XL CAPITAL LTD - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004

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

For the transition period from _____ to _____

Commission file number 1-10804

XL CAPITAL LTD

(Exact name of registrant as specified in its charter)

CAYMAN ISLANDS 98-0191089

(State or other Jurisdiction of (I.R.S. Employer

incorporation or organization) Identification No.)

XL House, One Bermudiana Road, Hamilton, Bermuda HM 11
(address of principal executive offices and zip code)

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

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 [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]

As of August 2, 2004, there were 138,381,763 outstanding Class A Ordinary Shares, $0.01 par value per share, of the registrant.

XL CAPITAL LTD

INDEX TO FORM 10-Q

PART I. FINANCIAL INFORMATION Page No

Item 1. Financial Statements:

Consolidated Balance Sheets as at June 30, 2004 (Unaudited) and
December 31, 2003 3

Consolidated Statements of Income for the Three Months Ended June 30,
2004 and 2003 (Unaudited) and the Six Months Ended June 30, 2004
and 2003 (Unaudited) 5

Consolidated Statements of Comprehensive Income for the Three Months
Ended June 30, 2004 and 2003 (Unaudited) and for the Six Months
Ended June 30, 2004 and 2003 (Unaudited) 6

Consolidated Statements of Shareholders’ Equity for the Six Months
Ended June 30, 2004 and 2003 (Unaudited) 7

Consolidated Statements of Cash Flows for the Six Months Ended
June 30, 2004 and 2003 (Unaudited) 8

Notes to Unaudited Consolidated Financial Statements 9

Item 2. Management’s Discussion and Analysis of Financial Condition and
Results of Operations 25

Item 3. Quantitative and Qualitative Disclosures About Market Risk 52

Item 4. Controls and Procedures 57

PART II. OTHER INFORMATION

Item 1. Legal Proceedings          58

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities           59

Item 4. Submission of Matters to a Vote of Security Holders           60

Item 6. Exhibits and Reports on Form 8-K           60

Signatures               62

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

XL CAPITAL LTD
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands)

(Unaudited)

June 30, December 31,

2004 2003

ASSETS

Investments:

      Fixed maturities, at fair value (amortized cost: 2004, $21,514,661;
            2003, $18,990,670)
$
21,534,257 $ 19,494,356

      Equity securities, at fair value (cost: 2004, $564,773; 2003, $473,112)
650,918 583,450

      Short-term investments, at fair value (amortized cost: 2004, $1,409,897;
            2003, $696,798)
1,414,821 697,450

                  Total investments available for sale
23,599,996 20,775,256

      Investments in affiliates
1,898,462 1,903,341

      Other investments
251,415 142,567

                  Total investments
25,749,873 22,821,164

Cash and cash equivalents
2,744,878 2,403,121

Accrued investment income
299,995 294,615

Deferred acquisition costs
987,032 777,882

Prepaid reinsurance premiums
1,021,729 977,595

Premiums receivable
4,637,369 3,487,322

Reinsurance balances receivable
1,302,475 1,359,486

Unpaid losses and loss expenses recoverable
5,826,619 5,779,997

Goodwill and other intangible assets
1,841,997 1,845,507

Deferred tax assets, net
307,574 310,077

Other assets
740,494 707,449

                  Total assets
$
45,460,035 $ 40,764,215

LIABILITIES AND SHAREHOLDERS’ EQUITY

Liabilities:

      Unpaid losses and loss expenses
$
17,076,770 $ 16,558,788

      Deposit liabilities
4,769,276 4,050,334

      Future policy benefit reserves
4,104,763 3,233,845

      Unearned premiums
5,963,401 4,729,989

      Notes payable and debt
2,743,368 1,905,483

      Reinsurance balances payable
1,628,225 1,525,739

      Net payable for investments purchased
312,680 96,571

      Other liabilities
1,728,933 1,666,397

      Minority interest
56,047 60,154

                  Total liabilities
$
38,383,463 $ 33,827,300

See accompanying Notes to Unaudited Consolidated Financial Statements

XL CAPITAL LTD
CONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share amounts)

(Unaudited)

June 30, December 31,

2004 2003

Commitments and Contingencies

Shareholders’ Equity:

      Series A preference ordinary shares, 9,200,000 authorized,
            par value $0.01, issued and outstanding: 2004, 9,200,000;
            2003, 9,200,000 $ 92 $ 92

      Series B preference ordinary shares, 11,500,000 authorized,
            par value $0.01, issued and outstanding: 2004, 11,500,000;
            2003, 11,500,000 115 115

      Series C preference ordinary shares, 20,000,000 authorized,
            par value $0.01 Issued and outstanding 2004 and 2003, nil — —

      Class A ordinary shares, 999,990,000 authorized, par value $0.01,
            issued and outstanding: 2004, 138,380,904; 2003, 137,343,232 1,383 1,373

      Additional paid in capital 3,901,680 3,949,421

      Accumulated other comprehensive income 29,019 490,195

      Deferred compensation (77,009) (46,124)

      Retained earnings 3,221,292 2,541,843

                  Total shareholders’ equity $ 7,076,572 $ 6,936,915

                  Total liabilities and shareholders’ equity $ 45,460,035 $ 40,764,215

See accompanying Notes to Unaudited Consolidated Financial Statements

XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF INCOME
(U.S. dollars and shares in thousands, except per share amounts)

(Unaudited) (Unaudited)

Three Months Ended Six Months Ended

June 30, June 30,

2004 2003 2004 2003

Revenues:

      Net premiums earned $ 2,858,297 $ 1,575,809 $ 4,582,742 $ 3,127,440

      Net investment income 235,177 190,551 463,523 382,455

      Net realized gains on investments 8,763 93,687 124,100 89,024

      Net realized and unrealized gains (losses) on
            derivative instruments 42,140 (12,257) 53,737 2,236

      Equity in net income of investment affiliates 26,733 34,306 97,109 61,104

      Fee income and other 8,152 9,792 15,059 22,069

            Total revenues $ 3,179,262 $ 1,891,888 $ 5,336,270 $ 3,684,328

Expenses:

      Net losses and loss expenses incurred $ 1,099,910 $ 937,575 $ 2,063,854 $ 1,822,829

      Claims and policy benefits 1,006,509 83,225 1,140,572 202,783

      Acquisition costs 347,408 298,550 624,678 538,862

      Operating expenses 247,716 193,908 493,016 384,427

      Exchange losses (gains) 15,913 (23,352) 5,189 (26,054)

      Interest expense 54,961 46,282 95,018 92,422

      Amortization of intangible assets 3,257 375 6,514 750

            Total expenses $ 2,775,674 $ 1,536,563 $ 4,428,841 $ 3,016,019

Income before minority interest, income tax
      and equity in net (income) loss of insurance
      and financial affiliates $ 403,588 $ 355,325 $ 907,429 $ 668,309

      Minority interest 2,284 3,166 6,944 5,028

      Income tax 31,176 11,009 66,533 31,039

      Equity in net (income) loss of insurance and
            financial affiliates (3,556) (16,522) (1,981) 24,565

Net income 373,684 357,672 835,933 607,677

Preference share dividends (10,080) (10,013) (20,160) (20,161)

Net income available to ordinary shareholders $ 363,604 $ 347,659 $ 815,773 $ 587,516

Weighted average ordinary shares and ordinary share
      equivalents outstanding — basic 137,655 136,791 137,568 136,527

Weighted average ordinary shares and ordinary share
      equivalents outstanding — diluted 138,741 138,634 138,648 138,084

Earnings per ordinary share and ordinary share
      equivalent — basic $ 2.64 $ 2.54 $ 5.93 $ 4.30

Earnings per ordinary share and ordinary share
      equivalent — diluted $ 2.62 $ 2.51 $ 5.88 $ 4.25

See accompanying Notes to Unaudited Consolidated Financial Statements

XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(U.S. dollars in thousands)

(Unaudited) (Unaudited)

Three Months Ended Six Months Ended

June 30, June 30,

2004 2003 2004 2003

Net income $ 373,684 $ 357,672 $ 835,933 $ 607,677

Change in net unrealized appreciation of investments,
net of tax (585,146) 343,748 (469,941) 408,974

Foreign currency translation adjustments, net (17,817) 95,225 8,765 91,046

Comprehensive (loss) income $ (229,279) $ 796,645 $ 374,757 $ 1,107,697

See accompanying Notes to Unaudited Consolidated Financial Statements

XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(U.S. dollars in thousands)

(Unaudited)

Six Months Ended

June 30,

2004 2003

Series A and B Preference Ordinary Shares:

      Balance — beginning of year $ 207 $ 207

      Issue of shares — —

            Balance — end of period $ 207 $ 207

Class A Ordinary Shares:

      Balance — beginning of year $ 1,373 $ 1,360

      Issue of shares 5 5

      Exercise of stock options 5 6

      Repurchase of shares — —

            Balance — end of period $ 1,383 $ 1,371

Additional Paid in Capital:

      Balance — beginning of year $ 3,949,421 $ 3,979,979

      Issue of shares 43,445 33,011

      Stock option expense 6,000 2,088

      Repurchase of shares (1,631) —

      Exercise of stock options 16,746 29,573

      Equity units/debt value (112,301) —

            Balance — end of period $ 3,901,680 $ 4,044,651

Accumulated Other Comprehensive Income:

      Balance — beginning of year $ 490,195 $ 184,814

      Net change in unrealized gains on investment portfolio, net of tax (476,724) 411,433

      Net change in unrealized gains on investment portfolio of affiliates 6,783 (2,459)

      Currency translation adjustments 8,765 91,046

            Balance — end of period $ 29,019 $ 684,834

Deferred Compensation:

      Balance — beginning of year $ (46,124) $ (31,282)

      Issue of restricted shares (43,103) (33,078)

      Amortization 12,218 8,229

            Balance — end of period $ (77,009) $ (56,131)

Retained Earnings:

      Balance — beginning of year $ 2,541,843 $ 2,434,511

      Net income 835,933 607,677

      Dividends on Series A and B preference ordinary shares (20,160) (20,161)

      Dividends on Class A ordinary shares (135,278) (131,398)

      Repurchase of ordinary shares (1,046) (241)

            Balance — end of period $ 3,221,292 $ 2,890,388

Total Shareholders’ Equity $ 7,076,572 $ 7,565,320

See accompanying Notes to Unaudited Consolidated Financial Statements

XL CAPITAL LTD
CONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)

(Unaudited)

Six Months Ended

June 30,

2004 2003

Cash flows provided by operating activities:

      Net income $ 835,933 $ 607,677

Adjustments to reconcile net income (loss) to net cash provided by (used in)
      operating activities:

      Net realized gains on investments (124,100) (89,024)

      Net realized and unrealized gains on derivative instruments (53,737) (2,236)

      Amortization of premiums on fixed maturities 43,147 10,325

      Equity in net income of investment, insurance and financial affiliates (99,090) (36,539)

      Amortization of deferred compensation 12,218 8,229

      Accretion of convertible debt 12,882 12,522

      Accretion of deposit liabilities 44,835 48,654

      Unpaid losses and loss expenses 517,982 1,545,473

      Future policy benefit reserves 870,918 175,689

      Unearned premiums 1,233,412 1,170,964

      Premiums receivable (1,150,047) (928,680)

      Unpaid losses and loss expenses recoverable (46,622) (618,593)

      Prepaid reinsurance premiums (44,134) (192,272)

      Reinsurance balances receivable 57,011 19,148

      Deferred acquisition costs (209,150) (139,556)

      Reinsurance balances payable 102,486 (246,401)

      Deferred tax asset 2,503 25,193

      Other assets (61,316) 107,563

      Other 15,312 47,767

            Total adjustments 1,124,510 918,226

      Net cash provided by operating activities $ 1,960,443 $ 1,525,903

Cash flows used in investing activities:

      Proceeds from sale of fixed maturities and short-term investments $ 13,800,883 $ 14,044,006

      Proceeds from redemption of fixed maturities and short-term investments 2,482,888 8,918,014

      Proceeds from sale of equity securities 252,333 772,434

      Purchases of fixed maturities and short-term investments (19,210,284) (25,919,805)

      Purchases of equity securities (284,308) (416,356)

      Investments in affiliates, net of dividends received (1,322) (21,861)

      Other investments (1,632) (2,880)

      Net cash used in investing activities $ (2,961,442) $ (2,626,448)

Cash flows provided by financing activities:

      Proceeds from exercise of stock options 16,751 29,579

      Repurchase of shares (2,676) (240)

      Dividends paid (155,438) (151,559)

      Proceeds from notes payable and issuance of equity units 800,195 —

      Deposit liabilities 682,338 672,633

      Net cash provided by financing activities 1,341,170 550,413

Effects of exchange rate changes on foreign currency cash 1,586 (556)

Increase (decrease) in cash and cash equivalents 341,757 (550,688)

Cash and cash equivalents — beginning of period 2,403,121 3,557,815

Cash and cash equivalents — end of period $ 2,744,878 $ 3,007,127

See accompanying Notes to Unaudited Consolidated Financial Statements

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands, except per share amounts)

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 U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, these unaudited financial statements reflect all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of financial position and results of operations as at the end of and for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ 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 these changes in presentation.

Unless the context otherwise indicates, references herein to the Company include XL Capital Ltd and its consolidated subsidiaries.

2. Significant Accounting Policies

Effective January 1, 2003, the Company has adopted the fair value recognition provisions of FAS 123, as amended by FAS 148, under the prospective method for options granted subsequent to January 1, 2003. Prior to 2003, the Company accounted for options under the disclosure-only provisions of FAS 123 and no stock-based employee compensation cost was included in net income as all options granted had an exercise price equal to the market value of the Company’s ordinary shares on the date of the grant. Awards under the Company’s stock plans vest over periods ranging from three to four years. If the fair value based method had been applied to all awards since the original effective date of FAS 123, the cost related to employee stock based compensation included in the determination of net income would have been higher. The following table illustrates the net effect on net income and earnings per ordinary share if the fair value method had been applied to all outstanding and unvested awards in each period presented:

(Unaudited) (Unaudited)

Three Months Ended   Six Months Ended

June 30,
June 30,

2004 2003 2004 2003

Net income available to ordinary
      shareholders — as reported $ 363,604 $ 347,659 $ 815,773 $ 587,516

Add: Stock based employee compensation expense
      included in reported net income, net of related tax 3,601 1,288 6,000 2,088

Deduct: Total stock based employee compensation
      expense determined under fair value based method
      for all awards, net of related tax effects (10,665) (14,397) (21,757) (25,687)

Pro forma net income available to
      ordinary shareholders $ 356,540 $ 334,550 $ 800,016 $ 563,917

Earnings per ordinary share:

      Basic — as reported $ 2.64 $ 2.54 $ 5.93 $ 4.30

      Basic — pro forma $ 2.59 $ 2.45 $ 5.82 $ 4.13

      Diluted — as reported $ 2.62 $ 2.51 $ 5.88 $ 4.25

      Diluted — pro forma $ 2.57 $ 2.41 $ 5.77 $ 4.08

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

3. Recent Accounting Pronouncements

In April 2004, the FASB issued Staff Position No. FAS 129-1, “Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities” (“FSP FAS 129-1”). The purpose of FSP FAS 129-1 is to interpret how the disclosure provisions of Statement 129 apply to contingently convertible securities and to their potentially dilutive effects on EPS. The Company has provided the required disclosures related to its contingently convertible securities that are required by the FSP FAS 129-1 in its December 31, 2003 financial statements.

In March 2004, the FASB ratified Emerging Issues Task Force (“EITF”) Issue No. 03-16, “Accounting for Investments in Limited Liability Companies” (the “Issue”). In EITF Abstracts, Topic No. D-46, “Accounting for Limited Partnership Investments,” the SEC staff clarified its view that investments of more than three to five percent are considered to be more than minor and, therefore, should be accounted for using the equity method. Limited liability companies (“LLCs”) have characteristics of both corporations and partnerships, but are dissimilar from both in certain respects. Due to those similarities and differences, diversity in practice exists with respect to accounting for noncontrolling investments in LLCs. This Issue addresses whether an LLC should be viewed as similar to a corporation or similar to a partnership for purposes of determining whether a noncontrolling investment should be accounted for using the cost method or the equity method of accounting. The EITF reached a consensus that an investment in an LLC that maintains a “specific ownership account” for each investor, similar to a partnership capital account structure should be viewed as similar to an investment in a limited partnership for purposes of determining whether a noncontrolling investment in an LLC should be accounted for using the cost method or the equity method. This EITF applies to all investments in LLCs and is effective for reporting periods beginning after June 15, 2004. The adoption of the Issue is not expected to have a material effect on the Company’s financial condition or results of operations.

In June 2004, the FASB issued Staff Position No. FAS 97-1, Situations in Which Paragraphs 17(b) and 20 of FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses From the Sale of Investments, Permit or Require Accrual of an Unearned Revenue Liability (“FSP FAS 97-1”). FSP FAS 97-1 clarifies whether it is appropriate to recognize an unearned revenue liability to compensate the insurer for services to be performed over future periods when future profits are expected to decline from the current level, or only when current profits are expected to be followed by future losses (consistent with SOP 03-1). The adoption of this FSP FAS 97-1 is not expected to have a material effect on the Company’s financial condition or results of operations.

EITF Issue No. 02-14, Whether an Investor Should Apply the Equity Method of Accounting to Investments Other than Common Stock if the Investor Has the Ability to Exercise Significant Influence Over the Operating and Financial Policies of the Investee (“EITF 02-14”), addresses the issue as to whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means (such as convertible debt, preferred equity securities, options, warrants and interests in unincorporated entities). In July 2004, the EITF reached a consensus that investors should apply the equity method when they have an investment in either common stock or “in-substance common stock.” The consensus reached in EITF 02-14, is effective for reporting periods beginning after September 15, 2004. The Company is currently reviewing its investments in affiliates and other investments, however, the adoption of EITF 02-14 is not expected to have a material effect on the Company’s financial condition or results of operations.

The FASB has issued an Exposure Draft, Earnings per Share (an amendment of FASB No. 128) (the “Exposure Draft”), which would amend the computational guidance in FAS 128, Earnings per Share, for calculating the number of incremental shares included in diluted shares when applying the treasury stock method. Also, it eliminates the provisions that allow an entity to presume that contracts with the option of settling in either cash or stock will be settled in cash and would require that shares that will be issued upon conversion of a mandatory convertible security be included in the weighted-average number of ordinary shares outstanding used in computing basic earnings per share from the date on which conversion becomes mandatory. If the Exposure Draft is adopted as proposed, it will be effective for financial statements for both interim and annual periods beginning after December 15, 2004. If the Exposure Draft is adopted as proposed, after the effective date, all prior-period EPS data presented will be adjusted retrospectively (including interim financial statements, summaries of earnings, and selected financial data) to conform with the provisions of the Exposure Draft.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

3. Recent Accounting Pronouncements (continued)

In July 2004, the EITF reached a tentative conclusion regarding Issue No. 04-8, Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share (“EITF 04-8”), that contingently convertible securities should be included in diluted EPS in all periods regardless of whether the contingency is met and regardless of whether the market price contingency is substantive. If a consensus is reached regarding EITF 04-8 and ratified by the FASB, it will be effective for reporting periods ending after December 15, 2004. Prior period earnings per share amounts presented for comparative purposes will be restated to conform to this consensus.

