAL LTD 6. Segment Information (continued) The following tables summarize the Companys net premiums earned by line of business: Three months ended September 30, 2008:
Insurance
Reinsurance
Life
Total P&C Operations: Casualty professional lines
$
340,087
$
64,157
$
$
404,244 Casualty other lines
220,503
105,936
326,439 Property catastrophe
161
72,478
72,639 Other property
131,315
149,233
280,548 Marine, energy, aviation and satellite
157,909
34,849
192,758 Other specialty lines (1)
167,413
167,413 Other (2)
7,175
54,214
61,389 Structured indemnity
17,177
2,416
19,593 Total P&C Operations
$
1,041,740
$
483,283
$
$
1,525,023 Life Operations: Other Life
$
$
$
129,943
$
129,943 Annuity
39,665
39,665 Total Life Operations
$
$
$
169,608
$
169,608 Total
$
1,041,740
$
483,283
$
169,608
$
1,694,631 Three months ended September 30, 2007:
Insurance
Reinsurance
Life
Total P&C Operations: Casualty professional lines
$
354,622
$
66,140
$
$
420,762 Casualty other lines
186,190
139,224
325,414 Property catastrophe
17,075
70,396
87,471 Other property
139,055
205,967
345,022 Marine, energy, aviation and satellite
141,262
35,110
176,372 Other specialty lines (1)
151,852
151,852 Other (2)
5,037
51,476
56,513 Structured indemnity
17,052
2,885
19,937 Total P&C Operations
$
1,012,145
$
571,198
$
$
1,583,343 Life Operations: Other Life
$
$
$
98,892
$
98,892 Annuity
48,347
48,347 Total Life Operations
$
$
$
147,239
$
147,239 Total
$
1,012,145
$
571,198
$
147,239
$
1,730,582
(1)
Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, specie, middle markets and excess and surplus lines. (2) Other includes credit and surety, whole account contracts and other lines. 32
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. Segment Information (continued) Nine months ended September 30, 2008:
Insurance
Reinsurance
Life
Total P&C Operations: Casualty professional lines
$
1,028,254
$
194,593
$
$
1,222,847 Casualty other lines
645,873
328,581
974,454 Property catastrophe
268
243,988
244,256 Other property
390,081
491,607
881,688 Marine, energy, aviation and satellite
480,527
95,551
576,078 Other specialty lines (1)
492,337
492,337 Other (2)
(20,184
)
159,129
138,945 Structured indemnity
51,336
4,649
55,985 Total P&C Operations
$
3,068,492
$
1,518,098
$
$
4,586,590 Life Operations: Other Life
$
$
$
377,752
$
377,752 Annuity
124,373
124,373 Total Life Operations
$
$
$
502,125
$
502,125 Total
$
3,068,492
$
1,518,098
$
502,125
$
5,088,715 Nine months ended September 30, 2007:
Insurance
Reinsurance
Life
Syncora
Total P&C Operations: Casualty professional lines
$
1,078,366
$
199,926
$
$
$
1,278,292 Casualty other lines
610,551
457,652
1,068,203 Property catastrophe
48,054
202,756
250,810 Other property
397,602
553,998
951,600 Marine, energy, aviation and satellite
484,841
102,235
587,076 Other specialty lines (1)
431,733
431,733 Other (2)
27,314
175,773
203,087 Structured Indemnity
37,734
23,628
61,362 Total P&C Operations
$
3,116,195
$
1,715,968
$
$
$
4,832,163 Life operations: Other Life
$
$
$
305,257
$
$
305,257 Annuity
228,829
228,829 Total Life Operations
$
$
$
534,086
$
$
534,086 Syncora
$
$
$
$
85,682
$
85,682 Total
$
3,116,195
$
1,715,968
$
534,086
$
85,682
$
5,451,931
(1)
Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, specie, middle markets and excess and surplus lines. (2) Other includes credit and surety, whole account contracts and other lines. 33
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands)
(Unaudited)
Operations
(U.S. dollars in thousands)
(Unaudited)
Operations
XL CAPITAL LTD 7. Investments The cost (amortized cost for fixed maturities and short-term investments), fair value, gross unrealized gains and gross unrealized (losses) of the Companys investments at September 30, 2008 and December 31, 2007 were as follows: September 30, 2008:
Cost or
Gross
Gross
Fair Fixed maturities U.S. Government and Government agency
$
2,996,630
$
59,995
$
(19,388
)
$
3,037,237 Corporate
11,942,127
25,366
(1,679,533
)
10,287,960 Mortgage and asset-backed securities
10,903,639
48,931
(1,465,311
)
9,487,259 U.S. States and political subdivisions of the States
495,857
1,391
(23,021
)
474,227 Non-U.S. Sovereign Government
3,223,005
60,031
(68,241
)
3,214,795 Total fixed maturities
$
29,561,258
$
195,714
$
(3,255,494
)
$
26,501,478 Total short-term investments
$
1,647,249
$
8,513
$
(22,108
)
$
1,633,654 Total equity securities
$
479,767
$
51,287
$
(59,349
)
$
471,705 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 Individual security positions comprising the gross unrealized loss 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 the Companys ability and intent to hold the securities to recovery, among other factors included below. See also note 2(c) for further information on the factors considered by management. At September 30, 2008, management believed the Company had appropriate
available liquidity to support its ability to hold impaired securities to recovery. At September 30, 2008, there were $3,277.6 million of gross unrealized losses on fixed maturities and short-term investments, and $59.3 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 34
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 7. Investments (continued) September 30, 2008 and December 31, 2007, approximately 2.5% and 2.3%, respectively, of the Companys fixed income investment portfolio was invested in securities which were below investment grade or not rated. Approximately 5.3% of the unrealized losses in the Companys fixed income securities
portfolio at September 30, 2008 related to securities that were below investment grade or not rated. The information shown below about the gross unrealized losses on the Companys investments at September 30, 2008 concerns 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 declines. The following is an analysis of how long each category of those securities at September 30, 2008 had been in a continual unrealized loss position: September 30, 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
$
1,258,731
$
18,905
$
13,690
$
722 Corporate
4,694,794
471,765
5,042,760
1,222,055 Mortgage and asset-backed securities
4,186,003
420,799
3,711,573
1,044,512 U.S. States and political subdivisions of the States
322,196
16,831
41,185
6,190 Non-U.S. Sovereign Government
1,047,073
52,697
421,948
23,126 Total fixed maturities and short-term investments
$
11,508,797
$
980,997
$
9,231,156
$
2,296,605 Total equity securities
$
271,344
$
59,349
$
$
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
$
$
Factors considered in determining that additional other-than-temporary impairment charges were not warranted include managements consideration of current and near term liquidity needs and other available sources, 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. 35
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(U.S. dollars in thousands)
(Unaudited)
than 12 months
Value
Unrealized
Losses
Value
Unrealized
Losses
(U.S. dollars in thousands)
than 12 months
Value
Unrealized
Losses
Value
Unrealized
Losses
XL CAPITAL LTD 7. Investments (continued) Gross unrealized losses of $3.3 billion at September 30, 2008 can be attributed to the following significant drivers:
Gross unrealized losses of $0.9 billion related to the Companys Life Operations investment portfolio, which had a fair value of $6.0 billion as at September 30, 2008. Of this, $0.6 billion of gross unrealized losses related to $2.1 billion of exposures to corporate financials. At September 30, 2008,
this portfolio had average interest rate duration of 8.7 years, primarily denominated in U.K. Sterling and Euros. As a result of the long duration, significant gross losses have arisen as the fair values of these securities are more sensitive to prevailing government interest rates and credit spreads.
This portfolio has limited turnover as it is matched to corresponding long duration liabilities. A hypothetical parallel increase in both interest rates and credit spreads of 50 basis points, respectively, would increase the unrealized losses related to this portfolio at September 30, 2008 by
approximately $261.2 million and $204.2 million, respectively. Given the long term nature of this portfolio, and the level of credit spreads as at September 30, 2008 relative to historical averages within the U.K. and Euro-zone as well as the Companys liquidity needs at September 30, 2008, the
Company believes that these assets will continue to be held until such time as they mature, or credit spreads revert to levels more consistent with historical averages. The Company continues to explore strategic alternatives with respect to the Life Operations segment. The conclusion of such
consideration could impact the amount and timing of any impairment related to this portfolio. Gross unrealized losses of $0.9 billion related to the corporate holdings within the Companys non-life fixed maturity portfolios, which had a fair value of $6.3 billion as at September 30, 2008. The Company believes these impairments are a function of the currently elevated levels of corporate
credit spreads in the U.S. and globally, which spiked particularly during the month of September 2008, resulting in severely depressed level of valuations. The amount of these gross losses have proven very volatile as a result of the severe deterioration in credit spreads in recent months. For
example, the gross unrealized losses increased by approximately $350 million or 4.9% of amortized cost during the month of September 2008 alone, a period in which U.S. corporate credit spreads increased by approximately 150 basis points from what were already elevated levels, excluding the
impact of foreign currency movements and offset by the impact of interest rate declines. The Company believes that the gross unrealized losses are a reflection of a severe premium being charged by the market for credit, rather than fundamental deterioration in the debt service capabilities of the
issuers. Gross unrealized losses of $0.5 billion related to the Topical Asset portfolio (which consists of the Companys holdings of sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures), which had a fair value of $1.3 billion as at
September 30, 2008. The Company undertook a security level review of these securities and recognized charges to the extent it believed the intrinsic value of any security was below its amortized cost. The Company has recognized realized losses, consisting of charges for other-than-temporary
impairments and realized losses from sales, of approximately $0.5 billion since the beginning of 2007 and through September 30, 2008 on these asset classes. The Company purchased a number of these assets to support the previously written GIC and funding agreement contracts and has announced its intention to reduce its exposure to this asset class as part of its strategic portfolio realignment. The Company believes that based on market conditions
and liquidity needs at September 30, 2008, this reduction will 36
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 7. Investments (continued)
be realized through natural cash flows of the portfolio, and limited selective sales, rather than selling these assets into markets which continue to be illiquid and not reflective of the intrinsic value of these assets. The weighted average term-to-maturity of the sub-prime and Alt-A residential
holdings within this portfolio at September 30, 2008 were 3.3 years and 3.6 years respectively. The Company, based on current market conditions and liquidity needs, as well as its assessment of the holdings, believes it will continue to hold these securities until either maturity, or a return of
liquidity and valuations more reflective of intrinsic value of these holdings. Gross unrealized losses of $0.4 billion related to the non-life portfolio of Core CDO holdings (defined by the Company as investments in non-mortgage collateralized debt obligations), which consisted primarily of collateralized loan obligations and had a fair value of $0.8 billion as of
September 30, 2008. The Company undertook a security level review of these securities and recognized charges to the extent it believed the intrinsic value of the security was below the amortized cost. The Company believes that the level of impairment is primarily a function of historically wide
spreads in the CLO market during the period, driven by the high level of illiquidity in this market. The Company purchased a number of these assets to support the previously written GIC and Funding Agreement contracts and has announced its intention to reduce its exposure to this asset class
over time as a part of its strategic portfolio realignment. The Company, based on current market conditions, liquidity needs as well as its assessment of the holdings, believes it is likely that the Company will continue to hold these securities until either maturity, or a return of liquidity and
valuations more reflective of intrinsic value of these holdings, following which the Company intends to reduce its exposure to this asset class. The Company believes that the remaining balance of gross unrealized losses, including gross unrealized losses of $0.3 billion and $0.2 billion related to $2.3 billion and $0.7 billion of the non-life portfolios holdings in CMBS and Prime RMBS, respectively, was a reflection of a higher risk premium
being attached to both commercial and residential mortgage products, combined with general credit market conditions and the cumulative impact of interest rate movements. 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)
September 30, 2008
December 31, 2007
Amortized
Fair
Amortized
Fair Due after 1 through 5 years
$
6,530,562
$
6,152,643
$
5,980,146
$
5,946,528 Due after 5 through 10 years
5,791,162
5,409,254
6,559,877
6,536,884 Due after 10 years
6,335,895
5,452,322
6,811,805
6,630,501 Mortgage and asset-backed securities
10,903,639
9,487,259
14,881,988
14,493,877
$
29,561,258
$
26,501,478
$
34,233,816
$
33,607,790 The Company participates in a securities lending program operated by a third party banking institution, whereby certain assets are loaned out and for which the Company earns an incremental return. For securities on loan, the lending agent receives cash collateral generally worth 102 to 105% of the
loaned securities which must be returned to the borrower upon return of the securities and 37
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Cost
Value
Cost
Value
XL CAPITAL LTD 7. Investments (continued) which in the meantime is invested in a collateral pool managed by the banking institution. The collateral pool is subject to written investment guidelines with key objectives which includes safeguard of principal and adequate liquidity to meet anticipated needs with a maximum weighted average maturity
of ninety days. At September 30, 2008 and December 31, 2007, $290.3 million and $144.3 million, respectively, of securities included in investments available for sale were loaned to various counter parties through the securities lending program. The cash collateral received as at September 30, 2008 and
December 31, 2007 was $296.0 million and $146.6 million respectively. At September 30, 2008 and December 31, 2007, the value of the Companys share of the collateral pool held was $289.0 million and $146.2 million, respectively, in connection with these loans, and is included in cash and cash
equivalents, with a corresponding liability reflected in net payable for investments purchased. During the quarter ended September 30, 2008, the Company capped its maximum participation in the securities lending program at $300 million. 8. Share Capital Pursuant to the Companys shelf registration statement, the Company issued 143.8 million Class A ordinary shares in August 2008 at a price of $16.00 per share. The net proceeds from this issuance totaled approximately $2.2 billion. The proceeds were used to fund the payments described above in
relation to the Master Agreement as well as to redeem X.L. Americas $255 million 6.58% Guaranteed Notes as described below. In addition, proceeds were used for general corporate purposes and capital funding for certain of the Companys subsidiaries. In addition, as part of the Master Agreement, the Company issued 8,000,000 Class A ordinary shares, valued at $16.00 per share, to Syncora and its subsidiaries. The shares are subject to a registration rights agreement. In July 2008, the Board of Directors approved a reduction in the quarterly dividend payable on the Companys Class A Ordinary Shares to $0.19 per ordinary share beginning with the quarterly dividend paid in September 2008. Concurrent with the execution of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent capital facility entered into in July 2003, resulting in net proceeds to the Company of approximately $500 million in exchange for the issuance by the Company of
20,000,000 Series C Preference Ordinary Shares, par value U.S. $0.01 per share (the Series C Preference Shares). The liquidation preference of the Series C Preference Shares is $25 per share, plus accrued and unpaid dividends. The Company may redeem the Series C Preference Shares, in whole or in
part, on or after July 15, 2013, at a redemption price of $25 per share, plus accrued and unpaid dividends. The Company may, under certain circumstances, redeem the Series C Preference Shares before July 15, 2013 at specific redemption prices, plus accrued and unpaid dividends. These circumstances
include an amalgamation, consolidation or other similar transaction involving the Company in which the Series C Preference Shares are entitled to a class vote ($26 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Series C
Preference Shares ($25 per share redemption price). The Series C Preference Share may be redeemed by the holders after July 15, 2033. Until July 15, 2013, dividends on the Series C Preference Shares are payable semiannually on a cumulative basis, when, as and if declared by the Companys Board of
Directors, on January 15 and July 15 of each year at a fixed rate equal to 6.102% per annum on the liquidation preference. From and after July 15, 2013, dividends on the Series C Preference Shares are payable quarterly on a cumulative basis, when, as and if declared by the Companys Board of
Directors, on January 15, April 15, July 15 and October 15 of each year at a floating rate equal to three-month LIBOR plus 3.145% on the liquidation preference. The Series C Preference Shares have no stated maturity and are not subject to any sinking fund or mandatory redemption and are not
convertible into any of the Companys other securities. 38
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 8. Share Capital (continued) In connection with the exercise of the put option under the Companys Mangrove Bay contingent capital facility as described above, the Company reduced to nil the remaining liability which totaled $51.1 million, associated with the fair value of the remaining put option payments, and recorded a
corresponding credit to Additional paid in capital. 9. Notes Payable and Debt and Financing Arrangements Concurrent with the issuance of Class A ordinary shares as described above and pursuant to the Companys shelf registration statement, the Company, in August 2008, issued 23.0 million 10.75% Equity Security Units (the 10.75% Units) in a public offering in order to fund payments described
above in relation to the Master Agreement and remaining net proceeds were used for general corporate purposes. The Company received approximately $557.0 million in net proceeds from the sale of the 10.75% Units after deducting underwriting discounts. Each 10.75% Unit has a stated amount of $25
and consists of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Companys Class A Ordinary Shares on August 15, 2011 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due August 15, 2021
with a principal amount of $1,000. The senior notes are pledged by the holders to secure their obligations under the purchase contract. The number of shares issued under the purchase contract is contingently adjustable based on, among other things, the share price of the Company on the stock purchase date and the dividend rate of the Company. The Company will make quarterly payments at the annual rate of 2.50% and 8.25%
under the purchase contracts and senior notes, respectively. For all periods reported, the Company may defer the contract payments on the purchase contract, but not the senior notes, until the stock purchase date. In August 2011, the senior notes will be remarketed whereby the interest rate on the
senior notes will be reset in order to generate sufficient remarketing proceeds to satisfy the 10.75% Unit holders obligations under the purchase contracts. If the senior notes are not successfully remarketed, then the Company will exercise its rights as a secured party and may retain or dispose of the
senior notes to satisfy, in full, the 10.75% Unit holders obligations to purchase its ordinary shares under the purchase contracts. In connection with this transaction, $37.9 million, which is the estimated fair value of the purchase contract, was charged to Additional paid in capital and a corresponding liability was established. Of the $18.0 million total accrued costs associated with the issuance of the 10.75% Units, $14.7 million
was charged to Additional paid in capital with the remainder deferred and amortized over the term of the senior debt. The number of ordinary shares to be issued under each purchase contract depends on, among other things, the average market price of the ordinary shares on the settlement date. The maximum number of ordinary shares to be issued under the purchase contracts is approximately 35.9 million. The
Company accounts for the effect on the number of weighted average ordinary shares, assuming dilution, using the treasury stock method. The purchase contract component of the 10.75% Units will have no effect on the number of weighted average ordinary shares, assuming dilution, except when the
average market price of the Companys ordinary shares is above the threshold appreciation price of $18.88 per share. Because the average market price of the Companys ordinary shares during the period the 10.75% Units were outstanding was below this price, the shares issuable under the purchase
contracts were excluded from the computation of net income per ordinary share assuming dilution for the three and nine month periods ended September 30, 2008. As noted above, the Company utilized a portion of the net proceeds from the capital raising activities described above, to redeem, in August 2008, X.L. America, Inc.s $255 million 6.58% 39
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 9. Notes Payable and Debt and Financing Arrangements (continued) Guaranteed Senior Notes due April 2011 (the 6.58% Notes). In connection with the early redemption of the 6.58% Notes, the Company incurred debt extinguishment costs of approximately $22.5 million. 10. 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 Ltds
ability to obtain funds from its subsidiaries is subject to certain contractual restrictions, 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 approximately $5.3 billion as of December 31, 2007. However, it should be noted that in 2008, the Bermuda Monetary Authority issued the Bermuda Solvency Capital Requirement (BSCR), which is
effective for statutory filings for the year ending December 31, 2008. While the required statutory capital and surplus of the Companys
Bermuda-based operating subsidiaries are expected to increase under the BSCR,
those subsidiaries are expected to have excess capital and surplus under these
