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Table of Contents

 

 

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 September 30, 2009

OR

 

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

For the transition period from              to             

Commission file number 1-10804

 

 

XL CAPITAL LTD

(Exact name of registrant as specified in its charter)

 

 

 

Cayman Islands   98-0191089

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

XL House, One Bermudiana Road, Hamilton, Bermuda HM 08

(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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company   ¨

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

As of October 30, 2009, there were 342,128,869 outstanding Class A Ordinary Shares, $0.01 par value per share, of the registrant.

 

 

 


Table of Contents

XL CAPITAL LTD

INDEX TO FORM 10-Q

 

         Page No.
PART I—FINANCIAL INFORMATION
Item 1.   Financial Statements:   
 

Consolidated Balance Sheets as at September 30, 2009 (Unaudited) and December 31, 2008

   3
 

Consolidated Statements of Income and Comprehensive Income for the Three Months Ended September 30, 2009 and 2008 (Unaudited) and the Nine Months Ended September 30, 2009 and 2008 (Unaudited)

   4
 

Consolidated Statements of Shareholders’ Equity for the Nine Months Ended September 30, 2009 and 2008 (Unaudited)

   6
 

Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2009 and 2008 (Unaudited)

   7
 

Notes to Unaudited Consolidated Financial Statements

   8

Item 2.

 

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

   47

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

   82

Item 4.

 

Controls and Procedures

   88
PART II—OTHER INFORMATION

Item 1.

 

Legal Proceedings

   88

Item 1A.

 

Risk Factors

   90

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

   90

Item 5.

 

Other Information

   90

Item 6.

 

Exhibits

   91
 

Signatures

   92


Table of Contents

PART I—FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

XL CAPITAL LTD

CONSOLIDATED BALANCE SHEETS

 

(U.S. dollars in thousands, except share amounts)    (Unaudited)
September 30,
2009
    December 31,
2008
 
A S S E T S     

Investments:

    

Fixed maturities at fair value (amortized cost: 2009, $29,585,600; 2008, $28,990,477)

   $ 27,965,410      $ 25,636,368   

Equity securities, at fair value (cost: 2009, $47,755; 2008, $337,765)

     55,099        361,819   

Short-term investments, at fair value (amortized cost: 2009, $1,973,189; 2008, $1,500,767)

     1,990,230        1,466,323   
                

Total investments available for sale

     30,010,739        27,464,510   

Investments in affiliates

     1,193,917        1,552,789   

Other investments (cost: 2009, $767,292; 2008, $417,856)

     822,759        459,481   
                

Total investments

     32,027,415        29,476,780   

Cash and cash equivalents

     3,906,277        4,353,826   

Accrued investment income

     366,853        363,376   

Deferred acquisition costs

     779,090        713,501   

Ceded unearned premiums

     944,864        896,216   

Premiums receivable

     2,992,168        3,135,985   

Reinsurance balances receivable

     458,267        563,694   

Unpaid losses and loss expenses recoverable

     3,827,343        3,997,722   

Net receivable from investments sold

     —          125,991   

Goodwill and other intangible assets

     850,110        853,550   

Deferred tax asset, net

     288,005        331,348   

Other assets

     780,849        836,825   
                

Total assets

   $ 47,221,241      $ 45,648,814   
                
L I A B I L I T I E S    A N D    S H A R E H O L D E R S’    E Q U I T Y     

Liabilities:

    

Unpaid losses and loss expenses

   $ 21,202,343      $ 21,650,315   

Deposit liabilities

     2,442,800        2,710,987   

Future policy benefit reserves

     5,754,176        5,452,865   

Unearned premiums

     4,185,151        4,217,931   

Notes payable and debt

     2,452,373        3,189,734   

Reinsurance balances payable

     702,196        726,736   

Net payable from investments purchased

     224,658        26,536   

Other liabilities

     901,354        1,056,879   
                

Total liabilities

   $ 37,865,051      $ 39,031,983   
                

Commitments and Contingencies

    

Redeemable Series C preference ordinary shares, 20,000,000 authorized, par value $0.01 Issued and outstanding: (2009, 7,306,920; 2008, 20,000,000)

   $ 182,673      $ 500,000   

Shareholders’ Equity:

    

Non-controlling interest in equity of consolidated subsidiaries

   $ 2,362      $ 1,598   

Series E preference ordinary shares, 1,000,000 authorized, par value $0.01 Issued and outstanding: (2009, 1,000,000; 2008, 1,000,000)

     10        10   

Class A ordinary shares, 999,990,000 authorized, par value $0.01 Issued and outstanding: (2009, 342,128,946; 2008, 330,812,343)

     3,421        3,308   

Additional paid in capital

     10,463,267        9,792,371   

Accumulated other comprehensive (loss)

     (1,464,523     (3,364,927

Retained earnings (deficit)

     168,980        (315,529
                

Total shareholders’ equity

   $ 9,173,517      $ 6,116,831   
                

Total liabilities, redeemable preference ordinary shares and shareholders’ equity

   $ 47,221,241      $ 45,648,814   
                

See accompanying Notes to Unaudited Consolidated Financial Statements

 

3


Table of Contents

XL CAPITAL LTD

CONSOLIDATED STATEMENTS OF INCOME

 

     (Unaudited)
Three Months Ended
September 30,
    (Unaudited)
Nine Months Ended
September 30,
 
(U.S. dollars in thousands, except share amounts)    2009     2008     2009     2008  

Revenues:

        

Net premiums earned

   $ 1,445,719      $ 1,694,631      $ 4,326,940      $ 5,088,715   

Net investment income

     327,145        436,281        1,003,459        1,375,862   

Realized investment gains (losses):

        

Net realized gains (losses) on investments sold

     (3,829     (40,284     33,794        21,958   

Other-than-temporary impairments on investments

     (459,344     (252,619     (860,004     (415,072

Other-than-temporary impairments on investments transferred to other comprehensive income

     137,653        —          168,323        —     
                                

Total net realized (losses) on investments

     (325,520     (292,903     (657,887     (393,114

Net realized and unrealized gains (losses) on derivative instruments

     (9,133     (58,454     (9,571     (5,648

Net income (loss) from investment fund affiliates

     42,288        (54,886     52,481        (63,522

Fee income and other

     5,331        19,132        27,285        40,219   
                                

Total revenues

   $ 1,485,830      $ 1,743,801      $ 4,742,707      $ 6,042,512   
                                

Expenses:

        

Net losses and loss expenses incurred

   $ 818,238      $ 1,209,565      $ 2,388,149      $ 3,149,043   

Claims and policy benefits

     185,067        199,861        517,614        605,885   

Acquisition costs

     212,846        216,879        654,337        729,413   

Operating expenses

     230,908        319,432        763,514        881,554   

Exchange (gains) losses

     (16,843     (139,467     103,754        (63,786

Extinguishment of debt

     —          22,527        —          22,527   

Interest expense

     53,469        78,000        169,008        267,553   

Amortization of intangible assets

     465        1,386        1,394        2,226   
                                

Total expenses

   $ 1,484,150      $ 1,908,183      $ 4,597,770      $ 5,594,415   
                                

Income before income tax and income (loss) from operating affiliates

   $ 1,680      $ (164,382   $ 144,937      $ 448,097   

Provision for income tax

     (3,616     (47,843     (65,614     (129,750

Income (loss) from operating affiliates

     23,027        (1,404,299     30,366        (1,452,647
                                

Net income (loss)

   $ 21,091      $ (1,616,524   $ 109,689      $ (1,134,300

Non-controlling interest in net loss of subsidiary

     7        —          47        —     
                                

Net income (loss) attributable to XL Capital Ltd

   $ 21,098      $ (1,616,524   $ 109,736      $ (1,134,300

Preference share dividends

     (32,500     (32,500     (74,626     (65,000

Gain on redemption of Series C Preference Ordinary Shares

     —          —          211,816        —     
                                

Net income (loss) available to ordinary shareholders

   $ (11,402   $ (1,649,024   $ 246,926      $ (1,199,300
                                

Weighted average ordinary shares and ordinary share equivalents outstanding — basic

     342,118        273,084        339,095        210,387   
                                

Weighted average ordinary shares and ordinary share equivalents outstanding — diluted

     342,620        273,084        339,349        210,387   
                                

Earnings (loss) per ordinary share and ordinary share equivalent — basic

   $ (0.03   $ (6.04   $ 0.73      $ (5.70
                                

Earnings (loss) per ordinary share and ordinary share equivalent — diluted

   $ (0.03   $ (6.04   $ 0.73      $ (5.70
                                

See accompanying Notes to Unaudited Consolidated Financial Statements

 

4


Table of Contents

XL CAPITAL LTD

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

     (Unaudited)
Three Months Ended
September 30,
    (Unaudited)
Nine Months Ended
September 30,
 
(U.S. dollars in thousands)    2009     2008     2009     2008  

Net income (loss) attributable to XL Capital Ltd.