If adopted in their current form, the dilutive effect of the Exposure Draft and EITF 04-8 will be reflected in the calculation of earnings per share as they both relate to the accounting for the Company’s Zero Coupon Convertible Debentures (“CARZ”) and Liquid Yield Option Notes (“LYONs”) securities. The increase in diluted weighted average ordinary shares outstanding related to CARZ and LYONs would be 6,011 shares and 2,685 shares, respectively. This dilutive effect would be partially offset by the adding back of the related interest expense to net income available to ordinary shareholders.

4. Segment Information

The Company is organized into three operating segments — insurance, reinsurance and financial products and services — in addition to a corporate segment that includes the general investment and financing operations of the Company.

General, life and annuity, and financial operations are disclosed separately by segment. General operations include property and casualty lines of business.

The Company evaluates the performance of each segment based on underwriting results for general operations, net income from life and annuity operations and contribution from financial operations. Other items of revenue and expenditure of the Company are not evaluated at the segment level. In addition, the Company does not allocate assets by segment for its general operations. Investment assets related to the Company’s life and annuity and financial operations are held in separately identified portfolios. Net investment income from these assets is included in net income from life and annuity operations and contribution from financial operations, respectively.

Certain lines of business within general operations written by the Company have loss experience generally characterized as low frequency and high severity. This may result in volatility in both the Company’s results and operational cash flows.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

The following is an analysis of results by segment together with a reconciliation to net income:

Quarter ended June 30, 2004:
(U.S. dollars in thousands)
(Unaudited)
Financial

Products and

Insurance Reinsurance Services Total

General Operations:

      Net premiums earned $ 1,112,349 $ 717,876 $        — $ 1,830,225

      Fee income and other 5,565 2,194 — 7,759

      Net losses and loss expenses 709,617 382,959 — 1,092,576

      Acquisition costs 156,655 173,605 — 330,260

      Operating expenses (1) 131,432 49,068 — 180,500

      Exchange losses 10,442 5,576 — 16,018

      Underwriting profit $ 109,768 $ 108,862 $        — $ 218,630

Life and Annuity Operations:

      Life premiums earned $           — $ 969,097 $ 24,951 $ 994,048

      Fee income and other — 47 68 115

      Claims and policy benefits — 986,068 20,441 1,006,509

      Acquisition costs — 4,156 7,287 11,443

      Operating expenses (1) — 3,716 2,295 6,011

      Exchange (gains) losses — (105) — (105)

      Net investment income — 44,139 20,168 64,307

      Interest expense — (21) 10,416 10,395

      Net income from life and annuity operations $          — $ 19,469 $ 4,748 $ 24,217

Financial Operations:

      Net premiums earned $ 34,024 $ 34,024

      Fee income and other 278 278

      Net losses and loss expenses 7,334 7,334

      Acquisition costs 5,705 5,705

      Operating expenses (1) 16,408 16,408

      Underwriting profit $ 4,855 $ 4,855

      Investment income — financial guarantee $ 8,872 $ 8,872

      Net realized and unrealized gains on
            credit derivatives 26,289 26,289

      Net realized and unrealized gains on weather and
            energy derivatives 48 48

      Operating expenses — weather and energy (1) 6,005 6,005

      Equity in net income of financial affiliates 1,387 1,387

      Minority interest 2,427 2,427

      Contribution from financial operations $ 33,019 $ 33,019

See footnotes on following page.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

Quarter ended June 30, 2004 (continued):
(U.S. dollars in thousands, except ratios)
(Unaudited)

Financial

Products and

Insurance Reinsurance Services Total

      Net investment income — general operations $ 161,998

      Net realized and unrealized gains on investments
            and derivative instruments (3) 24,566

      Equity in net income of investment and
            insurance affiliates 28,902

      Interest expense (2) 44,566

      Amortization of intangible assets 3,257

      Corporate operating expenses 38,792

      Minority interest (143)

      Income tax 31,176

Net Income $ 373,684

General Operations:

      Loss and loss expense ratio (4) 63.8% 53.3% 59.7%

      Underwriting expense ratio (4) 25.9% 31.1% 27.9%

      Combined ratio (4) 89.7% 84.4% 87.6%

(1) Operating expenses exclude corporate operating expenses, shown separately.

(2) Interest expense excludes interest expense related to life and annuity operations, shown separately.

(3) This includes net realized gains on investments of $8.8 million and net realized and unrealized gains on investment derivatives of $15.8 million, but does not include unrealized appreciation or depreciation on investments, which are included in “accumulated other comprehensive income (loss)”.

(4) Ratios are based on net premiums earned from general operations. The underwriting expense ratio excludes exchange gains and losses.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

Quarter ended June 30, 2003:
(U.S. dollars in thousands)
(Unaudited)
Financial

Products and

Insurance Reinsurance Services Total

General Operations:

      Net premiums earned $ 870,079 $ 599,441 $         — $ 1,469,520

      Fee income and other 1,569 6,343 — 7,912

      Net losses and loss expenses 551,923 376,832 — 928,755

      Acquisition costs 143,829 141,566 — 285,395

      Operating expenses (1) 104,697 36,694 — 141,391

      Exchange gains (6,949) (13,083) — (20,032)

      Underwriting profit $ 78,148 $ 63,775 $         — $ 141,923

Life and Annuity Operations:

      Life premiums earned $         — $ 56,605 $ 13,877 $ 70,482

      Fee income and other — — 29 29

      Claims and policy benefits — 73,064 10,161 83,225

      Acquisition costs — 6,916 403 7,319

      Operating expenses (1) — 1,956 1,658 3,614

      Exchange (gains) losses — (3,320) — (3,320)

      Net investment income — 33,596 6,638 40,234

      Interest expense — — 2,791 2,791

      Net income from life and annuity operations $         — $ 11,585 $ 5,531 $ 17,116

Financial Operations:

      Net premiums earned $ 35,807 $ 35,807

      Fee income and other 1,851 1,851

      Net losses and loss expenses 8,820 8,820

      Acquisition costs 5,836 5,836

      Operating expenses (1) 9,019 9,019

      Underwriting profit $ 13,983 $ 13,983

      Investment income — financial guarantee $ 5,229 $ 5,229

      Net realized and unrealized losses on
            credit derivatives (21,363) (21,363)

      Net realized and unrealized gains on weather and
            energy derivatives 5,223 5,223

      Operating expenses — weather and energy (1) 5,239 5,239

      Equity in net income of financial affiliates 16,658 16,658

      Minority interest 3,228 3,228

      Contribution from financial operations $ 11,263 $ 11,263

See footnotes on following page.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

Quarter ended June 30, 2003 (continued):
(U.S. dollars in thousands, except ratios)
(Unaudited)
Financial

Products and

Insurance Reinsurance Services Total

      Net investment income — general operations $ 145,088

      Net realized and unrealized gains on investments
            and derivative instruments (3) 97,570

      Equity in net income of investment and
            insurance affiliates 34,170

      Interest expense (2) 43,491

      Amortization of intangible assets 375

      Corporate operating expenses 34,645

      Minority interest (62)

      Income tax 11,009

Net Income $ 357,672

General Operations:

      Loss and loss expense ratio (4) 63.4% 62.9% 63.2%

      Underwriting expense ratio (4) 28.6% 29.7% 29.0%

      Combined ratio (4) 92.0% 92.6% 92.2%

(1) Operating expenses exclude corporate operating expenses, shown separately.

(2) Interest expense excludes interest expense related to life and annuity operations, shown separately.

(3) This includes net realized gains on investments of $93.7 million and net realized and unrealized gains on investment derivatives of $3.9 million, but does not include unrealized appreciation or depreciation on investments, which are included in “accumulated other comprehensive income (loss)”.

(4) Ratios are based on net premiums earned from general operations. The underwriting expense ratio excludes exchange gains and losses.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

Six months ended June 30, 2004:
(U.S. dollars in thousands)
(Unaudited)

Financial

Products and

Insurance Reinsurance Services Total

General Operations:

      Net premiums earned $ 1,997,673 $ 1,407,477 $         — $ 3,405,150

      Fee income and other 7,896 6,104 — 14,000

      Net losses and loss expenses 1,254,543 799,781 — 2,054,324

      Acquisition costs 276,378 317,833 — 594,211

      Operating expenses (1) 260,421 92,823 — 353,244

      Exchange losses (gains) 12,022 (5,887) — 6,135

      Underwriting profit $ 202,205 $ 209,031 $         — $ 411,236

Life and Annuity Operations:

      Life premiums earned $          — $ 1,064,336 $ 46,644 $ 1,110,980

      Fee income and other — 93 137 230

      Claims and policy benefits — 1,102,244 38,328 1,140,572

      Acquisition costs — 11,839 9,995 21,834

      Operating expenses (1) — 6,680 5,552 12,232

      Exchange (gains) losses — (946) — (946)

      Net investment income — 89,550 38,459 128,009

      Interest expense (2) — 117 20,674 20,791

      Net income from life and annuity operations $         — $ 34,045 $ 10,691 $ 44,736

Financial Operations:

      Net premiums earned $ 66,612 $ 66,612

      Fee income and other 829 829

      Net losses and loss expenses 9,530 9,530

      Acquisition costs 8,633 8,633

      Operating expenses (1) 33,202 33,202

      Underwriting profit $ 16,076 $ 16,076

      Investment income — financial guarantee $ 17,005 $ 17,005

      Net realized and unrealized gains on
            credit derivatives 39,649 39,649

      Net realized and unrealized losses on weather and
            energy derivatives (4,616) (4,616)

      Operating expenses — weather and energy (1) 13,941 13,941

      Equity in net losses of financial affiliates (1,203) (1,203)

      Minority interest 7,087 7,087

      Contribution from financial operations $ 45,883 $ 45,883

See footnotes on following page.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

Six months ended June 30, 2004 (continued):
(U.S. dollars in thousands, except ratios)
(Unaudited)
Financial

Products and

Insurance Reinsurance Services Total

      Net investment income — general operations $ 318,509

      Net realized and unrealized gains on investments
            and derivative instruments (3) 142,804

      Equity in net income of investment and
            insurance affiliates 100,293

      Interest expense (2) 74,227

      Amortization of intangible assets 6,514

      Corporate operating expenses 80,397

      Minority interest (143)

      Income tax 66,533

Net Income $ 835,933

General Operations:

      Loss and loss expense ratio (4) 62.8% 56.8% 60.3%

      Underwriting expense ratio (4) 26.9% 29.2% 27.9%

      Combined ratio (4) 89.7% 86.0% 88.2%

(1) Operating expenses exclude corporate operating expenses, shown separately.

(2) Interest expense excludes interest expense related to life and annuity operations, shown separately.

(3) This includes net realized gains on investments of $124.1 million and net realized and unrealized gains on investment derivatives of $18.7 million, but does not include unrealized appreciation or depreciation on investments, which are included in “accumulated other comprehensive income (loss)”.

(4) Ratios are based on net premiums earned from general operations. The underwriting expense ratio excludes exchange gains and losses.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

Six months ended June 30, 2003:
(U.S. dollars in thousands)
(Unaudited)
Financial

Products and

Insurance Reinsurance Services Total

General Operations:

      Net premiums earned $ 1,751,306 $ 1,150,101 $ — $ 2,901,407

      Fee income and other 3,717 17,793 — 21,510

      Net losses and loss expenses 1,073,208 727,338 — 1,800,546

      Acquisition costs 268,279 246,215 — 514,494

      Operating expenses (1) 202,793 71,254 — 274,047

      Exchange losses (gains) 768 (23,208) — (22,440)

      Underwriting profit $ 209,975 $ 146,295 $ — $ 356,270

Life and Annuity Operations:

      Life premiums earned $ — $ 139,842 $ 23,411 $ 163,253

      Fee income and other — — 50 50

      Claims and policy benefits — 183,536 19,247 202,783

      Acquisition costs — 13,869 1,460 15,329

      Operating expenses (1) — 4,221 4,091 8,312

      Exchange (gains) losses — (3,614) — (3,614)

      Net investment income — 65,144 12,549 77,693

      Interest expense — — 4,927 4,927

      Net income from life and annuity operations $ — $ 6,974 $ 6,285 $ 13,259

Financial Operations:

      Net premiums earned $ 62,780 $ 62,780

      Fee income and other 509 509

      Net losses and loss expenses 22,283 22,283

      Acquisition costs 9,039 9,039

      Operating expenses (1) 22,306 22,306

      Underwriting profit $ 9,661 $ 9,661

      Investment income — financial guarantee $ 10,673 $ 10,673

      Net realized and unrealized losses on
            credit derivatives (21,930) (21,930)

      Net realized and unrealized gains on weather and
            energy derivatives 15,633 15,633

      Operating expenses — weather and energy (1) 10,810 10,810

      Equity in net income of financial affiliates 17,176 17,176

      Minority interest 5,298 5,298

      Contribution from financial operations $ 15,105 $ 15,105

See footnotes on following page.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

Six months ended June 30, 2003 (continued):
(U.S. dollars in thousands, except ratios)
(Unaudited)
Financial

Products and

Insurance Reinsurance Services Total

      Net investment income — general operations $ 294,089

      Net realized and unrealized gains on investments
            and derivative instruments (3) 97,557

      Equity in net income of investment and
            insurance affiliates 19,364

      Interest expense (2) 87,495

      Amortization of intangible assets 750

      Corporate operating expenses 68,953

      Minority interest (270)

      Income tax 31,039

Net Income $ 607,677

General Operations:

      Loss and loss expense ratio (4) 61.3% 63.2% 62.1%

      Underwriting expense ratio (4) 26.9% 27.6% 27.1%

      Combined ratio (4) 88.2% 90.8% 89.2%

(1) Operating expenses exclude corporate operating expenses, shown separately.

(2) Interest expense excludes interest expense related to life and annuity operations, shown separately.

(3) This includes net realized gains on investments of $89.0 million, net realized and unrealized gains on investment derivatives of $8.5 million, but does not include unrealized appreciation or depreciation on investments, which are included in “accumulated other comprehensive income (loss)”.

(4) Ratios are based on net premiums earned from general operations. The underwriting expense ratio excludes exchange gains and losses.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

The following tables summarize the Company’s net premiums earned by line of business:

Quarter ended June 30, 2004:
(U.S. dollars in thousands)
(Unaudited)
Financial

Products and

Insurance Reinsurance Services

General Operations:

      Professional liability $ 373,685 $ — $ —

      Casualty 253,689 320,457 —

      Property catastrophe 15,401 80,997 —

      Other property 155,690 191,789 —

      Marine, energy, aviation and satellite 238,178 44,678 —

      Accident and health 6,674 9,751 —

      Other (1) 69,032 70,204 —

Total general operations $ 1,112,349 $ 717,876 $ —

Life and Annuity Operations — 969,097 24,951

Financial Operations — — 34,024

Total $ 1,112,349 $ 1,686,973 $ 58,975

(1) Other, includes political risk, surety, bonding, warranty and other lines.

Quarter ended June 30, 2003:
(U.S. dollars in thousands)
(Unaudited)
Financial

Products and

Insurance Reinsurance Services

General Operations:

      Professional liability $ 203,120 $ — $ —

      Casualty 261,074 234,940 —

      Property catastrophe — 54,503 —

      Other property 104,778 194,306 —

      Marine, energy, aviation and satellite 240,216 44,695 —

      Accident and health 18,099 6,398 —

      Other (1) 42,792 64,599 —

Total general operations $ 870,079 $ 599,441 $ —

Life and Annuity Operations — 56,605 13,877

Financial Operations — — 35,807

Total $ 870,079 $ 656,046 $ 49,684

(1) Other, includes political risk, surety, bonding, warranty and other lines.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. Segment Information (continued)

The following tables summarize the Company’s net premiums earned by line of business:

Six months ended June 30, 2004:
(U.S. dollars in thousands)
(Unaudited)

Financial

Products and

Insurance Reinsurance Services

General Operations:

      Professional liability $ 647,272 $ — $ —

      Casualty 477,620 606,111 —

      Property catastrophe 26,974 145,985 —

      Other property 277,936 384,175 —

      Marine, energy, aviation and satellite 459,028 98,995 —

      Accident and health 8,087 20,144 —

      Other (1) 100,756 152,067 —

Total general operations $ 1,997,673 $ 1,407,477 $ —

Life and Annuity Operations — 1,064,336 46,644

Financial Operations — — 66,612

Total $ 1,997,673 $ 2,471,813 $ 113,256

(1) Other, includes political risk, surety, bonding, warranty and other lines.

Six months ended June 30, 2003:
(U.S. dollars in thousands)
(Unaudited)

Financial

Products and

Insurance Reinsurance Services

General Operations:

      Professional liability $ 415,943 $ — $ —

      Casualty 485,817 454,618 —

      Property catastrophe — 113,039 —

      Other property 262,750 370,590 —

      Marine, energy, aviation and satellite 418,551 94,561 —

      Accident and health 36,879 11,948 —

      Other (1) 131,366 105,345 —

Total general operations $ 1,751,306 $ 1,150,101 $ —

Life and Annuity Operations — 139,842 23,411

Financial Operations — 0 62,780

Total $ 1,751,306 $ 1,289,943 $ 86,191

(1) Other, includes political risk, surety, bonding, warranty and other lines.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

5. Notes Payable and Debt and Financing Arrangements

In March 2004 the Company issued 33 million 6.5% Equity Security Units (“Units”) in a public offering. The Company received approximately $800.2 million in proceeds from the sale of the Units after deducting underwriting discounts.

Each 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 Company’s Class A Ordinary Shares on May 15, 2007 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due May 15, 2009 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 3.97% and 2.53% under the purchase contracts and senior notes, respectively. The Company may defer the contract payments on the purchase contract, but not the senior notes, until the stock purchase date. In May 2007, 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 Unit holder’s obligation under the purchase contract. 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 Unit holders’ obligation to purchase its ordinary shares under the purchase contracts.

In connection with this transaction, $88.6 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 $26.9 million total costs associated with the issuance of the Units, $23.7 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. The maximum number of ordinary shares to be issued under the purchase contracts is approximately 11 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 Units will have no effect on the number of weighted average ordinary shares, assuming dilution, except when the average market price of the Company’s ordinary shares is above the threshold appreciation price of $93.99 per share. Because the average market price of the Company’s ordinary shares during the period the 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 six month periods ended June 30, 2004.

The Company entered into three new bilateral unsecured letter of credit facilities in 2004 to provide additional capacity to support the Company’s U.S. non-admitted business. The Company terminated two of these bilateral letter of credit facilities on June 30, 2004. The facilities amounted to $50.0 million and $25.0 million, respectively, and had been unutilized during the quarter. The remaining new facility is for $50.0 million, which was fully utilized at June 30, 2004.

The Company replaced its principal $2.5 billion credit and letter of credit facility that expired on June 23, 2004 with a new $1 billion facility that expires on June 22, 2005 and a new $2.0 billion facility that expires on June 22, 2007. Both facilities are available to provide revolving credit ($600.0 million in the aggregate) and letters of credit ($3.0 billion in the aggregate) and are syndicated and unsecured. The $1.0 billion facility was unutilized at June 30, 2004, and approximately $1.7 billion of the $2.0 billion facility was utilized to provide letters of credit at June 30, 2004.