new requirements. 11. Related Party Transactions For detailed information regarding the Companys transactions and agreements with Syncora, see Note 4 to the Consolidated Financial Statements, Syncora Holdings Ltd. (Syncora). At September 30, 2008 and December 31, 2007, the Company owned minority stakes in ten and eleven independent investment management companies (Investment Manager Affiliates), respectively. These ownership stakes are part of the Companys investment 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 Companys 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 three and nine months ended September 30, 2008, these contracts resulted in reported net premiums of
$3.3 million and $46.4 million, net paid claims of $8.2 million and $23.1 million, and reported acquisition costs of $12.6 million and $30.4 million, respectively. During the three and nine months ended September 30, 2007, these contracts resulted in reported net premiums of $43.8 million and $100.7
million, net paid claims of $13.4 million and $29.7 million, and reported acquisition costs of $32.7 million and $52.9 million, respectively. 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 Companys financial condition, results of operations and cash flows. 40
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 12. Deposit Liabilities Deposit liabilities include funding agreements, reinsurance and insurance deposits and previously, GICs. 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 Syncora Guarantee. Based on the
terms and conditions of the underlying GICs, upon the downgrade of Syncora Guarantee below certain ratings levels, all or portions of outstanding principal balances on such GICs would come due. Throughout 2008, several rating agencies downgraded Syncora and its subsidiaries and as a result, the
Company settled, in the first nine months of 2008, all of the GIC liabilities. At September 30, 2008, the remaining balance of funding agreements, excluding accrued interest of $10.0 million, was $850.0 million, with settlements scheduled from late 2008 through to 2010. Management does not expect any significant impact on the Companys results of operations or liquidity as a
result of the maturity of these contracts. 41
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
XL CAPITAL LTD 13. Computation of Earnings per Ordinary Share and Ordinary Share Equivalent
(U.S. dollars and shares in thousands, except
(Unaudited)
(Unaudited)
2008
2007
2008
2007 Basic (loss) earnings per ordinary share and ordinary share equivalents: Net (loss) income
$
(1,616,524
)
$
371,636
$
(1,134,300
)
$
1,488,758 Less: preference share dividends
(32,500
)
(43,661
)
(65,000
)
(66,530
) Net (loss) income available to ordinary shareholders
$
(1,649,024
)
$
327,975
$
(1,199,300
)
$
1,422,228 Weighted average ordinary shares outstanding
270,844
178,788
208,437
178,886 Basic (loss) earnings per ordinary share & ordinary share equivalents outstanding
$
(6.09
)
$
1.83
$
(5.75
)
$
7.95 Diluted (loss) earnings per ordinary share and ordinary share equivalents: Net (loss) income
$
(1,616,524
)
$
371,636
$
(1,134,300
)
$
1,488,758 Less: preference share dividends
(32,500
)
(43,661
)
(65,000
)
(66,530
) Net (loss) income available to ordinary shareholders
$
(1,649,024
)
$
327,975
$
(1,199,300
)
$
1,422,228 Weighted average ordinary shares outstanding basic
270,844
178,788
208,437
178,886 Impact of share based compensation and certain conversion features (1)(2)
993
1,454 Weighted average ordinary shares outstanding diluted
270,844
179,781
208,437
180,340 Diluted (loss) earnings per ordinary share & ordinary share equivalents outstanding
$
(6.09
)
$
1.82
$
(5.75
)
$
7.89 Dividends per ordinary share
$
0.19
$
0.38
$
0.95
$
1.14
(1)
Net of shares repurchased under the treasury stock method. (2) For the nine months ended September 30, 2007, the impact of share based compensation and certain conversion features includes the application of the if converted method of accounting for the 6.5% Units for the period from the announcement of the Companys intent to participate in the remarketing of the 2009 Senior Notes until the settlement of the related share
purchase contracts. 42
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)
per share amounts)
Three Months Ended
September 30,
Nine Months Ended
September 30,
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The following is a discussion of the Companys financial condition and liquidity and results of operations. Certain aspects of the Companys business have loss experience characterized as low frequency and high severity. This may result in volatility in both the Companys and an individual segments
results of operations and financial condition. This Managements 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 Companys 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 Managements 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 Companys
Annual Report on Form 10-K for the year ended December 31, 2007. Executive Overview See Executive Overview in Item 7 of the Companys Form 10-K for the year ended December 31, 2007. Results of Operations The following table presents an analysis of the Companys net (loss) income available to ordinary shareholders and other financial measures (described below) for the three months ended September 30, 2008 and 2007: (U.S. dollars and shares in thousands, except per share amounts)
(Unaudited)
2008
2007 Net (loss) income available to ordinary shareholders
$
(1,649,024
)
$
327,975 (Loss) earnings per ordinary share and ordinary share equivalents basic
$
(6.09
)
$
1.83 (Loss) earnings per ordinary share and ordinary share equivalents diluted
$
(6.09
)
$
1.82 Weighted average number of ordinary shares and ordinary share equivalents basic
270,844
178,788 Weighted average number of ordinary shares and ordinary share equivalents diluted
270,844
179,781 43
Three Months Ended
September 30,
The following table presents an analysis of the Companys net (loss) income available to ordinary shareholders and other financial measures (described below) for the nine months ended September 30, 2008 and 2007: (U.S. dollars and shares in thousands, except per share amounts)
(Unaudited)
2008
2007 Net (loss) income available to ordinary shareholders
$
(1,199,300
)
$
1,422,228 (Loss) earnings per ordinary share and ordinary share equivalentsbasic
$
(5.75
)
$
7.95 (Loss) earnings per ordinary share and ordinary share equivalentsdiluted
$
(5.75
)
$
7.89 Weighted average number of ordinary shares and ordinary share equivalentsbasic
208,437
178,886 Weighted average number of ordinary shares and ordinary share equivalentsdiluted
208,437
180,340 The Companys net (loss) income and other financial measures as shown below for the three and nine months ended September 30, 2008 have been affected by, among other things, the following significant items: 1) Agreement with Syncora with Respect to Pre-IPO Guarantees and Reinsurance Agreements and Service Agreements On July 28, 2008, the Company announced that it and certain of its subsidiaries had entered into an agreement (the Master Agreement) with Syncora and certain of its subsidiaries (sometimes collectively referred to herein as Syncora) as well as certain counterparties to credit default swap
agreements (the Counterparties), in connection with the termination of certain reinsurance and other agreements. The transactions and termination of certain reinsurance and other agreements under the Master Agreement closed on August 5, 2008. For a description of the Master Agreement, see Note 4
to the Consolidated Financial Statements, Syncora Holdings Ltd. (Syncora). After the closing of the Master Agreement on August 5, 2008, approximately $64.6 billion of the Companys total net exposure (which was $65.7 billion as at June 30, 2008) under reinsurance agreements and guarantees with Syncora subsidiaries was eliminated. Pursuant to the terms of the Master
Agreement, Syncora is required to use commercially reasonable efforts to commute the agreements that are the subject of the Companys guarantee of Syncora Guarantees obligations under certain financial guarantees issued by Syncora Guarantee to the European Investment Bank (the EIB Policies),
subject to certain limitations. As at September 30, 2008, the Companys exposures relating to the EIB Policies (which relate to project finance transactions) was approximately $1.0 billion reduced from $1.1 billion at June 30, 2008 mainly due to the strengthening of the U.S. dollar against the currencies of
the underlying obligations. As of September 30, 2008, there have been no reported events of default on the underlying obligations, accordingly, no reserves have been recorded. The terms of the Master Agreement were determined in consideration of a number of commercial and economic factors associated with all existing relationships with Syncora, including, but not limited to, a valuation of the consideration for the commuted agreements and any potential future claims
thereunder and the impact of outstanding uncertainty on both the ratings and business operations of the Company. The total value of the consideration noted above of $1.775 billion as well as the eight million ordinary shares of the Company transferred to Syncora valued at $128.0 million, significantly
exceeded the carried net liabilities of approximately $490.7 million related to such reinsurances and guarantees. Management considers the execution of the Master Agreement as the event giving rise to the additional liability. As detailed in the table below, the Company 44
Nine Months Ended
September 30,
recorded a loss of approximately $1.4 billion in respect of the closing of the Master Agreement during the three month period ended September 30, 2008:
(U.S. dollars in millions) Carried liabilities in relation to reinsurance and guarantee agreements commuted under the Master Agreement as at June 30, 2008
$
490.7 Other accruals
(5.2
) Cash payment made to Syncora in August 2008
(1,775.0
) Value of XL common shares transferred under the Master Agreement
(128.0
) Net loss associated with Master Agreement recorded in the three months ended September 30, 2008
$
(1,417.5
) 2) The impact of Hurricanes Gustav and Ike On September 1, 2008, Hurricane Gustav hit the Louisiana coast of the U.S. as a Category 2 hurricane, causing considerable damage to insured property and loss of life. On September 13, 2008, Hurricane Ike made landfall near Galveston, Texas as a strong Category 2 hurricane, causing significantly
more damage and loss of life than Hurricane Gustav. Based on market estimates, Hurricane Ike is estimated to have caused the third largest ever insured loss in the U.S. from a wind storm. Combined, Hurricanes Gustav and Ike had a significant impact on the results of the Company for the three and nine month periods ended September 30, 2008. The Company has estimated losses incurred, net of reinsurance recoveries and reinstatement premiums, of $27.4 million and $194.4 million
related to Hurricanes Gustav and Ike, respectively, based on preliminary reports and estimates of loss and damage. The Company performed an analysis of contracts it believes are exposed to Hurricanes Gustav and Ike, and together with preliminary information received from insureds and cedants as well
as commmercially developed industry models, determined its current best estimate for the expected ultimate loss. Actual losses may vary from this estimate based on a number of factors, including receipt of additional information from insureds and brokers, the attribution of losses to coverages that had
not previously been considered as exposed and inflation in repair costs due to additional demand for labor and materials. 3) Impact of credit market movements on the Companys investment portfolio and investment fund affiliates In the first nine months of 2008, particularly in the first and third quarters, financial market conditions continued to be extremely challenging as the global credit crisis that began in July 2007 continued to adversely impact global markets. This unprecedented market volatility directly and materially
affected the Companys results of operations and investment portfolio during the quarter ended September 30, 2008. The fixed-income markets experienced a period of extreme volatility during such quarter, negatively impacting market liquidity conditions. As a result, the market for fixed-income
instruments experienced decreased liquidity, increased price volatility, credit downgrade events, and increased probability of default. Domestic and international equity markets also experienced heightened volatility and turmoil during this period. During
the first quarter of 2008, the Company reported significant decreases in
asset values in respect of the Companys holdings of sub-prime non-agency
securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A
mortgage exposures (Topical Assets). While credit spreads on
both corporate and structured credit rallied modestly in the second quarter
of 2008, during the third quarter of 2008 there was unprecedented widening
of corporate credit spreads particularly in the financial sector. While there
was some continued asset value deterioration in the Companys structured
credit portfolio, primarily in commercial mortgage-backed securities (CMBSs),
core collateralized debt obligations (CDOs) and Alt-As,
as well as moderate benefit from declining interest rates, the primary driver
of movements in the Companys invested asset values in the third 45
quarter of 2008 was corporate credit deterioration. Credit spreads across the entire rating spectrum and all spread asset classes widened significantly, following the bankruptcy of Lehman Brothers Holdings Inc. (Lehman) in September 2008 and the subsequent failure or near failure of other financial institutions. The following table provides further details regarding the extreme volatility in the global credit markets, as well as in government interest rates using some sample market indices:
Interest Rate Movement for the three months ended September 30, 2008 (1)
Credit Spread Movement for the three months ended September 30, 2008 (2)
United States
- 35 basis points (5 year treasury)
+ 199 basis points (US Corporate A rated)
United Kingdom
- 68 basis points (10 year Gilt)
+ 84 basis points (UK corporate, AA rated)
Euro-zone
- 87 basis points (5 year Bund)
+ 139 basis points (Europe Corporate, A rated)
Interest Rate Movement for the nine months ended September 30, 2008
Credit Spread Movement for the nine months ended September 30, 2008
United States
- 46 basis points (5 year treasury)
+ 274 basis points (US Corporate A rated)
United Kingdom
- 6 basis points (10 year Gilt)
+ 122 basis points (UK corporate, AA rated)
Euro-zone
- 35 basis points (5 year Bund)
+ 190 basis points (Europe Corporate, A rated)
(1)
Source: Bloomberg Finance L.P. (2) Source:
Merrill Lynch Global Index The net impact of the market conditions over the course of 2008 on the Companys investment portfolio for the first nine months of the year has resulted in realized losses of $393.1 million and an increase in net unrealized losses on available-for-sale investments of $2.6 billion. This represents
approximately a 9.3% deterioration on average assets for the nine months ended September 30, 2008. See Item 1A. Risk Factors Deterioration in the public debt and equity markets could lead to additional investment losses below. In addition, see We are exposed to significant capital markets risk
related to changes in interest rates, credit spreads, equity prices and foreign exchange rates which may adversely affect our results of operations, financial condition or cash flows in the Companys Quarterly Report on Form 10-Q for the quarter ended June 30, 2008. Since the time of the Companys
August 2008 public offering of ordinary shares and equity security units (See Capital Management below), the volatility and disruption in the global capital markets have reached unprecedented levels and substantially increased during the third quarter of 2008. Corporate credit portfolio The following table details the Companys corporate credit exposures by certain asset classes as well as ratings levels within the Companys fixed maturity portfolio and the current net unrealized (loss) position as at September 30, 2008:
(U.S. dollars in millions)
AAA
AA
A
BBB
BB & Below
Total Financials Fair value
$
750.3
$
1,809.0
$
2,179.9
$
374.3
$
113.1
$
5,226.6 Net unrealized gain (loss)
$
(36.3
)
$
(225.9
)
$
(597.7
)
$
(115.4
)
$
(28.3
)
$
(1,003.6
) Non-Financials Fair value
$
577.2
$
695.7
$
2,374.7
$
1,612.1
$
609.6
$
5,869.3 Net unrealized gain (loss)
$
(41.3
)
$
(63.4
)
$
(257.2
)
$
(186.9
)
$
(96.0
)
$
(644.8
) Total Fair value
$
1,327.5
$
2,504.7
$
4,554.6
$
1,986.4
$
722.7
$
11,095.9 Net unrealized gain (loss)
$
(77.6
)
$
(289.3
)
$
(854.9
)
$
(302.3
)
$
(124.3
)
$
(1,648.4
) 46
+ 11 basis points (US RMBS, AAA rated)
+ 181 basis points (US CMBS, AAA rated)
+ 43 basis points (US RMBS, AAA rated)
+ 285 basis points (US CMBS, AAA rated)
At September 30, 2008, approximately $2.2 billion of the Companys $5.2 billion in corporate financial sector securities was held in the portfolios supporting the Companys Life Reinsurance Operations. Management continues the strategic analysis of the Companys life reinsurance business, and it is
relevant that the assets associated with that business are more heavily weighted towards longer term debt from financial institutions, including Tier 1 and Tier 2 paper, with a fair value of $1.1 billion representing committed term debt and hybrid instruments senior to the common and preferred equity of
the financial institutions, and accounted for $574.2 million of the Companys net unrealized loss as at September 30, 2008. As at September 30, 2008 approximately 40% of the overall sensitivity to each of interest rate and credit risk was related to the life reinsurance portfolio, despite these portfolios
accounting for only 17% of total assets as of such date. Structured credit portfolio The following tables details the Companys structured credit exposures by certain asset classes as well as ratings levels within the Companys fixed maturity portfolio and the current net unrealized gain (loss) position as at September 30, 2008:
(U.S. dollars in millions)
AAA
AA
A
BBB
BB & Below
Total CMBS Fair value
$
2,342.6
$
9.2
$
22.3
$
18.4
$
17.2
$
2,409.7 Net unrealized gain (loss)
$
(264.5
)
$
(1.8
)
$
(4.4
)
$
(3.7
)
$
(5.1
)
$
(279.5
) Prime RMBS Fair value
$
2,925.1
$
61.9
$
62.3
$
23.9
$
19.5
$
3,092.7 Net unrealized gain (loss)
$
(165.2
)
$
(11.5
)
$
(8.6
)
$
(3.3
)
$
(0.8
)
$
(189.4
) Topical Assets Fair value
$
798.0
$
312.9
$
67.1
$
58.6
$
34.0
$
1,270.6 Net unrealized gain (loss)
$
(251.5
)
$
(113.4
)
$
(49.7
)
$
5.3
$
(21.2
)
$
(430.5
) Core CDO (1) Fair value
$
216.4
$
352.7
$
53.3
$
126.7
$
8.4
$
757.5 Net unrealized gain (loss)
$
(44.1
)
$
(177.4
)
$
(29.8
)
$
(122.9
)
$
(5.2
)
$
(379.4
)
Other Asset & Mortgage Backed Securities Fair value
$
1,437.3
$
165.1
$
306.9
$
73.0
$
32.7
$
2,015.0 Net unrealized gain (loss)
$
(46.1
)
$
(20.8
)
$
(50.0
)
$
(15.2
)
$
4.2
$
(127.9
) Total Fair value
$
7,719.4
$
901.8
$
511.9
$
300.6
$
111.8
$
9,545.5 Net unrealized gain (loss)
$
(771.4
)
$
(324.9
)
$
(142.5
)
$
(139.8
)
$
(28.1
)
$
(1,406.7
)
(1)
The Company defines Core CDOs as investments in non-mortgage collateralized debt obligations, primarily consisting of collateralized loan obligations.
The following table details the current exposures to Topical Assets within the Companys fixed income portfolio as well as the current net unrealized (loss) gain position as at September 30, 2008 and December 31, 2007: 47
(U.S. dollars in thousands)
As at
As at
Percent
Net
Holding at
Percent
Net
Holding at Topical Assets: Sub-prime first lien mortgages
$
659,378
2.0
%
$
(200,909
)
$
995,947
2.5
%
$
(145,785
) Alt-A mortgages
525,424
1.6
%
(227,424
)
924,783
2.3
%
(40,145
) Second lien mortgages (including sub-prime second lien mortgages)
71,129
0.2
%
3,281
97,647
0.3
%
788 ABS CDOs with sub-prime collateral
14,638
0.0
%
(5,324
)
39,317
0.1
%
101 Total exposure to Topical Assets
$
1,270,569
3.8
%
$
(430,376
)
$
2,057,694
5.2
%
$
(185,041
) Of the total Topical Assets with fair value exposure as at September 30, 2008 and December 31, 2007 of $1.3 billion and $2.0 billion, respectively, approximately $50.0 million and $76.8 million, respectively, of the related securities had ratings dependent on guarantees issued by third party guarantors
(i.e., monoline insurers). Decreases in the ratings of such third party guarantors would typically decrease the fair value of guaranteed securities; however, at September 30, 2008, in the event of non-performance at such date on the part of these third party guarantors, the Company estimated that the
average credit quality of this portfolio would be A and that approximately 95.6% would have remained investment grade at such date. In addition, of the total fixed income portfolio as at September 30, 2008 and December 31, 2007, of $33.4 billion and $39.1 billion, respectively, less than 2% were
guaranteed by such third parties with no individual third party representing more than 1%. At September 30, 2008, the Companys sub-prime and Alt-A exposures remained primarily highly rated, had strong underlying loan characteristics and the Company believed at such date that they were supported by adequate subordination levels based on current expectations of house price declines,
loss severities and default levels. The Company had approximately $159 million of Topical Assets downgraded during the quarter ended September 30, 2008 and approximately $427 million during the nine months ended September 30, 2008. Liquidations necessary to fund the repayment of the guaranteed investment contract (GIC) liabilities following the downgrade of Syncora Guarantee and the maturity of certain funding agreements were funded through sales of assets in the Other Financial Lines segment investment portfolios as
well as the general investment portfolio. Managements 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. Realized losses and other than temporary impairments During the three and nine month periods ended September 30, 2008, net realized losses of $252.6 million and $415.1 million, respectively, related to the write-down of certain of the Companys fixed income and equity investments, including securities of Lehman, where the Company determined that
there was an other than temporary decline in the value of those investments. Managements analysis of the remaining securities in unrealized loss positions at September 30, 2008 indicated that these assets will ultimately pay out all expected cash flows and that the Company had at such date the intent
and the ability to hold them until recovery. Included in the impairment charge for the third quarter ended September 30, 2008, was approximately $117 million of related exposures to financial institutions, primarily related to Lehman. The remaining third quarter impairment was spread across the portfolio including structured credit, equity and
other fixed income investments, with $67.9 million related to securities 48
September 30, 2008
December 31, 2007
of Fixed
Income
Portfolio
Unrealized
(Loss) Gain
Fair Value
of Fixed
Income
Portfolio
Unrealized
(Loss) Gain
Fair Value
with sub-prime and Alt- A collateral. Consistent with prior quarters, management continues to evaluate the impairment
of the portfolio and satisfy itself that the conclusions are appropriate. The following table provides the earnings and comprehensive earnings impact related to the Topical Assets in the three and nine months ended September 30, 2008: (U.S. dollars in thousands)
Three Months Ended
Nine Months Ended
Realized
Change
Realized
Change Topical Assets: Sub-prime first lien mortgages
$
(27,129
)
$
11,460
$
(43,018
)
$
(55,124
) Alt-A mortgages.