   $ 21,098      $ (1,616,524   $ 109,736      $ (1,134,300

Impact of adoption of new authoritative other-than-temporary impairment (“OTTI”) guidance, net of taxes

     —          —          (229,670     —     

Change in net unrealized gains (losses) on investments, net of tax

     1,777,621        (825,288     2,104,101        (2,587,155

Change in OTTI losses recognized in other comprehensive income, net of tax

     (128,004     —          (153,599     —     

Change in underfunded pension liability

     180        319        (136     254   

Change in value of cash flow hedge

     111        111        329        329   

Foreign currency translation adjustments, net

     85,908        (457,384     175,547        (219,966

Change in net unrealized gain (loss) on future policy benefit reserves

     1,825        (872     3,832        (2,560
                                

Comprehensive income (loss)

   $ 1,758,739      $ (2,899,638   $ 2,010,140      $ (3,943,398
                                

See accompanying Notes to Unaudited Consolidated Financial Statements

 

5


Table of Contents

XL CAPITAL LTD

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

     (Unaudited)
Nine months Ended
September 30,
 
(U.S. dollars in thousands)    2009     2008  

Non-controlling Interest in Equity of Consolidated Subsidiaries:

    

Balance – beginning of year

   $ 1,598      $ 2,419   

Non-controlling interest in net income (loss) of subsidiary

     (47     —     

Non-controlling interest share in change in accumulated other comprehensive (loss) income

     811        (822
                

Balance – end of period

   $ 2,362      $ 1,597   
                

Series E Preference Ordinary Shares:

    

Balance – beginning of year

   $ 10      $ 10   
                

Balance – end of period

   $ 10      $ 10   
                

Class A Ordinary Shares:

    

Balance – beginning of year

   $ 3,308      $ 1,779   

Issuance of Class A ordinary shares

     115        1,530   

Exercise of stock options

     1        —     

Repurchase of shares

     (3     (1
                

Balance – end of period

   $ 3,421      $ 3,308   
                

Additional Paid in Capital:

    

Balance – beginning of year

   $ 9,792,371      $ 7,358,801   

Issuance of Class A ordinary shares

     741,597        2,389,558   

Repurchase of Class A ordinary shares

     —          (4,834

Fair value of purchase contracts associated with equity security units

     —          (37,860

Outstanding accrued contingent capital put premium

     —          51,064   

Dividends on Class A ordinary shares

     (68,389     —     

Dividends on preference ordinary shares

     (42,126     —     

Stock option expense

     11,792        16,499   

Exercise of stock options

     —          6,207   

Net change in deferred compensation

     28,022        (2,703
                

Balance – end of period

   $ 10,463,267      $ 9,776,732   
                

Accumulated Other Comprehensive (Loss) Income:

    

Balance – beginning of year

   $ (3,364,927   $ 9,159   

Impact of adoption of new authoritative OTTI guidance, net of taxes

     (229,670     —     

Change in net unrealized gains (losses) on investment portfolio, net of tax

     2,090,258        (2,572,684

Change in OTTI losses recognized in other comprehensive income, net of tax

     (153,599     —     

Change in net unrealized (losses) gains on affiliate and other investments, net of tax

     13,843        (14,471

Change in underfunded pension liability

     (136     254   

Change in value of cash flow hedge

     329        329   

Foreign currency translation adjustments

     175,547        (219,966

Change in net unrealized gain (loss) on future policy benefit reserves

     3,832        (2,560
                

Balance – end of period

   $ (1,464,523   $ (2,799,939
                

Retained (Deficit) Earnings:

    

Balance – beginning of year

   $ (315,529   $ 2,578,393   

Impact of adoption of new authoritative OTTI guidance, net of taxes

     229,670        —     

Net income (loss) attributable to XL Capital Ltd.

     109,736        (1,134,300

Dividends on preference ordinary shares

     (32,500     (65,000

Dividends on Class A ordinary shares

     (34,213     (198,661

Gain on redemption of Series C preference ordinary shares

     211,816        —     
                

Balance – end of period

   $ 168,980      $ 1,180,432   
                

Total Shareholders’ Equity

   $ 9,173,517      $ 8,162,140   
                

See accompanying Notes to Unaudited Consolidated Financial Statements

 

6


Table of Contents

XL CAPITAL LTD

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     (Unaudited)
Nine Months Ended
September 30,
 
(U.S. dollars in thousands)    2009     2008  

Cash flows provided by (used in) operating activities:

    

Net income (loss) attributable to XL Capital Ltd

   $ 109,736      $ (1,134,300

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

    

Net realized losses on investments

     657,887        393,114   

Net realized and unrealized losses (gains) on derivative instruments

     9,571        5,648   

Amortization of (discounts) on fixed maturities

     (16,512     (31,403

Loss (income) from investment and operating affiliates

     (82,847     1,516,169   

Cash paid to Syncora as part of Master Agreement

     —          (1,775,000

Amortization of deferred compensation

     25,376        46,591   

Accretion of convertible debt

     749        751   

Accretion of deposit liabilities

     32,401        117,787   

Unpaid losses and loss expenses

     (771,209     (478,748

Future policy benefit reserves

     (100,948     (3,285

Unearned premiums

     (142,345     434,674   

Premiums receivable

     247,838        (90,717

Unpaid losses and loss expenses recoverable

     231,680        594,596   

Prepaid reinsurance premiums

     (27,634     (242,118

Reinsurance balances receivable

     109,921        152,100   

Deferred acquisition costs

     (39,601     (99,415

Reinsurance balances payable

     (47,926     106,018   

Deferred tax asset

     (40,378     94,224   

Other

     (130,676     (270,617
                

Total adjustments

   $ (84,653   $ 470,369   
                

Net cash provided by (used in) operating activities

   $ 25,083      $ (663,931
                

Cash flows provided by investing activities:

    

Proceeds from sale of fixed maturities and short-term investments

   $ 6,960,410      $ 11,614,263   

Proceeds from redemption of fixed maturities and short-term investments

     4,013,162        2,403,975   

Proceeds from sale of equity securities

     356,344        720,928   

Purchases of fixed maturities and short-term investments

     (11,752,333     (9,878,649

Purchases of equity securities

     (18,967     (507,426

Net disposition of investment affiliates

     724,800        302,671   

Other investments

     (139,890     77,162   
                

Net cash provided by investing activities

   $ 143,526      $ 4,732,924   
                

Cash flows (used in) financing activities:

    

Proceeds from issuance of Class A ordinary shares

   $ 745,000      $ 2,731,000   

Repurchase of Class A ordinary shares

     (576     (4,835

Redemption of Series C preference ordinary shares

     (104,718     —     

Dividends paid on Class A ordinary shares

     (102,565     (198,386

Dividends paid on preference ordinary shares

     (55,751     (32,500

Proceeds from issuance of debt

     —          557,750   

Deposit liabilities

     (198,353     (5,267,966

Repayment of debt

     (745,000     (255,000

Net cash flow on securities lending

     (242,662     149,850   
                

Net cash (used in) financing activities

   $ (704,625   $ (2,320,087

Effects of exchange rate changes on foreign currency cash

     88,467        (18,933
                

Increase (decrease) in cash and cash equivalents

     (447,549     1,729,973   

Cash and cash equivalents – beginning of period

     4,353,826        3,880,030   
                

Cash and cash equivalents – end of period

   $ 3,906,277      $ 5,610,003   
                

See accompanying Notes to Unaudited Consolidated Financial Statements

 

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Table of Contents

XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Preparation and Consolidation

These unaudited consolidated financial statements include the accounts of the Company and all of its subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In addition, the year-end balance sheet data was derived from audited financial statements but does not include all disclosures required by GAAP. In the opinion of management, these unaudited financial statements reflect all adjustments (consisting of normal recurring accruals) considered necessary for a fair statement of the Company’s financial position and results of operations as at the end of and for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All significant inter-company accounts and transactions have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from these estimates.

To facilitate period-to-period comparisons, certain reclassifications have been made to prior period consolidated financial statement amounts to conform to current period presentation. There was no effect on net income from this change in presentation.

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

The Company has performed an evaluation of subsequent events through November 5, 2009, which is the date the financial statements were issued.

2. Significant Accounting Policies

(a) Recent Accounting Pronouncements

In December 2007, the FASB issued final authoritative guidance regarding noncontrolling interests in consolidated financial statements to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary was issued. This guidance requires a company to clearly identify and present ownership interests in subsidiaries held by parties other than the company in the consolidated financial statements within the equity section but separate from the company’s equity. It also requires the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; requires any changes in ownership interest of the subsidiary be accounted for as equity transactions; and requires that when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary and the gain or loss on the deconsolidation of the subsidiary be measured at fair value. This guidance is effective for interim and annual financial statements issued after January 1, 2009. While the adoption of this guidance did not have a material impact on the Company’s financial condition or results of operations, such adoption did result in certain changes in the presentation and disclosure of noncontrolling interests as noted above.

In March 2008, the FASB issued final authoritative guidance surrounding disclosures about derivative instruments and hedging activities which requires enhanced disclosures about an entity’s derivative and hedging activities, and was effective for financial statements issued for fiscal years beginning after November 15, 2008, with early application encouraged. The Company adopted the standard as of January 1, 2009. This guidance requires only additional disclosures concerning derivatives and hedging activities, and therefore the adoption did not have an impact on the Company’s financial condition and results of operations. See Note 2-(c), “Significant Accounting Policies – Derivative Instruments” and Note 8, “Derivative Instruments” for disclosures required under this standard.

 

8


Table of Contents

XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

2. Significant Accounting Policies (Continued)

 

(a) Recent Accounting Pronouncements (Continued)

 

In May 2008, the FASB issued final authoritative guidance on accounting for financial guarantee insurance contracts to address current diversity in practice with respect to accounting for financial guarantee insurance contracts by insurance enterprises under the existing authoritative guidance over accounting and reporting by insurance enterprises. That diversity resulted in inconsistencies in the recognition and measurement of claim liabilities because of differing views regarding when a loss has been incurred under guidance surrounding accounting for contingencies. The final financial guarantee accounting guidance requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. The guidance also clarifies how the existing insurance accounting guidance applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. Those clarifications will increase comparability in financial reporting of financial guarantee insurance contracts by insurance enterprises. The guidance also requires expanded disclosures about financial guarantee insurance contracts. The standard was adopted by the Company as of January 1, 2009. The adoption of this guidance during 2009 did not have a material impact on the Company’s financial condition or results of operations.