On May 18, 2004, the Company announced that it was to make a one-time cash payment to holders of its zero-coupon convertible debentures due May 2021 (“CARZ”) for not exercising their put rights. No bonds were put to the Company and, consequently, the Company paid $15.0 million ($14.84 per bond) to the holders of record on May 26, 2004.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

6. Exposures Under Guaranties

The Company provides and reinsures financial guaranties issued to support public and private borrowing arrangements. Financial guaranties are conditional commitments that guarantee the performance of an obligor to a third party, typically the timely repayment of principal and interest. The Company’s potential liability in the event of non-payment by the issuer of the insured obligation is represented by its proportionate share of the aggregate outstanding principal and interest payable on such insured obligation. In synthetic transactions, the Company guarantees payment obligations of counterparties under credit default swaps. The Company does not record a carrying value for future installment premiums on financial guaranties as they are recognized over the term of the contract.

The net outstanding exposure as at June 30, 2004 of financial guaranty aggregate insured portfolios was $57.3 billion, which includes credit default swap exposures of $10.0 billion. The net liability for these credit default swaps has a carrying value of $106.2 million.

7. Derivative Instruments

The Company enters into derivative instruments for both risk management and trading purposes. The Company is exposed to potential loss from various market risks and manages its market risks based on guidelines established by management. These derivative instruments are carried at fair value with the resulting gains and losses recognized in income in the period in which they occur.

The following table summarizes the net realized and unrealized gains (losses) on derivative instruments included in net income for the three and six months ended June 30, 2004 and 2003, respectively:

(U.S. dollars in thousands)

(Unaudited)
Three Months Ended
June 30, (Unaudited)
Six Months Ended
June 30,

2004 2003 2004 2003

Credit derivatives $ 26,289 $ (21,363) $ 39,649 $ (21,930)

Weather and energy risk management derivatives 48 5,223 (4,616) 15,633

Investment derivatives 15,803 3,883 18,704 8,533

Net realized and unrealized gains (losses)
on derivatives $ 42,140 $ (12,257) $ 53,737 $ 2,236

8. XL Capital Finance (Europe) plc

XL Capital Finance (Europe) plc (“XLFE”) is a wholly owned finance subsidiary of the Company. In January 2002, XLFE issued $600.0 million par value 6.5% Guaranteed Senior Notes due January 2012. These Notes are fully and unconditionally guaranteed by the Company. The Company’s 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 $3.0 billion as of December 31, 2003.

XL CAPITAL LTD
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (continued)

9. Computation of Earnings Per Ordinary Share and Ordinary Share Equivalent

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

(Unaudited)
Three Months Ended
June 30, (Unaudited)
Six Months Ended
June 30,

2004 2003 2004 2003

Basic earnings per ordinary share:

      Net income $ 373,684 $ 357,672 $ 835,933 $ 607,677

      Less: preference share dividends (10,080) (10,013) (20,160) (20,161)

      Net income available to ordinary shareholders $ 363,604 $ 347,659 $ 815,773 $ 587,516

      Weighted average ordinary shares outstanding 137,655 136,791 137,568 136,527

      Basic earnings per ordinary share $ 2.64 $ 2.54 $ 5.93 $ 4.30

Diluted earnings per ordinary share:

      Net income $ 373,684 $ 357,672 $ 835,933 $ 607,677

      Less: preference share dividends (10,080) (10,013) (20,160) (20,161)

      Net income available to ordinary shareholders $ 363,604 $ 347,659 $ 815,773 $ 587,516

      Weighted average ordinary shares
            outstanding — basic 137,655 136,791 137,568 136,527

      Average stock options outstanding (1) 1,086 1,843 1,080 1,557

      Weighted average ordinary shares
            outstanding — diluted 138,741 138,634 138,648 138,084

      Diluted earnings per ordinary share $ 2.62 $ 2.51 $ 5.88 $ 4.25

Dividends per ordinary share $ 0.49 $ 0.48 $ 0.98 $ 0.96

(1) Net of shares repurchased under the treasury stock method.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

The following is a discussion of the Company’s financial condition and liquidity and results of operations. Certain aspects of the Company’s business have loss experience characterized as low frequency and high severity. This may result in volatility in both the Company’s and an individual segment’s results of operations and financial condition.

This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about the Company’s beliefs and expectations, are forward-looking statements. These statements are based upon current plans, estimates and projections. Actual results may differ materially from those projected in such forward-looking statements, and therefore undue reliance should not be placed on them. See “Cautionary Note Regarding Forward-Looking Statements” below for a list of factors that could cause actual results to differ materially from those contained in any forward-looking statement.

This discussion and analysis should be read in conjunction with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and the audited Consolidated Financial Statements and notes thereto, presented under Item 7 and Item 8, respectively, of the Company’s Form 10-K for the year ended December 31, 2003.

Executive Overview

See Executive Overview in Item 7 of the Company’s Form 10-K for the year ended December 31, 2003.

Results of Operations

The following table presents an analysis of the Company’s net income available to ordinary shareholders and other financial measures (described below) for the three months ended June 30, 2004 and 2003:

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

(Unaudited)
Three Months Ended
June 30,

2004 2003

Net income available to ordinary shareholders $ 363,604 $ 347,659

Earnings per ordinary share — basic $ 2.64 $ 2.54

Earnings per ordinary share — diluted (1) 2.62 2.51

Weighted average number of ordinary shares and ordinary share
equivalents — basic 137,655 136,791

Weighted average number of ordinary shares and ordinary share
equivalents — diluted (1) 138,741 138,634

(1) Average stock options outstanding have been excluded where anti-dilutive to earnings per ordinary share.

The following table presents an analysis of the Company’s net income available to ordinary shareholders and other financial measures (described below) for the six months ended June 30, 2004 and 2003.

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

(Unaudited)
Six Months Ended
June 30,

2004 2003

Net income available to ordinary shareholders $ 815,773 $ 587,516

Earnings per ordinary share — basic $ 5.93 $ 4.30

Earnings per ordinary share — diluted (1) 5.88 4.25

Weighted average number of ordinary shares and ordinary share
equivalents — basic 137,568 136,527

Weighted average number of ordinary shares and ordinary share
equivalents — diluted (1) 138,648 138,084

(1) Average stock options outstanding have been excluded where anti-dilutive to earnings per ordinary share.

The Company’s net income and other financial measures as shown below for the three and six months ended June 30, 2004 have been affected, among other things, by the following significant items:

1) A continued competitive underwriting environment in most product lines.

2) Stable reported losses with low levels of catastrophe losses in the year to date.

1. A competitive underwriting environment.

Overall market conditions remained strong although competition continued to increase in all segments in the second quarter causing further moderation in pricing. Given the differing dynamics of the markets in which the Company operates, moderation of pricing takes place at a different pace in different markets. Property lines continue to see the rate decreases noted in the first quarter. Rate decreases have also been experienced in professional lines. Based on continued solid demand and the benefits of price increases and improved terms achieved over the last several years’ renewals, the Company believes that business in the insurance and reinsurance markets remains adequately priced. Performance by segment is further discussed in the segment analysis below.

2. Stable reported losses with low levels of catastrophe losses in the year to date.

The Company’s loss and loss expense ratio (net losses and loss expenses incurred as a percent of net premiums earned) on general operations was 59.7% and 60.3%, respectively, for the three and six months ended June 30, 2004, compared with 63.2% and 62.1% for the same periods in 2003. These decreases were primarily due to the lower level of catastrophic losses in the period combined with the earning of price improvements over the last year, particularly in the reinsurance segment. This is further discussed in the segment analysis below.

Financial Measures

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

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

(Unaudited)
Three Months Ended
June 30,

2004 2003

      Underwriting profit — general operations $ 218,630 $ 141,923

      Combined ratio — general operations 87.6% 92.2%

      Investment income — general operations $ 161,998 $ 145,088

(Unaudited)
Six Months Ended
June 30,

2004 2003

      Underwriting profit — general operations $ 411,236 $ 356,270

      Combined ratio — general operations 88.2% 89.2%

      Investment income — general operations $ 318,509 $ 294,089

      Annualized return on average ordinary shareholders’ equity 25.1% 17.9%

(Unaudited)
June 30,
2004 December 31,
2003

      Book value per ordinary share $ 47.40 $ 46.74

Underwriting profit — general operations

One way the Company evaluates the performance of its property and casualty insurance and reinsurance general 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 the underwriting activities. Underwriting profits in the three and six months ended June 30, 2004 are primarily reflective of the combined ratio discussed below.

Combined ratio — general operations

The combined ratio for general operations is used by the Company, and many other property and casualty insurance and reinsurance companies, as another measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company’s general insurance and reinsurance operations. A combined ratio of less than 100% indicates an underwriting profit and over 100% reflects an underwriting loss. Decreases in the Company’s combined ratio for the three and six months ended June 30, 2004 compared to the same periods in the previous year were primarily a result of a lower loss and loss expense ratio. The underwriting expense ratio has remained relatively stable. The decrease in loss and loss expense ratio was primarily due to improved results in U.S. casualty lines compared to 2003, combined with an absence of catastrophic events over the first six months of the year.

Net investment income — general operations

Net investment income from the Company’s general operations is an important measure which affects the Company’s overall profitability. The largest liability of the Company relates to its unpaid loss reserves, and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due. A significant part of the portfolio is in fixed income securities. Net investment income is affected by overall market interest rates and also the size of the portfolio. The average investment portfolio outstanding during the quarter ended June 30, 2004 has increased as compared to the same period in 2003 due to positive cash flows combined with capital raising activities. Total investments as at June 30, 2004 were $25.7 billion as compared to $20.3 billion as at June 30, 2003. Interest rates have risen in 2004 which has also contributed to the increase in investment income.

Book value per ordinary share

Management also views the Company’s book value per ordinary share as an additional measure of the Company’s performance. Book value per share is calculated by dividing ordinary shareholders’ equity by the number of outstanding ordinary shares at any period end. Book value per ordinary share is affected primarily by the Company’s net income and also by any changes in the net unrealized gains and losses on its investment portfolio. Book value per ordinary share has increased by $0.66 in the first half of 2004. While the Company’s continued growth and profitability has created $835.9 million in net income for the first half of the year, the net unrealized gains associated with the Company’s fixed income investment portfolio decreased as interest rates have risen.

Annualized return on average ordinary shareholders’ equity

Annualized return on average ordinary shareholder’s equity (“ROE”) is a widely used measure of a company’s profitability. It is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholders’ equity. The Company establishes target ROE’s for its total operations, segments and lines of business. If the Company’s ROE return targets are not met with respect to any line of business over time, the Company seeks to reevaluate these lines. In addition, the Company’s compensation of its senior officers is significantly dependant on the achievement of the Company’s performance goals to enhance shareholder value, including ROE. The improvement in this financial measure was due to the key operating factors noted above combined with a 6.2% increase in return related specifically to the net realized gains on investments and derivatives recognized in the period.

Other Key Focuses of Management

See the discussion of the Other Key Focuses of Management in Item 7 of the Company’s Form 10-K for the year ended December 31, 2003.

Critical Accounting Policies and Estimates

See the discussion of the Company’s Critical Accounting Policies and Estimates in Item 7 of the Company’s Form 10-K for the year ended December 31, 2003.

Variable Interest Entities and Other Off-Balance Sheet Arrangements

See the discussion of the Company’s variable interest entities and other off-balance sheet arrangements in Item 7 of the Company’s Form 10-K for the year ended December 31, 2003.

Segment Results for the three months ended June 30, 2004 compared to the three months ended June 30, 2003

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 insurance, environmental liability insurance, political risk insurance, professional liability, property catastrophe, aviation and satellite insurance, employment practices liability insurance, surety, marine, specie, bloodstock and certain other insurance coverages including program business.

A large part of the Company’s casualty insurance business written has loss experience that is low frequency and high severity. As a result, large losses, though infrequent, can have a significant impact on the Company’s results of operations, financial condition and liquidity. The Company attempts to mitigate this risk by using strict underwriting guidelines and various reinsurance arrangements.

The following table summarizes the underwriting results for this segment:

(U.S. dollars in thousands)

(Unaudited)
Three Months Ended
June 30,

2004 2003 % Change

Gross premiums written $ 1,518,691 $ 1,238,260 22.6%

Net premiums written 1,201,750 881,354 36.4%

Net premiums earned 1,112,349 870,079 27.8%

Fee income and other 5,565 1,569 NM

Net losses and loss expenses 709,617 551,923 28.6%

Acquisition costs 156,655 143,829 8.9%

Operating expenses 131,432 104,697 25.5%

Exchange losses (gains) 10,442 (6,949) NM

Underwriting profit $ 109,768 $ 78,148 40.5%

* NM — Not Meaningful

Gross and net premiums written increased by 22.6% and 36.4%, respectively, in the quarter ended June 30, 2004 compared with the quarter ended June 30, 2003. This increase was primarily due to new business written across most lines, first quarter premiums in excess of our estimated amounts recorded in the second quarter and favorable foreign exchange movements. While pricing remained attractive in the quarter, there continued to be moderate rate reductions in property and professional lines and growing rate pressures on most casualty lines. The most significant growth due to new business was seen in professional business, in which gross premiums written increased by $102.0 million over the same period in the prior year. Of the gains seen in the professional lines, new product offerings, in the areas of small and midsize law firms as well as architects and engineers, represented $56.0 million in new premiums in the quarter. In addition, new insurance initiatives in the property catastrophe lines contributed $28.0 million in new gross written premiums. Net premiums written have grown by a larger percentage than gross premiums written primarily as a result of ceded reinsurance commutations related to professional lines in the second quarter of 2004.

Net premiums earned increased by 27.8% in the quarter ended June 30, 2004 compared with the quarter ended June 30, 2003. The increase was due to the earning of additional net premiums written in the current and prior year combined with the factors affecting net premiums written. The ceded reinsurance commutations increased net premium earned by $63.4 million in the second quarter of 2004. Growth in net premiums earned was partially offset by several non-renewed portfolios (specialty workers’ compensation, certain Lloyd’s international programs, and accident & health) as the earned premium effect of the non-renewed business lags the written premium impact. The weakening of the U.S. dollar against the U.K. sterling and the Euro as compared to the same period in 2003 accounted for approximately $34.0 million of the increase in net premiums earned for the three months ended June 30, 2004.

Fee income and other is mainly generated by the Company’s risk engineering services.

Exchange losses in the quarter ended June 30, 2004 were primarily due to the weakening of the U.K. sterling and the Euro against the U.S. dollar in those entities whose functional currency is the Euro or U.K. Sterling and which are exposed to net U.S. dollar liabilities.

The following table presents the ratios for this segment:

(Unaudited)
Three Months Ended
June 30,

2004 2003

Loss and loss expense ratio 63.8% 63.4%

Underwriting expense ratio 25.9% 28.6%

Combined ratio 89.7% 92.0%

The loss and loss expense ratio includes net losses incurred for both the current year and any adverse or favorable prior year development of loss and loss reserves held at the beginning of the year. The loss ratio for the three months ended June 30, 2004 remained relatively consistent compared with the three months ended June 30, 2003. The current quarter losses included approximately $29.0 million in net prior period reserve strengthening while the same period in 2003 included several large individual losses.

The decrease in the underwriting expense ratio in the three months ended June 30, 2004 compared to the same period in 2003 was due to a decrease in the acquisition expense ratio of 2.4 points (14.1% as compared to 16.5%) while the operating expense ratio remained consistent. The reduction in the acquisition expense ratio was due primarily to a change in the mix of business earned during the quarter compared to the same quarter in the prior year as well as the effects of the professional lines ceded reinsurance commutation described above.

Reinsurance

Reinsurance — General Operations

General reinsurance business written includes casualty, property, accident and health and other specialty reinsurance on a global basis. The Company’s reinsurance property business generally has loss experience characterized as low frequency and high severity that can have a negative impact on the Company’s results of operations, financial condition and liquidity. The Company endeavors to manage its exposures to catastrophic events by limiting the amount of its exposure in each geographic zone worldwide and requiring that its property catastrophe contracts provide for aggregate limits and varying attachment points.

The following table summarizes the underwriting results for the general operations of this segment:

(U.S. dollars in thousands)

(Unaudited)
Three Months Ended
June 30,

2004 2003 % Change

Gross premiums written $ 632,155 $ 616,778 2.5%

Net premiums written 536,978 522,359 2.8%

Net premiums earned 717,876 599,441 19.8%

Fee income and other 2,194 6,343 (65.4)%

Net losses and loss expenses 382,959 376,832 1.6%

Acquisition costs 173,605 141,566 22.6%

Operating expenses 49,068 36,694 33.7%

Exchange losses (gains) 5,576 (13,083) NM

Underwriting profit $ 108,862 $ 63,775 70.7%

Gross and net premiums written increased 2.5% and 2.8%, respectively, in the second quarter of 2004 as compared to the second quarter of 2003. The growth in gross written premiums was seen primarily in the U.S. casualty business and the property catastrophe business. These increases reflect increases in volume of new and renewal business combined with underlying rate improvements on the U.S. and London casualty portfolio offset by rate decreases generally across property and U.S. casualty lines compared to the same period last year. Favorable foreign exchange movements also contributed approximately $11.0 million to the growth in gross written premiums. Net written premiums reflected the above gross changes in gross premiums written.

Net premiums earned in the second quarter of 2004 increased 19.8% as compared to the second quarter of 2003, due primarily to the earning of net written premium growth in the last year. Casualty reinsurance net premiums earned were $320.4 million in the second quarter of 2004 as compared to $234.9 million in the same period in 2003.

Fee income and other relates primarily to fees earned on structured risk contracts which are earned based on individual underlying contractual terms and conditions.

The following table presents the ratios for this segment:

(Unaudited)
Three Months Ended
June 30,

2004

2003

            Loss and loss expense ratio 53.3% 62.9%

            Underwriting expense ratio 31.1% 29.7%

            Combined ratio 84.4% 92.6%

The loss and loss expense ratio includes net losses incurred for both the current year and any adverse or favorable prior year development of loss reserves held at the beginning of the year. The decrease in the loss and loss expense ratio in the quarter ended June 30, 2004 compared to the same quarter in 2003 primarily reflected lower than expected development in the quarter relating to several large losses in recent underwriting years, including a release of $12.0 million related to the September 11 event, and price improvements on earned premiums compared to prior periods.

The increase in the underwriting expense ratio in the second quarter of 2004 as compared with the second quarter of 2003 was primarily due to an increase in the acquisition expense ratio to 24.2% as compared to 23.6% in the second quarter of 2003. This increase was mainly due to increased profit commissions paid or due to reinsurers which resulted from favorable loss development in the period. The operating expense ratio increased from 6.1% for the second quarter of 2003 to 6.8% in the same quarter in 2004. The increase in operating expenses compared to the second quarter of 2003 was primarily due to the increased allocation of certain corporate expenses and the effects of foreign exchange movements.

Exchange losses in the three months ended June 30, 2004 were mainly attributable to an overall strengthening in the value of the U.S. dollar against U.K. Sterling and the Euro in those operations with U.S. dollars as their functional currency and net UK sterling and Euro assets.

Reinsurance — Life and Annuity Operations

Life and annuity business written by the reinsurance operations is primarily European life reinsurance. This includes term assurances, group life, critical illness cover, immediate annuities and disability income business. Due to the nature of these contracts, premium volume may vary significantly from period to period.