(35,552
)
(52,919
)
(64,238
)
(187,279
) Second lien mortgages (including sub-prime second lien mortgages)
(1,921
)
10,842
(25,352
)
2,493 ABS CDOs with sub-prime collateral
(2,319
)
(467
)
(9,000
)
(5,425
) Total
$
(66,921
)
$
(31,084
)
$
(141,608
)
$
(245,335
) All portfolio holdings, including those with sub-prime exposure, are reviewed as part of the ongoing other than temporary impairment monitoring process. The Company continues to actively monitor its exposures, and to the extent market disruptions continue, including but not limited to disruptions
in the residential mortgage market and the related impacts on the assumptions embedded in the Companys impairment assessments and estimates of future cash flows, the Companys financial position could be negatively impacted. See Item 1A. Risk Factors Deterioration in the public debt and equity
markets could lead to additional investment losses below. Alternative investment portfolio Net income from investment fund affiliates was negative in the first nine months of 2008 as the markets were particularly challenging for strategies employed by the Companys alternative investment managers given the extreme volatility and overall pull back of credit availability. The Companys
alternative investments are managed to maximize total-return on a risk-adjusted basis, and the results over the first nine months of 2007 as compared to the first nine months of 2008 were reflective of different market conditions and opportunities available over these periods. Preliminary
estimates indicate that the Companys returns from its alternative investment
portfolio for the month of September 2008, which will be reflected in the
results for the fourth quarter of 2008, are at the low end of industry loss
estimates which saw declines in the range of 5% to 8% for the month. Conditions
in October 2008 continued to be challenging for alternative investment strategies. 4) Continuing competitive underwriting environment Certain Recent Impacts on the Companys P&C Operations Since September 30, 2008, unprecedented economic conditions continued to impact the Company. These conditions, combined with the recent volatility in the Companys share price, rating agency actions with respect to the Company and issues faced by some of the Companys competitors, have
created challenges as well as certain opportunities for the Companys P&C operations. Insurance The Companys insurance segment continues to experience soft property and casualty market conditions as premium rates across most lines of business decreased by approximately 7% in the aggregate and competitive pressures continued. Overall, throughout the first nine months of 2008, 49
September 30, 2008
September 30, 2008
(Loss) and
(Impairments)
in Net
Unrealized
(Loss)
(Loss) and
(Impairments)
in Net
Unrealized
(Loss)
property renewals reflected decreases in premium rates of approximately 12% on average, while certain casualty lines experienced premium rate reductions averaging approximately 10%. In addition, premium rates within certain specialty lines of business decreased by up to 5%. Offsetting these premium
rate decreases was strong pricing in the U.S. professional D&O book of business, specifically with regards to financial institutions, and more recently on the offshore energy book as a result of the September 2008 hurricane losses. New business writings have been impacted by market conditions as competitors continue to focus on retaining business in all lines and markets. However, through September 30, 2008, the Company wrote approximately $725 million in new business (excluding program business and long-term
agreements). This was largely as a result of successes in the Companys organic growth strategies which include E&S, private D&O as well as construction and upper middle market. Renewal ratios for core property, casualty and professional lines ranged from approximately 81% to 86%. The following table provides an analysis of gross premiums written, net premiums written and net premiums earned for the Insurance segment for the nine month periods ended September 30, 2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
(Unaudited)
Gross
Net
Net
Gross
Net
Net Casualty professional lines
$
1,076,150
$
981,802
$
1,028,254
$
1,134,326
$
1,031,880
$
1,078,366 Casualty other lines
1,076,292
671,775
645,873
1,078,947
679,672
610,551 Property catastrophe
(72
)
(2,177
)
268
15,358
(6,167
)
48,054 Other property
765,042
411,413
390,081
630,361
410,627
397,602 Marine, energy, aviation, and satellite
594,577
472,630
480,527
602,690
450,061
484,841 Other specialty lines (1)
645,832
544,907
492,337
632,339
535,962
431,733 Other (2)
18,482
(23,894
)
(20,184
)
27,174
23,320
27,314 Structured indemnity
54,808
52,004
51,336
45,514
43,587
37,734 Total
$
4,231,111
$
3,108,460
$
3,068,492
$
4,166,709
$
3,168,942
$
3,116,195
(1)
Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, specie, middle markets and excess and surplus lines. (2) Other
includes credit and surety and other lines. Reinsurance In the Reinsurance segment, the first nine months of 2008 reflected a decline in premium rates across most major lines of business, as market conditions continued to soften and the reinsurance industry continued to experience pricing erosion, increased competitive pressures and increased retentions
by cedants. Renewals and new business in 2008 continued to be assessed against internal hurdle rates with a continued focus on underwriting discipline. U.S. and non-U.S. catastrophe exposed property lines experienced rate declines of approximately 10% while other property lines of business saw rates
decrease by 10% to 15%. Ocean marine pricing rates remained flat to down 5%, while rates within the aviation market decreased by up to 10%. Casualty pricing trends in the reinsurance market experienced deterioration in rates of up to 15%, however, rate changes on business actually bound in this
line of business decreased between 10 to 15%. It should be noted, however, that with increased hurricane and other loss activity during the third quarter of 2008, taken together with the distressed state of the financial markets, rate declines across all lines of business began to slow in September. The following table provides an analysis of gross premiums written, net premiums written and net premiums earned for the Reinsurance segment for the nine month periods ended September 30, 2008 and 2007: 50
Nine Months Ended
September 30, 2008
Nine Months Ended
September 30, 2007
Premiums
Written
Premiums
Written
Premiums
Earned
Premiums
Written
Premiums
Written
Premiums
Earned
(U.S. dollars in thousands)
(Unaudited)
(Unaudited)
Gross
Net
Net
Gross
Net
Net Casualty professional lines
$
205,409
$
205,388
$
194,593
$
237,630
$
241,712
$
199,926 Casualty other lines
317,083
308,310
328,581
483,698
465,452
457,652 Property catastrophe
390,943
275,948
243,988
465,157
267,379
202,756 Other property
878,114
527,322
491,607
938,753
663,224
553,998 Marine, energy, aviation, and satellite
105,984
99,467
95,551
133,789
120,987
102,235 Other (1)
220,827
191,410
159,129
238,219
202,701
175,773 Structured Indemnity
37,629
37,629
4,649
28,261
28,261
23,628 Total
$
2,155,989
$
1,645,474
$
1,518,098
$
2,525,507
$
1,989,716
$
1,715,968
(1)
Other includes credit and surety, whole account contracts and other lines.
5) Favorable prior year reserve development During the three and nine month periods ended September 30, 2008, the Company had net favorable prior year reserve development in its property and casualty operations of $92.8 million and $342.4 million, respectively, compared to net favorable prior year reserve development of $144.0 million
and $332.8 million, respectively, for the same periods in 2007. For the three months ended September 30, 2008, Reinsurance segment favorable development accounted for $87.7 million of the total release, while favorable development within the Insurance segment totaled $5.1 million for the same period. The Reinsurance segment released reserves in property
and other short-tail lines of business of $26.4 million and $61.3 million in casualty and other lines. The Insurance segment had favorable development of $11.4 million in property lines of business and was partially offset by net adverse development of $3.9 million in casualty and professional lines, and net
adverse development of $2.4 million in specialty and other lines, including structured indemnity. For the nine months ended September 30, 2008, Reinsurance segment favorable development accounted for $220.3 million of the total release, while favorable development within the Insurance segment totaled $122.1 million for the same period. The Reinsurance segment released reserves in property
and other short-tail lines of business of $98.1 million, $120.8 million in casualty and other lines and $1.4 million in structural indemnity lines. The Insurance segment reserve releases of $122.1 million consisted of favorable development of $75.9 million in property lines of business, $58.0 million in casualty
and professional lines, and was partially offset by net adverse development of $11.8 million in specialty and other lines, including structured indemnity. For further details see the segment results in the Statement of Income Analysis below. Financial Measures The following are some of the financial measures management considers important in evaluating the Companys operating performance:
(U.S. dollars and shares in thousands, except ratios and per share amounts)
(Unaudited)
2008
2007 Underwriting (loss) profit property and casualty operations
$
(89,766
)
$
236,888 Combined ratio property and casualty operations
107.1
%
85.3
% Net investment income property and casualty operations (1)
$
293,109
$
325,543 51
Nine Months Ended
September 30, 2008
Nine Months Ended
September 30, 2007
Premiums
Written
Premiums
Written
Premiums
Earned
Premiums
Written
Premiums
Written
Premiums
Earned
Three Months Ended
September 30,
(U.S. dollars and shares in thousands, except ratios and per share amounts)
(Unaudited)
2008
2007 Underwriting profit property and casualty operations
$
146,521
$
629,329 Combined ratio property and casualty operations
97.7
%
87.2
% Net investment income property and casualty operations (1)
$
899,278
$
962,721 Annualized return on average ordinary shareholders equity
NM
*
19.2
%
(Unaudited)
December 31, Book value per ordinary share
$
21.65
$
50.30 Fully diluted book value per ordinary share (2)
$
21.65
$
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. * NM Not Meaningful 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. The Companys underwriting loss in the three month period ended September 30, 2008 and profit in the nine month period ended September 30, 2008
were 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 Companys insurance and reinsurance operations. A combined ratio of less than 100% indicates an underwriting profit and greater than 100% reflects an underwriting loss. The Companys combined ratio for the three and nine months ended September 30, 2008, was higher than
the same periods in the previous year, primarily as a result of an increase in the loss and loss expense ratio as well as the underwriting expense ratio. The higher loss and loss expense ratio resulted from higher current year attritional and catastrophe losses, primarily in property lines, combined with lower
net premiums earned in the three and nine months ended September 30, 2008, as compared to the same periods in 2007, as a result of the continuing competitive underwriting environment and softening market conditions noted above. Partially offsetting the increase in incurred losses was higher favorable
prior year reserve development in the Reinsurance segment during the nine months ended September 30, 2008. While acquisition expenses have decreased during the three and nine months ended September 30, 2008 as compared to same periods in 2007, the increase in operating expenses combined with
the impact from the lower level of net premiums earned has caused an increase in the underwriting expense ratio. Net investment income property and casualty operations Net investment income related to property and casualty operations is an important measure that affects the Companys overall profitability. The largest liability of the Company relates to its unpaid loss reserves, and the Companys 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 52
Nine Months Ended
September 30,
September 30,
2008
2007
securities. Net investment income is influenced by a number of factors, including the average size of the investment portfolio, amounts and timing of inward and outward cash flows, the level of interest rates and credit spreads and changes in overall asset allocation. Net investment income related to
property and casualty operations, excluding structured products, decreased by $32.4 million and $63.4 million during the three and nine months ended September 30, 2008, respectively, as compared to same periods 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 overall during the last twelve months. The portfolio mix has also changed as a result of the settlement of the GIC
and funding agreement liabilities, as the property and casualty operations assumed a number of the floating rate securities previously held in the Companys Other Financial Lines segment. Book value per ordinary share Management also views the change in the Companys book value per ordinary share as an additional measure of the Companys 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 Companys 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 $28.65
in the first nine months of 2008 as compared to an increase of $3.33 in the first nine months of 2007. The decrease was primarily as a result of the Companys issuance of Class A ordinary shares issued at a discount to book value (as described below), the Companys net loss of $1.2 billion during the
nine month period ended September 30, 2008 and the increase in net unrealized losses on investments of approximately $2.6 billion, net of tax, during the same period. In addition, book value per ordinary share decreased as a result of unfavorable foreign currency translation adjustments of $220.0 million
during the first nine months of 2008. In August 2008, the Company issued 143.8 million Class A ordinary shares at a price of $16.00 per share, which was lower than the Companys book value per ordinary share at the time and thus dilutive. The Companys net loss of $1.2 billion was mainly due to the
impact of the closing of the Master Agreement in August 2008 as described above, as well as from net realized losses on investments during the nine months ended September 30, 2008. The increase in net unrealized losses on investments of $2.6 billion, net of tax, during the first nine months of 2008 was
mainly as a result of widening credit spreads on corporate and structured credit assets while unfavorable foreign currency translation adjustments during the same period resulted from the increase in value of the U.S. dollar against most major currencies including the Euro and U.K. Sterling. Annualized return on average ordinary shareholders equity Annualized return on average ordinary shareholders equity (ROE) is another financial measure that management considers important in evaluating the Companys 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 Companys 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
the first nine months of 2008, ROE was negative mainly as a result of the impact of the closing of the Master Agreement in August 2008 as described above, as well as from catastrophe losses and net realized losses on investments during the nine months ended September 30, 2008. In the first nine
months of 2007, ROE was 19.2% due to solid underwriting results throughout its property and casualty operations combined with strong investment fund affiliate income. The Company uses ROE (adjusted for certain items considered to be non-operating in nature) as a performance measure in its long-
term and annual incentive program. 53
Other Key Focuses of Management Concurrent with the Companys announcement relating to the execution of the Master Agreement in the third quarter of 2008, management highlighted its priorities for the Company going forward which included, among other things, simplifying the Companys business model to focus on core
property and casualty business and enhancing its enterprise risk management capabilities. Details relating to these initiatives are highlighted below. Simplify the Companys Business Model and Enhance Risk Management In relation to this top management priority, certain initiatives that have taken place or are underway include the following:
Focus on P&C Businesses: In order to support the Companys focus on its dual platform of Insurance and Reinsurance P&C businesses, the Company ceased certain operations that included the closure of the XLFS business unit and reassignment of responsibility for structured indemnity business to
either the insurance or reinsurance segment depending on the underlying nature of the transactions. In addition, the Company announced its intention to review strategic opportunities relating to its Life reinsurance business. Going forward, the Company will continue to focus on its core P&C
operations through leveraging its strong underwriting talent and maintaining underwriting discipline. Enterprise Risk Management: The Company is focused on enhancing its risk management capabilities throughout all facets of its operations. This initiative is led by the Companys newly hired Chief Enterprise Risk Officer (CERO) as noted below. The CERO is supported by, among others,
the Companys Enterprise Risk Management Committee (the ERM Committee) comprised of the most senior risk takers and managers of the Company. The ERM Committee will continue to assist with the efficient identification, assessment, monitoring, and reporting of key risks across the
Company. On September 15, 2008, Mr. Jacob D. Rosengarten joined the Company as Executive Vice President and Chief Enterprise Risk Officer. Mr. Rosengarten reports directly to the Companys Chief Executive Officer, Michael S. McGavick, and chairs the Companys ERM Committee. Simplify Investment Portfolio Over Time: In order to reposition the Companys investment portfolio to one that supports a P&C focused operation, the Company is repositioning the portfolio so that a) book value volatility arising from the portfolio is reduced, b) a reduction in lower rated fixed
income securities is achieved, c) exposure to securities issued by financial institutions and CMBS securities is reduced and d) a reduction in asset classes previously supporting Other Financial Lines activities is achieved. Realignment will be achieved primarily through cash generated from bond
maturities and coupon reinvestment and cash flow from business operations. Consistent with this strategy, management continued the process of reducing risk in the investment portfolio during the third quarter. Fannie Mae and Freddie Mac preferred positions were sold early in the quarter as well as securities of a number of regional banks. Most of this was accomplished
prior to the Lehman bankruptcy when credit markets became even more disrupted. In addition, management reduced the aggregate sub-prime, Alt A, CMBS and CDO portfolio holdings significantly, through natural cash flows and certain opportunistic sales, in particular in the CMBS portfolio,
as well as reducing the aggregate corporate portfolios. Management further reduced interest rate risk exposure by shortening the duration of the portfolio supporting the U.S. property and casualty operations by 0.3 years. Cash and government agency holdings were increased by approximately $2 billion to approximately $13 billion representing
approximately 37% of the fixed income portfolio at September 30, 2008. Reduction of Expenses to Reflect Simplified Business: In light of the changes in business strategy noted above and in response to expense pressure from softening market 54
conditions, the Company implemented in the third quarter of 2008, an expense reduction initiative designed to streamline certain of its processes and functions and reduce the Companys expense across all major geographic locations, with primary emphasis on corporate functions. In relation to
this initiative, the Company recorded restructuring charges totaling $41.7 million during the three months ended September 30, 2008 and expects to record further charges of approximately $12.0 million during the remainder of 2008 and early 2009. Restructuring charges relate mainly to employee
termination benefits as well as ceasing to use certain leased property.
Capital Management Fundamental to supporting the Companys business model is its ability to underwrite business, which is largely dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company is downgraded, its
ability to write business as well as its financial condition and/or results of operations, could be materially adversely affected. See Ratings below for further information regarding recent rating actions by the various rating agencies as well as details regarding the Companys financial strength and debt
ratings. In relation to the Companys capital position, several activities occurred throughout the third quarter, including the following:
In order to fund payments under the Master Agreement described above, in August 2008, the Company raised approximately $2.8 billion of additional capital through an issuance of both ordinary shares and equity security units (the ESUs). The ESUs consist of: (i) forward purchase contracts
to purchase, and the Company to issue, its ordinary shares and (ii) debt securities. For further details relating to the Master Agreement, see Note 4 to the Consolidated Financial Statements, Syncora Holdings Ltd. (Syncora) for further information. In addition to the payments to Syncora, the Company used the net proceeds from the offerings for general corporate purposes, and the redemption of X.L. America, Inc.s $255 million 6.58% Guaranteed Senior Notes due April 2011 and capital funding of certain of the Companys subsidiaries. Concurrent with the closing of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent capital facility entered into in July 2003 resulting in net proceeds to the Company of approximately $500.0 million in exchange for the issuance by the Company of
20,000,000 Series C Preference Ordinary Shares. See Capital Resources below for further details relating to the Series C Preference Ordinary Shares. In July 2008, the Board of Directors approved a reduction in the quarterly dividend payable on the Companys Class A Ordinary Shares to $0.19 per ordinary share beginning with the quarterly dividend paid in September 2008. Other capital management initiatives undertaken in 2008 included the following:
Upon expiration of the Companys quota share reinsurance treaty with Cyrus Reinsurance Ltd. (Cyrus Re) which reduced the Companys catastrophe exposures, the Company, effective January 1, 2008, 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 55
the business. The quota share reinsurance treaty also provides for a profit commission payable to the Company. In the second quarter of 2008, the Company purchased additional reinsurance including several tranches of industry loss warranty contracts attaching at various levels. In relation to catastrophe risk management, the Company considers the loss of capital due to a single large event and the loss of
capital that would occur from multiple (but potentially smaller) events in any given year. The Company imposes a limit to catastrophe risk from any single loss in a given region/peril at a 1% exceedance probability. The Company manages its limits to a catastrophe risk from a single loss in a
given peril/region at a 1% exceedance probability. Tier 1 limits which include natural catastrophes and other realistic disaster scenarios are targeted at a level not to exceed 10% of shareholders equity, where Tier 2 limits, which include pandemic, longevity and country risk, are established at no
more than half of Tier 1 limits. These target limits are established by a combination of commercially available models, internally developed Probable Maximum Loss estimates and the judgment of management. In addition to the above noted key priorities of the Company, other key focuses of management during the nine months ended September 30, 2008 have included the following: Operational Transformation Program The Company is committed to achieving competitive differentiation through the strategic alignment of initiatives that will deliver flexible and robust technology platforms to the Company and its customers. The focal point of this strategy is the development and enhancement of a reliable infrastructure
through initiatives that will improve operational efficiency, standardize processes and optimize costs. As such, in 2008, the Insurance segment began a multiple year operational transformation program that when completed, is expected to consolidate numerous business processes and technology systems into
a unified global architecture and ultimately result in enhanced product differentiation and business process standardization aligned with the segments growth strategy. Evaluation of the Impact of Credit Market Volatility on Core Underwriting Operations In addition to the evaluation of the impact of the distressed credit and sub prime markets on the Companys investment portfolio, as discussed above, management has also completed detailed assessments of the exposure to these credit related issues in the core P&C insurance and reinsurance
businesses, in particular the Insurance segment professional lines portfolio exposures through D&O and E&O policies. Actual policy notices as well as potential further notice activity that could arise from insureds that have been linked to sub-prime related matters are monitored on a monthly basis. Such
notice activity is considered in establishing loss and loss expense reserves at each quarter end. In the Insurance segment, the Company received 13 new policy notices during the three months ended September 30, 2008, two notices in July, four in August and seven in September. For 2007, 56% of gross
limits are side-A and for 2008, 47% are side-A. During the reserve review process in the first quarter of 2008, the loss ratio for the 2008 reporting year was established to provide a provision for clash-type events such as the sub-prime crisis was increased by approximately 5 points over the 2007 clash loss ratio. This increase applied to standard
professional lines including D&O, E&O and Fiduciary exposures where the sub-prime related notice activity has been concentrated. Notice activity during the second and third quarters of 2008 was in line with expectations and no further adjustment was made to the loss ratio established in the first quarter. Minor adjustments were made to the current year loss ratios and prior year reserves in the Reinsurance segment professional lines portfolio during the first nine months of 2008 reflecting updated claim activity. Such adjustments had less than a one point impact on the year-to-date loss ratio for the
segment and the reserve strengthening in more recent underwriting years was more than offset by favorable development on older underwriting years within professional lines. Global 56
credit events have also had an impact on the trade credit portfolio written in the European reinsurance operations and this is reflected in the second and third quarter 2008 loss ratios. Retention and Motivation The Company is focused on the performance and retention of its employees. As part of this effort, the Company granted to certain employees, options to purchase, in the aggregate, 2,831,000 ordinary shares under the Companys Amended and Restated 1991 Performance Incentive Program. The
grant date, August 11, 2008, was ten days following the date of pricing of the offering noted above. The exercise price of $19.62 was the closing sale price per share of the Companys ordinary shares on such date. Options granted to executive management on such date are subject to performance vesting. Establishment of Reinsurance Operations in Brazil In response to the liberalization of the Brazilian reinsurance market in mid-April 2008, the Companys Reinsurance segment made plans to establish both an admitted foreign reinsurer and a locally domiciled reinsurer. In June 2008, Brazils insurance regulatory body, SUSEP, granted regulatory
approval to the Companys admitted foreign reinsurer. Following regulatory approval of the Companys locally domiciled reinsurer, 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 Companys Critical Accounting Policies and Estimates in Item 7 of the Companys Annual Report on Form 10-K for the year ended December 31, 2007. Variable Interest Entities and Other Off-Balance Sheet Arrangements See the discussion of the Companys variable interest entities and other off-balance sheet arrangements in Item 7 of the Companys Annual Report on Form 10-K for the year ended December 31, 2007. Statement of Income Analysis Segment Results for the three months ended September 30, 2008 compared to the three months ended September 30, 2007 The Company is organized into four operating segments: Insurance, Reinsurance, Life Operations and Other Financial Linesin addition to a corporate segment that includes the general investment and financing operations of the Company. The Companys Insurance and Reinsurance segments are
sometimes collectively referred to as property and casualty or P&C operations. 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 Companys 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. 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, 57
certain structured indemnity products previously 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 Companys 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 Companys 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 Gross premiums written
$
1,213,991
$
1,169,435
3.8
% Net premiums written
839,788
818,185
2.6
% Net premiums earned
1,041,740
1,012,145
2.9
% Fee income and other
11,451
3,195
NM
* Net losses and loss expenses
830,789
634,872
30.9
% Acquisition costs
112,175
105,650
6.2
% Operating expenses
181,478
145,121
25.1
% Underwriting (loss) profit
$
(71,251
)
$
129,697
NM
* Exchange (gains) losses
$
(67,948
)
$
10,277
NM
* Net results structured products
$
(14,591
)
$
1,244
NM
*
*
NM Not Meaningful
Gross and net premiums written increased by 3.8% and 2.6%, respectively, during the three months ended September 30, 2008 compared with the three months ended September 30, 2007. Gross premiums written increased mainly as a result of growth in certain property and professional lines of
business and favorable foreign exchange rate impacts of $23.0 million. Growth in property lines was as a result of increased premiums associated with long-term agreements as well as new business written within the construction portfolio. Growth in professional lines related to new business opportunities
within the select book of business as well as improved retention ratios, higher rates and new business within the design book of business. Partially offsetting these increases was a reduction in premium rates across most lines of business as market conditions continued to soften and selective non-renewals.