As of September 30, 2009, the Company’s outstanding financial guarantee contracts that were subject to the new accounting guidance included the reinsurance of 39 financial guarantee contracts with total insured contractual payments outstanding of $649.4 million ($514.1 million of principal and $135.3 million of interest) with a remaining weighted-average contract period of 9.0 years. The total gross claim liability and unearned premiums recorded at September 30, 2009 were $14.5 million and $1.9 million, respectively. Of the contractual exposure existing at September 30, 2009, the Company had reinsured $370.8 million with subsidiaries of Syncora Holdings Ltd (“Syncora”), however, as at September 30, 2009 no reinsurance balances recoverable from Syncora had been recorded. Of the 39 contracts noted above, 3 contracts with total insured contractual payments outstanding of $16.5 million had experienced an event of default and were considered by the Company to be non-performing at September 30, 2009, while the remaining 36 contracts were considered to be performing at such date. As of December 31, 2008, the Company’s outstanding financial guarantee contracts that were subject to the new accounting guidance included the reinsurance of 48 financial guarantee contracts with total insured contractual payments outstanding of $936.6 million ($798.5 million of principal and $138.1 million of interest) with a remaining weighted-average contract period of 7.9 years. The total gross claim liability and unearned premiums recorded at December 31, 2008 were $14.5 million and $3.1 million, respectively. Of the contractual exposure existing at December 31, 2008, the Company had reinsured $360.5 million with subsidiaries of Syncora, however as at December 31, 2008 no reinsurance balances recoverable from Syncora had been recorded. Surveillance procedures to track and monitor credit deteriorations in the insured financial obligations are performed by the primary obligors for each transaction on the Company’s behalf. Information regarding the performance status and updated exposure values is provided to the Company on a quarterly basis and evaluated by management in recording claims reserves.

While not financial guarantee insurance contracts under the specific accounting guidance noted above, the Company’s guarantees to the European Investment Bank in respect of financial guaranty policies issued by subsidiaries of Syncora to the European Investment Bank (the “EIB Policies”), subject to certain limitations, have been accounted for under Accounting Standards Codification (“ASC” or “Codification”) section 460-10, Guarantees (previously FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.”) These guarantees were provided for the benefit of EIB polices relating to project finance transactions comprised of transportation, school and hospital projects with an average rating of BBB, written between 2001 and 2006 with anticipated maturities ranging between 2027 and 2038. As at September 30, 2009, the Company’s exposures relating to the EIB Policies was approximately $930.6 million, as compared to $955.4 million at December 31, 2008, decreasing mainly due to the strengthening of the U.S. dollar against the currencies of the underlying obligations. As of September 30, 2009, there have been no reported events of default on the underlying obligations. Accordingly, no reserves have been recorded.

In June 2008, the FASB issued final authoritative guidance on determining whether instruments granted in share-based payment transactions are participating securities. This guidance addresses whether instruments granted in share-based payment transactions may be participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing basic earnings per share (“EPS”) pursuant to the two-class method described in authoritative earnings per share guidance.

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

2. Significant Accounting Policies (Continued)

 

(a) Recent Accounting Pronouncements (Continued)

 

A share-based payment award that contains a non-forfeitable right to receive cash when dividends are paid to ordinary shareholders irrespective of whether that award ultimately vests or remains unvested shall be considered a participating security as these rights to dividends provide a non-contingent transfer of value to the holder of the share-based payment award. Accordingly, these awards should be included in the computation of basic EPS pursuant to the two-class method. This guidance was effective for the Company as of January 1, 2009. All prior period EPS data presented was adjusted retrospectively to conform to the provisions of the guidance. Under the terms of the Company’s restricted stock awards, grantees are entitled to the right to receive dividends on the unvested portions of their awards. There is no requirement to return these dividends in the event the unvested awards are forfeited in the future. Accordingly, this guidance had an impact on the Company’s EPS calculations. See Note 14, “Computation of Earnings Per Ordinary Share and Ordinary Share Equivalent”, for a description of the impact of the adoption of this guidance on the 2008 EPS figures.

In April 2009, the FASB issued final authoritative guidance on determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly which provides additional guidance for estimating fair value in accordance with existing fair value measurements guidance, when the volume and level of activity for the asset or liability has significantly decreased. Guidance is also included on identifying circumstances that indicate a transaction is not orderly and amends certain fair value measurement disclosure guidance. This new authoritative guidance was effective for interim and annual reporting periods ending after June 15, 2009. The adoption of this standard did not have a material impact on the Company’s financial condition or results of operations.

In April 2009, the FASB issued final authoritative guidance on recognition and presentation of other-than-temporary Impairments (“OTTI”) which amends the OTTI guidance for debt securities to make the guidance more operational and to improve the presentation and disclosure of OTTI on debt and equity securities in the financial statements. This guidance does not amend existing recognition and measurement guidance related to OTTI of equity securities. This guidance was effective for interim and annual reporting periods ending after June 15, 2009. The Company adopted this guidance effective April 1, 2009, which resulted in a net after-tax increase to retained earnings and decrease to Accumulated Other Comprehensive Income (Loss) of $229.7 million, as of April 1, 2009. The disclosures required by this guidance are provided in Note 6, “Investments”.

In April 2009, the FASB issued final authoritative guidance on interim disclosures about fair value of financial instruments which amends existing guidance to require disclosures about the fair value of financial instruments for interim reporting periods as well as in annual financial statements. This guidance was effective for interim reporting periods ending after June 15, 2009. This guidance affected disclosures only and accordingly did not have an impact on the Company’s financial condition or results of operations. The disclosures required by this guidance are provided in Note 3, “Fair Value Measurements”.

In April 2009, the FASB issued final authoritative guidance on accounting for assets acquired and liabilities assumed in a business combination that arise from contingencies. This guidance requires an asset acquired or liability assumed in a business combination that arises from a contingency to be recognized at fair value at the acquisition date, if the acquisition date fair value of that asset or liability can be determined during the measurement period. If the acquisition date fair value of an asset acquired or liability assumed in a business combination that arises from a contingency cannot be determined during the measurement period, the asset or liability shall be recognized at the acquisition date using the guidance governing accounting for contingencies. This guidance also amends disclosure requirements and is effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after January 1, 2009. The Company’s adoption of this guidance effective January 1, 2009 did not have a material effect on the Company’s financial position or results of operations.

In May 2009, the FASB issued final authoritative guidance on accounting for and reporting of subsequent events. This standard incorporates into authoritative accounting literature certain guidance that already existed within generally accepted auditing standards, but the rules concerning recognition and disclosure of subsequent events will remain essentially unchanged. Subsequent events guidance addresses events which occur after the balance sheet date but before the issuance of financial statements. Under the new guidance, as under current practice, an entity must record the effects of subsequent events that provide evidence about conditions that existed at the balance sheet date and must disclose but not record the effects of subsequent events which provide evidence about conditions that did not exist at the balance sheet date. This guidance was effective for interim and annual periods ending after June 15, 2009. The adoption of this guidance did not have any impact on the Company’s financial condition or results of operations.

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

2. Significant Accounting Policies (Continued)

 

(a) Recent Accounting Pronouncements (Continued)

 

In June 2009, the FASB issued final authoritative guidance over accounting for transfers of financial assets which removes the concept of a qualifying special-purpose entity from existing accounting guidance over transfers of financial assets and also removes the exception from applying guidance surrounding consolidation of variable interest entities to qualifying special-purpose entities. This new guidance must be applied from January 1, 2010 for the Company, for both interim and annual periods. Earlier application is prohibited. The guidance must be applied to transfers occurring on or after the effective date. The Company is currently evaluating the potential impact of this guidance. However, it is not currently expected to have a material impact on the Company’s financial condition or results of operations.

In June 2009, the FASB issued final authoritative accounting guidance in an effort to improve financial reporting by enterprises involved with variable interest entities. This guidance retains the scope of the previous standard covering variable interest entities with the addition of entities previously considered qualifying special-purpose entities, as the concept of these entities was eliminated in the new authoritative guidance. The new guidance requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity under revised guidelines that are more qualitative than under previous guidance and amends previous guidance to require ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity. Before this update, previous guidance required reconsideration of whether an enterprise is the primary beneficiary of a variable interest entity only when specific events occurred. The new guidance also amends previous guidance to require enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement with a variable interest entity. The enhanced disclosures are required for any enterprise that holds a variable interest in a variable interest entity. The content of the enhanced disclosures required by this new guidance is generally consistent with that required by the previous standards. This new guidance will be effective for the Company for interim and annual periods beginning on January 1, 2010. The Company is currently evaluating the potential impact of this guidance on its financial condition and results of operations.

In June 2009, the FASB issued its Accounting Standards Codification and guidance over the hierarchy of generally accepted accounting principles. This guidance specifies that the FASB Codification has become the source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. For financial statements issued for interim and annual periods ending after September 15, 2009, the effective date of this final guidance, the Codification superseded all then-existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification became non-authoritative. While the Codification did not change GAAP, it introduced a new structure—one that is intended to be organized in an easily accessible, user-friendly online research system. The adoption of this standard did not have an impact on the Company’s financial condition or results of operations.

In August 2009, the FASB issued a draft Accounting Standards Update discussing the measurement of liabilities at fair value, which provides clarification for circumstances in which a quoted price in an active market for an identical liability is not available. The amendments are intended to reduce potential ambiguity in financial reporting when measuring the fair value of liabilities. The guidance will be effective for the first reporting period (including interim period) beginning after issuance of a final document. This potential guidance concerns disclosure only and will not have an impact on the Company’s financial condition or results of operations.