The following summarizes net income from life and annuity operations:

(U.S. dollars in thousands)

(Unaudited)
Three Months Ended
June 30,

2004

2003

% Change

Gross premiums written $ 968,226 $ 57,196 NM

Net premiums written 968,218 51,541 NM

Net premiums earned 969,097 56,605 NM

Fee income and other 47 — NM

Claims and policy benefits 986,068 73,064 NM

Acquisition costs 4,156 6,916 (39.9)%

Operating expenses 3,716 1,956 90.0%

Exchange gains (105) (3,320) NM

Net investment income 44,139 33,596 31.4%

Interest Expense (21) — NM

Net income from life and annuity operations $ 19,469 $ 11,585 68.1%

* NM — Not Meaningful

Gross and net premiums written as well as net premiums earned and claims and policy benefits increased significantly in the second quarter of 2004 as compared to the second quarter of 2003. These increases were primarily a result of a large immediate annuity portfolio contract written in the current quarter, representing $898.0 million in net premiums written and earned. In addition, the Company wrote several new premium term assurance contracts in the fourth quarter of 2003, which generated further written premiums in the current quarter. The increase in percentage of net premiums written to gross premiums written was primarily due to the termination of a retrocession agreement with an insurance affiliate in the third quarter of 2003.

Claims and policy benefits also increased significantly as a result of the annuity payout liabilities assumed under the contract noted above. Changes in claims and policy benefits also include the movement in policy benefit reserves related to other contracts where investment assets were acquired with the assumption of the policy benefit reserves at the inception of the contract.

Acquisition costs decreased in the second quarter of 2004 as compared to the second quarter of 2003 due to a timing difference arising from late renewal of a contract in 2003. Operating expenses increased in the second quarter of 2004 compared to the second quarter of 2003 reflecting the build out of existing operations and start-up costs of new life operations in the U.S.

Net investment income is included in the calculation of net income from life and annuity operations as it relates to income earned on portfolios of separately identified and managed life investment assets and other allocated assets. Several new large annuity contracts have been written since the second quarter of 2003, which significantly increased the invested assets relating to these operations.

Financial Products and Services

Financial Products and Services — Financial Operations

Financial Products and Services — Financial Operations business written includes insurance, reinsurance and derivative solutions for complex financial risks including financial guaranty insurance and reinsurance and weather and energy risk management products. Many of these transactions are unique and tailored to the specific needs of the insured or user.

Financial guaranty insurance and reinsurance generally guarantees payments of interest and principal on an issuer’s obligations when due. Obligations guaranteed or enhanced by the Company range in duration and premiums are received either on an installment basis or upfront. Guaranties written in derivative form provide coverage for losses upon the occurrence of specified credit events set forth in the swap documentation.

The Company’s weather and energy risk management products are customized solutions designed to assist corporate customers, primarily energy companies and utilities, to manage their financial exposure to variations in underlying weather conditions and related energy markets. The Company may use the capital markets to hedge portions of these risks written.

The following table summarizes the contribution for this segment:

(U.S. dollars in thousands)

(Unaudited)
Three Months Ended
June 30,

2004 2003 % Change

Gross premiums written $ 74,788 $ 106,266 (29.6)%

Net premiums written 71,850 104,466 (31.2)%

Net premiums earned 34,024 35,807 (5.0)%

Fee income and other 278 1,851 (85.0)%

Net losses and loss expenses 7,334 8,820 (16.8)%

Acquisition costs 5,705 5,836 (2.2)%

Operating expenses 16,408 9,019 81.9%

Underwriting profit $ 4,855 $ 13,983 (65.3)%

Net investment income — financial guarantee $ 8,872 $ 5,229 69.7%

Net realized and unrealized gains on weather and
energy derivatives 48 5,223 (99.1)%

Operating expenses — weather and energy 6,005 5,239 14.6%

Equity in net income of financial affiliates 1,387 16,658 91.7%

Minority interest 2,427 3,228 NM

Net realized and unrealized gains (losses) on
credit default swaps 26,289 (21,363) NM

Net contribution from financial operations $ 33,019 $ 11,263 NM

* NM — Not Meaningful

Gross and net premiums written primarily relate to the financial guaranty line of business and reflect premiums received and accrued for in the period and do not include the present value of future cash receipts expected from installment premium policies written in the period. Decreases in gross and net premiums written of 29.6% and 31.2%, respectively, in the second quarter of 2004 as compared to the same period in 2003 were primarily due to the combination of conscious underwriting discipline during generally weaker market conditions in the quarter and the absence in the current quarter of several large upfront premium contracts written in the second quarter of 2003. Market conditions are being driven by credit spread compression, higher interest rates, increased competition and reduced public financing.

The slight decline in net premiums earned in the second quarter of 2004 as compared to the same period in 2003 was primarily due to the earning of short term contract enhancements in the second quarter of 2003. Excluding this, financial guarantee premiums earned increased by $4.0 million over the same quarter last year. Premiums earned do not include premiums on contracts written in derivative form, which are included in “Net realized and unrealized gains (losses) on credit default swaps”.

As with the Company’s property and casualty insurance and reinsurance operations, net losses and loss expenses include current year net losses incurred and adverse or favorable development of prior year net loss and loss expenses reserves. Net losses and loss expenses in the quarter ended June 30, 2004 decreased compared to the same period in 2003. This decrease was primarily a result of the release of prior period unallocated reserves for financial guaranty exposures as the underlying in force policies get closer to maturity.

In the three months ended June 30, 2004, acquisition costs as a percentage of net premiums earned remained consistent with the same period in the prior year.

Operating expenses increased in the second quarter of 2004 as compared to the second quarter of 2003 due to expansion of all activities in the segment over the last year as well as an increase in the allocation of certain corporate expenses.

Net investment income related to the financial guaranty business increased in 2004 due to the larger investment portfolio created by growth in premium receipts and a $100.0 million capital infusion to this segment in the fourth quarter of 2003.

The net realized and unrealized positions on weather and energy risk management derivative instruments resulted in a small gain in the quarter ended June 30, 2004 as compared to much larger gains in the same quarter in 2003. In the period since June 30, 2003 the positions and activity in the gas area has been significantly reduced, those in the weather area have been increased slightly, and new contingent risk products were introduced.

Equity in net income of financial affiliates decreased in the second quarter of 2004 as compared to the second quarter of 2003 due primarily to the Company’s investment in Primus Guaranty, Ltd (“Primus”). Primus specializes in providing credit risk protection through credit derivatives. Primus had a negative mark-to-market adjustment in the quarter ended June 30, 2004.

The decrease in minority interest in the second quarter of 2004 and the second quarter of 2003 was due to a decrease in the profits in the current quarter of XL Financial Assurance Ltd., of which 15% is held by a minority shareholder.

The Company’s credit derivative transactions relate primarily to financial guaranty coverage that is written in swap form and pertains to tranches of collateralized debt obligations and asset backed securities. The net realized and unrealized gains in the quarter ended June 30, 2004 related to the fair value adjustment for transactions written in a derivative form as well as the premiums earned associated with these transactions. These gains were mainly unrealized and related to the improvement of credit quality for certain credit pools and the general tightening of spreads in the period, although also included in this fair value change is $11.4 million of earnings on premium received in the quarter. In the second quarter of 2003 the opposite conditions existed and the fair value change was negative. The Company continues to monitor its credit exposures and cash flows and adjust the fair value of these derivatives as required.

Financial Products and Services — Life and Annuity Operations

The Company commenced writing life business in this segment in the fourth quarter of 2002. The Company writes municipal reinvestment contracts, funding agreements and institutional life products.

The Company commenced writing municipal reinvestment contracts in 2002 and funding agreements in 2003 whereby the Company receives deposits at contractual interest rates. The Company has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the estimated ultimate liability.

The following summarizes net income from life operations:

(U.S. dollars in thousands)

(Unaudited)
Three Months Ended
June 30,

2004 2003 % Change

Gross premiums written $ 24,809 $ 18,693 32.7%

Net premiums written 24,951 12,162 105.2%

Net premiums earned 24,951 13,877 79.8%

Fee income and other 68 29 134.5%

Claims and policy benefits 20,441 10,161 101.1%

Acquisition costs 7,287 403 NM

Operating expenses 2,295 1,658 38.4%

Net investment income 20,168 6,638 203.8%

Interest expense 10,416 2,791 NM

Net income from life and annuity operations $ 4,748 $ 5,531 (14.2)%

* NM — Not Meaningful

In December 2002, certain blocks of U.S.-based mortality reinsurance business written were novated to the Company from an insurance affiliate. Gross and net premiums earned, claims and policy benefit reserves and acquisition costs are all related to this novated block of business. During the quarter ended September 30, 2003, the Company exercised its right and terminated a retrocession agreement relating to certain of these exposures which led to the significant increase in premiums earned and related claims as compared to the quarter ended June 30, 2003. In the quarter ended June 30, 2004 approximately $3.0 million in additional claims and policy benefit reserves were recorded related to this block of business.

Net investment income and interest expense relate to municipal reinvestment contracts and funding agreements transactions. The increase in investment income and the related interest expense were due to the initiation of funding agreements in the second quarter of 2003 combined with increases in the average balances outstanding related to the book of municipal reinvestment contracts. The balances outstanding for funding agreements and municipal reinvestment contracts have increased from $0.3 billion and $1.0 billion, respectively, as at June 30, 2003 to
$0.9 billion and $1.9 billion, respectively, as at June 30, 2004.

Investment Activities

The following table illustrates the change in net investment income from general operations, equity in net income of investment affiliates, net realized gains and losses on investments and net realized and unrealized gains and losses on investment derivatives from general operations for the quarters ended June 30, 2004 and 2003:

(U.S. dollars in thousands)

(Unaudited)
Three Months Ended
June 30,

2004 2003 % Change

Net investment income — general operations $ 161,998 $ 145,088 11.6%

Equity in net income of investment affiliates 26,733 34,306 (22.1)%

Net realized gains on investments 8,763 93,687 (90.6)%

Net realized and unrealized gains on investment
derivative instruments — general operations 15,803 3,883
NM

* NM — Not Meaningful

Net investment income related to general operations increased in the second quarter of 2004 as compared to the second quarter of 2003 due primarily to a higher investment base. The growth in the investment base reflected the Company’s cash flow from operations. The market yield to maturity on the total fixed income portfolio was 4.1% at June 30, 2004 as compared to 3.7% at June 30, 2003.

Equity in net income of investment affiliates decreased in the second quarter of 2004 compared to the second quarter of 2003. In the second quarter of 2004 the Company experienced very strong performance in the financial results of the investment managers where the Company has a minority stake. However, the Company’s returns from its fund investment affiliates were marginally positive for the quarter as a result of difficult investment conditions in the majority of capital markets.

The Company manages portfolios consisting of structured portfolios (i.e., assets supporting deposit liabilities and future policy benefit reserves) and Asset/Liability portfolios, where, due to the unique nature of the underlying liabilities, customized liability-based benchmarks are used to measure performance. The Company also manages Risk Asset portfolios, which constitute approximately 10% of the Company’s invested assets. These are compared to applicable public indices. The following is a summary of the investment performance for the quarters ended June 30, 2004 and June 30, 2003, respectively:

(Unaudited)
Three Months Ended
June 30,

2004 2003

Risk Asset Portfolios — Fixed Income (Note 1)

U.S. High Yield (1.0)% 8.4%

CS First Boston High Yield Index (0.2)% 9.7%

Relative Performance (0.8)% (1.3)%

Risk Asset Portfolios — Equities

U.S. Large Cap Growth Equity 2.6% 14.1%

Russell 1000 Growth Index 1.9% 14.3%

Relative Performance 0.7% (0.2)%

U.S. Large Cap Value Equity (0.2)% 16.8%

Russell 1000 Value Index 0.8% 17.2%

Relative Performance (1.0)% (0.4)%

U.S. Small Cap Equity 0.7% 22.8%

Russell 2000 Index 0.4% 23.4%

Relative Performance 0.3% (0.6)%

Non-U.S. Equity (1.8)% 16.5%

MSCE ACWI ex US Index (Note 2) (0.7)% 19.3%

Relative Performance (1.1)% (2.8)%

Risk Asset Portfolios — Alternative Investments

Alternative Investments — (Note 3) 0.4% 2.9%

Standard and Poor’s 500 Index — (Note 3) (1.7)% 13.9%

Relative Performance 2.1% (11.0)%

Note 1 — All U.S. and Sterling fixed income portfolios within Asset/Liability investment portfolios are now managed relative to custom liability benchmarks.

Note 2 — The benchmark for the Non-U.S. Equity portfolios changed from the MSCI EAFE to the MSCE ACWI ex US Index in the quarter. Comparative figures reflect the previous index.

Note 3 — Effective June 30, 2003, alternative investments are priced one month in arrears; however, cash flows are reflected in the current reporting period. For comparative purposes, effective June 2003, the Standard & Poor’s 500 Index returns are lagged one month.

Net Realized Gains and Losses and other than temporary declines in the value of investments

Net realized gains on investments in the second quarter of 2004 included net realized gains of $12.5 million from sales of investments and net realized losses of approximately $3.7 million related to the write-down of certain of the Company’s fixed income and equity investments where the Company determined that there was an other than temporary decline in the value of those investments.

Net realized gains on investments in the second quarter of 2003 included net realized gains of $132.3 million from sales of investments and net realized losses of approximately $38.6 million related to the write-down of certain of the Company’s fixed income and equity investments where the Company determined that there was an other than temporary decline in the value of those investments.

The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These factors include: (i) the time period during which there has been a significant decline in value; (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer; (iii) the significance of the decline; (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question; and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized.

Net Unrealized Gains and Losses on Investments

At June 30, 2004, the Company had net unrealized gains on fixed income securities of $19.6 million and net unrealized gains on equities of $86.1 million. Of these amounts, gross unrealized losses on fixed income securities and equities were $281.8 million and $9.2 million, respectively. The information presented below for the gross unrealized losses on the Company’s investments at June 30, 2004 shows the potential effect upon the Company’s 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. Interest rates have risen over the first two quarters of the year which has reduced the market values of most fixed income investments.

At June 30, 2004, approximately 7,200 fixed income securities out of a total of approximately 14,800 securities were in an unrealized loss position. The largest unrealized loss in the fixed income portfolio was $10.5 million. The number of fixed income securities in an unrealized loss position increased from 2,100 individual securities with total unrealized losses of $53.0 million at March 31, 2004. This increase was a result of an increase in prevailing market rates during the quarter. Approximately 300 equity securities out of a total of approximately 1,800 securities were in an unrealized loss position at June 30, 2004 with the largest individual loss being $1.0 million.

The following is an analysis of how long each of those securities with an unrealized loss at June 30, 2004 had been in a continual unrealized loss position:

(U.S. dollars in thousands)

Type of Securities Length of time in a continual
unrealized loss position (Unaudited)
Amount of unrealized
loss at June 30, 2004

Fixed Income and
Short-Term
Less than six months
$ 208,890

At least 6 months but less than 12 months
20,770

At least 12 months but less than 2 years
51,015

2 years and over
1,160

Total $
281,835

Equities
Less than six months
$
5,786

At least 6 months but less than 12 months

3,389

At least 12 months but less than 2 years

19

2 years and over

—

Total $
9,194

At June 30, 2004, the following was the maturity profile of the fixed income securities that were in a gross unrealized loss position:

(U.S. dollars in thousands)

Maturity profile in years of fixed
income securities in a continual
unrealized loss position (Unaudited)
Amount of unrealized loss at
June 30, 2004

Less than 1 year remaining $ 1,669

1 or more years and less than 5 years remaining 59,463

5 or more years and less than 10 years remaining 93,409

10 or more years and less than 20 years remaining 39,346

20 years or more remaining 49,256

Mortgage backed securities 38,692

Total $ 281,835

The Company operates a risk asset portfolio that includes high yield (below investment grade) fixed income securities. These represented approximately 4.0% of the total fixed income portfolio market value at June 30, 2004. The change in fair value of these securities has a higher volatility than investment grade securities. Of the total gross unrealized losses in the Company’s fixed income portfolio at June 30, 2004, $12.2 million related to securities that were below investment grade or not rated. The following is an analysis of how long each of these below investment grade and unrated securities had been in a continual unrealized loss position at the date indicated:

(U.S. dollars in thousands)

(Unaudited)
Amount of unrealized loss at
June 30, 2004

Length of time in a continual unrealized loss position

Less than six months $ 8,498

At least 6 months but less than 12 months 862

At least 12 months but less than 2 years 2,088

2 years or more 751

Total $ 12,199

Other Revenues and Expenses

The following table sets forth other revenues and expenses for the three months ended June 30, 2004 and 2003:

(U.S. dollars in thousands)

(Unaudited)
Three Months Ended
June 30,

2004

2003

% Change

Equity in net income (loss) of insurance affiliates $ 2,169 $ (136) NM

Amortization of intangible assets 3,257 375 NM

Corporate operating expenses 38,792 34,645 12.0%

Interest expense 44,566 43,491 2.5%

Income tax expense 31,176 11,009 183.2%

* NM — Not Meaningful

Corporate operating expenses in the second quarter ended June 30, 2004 increased compared to the three months ended June 30, 2003 due to the continued build out of the Company’s global infrastructure in developing its network of shared service organizations to support operations in certain locations, costs related to compliance with the Sarbanes-Oxley Act and costs related to the Company’s global branding campaign.

The increase in interest expense was primarily due to additional interest expense related to the 2.53% Senior Notes issued in March 2004 which was partially offset by the commutation of certain finite reinsurance contracts. For more information on the Company’s financing structure, see “Financial Condition and Liquidity.”

The increase in the Company’s income taxes arose principally from an improvement in the profitability of the Company’s U.S. and European operations.

Segment Results for the six months ended June 30, 2004 compared to the six months ended June 30, 2003

Insurance

The following table summarizes the underwriting results for this segment:

(U.S. dollars in thousands)

(Unaudited)
Six Months Ended
June 30,

2004 2003 % Change

Gross premiums written $ 3,238,936 $ 2,715,514 19.3%

Net premiums written 2,497,673 1,969,759 26.8%

Net premiums earned 1,997,673 1,751,306 14.1%

Fee income and other 7,896 3,717 112.4%

Net losses and loss expenses 1,254,543 1,073,208 16.9%

Acquisition costs 276,378 268,279 3.0%

Operating expenses 260,421 202,793 28.4%

Exchange losses 12,022 768 NM

Underwriting profit $ 202,205 $ 209,975 (3.7)%

* NM — Not Meaningful

Gross and net premiums written increased by 19.3% and 26.8%, respectively, in the half year ended June 30, 2004 compared with the half year ended June 30, 2003. These increases are primarily due to new business written across most lines and favorable foreign exchange movements. The most significant growth due to new business was seen in casualty, professional and marine lines of business combined with several new product offerings in the professional liability and property catastrophe lines. The new insurance initiatives added, in total, approximately $150.0 million to gross written premium. The weakening of the U.S. dollar against the U.K. sterling and the Euro as compared

to the second half of 2003 accounted for approximately $140.0 million of the increase in gross premiums written in the six months ended June 30, 2004. Partially offsetting the growth in net and gross premiums written in 2004 were moderate rate reductions in certain property lines and growing rate pressures on most casualty lines. Net premiums written have grown by a larger percentage than gross premiums written as a result of a ceded reinsurance commutations related to professional lines.

Net premiums earned increased by 14.1% in the six months ended June 30, 2004 compared with the six months ended June 30, 2003. The increase was due to the earning of additional net premiums written in the current and prior year combined with an increase in net retentions as a result of a ceded reinsurance commutation noted above. Growth in net premiums earned was partially offset by several non-renewed portfolios (specialty workers’ compensation, certain Lloyd’s international programs, and accident & health) as the earned premium impact of the non-renewed business lags the written premium impact.