Increases in net premiums written was as a result of the factors noted above impacting gross premiums written, partially offset by higher ceded premiums written mainly as a result of increased cessions associated with long-term agreements, reinstatement premiums relating to third quarter catastrophe and
other property loss events. See Continuing competitive underwriting environment above. Net premiums earned increased by 2.9% in the three months ended September 30, 2008 compared with the three months ended September 30, 2007. The increase resulted primarily from favorable movements in foreign exchange rates of $29.0 million and growth in the excess and surplus and marine
lines of business, partially offset by lower premiums in property and other specialty lines. Fee income increased in the third quarter of 2008 as compared to the third quarter of 2007 mainly as a result of higher engineering fee revenue associated with XL GAPS, which formed in late 2007 following the acquisition of GAPS, a loss prevention consulting service provider. 58
Three Months Ended
September 30,
The following table presents the ratios for this segment:
(Unaudited)
2008
2007 Loss and loss expense ratio
79.8
%
62.7
% Underwriting expense ratio
28.1
%
24.7
% Combined ratio
107.9
%
87.4
% 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 following table summarizes the net (favorable) adverse prior year development relating to
the Insurance segment for the three month periods ended September 30, 2008 and 2007: (U.S. dollars in millions)
(Unaudited)
2008
2007 Property
$
(11.4
)
$
(20.9
) Casualty and professional
3.9
(87.4
) Specialty and other
(2.6
)
47.6 Structured indemnity
5.0
Total
$
(5.1
)
$
(60.7
) Loss and loss expense ratio excluding prior year development
80.2
%
68.7
% Net prior year reserve releases for the quarter ended September 30, 2008 resulted primarily from favorable loss experience on certain large property loss case reserves with minor adjustments in other lines of business. Excluding prior year development, the loss ratio for the three months ended
September 30, 2008 increased by 11.5 loss percentage points as compared to the same period in 2007, with 5.8 loss ratio points attributed to an increase in catastrophe losses (i.e., 6.5 loss ratio points in the current quarter versus 0.7 loss ratio points in the third quarter of 2007), mainly as a result of the
impact of Hurricanes Ike and Gustav, both occurring in the third quarter of 2008. The remainder of the increase was mainly due to an increase in property loss activity and an increase in loss ratio on the D&O portfolio related to sub-prime exposures as well as a softening rate environment impacting most
lines of business. Net releases in casualty lines for the three months ended September 30, 2007 reflected favorable development in the 2002-2005 years partially offset by strengthening in years prior to 2002, while net favorable development in property lines represented a release of reserves related to
attritional losses. Within specialty and other lines, reserve strengthening within the marine book of business resulted from a detailed review in the current quarter of the marine excess liability portfolio which highlighted an increase in loss frequency across several recent years. The increase in the underwriting expense ratio in the three months ended September 30, 2008, compared to the same period in 2007 was due to an increase in both the operating and acquisition expense ratios of 3.0 points (17.3% as compared to 14.3%) and 0.4 points (10.8% as compared to 10.4%),
respectively. The increase in the operating expense ratio was mainly as a result of a decrease in the prior year to the fees/boards and bureaus accruals, higher compensation costs due to higher overall headcount, increases in professional fees, and costs associated with the Companys expense reduction
initiative. The increase in headcount and professional fees both supported new segment initiatives, including the Operational Transformation program, discussed above, as well as the formation of XL GAPS in late 2007. Costs related to the Companys expense reduction initiative were mainly due to
employee termination benefits. The acquisition expense ratio increased mainly due to a general increase in commissions and brokerage experienced in the marketplace, changes in the mix of business towards certain casualty lines which carried lower commission rates, combined with the impact in 2007
from an increase in ceded reinsurance profit commissions. 59
Three Months
Ended
September 30,
Three Months Ended
September 30,
Foreign exchange gains in the three months ended September 30, 2008 and losses in the three months ended September 30, 2007, were due primarily to the change in the value of the U.S. dollar against certain European currencies including the U.K. Sterling, the Euro and the Swiss Franc on certain
inter-company balances. Net results from structured insurance products include certain structured indemnity contracts that are accounted for as deposit contracts. In order to support the Companys focus on its dual platform of Insurance and Reinsurance P&C businesses, the Company ceased certain operations in the third
quarter of 2008 that included the closure of the XLFS business unit and reassignment of responsibility for structured indemnity business to either the Insurance or Reinsurance segment depending on the underlying nature of the transactions. Net results from these contracts for the three months ended
September 30, 2008, decreased compared to the same period in 2007 mainly due to lower net investment income recorded in 2008 combined with both higher interest expense and operating expenses. Net investment income decreased as a result of lower yields earned on investment income while interest
expense increased as a result of an accretion adjustment recorded in the third quarter of 2008 based on changes in expected cash flows on a structured indemnity contract. In addition, operating expenses increased mainly as a result of costs recorded in the third quarter of 2008 associated with employee
termination benefits relating to the closure of the XLFS business unit noted above. Reinsurance Reinsurance business written includes casualty, property, marine, aviation and other specialty reinsurance on a global basis. In addition, the results of previously written transactions structured by XLFS that were generally written on an aggregate stop loss or excess of loss basis are included within the
results of the Reinsurance segment. The Companys reinsurance property business generally has loss experience characterized as low frequency and high severity, which can have a negative impact on the Companys 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 Gross premiums written
$
685,984
$
624,303
9.9
% Net premiums written
418,126
437,933
(4.5
)% Net premiums earned
483,283
571,198
(15.4
)% Fee income and other
7,606
380
NM
* Net losses and loss expenses
378,776
285,692
32.6
% Acquisition costs
79,205
126,687
(37.5
)% Operating expenses.
51,423
52,008
(1.1
)% Underwriting (loss) profit.
$
(18,515
)
$
107,191
NM
* Exchange (gains)
$
(73,030
)
$
(33,467
)
118.2
% Net results structured products
$
7,699
$
13,392
(42.5
)%
*
NM Not Meaningful
Gross premiums written increased by 9.9% while net premiums written decreased by 4.5% in the third quarter of 2008 as compared to the third quarter in 2007. The favorable variance in gross premiums written was mainly due to increases of $75.0 million associated with a U.S. agricultural program
whose rates are tied to commodity prices, which have increased in 2008, and $16.5 million of reinstatement premiums related to losses from Hurricanes Gustav and Ike. Partially offsetting these increases were decreases relating to softening market conditions and the Company declining business due to the
continuing trend of certain market rates below the Companys acceptable 60
Three Months Ended
September 30,
underwriting return levels, together with increased client retentions. For the three months ended September 30, 2008, premium rate decreases were most significant in U.S. property and casualty lines of business. Decreases in net premiums written in the third quarter of 2008 as compared to same period in
2007 reflect the above noted increases in gross premiums written but were more than offset by an increase in ceded premiums written mainly due to higher cessions in 2008 as compared to 2007 associated with the U.S. agricultural program noted above. Partially offsetting the increase in ceded premiums
written were decreases in property catastrophe cessions to Cyrus Re II of 10% in 2008 as compared to a 35% cession to Cyrus Re throughout 2007. Net premiums earned in the third quarter of 2008 decreased 15.4% as compared to the third quarter of 2007. This decrease was a reflection of the overall reduction of net premiums written over the last 12 to 24 months. Fee income increased by $7.2 million during the three months ended September 30, 2008 as compared to the same period in 2007 mainly as a result of fees associated with capacity utilization with certain Lloyds syndicates. The following table presents the ratios for this segment:
(Unaudited)
2008
2007 Loss and loss expense ratio
78.4
%
50.0
% Underwriting expense ratio
27.0
%
31.3
% Combined ratio
105.4
%
81.3
% 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 reserves held at the beginning of the year. The following table summarizes the net (favorable) adverse prior year development relating to the Reinsurance
segment for the three month periods ended September 30, 2008 and 2007: (U.S. dollars in millions)
(Unaudited)
2008
2007 Property and other short-tail lines
$
(26.4
)
$
(45.1
) Casualty and other
(61.3
)
(37.9
) Structured indemnity
(0.3
) Total
$
(87.7
)
$
(83.3
) Loss and loss expense ratio excluding prior year development
96.5
%
64.6
% For the three months ended September 30, 2008, casualty and other lines net favorable development related primarily to the reinsurance-to-close (RITC) of the 2005 year of account for whole account business written with several Lloyds syndicates, while favorable development in property and
other short-tail lines were centered largely in property catastrophe and property other lines of business in the 2004 to 2007 years. Excluding prior year development, the loss ratio for the three months ended September 30, 2008 increased by 31.9 loss percentage points as compared to the same period in
2007 with 27.5 loss ratio points attributed to the impact of catastrophe losses occurring during the third quarter of 2008 (30.1 points), including Hurricanes Ike and Gustav, compared to the third quarter of 2007 (2.6 points). The remaining difference of 4.4 loss ratio points was due to the softening rate
environment and higher anticipated loss activity in the professional and trade credit portfolios. For the three months ended September 30, 2007, property and other short-tail lines reserve releases were primarily due to favorable attritional loss activity in both the property catastrophe and property risk
portfolios. Casualty reserve releases of $35.4 million related primarily to non-U.S. casualty business written through the Companys European and Bermuda operations and to a lesser extent the Companys U.S. casualty business. 61
Three Months Ended
September 30,
Three Months Ended
September 30,
The decrease in the underwriting expense ratio in the three months ended September 30, 2008, as compared with the three months ended September 30, 2007, was due to a decrease in the acquisition expense ratio of 5.8 points (16.4% compared to 22.2%) and partially offset by an increase in the
operating expense ratio of 1.5 points (10.6% compared to 9.1%). The decrease in the acquisition expense ratio was due primarily to a favorable variance in performance-related commissions recorded in the third quarter of 2008 as compared to the third quarter of 2007. Although operating expenses are
slightly lower in the three months ended September 30, 2008 as compared to the same period in 2007, the lower level of net premiums earned as noted above has caused an increase in the operating expense ratio. The decrease in operating expenses was mainly as a result of a bad debt provision recorded
in 2007 and was partially offset by the impact in 2008 of a write-off of certain system related costs and employee termination benefits recorded under the Companys expense reduction initiative. Foreign exchange gains in the three months ended September 30, 2008 and losses in 2007 were due primarily to the change in the value of the U.S. dollar against certain European currencies including the U.K. Sterling, the Euro and the Swiss Franc on certain inter-company balances. Net results from structured reinsurance products include certain structured indemnity contracts that are accounted for as deposit contracts. In order to support the Companys focus on its dual platform of Insurance and Reinsurance P&C businesses, the Company ceased certain operations in the third
quarter of 2008 that included the closure of the XLFS business unit and reassignment of responsibility for structured indemnity business to either the Insurance or Reinsurance segment depending on the underlying nature of the transactions. Results from these products for the three months ended
September 30, 2008, have decreased compared to the same period in 2007 mainly due to lower net investment income and higher operating expenses. Net investment income decreased as a result of lower yields earned on invested assets in the third quarter of 2008 as compared to the third quarter of 2007
while operating expenses increased as a result of employee termination benefits associated with the closure of the XLFS business unit noted above. 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 accident and health business. Due to the nature of these contracts, premium volume may
vary significantly from period to period. As noted above, the Company announced its intention to review strategic opportunities relating to its Life reinsurance business. The following summarizes contribution from this segment: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Gross premiums written
$
156,148
$
140,694
11.0
% Net premiums written
145,741
129,353
12.7
% Net premiums earned
169,608
147,239
15.2
% Fee income and other
75
78
(3.8
)% Claims and policy benefits.
199,861
195,440
2.3
% Acquisition costs
25,499
20,740
22.9
% Operating expenses.
7,864
7,195
9.3
% Exchange losses (gains).
1,511
(3,014
)
NM
* Net investment income
102,636
100,005
2.6
% Contribution from Life Operations
$
37,584
$
26,961
39.4
%
*
NM Not Meaningful
62
Three Months Ended
September 30,
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 September 30, 2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
(Unaudited)
Gross
Net
Net
Gross
Net
Net Other Life
$
107,809
$
106,076
$
129,943
$
87,023
$
81,006
$
98,892 Annuity
48,339
39,665
39,665
53,671
48,347
48,347 Total
$
156,148
$
145,741
$
169,608
$
140,694
$
129,353
$
147,239 Gross premiums written relating to other life business increased by $20.8 million in the three months ended September 30, 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 $13.4 million as well
as an increase in U.S. business of $8.4 million. Partially offsetting these increases was a decrease of $1.0 million in short-term life, accident and health business primarily as a result of soft market conditions and cancellations experienced in the third quarter of 2008 exceeding new business written during
the period. Gross premiums written relating to annuity business decreased by $5.3 million in the three months ended September 30, 2008 as compared to the same period in the prior year primarily as a result of unfavorable foreign exchange rate movements. Ceded premiums written were roughly
consistent with the prior year. Net premiums earned in the third quarter of 2008 increased 15.2% as compared to the third quarter of 2007. This increase was consistent with the increase in gross and net premiums written as described above. 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. Claims and policy benefit reserves
increased by $4.4 million or 2.3% in the three months ended September 30, 2008 as compared to the three months ended September 30, 2007, primarily as a result of the factors noted above affecting gross and net premiums written, partially offset by favorable foreign exchange rate movements of $9.0
million. For the three months ended September 30, 2008, acquisition costs increased by 22.9% largely as a result of costs associated with the growth in the core underlying book of term assurance and critical illness business. Operating expenses increased by 9.3% in the third quarter of 2008 as compared to
the same period in 2007 primarily due to higher corporate allocations and increased compensation costs associated with a higher headcount in 2008 as compared to 2007. 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 $2.6 million or 2.6% in the three months
ended September 30, 2008, as compared to the same period in 2007 primarily as a result of the growth in the average size of the investment asset balances due to premiums associated with regular premium business and partially offset by lower investment yields. Other Financial Lines The Other Financial Lines segment is comprised of the funding agreement business and previously, the GIC business. As at December 31, 2007, the Company had approximately $4.0 billion of deposit liabilities associated with GICs which were correspondingly matched with invested assets. Based on
the terms and conditions of the underlying GICs, upon the downgrade of Syncora Guarantee (formerly XL Capital Assurance Inc. or XLCA), below certain ratings levels, all or portions of outstanding principal balances on such GICs would come due. Throughout 2008, several 63
Three Months Ended
September 30, 2008
Three Months Ended
September 30, 2007
Premiums
Written
Premiums
Written
Premiums
Earned
Premiums
Written
Premiums
Written
Premiums
Earned
rating agencies downgraded Syncora and its subsidiaries and, as a result, the Company settled, in the first nine months of 2008 all of the GIC liabilities. At September 30, 2008, the remaining balance of funding agreements, excluding accrued interest of $10.0 million, was $850.0 million, with settlements
scheduled from late 2008 through to 2010. Management does not expect any significant impact on the Companys 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
Companys Other Financial Lines segment portfolios was comprised of
Topical Assets and CDOs. Liquidations necessary to fund the repayment of
the GIC liabilities following the downgrade of Syncora Guarantee and the
maturity of certain funding agreements, were funded through sales of assets
in these portfolios as well as the general investment portfolios. Managements
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 CDOs and these were transferred to the general investment portfolio
in exchange for those assets that were liquidated. For the three month period ended September 30, 2008, the net results from Other Financial Lines businesses were $3.7 million and included net investment income, interest expense and operating expenses of $13.1 million, $7.4 million, and $2.0 million, respectively, while the results for the same
period in 2007 were $16.5 million and included net investment income, interest expense and operating expenses of $107.3 million, $86.9 million, and $3.9 million, respectively. For the three months ended September 30, 2008, net investment income, interest expense and operating expenses decreased
primarily as a result of a decrease in the average deposit liability balance and the associated asset portfolios as a result of the settlement of the GIC and funding agreement portfolio noted above. In addition, operating expenses decreased due to a reduction in compensation expense associated with a
lower headcount. Investment Activities The
following table illustrates the change in net investment income from property
and casualty operations, net (loss) income from investment fund affiliates,
net realized (losses) on investments and net realized and unrealized losses
on investment and other derivative instruments for the three months ended
September 30, 2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Net investment income property and casualty operations (1)
$
293,109
$
325,543
(10.0
)% Net (loss) income from investment fund affiliates (2)
(54,886
)
69,435
NM
* Net realized (losses) on investments
(292,903
)
(160,208
)
(82.8
)% Net realized and unrealized (losses) on investment and other derivative instruments
(58,454
)
(58,162
)
(0.5
)%
(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 accelerated filing deadlines. * NM Not meaningful Net investment income related to property and casualty operations decreased in the third quarter of 2008 as compared to the third 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 overall during the last twelve months. The portfolio mix also changed as a result of the settlement of the GIC and funding agreement liabilities, as the 64
Three Months Ended
September 30,
property and casualty operations assumed a number of the floating rate securities previously held in the Companys Other Financial Lines segment. In the three months ended September 30, 2008, the net loss from investment fund affiliates was due primarily to the results from the Companys alternative funds, which were negative in the three months ended September 30, 2008 as compared to positive results in the same period of the prior year.