In September 2009, the FASB issued authoritative guidance associated with estimating the fair value for investments in certain entities that do not have a quoted market price but calculate net asset value per share or its equivalent. This guidance covers investments often referred to as “alternative investments” that would include hedge funds, private equity funds, venture capital funds, offshore fund vehicles and funds of funds. When certain criteria are met, this guidance would permit an entity, as a practical expedient, to estimate the fair value of an investment within the scope of this guidance using the net asset value per share of the investment. Therefore, certain attributes of the investment (such as restrictions on redemption) and transaction prices from principal-to-principal or brokered transactions will not be considered in measuring the fair value of the investment if the practical expedient is used. The proposed amendments also require disclosures by major category of investment about the attributes of those investments, such as the nature of any restrictions on the investor’s ability to redeem its investments at the measurement date, any unfunded commitments, and the investment strategies of the investees. These amendments will be effective for the Company for the December 31, 2009 year end reporting. The Company is currently evaluating the potential impact of this guidance on its financial condition and results of operations. However, it is not expected to have a material impact on the Company’s financial condition or results of operations.

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

2. Significant Accounting Policies (Continued)

 

(b) Fair Value Measurements and Total Investments

Accounting guidance over fair value measurements requires that a fair value measurement reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the “exit price”). Instruments that the Company owns (“long positions”) are marked to bid prices and instruments that the Company has sold but not yet purchased (“short positions”) are marked to offer prices. Fair value measurements are not adjusted for transaction costs.

Basis of Fair Value Measurement

Fair value measurements accounting guidance also establishes a fair value hierarchy that prioritizes the inputs to the respective valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). An asset’s or liability’s classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. The three levels of the fair value hierarchy are described further below:

 

   

Level 1 – Quoted prices in active markets for identical assets or liabilities (unadjusted); no blockage factors.

 

   

Level 2 – Other observable inputs (quoted prices in markets that are not active or inputs that are observable either directly or indirectly) – include quoted prices for similar assets/liabilities (adjusted) other than quoted prices in Level 1; quoted prices in markets that are not active; or other inputs that are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities.

 

   

Level 3 – Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability. Level 3 assets and liabilities include financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

Investments Available For Sale

Investments that are considered available for sale (comprised of the Company’s fixed maturities, equity securities and short-term investments) are carried at fair value. The fair values for available for sale investments are generally sourced from third parties. The fair value of fixed maturity securities is based upon quoted market values where available, “evaluated bid” prices provided by third party pricing services (“pricing services”) where quoted market values are not available, or by reference to broker or underwriter bid indications where pricing services do not provide coverage for a particular security. To the extent the Company believes current trading conditions represent distressed transactions, the Company may elect to utilize internally generated models. The pricing services use market approaches to valuations using primarily Level 2 inputs in the vast majority of valuations, or some form of discounted cash flow analysis, to obtain investment values for a small percentage of fixed maturity securities for which they provide a price. Pricing services indicate that they will only produce an estimate of fair value if there is objectively verifiable information available to produce a valuation. Standard inputs to the valuations provided by the pricing services listed in approximate order of priority for use when available include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data. The pricing services may prioritize inputs differently on any given day for any security, and not all inputs listed are available for use in the evaluation process on any given day for each security evaluation; however, the pricing services also monitor market indicators, industry and economic events. Information of this nature is a trigger to acquire further corroborating market data. When these inputs are not available, they identify “buckets” of similar securities (allocated by asset class types, sectors, sub-sectors, contractual cash flows/structure, and credit rating characteristics) and apply some form of matrix or other modeled pricing to determine an appropriate security value which represents their best estimate as to what a buyer in the marketplace would pay for a security in a current sale. While the Company receives values for the majority of the investment securities it holds from one or more pricing services, it is ultimately management’s responsibility to determine whether the values received and recorded in the financial statements are representative of appropriate fair value measurements. It is common industry practice to utilize pricing services as a source for determining the fair values of investments where the pricing services are able to obtain sufficient market corroborating information to allow them to produce a valuation at a reporting date. In addition, in the majority of cases, although a value may be obtained from a particular pricing service for a security or class of similar securities, these values are corroborated against values provided by other pricing sources.

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

2. Significant Accounting Policies (Continued)

 

(b) Fair Value Measurements and Total Investments (Continued)

 

Broker quotations are used to value fixed maturities where prices are unavailable from pricing services due to factors specific to the security such as limited liquidity, lack of current transactions, or trades only taking place in privately negotiated transactions. These are considered Level 3 valuations, as significant inputs utilized by brokers may be difficult to corroborate with observable market data, or sufficient information regarding the specific inputs utilized by the broker was not obtained to support a Level 2 classification.

Prices provided by independent pricing services and independent broker quotes can vary widely even for the same security. The use of different methodologies and assumptions may have a material effect on the estimated fair value amounts. During periods of market disruption including periods of significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain of the Company’s securities, for example, collateralized loan obligations (“CLOs”), Alt-A and sub-prime mortgage backed securities, if trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes that were in active markets with significant observable data that become illiquid due to the current financial environment. In such cases, more securities may fall to Level 3 and thus require more subjectivity and management judgment with regard to fair value. As such, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods which are more sophisticated or require greater estimation, thereby resulting in values which may be different than the value at which the investments may be ultimately sold.

The net unrealized gain or loss on investments, net of tax, is included in “accumulated other comprehensive income (loss).” Any unrealized depreciation in value considered by management to be other than temporary is charged to income in the period in which that determination is made.

Short-term investments comprise investments with a remaining maturity of less than one year and are valued using the same external factors and in the same manner as fixed maturity securities.

Equity securities include investments in open end mutual funds and shares of publicly traded alternative funds. The fair value of equity securities is based upon quoted market values (Level 1), or monthly net asset value statements provided by the investment managers upon which subscriptions and redemptions can be executed (Level 2).

All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of equities and fixed income investments are determined on the basis of average cost and amortized cost, respectively. Investment income is recognized when earned and includes interest and dividend income together with the amortization of premium and discount on fixed maturities and short-term investments. Amortization of discounts on fixed maturities includes amortization to expected recovery values for investments which have previously been recorded as other than temporarily impaired. For mortgage-backed securities, and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Prepayment fees or call premiums that are only payable to the Company when a security is called prior to its maturity, are earned when received and reflected in net investment income.

Investment In Affiliates

Investments in which the Company has significant influence over the operating and financial policies of the investee are classified as investments in affiliates on the Company’s balance sheet and are accounted for under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss from such investments in its results for the period as well as its portion of movements in certain of the investee shareholders’ equity balances. When financial statements of the affiliate are not available on a timely basis to record the Company’s share of income or loss for the same reporting periods as the Company, the most recently available financial statements are used. This lag in reporting is applied consistently. Significant influence is generally deemed to exist where the Company has an investment of 20% or more in the common stock of a corporation or an investment of 3% or greater in closed end funds, limited partnerships, LLCs or similar investment vehicles. The Company records its alternative and private fund affiliates on a one month and three month lag, respectively, and its operating affiliates on a three month lag. Significant influence is considered for other strategic investments on a case- by-case basis. Investments in affiliates are not subject to fair value measurement guidance as they are not considered to be fair value measurements under U.S. GAAP. However, impairments associated with investments in affiliates that are deemed to be other-than-temporary are calculated in accordance with fair value measurement guidance and appropriate disclosures included within the financial statements during the period the losses are recorded.

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

2. Significant Accounting Policies (Continued)

 

(b) Fair Value Measurements and Total Investments (Continued)

 

Other investments

Contained within this asset class are investments including direct equity investments, investment funds, limited partnerships, unrated tranches of collateralized debt obligations and certain structured project finance transactions. The Company accounts for its other investments that do not have readily determinable market values at estimated fair value as it has no significant influence (as defined above) over these entities.

Fair values for other investments, principally other direct equity investments, investment funds and limited partnerships, are primarily based on the net asset value provided by the investment manager, the general partner or the respective entity, recent financial information, available market data and, in certain cases, management judgment may be required. These entities generally carry their trading positions and investments, the majority of which have underlying securities valued using Level 1 or Level 2 inputs, at fair value as determined by their respective investment managers; accordingly, these investments are generally classified as Level 2. Private equity investments are classified as Level 3. The net unrealized gain or loss on investments, net of tax, is included in “Accumulated other comprehensive income (loss)”. Any unrealized loss in value considered by management to be other than temporary is charged to income in the period that it is determined.

Income on unrated tranches of collateralized debt obligations is reflected only to the extent the Company’s principal has been fully recovered. This is not considered to be a fair value measurement under U.S. GAAP and accordingly these investments have been excluded from the fair value measurement disclosures. These investments are carried under the cost recovery method given the uncertainty of future cash flows. The carrying value of these investments held by the Company at September 30, 2009 and December 31, 2008 was $11.7 million and $14.7 million, respectively.

The Company historically participated in structured transactions in project finance related areas under which the Company provided a cash loan supporting trade finance transactions. These transactions are accounted for in accordance with guidance governing accounting by certain entities (including entities with trade receivables) that lend to or finance the activities of others under which the loans are considered held for investment as the Company has the intent and ability to hold for the foreseeable future or until maturity or payoff. Accordingly, these funded loan participations are reported in the balance sheet at outstanding principal adjusted for any allowance for loan losses as considered necessary by management. In addition, the Company invested in a payment obligation that is carried at amortized cost as described in Note 7, “Other Investments”, and has provided liquidity financing to a structured credit vehicle as a part of a third party medium term note facility. See Note 3, “Fair Value Measurements” for further information. These investments are not considered to be fair value measurements under U.S. GAAP and accordingly they have been excluded from the fair value measurement disclosures. The carrying value of these investments held by the Company at September 30, 2009 and December 31, 2008 was $354.0 million and $80.1 million, respectively.