Exchange losses in the six months ended June 30, 2004 were primarily due to the strengthening of the U.S. dollar in the first half of 2004 against the Euro and other major currencies in those entities whose functional currency is other than U.S. dollars and which are exposed to net U.S. dollar liabilities.

The decrease in the underwriting profit in the first half of 2004 as compared with the very strong performance in the first half of 2003 was also reflective of the combined ratios as shown below.

The following table presents the ratios for this segment:

(Unaudited)
Six Months Ended
June 30,

2004 2003

            Loss and loss expense ratio 62.8% 61.3%

            Underwriting expense ratio 26.9% 26.9%

            Combined ratio 89.7% 88.2%

The loss and loss expense ratio includes net losses incurred for both the current year and any adverse or favorable prior year development of loss and loss reserves held at the beginning of the year. The loss ratio for the six months ended June 30, 2004 increased compared with the six months ended June 30, 2003 largely due to minor prior period reserve strengthening in the first half of 2004.

The underwriting expense ratio in the half year ended June 30, 2004 compared to the same period in 2003 was flat as an increase in the operating expense ratio of 1.5 points (13.1% as compared to 11.6%) was offset by a reduction in the acquisition expense ratio of 1.5 points (13.8% as compared to 15.3%). The increase in the operating expense ratio was due primarily to the increased costs associated with supporting new business growth in the segment operations globally and in particular the start up operations, the impact of foreign exchange movements and an allocation of certain corporate expenses to the segment. The reduction in the acquisition expense ratio was due primarily to a change in the mix of business earned during the first half of the year compared to the same period in the prior year.

Reinsurance

Reinsurance — General Operations

The following table summarizes the underwriting results for the general operations of this segment:

(U.S. dollars in thousands)

  (Unaudited)


Six Months Ended


June 30,

2004 2003 % Change

Gross premiums written $ 2,312,592 $ 2,130,573 8.5%

Net premiums written 2,025,816 1,781,729 13.7%

Net premiums earned 1,407,477 1,150,101 22.4%

Fee income and other 6,104 17,793 (65.7)%

Net losses and loss expenses 799,781 727,338 10.0%

Acquisition costs 317,833 246,215 29.1%

Operating expenses 92,823 71,254 30.3%

Exchange gains (5,887) (23,208) NM

Underwriting profit $ 209,031 $ 146,295 42.9%

Gross and net premiums written increased 8.5% and 13.7%, respectively, in the first half of 2004 as compared to the first half of 2003. The growth in gross written premiums was seen primarily in the U.S. casualty business and the property lines of business. These increases reflect increases in volume of new and renewal business combined with underlying rate improvements in the range of 10%-15% on the U.S. and London casualty portfolio and rate decreases generally in the range of up to 15% across U.S. property lines. Some international property rates also saw reductions but to a lesser extent. Rate decreases also occurred in the marine, aviation and satellite lines. Favorable foreign exchange movements also contributed to the growth in gross written premiums. Net written premiums reflect the above gross changes, together with higher retentions, including approximately $49.0 million of quota share premiums from Le Mans Re previously ceded but now retained within the group.

Net premiums earned in the first half of 2004 increased 22.4% as compared to the first half of 2003, due primarily to the earning of net written premium growth in the last year. Casualty reinsurance net premiums earned were $606.0 million in the first half of 2004 as compared to $455.0 million in the same period in 2003.

Fee income and other relates primarily to fees earned on deposit liability contracts which are earned based on individual underlying contractual terms and conditions. The decrease in fee income was in line with management expectations given those terms and conditions.

The following table presents the ratios for this segment:

(Unaudited)

Six Months Ended

June 30,

2004 2003

            Loss and loss expense ratio 56.8% 63.2%

            Underwriting expense ratio 29.2% 27.6%

            Combined ratio 86.0% 90.8%

The loss and loss expense ratio includes net losses incurred for both the current year and any adverse or favorable prior year development of loss reserves held at the beginning of the year.

There were no significant catastrophic loss events affecting the Company in the first half of 2004 or 2003. The decrease in the loss and loss expense ratio in the half year ended June 30, 2004 compared to the same period in 2003 primarily reflected lower than expected incurred loss development in the first half of the year relating to recent underwriting years, including a release of $12 million related to the September 11 event, and price improvements on earned premiums from prior periods.

The increase in the underwriting expense ratio in the first half of 2004 as compared with the first half of 2003 was primarily due to an increase in the acquisition expense ratio to 22.6% as compared to 21.4% in the first half of 2003. This increase was mainly due to increased profit commissions which resulted from favorable loss development in the period. The operating expense ratio remained relatively consistent increasing to 6.6% for the first half of 2004 from 6.2% in the same period in 2003.

Exchange gains in the six months ended June 30, 2004 were mainly attributable to an overall weakening in the value of the U.S. dollar against the UK Sterling and the Euro in those operations with U.S. dollars as their functional currency and net U.K. sterling and Euro assets.

Reinsurance — Life and Annuity Operations

The following summarizes net income from life operations:

(U.S. dollars in thousands)

(Unaudited)

Six Months Ended

June 30,

2004 2003 % Change

Gross premiums written $ 1,062,495 $ 150,333 NM

Net premiums written 1,062,409 137,730 NM

Net premiums earned 1,064,336 139,842 NM

Fee income and other 93 — NM

Claims and policy benefits 1,102,244 183,536 NM

Acquisition costs 11,839 13,869 (14.6)%

Operating expenses 6,680 4,221 58.3%

Exchange gains (946) (3,614) (73.8)%

Net investment income 89,550 65,144 37.5%

Interest expense 117 — NM

Net income from life operations $ 34,045 $ 6,974 NM

* NM — Not Meaningful

Gross and net premiums written as well as net premiums earned and claims and policy benefits increased significantly in the first half of 2004 as compared to the first half of 2003 primarily as a result of a large immediate annuity portfolio contract bound in the second quarter, representing $898.0 million in net premium earned. In addition, the Company wrote several new regular premium term assurance contracts in the fourth quarter of 2003, which were generating further written premiums in the current and subsequent quarters. The increase in percentage of net premiums written to gross premiums written was primarily due to the termination of a retrocession agreement with an insurance affiliate in the third quarter of 2003.

Claims and policy benefits also increased significantly as a result of the annuity payout liabilities accepted under the contract noted above. Changes in claims and policy benefits also included the movement in policy benefit reserves related to other contracts where investment assets were acquired with the assumption of the policy benefit reserves at the inception of the contract.

Acquisition costs decreased in the first half of 2004 as compared to the first half of 2003 due to a timing difference arising from late renewal of a contract in France. Operating expenses increased in the first half of 2004 compared to the first half of 2003 reflecting the build out of existing operations and start-up costs of new Life operations in the U.S. Net investment income increased in the first half of 2004 compared to the first half of 2003 reflecting the increase in life business invested assets primarily arising from new large annuity contracts written since June 30, 2003.

Financial Products and Services

Financial Products and Services – Financial Operations

The following table summarizes the underwriting results for this segment:

(U.S. dollars in thousands)

(Unaudited)


Six Months Ended


June 30,

2004 2003 % Change

Gross premiums written $ 131,677 $ 151,032 (12.8)%

Net premiums written 124,184 148,462 (16.4)%

Net premiums earned 66,612 62,780 6.1%

Fee income and other 829 509 62.9%

Net losses and loss expenses 9,530 22,283 (57.2)%

Acquisition costs 8,633 9,039 (4.5)%

Operating expenses 33,202 22,306 48.8%

Underwriting profit $ 16,076 $ 9,661 66.4%

Net investment income — financial guarantee $ 17,005 $ 10,673 59.3%

Net realized and unrealized (losses) gains on weather
      and energy derivatives (4,616) 15,633 (129.5)%

Operating expenses — weather and energy 13,941 10,810 29.0%

Equity in net (loss) income of financial affiliates (1,203) 17,176 NM

Minority interest 7,087 5,298 33.8%

Net realized and unrealized gains (losses) on credit
      default swaps 39,649 (21,930) NM

Net contribution from financial operations $ 45,883 $ 15,105 204%

* NM — Not Meaningful

Gross and net premiums written primarily relate to the financial guaranty line of business and reflect premiums received and accrued for in the period and do not include the present value of future cash receipts expected from installment premium policies written in the period. Decreases in gross and net premiums written of 12.8% and 16.4%, respectively, in the first half of 2004 as compared to the same period in 2003 were primarily due to the combination of conscious underwriting discipline during generally weaker market conditions in the quarter and the absence in the current quarter of several large upfront premium contracts written in the second quarter of 2003. Market conditions are being driven by credit spread compression, higher interest rates, increased competition and reduced public financing.

Net premiums earned in the first half of 2004 as compared to the same period in 2003 showed growth in contrast to the decrease in net premiums written over the same period. This is because these premiums earn out over the life of the underlying exposures, which are typically longer than the risk periods related to the Company’s insurance and reinsurance general operations. The increase was partially offset by the earning of a large benefit relating to short term contract enhancements in the first half of 2003. Premiums earned do not include premiums on contracts written in derivative form, which are included in “Net realized and unrealized gains (losses) on credit default swaps”.

As with the Company’s property and casualty insurance and reinsurance operations, net losses and loss expenses include current year net losses incurred and adverse or favorable development of prior year net loss and loss expenses reserves. Net losses and loss expenses in the six months ended June 30, 2004 decreased significantly compared to the same period in 2003. This decrease was primarily a result of the release of prior period reserves related to financial guaranty exposures as the underlying in force policies get closer to maturity.

In the six months ended June 30, 2004, acquisition costs as a percentage of net premiums earned decreased as compared to the first half of 2003. This was due to a change in the average term over which the acquisition costs were being expensed which more accurately reflected the life of the exposures.

Operating expenses increased in the first half of 2004 as compared to the first half of 2003 due to the investment in segment infrastructure over the last year as well as an increase in the allocation of certain corporate expenses.

The net realized and unrealized positions on weather and energy risk management derivative instruments resulted in a loss in the half year ended June 30, 2004 as compared to a significant gain in the same period in 2003. During the first half of 2004 the winter weather and gas portfolios experienced losses due to higher than expected temperature volatility. During the first half of 2003, $9.1 million in gains were recognized on derivative contracts related to natural gas exposures that were not repeated in 2004. In the period since June 30, 2003 the positions and activity in the gas area has been significantly reduced, those in the weather area have been increased slightly, and new contingent risk products were introduced.

Equity in net income of financial affiliates decreased in the first half of 2004 as compared to the second half of 2003 due primarily to the Company’s investment in Primus. Primus specializes in providing credit risk protection through credit derivatives. Primus had a negative mark-to-market adjustment in the period.

The increase in minority interest in 2004 compared to 2003 is due to an increase in the profitability of XL Financial Assurance Ltd., of which 15% is held by a minority shareholder.

The Company’s credit derivative transactions relate primarily to financial guaranty coverage that is written in swap form and pertains to tranches of collateralized debt obligations and asset backed securities. The net realized and unrealized gains in the six months ended June 30, 2004 related to the fair value adjustment for transactions written in derivative form as well as the premiums earned associated with these transactions. These gains were mainly unrealized and related to the improvement of credit quality for certain credit pools. In the first half of 2003 the opposite conditions existed and the fair value change was negative. The Company continues to monitor its credit exposures and adjust the fair value of these derivatives as required.

Financial Products and Services — Life and Annuity Operations

The following summarizes net income from life operations:

(U.S. dollars in thousands)

(Unaudited)

Six Months Ended

June 30,

2004 2003 % Change

Gross premiums written $ 46,425 $ 36,880 25.9%

Net premiums written 46,644 23,286 100.3%

Net premiums earned 46,644 23,411 99.1%

Fee income and other 137 50 174.0%

Claims and policy benefits 38,328 19,247 99.1%

Acquisition costs 9,995 1,460 NM

Operating expenses 5,552 4,091 35.7%

Net investment income 38,459 12,549 NM

Interest expense 20,674 4,927 NM

Net income from life and annuity operations $ 10,691 $ 6,285 70.1%

* NM — Not Meaningful

Gross and net premiums written and earned relate to the blocks of U.S.-based mortality reinsurance business. Claims and policy benefits from this book of business are in line with management’s expectations.

In December 2002, certain blocks of U.S.-based mortality reinsurance business written were novated to the Company from an insurance affiliate. Gross and net premiums earned, claims and policy benefit reserves and acquisition costs are all related to this novated block of business. During the quarter ended September 30, 2003, the Company exercised its right and terminated a retrocession agreement of certain of these exposures which led to the significant increase in net premiums written in the first half of 2004 compared to the same period in 2003. In the quarter ended June 30, 2004 approximately $3.0 million in additional claims and policy benefit reserves were recorded related to this block of business.

Net investment income and interest expense relate to municipal reinvestment contracts and funding agreements

transactions. The increase in investment income and the related interest expense was due to the initiation of the funding agreements in the second quarter of 2003 combined with increases in the average balances outstanding related to the book of municipal reinvestment contracts. The balances outstanding for funding agreements and municipal reinvestment contracts have increased from $0.3 and $1.0 billion, respectively, as at June 30, 2003 to $0.9 million and $1.9 billion, respectively, as at June 30, 2004.

Investment Activities

(U.S. dollars in thousands)

   (Unaudited)


Six Months Ended


June 30,

2004 2003 % Change

Net investment income — general operations $ 318,509 $ 294,089 8.3%

Equity in net income of investment affiliates 97,109 61,104 58.9%

Net realized gains on investments 124,100 89,024 NM

Net realized and unrealized gains on
      investment derivative instruments — general operations 18,704 8,533 NM

* NM — Not Meaningful

Net investment income related to general operations increased in the first six months of 2004 as compared to the first six months of 2003 due primarily to a higher investment base. The growth in the investment base reflects the Company’s cash flow from operations. The market yield to maturity on the total fixed income portfolio was 4.1% at June 30, 2004 as compared to 3.7% at June 30, 2003.

Equity in net income of investment affiliates increased in the first six months of 2004 compared to the first six months of 2003 mainly due to strong performance in both the alternative portfolio and financial results of the investment managers where the Company has a minority stake.

The Company manages portfolios consisting of structured portfolios (i.e., assets supporting deposit liabilities and future policy benefit reserves) and Asset/Liability portfolios where, due to the unique nature of the underlying liabilities, customized liability-based benchmarks are used to measure performance. The Company also manages Risk Asset portfolios, which constitute approximately 10% of the Company’s invested assets. These are compared to applicable public indices. The following is a summary of the investment performance for the six months ended June 30, 2004 and June 30, 2003, respectively:

(Unaudited)

Six Months Ended

June 30,

2004 2003

(Note 1)

U.S. High Yield 0.7% 13.7%

CS First Boston High Yield Index 2.5% 17.3%

Relative Performance (1.8)% (3.6)%

Risk Asset Portfolios — Equities

U.S. Large Cap Growth Equity 2.3% (12.8)%

Russell 1000 Growth Index 2.6% (13.0)%

Relative Performance (0.3)% 0.2%

U.S. Large Cap Value Equity 4.6% 12.4%

Russell 1000 Value Index 3.7% 11.4%

Relative Performance 0.9% 1.0%

U.S. Small Cap Equity 6.7% 19.2%

Russell 2000 Index 6.7% 17.8%

Relative Performance — 1.4%

Non-U.S. Equity 4.2% 8.2%

MSCE ACWI ex US Index (Note 2) 3.6% 9.5%

Relative Performance 0.6% (1.3)%

Risk Asset Portfolios — Alternative Investments

Alternative Investments (Note 3) 4.4% 4.7%

Standard and Poor’s 500 Index (Note 3) (0.1)% 10.4%

Relative Performance 4.5% (5.7)%

Note 1 — All U.S. and Sterling fixed income portfolios within Asset/Liability investment portfolios are now managed relative to custom liability benchmarks.

Note 2 — The benchmark for the Non-U.S. Equity portfolios changed from the MSCI EAFE to the MSCE ACWI ex US Index in the quarter. Comparative figures reflect the previous index.

Note 3 — Effective June 30, 2003, alternative investments are priced one month in arrears; however, cash flows are reflected in the current reporting period. For comparative purposes, effective June 2003, the Standard & Poor’s 500 Index returns are lagged one month.

Net Realized Gains and Losses and other than temporary declines in the value of investments

Net realized gains on investments in the first six months of 2004 included net realized gains of $128.2 million from sales of investments and net realized losses of approximately $4.1 million related to the write-down of certain of the Company’s fixed income and equity investments where the Company determined that there was an other than temporary decline in the value of those investments.

Net realized gains on investments in the first six months of 2003 included net realized gains of $202.7 million from sales of investments and net realized losses of approximately $113.7 million related to the write-down of certain of the Company’s fixed income and equity investments where the Company determined that there was an other than temporary decline in the value of those investments.

significant decline in value; (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer; (iii) the significance of the decline; (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question; and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized.

Net realized and unrealized gains on investment derivatives in the first six months of 2004 resulted from the Company’s investment strategy to economically hedge against interest and foreign exchange risk within the investment portfolio.

Other Revenues and Expenses

The following table sets forth other revenues and expenses for the six months ended June 30, 2004 and 2003:

(U.S. dollars in thousands)

(Unaudited)


Six Months Ended


June 30,

2004 2003 % Change

Equity in net income (loss) of insurance affiliates $ 3,184 $ (41,741) NM

Amortization of intangible assets 6,514 750 NM

Corporate operating expenses 80,397 68,953 16.6%

Interest expense 74,227 87,495 (15.2)%

Income tax expense 66,533 31,039 114.4%

* NM — Not Meaningful

The equity in net loss of insurance affiliates for the six months ended June 30, 2003 includes an other than temporary decline of $40.9 million in the value of the Company’s investment in Annuity and Life Re. The investment was written down to its fair value of $2.1 million at March 31, 2003.

Corporate operating expenses in the six months ended June 30, 2004 increased compared to the six months ended June 30, 2003 due to the continued build-out of the Company’s global infrastructure in developing its network of shared service organizations to support operations in certain locations, costs related to compliance with the Sarbanes-Oxley Act, and new costs related to the Company’s global branding campaign.

The decrease in interest expense primarily reflected a lower accretion charge on the deposit liabilities due to the commutation of certain finite reinsurance contracts offset by additional interest expense related to the 2.53% Senior Notes issued in March 2004. For more information on the Company’s financing structure, see “Financial Condition and Liquidity.”

The increase in the Company’s income taxes arose principally from an increase in the profitability of certain of the Company’s U.S. and European operations during the first half of 2004.

Financial Condition, Liquidity and Capital Resources

As a holding company, the Company’s assets consist primarily of its investments in subsidiaries, and the Company’s future cash flows depend on the availability of dividends or other statutorily permissible payments from its subsidiaries. The ability to pay such dividends is limited by the applicable laws and regulations of the various countries the Company operates in, including, among others, Bermuda, the United States, Ireland, Switzerland and the United Kingdom, and those of the Society of Lloyd’s and certain contractual provisions. No assurance can be given that the Company or its subsidiaries will be permitted to pay dividends in the future.

The Company and its subsidiaries provide no guarantees or other commitments (express or implied) of financial support to the Company’s subsidiaries or affiliates, except for express written financial support provided by XL Insurance (Bermuda) Ltd in connection with the Company’s financial guaranty subsidiaries and where other express written guaranty or other financial support arrangements are in place.