These results reflect negative returns in the Companys alternative portfolio as the markets during the quarter were particularly challenging for strategies employed by the Companys alternative investment managers given the extreme volatility and overall pull back of credit availability. Net income from
investment affiliates in the third quarter of 2007 was due primarily to strong performance in alternative fund affiliates. 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:
(Unaudited)
2008 (1)
2007 (1) Asset/Liability portfolios USD fixed income portfolio
(3.7
)%
0.3
% Non USD fixed income portfolio
(0.5
)%
1.6
% Risk Asset portfolios Alternative portfolio (2)
(4.2
)%
1.8
% Equity portfolio
(18.7
)%
1.5
% High-Yield fixed income portfolio
(5.8
)%
(2.1
)%
(1)
Portfolio returns are calculated by dividing the sum of net investment income or net income from investment fund 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 August 31, 2008 and August 31, 2008, respectively, due to the reporting lag as described above. Net Realized Gains and Losses and Other than Temporary Declines in the Value of Investments Net
realized losses on investments in the third quarter of 2008 included net
realized losses of $252.6 million related to the write-down of certain of
the Companys fixed income and equity investments, including Lehman,
where the Company determined that there was an other than temporary decline
in the value of those investments as well as net realized losses of $40.3 million
from sales of investments. Included in the 2008 balances noted above are
realized losses and impairments in the sub-prime related mortgage exposed
portfolios totaling $66.9 million. Net realized losses on investments in the third quarter of 2007 included net realized losses of $110.9 million related to the write-down of certain of the Companys fixed income and equity investments where the Company determined that there was an other than temporary decline in the value of
those investments as well as net realized losses of $49.3 million from sales of investments. Included in the 2007 balances noted above are realized losses and impairments in the sub-prime related mortgage exposed portfolios totaling $138.9 million. The Companys 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 Companys intent and ability to 65
Three Months Ended
September 30,
hold the investment for
a sufficient period of time for the value to recover. See Note 2(c) to the
Consolidated Financial Statements for further information. During the current
quarter, particular focus was placed on structured credit holdings and in
particular those with residential mortgage exposure. Where the Companys
analysis of the above factors results in the Companys 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 and Losses on Derivatives Net realized and unrealized losses on investment derivatives for the three month period ended September 30, 2008 resulted from the Companys investment strategy to manage interest rate risk, foreign exchange risk, and credit risk and to replicate permitted investments. In addition, in 2007, net
realized and unrealized losses on investment derivatives included a mark-to-market loss of $37.0 million with respect to a total return swap on the capital notes of a structured investment vehicle impacted by the markdown in the underlying net asset value of the assets of the capital notes, combined with
mark-to-market losses associated with the Companys capital, investment and hedging activities. Other Revenues and Expenses The following table sets forth other revenues and expenses for the three months ended September 30, 2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Net (loss) income from operating affiliates (1)
$
(1,404,299
)
$
41,919
NM
* Amortization of intangible assets
1,386
420
230.0
% Corporate operating expenses
61,656
56,872
8.4
% Interest expense (2)
51,277
49,029
4.6
% Income tax expense
47,843
58,715
(18.5
)%
(1)
The Company records the income related to its operating affiliates on a three month lag in order for the Company to meet accelerated filing deadlines. (2) Interest expense does not include interest expense related to structured products as reported within the Insurance and Reinsurance segments. * NM Not meaningful The following table sets forth the net (loss) income from operating affiliates for the three months ended September 30, 2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Net (loss) income from financial operating affiliates
$
(1,417,526
)
$
7,047
NM
* Net income from investment manager affiliates
1,027
23,161
(95.6
)% Net income from other strategic operating affiliates
12,200
11,711
4.2
% Total
$
(1,404,299
)
$
41,919
NM
*
(1)
NM Not Meaningful
The net loss from financial operating affiliates for the three months ended September 30, 2008 was primarily as a result of the loss of approximately $1.4 billion recorded in August 2008 in relation to the closing of the Master Agreement. For further details relating to the Master Agreement, see
Results of Operations above as well as Note 4 to the Consolidated Financial Statements, Syncora Holdings Ltd. (Syncora). 66
Three Months Ended
September 30,
Three Months Ended
September 30,
Investment manager affiliate income decreased by $22.1 million or 95.6% during the third quarter of 2008 as compared to the same period in the prior year primarily as a result of recent volatility in both the credit and equity markets, impacting most significantly, investment manager affiliates
specializing in global equities as well as fixed income securities. Income from other strategic operating affiliates increased in the third quarter of 2008 as compared to the third quarter of 2007 mainly due to earnings from an investment in an affiliate entered into in the second quarter of 2008 that provides reinsurance to certain Lloyds syndicates. Corporate operating expenses in the three months ended September 30, 2008 increased compared to the three months ended September 30, 2007 primarily as a result of an increase in professional fees associated with the capital raise and settlement under the Master Agreement, described above, as
well as costs recorded in the third quarter of 2008 relating to the Companys expense reduction initiative, including employee termination benefits and asset impairment charges. For further information relating to the Companys expense reduction initiative, see Note 5 to the Consolidated Financial
Statements, Restructuring and Asset Impairment Charges. Interest expense for the three months ended September 30, 2008 as compared to the same period in 2007 was higher as a result of interest recorded in the third quarter of 2008 associated with the 10.75% Units issued in August 2008. For more information on the Companys financial structure, see
Liquidity and Capital Resources. The decrease in the Companys income taxes arose principally from the decrease in the profitability of the Companys U.S. and European operations. In addition, losses associated with the Master Agreement related to operating entities in jurisdictions not subject to income tax. Segment Results for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007 Insurance The following table summarizes the underwriting results for this segment: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Gross premiums written
$
4,231,111
$
4,166,709
1.5
% Net premiums written
3,108,460
3,168,942
(1.9
)% Net premiums earned
3,068,492
3,116,195
(1.5
)% Fee income and other
31,104
10,480
196.8
% Net losses and loss expenses
2,169,423
1,941,559
11.7
% Acquisition costs
351,888
361,804
(2.7
)% Operating expenses
535,065
474,558
12.8
% Underwriting profit
$
43,220
$
348,754
(87.6
)% Exchange (gains) losses
$
(8,746
)
$
25,429
NM
* Net results structured products
$
(11,418
)
$
3,038
NM
*
*
NM Not Meaningful
Gross premiums written increased by 1.5% during the nine months ended September 30, 2008 compared with the nine months ended September 30, 2007, primarily as a result of growth in certain property lines, particularly in the construction book, as well as excess and surplus and middle market
lines, higher levels of long-term agreements and favorable foreign exchange rate movements of $125.0 million. Partially offsetting these increases were continued decreases in premium rates as market conditions continued to soften, selective non-renewals and the impact of the runoff of certain property
catastrophe program exposures. Net premiums written decreased by 1.9% during the first nine months of 2008 as compared to same period in 2007 primarily as a result of an increase in 67
Nine Months Ended
September 30,
ceded premiums written related to a change in the mix of business including an increase in long-term agreements with higher cession ratios and the impact from the purchase of an adverse development cover associated with a Company owned Lloyds syndicate. Net premiums earned decreased by 1.5% in the nine months ended September 30, 2008 compared with the nine months ended September 30, 2007. The decrease was primarily a reflection of the overall reduction of net premiums written over the last 12 to 24 months. Fee income increased in the first nine months of 2008 as compared to the same period in 2007 mainly as a result of higher engineering fee revenue associated with XL GAPS, which formed in late 2007 following the acquisition of GAPS, a loss prevention consulting service provider. The following table presents the ratios for this segment:
(Unaudited)
2008
2007 Loss and loss expense ratio
70.7
%
62.3
% Underwriting expense ratio
28.9
%
26.8
% Combined ratio
99.6
%
89.1
% 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 following table summarizes the net (favorable) adverse prior year development relating to
the Insurance segment for the nine month periods ended September 30, 2008 and 2007: (U.S. dollars in millions)
(Unaudited)
2008
2007 Property
$
(75.9
)
$
(65.3
) Casualty and Professional
(58.0
)
(130.2
) Specialty and Other
6.8
70.9 Structured Indemnity
5.0
Total
$
(122.1
)
$
(124.6
) Loss and loss expense ratio excluding prior year development
74.7
%
66.3
% Net prior year releases in the nine months ended September 30, 2008, totaled $122.1 million and were due primarily to favorable reserve development in global property lines of business as a result of favorable claim development as well as reserve releases in certain casualty lines primarily in 2004 to
2006 years due to lower than expected reported loss activity. Offsetting this favorable development was modest reserve strengthening within specialty lines as well as strengthening associated with certain structured indemnity contracts. Excluding prior year development, the loss ratio for the nine months
ended September 30, 2008 increased by 8.4 loss percentage points as compared to the same period in 2007 with 4.1 points of the loss ratio increase attributable to a higher level of catastrophe losses in the current year. The remainder of the increase in loss ratio was attributable to the softening rate
environment impacting most lines of business and an increase in loss activity in property and loss activity anticipated for professional lines related to sub-prime and related credit events. Net prior year releases in the nine months ended September 30, 2007 occurred in certain property and casualty lines of
business, partially offset by adverse prior year reserve development in certain specialty lines, particularly in the London Market portfolio including the run-off of the surety portfolio. Gross prior year favorable development for the nine months ended September 30, 2008 of $429.8 million exceeded the corresponding net favorable development during the same period of 68
Nine Months Ended
September 30,
Nine Months Ended
September 30,
$122.1 million, as the impact of reductions in gross reported losses on older years in certain casualty lines was mostly offset by the impact of the reinsurance recoverable component on such losses. In addition, the impact of gross reserve releases in professional and specialty lines was mostly offset by the
impact of a reduction in estimated ceded IBNR following a reserve review in these lines. The increase in the underwriting expense ratio in the nine months ended September 30, 2008, compared to the same period in 2007, was due to an increase in the operating expense ratio of 2.2 points (17.4% as compared to 15.2%) and partially offset by a decrease in the acquisition expense ratio of
0.1 points (11.5% as compared to 11.6%). The increase in the operating expense ratio was mainly as a result of a higher headcount which increased compensation, increases in professional fees and the impact of employee termination benefits recorded in the third quarter of 2008, against lower net
premiums earned. The increase in headcount and professional fees both supported new segment initiatives, including an operational transformation program as well as the formation of XL GAPS in late 2007. The acquisition expense ratio decreased mainly due to a reduction in foreign excise taxes as a
result of a decrease in the cession percentage of an internal quota share from 75% to 50%, lower guarantee fund assessments and the impact of the changes in the mix of business written. Foreign exchange gains in the nine months ended September 30, 2008 and losses in 2007 were due primarily to the change in the value of the U.S. dollar against certain European currencies including the Euro, U.K. Sterling and Swiss Franc on certain inter-company balances. Net results from structured insurance products include certain structured indemnity contracts that are accounted for as deposit contracts. Results from these contracts for the nine months ended September 30, 2008, decreased compared to the same period in 2007 mainly due to lower net investment
income and higher operating expenses, partially offset by lower interest expense. Net investment income decreased as a result of lower yields earned on investment income while operating expenses increased as a result of costs recorded in the third quarter of 2008 associated with employee termination
benefits relating to the closure of the XLFS business unit as noted above. Interest expense decreased mainly due to a negotiated cancellation of a contract in the second quarter of 2008 that resulted in a gain of $10.9 million and was partially offset by an accretion adjustment recorded in the first nine
months of 2008 based on changes in expected cash flows on a structured indemnity contract. Reinsurance The following table summarizes the underwriting results for this segment: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Gross premiums written
$
2,155,989
$
2,525,507
(14.6
)% Net premiums written
1,645,474
1,989,716
(17.3
)% Net premiums earned
1,518,098
1,715,968
(11.5
)% Fee income and other
8,840
869
NM
* Net losses and loss expenses
979,620
914,313
7.1
% Acquisition costs
302,077
377,871
(20.1
)% Operating expenses
141,940
144,078
(1.5
)% Underwriting profit
$
103,301
$
280,575
(63.2
)% Exchange (gains)
$
(55,549
)
$
(514
)
NM
* Net results structured products
$
21,102
$
28,802
(26.7
)%
*
NM Not Meaningful
Gross and net premiums written decreased by 14.6% and 17.3%, respectively, in the first nine months of 2008 as compared to the first nine months of 2007. These decreases resulted from the Company declining business due to competitive pressures continuing to drive certain rates below the
Companys acceptable underwriting return levels together with increased client retentions. Partially offsetting these decreases in gross premiums written were favorable foreign exchange rate 69
Nine Months Ended
September 30,
movements of $57.0 million and increases of $75.0 million associated with a U.S. agricultural program whose rates are tied to commodity prices, which have increased in 2008. Ceded premiums written decreased mainly as a result of the impact of a reduction in property catastrophe cessions to Cyrus Re II
of 10% in 2008 as compared to a 35% cession to Cyrus Re throughout 2007, partially offset by ceded premiums totaling $23.3 million associated with the purchase of additional catastrophe loss protection in the form of industry loss warranty covers. However, the overall ceded ratio increased mainly due
to lower net retention in 2008 as compared to 2007, mainly due to higher cession ratios associated with the U.S. agricultural program noted above, causing net premiums written to decrease at a higher percentage than gross premiums written. Net premiums earned in the first nine months of 2008 decreased 11.5% as compared to the same period in of 2007. This decrease was a reflection of the overall reduction of net premiums written over the last 24 months. Fee income increased by $8.0 million during the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 as a result of fees associated with capacity utilization with certain Lloyds syndicates. The following table presents the ratios for this segment:
(Unaudited)
2008
2007 Loss and loss expense ratio
64.5
%
53.3
% Underwriting expense ratio
29.3
%
30.4
% Combined ratio
93.8
%
83.7
% 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 reserves held at the beginning of the year. The following table summarizes the net (favorable) adverse prior year development relating to the Reinsurance
segment for the nine month periods ended September 30, 2008 and 2007: (U.S. dollars in millions)
(Unaudited)
2008
2007 Property and other short-tail lines
$
(98.1
)
$
(140.3
) Casualty and other
(120.8
)
(76.7
) Structured Indemnity
(1.4
)
8.8 Total
$
(220.3
)
$
(208.2
) Loss and loss expense ratio excluding prior year development
79.0
%
65.4
% For the nine months ended September 30, 2008, casualty and other lines reserve releases included favorable development in both European and U.S. casualty and professional portfolios as well as reserve releases associated with the RITC relating to the 2005 year of account on certain Lloyds sourced
business. In the same period, property and other short-tail lines reserve releases were attributable to most business units globally. Excluding prior year development, the loss ratio for the nine months ended September 30, 2008 increased by 13.6 loss percentage points as compared to the same period in
2007 with 9.0 points attributable to an increase in catastrophe losses occurring during the first nine months of 2008 (13.8 points in 2008 versus 4.8 points in 2007). The remaining increase of 4.6 loss ratio points was attributable to the softening rate environment, higher attritional property losses and higher
anticipated loss activity in the professional and trade credit portfolios. For the nine months ended September 30, 2007, property and other short-tail lines reserve releases were 70
Nine Months Ended
September 30,
Nine Months Ended
September 30,
seen largely in property risk and property catastrophe portfolios while casualty releases related to both U.S. and non-U.S. source exposures. Gross prior year favorable development for the nine months ended September 30, 2008 of $353.9 million exceeded the corresponding net favorable development during the same period of $220.3 million as the impact of favorable loss experience related to a large crop program was mostly offset by the
impact of retrocessional protection related to this program. The decrease in the underwriting expense ratio in the nine months ended September 30, 2008, as compared with the nine months ended September 30, 2007, was due to a decrease in the acquisition expense ratio of 2.1 points (19.9% compared to 22.0%) and was partially offset by an increase in the
operating expense ratio of 1.0 points (9.4% compared to 8.4%). The decrease in the acquisition expense ratio was primarily due to a favorable variance in performance-related commissions in the first nine months of 2008 as compared to 2007. Although operating expenses were lower in the first nine
months of 2008 as compared to the same period in 2007, the lower level of net premiums earned as noted above caused an increase in the operating expense ratio. The decrease in operating expenses was mainly as a result of a bad debt provision recorded in 2007 and was partially offset by the impact in
2008 of the write-off of certain system related costs. Foreign exchange gains in the nine months ended September 30, 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 nine months ended September 30, 2008, have decreased compared to the same period in 2007 mainly due to lower net
investment income and higher operating expenses. Net investment income decreased as a result of lower yields earned on invested assets in the first nine months of 2008 as compared to the same period in 2007 while operating expenses increased as a result of employee termination benefits associated with
the closure of the XLFS business unit as noted above. Life Operations The following summarizes the contribution from this segment: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Gross premiums written
$
552,357
$
588,930
(6.2
)% Net premiums written
520,887
556,778
(6.4
)% Net premiums earned
502,125
534,086
(6.0
)% Fee income and other
275
227
21.1
% Claims and policy benefits
605,885
662,883
(8.6
)% Acquisition costs
75,448
64,622
16.8
% Operating expenses
25,246
25,867
(2.4
)% Exchange losses (gains)
509
(4,989
)
NM
* Net investment income
297,829
288,788
3.1
% Contribution from Life operations
$
93,141
$
74,718
24.7
%
*
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 nine month periods ended September 30, 2008 and 2007: 71
Nine Months Ended
September 30,
(U.S. dollars in thousands)
(Unaudited)
(Unaudited)
Gross
Net
Net
Gross
Net
Net Other Life
$
400,287
$
396,514
$
377,752
$
335,992
$
327,949
$
305,257 Annuity
152,070
124,373
124,373
252,938
228,829
228,829 Total
$
552,357
$
520,887
$
502,125
$
588,930
$
556,778
$
534,086 Gross premiums written relating to other life business increased by $64.3 million in the nine months ended September 30, 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 $37.4 million, premium
growth in U.S. business of $20.0 million and favorable foreign exchange rate movements of $0.3 million. In addition, gross premiums written related to short-term life, accident and health business increased by $6.6 million primarily as a result of favorable foreign exchange rate movements and partially
offset by decreases in gross premiums written associated with soft market conditions experienced in the first nine months of 2008. Gross premiums written relating to annuity business decreased by $100.9 million in the nine months ended September 30, 2008 as compared to the same period in 2007 mainly
due to a single Irish immediate annuity contract totaling $94.6 million written during the first nine months of 2007, unfavorable foreign exchange rate movements of $3.6 million and $2.7 million lower premiums from other annuity business which decreases through time as defined by the treaties. Ceded
premiums written were roughly consistent with the prior year. Net premiums earned in the first nine months of 2008 decreased 6.0% as compared to the same period in 2007. This decrease was consistent with the decrease in gross and net premiums written as described above. 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. Claims and policy benefit reserves
decreased by $57.0 million or 8.6% in the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007, primarily as a result of the factors noted above affecting gross and net premiums written, partially offset by higher incurred losses of $12.0 million associated with
certain short-term life, accident and health business, in part due to adverse exchange rate movements. For the nine months ended September 30, 2008, acquisition costs increased by 16.8% as compared to the same period in 2007, largely as a result of the growth in regular premium business as noted above and unfavorable foreign exchange rate movements. Operating expenses decreased by 2.4% in the
first nine months of 2008 as compared to the same period in the prior year mainly due to lower professional fees as a result of costs recorded in 2007 related to an actuarial loss reserve review and partially offset by higher corporate allocations in the first nine months 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 $9.0 million or 3.1% in the nine months
ended September 30, 2008, as compared to the same period in 2007 primarily as a result of growth in the average size of the investment asset balances due to premiums associated with regular premium business. However, it should be noted that as at September 30, 2008, approximately $896.3 million of
the gross unrealized losses on the Companys investments related to portfolios of Life Operations investment assets primarily as a result of increases in credit spreads during this period, primarily in the U.K. and Euro-zone, and the long duration of the underlying assets. Refer to Balance Sheet Analysis
below for further discussion of unrealized losses and gains on investments. 72
Nine Months Ended
September 30, 2008
Nine Months Ended
September 30, 2007
Premiums
Written
Premiums
Written
Premiums
Earned
Premiums
Written
Premiums
Written
Premiums
Earned
Other Financial Lines The Other Financial Lines segment is comprised of the funding agreement business and previously, the guaranteed investment contract (GIC) business. For the nine month period ended September 30, 2008, the net results from these products were $17.6 million and included net investment income,
interest expense and operating expenses of $92.2 million, $66.2 million, and $8.4 million, respectively, while the net results from these products for the same period in 2007 were $32.4 million and included net investment income, interest expense and operating expenses of $289.8 million, $247.3 million, and
$10.1 million, respectively. For the nine months ended September 30, 2008, net investment income, interest expense and operating expenses decreased primarily as a result of a decrease in the average deposit liability balance and the associated asset portfolios as a result of the settlement of the GIC
portfolio and certain funding agreements noted above. In addition, operating expenses decreased due to a reduction in compensation expense associated with a lower headcount. While not reported within the contribution from the Other Financial Lines segment, approximately $73.4 million of the reported
realized losses on investments during the first nine months of 2008 related to portfolios associated with GICs and funding agreements. Syncora For information on Syncora, see Results of Operations and Other Revenues and Expenses within Managements Discussion and Analysis of Financial Condition and Results of Operations. In addition, see Note 4 to the Consolidated Financial Statements, Syncora Holdings Ltd. (Syncora), for
further information. Investment Activities The
following table illustrates the change in net investment income from property
and casualty operations, net (loss) income from investment affiliates, net
realized (losses) on investments and net realized and unrealized (losses)
gains on investment and other derivative instruments for the nine months
ended September 30, 2008 and 2007: (U.S. dollars in thousands)
(Unaudited)
% Change
2008
2007 Net investment income property and casualty operations (1)
$
899,278
$
962,721
(6.6
)% Net (loss) income from investment fund affiliates (2)
(63,522
)
255,414
NM
* Net realized (losses) on investments
(393,114
)
(132,620
)
(196.4
)% Net realized and unrealized (losses) on investment and other derivative instruments
(5,648
)
(41,233
)
86.3
%
(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 affiliates on a three month lag in order for the Company to meet accelerated filing deadlines. * NM Not meaningful Net investment income related to property and casualty operations decreased in the nine months ended September 30, 2008 as compared to the same period in 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 GIC and funding agreements liabilities, as the property and
casualty operations assumed a number of the floating rate securities previously held in the Companys Other Financial Lines segment. The Companys net loss from investment fund affiliates during the first nine months of 2008 reflected negative returns in the Companys alternative portfolio as the markets during the first nine 73
Nine Months Ended
September 30,
months of 2008 were particularly challenging for strategies employed by the Companys alternative investment managers given the extreme volatility and overall pull back of credit availability. Net income from investment affiliates in the first nine months of 2007 was due primarily to strong results in the
equity accounted portion of the alternative portfolio and a higher investment asset base. 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 nine months ended September 30,
2008 and 2007:
(Unaudited)
2008 (1)
2007 (1) Asset/Liability portfolios USD fixed income portfolio
(7.0
)%
1.6
% Non USD fixed income portfolio
(3.4
)%
(0.3
)% Risk Asset portfolios Alternative portfolio (2)
(4.3
)%
12.0
% Equity portfolio
(27.8
)%
11.4
% High-Yield fixed income portfolio
(9.2
)%
1.0
%
(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 nine months ended August 31, 2008 and August 31, 2007, respectively. Net Realized Gains and Losses and Other than Temporary Declines in the Value of Investments Net realized losses on investments in the first nine months of 2008 included net realized losses of $415.1 million related to the write-down of certain of the Companys fixed income, equity and other investments, including Lehman, where the Company determined that there was an other than
temporary decline in the value of those investments as well as net realized gains of $22.0 million from sales of investments. Included in the balances noted above are realized losses and impairments in Topical Assets totaling $141.6 million. Net realized losses on investments in the first nine months of 2007 included net realized losses of $194.7 million related to the write-down of certain of the Companys fixed income and equity investments where the Company determined that there was an other than temporary decline in the value of
those investments and net realized losses of $19.2 million from sales of investments, both of which were largely driven by impairments and realized losses in the sub-prime and mortgage exposed portfolios. Offsetting these losses was a net realized gain of $81.3 million from the secondary offering of
Syncora common shares. Net Realized and Unrealized Gains and Losses on Derivatives Net realized and unrealized losses on investment derivatives for the nine month period ended September 30, 2008 resulted from the Companys investment strategy to manage interest rate risk, foreign exchange risk and credit risk, and to replicate permitted investments. Net realized and unrealized
losses on investment and other derivatives for the nine month period ended September 30, 2007, resulted primarily from a mark-to-market loss of $37.0 million with respect to a total return swap on the capital notes of a structured investment vehicle impacted by the markdown in the underlying net asset
value of the assets of the capital notes, combined with a mark-to-market losses associated with the Companys capital, investment and hedging activities. 74
Nine Months Ended
September 30,
Other Revenues and Expenses The following table sets forth other revenues and expenses for the nine months ended September 30, 2008 and 2007: (U.S.