Cash Equivalents

Cash equivalents include fixed interest deposits placed with a maturity of under 90 days when purchased. Bank deposits are not considered to be fair value measurements and as such are not subject to fair value measurement disclosures. Money market funds are classified as Level 1 as these instruments are considered actively traded; however, certificates of deposit are classified as Level 2.

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

2. Significant Accounting Policies (Continued)

 

(c) Derivative Instruments

The Company recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value. The changes in fair value of derivatives are shown in the consolidated statement of income as “net realized and unrealized gains and losses on derivative instruments” unless the derivatives are designated as hedging instruments. The accounting for derivatives which are designated as hedging instruments is discussed below. Changes in fair value of derivatives may create volatility in the Company’s results of operations from period to period. Amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) are offset against net fair value amounts recognized in the consolidated balance sheet for derivative instruments executed with the same counterparty under the same netting arrangement.

Derivative contracts can be exchange-traded or over-the-counter (“OTC”). Exchange-traded derivatives (futures and options) typically fall within Level 1 of the fair value hierarchy depending on whether they are deemed to be actively traded or not. OTC derivatives are valued using market transactions and other market evidence whenever possible, including market-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations or alternative pricing sources where an understanding of the inputs utilized in arriving at the valuations is obtained. Where models are used, the selection of a particular model to value an OTC derivative depends upon the contractual terms and specific risks inherent in the instrument as well as the availability of pricing information in the market. The Company generally uses similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, interest rate swaps and options, model inputs can generally be verified and model selection does not involve significant management judgment. Such instruments comprise the majority of derivatives held by the Company and are typically classified within Level 2 of the fair value hierarchy.

Certain OTC derivatives trade in less liquid markets with limited pricing information, or required model inputs which are not directly market corroborated, which causes the determination of fair value for these derivatives to be inherently more subjective. Accordingly, such derivatives are classified within Level 3 of the fair value hierarchy. The valuations of less standard or liquid OTC derivatives are typically based on Level 1 and/or Level 2 inputs that can be observed in the market, as well as unobservable Level 3 inputs. Level 1 and Level 2 inputs are regularly updated to reflect observable market changes, with resulting gains and losses reflected within Level 3. Level 3 inputs are only changed when corroborated by evidence such as similar market transactions, pricing services and/or broker or dealer quotations. The Company conducts its derivatives activities in four main areas: investment related derivatives, credit derivatives, other non-investment related derivatives, and until late 2008 it also utilized weather and energy derivatives.

Investment related derivatives

The Company’s direct use of derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, reference rates or a combination of these factors. The Company uses derivatives to manage duration, credit and foreign currency exposure for its investment portfolio as well as to add value to the investment portfolio through replicating permitted investments, provided the use of such investments is incorporated into the overall portfolio evaluation and complies with the Company’s investment guidelines.

The Company also uses derivative instruments, primarily interest rate swaps, to manage the interest rate exposure associated with certain assets and liabilities. These derivatives are recorded at fair value. On the date the derivative contract is entered into, the Company may designate the derivative as a hedge of the fair value of a recognized asset or liability (“fair value” hedge); a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset or liability (“cash flow” hedge); a hedge of a net investment in a foreign operation; or the Company may not designate any hedging relationship for a derivative contract. In addition, the company previously wrote a number of resettable strike swaps contracts relating to an absolute return index and diversified basket of funds.

Credit derivatives

Credit derivatives are recorded at fair value, which is determined using either models developed by the Company or third party prices and are dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change resulting from movements in credit and credit quality spreads is unrealized as the credit derivatives are not traded to realize this resultant value.

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

2. Significant Accounting Policies (Continued)

 

(c) Derivative Instruments (continued)

 

Other Non-Investment Related Derivatives

The Company may also enter into derivatives as part of contingent capital facilities, including put options and interest rate swaps, or hold contracts containing embedded derivatives, such as life reinsurance contracts containing guaranteed minimum income benefits (“GMIB”) over the account balance upon the policyholder’s election to take the income benefit. The fair value of this derivatives component is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return based on a portfolio of fixed income securities; as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated from the funds withheld balance and recorded at fair value with changes in fair value recognized in earnings through net realized and unrealized gains and losses on derivative instruments.

Weather and Energy derivatives

Fair values for the Company’s historical portfolio of natural gas contracts are determined through the use of quoted market prices when available. As quoted market prices are not widely available in the weather and electricity derivative markets, management uses available market data and internal pricing models based upon consistent statistical methodologies to estimate fair values. Estimating the fair value of instruments which do not have quoted market prices requires management’s judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.

Fair Value Hedges

Changes in the fair value of a derivative that is designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings (through “net realized and unrealized gains and losses on derivative instruments”) with any differences between the net change in fair value of the derivative and the hedged item representing the hedge ineffectiveness. Periodic derivative net coupon settlements are recorded in net investment income with the exception of hedges of Company issued debt which are recorded in interest expense. The Company may designate fair value hedging relationships where interest rate swaps are used to hedge the changes in fair value of certain fixed rate liabilities and fixed maturity securities due to changes in the designated benchmark interest rate.

Cash Flow Hedges

Changes in the fair value of a derivative that is designated and qualifies as a cash flow hedge are recorded in accumulated other comprehensive income (“AOCI”) and are reclassified into earnings when the variability of the cash flow of the hedged item impacts earnings. Gains and losses on derivative contracts that are reclassified from AOCI to current period earnings are included in the line item in the consolidated statements of operations in which the cash flows of the hedged item are recorded. Any hedge ineffectiveness is recorded immediately in current period earnings as “net realized and unrealized gains and losses on derivative instruments.” Periodic derivative net coupon settlements are recorded in net investment income. The Company may designate cash flow hedging relationships where interest rate swaps are used to mitigate interest rate risk associated with anticipated issuances of debt or other forecasted transactions.

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

3. Fair Value Measurements

Effective January 1, 2008, the Company adopted the authoritative accounting guidance over fair value measurements, which requires disclosures about the Company’s assets and liabilities that are carried at fair value. As required by this guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

The following tables set forth the Company’s assets and liabilities that were accounted for at fair value as of September 30, 2009 and December 31, 2008 by level within the fair value hierarchy (for further information, see Note 2 (b) to the Consolidated Financial Statements, “Significant Accounting Policies – Fair Value Measurements” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 and Note 2 (b) above):

 

(U.S. dollars in thousands)

(Unaudited)

   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Collateral and
Counterparty
Netting
    Balance
as of
September 30,
2009

Assets

             

U.S. Government and Government agency

   $ —      $ 4,252,334    $ —      $ —        $ 4,252,334

Corporate (7)

     —        10,114,185      19,895      —          10,134,080

Residential mortgage-backed securities – Agency

     —        4,187,915      —        —          4,187,915

Residential mortgage-backed securities – Non-Agency

     —        1,577,775      34,399      —          1,612,174

Commercial mortgage-backed securities

     —        1,647,936      2,673      —          1,650,609

Collateralized debt obligations

     —        368,210      185,695      —          553,905

Other asset-backed securities

     —        911,639      35,846      —          947,485

U.S. States and political subdivisions of the States

     —        627,304      —        —          627,304

Non-U.S. Sovereign Government

     —        3,991,103      8,501      —          3,999,604
                                   

Total Fixed maturities, at fair value

   $ —      $ 27,678,401    $ 287,009    $ —        $ 27,965,410

Equity securities, at fair value

     15,227      39,872      —        —          55,099

Short-term investments, at fair value (6)

     —        1,978,284      11,946      —          1,990,230
                                   

Total investments available for sale

   $ 15,227    $ 29,696,557    $ 298,955    $ —        $ 30,010,739

Cash equivalents (1)

     2,175,968      777,986      —        —          2,953,954

Other investments (2)

     —        392,577      64,444      —          457,021

Other assets (3)(4)

     —        128,854      226,781      (259,605     96,030
                                   

Total assets accounted for at fair value

   $ 2,191,195    $ 30,995,974    $ 590,180    $ (259,605   $ 33,517,744
                                   

Liabilities

             

Financial instruments sold, but not yet purchased (5)

   $ —      $ 31,424    $ —      $ —        $ 31,424

Other liabilities (3)(4)

     —        18,030      87,794      (57,212     48,612
                                   

Total liabilities accounted for at fair value

   $ —      $ 49,454    $ 87,794    $ (57,212   $ 80,036
                                   

 

17


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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

3. Fair Value Measurements (Continued)

 

(U.S. dollars in thousands)

(Unaudited)

   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Collateral and
Counterparty
Netting
    Balance
as of
December 31,
2008

Assets

             

U.S. Government and Government agency

   $ —      $ 3,978,342    $ —      $ —        $ 3,978,342

Corporate (7)

     —        9,226,097      62,506      —          9,288,603

Residential mortgage-backed securities – Agency

     —        2,099,955      —        —          2,099,955

Residential mortgage-backed securities – Non-Agency

     —        1,858,517      79,429      —          1,937,946

Commercial mortgage-backed securities

     —        2,097,757      43,811      —          2,141,568

Collateralized debt obligations

     —        40,669      598,110      —          638,779

Other asset-backed securities

     —        1,629,137      78,871      —          1,708,008

U.S. States and political subdivisions of the States

     —        468,770      —        —          468,770

Non-U.S. Sovereign Government

     —        3,285,245      89,152      —          3,374,397
                                   

Total Fixed maturities, at fair value

   $ —      $ 24,684,489    $ 951,879    $ —        $ 25,636,368

Equity securities, at fair value

     276,040      85,779      —        —          361,819

Short-term investments, at fair value (6)