The Company’s ability to underwrite business is dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company is downgraded,

its ability to write business would be adversely affected in financial guaranty and long-tailed insurance and reinsurance lines of business. In the normal course of business, the Company evaluates its capital needs to support the volume of business written in order to maintain its claims paying and financial strength ratings. In January 2004 several of the internationally recognized rating agencies amended their financial strength ratings of the Company’s principal insurance and reinsurance subsidiaries and pools following the announcement by the Company of an increase in the prior period loss reserves in the fourth quarter of 2003. The Company regularly provides financial information to rating agencies to both maintain and enhance existing ratings.

The following are the current financial strength and claims paying ratings from internationally recognized rating agencies in relation to the Company’s principal insurance and reinsurance subsidiaries and pools:

Rating agency Rating

Standard & Poor’s AA– (Outlook Stable)

Fitch AA (Stable)

A.M. Best A+ (Outlook Negative)

Moody’s Investor Services Aa2 (except members of the XL America Pool, XL Re Ltd and XL Life Insurance and Annuity Company, which are rated Aa3, outlook for both ratings is stable)

The following are the financial strength ratings from internationally recognized rating agencies in relation to the Company’s principal financial guaranty insurance and reinsurance subsidiaries:

Rating agency Rating

Standard & Poor’s AAA

Fitch AAA

Moody’s Investor Services Aaa

There can be no assurance that any such ratings will be retained for any period of time or that they will not be qualified, suspended, revised downward or withdrawn entirely by such agencies.

In addition, XL Capital Ltd. currently has the following long term debt ratings: “a–” (Outlook Negative) from A.M. Best, “A” (Negative) from Standard and Poor’s, “A2” (Stable) from Moody’s and “A” (Stable) from Fitch.

Financial Condition

At June 30, 2004 total investments available for sale and cash, net of unsettled investment trades, were $26.0 billion compared to $23.1 billion at December 31, 2003. This increase in investment assets related primarily to proceeds of notes payable and the issuance of equity units of $800.2 million, cash flow generated from operating activities for the quarter of $2.0 billion, and the receipt of deposit liabilities of $682.3 million. Of the Company’s total investments available for sale, including fixed maturities, short-term investments and equity securities, at June 30, 2004, approximately 99% was managed by several outside investment management firms. Approximately 95.5% of fixed maturity and short-term investments are investment grade, with 67.5% rated “Aa” or “AA” or better by a nationally recognized rating agency. Using the Standard & Poor’s rating scale, the average quality of the fixed income portfolio was “AA”.

As a significant portion of the Company’s net premium written incepts in the first half of the year, certain assets and liabilities have increased at June 30, 2004 compared to December 31, 2003. This includes deferred acquisition costs, unearned premiums, premiums receivable and prepaid reinsurance premiums. For the six months ended June 30, 2004, currency translation adjustment losses were $17.8 million. This is shown as part of accumulated other comprehensive income and primarily related to unrealized losses on foreign currency exchange rate movement in those operations where the functional currency is not the U.S. dollar.

The Company establishes reserves to provide for estimated claims, the general expenses of administering the claims adjustment process and for losses incurred but not reported. These reserves are calculated using actuarial and other reserving techniques to project the estimated ultimate net liability for losses and loss expenses. The Company’s reserving practices, and the establishment of any particular reserve, reflect management’s judgment concerning sound financial practice and do not represent any admission of liability with respect to any claims made against the Company. No assurance can be given that actual claims made and payments related thereto will not be in excess of the amounts reserved.

Included in unpaid loss and loss expenses recoverable at June 30, 2004 is an unsecured, net recoverable from Winterthur Swiss Insurance Company (the “Seller”) of $925 million, related to certain contractual arrangements from the Company’s acquisition of Winterthur International in July 2001. This amount is subject to ongoing adjustment as described below, and the Seller is currently rated “A” (negative credit watch) by S&P. The sale and purchase agreement, as amended, including the amendments filed as Exhibits 10.15 and 10.16 to this Report (“SPA”), provides the Company with post-closing protection determined as of June 30, 2004 with respect to, among other things, adverse development of net loss and unearned premium reserves relating to the acquired Winterthur International business. This protection is based upon net loss experience and development over a three-year, post-closing seasoning period based on actual loss development experience, collectible reinsurance and certain other factors set forth in the SPA. The SPA includes a process for determining the adjustment amount due from the Seller, which process contemplates negotiation between the parties and, if no agreement is reached, a binding determination by an independent actuary in London who must select one of the two numbers submitted by the parties based on which of these is closest to the amount determined by the independent actuary. In addition, the Seller provides protection to the Company with respect to reinsurance recoverables related to the Winterthur International acquisition in the aggregate amount of $2.3 billion as of June 30, 2004; certain reinsurers responsible for some portions thereof have raised issues as to whether amounts claimed are due and the resolution of those discussions is also currently ongoing. The Company expects that the process will likely result in a material increase in the net recoverable from the Seller, the ultimate amount of which presently is not determinable. The Company may recognize a loss in future periods if the amount finally agreed or determined to be due to the Company from the Seller is less than the adverse development of net loss and unearned premium reserves and any unrecovered amounts included within reinsurance recoverables related to the Winterthur International acquisition or to the extent that any amount proves to be uncollectible from the Seller for any reason.

Inflation can, among other things, potentially result in larger claims. The Company’s underwriting philosophy is to adjust premiums in response to inflation.

Liquidity and Capital Resources

As at June 30, 2004, the Company had bank, letter of credit and loan facilities available from a variety of sources including commercial banks totaling $7.6 billion, of which $2.7 billion in debt was outstanding. In addition, $2.8 billion of letters of credit were outstanding as of June 30, 2004, 8% of which were collateralized by the Company’s investment portfolio, principally supporting U.S. non-admitted business and the Company’s Lloyd’s capital requirements.

In May 2004, the Company paid $15.0 million to the holders of record as at close of business on May 26, 2004, of its Zero Coupon Convertible Debentures (“CARZ”) originally issued in May 2001. No bondholders put bonds to the Company and, consequently, all bonds remain outstanding. The next put date for these securities is May 23, 2006. The LYONs may be “put” at their accreted value or converted by the bondholders at various times prior to the 2021 redemption date. The next “put” date is September 7, 2004. The Company may also choose to “call” the debt at its accreted value from that same date. To the extent that holders of the LYONs tender any debentures for repurchase by the Company on September 7, 2004, the Company has elected to pay all of the purchase price for such debentures in cash. The Company believes that it has the appropriate liquid resources in place to make such a payment should the holders elect to exercise this option.

In March, 2004 the Company issued 33 million 6.5% Equity Security Units (“Units”) in a public offering. The Company received approximately $800.2 million in proceeds from the sale of the Units after deducting underwriting discounts. The Company intends to use the net proceeds from the sale of the Units for general corporate purposes.

Each 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 Company’s Class A Ordinary Shares (“ordinary shares”) on May 15, 2007 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due May 15, 2009 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 3.97% and 2.53% under the purchase contracts and senior notes, respectively. The Company may defer the contract payments on the purchase contract, but not the senior notes, until the stock purchase date. In May 2007, 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 Unit holders’ obligation under the purchase contract. 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 holder’s obligation to purchase its ordinary shares under the purchase contracts.

The Company entered into three new bilateral unsecured letter of credit facilities in 2004 to provide additional capacity to support the Company’s U.S. non-admitted business. The new facilities totaled $125.0 million of which $50.0 million was utilized at June 30, 2004. Two of these facilities totaling $75.0 million were subsequently cancelled effective June 30, 2004.

The Company replaced its principal $2.5 billion credit and letter of credit facility which expired on June 23, 2004, with a new $1.0 billion facility which expires on June 22, 2005, and a new $2.0 billion facility which expires on June 22, 2007. Both facilities are available to provide revolving credit ($600.0 million in the aggregate) and letters of credit ($3.0 billion in the aggregate) and are syndicated and unsecured. The $1.0 billion facility was unutilized at June 30, 2004, and approximately $1.7 billion of the $2.0 billion facility was utilized to provide letters of credit at June 30, 2004.

The following tables present the Company’s indebtedness under outstanding securities and lenders’ commitments as at June 30, 2004:

(U.S. dollars in thousands)
(Unaudited)

Payments Due By Period

Year Of Less Than 1 To 3 4 To 5 After 5

Notes Payable And Debt Commitment In Use Expiry 1 Year Years Years Years

Revolving credit facilities $ 600,000 $ — 2004 $ — $ — $ — $ —

7.15% Senior Notes 99,990 99,990 2005 — 100,000 — —

6.58% Guaranteed Senior Notes 255,000 255,000 2011 — — — 255,000

6.50% Guaranteed Senior Notes (1) 597,600 597,600 2012 — — — 600,000

Zero Coupon Convertible
Debentures (“CARZ”) (1) 650,670 650,670 2021 — — — 1,010,833

Liquid Yield Option Notes™
(“LYONS”) (1) 315,108 315,108 2021 — — — 514,622

2.53% Senior Notes (2) 825,000 825,000 2009 — — 825,000 —

Total $ 3,343,368 $ 2,743,368 $ — $ 100,000 $ 825,000 $ 2,380,455

(1) “Commitment” and “In Use” data represent June 30, 2004 accreted values. “Payments due by period” represents ultimate redemption values. The convertibles may be “put” or converted by the bondholders at various times prior to the 2021 redemption dates. The next “put” date is May 23, 2006 for the CARZ and September 7, 2004 for the LYONs. The Company may also choose to “call” the debt from May and September 2004 onwards for the CARZ and LYONS, respectively.

(2) The 2.53% Senior Notes are a component of the Units issued in March 2004. In addition to the Senior Notes coupon of 2.53%, contract adjustment payments of 3.97% per annum are being paid on forward purchase contracts for ordinary shares for a total distribution per annum on the Units of 6.50%. The forward purchase contracts mature on May 15, 2007, and the Senior Notes will mature on May 15, 2009.

The total pre-tax interest expense on the borrowings described above was $28.8 million and $21.8 million for the three months ended June 30, 2004 and 2003, respectively.

The following table presents, as at June 30, 2004, the Company’s letter of credit facilities available and in use and when those facilities are due to expire:

(U.S. dollars in thousands)
(Unaudited)

Amount of Commitment

Expiration Per Period

Year Of Less Than 1 To 3 4 To 5 After 5

Other Commercial Commitments
Commitment

In Use

Expiry
1 Year
Years

Years
Years

Letter of Credit Facilities $ 4,264,153 $ 2,843,563 2004-7 $ 2,264,153 $ 2,000,000 $ — $ —

The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are principally utilized to support non-admitted insurance and reinsurance operations in the United States and capital requirements at Lloyd’s. In addition to letters of credit, the Company has established insurance

trusts in the U.S. that provide cedents 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 cedents. This could take the form of additional insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business.

For information regarding cross-default and certain other provisions in the Company’s debt and convertible securities documents, see Item 7 of the Company’s Form 10-K for the year ended December 31, 2003.

The Company has had several share repurchase programs in the past as part of its capital management strategy. On January 9, 2000, the Board of Directors authorized a program for the repurchase of shares up to $500.0 million. Under this plan, the Company has purchased 6.6 million shares at an aggregate cost of $364.6 million or an average cost of $55.24 per share. The Company has $135.4 million remaining in its share repurchase authorization. During the six months ended June 30, 2004, no shares were repurchased in the open market. The Company has repurchased shares from employees and directors in relation to withholding tax on restricted stock. See Part II Item 2

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. Any prospectus, prospectus supplement, the Company’s Annual Report to ordinary shareholders, any proxy statement, any other Form 10-K, Form 10-Q or Form 8-K of the Company or any other written or oral statements made by or on behalf of the Company may include forward looking statements which reflect the Company’s current views with respect to future events and financial performance. Such statements include forward-looking statements both with respect to the Company in general, and to the insurance, reinsurance and financial products and services sectors in particular (both as to underwriting and investment matters). Statements which include the words “expect”, “intend”, “plan”, “believe”, “project”, “anticipate”, “will”, and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the PSLRA or otherwise.

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) the timely and full recoverability of reinsurance placed by the Company with third parties, or other amounts due to the Company, including, without limitation, amounts due to the Company from the Seller in connection with the Company’s acquisition of the Winterthur International operations; (ii) the projected amount of ceded reinsurance recoverables and the ratings and creditworthiness of reinsurers may change; (iii) the timing of claims payments being faster or the receipt of reinsurance recoverables being slower than anticipated by the Company; (iv) ineffectiveness or obsolescence of the Company’s business strategy due to changes in current or future market conditions; (v) increased competition on the basis of pricing, capacity, coverage terms or other factors; (vi) greater frequency or severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than the Company’s underwriting, reserving or investment practices anticipate based on historical experience or industry data; (vii) developments in the world’s financial and capital markets which adversely affect the performance of the Company’s investments and the Company’s access to such markets; (viii) the potential impact on the Company from government-mandated insurance coverage for acts of terrorism; (ix) the potential impact of variable interest entities or other off-balance sheet arrangements on the Company; (x) 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; (xi) availability of borrowings and letters of credit under the Company’s credit facilities; (xii) changes in regulation or tax laws applicable to the Company or its subsidiaries, brokers or customers; (xiii) acceptance of the Company’s products and services, including new products and services; (xiv) changes in the availability, cost or quality of reinsurance; (xv) changes in the distribution or placement of risks due to increased consolidation of insurance and reinsurance brokers; (xvi) loss of key personnel; (xvii) the effects of mergers, acquisitions and divestitures; (xviii) changes in rating agency policies or practices; (xix) changes in accounting policies or practices or the application thereof; (xx) legislative or regulatory developments; (xxi) changes in general economic conditions, including inflation, foreign currency exchange rates and other factors; (xxii) the effects of business disruption or economic contraction due to war, terrorism or other hostilities; and (xxiii) the other factors set forth in the Company’s other documents on file with the SEC. The foregoing review of important factors should not be construed

as exhaustive and should be read in conjunction with the other cautionary statements that are included herein or elsewhere. The Company undertakes no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Except as described below, there have been no material changes in the Company’s market risk exposures, or how those exposures are managed, since December 31, 2003. The following discussion should be read in conjunction with “Quantitative and Qualitative Disclosures About Market Risk” presented under Item 7A of the Company’s Form 10-K for the year ended December 31, 2003.

The Company enters into derivatives and other financial instruments primarily for risk management purposes. The Company’s derivative transactions can expose the Company to credit default swap risk, weather and energy risk, investment market risk, interest rate risk and foreign currency exchange rate risk. The Company attempts to manage these risks based on guidelines established by senior management. Derivative instruments are carried at fair value with resulting changes in fair value recognized in income in the period in which they occur.

Value-at-risk (“VaR”) is one of the tools used by management to estimate potential losses in fair values using historical rates, market movements and credit spreads to estimate the volatility and correlation of these factors to calculate the potential loss that could occur over a defined period of time given a certain probability.

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. 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.”

Credit Default Swaps

The Company has written certain financial guaranty transactions in derivative or swap form. The Company does not actively trade these transactions and generally issues and holds these contracts to maturity. Changes in fair value can result from changes in market credit spreads, supply and demand for similar type instruments, changes in future loss and/or recovery estimates, interest rates and credit rating upgrades or downgrades. The Company therefore is at risk for changes in fair value due to changes in any of the above factors.

Weather and Energy Market Risk

The Company offers weather and energy risk management products in insurance or derivative form to end-users, while managing the risks in the over-the-counter and exchange traded derivatives markets in a weather and energy derivatives trading portfolio.

Fair values for the Company’s 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 which do not have quoted market prices requires management judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, realized and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.

The following table summarizes the movement in the fair value of weather and energy contracts outstanding during the six months ended June 30, 2004:

(U.S. dollars in thousands)

(Unaudited)

Six Months

Ended

June 30, 2004

Fair value of contracts outstanding, beginning of the year $ (11,490)

Option premiums received, net of premiums realized (1) 19,436

Reclassification of settled contracts to realized (2) 40,677

Other changes in fair value (3) (42,583)

Fair value of contracts outstanding, end of period $ 6,040

(1) The Company collected $17.4 million of paid premiums and realized $36.8 million of premiums on expired transactions for a net increase in the balance sheet derivative asset of $19.4 million.

(2) The Company paid $40.7 million to settle derivative positions during the period resulting in a reclassification of this amount from unrealized to realized and an increase in the derivative asset on the balance sheet.

(3) This represents the effects of changes in commodity prices, the time value of options, and other valuation adjustments of ($42.6) million on the Company’s derivative positions, primarily attributable to hedges of the positions that realized $36.8 million of premiums.

The change in the fair value of contracts outstanding at June 30, 2004 as compared to the beginning of the year is primarily due to the expiration of natural gas positions, which were not replaced due to management’s decision to reduce the size of its natural gas portfolio.

The following table summarizes the maturity of contracts outstanding as of June 30, 2004:

(U.S. dollars in thousands)
(Unaudited)

Less Than Greater Than Total

Source Of Fair Value 1 Year 1-3 Years 4-5 Years 5 Years Fair Value

Prices actively quoted $ (1,502) $ — $ — $ — $ (1,502)

Prices based on models and other
valuation methods (1,910) 9,326 126 7,542

Total fair value of contracts outstanding $ (3,412) $ 9,326 $ 126 $ — $ 6,040

The Company manages its weather and energy portfolio through the employment of a variety of strategies. These include geographical and directional diversification of risk exposures and direct hedging within the capital and reinsurance markets. Risk management is undertaken on a product portfolio-wide basis, to maintain a portfolio that the Company believes is well diversified and which remains within the aggregate risk tolerance established by the Company’s senior management.

The Company’s aggregate average, low and high seasonal VaR amounts for its weather risk management portfolio, calculated at a 99% confidence level, during the period ended June 30, 2004 were $163.2 million, $126.5 million and $214.0 million, respectively. The corresponding levels for the weather risk management portfolio during the period ended June 30, 2003 were $151.8 million, $131.8 million and $175.6 million, respectively. The Company calculates its aggregate VaR by summing the VaR amounts for each of its seasonal portfolios. The Company’s aggregation methodology yields a conservative aggregate portfolio VaR, given that current weather events and patterns have an immaterial effect on expectations for future seasons and the Company could therefore greatly reduce or eliminate its VaR on future seasons by selling its positions prior to the beginning of a season. At present, the Company’s VaR calculation does not exceed $80.0 million in any one season or $95.0 million prior to the start of the winter season in the then current year.

For the natural gas portfolio, VaR is calculated using a one-day holding period. Management has established a daily VaR limit for this portfolio of $0.3 million. The Company’s average, low and high daily VaR amounts calculated at a 99% confidence level, during the period ended June 30, 2004 were $0.1 million, nil and $0.2 million, respectively. The corresponding amounts during the period ended June 30, 2003 were $2.4 million, $1.8 million and $2.9 million, respectively.

For electricity generation outage insurance products, VaR is calculated using an annual holding period. Management has established an annual VaR limit of $25 million for this book of business. The Company’s average, low and high annual VaR amounts, calculated at a 99% confidence level, during the period ended June 30, 2004 were $4.2 million, $2.6 million, and $7.6 million, respectively. The corresponding amounts during the period ended June 30, 2003 were $3.2 million, $1.3 million, and $5.3 million, respectively.

Investment Market Risk

The Company’s investment portfolio consists of exposures to fixed income securities, equities, alternative investments, derivatives, business and other investments and cash. These securities and investments are denominated in both U.S. dollar and foreign currencies.