dollars in thousands) %
Change (Unaudited) 2008 2007 Net
(loss) income from operating affiliates (1) $ (1,452,647 ) $ 140,640 NM * Amortization
of intangible assets 2,226 1,260 76.7 % Corporate
operating expenses 144,686 144,875 (0.1 )% Interest
expense (2) 150,719 159,059 (5.2 )% Income
tax expense 129,750 192,758 (32.7 )% Minority
Interest 23,994 NM *
(1)
The Company records the income related to its operating affiliates on a three month lag in order for the Company to meet accelerated filing deadlines. (2) Interest expense does not include interest expense related structured products as reported within the Insurance and Reinsurance segments. * NM Not meaningful The following table sets forth the net (loss) income from operating affiliates for the nine months ended September 30, 2008 and 2007: (U.S. dollars in thousands)
% Change
(Unaudited)
2008
2007 Net (loss) income from financial operating affiliates
$
(1,503,474
)
$
12,347
NM
* Net income from investment manager affiliates
15,647
104,476
(85.0
)% Net income from other strategic operating affiliates
35,180
23,817
47.7
% Total
$
(1,452,647
)
$
140,640
NM
*
*
NM Not meaningful
The net (loss) from financial operating affiliates for the nine months ended September 30, 2008 was primarily as a result of the loss of approximately $1.4 billion recorded in August 2008 in relation to the closing of the Master Agreement as well as losses recorded throughout 2008 and up until the
closing of the Master Agreement that were associated with previous reinsurance and guarantee agreements with Syncora. For further details relating to the closing of the Master Agreement, see Results of Operations above as well as Note 4 to the Consolidated Financial Statements, Syncora Holdings
Ltd. (Syncora). Investment manager affiliate income decreased by $88.8 million or 85.0% during the first nine months of 2008 as compared to the same period in the prior year primarily as a result of recent volatility in both the credit and equity markets, impacting most significantly, investment manager affiliates
specializing in global equities as well as fixed income securities. Income from other strategic operating affiliates increased in the first nine months of 2008 as compared to the same period in 2007 mainly due to strong earnings reported in the first nine months of 2008 relating to an insurance affiliate which writes largely direct U.S. homeowners insurance combined
with earnings from an investment in an affiliate entered into in the second quarter of 2008 that provides reinsurance to certain Lloyds syndicates. 75
Nine Months Ended
September 30,
Nine Months Ended
September 30,
Corporate operating expenses in the nine months ended September 30, 2008 decreased compared to the nine months ended September 30, 2007 primarily as a result of lower compensation expenses as a result of performance based accruals recorded in the first nine months of 2007, partially offset by
an increase in professional fees associated with the capital raise described above as well as costs recorded in the first nine months of 2008 relating to the Companys expense reduction initiative, including employee termination benefits as well as costs associated with ceasing to use certain leased property
accounted for as operating leases. For further information, see Note 5 to the Consolidated Financial Statements, Restructuring and Asset Impairment Charges. Interest expense for the nine months ended September 30, 2008 as compared to the same period in 2007 was lower primarily due to costs associated with the retirement of the 2009 Senior Notes in the first nine months of 2007 and was partially offset by interest expense associated with the 10.75%
Units issued in August 2008. For more information on the Companys financial structure, see Liquidity and Capital Resources. The decrease in the Companys income taxes arose principally from the decrease in the profitability of the Companys U.S. and European operations. In addition, losses associated with the Master Agreement related to operating entities in jurisdictions not subject to income tax. 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 Company over the longer term. The strategy strives to maximize investment returns while taking into account
market and credit risk. The Companys 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 September 30, 2008 and December 31, 2007, total investments, cash and cash equivalents, accrued investment income and net payable for investments purchased were $36.7 billion and $43.7 billion, respectively. The following table summarizes the composition of the Companys total investments
and cash and cash equivalents: (U.S. dollars in thousands)
(Unaudited)
Percent of
Fair Value
Percent of Cash and cash equivalents
$
5,610,003
15.3
%
$
3,880,030
8.9
% Net payable for investments purchased
(770,640
)
(2.1
)%
(191,472
)
(0.4
)% Accrued investment income
387,192
1.1
%
447,660
1.0
% Short-term investments
1,633,654
4.4
%
1,803,198
4.1
% Fixed maturities: U.S. Government and Government agency
$
3,037,237
8.3
%
$
2,685,773
6.1
% Corporate
10,287,960
28.0
%
12,987,248
29.7
% Mortgage and asset-backed securities
9,487,259
25.8
%
14,493,877
33.1
% U.S. States and political subdivisions of the States
474,227
1.3
%
253,534
0.6
% Non-U.S. Sovereign Government
3,214,795
8.7
%
3,187,358
7.3
% Total fixed maturities
$
26,501,478
72.1
%
$
33,607,790
76.8
% Equity securities
471,705
1.3
%
854,815
2.0
% Investments in affiliates
2,325,505
6.3
%
2,611,149
6.0
% Other investments
586,664
1.6
%
708,476
1.6
% Total investments and cash and cash equivalents
$
36,745,561
100.0
%
$
43,721,646
100.0
% 76
Fair Value at
September 30,
2008
Total
at December 31,
2007
Total
The Company reviews on a regular basis its corporate debt concentration, credit quality and compliance with established guidelines. At September 30, 2008 and December 31, 2007, the average credit quality of the Companys total fixed income portfolio was AA. As at September 30, 2008,
approximately 53.2% of the fixed income portfolio was rated AAA by one or more of the principal ratings agencies. Approximately 2.5% was below investment grade or not rated as such date. Net Unrealized Gains and Losses on Investments At September 30, 2008, the Company had net unrealized losses on fixed maturities and short-term investments of $3,073.4 million and net unrealized losses on equities of $8.1 million. Of these amounts, gross unrealized losses on fixed maturities and short term investments and equities were $3,277.6
million and $59.3 million, respectively. The information presented below for the gross unrealized losses on the Companys investments at September 30, 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. Realized losses or impairments, depending on their magnitude, may have a material adverse effect on the Companys operations. The increase in net unrealized losses on investments during the nine months ended September 30, 2008 was primarily
due to a widening of credit spreads. See Item 3. Quantitative and Qualitative Disclosures about Market Risk Credit Risk." The following is an analysis of how long each of those securities with an unrealized loss at September 30, 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 Income and
Short-Term
Less than six months
$
311,372
$
6,022,464
At least 6 months but less than 12
months
669,625
5,486,333
At least 12 months but less than 2
years
1,924,230
7,491,529
2 years and over
372,375
1,739,627
Total
$
3,277,602
$
20,739,953
Equities
Less than six months
$
50,877
$
247,444
At least 6 months but less than 12
months
8,472
23,900
Total
$
59,349
$
271,344 The following is the maturity profile of the fixed income securities that were in a gross unrealized loss position at September 30, 2008: (U.S. dollars in thousands)
Maturity profile in years of fixed
(Unaudited)
(Unaudited) Less than 1 year remaining
$
22,108
$
694,189 At least 1 year but less than 5 years remaining
416,117
3,843,971 At least 5 years but less than 10 years remaining
428,640
3,900,466 At least 10 years but less than 20 years remaining
197,478
1,443,946 At least 20 years or more remaining
747,948
2,959,805 Mortgage and asset-backed securities
1,465,311
7,897,576 Total
$
3,277,602
$
20,739,953 77
unrealized loss position
Amount of
unrealized loss at
September 30, 2008
Fair Value of Securities in
an unrealized loss position
at September 30, 2008
income securities in a continual
unrealized loss position
Amount of
unrealized loss at
September 30, 2008
Fair value of securities in
an unrealized loss position
at September 30, 2008
Factors considered in determining that additional other-than-temporary impairment charges were not warranted include managements consideration of current and near term liquidity needs and other available sources, 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. Gross unrealized losses of $3.3 billion at September 30, 2008 can be attributed to the following significant drivers:
Gross unrealized losses of $0.9 billion related to the Companys Life Operations investment portfolio, which had a fair value of $6.0 billion as at September 30, 2008. Of this, $0.6 billion of gross unrealized losses related to $2.1 billion of exposures to corporate financials. At September 30, 2008,
this portfolio had average interest rate duration of 8.7 years, primarily denominated in U.K. Sterling and Euros. As a result of the long duration, significant gross losses have arisen as the fair values of these securities are more sensitive to prevailing government interest rates and credit spreads.
This portfolio has limited turnover as it is matched to corresponding long duration liabilities. A hypothetical parallel increase in both interest rates and credit spreads of 50 basis points, respectively, would increase the unrealized losses related to this portfolio at September 30, 2008 by
approximately $261.2 million and $204.2 million, respectively. Given the long term nature of this portfolio, and the level of credit spreads as at September 30, 2008 relative to historical averages within the U.K. and Euro-zone as well as the Companys liquidity needs at September 30, 2008, the
Company believes that these assets will continue to be held until such time as they mature, or credit spreads revert to levels more consistent with historical averages. The Company continues to explore strategic alternatives with respect to the Life Operations segment. The conclusion of such
consideration could impact the amount and timing of any impairment related to this portfolio. Gross unrealized losses of $0.9 billion related to the corporate holdings within the Companys non-life fixed maturity portfolios, which had a fair value of $6.3 billion as at September 30, 2008. The Company believes these impairments are a function of the currently elevated levels of corporate
credit spreads in the U.S. and globally, which spiked particularly during the month of September 2008, resulting in a severely depressed level of valuations. The amount of these gross losses have proven very volatile as a result of the severe deterioration in credit spreads in recent months. For
example, the gross unrealized losses increased by approximately $350 million or 4.9% of amortized cost during the month of September 2008 alone, a period in which U.S. corporate credit spreads increased by approximately 150 basis points from what were already elevated levels, excluding the
impact of foreign currency movements and offset by the impact of interest rate declines. The Company believes that the gross unrealized losses are a reflection of a severe premium being charged by the market for credit, rather than fundamental deterioration in the debt service capabilities of the
issuers. Gross unrealized losses of $0.5 billion related to the Topical Asset portfolio (which consists of the Companys holdings of sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures), which had a fair value of $1.3 billion as at
September 30, 2008. The Company undertook a security level review of these securities and recognized charges to the extent it believed the intrinsic value of any security was below its amortized cost. The Company has recognized realized losses, consisting of charges for other-than-temporary
impairments and realized losses from sales, of approximately $0.5 billion since the beginning of 2007 and through September 30, 2008 on these asset classes. The Company purchased a number of these assets to support the previously written GIC and funding agreement contracts and has announced its intention to reduce its exposure to this asset class as part of its strategic portfolio realignment. The Company believes that based on market conditions
and liquidity needs at September 30, 2008, this reduction will be realized through natural cash flows of the portfolio, and limited selective sales, rather 78
than selling these assets into markets which continue to be illiquid and not reflective of the intrinsic value of these assets. The weighted average term-to-maturity of the sub-prime and Alt-A residential holdings within this portfolio at September 30, 2008 were 3.3 years and 3.6 years, respectively.
The Company, based on current market conditions and liquidity needs as well as its assessment of the holdings, believes it will continue to hold these securities until either maturity, or a return of liquidity and valuations more reflective of intrinsic value of these holdings. Gross unrealized losses of $0.4 billion related to the non-life portfolio of Core CDO holdings (defined by the Company as investments in non-mortgage collateralized debt obligations), which consisted primarily of collateralized loan obligations and had a fair value of $0.8 billion as of
September 30, 2008. The Company undertook a security level review of these securities and recognized charges to the extent it believed the intrinsic value of the security was below the amortized cost. The Company believes that the level of impairment is primarily a function of historically wide
spreads in the collateralized loan obligations market during the period, driven by the high level of illiquidity in this market. The Company purchased a number of these assets to support the previously written GIC and Funding Agreement contracts and has announced its intention to reduce its
exposure to this asset class over time as a part of its strategic portfolio realignment. The Company, based on current market conditions and liquidity needs as well as its assessment of the holdings, believes it is likely that the Company will continue to hold these securities until either maturity, or
a return of liquidity and valuations more reflective of intrinsic value of these holdings, following which the Company intends to reduce its exposure to this asset class. The Company believes that the remaining balance of gross unrealized losses, including gross unrealized losses of $0.3 billion and $0.2 billion related to $2.3 billion and $0.7 billion of the non-life portfolios holdings in CMBS and Prime RMBS, respectively, was a reflection of a higher risk premium
being attached to both commercial and residential mortgage products, combined with general credit market conditions and the cumulative impact of interest rate movements. 79
The following table summarizes the fair value, gross unrealized losses, credit rating and asset class of securities in an unrealized loss position within the Companys structured credit and corporate portfolios, which comprised $3.0 billion of the Companys total gross unrealized loss position of $3.3
billion at September 30, 2008: Corporates
AAA
AA
A
BBB
BB & Below
Total Fair value
$
624.6
$
1,618.1
$
2,131.8
$
360.8
$
79.2
$
4,814.5 Gross unrealized loss
$
(39.5
)
$
(227.6
)
$
(598.1
)
$
(116.5
)
$
(28.6
)
$
(1,010.3
) Non-Financials Fair value
$
443.9
$
583.0
$
2,015.3
$
1,493.4
$
558.2
$
5,093.8 Gross unrealized loss
$
(43.0
)
$
(65.0
)
$
(264.0
)
$
(189.7
)
$
(108.0
)
$
(669.7
) Total Fair value
$
1,068.5
$
2,201.1
$
4,147.1
$
1,854.2
$
637.4
$
9,908.3 Gross unrealized loss
$
(82.5
)
$
(292.6
)
$
(862.1
)
$
(306.2
)
$
(136.6
)
$
(1,680.0
) % Impaired
(7.3
)%
(12.0
)%
(17.5
)%
(14.4
)%
(17.9
)%
(14.8
)% Structured Credit
AAA
AA
A
BBB
BB & Below
Total CMBS Fair value
$
2,332.0
$
9.2
$
20.6
$
17.9
$
13.7
$
2,393.4 Gross unrealized loss
$
(264.7
)
$
(1.8
)
$
(4.5
)
$
(3.7
)
$
(5.2
)
$
(279.9
) Prime RMBS Fair value
$
1,713.8
$
54.0
$
62.3
$
12.8
$
2.4
$
1,845.3 Gross unrealized loss
$
(181.8
)
$
(13.0
)
$
(8.6
)
$
(5.3
)
$
(1.7
)
$
(210.4
) Topical Assets Fair value
$
734.5
$
279.2
$
55.4
$
17.1
$
13.6
$
1,099.8 Gross unrealized loss
$
(251.9
)
$
(113.9
)
$
(51.8
)
$
(8.2
)
$
(23.6
)
$
(449.4
) Core CDO (1) Fair value
$
206.9
$
352.2
$
50.6
$
125.5
$
7.6
$
742.8 Gross unrealized loss
$
(44.2
)
$
(177.4
)
$
(29.9
)
$
(122.9
)
$
(5.2
)
$
(379.6
) Other Asset & Mortgage Backed Securities Fair value
$
1,331.1
$
142.7
$
306.9
$
69.0
$
3.6
$
1,853.3 Gross unrealized loss
$
(47.6
)
$
(20.8
)
$
(50.0
)
$
(15.3
)
$
(0.4
)
$
(134.1
) Total Fair Value
$
6,318.3
$
837.3
$
495.8
$
242.3
$
40.9
$
7,934.6 Gross unrealized loss
$
(790.2
)
$
(326.9
)
$
(144.8
)
$
(155.4
)
$
(36.1
)
$
(1,453.4
) % Impaired
(11.2
)%
(28.2
)%
(22.7
)%
(39.3
)%
(47.3
)%
(15.5
)%
(1)
The Company defines Core CDOs as investments in non-mortgage collateralized debt obligations, primarily consisting of collateralized loan obligations.
As noted in Note 2 to the Consolidated Financial Statements, Significant Accounting Policies, the determination of the amount of other than temporary impairments vary by investment type and is based upon managements periodic evaluation and assessment of known and inherent risks associated
with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management considers a wide range of factors about the security issuer and uses their best judgment in evaluating the cause of the decline in the estimated fair value
of the security and in assessing the prospects for near-term recovery. Inherent in managements evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Management updates its evaluations regularly and reflects additional impairments in
net income as determinations are made. Managements determination of the amount of the impairment taken on investments is highly subjective and could materially adversely impact the Companys results of operations. There can be no assurance that management has accurately assessed the level of
other than temporary impairments taken and reflected in the Companys financial statements. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments. 80
Financials
Levels of write down or other than temporary impairment are also impacted by the Companys assessment of the intent and ability to hold securities which have declined in value until recovery. If, due to changes in circumstances, the Company determines to reposition or realign portions of the
portfolio where the Company determines not to hold certain securities in an unrealized loss position to recovery, then the Company will incur other-than-temporary impairment charges, which charges could be significant. If the Company were forced to sell certain of its assets in a period of market disruption, there can be no assurance that the Company will be able to sell them for the prices at which the Company has recorded them. 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 Companys reserving practices and the establishment of any particular reserve reflects managements 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 $22.2 billion at September 30, 2008, and $23.2 billion at December 31, 2007. The table below represents a reconciliation of the Companys unpaid losses and loss expenses for the nine months ended September 30, 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
3,611,964
(462,921
)
3,149,043 Losses and loss expenses paid/recovered (1)
(4,275,474
)
1,043,212
(3,232,262
) Incurred case losses and unwind of discount on reserves associated with reinsurance agreements with Syncora
50,663
50,663 Foreign exchange and other
(416,070
)
35,600
(380,470
) Balance as at September 30, 2008
$
22,178,777
$
(4,049,724
)
$
18,129,053
(1)
Includes paid losses relating to loss reserves associated with previous reinsurance agreements with Syncora that were settled as part of the Master Agreement.
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, Losses and Loss Expenses and Item 1A. Risk Factors,
each in the Companys Annual Report on Form 10-K for the year ended December 31, 2007 for further discussion. Unpaid Losses and Loss Expenses Recoverable and Reinsurance Balances Receivable 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 Companys 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 Companys total unpaid gross losses. Unpaid losses and loss
expenses recoverable relate to estimated reinsurance recoveries on the unpaid loss and loss expense reserves. 81
Gross unpaid
losses and loss
expenses
Unpaid
losses and
loss expenses
recoverable
Net unpaid
losses
and loss
expenses
At both September 30, 2008 and December 31, 2007, unpaid losses and loss expenses recoverables were $4.1 billion and $4.7 billion, respectively. The table below presents the Companys net paid and unpaid losses and loss expenses recoverable and reinsurance balances receivable at September 30, 2008 and December 31, 2007. (U.S. dollars in thousands)
(Unaudited)
December 31, Reinsurance balances receivable
$
727,472
$
872,465 Reinsurance recoverable on future policy benefits
33,297
31,856 Unpaid losses and loss expenses recoverable.
4,135,875
4,804,209 Bad debt reserve on unpaid losses and loss expenses recoverable and reinsurance balances receivable.