     —        1,445,577      20,746      —          1,466,323
                                   

Total investments available for sale

   $ 276,040    $ 26,215,845    $ 972,625    $ —        $ 27,464,510

Cash equivalents (1)

     1,082,813      1,227,461      —        —          2,310,274

Other investments (2)

     —        299,325      65,354      —          364,679

Other assets (3)(4)

     —        219,366      314,906      (411,316     122,956
                                   

Total assets accounted for at fair value

   $ 1,358,853    $ 27,961,997    $ 1,352,885    $ (411,316   $ 30,262,419
                                   

Liabilities

             

Financial instruments sold, but not yet purchased (5)

   $ —      $ 26,536    $ —      $ —        $ 26,536

Other liabilities (3)(4)

     —        53,101      88,088      (65,232     75,957
                                   

Total liabilities accounted for at fair value

   $ —      $ 79,637    $ 88,088    $ (65,232   $ 102,493
                                   

 

(1) Cash equivalents balances subject to fair value measurement include certificates of deposit and money market funds. Operating cash balances are not subject to fair value measurement guidance.
(2) The Other investments balance excludes certain unrated tranches of collateralized loan obligations which are carried under the cost recovery method given the uncertainty of future cash flows that totaled $11.7 million and $14.7 million at September 30, 2009 and December 31, 2008, respectively. The Company also has certain investments in project finance transactions, a payment obligation (as described in Note 7, “Other Investments”), and has provided liquidity financing to a structured credit vehicle as a part of a third party medium term note facility. These investments are carried at amortized cost that totaled $354.0 million at September 30, 2009 and $80.1 million at December 31, 2008.
(3) Other assets and other liabilities include derivative instruments.
(4) The derivative balances included in each category above are reported on a gross basis by level with a netting adjustment presented separately in the “Collateral and Counterparty Netting” column. The Company often enters into different types of derivative contracts with a single counterparty and these contracts are covered under a netting agreement. In addition, the Company held net cash collateral related to derivative assets of approximately $202.4 million and $346.1 million at September 30, 2009 and December 31, 2008, respectively. This balance is included within cash and cash equivalents and the corresponding liability to return the collateral has been offset against the derivative asset within the balance sheet as appropriate under the netting agreement. The fair value of the individual derivative contracts are reported gross in their respective levels based on the fair value hierarchy.
(5) Financial instruments sold, but not purchased are included within “Net payable for investments purchased” on the balance sheet.
(6) Short-term investments consist primarily of corporate, U.S. Government and Government Agency securities, Corporate and non-U.S. Sovereign Government securities.
(7) Included within Corporate are certain floating rate medium term notes supported primarily by pools of European corporate bonds with varying degrees of leverage. The notes have a fair value of $565.3 million and $491.9 million and an amortized cost of $730.5 million and $922.7 million at September 30, 2009 and December 31, 2008, respectively. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.

 

18


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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

3. Fair Value Measurements (Continued)

 

Level 3 Gains and Losses

The tables below present additional information about assets and liabilities measured at fair value on a recurring basis and for which Level 3 inputs were utilized to determine fair value. The table reflects gains and losses for the three and nine month periods ended September 30, 2009 for all financial assets and liabilities categorized as Level 3 as of June 30, 2009 and September 30, 2009, respectively. The tables do not include gains or losses that were reported in Level 3 in prior periods for assets that were transferred out of Level 3 prior to September 30, 2009. Gains and losses for assets and liabilities classified within Level 3 in the table below may include changes in fair value that are attributable to both observable inputs (Levels 1 and 2) and unobservable inputs (Level 3). Further, it should be noted that the following table does not take into consideration the effect of offsetting Level 1 and 2 financial instruments entered into by the Company that are either economically hedged by certain exposures to the Level 3 positions or that hedge the exposures in Level 3 positions.

 

     Level 3 Assets and Liabilities
Three Months Ended September 30, 2009
 

(U.S. dollars in thousands)

(Unaudited)

   Corporate     Residential
mortgage-backed
securities – Non Agency
    Commercial
mortgage-backed
securities
    Collateralized debt
obligations
    Other asset
backed securities
 

Balance, beginning of period

   $ 21,462      $ 26,964      $ 33,289      $ 503,168      $ 35,315   

Realized (losses) gains

     10        (1,486     —          (2,677     (5,188

Movement in unrealized gains (losses)

     2,060        8,485        74        40,172        5,930   

Purchases, sales issuances and settlements, net

     4,734        (814     —          (2,369     —     

Transfers into Level 3

     —          2,464        —          10,017        —     

Transfers out of Level 3

     (8,371     (1,214     (30,690     (358,683     (211

Fixed maturities to short term investments classification change

     —          —          —          (3,933     —     
                                        

Balance, end of period

   $ 19,895      $ 34,399      $ 2,673      $ 185,695      $ 35,846   
                                        

Movement in total (losses) above relating to instruments still held at the reporting date

   $ 1,926      $ 7,244      $ 231      $ 39,803      $ (128
                                        

 

     Level 3 Assets and Liabilities
Three Months Ended September 30, 2009 (continued)
 

(U.S. dollars in thousands)

(Unaudited)

   Non-U.S. Sovereign
Government
    Short-term Investments     Other investments     Derivative Contracts - Net  

Balance, beginning of period

   $ 42,585      $ 20,614      $ 65,134      $ 120,735   

Realized gains (losses)

     —          (10,193     —          (16

Movement in unrealized gains (losses)

     438        978        1,452        15,529   

Purchases, sales issuances and settlements, net

     —          (45     (2,142     2,739   

Transfers into Level 3

     —          —          —          —     

Transfers out of Level 3

     (34,522     (3,341     —          —     

Fixed maturities to short term investments classification change

     —          3,933        —          —     
                                

Balance, end of period

   $ 8,501      $ 11,946      $ 64,444      $ 138,987   
                                

Movement in total (losses) above relating to instruments still held at the reporting date

   $ 152      $ 480      $ 1,452      $ 15,529   
                                

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

3. Fair Value Measurements (Continued)

 

Level 3 Gains and Losses (continued)

 

     Level 3 Assets and Liabilities
Nine Months Ended September 30, 2009
 

(U.S. dollars in thousands)

(Unaudited)

   Corporate     Residential
mortgage-backed
securities – Non Agency
    Commercial
mortgage-backed
securities
    Collateralized debt
obligations
    Other asset
backed securities
 

Balance, beginning of period

   $ 62,506      $ 79,429      $ 43,811      $ 598,110      $ 78,871   

Realized gains (losses)

     (1,574     (5,189     (7,292     (31,991     (8,245

Movement in unrealized gains (losses)

     4,946        5,717        1,455        26,289        (35

Purchases, sales issuances and settlements, net

     5,217        1,277        (3,345     (8,885     (2,831

Transfers into Level 3

     1,290        4,017        1,470        11,810        —     

Transfers out of Level 3

     (52,490     (50,852     (33,426     (405,705     (31,914

Fixed maturities to short term investments classification change

     —          —          —          (3,933     —     
                                        

Balance, end of period

   $ 19,895      $ 34,399      $ 2,673      $ 185,695      $ 35,846   
                                        

Movement in total (losses) above relating to instruments still held at the reporting date

   $ 4,872      $ 4,998      $ (356   $ 7,149      $ (6,926
                                        

 

     Level 3 Assets and Liabilities
Nine Months Ended September 30, 2009 (continued)
 

(U.S. dollars in thousands)

(Unaudited)

   Non-U.S. Sovereign
Government
    Short-term Investments     Other investments     Derivative Contracts - Net  

Balance, beginning of period

   $ 89,152      $ 20,746      $ 65,354      $ 226,818   

Realized gains (losses)

     —          (11,343     —          2,807   

Movement in unrealized gains (losses)

     (309     4,467        (4,446     (103,275

Purchases, sales issuances and settlements, net

     (12,985     (5,589     3,536        12,637   

Transfers into Level 3

     —          —          —          —     

Transfers out of Level 3

     (67,357     (268     —          —     

Fixed maturities to short term investments classification change

     —          3,933        —          —     
                                

Balance, end of period

   $ 8,501      $ 11,946      $ 64,444      $ 138,987   
                                

Movement in total (losses) above relating to instruments still held at the reporting date

   $ (143   $ 1,954      $ (4,446   $ (103,275
                                

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

3. Fair Value Measurements (Continued)

 

Level 3 Gains and Losses (Continued)

 

           Level 3 Assets and
Liabilities
Three Months Ended
September 30, 2008
     

(U.S. dollars in thousands)

(Unaudited)

   Fixed
Maturities
    Short-term
Investments
    Other
Investments
    Derivative
Contracts — Net

Balance, beginning of period

   $ 1,527,740      $ 8,443      $ 61,593      $ 55,351

Realized gains (losses)

     (32,779     —          —          113

Movement in unrealized gains (losses)

     (126,358     (29     228        12,543

Purchases, issuances and settlements

     29,309        (5,615     2,980        4,780

Transfers in and/or out of Level 3

     (492,282     —          —          —  
                              

Balance, end of period

   $ 905,630      $ 2,799      $ 64,801      $ 72,787
                              

Movement in total gains (losses) above relating to instruments still held at the reporting date

   $ (112,147   $ 82      $ 228      $ 12,543
                              
           Level 3 Assets and
Liabilities
Nine Months Ended
September 30, 2008
     

(U.S. dollars in thousands)

(Unaudited)

   Fixed
Maturities
    Short-term
Investments
    Other
Investments
    Derivative
Contracts — Net

Balance, beginning of period

   $ 1,385,601      $ 15,606      $ 40,354      $ 12,283

Realized gains (losses)

     (170,905     (46     —          26,956

Movement in unrealized gains (losses)

     (246,929     2        (3,266     18,732

Purchases, issuances and settlements

     111,183        (11,873     27,713        14,816

Transfers in and/or out of Level 3

     (173,320     (890     —          —  
                              

Balance, end of period

   $ 905,630      $ 2,799      $ 64,801      $ 72,787
                              

Movement in total (losses) gains above relating to instruments still held at the reporting date

   $ (238,451   $ —        $ (3,266   $ 18,732
                              

Level 3 assets include securities for which the values were obtained from brokers where either significant inputs were utilized in determining the value that were difficult to corroborate with observable market data, or sufficient information regarding the specific inputs utilized by the broker was not available to support a Level 2 classification. Level 3 assets also include securities for which the Company determined current market trades represent distressed transactions, and accordingly, the Company determined fair value using certain inputs that are not observable to market participants. Transfers from Level 3 to Level 2 during the quarter ended September 30, 2009, were primarily as a result of the Company utilizing pricing services containing significant observable inputs over other Level 3 valuations for certain assets.