Through the structure of the Company’s investment portfolio, the Company’s book value is directly affected by changes in the valuations of the securities and investments held in the investment portfolio. These valuation changes reflect changes in fixed income security prices (e.g. slope and curvature of the yield curves, volatility of interest rates, credit spreads and mortgage prepayment speeds), equity prices (e.g. changes in prices and volatilities of individual securities, equity baskets and equity indices) and foreign currency exchange rates (e.g. changes in spot prices, forward prices and volatilities of currency rates). Market risk therefore arises due to the uncertainty surrounding the future valuations of these different assets, the factors that impact their values and the impact that this could have on the Company’s book value.

The Company generally seeks to manage the risks of the investment portfolio through a combination of asset class, country, industry and security level diversification and investment manager allocations. Further, individual security and issuer exposures are generally controlled and monitored at the investment portfolio level, via specific investment constraints outlined in investment guidelines and agreed with the appropriate external investment professionals. Additional constraints may be agreed with the external investment professionals that may address exposures to eligible securities, prohibited investments/transactions, credit quality and general concentration limits.

The Company’s direct use of investment derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, references rates or a combination of these factors. When investment guidelines allow for the use of derivatives, these can generally only be used for the purposes of managing interest rate risk, foreign exchange risk and credit risk, provided the use of such instruments is incorporated in the overall portfolio duration, spread, convexity and other relevant portfolio metrics. The direct use of derivatives is not permitted to economically leverage the portfolio outside of the stated guidelines. Derivatives may also be used to add value to the investment portfolio where market inefficiencies are perceived to exist, to utilize cash holdings to purchase equity indexed derivatives and to adjust the duration of a portfolio of fixed income securities to match the duration of related deposit liabilities.

Investment Value-At-Risk

In the third quarter of 2003, the Company introduced a new, more widely used risk management system to generate the investment VaR and to stress test the investment portfolio. Although the overall methodology is consistent between the two systems, there are certain differences between these systems relating to security pricing models, time series, time periods and proxies used for individual instruments. Accordingly, the VaR for the investment portfolio and the stress tests on the investment portfolio are not directly comparable to periods prior to the fourth quarter of 2003.

The VaR of the total investment portfolio at June 30, 2004, based on a 95% confidence level with a one month holding period, was approximately $564.1 million. The VaR of all investment related derivatives as at June 30, 2004 was approximately $11.3 million. The Company’s investment portfolio VaR as at June 30, 2004 is not necessarily indicative of future VaR levels.

To complement the VaR analysis which is based on normal market environments, the Company considers the impact on the investment portfolio in 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 reflect current shareholders equity, market conditions and the Company’s total risk profile. Given the investment portfolio allocations as at June 30, 2004, the Company would expect to lose approximately

5.6% of the portfolio if the most damaging event stress tested was repeated, all other things held equal. Given the investment portfolio allocations as at June 30, 2004, the Company would expect to gain approximately 18.4% on the portfolio if the most favorable event stress tested was repeated, all other things held equal. The Company assumes that no action is taken during the stress period to either liquidate or rebalance the portfolio and believes that this fairly reflects the potential decreased liquidity that is often associated with stressed market environments.

Fixed Income Portfolio

The Company’s fixed income portfolio is exposed to credit and interest rate risk through its portfolio of debt securities. The fixed income portfolio includes fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased.

As at June 30, 2004, the value of the Company’s fixed income portfolio, including cash and cash equivalents and net payable for investments purchased, was approximately $25.4 billion as compared to approximately $20.0 billion at June 30, 2003. As at June 30, 2004, the fixed income portfolio consisted of approximately 89.1% of the total investment portfolio (including cash and cash equivalents, and net payable for investments purchased) as compared to approximately 87.8% as at June 30, 2003.

The table below shows the Company’s fixed income portfolio by credit rating in percentage terms of the Company’s total fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased) as at June 30, 2004.

Total

AAA
55.7%

AA
11.8%

A
17.5%

BBB
10.5%

BB & BELOW
4.1%

NR
0.4%

Total
100.0%

At June 30, 2004 the average credit quality of the Company’s total fixed income portfolio was “AA”.

As at June 30, 2004, the top 10 corporate holdings represented approximately 8.2% of the total fixed income portfolio and approximately 33.8% of all corporate holdings. The top 10 corporate holdings listed below utilizes a conservative approach to aggregation as it includes unsecured as well as securitized, credit enhanced and collateralized securities issued by parent companies and their affiliates.

Top 10 Corporate Holdings (2) Percentage of Total Fixed Income Portfolio (1)

Citigroup Inc 1.31%

JPMorgan Chase & Co (3) 1.29%

Bank of America Corporation 1.11%

Morgan Stanley 0.83%

Bear, Stearns & Co. Inc 0.65%

MBNA Corp 0.63%

General Electric Company 0.60%

DaimlerChrysler AG 0.60%

Bank One Corp (3) 0.58%

Washington Mutual Inc 0.56%

(1) Including fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased.

(2) Corporate holdings include parent and affiliated companies that issue fixed income securities. In some cases a portion of the market value may be invested in bonds that are securitized or have sufficient credit enhancement that provides a long-term credit rating that is higher than the rating of the unsecured debt of the parent company.

(3) Effective July 1, 2004 JPMorgan Chase & Co and Bank One Corp have merged.

The Company’s fixed income portfolio is exposed to interest rate risk. Interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. The hypothetical case of an immediate 100 basis point adverse parallel shift in global bond curves as at June 30, 2004 would decrease the fair value of the Company’s fixed income portfolio by approximately 4.5% or $1.1 billion as compared to approximately 5.0% or $0.8 billion as at June 30,

2003. Based on historical observations, it is unlikely that all global yield curves would shift in the same direction, by the same amount and at the same time.

Equity Portfolio

As at June 30, 2004, the Company’s equity portfolio was $651.0 million as compared to $550.0 million as at June 30, 2003. As at June 30, 2004, the Company’s allocation to equity securities was approximately 2.3% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net payable for investments purchased) as compared to approximately 2.4% as at June 30, 2003.

As at June 30, 2004, approximately 56.8% of the equity portfolio was invested in U.S. companies as compared to approximately 35.0% as at June 30, 2003. As at June 30, 2004, the top ten equity holdings represented approximately 7.8% of the Company’s total equity portfolio as compared to approximately 7.6% as at June 30, 2003.

The Company’s equity portfolio is exposed to price risk. Equity price risk is the potential loss arising from decreases in the market value of equities. An immediate hypothetical 10% change in the value of each equity position would affect the fair value of the portfolio by approximately $65.1 million as at June 30, 2004 as compared to $55.0 million as at June 30, 2003.

Alternative Investment Portfolio

The Company’s alternative investment portfolio (included in investments in affiliates or other investments) had approximately 100 separate investments in different funds at June 30, 2004 with a total portfolio of $1.6 billion representing approximately 5.5% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net payable for investments purchased) as compared to June 30, 2003 where the Company had approximately 100 separate fund investments with a total exposure of $1.4 billion representing approximately 6.0% of the total investment portfolio.

As at June 30, 2004, the alternative investment style allocation was 24.0% in arbitrage strategies, 42.0% in directional/tactical strategies, 25.0% in event driven strategies and 9.0% in multi-strategy strategies.

Private Investment Portfolio

As at June 30, 2004, the Company’s exposure to private investments was approximately $195.8 million compared to $191.2 million as at June 30, 2003. As at June 30, 2004, the Company’s exposure to private investments consisted of approximately 0.7% of the total investment portfolio (including cash and cash equivalents, accrued investment income and net payable for investments purchased), as compared to 0.8% as at June 30, 2003.

Bond and Stock Index Futures Exposure

As at June 30, 2004, bond and stock index futures outstanding were $41.6 million with underlying investments having a market value of $265.3 million. A 10% appreciation or depreciation of these derivative instruments would have resulted in realized gains and realized losses of $4.1 million respectively. The Company reduces its exposure to these futures through offsetting transactions, including options and forwards.

Foreign Currency Exchange Risk

The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of its foreign currency fixed maturities and certain of its foreign currency equity investments. These contracts are not designated as specific hedges for financial reporting purposes and, therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of three months or less. At June 30, 2004 and 2003, forward foreign exchange contracts with notional principal amounts totaling $271.0 million and $62.0 million, respectively, were outstanding. The fair value of these contracts as at June 30, 2004 and 2003 was $266.0 million and $59.4 million, respectively, with an unrealized gain of $5.0 million in 2004 and an unrealized gain of $2.6 million in 2003. For the six months ended June 30, 2004 and 2003, realized losses of $3.0 million and realized gains of $1.6 million, respectively, and unrealized gains of $1.3 million and of $3.8 million, respectively, were recorded in net realized and unrealized gains and losses on derivative instruments.

The Company attempts to manage the exchange volatility arising on certain costs denominated in foreign currencies. Throughout the year, forward contracts are entered into to acquire foreign currencies at an agreed rate in the future. At June 30, 2004, the Company had forward contracts outstanding for the purchase of the equivalent of $207.2 million in Euros and the equivalent of $99.8 million in GBP at fixed rates. The unrealized loss on these contracts at June 30, 2004 was $5.9 million and $1.4 million, respectively.

ITEM 4. CONTROLS AND PROCEDURES

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of disclosure controls and procedures pursuant to Rules 13a-15 and 15d-15 promulgated under the Securities Exchange Act of 1934 as 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. There have been no changes in internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

The Company’s management, including the Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls or its internal controls will prevent all errors and all fraud. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. As a result of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. As a result of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Accordingly, the Company’s disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the disclosure controls and procedures are met.

XL CAPITAL LTD
PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On March 17, 2004, certain current and former directors and officers of the Company were named as defendants in a putative “shareholder derivative complaint” (Marilyn Clark, Derivatively on Behalf of XL Capital Ltd v. Brian O’Hara et al.) filed in Connecticut Superior Court by a California shareholder (the “Action”). The Company is named as a nominal defendant. The complaint alleges several causes of action including breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment during the time period “from November 2001 to the present” (the “Relevant Period”). The Action alleges that the Company maintained inadequate loss reserves for its NAC Re subsidiary (now known as XL Reinsurance America, Inc.) during the Relevant Period and that, as a consequence, the Company’s earnings and assets were materially overstated. The relief sought against certain of the defendants includes profits made on sales of the Company’s shares over a two year period. Defendants have filed a motion to dismiss the complaint on various grounds including lack of subject matter jurisdiction and that it has been filed in an incorrect forum. If the complaint is not dismissed, the defendants intend to vigorously defend the claims asserted against them. There has been no discovery in the Action.

On June 21, 2004, a consolidated and amended class action complaint (the “Amended Complaint”) was served on the Company and certain of its present and former directors and officers as defendants in a putative class action (Malin et al. v. XL Capital Ltd et al.) filed in United States District Court, District of Connecticut (the “Malin Action”). The Malin Action purports to be on behalf of purchasers of the Company’s common stock between November 1, 2001 and October 16, 2003, and alleges claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder (“Securities Laws”). The Amended Complaint alleges that the defendants violated the Securities Laws by, among other things, failing to disclose in various public and shareholder and investor reports and other communications the alleged inadequacy of the Company’s loss reserves for its NAC Re subsidiary (now known as XL Reinsurance America, Inc.) and that, as a consequence, the Company’s earnings and assets were materially overstated. The time for the Company and the individual defendants to respond to the Amended Complaint has not occurred and there has been no discovery in the Malin Action. The Company and the defendant present and former officers and directors intend to vigorously defend the claims asserted against them.

On June 17, 2004, William Kronenberg, III, Frank A. Piliero and David M. Rosenberg (together, the “Claimants”) commenced an arbitration against the Company before the American Arbitration Association (“AAA”) in New York, New York. The Claimants and the Company were parties to a stock purchase agreement dated June 1, 1999, pursuant to which the Company acquired the outstanding capital stock of ECS, Inc (the “Stock Purchase Agreement”). In their AAA arbitration demand, the Claimants assert claims of fraud and deceitful conduct, negligent misrepresentation, and breach of contract and a covenant of good faith and fair dealing, all relating to the allegation that the Company failed to make certain contingent payments allegedly due to Claimants under the Stock Purchase Agreement. Claimants seek $85 million (the maximum amount payable under the contingent payment provision at issue), plus punitive damages, interest, costs and attorneys’ fees. On July 30, 2004, the Company filed an Answering Statement and Motion to Stay or Dismiss the AAA arbitration. On April 13, 2004, the Company commenced a separate arbitration procedure, as provided in the Stock Purchase Agreement, but the Claimants have refused to participate in such procedure. On July 15, 2004, the Company filed a petition in the United States District Court for the Southern District of New York, seeking an order of the Court compelling the Claimants to arbitrate the dispute pursuant to those procedures and staying or dismissing the AAA arbitration. Oral argument for the petition is scheduled for August 10, 2004. The Company intends to vigorously defend against the Claimants’ claims.

On July 15, 2003, the Company and Messrs. Esposito and O’Hara were named in a Consolidated Amended Class Action Complaint (the “Amended Complaint”) filed by certain shareholders of Annuity and Life Re (Holdings), Ltd. (“ANR”) against ANR and certain present and former officers and directors of ANR in the United States District Court for the District of Connecticut seeking unspecified money damages on behalf of purchasers of ANR stock. Schnall v. Annuity and Life Re (Holdings), Ltd., Civil Action No. 02-CV-2133 (GLG) (the “Schnall Action”). The plaintiffs claim that the defendants violated certain provisions of the United States securities laws by making (or being responsible as alleged controlling persons for) various alleged material misstatements and omissions in public filings and press releases of ANR. On July 19, 2004, an agreement in principle was reached with plaintiffs to settle the Schnall Action. The settlement is without any admission of liability or wrongdoing and would include a nominal cash payment by the Company. The settlement is subject to certain approvals, full documentation, notice to the class,

court approval and certain other steps required to consummate a class action settlement.

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 and are typical for the Company and for the property and casualty insurance and reinsurance industry in general. Such legal proceedings are considered in connection with the Company’s loss and loss expense reserves. Reserves in varying amounts may or may not be established in respect of particular claims proceedings based on many factors, including the legal merits thereof and other factors. 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 insurance or reinsurance policies.

The Company believes that the ultimate outcomes of all outstanding litigation and arbitration will not have a material adverse effect on its consolidated financial condition, future operating results and/or liquidity, although an adverse resolution of a number of these items could have a material adverse effect on the Company’s results of operations in a particular fiscal quarter or year.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

The following table provides information about purchases by the Company during the quarter ended June 30, 2004 of equity securities that are registered by the company pursuant to Section 12 of the Exchange Act:

ISSUER PURCHASES OF EQUITY SECURITIES

Total Number Approximate Dollar

of Shares Value of Shares

Purchased as that May Yet Be

Part of Purchased Under

Total Number Average Price Publicly the Plans

of Shares Paid Announced Plans or Programs

Period Purchased (1) per Share (2) or Programs (3)

April 1-30, 2004 34,879 $ 76.71 — $ 135.4 million

May 1-31, 2004 — — — $ 135.4 million

June 1-30, 2004 — — — $ 135.4 million

Total 34,879 $ 76.71 — $ 135.4 million

(1) All of the shares included in each period were purchased in connection with the vesting of restricted shares granted under the Company’s restricted stock plan. All of these purchases were made in connection with satisfying tax withholding obligations of those employees. These shares were not purchased as part of the Company’s publicly announced share repurchase program.

(2) The price paid per share is the closing price of the shares on the vesting date.

(3) On January 9, 2000, the Board of Directors previously authorized a $500.0 million share repurchase program. The Company did not repurchase any equity securities under the program during the three or six months ended June 30, 2004. As of June 30, 2004, the Company could repurchase up to approximately $135.4 million of our equity securities under the Company’s share repurchase program.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

At the Annual General Meeting of Class A Shareholders held on April 30, 2004 at the Executive Offices of the Company, XL House, One Bermudiana Road, Hamilton HM 11, Bermuda, the ordinary shareholders approved the following:

1. The election of three Class III Directors to hold office until 2007:

Votes in Favor Votes Withheld

      J. Loudon 115,929,345 2,256,200

      R.S. Parker 116,615,861 1,569,684

      A. Senter 116,403,266 1,782,279

2. The appointment of PricewaterhouseCoopers LLP, New York, New York, to act as the independent auditors of the Company for the fiscal year ending December 31, 2004:

Votes In Favor Votes Against Abstentions

116,451,445

1,152,617

581,483

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

10.1 Amendment, dated as of May 10, 2004, to (i) the Revolving Credit and Security Agreement, dated as of February 25, 2003, among XL Re Ltd, as the borrower, CAFCO, LLC, CRC Funding, LLC, CHARTA, LLC, CIESCO, LLC, Citibank, N.A. and Citicorp North America, Inc., as agent, and (ii) the Control Agreement, dated as of February 25, 2003, among XL Re Ltd, as the borrower, Citibank North America, Inc., as Agent and Mellon Bank, N.A., as the securities intermediary.

10.2 364-Day Credit Agreement, dated as of June 23, 2004, between XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd and XL Re Ltd, as Account Parties and Guarantors, the lenders party thereto, and JPMorgan Chase Bank, as Administrative Agent.

10.3 Three-Year Credit Agreement, dated as of June 23, 2004, between XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd and XL Re Ltd, as Account Parties and Guarantors, the lenders party thereto, and JPMorgan Chase Bank, as Administrative Agent.

10.4 Form of Non-Statutory Stock Option Agreement (One-Time Vesting).

10.5 Form of Non-Statutory Stock Option Agreement (Incremental Vesting).

10.6 Form of Incentive Stock Option Agreement.

10.7 Form of Restricted Stock Agreement.

10.8 Form of Non-Statutory Stock Option Agreement (Renewal Form).

10.9 Form of Non-Statutory Stock Option Agreement (Non-Employee Director Renewal Form).

10.10 Form of Directors Restricted Stock Agreement.

10.11 Form of Performance Restricted Stock Agreement.

10.12 Form of Performance Restricted Stock Unit Agreement.

10.13 Form of Restricted Stock Unit Agreement.

10.14 Form of Director Stock Option Agreement.

10.15 Agreement, dated December 24, 2003, between Winterthur Swiss Insurance Company and XL Insurance (Bermuda) Ltd (including Schedule B thereto), relating to the Second Amended and Restated Agreement for the Sale and Purchase of Winterthur International, dated February 15, 2001.

10.16 Amendment Agreement, dated July 27, 2004, between Winterthur Swiss Insurance Company and XL Insurance (Bermuda) Ltd, relating to the Second Amended and Restated Agreement for the Sale and Purchase of Winterthur International, dated February 15, 2001.

31 Rule 13a-14(a)/15d-14(a) Certifications.

32 Section 1350 Certification.

99.1 XL Capital Assurance Inc. condensed consolidated financial statements (unaudited) for the three and six month periods ended June 30, 2004 and 2003.

99.2 XL Financial Assurance Ltd. condensed financial statements (unaudited) for the three and six month periods ended June 30, 2004 and 2003.

(b) Reports on Form 8-K

Current Report on Form 8-K filed on May 19, 2004, under Item 5 and Item 7 thereof.

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

XL CAPITAL LTD

(Registrant)

Dated: August 9, 2004 /s/ BRIAN M. O’HARA

Brian M. O’Hara

President and Chief Executive Officer

Dated: August 9, 2004 /s/ JERRY DE ST. PAER

Jerry de St. Paer

Executive Vice President and

Chief Financial Officer

		CAYMAN ISLANDS		98-0191089
		(State or other Jurisdiction of		(I.R.S. Employer
		incorporation or organization)		Identification No.)