(153,683
)
(193,128
) Net paid and unpaid losses and loss expenses recoverable and reinsurance balances receivable
$
4,742,961
$
5,515,402 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 and has accordingly provided required disclosures by level within the fair value hierarchy of the Companys 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 entitys own assumptions about market participant assumptions, applied to a modeled valuation, however, this is not the
case with respect to the Companys 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. At September 30, 2008, a significant component of Level 3 assets represented either Core CDOs, totaling $618.8 million, or securities
within the Companys portfolio of Topical Assets, totaling $89.0 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
the use of broker quotes. In addition, in certain instances given the market dislocation, the Company had elected to utilize Level 3 broker valuations over available pricing service valuations during the prior quarter; however, during the third quarter of 2008, fixed maturity investments were recorded based
upon pricing service valuations where available resulting in transfers being recorded from Level 3 to Level 2. 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, was not available to enable a third party pricing service to provide a price and as such valuation is determined based on broker quotes for which sufficient information regarding the specific inputs utilized by the broker in determining the fair value was not obtained to support a Level 2
classification. While the remainder of the Companys 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 services 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 Companys impairment analysis, the Company continues to report, at September 30, 2008, gross unrealized losses of $383.9 million related to Level 3 available-for-sale investments. Management completed a detailed
review, in conjunction with is external investment managers and third party advisors, of the Companys underlying sub-prime and related residential mortgage exposures, as well 82
September 30,
2008
2007
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 those 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 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 Companys behalf which provides additional comfort over the reasonableness of the fair values recorded in the Companys 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 September 30, 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 September 30, 2008. Fair Value of Level 3 Assets and Liabilities At September 30, 2008, the fair value of Level 3 assets and liabilities as a percentage of the Companys 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
$
26,501,478
$
905,630
3.4
% Equity securities, at fair value
471,705
0.0
% Short term investments, at fair value
1,633,654
2,799
0.2
% Total investments available for sale
$
28,606,837
$
908,429
3.2
% Cash equivalents (1)
4,443,847
0.0
% Other investments (2)
487,826
64,801
13.3
% Other assets (3) (4)
187,636
105,509
56.2
% Total assets carried at fair value
$
33,726,146
$
1,078,739
3.2
% Liabilities Financial instruments sold, but not yet purchased (5)
$
37,573
$
0.0
% Other liabilities (4) (6)
73,345
32,722
44.6
% Total liabilities carried at fair value
$
110,918
$
32,722
29.5
%
(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. 83
(Unaudited)
Liabilities Carried
at Fair Value at
September 30, 2008
Level 3 Assets
and Liabilities
and Liabilities as
a Percentage of
Total Assets and
Liabilities
Carried at Fair
Value, by class
(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 September 30, 2008, the balance of Level 3 assets as a percentage of the Companys total assets that were carried at fair value was 3.2%. The comparable percentage at December 31, 2007 was 3.7%. The decrease was primarily as a result of the Company, during the third quarter of 2008,
recording the fair value of fixed maturity investments based upon pricing service valuations where available, resulting in transfers being recorded from Level 3 to Level 2. The increase in the percentage of total invested assets that is made up of assets which are experiencing increased market illiquidity
does reduce the overall liquidity of the Companys capital resources; however, management do not believe that this change is significant given the many other sources of liquid assets available as at September 30, 2008. Level 3 liabilities at September 30, 2008 represent derivative instruments in a liability
position. For further discussion of the Companys 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. Liquidity and Capital Resources Liquidity Liquidity is a measure of the Companys ability to generate sufficient cash flows to meet the short- and long-term cash requirements of the Companys business operations. As a holding company, XL Capital Ltd has no operations of its own and its assets consist primarily of its investments in its subsidiaries. Accordingly, XL Capital Ltds 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 and states in which XL Capital Ltds subsidiaries operate, including, among others, Bermuda, Delaware, New York, Ireland, Switzerland and the United Kingdom. See Risk Factors Risks Related to the
Company Because we are a holding company, if our subsidiaries do not make dividend and other payments to us, we may not be able to pay dividends or make payments on our debt securities and other obligations in Item 1A of the Companys Quarterly Report on Form 10-Q for the quarter ended
June 30, 2008. The ability to pay such dividends is also limited by the regulations of the Society of Lloyds and certain contractual provisions. No assurance can be given that the Companys subsidiaries will pay dividends in the future to XL Capital Ltd. XL Capital Ltds principal uses of liquidity are for dividend payments to holders of its ordinary shares and preferred shares, interest and principal payments on debt, capital investments in its subsidiaries and corporate operating expenses. The Company and its subsidiaries provide no guarantees or other commitments (express or implied) of financial support to the Companys subsidiaries or affiliates, except for such guarantees or commitments that are in writing. Historically, cash receipts from operations, consisting of premiums and investment income, generally have provided sufficient funds to pay losses as well as operating expenses of the Companys subsidiaries and to fund dividends to XL Capital Ltd. Cash receipts from operations is generally derived
from the receipt of investment income on the Companys total investment portfolio as well as the net receipt of premiums less claims and expenses related to the Companys underwriting activities in its property and casualty operations as well as its Life Operations segment. The Companys 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. During the first nine months of 2008, net cash flows used in operating activities were $663.9 million primarily as a result of the payment of approximately $1.8 billion to Syncora under the Master Agreement. The Company funded the payment to Syncora by using proceeds from the 84
offering of both ordinary shares and ESUs as described below. Excluding the payment to Syncora, net cash flows from operations would have been approximately $1.1 billion for the first nine months of 2008. For the same period in 2007, net cash flows from operations was $2.0 billion. The decrease in
net cash flow from operations, excluding the payment to Syncora, was primarily as a result of decreases in net premiums written in the Companys P&C operations as described above, combined with increases in paid losses associated with attritional and catastrophe losses that have occurred over the past
twelve months. In addition, decreases in operating cash flow resulted from lower net investment income related to both P&C operations and structured products mainly due to decreased yields earned on investment of cash flows and reinvestment of maturing or sold securities, as prevailing market interest
rates, particularly in the U.S., decreased overall during the last twelve months. As at September 30, 2008, the Company had cash and cash equivalents of approximately $5.6 billion as compared to approximately $3.9 billion at December 31, 2007. In addition, the Company maintains credit facilities which provide additional liquidity. Details of these facilities are described below in
Capital Resources. In July 2008, in conjunction with the issuance of ordinary shares and ESUs as described below, the Board of Directors approved a reduction in the quarterly dividend payable on the Companys Class A Ordinary Shares to $0.19 per ordinary share beginning with the quarterly
dividend paid in September 2008. As part of the recent financial market turbulence that persisted throughout the first nine months of 2008, increasingly thin market liquidity has persisted throughout the U.S. and other financial markets. During this period, the Company raised over $4 billion of cash by selling assets from its fixed
income portfolio in order to settle, in the first nine months of 2008, the entire GIC portfolio and funding agreements that have matured. At September 30, 2008, the remaining balance of funding agreements, excluding accrued interest of $10.0 million, was $850.0 million, with settlements scheduled as
follows: $250.0 million in December 2008, $150.0 million in October 2009 and $450.0 million in August 2010. 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. The Companys
liquidity needs may change. For instance, in the event of certain ratings
downgrades, the Company may be required to post cash collateral in connection
with its letters of credit and revolving credit facilities, to return premiums
to clients in the case of the cancellation of certain reinsurance agreements
and to return cash or assets to settle certain derivative transactions. See Ratings below. Capital Resources At September 30, 2008, the Company had total shareholders equity of $8.7 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. The continuation of
the current capital and credit market disruption, as well as any future disruptions or rating agency actions, could limit the Companys ability to raise capital in the future. If the Companys sources of liquidity described above prove to be insufficient, the Company may not be able to successfully obtain
additional financing on favorable terms, or at all. In order to fund the payment of approximately $1.8 billion to Syncora under the Master Agreement and the payment of approximately $283 million to consummate the redemption of X.L. America, Inc.s $255 million 6.58% Guaranteed Senior Notes, due 2011, the Company, raised approximately $2.8
billion in August 2008 through an issuance of both ordinary shares and ESUs. The ESUs consisted of: (i) forward purchase contracts for holders to purchase, and the Company to issue, ordinary shares and (ii) debt securities. The Company is using the remaining proceeds from 85
the offerings for general corporate purposes, including the replenishment of the capital base of certain of its subsidiaries. For further details relating to the Master Agreement, see Note 4 to the Consolidated Financial Statements, Syncora Holdings Ltd. (Syncora). Concurrent with the execution of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent capital facility entered into in July 2003, resulting in net proceeds to the Company of approximately $500 million in exchange for the issuance by the Company of
20,000,000 Series C Preference Ordinary Shares, par value U.S. $0.01 per share (the Series C Preference Shares). The liquidation preference of the Series C Preference Shares is $25 per share, plus accrued and unpaid dividends. The Company may redeem the Series C Preference Shares, in whole or in
part, on or after July 15, 2013, at a redemption price of $25 per share, plus accrued and unpaid dividends. The Company may, under certain circumstances, redeem the Series C Preference Shares before July 15, 2013 at specific redemption prices, plus accrued and unpaid dividends. These circumstances
include an amalgamation, consolidation or other similar transaction involving the Company in which the Series C Preference Shares are entitled to a class vote ($26 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Series C
Preference Shares ($25 per share redemption price). The Series C Preference Shares may be redeemed by the holders after July 15, 2033. Until July 15, 2013, dividends on the Series C Preference Shares are payable semiannually on a cumulative basis, when, as and if declared by the Companys Board of
Directors, on January 15 and July 15 of each year at a fixed rate equal to 6.102% per annum on the liquidation preference. From and after July 15, 2013, dividends on the Series C Preference Shares are payable quarterly on a cumulative basis, when, as and if declared by the Companys Board of
Directors, on January 15, April 15, July 15 and October 15 of each year at a floating rate equal to three-month LIBOR plus 3.145% on the liquidation preference. The Series C Preference Shares have no stated maturity and are not subject to any sinking fund or mandatory redemption and are not
convertible into any of the Companys other securities. Debt The following table presents the Companys indebtedness under outstanding debt securities and lenders commitments as at September 30, 2008:
Notes Payable and Debt
Commitment
In Use
Year of
Payments Due by Period
Less
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
6.50% Guaranteed Senior Notes
598,967
598,967
2012
600,000
5.25% Senior Notes
596,104
596,104
2014
600,000 8.25% Senior Notes
575,000
575,000
2021
575,000 6.375% Senior Notes
350,000
350,000
2024
350,000 6.25% Senior Notes
324,411
324,411
2027
325,000
$
4,289,482
$
3,189,482
$
$
745,000
$
600,000
$
1,850,000 Commitment and In Use data represent September 30, 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 September 30, 2008, the Company had six letter of credit facilities in place with total availability of $7.2 billion, of which $3.2 billion was utilized. 86
(U.S. dollars in thousands)
Expiry
than
1 Year
Years
Years
Years
Other Commercial
Commitment
In Use
Year of
Amount of Commitment
Less
1 to 3
3 to 5
After 5 Letter of Credit Facility
$
200,000
$
147,427
Continuous
$
200,000
$
$
$
Letter of Credit Facility (1)(2)
2,250,000
2010
2,250,000
Letter of Credit Facility (1)(2)
4,000,000
2,460,670
2012
4,000,000
Letter of Credit Facility
317
281
2008
317
Letter of Credit Facility
133
133
2008
133
Letter of Credit Facility
713,120
550,112
2009
713,120
Six letter of credit facilities
$
7,163,570
$
3,158,623
$
200,450
$
2,963,120
$
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.
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 Lloyds. 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 Companys investment portfolio or funds withheld using the Companys 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 previously entered into contingent capital transactions whereby 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. As noted above, concurrent with the closing of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent
capital facility entered into in July 2003 resulting in net proceeds to the Company of approximately $500 million in exchange for the issuance by the Company of 20,000,000 Series C Preference Ordinary Shares. As at September 30, 2008, the Companys remaining contingent capital facility was the
Stoneheath Re facility with an aggregate value of $350.0 million. For further information, see Note 16 to the Consolidated Financial Statements, Off-Balance Sheet Arrangements in the Companys Annual Report on Form 10-K for the year ended December 31, 2007. Ratings The Companys ability to underwrite business is dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company is downgraded, its ability to write business as well as its financial condition and/or results of operations, could be materially adversely affected. A downgrade below A of the Companys principal insurance and reinsurance subsidiaries by either S&P or A.M. Best, which is currently three notches below the current S&P financial strength rating of A+ (Negative) and two notches below the current A.M. Best financial strength rating of A
(Stable) of these subsidiaries, may require the posting of cash collateral in support of certain in use portions of the Companys letter of credit and revolving credit facilities (see Liquidity and Capital Resources above). In addition, such a downgrade would trigger cancellation provisions in a significant
amount of the Companys assumed reinsurance contracts and may potentially require the Company to return unearned premium to cedants. In certain limited instances, such downgrades may require the Company to return cash or assets to counterparties to settle certain derivative 87
Commitments
(U.S. dollars in thousands)
Expiry
Expiration per period
than
1 Year
Years
Years
Years
transactions with the respective counterparties. See Risk Factors titled A downgrade in our current ratings by one or more rating agencies could materially and negatively impact our business, financial condition, results of operations, and/or liquidity and A decline in our ratings may allow many of our
clients to terminate contracts with us in the Companys quarterly report on Form 10-Q for the quarter ended June 30, 2008. During the third quarter of 2008, various rating agency actions were taken following the closing of the Master Agreement and the capital raise which affirmed the Companys ratings at the time. However, shortly after the Companys release of preliminary third quarter 2008 results and following
significant decreases in the Companys share price in early October 2008, additional rating agency actions were taken as follows:
A.M. Best commented that the A financial strength rating with a stable outlook for the Companys principal insurance and reinsurance subsidiaries, remained unchanged. Standard and Poors (S&P) affirmed the A+ financial strength rating with a negative outlook for the Companys leading property and casualty operating companies. FitchRatings (Fitch) placed the A+ financial strength rating of the Companys leading insurance and reinsurance subsidiaries on Rating Watch Negative. Moodys Investor Services, Inc. (Moodys) placed the A1 financial strength rating of the Companys principal insurance and reinsurance subsidiaries On Review for Possible Downgrade. In their public rating action announcements, the rating agencies expressed concerns regarding, among other things, the Companys enterprise risk management, potential further declines in its investment portfolio and the possible effect on the Companys capital. In addition, in relation to the Companys life reinsurance business, in October 2008, A.M. Best downgraded the financial strength rating to A (Excellent) from A (Excellent) and issuer credit rating (ICR) to a from a of XL Life Ltd (XL Life). The outlook for both ratings is stable. In their public
rating action announcement, A.M. Best noted that the rating actions reflected XL Lifes diminishing business profile within the Company, the pressure on capitalization primarily due to realized and unrealized investment losses and the generally declining premium produced by XL Life. In addition, the
rating action announcement highlighted that the Company has indicated that its life reinsurance business has been undergoing a strategic review. The following are the financial strength and claims paying ratings from internationally recognized rating agencies as at October 21, 2008, in relation to the Companys principal insurance and reinsurance subsidiaries and pools:
Rating agency
Rating
Outlook S&P
A+
(Negative) Fitch
A+
(Rating Watch Negative) A.M. Best
A
(Stable) Moodys
A1
(On Review for Possible Downgrade) In addition, XL Capital Ltd had the following long term debt ratings as at September 30, 2008: bbb (Stable) from A.M. Best, A(Negative) from S&P, Baa1 (On Review for Possible Downgrade) from Moodys and A (Stable) from Fitch. The Company regularly evaluates its capital needs to support its financial strength ratings. The Company regularly provides financial information to rating agencies to both maintain and enhance existing ratings. Other For information regarding cross-default and certain other provisions in the Companys debt and convertible securities documents, see Item 7 of the Companys Annual Report on 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. 88
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 Companys 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 Companys current views with respect to future events and financial performance. Such statements include forward-looking statements both with respect to the
Company in general, and to the insurance 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 in ratings, rating agency policies or practices; (ii)
changes to the size of the Companys claims relating to natural catastrophes;
(iii) the timely and full recoverability of reinsurance placed by the Company
with third parties, or other amounts due to the Company; (iv) the projected
amount of ceded reinsurance recoverables and the ratings and creditworthiness
of reinsurers may change; (v) the timing of claims payments being faster
or the receipt of reinsurance recoverables being slower than anticipated
by the Company; (vi) ineffectiveness or obsolescence of the Companys
business strategy due to changes in current or future market conditions;
(vii) increased competition on the basis of pricing, capacity, coverage terms
or other factors; (viii) greater frequency or severity of claims and loss
activity, including as a result of natural or man-made catastrophic events,
than the Companys
underwriting, reserving or investment practices anticipate based on historical
experience or industry data; (ix) developments in the worlds financial
and capital markets that adversely affect the performance of the Companys
investments and the Companys access to such markets including, but
not limited to, the global credit crisis that began in 2007; (x) the potential
impact on the Company from government-mandated insurance coverage for acts
of terrorism; (xi) the potential impact of variable interest entities or
other off-balance sheet arrangements on the Company; (xii) 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; (xiii) availability
of borrowings and letters of credit under the Companys credit facilities;
(xiv) changes in regulation or tax laws applicable to the Company or its
subsidiaries, brokers or customers; (xv) acceptance of the Companys
products and services, including new products and services; (xvi) changes
in the availability, cost or quality of reinsurance; (xvii) changes in the
distribution or placement of risks due to increased consolidation of insurance
and reinsurance brokers; (xviii) loss of key personnel; (xix) the effects
of mergers, acquisitions and divestitures; (xx) changes in accounting policies
or practices or the application thereof; (xxi) legislative or regulatory
developments including, but not limited to, changes in regulatory capital
balances that must be maintained by the Companys operating subsidiaries
and recent governmental actions for the purpose of stabilizing the financial
markets; (xxii) changes in general economic conditions, including inflation,
foreign currency exchange rates and other factors; (xxiii) the effects of
business disruption or economic contraction due to war, terrorism or other
hostilities; and (xiv) the other factors set forth in the Companys
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 Companys market risk exposures or how those exposures are managed, since December 31, 2007. The following discussion 89
should be read in conjunction with Quantitative and Qualitative Disclosures about Market Risk, presented under Item 7A of the Companys 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, foreign currency exchange rate risk; equity price risk; credit risk; weather and energy-related risk, and other related market risks. For a discussion of related risks, see the risk factor titled We are exposed to significant
capital markets risk related to changes in interest rates, credit spreads, equity prices and foreign exchange rates which may adversely affect our results of operations, financial condition or cash flows in the Companys Quarterly Report on Form 10-Q for the quarter ended June 30, 2008 as well as the risk
factors set forth under Item 1A Risk Factors in the report. The Companys 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 Companys 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 or loss and shareholders equity but may not have an immediate effect on net income. Changes in interest rates, credit spreads, equity prices and other related market instruments affect
consolidated net income when, and if, a security is sold or impaired. The Company conducts its derivative activities primarily in investment-related derivatives, which may include credit derivatives, and previously within weather and energy derivatives. From time to time, the Company 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 Companys derivative transactions can expose or have exposed 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. Credit derivatives are purchased within the Companys investment portfolio, have been sold through a limited number of contracts written as part of the Companys previous XL Financial Solutions business, and were previously entered into through the Companys prior reinsurance agreements
with Syncora. Following the closing of the Master Agreement which terminated certain reinsurance and other agreements, these credit derivative exposures were eliminated by virtue of the commutation of the relevant reinsurance agreement. As of September 30, 2008, the remaining credit derivative
exposure outside of the Companys investment portfolio consists of 25 contracts written by the Company that provide credit protection on senior tranches of structured finance transactions with total net par values outstanding of $661.1 million, a weighted average contractual term to maturity of 5.9 years,
and a total liability recorded of $19.7 million. 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 Companys 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 Companys 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. A rise in interest rates generally would decrease the fair value of the Companys investment portfolio, offset by the 90
Companys ability to earn higher rates of return on funds reinvested. Conversely, a decline in interest rates generally would increase the fair value of the Companys investment portfolio, offset by lower rates of return on funds reinvested. 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. In addition, the Companys estimate of the liability cash flow profile may be inaccurate and the Company may be forced to liquidate investments prior to maturity at a loss in order to cover losses. The
hypothetical case of an immediate 100 basis point adverse parallel shift in global bond curves as at September 30, 2008, would have decreased the fair value of the Companys fixed income portfolio by approximately 4.1% or $1.4 billion. Foreign Currency Exchange Rate Risk Many of the Companys 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 Companys 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 Companys investment portfolio, and the cumulative translation adjustments resulting
from the translation of foreign subsidiary results. The principal currencies creating foreign exchange risk for the Company are the British pound sterling, the Euro, the Swiss Franc, and the Canadian dollar. The Companys net notional foreign currency denominated exposure on foreign exchange contracts was $413.6 million and $341.7 million as at
September 30, 2008 and December 31, 2007, respectively, with a net unrealized loss of $17.5 million and net unrealized gain of $0.9 million as at September 30, 2008 and December 31, 2007, respectively. Equity Price Risk The Companys 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
Companys equity portfolio would affect the fair value of the portfolio by approximately $42.6 million as at September 30, 2008. This excludes exposures to equities in the Companys affiliate investments. As at September 30, 2008, the Companys equity portfolio was approximately $426 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 September 30, 2008, the Companys allocation to equity securities was approximately 1.2% 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 September 30, 2008, the top ten equity holdings represented approximately 9.6% of the Companys total equity portfolio as compared to approximately 11.5% as at December 31, 2007. Credit Risk The Companys exposure to credit spreads primarily relates to market price and cash flow variability associated with changes in credit spreads. A widening of credit spreads will increase the net unrealized loss position of the investment portfolio, will increase losses associated with credit based non-
qualifying derivatives where the Company assumes credit exposure, and, if issuer credit spreads increase significantly or for an extended period of time, would likely result in higher other-than-temporary impairments. Credit spread tightening will reduce net investment income associated with new
purchases of fixed maturities. In addition, market volatility can make it difficult to value certain of the Companys securities if trading becomes less frequent. As such, valuations may include assumptions or estimates that may have significant period to period changes which could have a 91
material adverse effect on the Companys consolidated results of operations or financial condition. Credit spreads on both corporate and structured securities widened during the quarter ended September 30, 2008 and continued to widen following the quarter end, resulting in continuing depressed pricing.
Continuing challenges include continued weakness in the U.S. real estate market and increased mortgage delinquencies, investor anxiety over the U.S. economy, rating agency downgrades of various structured products and financial issuers, unresolved issues with structured investment vehicles and
monolines, deleveraging of financial institutions and hedge funds and a serious dislocation in the inter-bank market. If significant, continued volatility, changes in interest rates, changes in credit spreads and defaults, a lack of pricing transparency, market liquidity, declines in equity prices, and the
strengthening or weakening of foreign currencies against the U.S. dollar, individually or in tandem, could have a material adverse effect on the Companys consolidated results of operations, financial condition or cash flows through realized losses, impairments, and changes in unrealized positions. The
Companys exposure to market movements related to credit risk is primarily
due to its investment portfolio, receivable and ceded reinsurance balances.
Within the investment portfolio, credit risk is the exposure to adverse changes
in the creditworthiness of individual investment holdings, issuers, groups
of issuers, industries or countries. The hypothetical case of an immediate
25 basis point increase in all the global corporate and structured credit
spreads to which the Companys fixed income portfolio is exposed to
at September 30, 2008, would decrease the fair value of the Companys
fixed income portfolio by approximately $253.6 million. This excludes exposure
to credit in the Companys affiliate investment. In addition, credit risk pertains to adverse changes in the creditworthiness of the Companys reinsurers and retrocessionaires, and their ability to pay certain reinsurance receivable and recoverable balances. The table below shows the Companys fixed income investment portfolio by credit rating in percentage terms of the Companys 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 September 30, 2008:
Total AAA
53.2
% AA
21.2
% A
16.0
% BBB
7.1
% BB & below
2.5
% NR
0.0
% Total
100.0
% At September 30, 2008, the average credit quality of the Companys total fixed income portfolio was AA. 92
The Company is closely monitoring its corporate financial bond holdings in light of the current credit market conditions. The table below summarizes the Companys significant exposures (defined as bonds issued by financial institutions with an amortized cost in excess of $50.0 million) to corporate
bonds of financial issuers held within its investment portfolio, representing both amortized cost and unrealized gains (losses): (U.S. dollars in millions)
Issuer (by Global Ultimate Parent)
Amortized Cost at
Unrealized Gain HBOS plc
$
237.8
$
(41.8
) Citigroup Inc.