Fixed maturities and short term investments

At September 30, 2009, certain assets which were previously classified as Level 3 assets due to a lack of observable market data are now classified as Level 2 assets.

At June 30, 2009, the Company utilized internal valuation models for collateralized debt obligations holdings (“CDOs”) with a fair value of $450.5 million and a par value of $807.5 million. Up to June 30, 2009, the Company had determined that internal models were more appropriate and better representative of the fair value of the CDO holdings. However, as a result of numerous market factors, including increased volumes of trading, the Company believes that transactions are no longer distressed. Accordingly, the Company has reverted to third-party vendor pricing sources where available for these securities at September 30, 2009, and where not available the valuation was based on broker quotes. Accordingly, as at September 30, 2009, for those CDOs which were previously valued using internal models, the Company now carries these assets at a fair value of $407.2 million and a par value of $793.1 million. Of these holdings, $326.1 million were valued by third party vendors and accordingly are now classified as Level 2, and $81.1 million were valued using broker quotations and accordingly remain classified as Level 3.

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

3. Fair Value Measurements (Continued)

 

The remainder of the Level 3 assets relate to private equity investments where the nature of the underlying assets held by the investee include positions such as private business ventures and are such that significant Level 3 inputs are utilized in the valuation, and certain derivative positions.

Other investments

Included within the Other Investments component of the Company’s Level 3 valuations are private investments where the Company is not deemed to have significant influence over the investee. The fair value of these investments is based upon net asset values received from the investment manager or general partner of the respective entity. The nature of the underlying investments held by the investee which form the basis of the net asset value include assets such as private business ventures and are such that significant Level 3 inputs are utilized in the determination of the individual underlying holding values and accordingly the fair value of the Company’s investment in each entity is classified within Level 3. The Company also incorporates factors such as the most recent financial information received, the values at which capital transactions with the investee take place, and management’s judgment regarding whether any adjustments should be made to the net asset value in recording the fair value of each position.

Derivative instruments

Derivative instruments classified within Level 3 include: (i) certain interest rate swaps where the duration of the contract the Company holds exceeds that of the longest term on a market observable input, (ii) weather and energy derivatives, (iii) GMIB benefits embedded within a certain reinsurance contract, (iv) a put option included within the Company’s remaining contingent capital facility and (v) credit derivatives sold providing protection on senior tranches of structured finance transactions where the value is obtained directly from the investment bank counterparty for which sufficient information regarding the inputs utilized in the valuation was not obtained to support a Level 2 classification. The majority of inputs utilized in the valuations of these types of derivative contracts are considered Level 1 or Level 2; however, each valuation includes at least one Level 3 input that was significant to the valuation and accordingly the values are disclosed within Level 3.

In addition, see Item 8, Note 2 to the Consolidated Financial Statements, “Significant Accounting Policies” in the Company’s Annual Report on Form 10-K for a general discussion of types of assets and liabilities that are classified within Level 3 of the fair value hierarchy as well as the Company’s valuation policies for such instruments.

Financial Instruments Not Carried at Fair Value

Authoritative guidance over disclosures about fair value of financial instruments requires additional disclosure of fair value information for financial instruments not carried at fair value in both interim and annual reporting periods. Certain financial instruments, particularly insurance contracts, are excluded from these fair value disclosure requirements. The carrying values of cash and cash equivalents, accrued investment income, net receivable from investments sold, other assets, net payable for investments purchased, other liabilities and other financial instruments not included below approximated their fair values. The following table includes financial instruments for which the carrying amount differs from the estimated fair values:

 

     As of September 30, 2009    As of December 31, 2008

(U.S. dollars in thousands)

(Unaudited)

   Carrying
Value
   Fair
Value
   Carrying
Value
   Fair
Value

Other investments

   $ 822.8    $ 814.8    $ 459.5    $ 443.3
                           

Financial Assets

   $ 822.8    $ 814.8    $ 459.5    $ 443.3
                           

Deposit Liabilities

   $ 2,442.8    $ 2,298.3    $ 2,711.0    $ 1,764.0

Notes payable and debt

     2,452.4      2,449.7      3,189.7      1,215.0
                           

Financial Liabilities

   $ 4,895.2    $ 4,748.0    $ 5,900.7    $ 2,979.0
                           

Redeemable series C preference ordinary shares

   $ 182.7    $ 127.9    $ 500.0    $ 110.0
                           

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

3. Fair Value Measurements (Continued)

 

Other investments includes direct equity investments, investment funds, limited partnerships, certain structured project finance transactions, and unrated tranches of collateralized debt obligations. Items included in other investments are carried at fair value except as mentioned below.

The Company historically participated in project finance related loan transactions. These transactions are accounted for in accordance with guidance governing accounting by certain entities (including entities with trade receivables) that lend to or finance the activities of others under which the loans are considered held for investment as the Company has the intent and ability to hold for the foreseeable future or until maturity or payoff. Accordingly, these funded loan participations are reported in the balance sheet as outstanding principal adjusted for any allowance for loan losses as considered necessary by management. The carrying value and estimated fair value of these investments were $78.6 million and $64.5 million as of September 30, 2009 and were $80.1 million and $63.9 million as of December 31, 2008, respectively. In addition, the Company invested in a payment obligation that is carried at amortized cost as described in Note 7, “Other Investments”. The carrying value and estimated fair value of this investment were $128.3 million and $129.6 million as of September 30, 2009. This investment was not held at December 31, 2008. The Company also provided liquidity financing to a structured credit vehicle as a part of a third party medium term note facility during the quarter ended September 30, 2009. This investment had a carrying value and an estimated fair value of $147.0 million and $151.9 million as of September 30, 2009. These investments are not considered to be fair value measurements under U.S. GAAP guidance and accordingly they have been excluded from the fair value measurements disclosures. The fair value of these investments held by the Company is determined through use of internal models utilizing reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data.

Unrated tranches of CDOs are carried under the cost recovery method given the uncertainty of future cash flows and accordingly it is not practicable to determine an estimate of the fair value of these positions. The carrying value of these investments held by the Company at September 30, 2009 and December 31, 2008 was $11.7 million and $14.7 million, respectively.

Deposit liabilities include obligations under structured insurance and reinsurance transactions as well as funding agreements issued. For purposes of fair value disclosures, the Company determines the fair value of the deposit liabilities by assuming a discount rate equal to the appropriate U.S. Treasury rate plus 163 basis points and the appropriate U.S. Treasury Rate plus 902 basis points at September 30, 2009 and December 31, 2008, respectively, to determine the present value of projected contractual liability payments through final maturity. The discount rate incorporates the Company’s own credit risk into the determination of estimated fair value. The carrying value and estimated fair value of these liabilities were $2.44 billion and $2.30 billion as of September 30, 2009 and were $2.7 billion and $1.7 billion as of December 31, 2008, respectively.

The fair value of the Company’s notes payable and debt outstanding are determined based on quoted market prices. The carrying value and estimated fair value of notes payable and debt outstanding were $2.45 billion and $2.45 billion as of September 30, 2009 and were $3.2 billion and $1.2 billion as of December 31, 2008, respectively.

The fair value of the Company’s redeemable series C preference ordinary shares outstanding is determined based on indicative quotes provided by brokers. The carrying value and estimated fair value of the redeemable series C preference ordinary shares outstanding were $182.7 million and $127.9 million as of September 30, 2009 and were $500.0 million and $110.0 million as of December 31, 2008, respectively.

There are no significant concentrations of credit risk within the Company’s financial instruments as defined in the authoritative guidance over disclosures of fair value of financial instruments not carried at fair value.

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

4. Segment Information

Following a streamlining of the Company’s operating segments in the first quarter of 2009, the Company is organized into three operating segments: Insurance, Reinsurance and Life Operations – in addition to a Corporate segment that includes the general investment and financing operations of the Company.

The Company evaluates the performance for both the Insurance and Reinsurance segments based on underwriting profit and contribution from its Life Operations segment. Other items of revenue and expenditure of the Company are not evaluated at the segment level for reporting purposes. In addition, the Company does not allocate investment assets by segment for its property and casualty (“P&C”) operations. Investment assets related to the Company’s Life Operations and certain structured products included in the Insurance, Reinsurance and Corporate segments are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each of these segments.