	PART I. FINANCIAL INFORMATION	Page No

Item 1.	Financial Statements:

	Consolidated Balance Sheets as at June 30, 2004 (Unaudited) and December 31, 2003	3

	Consolidated Statements of Income for the Three Months Ended June 30, 2004 and 2003 (Unaudited) and the Six Months Ended June 30, 2004 and 2003 (Unaudited)	5

	Consolidated Statements of Comprehensive Income for the Three Months Ended June 30, 2004 and 2003 (Unaudited) and for the Six Months Ended June 30, 2004 and 2003 (Unaudited)	6

	Consolidated Statements of Shareholders’ Equity for the Six Months Ended June 30, 2004 and 2003 (Unaudited)	7

	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004 and 2003 (Unaudited)	8

	Notes to Unaudited Consolidated Financial Statements	9

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	52

Item 4.	Controls and Procedures	57

	PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	58

Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities	59

Item 4.	Submission of Matters to a Vote of Security Holders	60

Item 6.	Exhibits and Reports on Form 8-K	60

Signatures		62

		(Unaudited)
		June 30,		December 31,
		2004		2003

ASSETS
Investments:
Fixed maturities, at fair value (amortized cost: 2004, $21,514,661; 2003, $18,990,670)	$	21,534,257	$	19,494,356
Equity securities, at fair value (cost: 2004, $564,773; 2003, $473,112)		650,918		583,450
Short-term investments, at fair value (amortized cost: 2004, $1,409,897; 2003, $696,798)		1,414,821		697,450

Total investments available for sale		23,599,996		20,775,256
Investments in affiliates		1,898,462		1,903,341
Other investments		251,415		142,567

Total investments		25,749,873		22,821,164
Cash and cash equivalents		2,744,878		2,403,121
Accrued investment income		299,995		294,615
Deferred acquisition costs		987,032		777,882
Prepaid reinsurance premiums		1,021,729		977,595
Premiums receivable		4,637,369		3,487,322
Reinsurance balances receivable		1,302,475		1,359,486
Unpaid losses and loss expenses recoverable		5,826,619		5,779,997
Goodwill and other intangible assets		1,841,997		1,845,507
Deferred tax assets, net		307,574		310,077
Other assets		740,494		707,449

Total assets	$	45,460,035	$	40,764,215

LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Unpaid losses and loss expenses	$	17,076,770	$	16,558,788
Deposit liabilities		4,769,276		4,050,334
Future policy benefit reserves		4,104,763		3,233,845
Unearned premiums		5,963,401		4,729,989
Notes payable and debt		2,743,368		1,905,483
Reinsurance balances payable		1,628,225		1,525,739
Net payable for investments purchased		312,680		96,571
Other liabilities		1,728,933		1,666,397
Minority interest		56,047		60,154

Total liabilities	$	38,383,463	$	33,827,300


		(Unaudited)				(Unaudited)
		Three Months Ended				Six Months Ended
		June 30,				June 30,

		2004		2003		2004		2003

Revenues:
Net premiums earned	$	2,858,297	$	1,575,809	$	4,582,742	$	3,127,440
Net investment income		235,177		190,551		463,523		382,455
Net realized gains on investments		8,763		93,687		124,100		89,024
Net realized and unrealized gains (losses) on derivative instruments		42,140		(12,257)		53,737		2,236
Equity in net income of investment affiliates		26,733		34,306		97,109		61,104
Fee income and other		8,152		9,792		15,059		22,069

Total revenues	$	3,179,262	$	1,891,888	$	5,336,270	$	3,684,328

Expenses:
Net losses and loss expenses incurred	$	1,099,910	$	937,575	$	2,063,854	$	1,822,829
Claims and policy benefits		1,006,509		83,225		1,140,572		202,783
Acquisition costs		347,408		298,550		624,678		538,862
Operating expenses		247,716		193,908		493,016		384,427
Exchange losses (gains)		15,913		(23,352)		5,189		(26,054)
Interest expense		54,961		46,282		95,018		92,422
Amortization of intangible assets		3,257		375		6,514		750

Total expenses	$	2,775,674	$	1,536,563	$	4,428,841	$	3,016,019

Income before minority interest, income tax and equity in net (income) loss of insurance and financial affiliates	$	403,588	$	355,325	$	907,429	$	668,309
Minority interest		2,284		3,166		6,944		5,028
Income tax		31,176		11,009		66,533		31,039
Equity in net (income) loss of insurance and financial affiliates		(3,556)		(16,522)		(1,981)		24,565

Net income		373,684		357,672		835,933		607,677
Preference share dividends		(10,080)		(10,013)		(20,160)		(20,161)

Net income available to ordinary shareholders	$	363,604	$	347,659	$	815,773	$	587,516

Weighted average ordinary shares and ordinary share equivalents outstanding — basic		137,655		136,791		137,568		136,527

Weighted average ordinary shares and ordinary share equivalents outstanding — diluted		138,741		138,634		138,648		138,084

Earnings per ordinary share and ordinary share equivalent — basic	$	2.64	$	2.54	$	5.93	$	4.30

Earnings per ordinary share and ordinary share equivalent — diluted	$	2.62	$	2.51	$	5.88	$	4.25

						Financial
						Products and
		Insurance		Reinsurance		Services		Total

General Operations:
Net premiums earned	$	1,112,349	$	717,876	$	—	$	1,830,225
Fee income and other		5,565		2,194		—		7,759
Net losses and loss expenses		709,617		382,959		—		1,092,576
Acquisition costs		156,655		173,605		—		330,260
Operating expenses (1)		131,432		49,068		—		180,500
Exchange losses		10,442		5,576		—		16,018

Underwriting profit	$	109,768	$	108,862	$	—	$	218,630

Life and Annuity Operations:
Life premiums earned	$	—	$	969,097	$	24,951	$	994,048
Fee income and other		—		47		68		115
Claims and policy benefits		—		986,068		20,441		1,006,509
Acquisition costs		—		4,156		7,287		11,443
Operating expenses (1)		—		3,716		2,295		6,011
Exchange (gains) losses		—		(105)		—		(105)
Net investment income		—		44,139		20,168		64,307
Interest expense		—		(21)		10,416		10,395

Net income from life and annuity operations		$ —	$	19,469	$	4,748	$	24,217

Financial Operations:
Net premiums earned					$	34,024	$	34,024
Fee income and other						278		278
Net losses and loss expenses						7,334		7,334
Acquisition costs						5,705		5,705
Operating expenses (1)						16,408		16,408

Underwriting profit					$	4,855	$	4,855
Investment income — financial guarantee					$	8,872	$	8,872
Net realized and unrealized gains on credit derivatives						26,289		26,289
Net realized and unrealized gains on weather and energy derivatives						48		48
Operating expenses — weather and energy (1)						6,005		6,005
Equity in net income of financial affiliates						1,387		1,387
Minority interest						2,427		2,427

Contribution from financial operations					$	33,019	$	33,019


		(1)		Operating expenses exclude corporate operating expenses, shown separately.
		(2)		Interest expense excludes interest expense related to life and annuity operations, shown separately.
		(3)		This includes net realized gains on investments of $8.8 million and net realized and unrealized gains on investment derivatives of $15.8 million, but does not include unrealized appreciation or depreciation on investments, which are included in “accumulated other comprehensive income (loss)”.
		(4)		Ratios are based on net premiums earned from general operations. The underwriting expense ratio excludes exchange gains and losses.


		(1)		Other, includes political risk, surety, bonding, warranty and other lines.

		(Unaudited) Three Months Ended June 30,				(Unaudited) Six Months Ended June 30,

		2004		2003		2004		2003

Credit derivatives	$	26,289	$	(21,363)	$	39,649	$	(21,930)
Weather and energy risk management derivatives		48		5,223		(4,616)		15,633
Investment derivatives		15,803		3,883		18,704		8,533

Net realized and unrealized gains (losses) on derivatives	$	42,140	$	(12,257)	$	53,737	$	2,236

		(Unaudited) Three Months Ended June 30,				(Unaudited) Six Months Ended June 30,

		2004		2003		2004		2003

Basic earnings per ordinary share:
Net income	$	373,684	$	357,672	$	835,933	$	607,677
Less: preference share dividends		(10,080)		(10,013)		(20,160)		(20,161)

Net income available to ordinary shareholders	$	363,604	$	347,659	$	815,773	$	587,516

Weighted average ordinary shares outstanding		137,655		136,791		137,568		136,527
Basic earnings per ordinary share	$	2.64	$	2.54	$	5.93	$	4.30

Diluted earnings per ordinary share:
Net income	$	373,684	$	357,672	$	835,933	$	607,677
Less: preference share dividends		(10,080)		(10,013)		(20,160)		(20,161)

Net income available to ordinary shareholders	$	363,604	$	347,659	$	815,773	$	587,516

Weighted average ordinary shares outstanding — basic		137,655		136,791		137,568		136,527
Average stock options outstanding (1)		1,086		1,843		1,080		1,557

Weighted average ordinary shares outstanding — diluted		138,741		138,634		138,648		138,084

Diluted earnings per ordinary share	$	2.62	$	2.51	$	5.88	$	4.25

Dividends per ordinary share	$	0.49	$	0.48	$	0.98	$	0.96


	(1)	Net of shares repurchased under the treasury stock method.


	(1)	Average stock options outstanding have been excluded where anti-dilutive to earnings per ordinary share.

(U.S. dollars in thousands)
		(Unaudited) Three Months Ended June 30,

		2004		2003	% Change

Gross premiums written	$	24,809	$	18,693	32.7%
Net premiums written		24,951		12,162	105.2%
Net premiums earned		24,951		13,877	79.8%
Fee income and other		68		29	134.5%
Claims and policy benefits		20,441		10,161	101.1%
Acquisition costs		7,287		403	NM
Operating expenses		2,295		1,658	38.4%
Net investment income		20,168		6,638	203.8%
Interest expense		10,416		2,791	NM

Net income from life and annuity operations	$	4,748	$	5,531	(14.2)%


Note 1 — All U.S. and Sterling fixed income portfolios within Asset/Liability investment portfolios are now managed relative to custom liability benchmarks.
Note 2 — The benchmark for the Non-U.S. Equity portfolios changed from the MSCI EAFE to the MSCE ACWI ex US Index in the quarter. Comparative figures reflect the previous index.


Type of Securities	Length of time in a continual unrealized loss position	(Unaudited) Amount of unrealized loss at June 30, 2004

Fixed Income and Short-Term	Less than six months	$	208,890
	At least 6 months but less than 12 months		20,770
	At least 12 months but less than 2 years		51,015
	2 years and over		1,160

	Total	$	281,835

Equities	Less than six months	$	5,786
	At least 6 months but less than 12 months		3,389
	At least 12 months but less than 2 years		19
	2 years and over		—

	Total	$	9,194

(U.S. dollars in thousands)
Maturity profile in years of fixed income securities in a continual unrealized loss position	(Unaudited) Amount of unrealized loss at June 30, 2004

Less than 1 year remaining	$	1,669
1 or more years and less than 5 years remaining		59,463
5 or more years and less than 10 years remaining		93,409
10 or more years and less than 20 years remaining		39,346
20 years or more remaining		49,256
Mortgage backed securities		38,692

Total	$	281,835

(U.S. dollars in thousands)
	(Unaudited) Amount of unrealized loss at June 30, 2004
Length of time in a continual unrealized loss position	(Unaudited) Amount of unrealized loss at June 30, 2004

Less than six months	$	8,498
At least 6 months but less than 12 months		862
At least 12 months but less than 2 years		2,088
2 years or more		751

Total	$	12,199

Rating agency	Rating

Standard & Poor’s	AA–	(Outlook Stable)
Fitch	AA	(Stable)
A.M. Best	A+	(Outlook Negative)
Moody’s Investor Services	Aa2	(except members of the XL America Pool, XL Re Ltd and XL Life Insurance and Annuity Company, which are rated Aa3, outlook for both ratings is stable)

							Payments Due By Period

					Year Of		Less Than		1 To 3		4 To 5		After 5
Notes Payable And Debt		Commitment		In Use	Expiry		1 Year		Years		Years		Years

Revolving credit facilities	$	600,000	$	—	2004	$	—	$	—	$	—	$	—
7.15% Senior Notes		99,990		99,990	2005		—		100,000		—		—
6.58% Guaranteed Senior Notes		255,000		255,000	2011		—		—		—		255,000
6.50% Guaranteed Senior Notes (1)		597,600		597,600	2012		—		—		—		600,000
Zero Coupon Convertible Debentures (“CARZ”) (1)		650,670		650,670	2021		—		—		—		1,010,833
Liquid Yield Option Notes™ (“LYONS”) (1)		315,108		315,108	2021		—		—		—		514,622
2.53% Senior Notes (2)		825,000		825,000	2009		—		—		825,000		—

Total	$	3,343,368	$	2,743,368		$	—	$	100,000	$	825,000	$	2,380,455


		(1)		“Commitment” and “In Use” data represent June 30, 2004 accreted values. “Payments due by period” represents ultimate redemption values. The convertibles may be “put” or converted by the bondholders at various times prior to the 2021 redemption dates. The next “put” date is May 23, 2006 for the CARZ and September 7, 2004 for the LYONs. The Company may also choose to “call” the debt from May and September 2004 onwards for the CARZ and LYONS, respectively.
		(2)		The 2.53% Senior Notes are a component of the Units issued in March 2004. In addition to the Senior Notes coupon of 2.53%, contract adjustment payments of 3.97% per annum are being paid on forward purchase contracts for ordinary shares for a total distribution per annum on the Units of 6.50%. The forward purchase contracts mature on May 15, 2007, and the Senior Notes will mature on May 15, 2009.

							Amount of Commitment
							Expiration Per Period

					Year Of		Less Than		1 To 3		4 To 5		After 5
Other Commercial Commitments		Commitment		In Use	Expiry		1 Year		Years		Years		Years

Letter of Credit Facilities	$	4,264,153	$	2,843,563	2004-7	$	2,264,153	$	2,000,000	$	—	$	—

		(Unaudited)
		Six Months
		Ended
		June 30, 2004

Fair value of contracts outstanding, beginning of the year	$	(11,490)
Option premiums received, net of premiums realized (1)		19,436
Reclassification of settled contracts to realized (2)		40,677
Other changes in fair value (3)		(42,583)

Fair value of contracts outstanding, end of period	$	6,040


		(1)		The Company collected $17.4 million of paid premiums and realized $36.8 million of premiums on expired transactions for a net increase in the balance sheet derivative asset of $19.4 million.
		(2)		The Company paid $40.7 million to settle derivative positions during the period resulting in a reclassification of this amount from unrealized to realized and an increase in the derivative asset on the balance sheet.
		(3)		This represents the effects of changes in commodity prices, the time value of options, and other valuation adjustments of ($42.6) million on the Company’s derivative positions, primarily attributable to hedges of the positions that realized $36.8 million of premiums.

		Less Than						Greater Than		Total
Source Of Fair Value		1 Year		1-3 Years		4-5 Years		5 Years		Fair Value

Prices actively quoted	$	(1,502)	$	—	$	—	$	—	$	(1,502)
Prices based on models and other valuation methods		(1,910)		9,326		126				7,542

Total fair value of contracts outstanding	$	(3,412)	$	9,326	$	126	$	—	$	6,040

		Total

AAA		55.7%
AA		11.8%
A		17.5%
BBB		10.5%
BB & BELOW		4.1%
NR		0.4%

Total		100.0%

Top 10 Corporate Holdings (2)				Percentage of Total Fixed Income Portfolio (1)

Citigroup Inc				1.31%
JPMorgan Chase & Co (3)				1.29%
Bank of America Corporation				1.11%
Morgan Stanley				0.83%
Bear, Stearns & Co. Inc				0.65%
MBNA Corp				0.63%
General Electric Company				0.60%
DaimlerChrysler AG				0.60%
Bank One Corp (3)				0.58%
Washington Mutual Inc				0.56%


		(1)		Including fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased.
		(2)		Corporate holdings include parent and affiliated companies that issue fixed income securities. In some cases a portion of the market value may be invested in bonds that are securitized or have sufficient credit enhancement that provides a long-term credit rating that is higher than the rating of the unsecured debt of the parent company.
		(3)		Effective July 1, 2004 JPMorgan Chase & Co and Bank One Corp have merged.


		(1)		All of the shares included in each period were purchased in connection with the vesting of restricted shares granted under the Company’s restricted stock plan. All of these purchases were made in connection with satisfying tax withholding obligations of those employees. These shares were not purchased as part of the Company’s publicly announced share repurchase program.
		(2)		The price paid per share is the closing price of the shares on the vesting date.
		(3)		On January 9, 2000, the Board of Directors previously authorized a $500.0 million share repurchase program. The Company did not repurchase any equity securities under the program during the three or six months ended June 30, 2004. As of June 30, 2004, the Company could repurchase up to approximately $135.4 million of our equity securities under the Company’s share repurchase program.

	Votes in Favor	Votes Withheld

J. Loudon	115,929,345	2,256,200
R.S. Parker	116,615,861	1,569,684
A. Senter	116,403,266	1,782,279

Votes In Favor	Votes Against	Abstentions

116,451,445	1,152,617	581,483

		10.1		Amendment, dated as of May 10, 2004, to (i) the Revolving Credit and Security Agreement, dated as of February 25, 2003, among XL Re Ltd, as the borrower, CAFCO, LLC, CRC Funding, LLC, CHARTA, LLC, CIESCO, LLC, Citibank, N.A. and Citicorp North America, Inc., as agent, and (ii) the Control Agreement, dated as of February 25, 2003, among XL Re Ltd, as the borrower, Citibank North America, Inc., as Agent and Mellon Bank, N.A., as the securities intermediary.
		10.2		364-Day Credit Agreement, dated as of June 23, 2004, between XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd and XL Re Ltd, as Account Parties and Guarantors, the lenders party thereto, and JPMorgan Chase Bank, as Administrative Agent.
		10.3		Three-Year Credit Agreement, dated as of June 23, 2004, between XL Capital Ltd, X.L. America, Inc., XL Insurance (Bermuda) Ltd and XL Re Ltd, as Account Parties and Guarantors, the lenders party thereto, and JPMorgan Chase Bank, as Administrative Agent.
		10.4		Form of Non-Statutory Stock Option Agreement (One-Time Vesting).
		10.5		Form of Non-Statutory Stock Option Agreement (Incremental Vesting).
		10.6		Form of Incentive Stock Option Agreement.
		10.7		Form of Restricted Stock Agreement.
		10.8		Form of Non-Statutory Stock Option Agreement (Renewal Form).
		10.9		Form of Non-Statutory Stock Option Agreement (Non-Employee Director Renewal Form).
		10.10		Form of Directors Restricted Stock Agreement.
		10.11		Form of Performance Restricted Stock Agreement.
		10.12		Form of Performance Restricted Stock Unit Agreement.
		10.13		Form of Restricted Stock Unit Agreement.
		10.14		Form of Director Stock Option Agreement.
		10.15		Agreement, dated December 24, 2003, between Winterthur Swiss Insurance Company and XL Insurance (Bermuda) Ltd (including Schedule B thereto), relating to the Second Amended and Restated Agreement for the Sale and Purchase of Winterthur International, dated February 15, 2001.
		10.16		Amendment Agreement, dated July 27, 2004, between Winterthur Swiss Insurance Company and XL Insurance (Bermuda) Ltd, relating to the Second Amended and Restated Agreement for the Sale and Purchase of Winterthur International, dated February 15, 2001.