209.2
(36.0
) Bank of America Corporation
203.5
(28.0
) The Goldman Sachs Group, Inc.
198.9
(43.6
) HSBC Holdings Plc
160.7
(16.8
) Merrill Lynch & Co., Inc.
143.7
(22.9
) Lloyds TSB Group, Plc
143.3
(28.8
) Barclays Plc
127.9
(37.5
) The Royal Bank of Scotland
122.9
(29.1
) JPMorgan Chase & Co.
117.2
(12.4
) Banco Santander, S.A.
116.7
(20.6
) American International Group, Inc.
116.6
(42.6
) Morgan Stanley
115.0
(34.4
) Nationwide Building Society
108.9
(11.8
) Royal Bank of Canada
91.7
(3.3
) RFS Holdings B.V. (ABN AMRO)
90.6
(10.1
) Aviva Plc
88.2
(24.4
) Wells Fargo & Company
81.5
(3.2
) Northern Rock Plc
76.2
(5.4
) UBS AG
70.1
(14.0
) Australia & New Zealand Banking Group Ltd
67.5
(3.6
) Unicredit SpA
66.8
(10.0
) CIT Group Inc.
66.4
(24.1
) American Express Company
66.0
(4.1
) Assicurazioni Generali SpA
65.1
(16.1
) Legal & General Group Plc
65.1
(13.9
) Wachovia Corporation
64.8
(18.2
) The PNC Financial Services Group, Inc.
61.6
(2.6
) Credit Agricole SA
61.2
(13.5
) Danske Bank A/S
59.8
(13.9
) Caisse Nationale des Caisses DEpargne et de Prevoyance (CNCEP)
56.3
(12.9
) Allied Irish Banks PLC
51.4
(19.3
) As at September 30, 2008, the top 10 corporate holdings within the fixed income investment portfolio, which exclude government guaranteed and government sponsored enterprises, represented approximately 4.6% of the total fixed income portfolio and approximately 13.9% of all corporate holdings.
The top 10 corporate holdings listed below represent the direct exposure to the corporations listed below, including their subsidiaries, and exclude any securitized, credit enhanced and collateralized asset or mortgage backed securities, cash and cash equivalents, pooled notes and any over-the-counter
(OTC) derivative counterparty exposure, if applicable. 93
September 30,
2008
(Loss) at
September 30,
2008
Top 10 Corporate Holdings
Percentage of Total General Electric Company
0.7
% HBOS plc
0.6
% Bank of America Corporation
0.5
% Citigroup Inc
0.5
% The Goldman Sachs Group, Inc
0.5
% HSBC Holdings plc
0.4
% Merrill Lynch & Co., Inc
0.4
% Lloyds TSB Group plc
0.4
% JP Morgan Chase & Co.
0.3
% Nationwide Building Society
0.3
%
(1)
Including fixed maturities, short-term investments, cash and cash equivalents, accrued investment income and net payable for investments purchased.
As at September 30, 2008, the top 5 corporate sector exposures represented 26.2% of the total fixed income portfolio and 78.0% of all corporate holdings.
Top 5 Sector Exposures
Fair Value
Percent of Financials
$
5,226.5
15.7
% Consumer, Non-Cyclical
983.4
2.9
% Communications
855.4
2.6
% Industrials
846.2
2.5
% Utilities
827.6
2.5
% Total
$
8,739.1
26.2
% 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 $9.5 billion structured credit portfolio as at September 30, 2008, of which approximately 82% were AAA rated:
(U.S. dollars in millions)
Fair Value
Percent of Portfolio CMBS
$
2,409.7
25.2
% Agency
1,840.9
19.3
% Whole Loans
1,286.0
13.5
% Core CDO (non-ABS CDOs and CLOs)
757.4
7.9
% Other ABS: ABS Auto
768.5
8.1
% ABS Credit Cards
521.3
5.5
% ABS Other
691.2
7.2
% Topical: Sub-prime first lien
659.4
6.9
% Alt-A
525.4
5.5
% Second lien (including sub-prime second lien mortgages)
71.1
0.7
% ABS CDOs with sub-prime collateral
14.6
0.2
% Total
$
9,545.5
100.0
% For further discussion of the exposure to credit market movements in the Companys investment portfolio see the Investment Value-at-Risk section below. Credit derivatives are purchased within the Companys investment portfolio, have been sold through a limited number of contracts written as part of the Companys previous XL Financial Solutions business, and were previously sold through the Companys prior reinsurance agreements with Syncora
(as described above). The Company may purchase credit default swaps to hedge an existing position or concentration of its holdings. The credit derivatives are recorded at fair value. 94
Fixed Income
Portfolio (1)
Fixed Income
Portfolio
Following the secondary sale of Syncora common shares, the Company retained some credit derivative exposures written by Syncora and certain of its subsidiaries through reinsurance agreements that had certain derivatives exposures embedded within them. Following the closing of the Master Agreement
which terminated certain reinsurance and other agreements, these credit derivative exposures were eliminated by virtue of the commutation of the relevant reinsurance agreements. As of September 30, 2008, the remaining credit derivative exposure outside of the Companys investment portfolio consisted
of 25 contracts written by the Company that provide credit protection on senior tranches of structured finance transactions with total net par values outstanding of $661.1 million, a weighted average contractual term to maturity of 5.9 years, and a total liability recorded of $19.7 million. The Company has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, hedge funds and other investment funds and other institutions.
Many of these transactions expose the Company to credit risk in the event of default of the Companys counterparty. In addition, with respect to secured transactions, the Companys credit risk may be exacerbated when the collateral held by the Company cannot be realized upon or is liquidated at prices
not sufficient to recover the full amount of the loan or derivative exposure that is due. The Company also has exposure to financial institutions in the form of unsecured debt instruments, derivative transactions, revolving credit facility and letter of credit commitments and equity investments. There can be
no assurance that any such losses or impairments to the carrying value of these assets would not materially and adversely affect the Companys business and results of operations. 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 settle amounts due to the Company; however, these exposures are not marked to market. For further information
relating to reinsurer credit risk, see Managements 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 Companys
maximum credit exposure. Weather and Energy Risk Prior to August 2008, the Company previously offered weather and contingent energy risk management products in insurance or derivative form to end-users and managed the risks in the over-the-counter and exchange traded derivatives markets or through the use of quota share or excess of loss
arrangements. However, as part of the Companys strategy to focus on its core Insurance and Reinsurance P&C operations, the Company, in August 2008, closed this unit and ceased writing such weather and energy risk management products. Fair values for the Companys existing portfolio of previously written 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 managements 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 managements best estimate based on various factors including, but not limited to, realized and
forecasted weather conditions, changes in interest rates and other market factors. Previously, when the Company offered weather and contingent energy risk management products, the Company managed its portfolio of such products through the employment of a variety of strategies. These included geographical and directional diversification of risk exposures and direct 95
hedging within the capital and reinsurance markets. As at September 30, 2008, the Companys VaR related to these risks did not exceed $20.0 million in any one season. The majority of existing weather and energy contracts will expire by the end of 2008 with the remainder of the portfolio expected to
expire by mid-2009. Other Market Risks The Companys 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 September 30, 2008, the Companys exposure to private investments was $453.8 million compared to $427.5 million as at December 31, 2007. The Companys alternative investment portfolio, which is exposed to equity and credit risk as well as certain other market risks, had a total exposure of $1.9 billion making up approximately 5.2% of the total investment portfolio (including cash and cash equivalents, accrued investment income and
net payable for investments purchased) at September 30, 2008, as compared to December 31, 2007, where the Company had a total exposure of $2.3 billion representing approximately 5.2% of the total investment portfolio. The VaR associated with the alternative investment portfolio at September 30,
2008 was approximately $67.2 million. At September 30, 2008, bond and stock index futures outstanding had a net long position of $372.4 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 $37.2 million as at September 30, 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. The Company invests a portion of its invested assets in investment funds, many of which make private equity investments. The amount and timing of income from such investment funds tends to be uneven as a result of the performance of the underlying investments, including private equity
investments. The timing of distributions from the funds, which depends on particular events relating to the underlying investments, as well as the funds schedules for making distributions and their needs for cash, can be difficult to predict. As a result, the amount of income that the Company records from
these investments can vary substantially from quarter to quarter. Recent equity and credit market volatility may reduce investment income for these type of investments. Investment Value-at-Risk (VaR) The VaR of the investment portfolio at September 30, 2008, based on a 95% confidence level with a one month holding period was approximately $759 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 $60.7 million at September 30, 2008 as compared to $19.1 million at December 31, 2007. The Companys investment portfolio VaR as at September 30, 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 Companys total risk tolerance. Given the investment portfolio allocations as at September 30, 2008, the Company would expect to lose approximately 4.4% 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 September 30, 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 96
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 Companys 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 Companys 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 Companys internal control over financial reporting. 97
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 Companys 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 Companys loss
reserves for its NAC Re subsidiary (now known as XL Reinsurance America, Inc.) and that, as a consequence, the Companys 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 the parties await scheduling of argument. 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 (DOJ) 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. In June 2008, subsidiaries of the Company also received a subpoena from the Connecticut Attorney General and an Antitrust Civil Investigative Demand from the Office of the Florida Attorney General in connection with a coordinated multi-state Attorneys
General investigation into the matters referenced in the DOJ and SEC subpoenas. The Company is fully cooperating with these investigations. Commencing in March 2008, the Company and two of its subsidiaries were named, along with approximately 20 other providers and insurers of municipal Guaranteed Investment Contracts and similar derivative products in the United States (collectively Municipal Derivatives) as well as fourteen
brokers of such products, in several purported federal antitrust class actions. The Judicial Panel on Multidistrict Litigation ordered that these be consolidated for pretrial purposes and assigned them to the Southern District of New York. The consolidated amended complaint filed in August 2008 alleges
that there was a conspiracy among the defendants during the period from January 1, 1992 to the present to rig bids and otherwise unlawfully decrease the yield for Municipal Derivative products. The purported class of plaintiffs consists of purchasers of Municipal Derivatives. On October 21, 2008 most of
the defendants filed motions to dismiss the consolidated amended complaint. In addition, the same two subsidiaries of the Company have been named in a number of similar actions filed by various municipalities in California state courts. The Defendants have removed those cases to federal court. The
Plaintiffs have filed motions to remand. The Company intends to vigorously defend these actions. 98
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 Companys contingent commission arrangements with brokers and agents and/or the Companys insurance
and reinsurance practices in connection with certain finite-risk and loss mitigation products. Similarly, the Companys affiliates outside the United States have, from time to time, received and responded to requests from regulators relating to the Companys 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 Courts 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. All appellate briefs have now been filed. Oral argument in the appeal has been scheduled tentatively for April 2009. Various XL entities have been named as defendants in three of the many tag-along actions that have been consolidated into the MDL for pretrial purposes. 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, 99
Inc., XL Insurance Company Limited, Lloyds 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 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 Courts 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 Courts disposition of defendants motions to dismiss the Second Amended Complaint filed in the MDL. As at September 30, 2008, the New Cingular Lawsuit remained stayed. 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 Courts April 11, 2007 stay Order. As at September 30, 2008, the Henley Lawsuit remained stayed. 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. As at September 30, 2008, the Sears Lawsuit remained stayed. Three purported class actions on behalf of shareholders of Syncora Holdings Ltd (Syncora) have been filed against the Company and one of its subsidiaries (collectively XL), Syncora, four Syncora officers, and various underwriters of Syncora securities. The Judicial Panel on Multidistrict
Litigation ordered that these be consolidated for pretrial purposes and assigned them to the Southern District of New York. The consolidated amended complaint, filed in August 2008, alleges violations of the Securities Act of 1933 arising out of the secondary public offering of Syncora common shares
held by XL on June 6, 2007 and sales/exchanges by Syncora of certain preferred shares as well as under the Securities Exchange Act of 1934 arising out of trading in Syncora securities during the asserted class period of March 15, 2007 to March 17, 2008. The principal allegations are that Syncora failed
to appropriately and timely disclose its exposures under certain derivative contracts and insurance of tranches of structured securities. XL is named as the selling shareholder in the secondary public offering and as a party that controlled Syncora during the relevant time period. On October 14, 2008, XL
and other defendants filed motions to dismiss the consolidated amended complaint. The Company intends to vigorously defend these actions. 100
In connection with the secondary offering of the Companys Syncora shares, the Company and Syncora each agreed to indemnify the several underwriters of that offering against certain liabilities, including liabilities under the Securities Act of 1933 for payment of legal fees and expenses, settlements
and judgments incurred with respect to litigation such as this. The Company and Syncora have agreed to each bear 50% of this indemnity obligation. The Company is 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 Companys 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 Companys results. For updates to the Companys risk factors as contained in the Companys Annual Report on Form 10-K for the year ended December 31, 2007, refer to the risk factors disclosed in the Companys Quarterly Report on Form 10-Q for the quarter ended June 30, 2008 as well as the risk factors noted
below: Deterioration in the public debt and equity markets could lead to additional investment losses. The prolonged and severe disruptions in the public debt and equity markets, including among other things, widening of credit spreads, bankruptcies and government intervention in a number of large financial institutions, have resulted in significant realized and unrealized losses in the Companys
investment portfolio. For the nine months ended September 30, 2008, the Company incurred substantial realized and unrealized investment losses, as described in Managements Discussion and Analysis of Financial Condition and Results of Operations under Part I, Item 2 of this report. Subsequent to
September 30, 2008, through the date of this report, conditions in the public debt and equity markets have continued to deteriorate and pricing levels have continued to decline. The Company continues to closely monitor current market conditions and evaluate the long term impact of this recent market
volatility on all of its investment holdings. Depending on market conditions, the Company could incur additional realized and unrealized losses in future periods, which could have a material adverse effect on the Companys results of operations, financial condition and business. There can be no assurance as to the effect that governmental actions for the purpose of stabilizing the financial markets will have on such markets generally or on the Company in particular. In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, President Bush signed the Emergency Economic Stabilization Act of 2008 (the EESA) into law. Pursuant to the
EESA, the U.S. Treasury has the authority to, among other things, purchase up to $700 billion of mortgage-backed and other securities from financial institutions for the purpose of stabilizing the financial markets. In addition, the U.S. Treasury Department announced that it will make up to $250 billion
in preferred stock investments in U.S. banks and thrifts and that it is also considering taking equity stakes in insurance companies. The Federal Government, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address 101
the financial crisis. It is possible that competitors of the Company, such as companies that engage in both life and property casualty insurance lines of business, may participate in some or all of the EESA programs. There can be no assurance as to the effect that any such governmental actions will have
on the financial markets generally or on the Companys competitive position, business and financial condition in particular. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(a)
Unregistered issuances of the Companys equity securities were previously disclosed in the Companys Current Report on Form 8-K, filed on July 28, 2008.
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 September 30, 2008 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act: ISSUER PURCHASES OF EQUITY SECURITIES
Period
Total Number
Average Price
Total Number
Approximate Dollar July 1-31, 2008
4,238
$
21.78
$
375.5 million August 1-31, 2008
1,966
$
17.89
$
375.5 million September 1-30, 2008
25,473
$
18.08
$
375.5 million Total
31,677
$
18.56
$
375.5 million
(1)
All shares were purchased in connection with the vesting of restricted shares granted under the Companys 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 Companys share repurchase program noted below. (2) On September 24, 2007, the Board of Directors of the Company approved a share repurchase program, authorizing the Company to repurchase up to $500.0 million of its Class A ordinary shares. During the three and nine months ended September 30, 2008, no share repurchases were made under the share repurchase program. As at September 30, 2008, the Company could
repurchase $375.5 million of its equity securities under the share repurchase program. 102
(c)
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)
4.1
Fifth Supplemental Indenture, dated August 5, 2008, to the Indenture, dated as of June 2, 2004, between the Registrant and The Bank of New York Mellon, as trustee, incorporated by reference to Exhibit 4.1 to the Companys Current Report on Form 8-K filed on August 6, 2008.
4.2
Purchase Contract Agreement, dated August 5, 2008, between the Registrant and The Bank of New York Mellon, as Purchase Contract Agent, incorporated by reference to Exhibit 4.2 to the Companys Current Report on Form 8-K filed on August 6, 2008.
4.3
Pledge Agreement, dated August 5, 2008, by and among the Registrant and The Bank of New York Mellon, as Collateral Agent, Custodial Agent and Securities Intermediary, and The Bank of New York Mellon, as Purchase Contract Agent, incorporated by reference to Exhibit 4.3 to the
Companys Current Report on Form 8-K filed on August 6, 2008.
4.4
Registration Rights Agreement dated as of August 5, 2008, by and among the Registrant, Syncora Guarantee Re Ltd. and Syncora Guarantee Inc., incorporated by reference to Exhibit 4.4 to the Companys Current Report on Form 8-K filed on August 6, 2008.
4.5
Form of Normal Units Certificate (included in Exhibit 4.2 hereto), incorporated by reference to Exhibit 4.5 to the Companys Current Report on Form 8-K filed on August 6, 2008.
4.6
Form of Stripped Units Certificate (included in Exhibit 4.2 hereto), incorporated by reference to Exhibit 4.6 to the Companys Current Report on Form 8-K filed on August 6, 2008.
4.7
Form of Senior Note (included in Exhibit 4.1 hereto), incorporated by reference to Exhibit 4.7 to the Companys Current Report on Form 8-K filed on August 6, 2008.
10.1
Master Commutation, Release and Restructuring Agreement by and among XL Capital Ltd, XL Insurance (Bermuda) Ltd, XL Reinsurance America Inc., X.L. Global Services, Inc., XL Services (Bermuda) Ltd and X.L. America, Inc., Security Capital Assurance Ltd (SCA), certain of SCAs
subsidiaries and certain financial institutions who have entered into various credit default swaps with affiliates of SCA, dated as of July 28, 2008, incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed on July 28, 2008.
10.2
Amendment No. 1, dated as of July 28, 2008, to Employment Agreement, dated as of November 1, 2006, between XL Capital Ltd and Fiona E. Luck, incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed on July 28, 2008.
10.3
Agreement and Release, dated as of July 28, 2008, between XL Capital Ltd and Henry C.V. Keeling, incorporated by reference to Exhibit 10.3 to the Companys Current Report on Form 8-K filed on July 28, 2008.
31*
Rule 13a-14(a)/15d-14(a) Certifications.
32*
Section 1350 Certification.
* 103
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: November 3, 2008
/s/ MICHAEL S. MCGAVICK
Michael S. McGavick
Date: November 3, 2008
/s/ BRIAN W. NOCCO
Brian W. Nocco 104
(Registrant)
Chief Executive Officer
Executive Vice President and
Chief Financial Officer
Exhibit 31
Certification of Chief Executive Officer
XL Capital Ltd
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(Chapter 98, Title 15 U.S.C. SS. 7241)
I, Michael S. McGavick, certify that:
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1. |
I have reviewed this Quarterly Report on Form 10-Q of XL Capital Ltd; |
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2. |
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; |
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3. |
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; |
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4. |
The registrants other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: |
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a) |
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; |
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b) |
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; |
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c) |
Evaluated the effectiveness of the registrants disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and |
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d) |
Disclosed in this report any change in the registrants internal control over financial reporting that occurred during the registrants most recent fiscal quarter (the registrants fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrants internal control over financial reporting; and |
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5. |
The registrants other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrants auditors and the audit committee of the registrants board of directors (or persons performing the equivalent functions): |
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a) |
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrants ability to record, process, summarize and report financial information; and |
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b) |
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal control over financial reporting. |
Dated: November 3, 2008
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/S/ Michael S. McGavick |
Certification of Chief Financial Officer I, Brian W. Nocco, certify that:
1.
I have reviewed this Quarterly Report on Form 10-Q of XL Capital Ltd;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this
report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrants other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for
the registrant and have:
a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities,
particularly during the period in which this report is being prepared;
b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes
in accordance with generally accepted accounting principles;
c)
Evaluated the effectiveness of the registrants disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d)
Disclosed in this report any change in the registrants internal control over financial reporting that occurred during the registrants most recent fiscal quarter (the registrants fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially
affect, the registrants internal control over financial reporting; and
5.
The registrants other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrants auditors and the audit committee of the registrants board of directors (or persons performing the equivalent functions):
a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrants ability to record, process, summarize and report financial information; and
b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal control over financial reporting. Dated: November 3, 2008
/S/ Brian W. Nocco
XL Capital Ltd
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(Chapter 98, Title 15 U.S.C. SS. 7241)
BRIAN W. NOCCO
Executive Vice President,
Chief Financial Officer
Exhibit 32
Certification Accompanying Form 10-Q Report of
XL Capital Ltd
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(Chapter 63, Title 18 U.S.C. SS.SS. 1350(a) and (b))
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chapter 63, Title 18 U.S.C. ss.ss. 1350(a) and (b)), each of the undersigned hereby certifies that the Quarterly Report on Form 10-Q for the period ended September 30, 2008 of XL Capital Ltd (the Company) fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934 and that the information contained in such Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
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Dated: November 3, 2008 |
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/s/ Michael S. McGavick |
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Dated: November 3, 2008 |
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/s/ Brian W. Nocco |
A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to XL Capital Ltd and will be retained by XL Capital Ltd and furnished to the Securities and Exchange Commission or its staff upon request.