 

Three months ended September 30, 2009:           

(U.S. dollars in thousands, except ratios)

(Unaudited)

   Insurance     Reinsurance     Total P&C     Life
Operations
    Corporate     Total  

Gross premiums written

   $ 1,022,178      $ 562,031      $ 1,584,209      $ 156,870      $ —        $ 1,741,079   

Net premiums written

     818,244        376,875        1,195,119        146,941        —          1,342,060   

Net premiums earned

     905,350        388,529        1,293,879        151,840        —          1,445,719   

Net losses incurred

     630,324        187,914        818,238        185,067        —          1,003,305   

Acquisition expenses

     107,008        81,971        188,979        23,867        —          212,846   

Operating expenses (1)

     155,645        42,738        198,383        5,903        —          204,286   
                                                

Underwriting profit (loss)

   $ 12,373      $ 75,906      $ 88,279      $ (62,997   $ —        $ 25,282   

Net investment income

         211,781        88,788        —          300,569   

Net results structured products (2)

     3,852        7,729        11,581        —          3,694        15,275   

Net fee income and other (3)

     (5,894     578        (5,316     62        —          (5,254

Net realized gains (losses) on investments

         (309,601     (5,393     (10,526     (325,520
                                    

Contribution from P&C and Life Operations

       $ (3,276   $ 20,460      $ (6,832   $ 10,352   
                        

Corporate & other:

            

Net realized & unrealized gains (losses) on derivative instruments

           $ (9,133   $ (9,133

Net income (loss) from financial, investment and other operating affiliates

             65,315        65,315   

Exchange (gains) losses

             (16,843     (16,843

Corporate operating expenses

             14,955        14,955   

Interest expense (4)

             43,250        43,250   

Non-controlling interest in net income (loss) of subsidiary

             (7     (7

Income taxes and other

           $ 4,081      $ 4,081   
                        

Net Income

           $ 3,914      $ 21,098   
                        

Ratios – P&C operations: (5)

            

Loss and loss expense ratio

     69.6     48.4     63.2      

Underwriting expense ratio

     29.0     32.1     30.0      
                              

Combined ratio

     98.6     80.5     93.2      
                              

 

Notes:

(1) Operating expenses exclude Corporate operating expenses, shown separately.
(2) The net results from P&C and Corporate structured products includes net investment income, interest expense and operating expenses of $21.1 million and $ 5.4 million, $8.7 million and $1.5 million, and $0.8 million and $0.3 million, respectively.
(3) Net fee income and other includes operating expenses from the Company’s loss prevention consulting services business.
(4) Interest expense excludes interest expense related to deposit liabilities recorded in the Insurance, Reinsurance, and Corporate segments.
(5) Ratios are based on net premiums earned from property and casualty operations.

 

24


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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

4. Segment Information (Continued)

 

Three months ended September 30, 2008:           

(U.S. dollars in thousands, except ratios)

(Unaudited)

   Insurance     Reinsurance     Total P&C     Life
Operations
    Corporate     Total  

Gross premiums written

   $ 1,213,991      $ 685,984      $ 1,899,975      $ 156,148      $ —        $ 2,056,123   

Net premiums written

     839,788        418,126        1,257,914        145,741        —          1,403,655   

Net premiums earned

     1,041,740        483,283        1,525,023        169,608        —          1,694,631   

Net losses incurred

     830,789        378,776        1,209,565        199,861        —          1,409,426   

Acquisition expenses

     112,175        79,205        191,380        25,499        —          216,879   

Operating expenses (1)

     168,047        51,423        219,470        7,864        —          227,334   
                                                

Underwriting profit (loss)

   $ (69,271   $ (26,121   $ (95,392   $ (63,616   $ —        $ (159,008

Net investment income

         293,109        102,636        —          395,745   

Net investment results structured products (2)

     (14,591     7,699        (6,892     —          3,694        (3,198

Net fee income and other (3)

     (1,980     7,606        5,626        75        —          5,701   

Net realized gains (losses) on investments

         (253,399     (29,167     (10,337     (292,903
                                    

Contribution from P&C and Life Operations

       $ (56,948   $ 9,928      $ (6,643   $ (53,663
                        

Corporate & other:

            

Net realized & unrealized gains (losses) on derivative instruments

           $ (58,454   $ (58,454

Net income (loss) from financial, investment and other operating affiliates (4)

             (1,459,185     (1,459,185

Exchange (gains) losses

             (139,467     (139,467

Corporate operating expenses

             61,656        61,656   

Extinguishment of debt

             22,527        22,527   

Interest expense (5)

             51,277        51,277   

Income taxes and other

             49,229        49,229   
                        

Net Income

           $ (1,569,504   $ (1,616,524
                        

Ratios – P&C operations: (6)

            

Loss and loss expense ratio

     79.8     78.4     79.3      

Underwriting expense ratio

     26.8     27.0     27.0      
                              

Combined ratio

     106.6     105.4     106.3      
                              

 

Notes:

(1) Operating expenses exclude Corporate operating expenses, shown separately.
(2) The net results from P&C and Corporate structured products includes net investment income, interest expense and operating expenses of $27.4 million and $13.1 million, $19.4 million and $7.4 million, and $15.0 million and $2.0 million, respectively.
(3) Net fee income and other includes operating expenses from the Company’s loss prevention consulting services business.
(4) Net loss from investment fund and operating affiliates for the three months ended September 30, 2008 includes additional losses totaling $1.4 billion related to the reinsurance and guarantee agreements with Syncora.
(5) Interest expense excludes interest expense related to deposit liabilities recorded in the Insurance, Reinsurance, and Corporate segments.
(6) Ratios are based on net premiums earned from property and casualty operations. The underwriting expense ratio excludes exchange gains and losses.

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

4. Segment Information (Continued)

 

Nine months ended September 30, 2009:           

(U.S. dollars in thousands, except ratios)

(Unaudited)

   Insurance     Reinsurance     Total P&C     Life
Operations
    Corporate     Total  

Gross premiums written

   $ 3,237,643      $ 1,725,984      $ 4,963,627      $ 442,693      $ —        $ 5,406,320   

Net premiums written

     2,417,018        1,361,690        3,778,708        409,200        —          4,187,908   

Net premiums earned

     2,696,951        1,200,364        3,897,315        429,625        —          4,326,940   

Net losses incurred

     1,844,322        543,827        2,388,149        517,614        —          2,905,763   

Acquisition expenses

     324,850        262,997        587,847        66,490        —          654,337   

Operating expenses (1)

     502,904        136,845        639,749        14,013        —          653,762   
                                                

Underwriting profit (loss)

   $ 24,875      $ 256,695      $ 281,570      $ (168,492   $ —        $ 113,078   

Net investment income

         672,437        249,165        —          921,602   

Net results structured products (2)

     11,066        22,325        33,391        —          13,358        46,749   

Net fee income and other (3)

     (10,114     3,174        (6,940     236        —          (6,704

Net realized gains (losses) on investments

         (506,984     (131,706     (19,197     (657,887
                                    

Contribution from P&C and Life Operations

       $ 473,474      $ (50,797   $ (5,839   $ 416,838   
                        

Corporate & other:

            

Net realized & unrealized gains (losses) on derivative instruments

           $ (9,571   $ (9,571

Net income (loss) from financial, investment and other operating affiliates

             82,847        82,847   

Exchange losses

             103,754        103,754   

Corporate operating expenses

             73,886        73,886   

Interest expense (4)

             135,777        135,777   

Non-controlling interest in net income (loss) of subsidiary

             (47     (47

Income taxes and other

             67,008        67,008   
                        

Net Income

           $ (312,941   $ 109,736   
                        

Ratios – P&C operations: (5)

            

Loss and loss expense ratio

     68.4     45.3     61.3      

Underwriting expense ratio

     30.7     33.3     31.5      
                              

Combined ratio

     99.1     78.6     92.8      
                              

 

Notes:

(1) Operating expenses exclude Corporate operating expenses, shown separately.
(2) The net results from P&C and Corporate structured products includes net investment income, interest expense and operating expenses of $60.8 million and $21.0 million, $26.6 million and $6.6 million, and $0.8 million and $1.0 million, respectively.
(3) Net fee income and other includes operating expenses from the Company’s loss prevention consulting services business.
(4) Interest expense excludes interest expense related to deposit liabilities recorded in the Insurance, Reinsurance, and Corporate segments.
(5) Ratios are based on net premiums earned from property and casualty operations.

 

26


Table of Contents

XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

4. Segment Information (Continued)

 

Nine months ended September 30, 2008:

  

       

(U.S. dollars in thousands, except ratios)

(Unaudited)

   Insurance     Reinsurance     Total P&C     Life
Operations
    Corporate     Total  

Gross premiums written

   $ 4,231,111      $ 2,155,989      $ 6,387,100      $ 552,357      $ —        $ 6,939,457   

Net premiums written

     3,108,460        1,645,474        4,753,934        520,887        —          5,274,821   

Net premiums earned

     3,068,492        1,518,098        4,586,590        502,125        —          5,088,715   

Net losses incurred

     2,169,423        979,620        3,149,043        605,885        —          3,754,928   

Acquisition expenses

     351,888        302,077        653,965        75,448        —          729,413   

Operating expenses (1)

     500,822        141,940        642,762        25,246        —          668,008   
                                                

Underwriting profit (loss)

   $ 46,359      $ 94,461      $ 140,820      $ (204,454   $        $ (63,634

Net investment income

         899,278        297,829          1,197,107   

Net investments results structured products (2)

     (11,418     21,102        9,684        —          17,620        27,304   

Net fee income and other (3)

     (3,139     8,840        5,701        275        —          5,976   

Net realized gains (losses) on investments

         (296,149     (22,419     (74,546     (393,114
                                    

Contribution from P&C and Life Operations

       $ 759,334      $ 71,231      $ (56,926   $ 773,639   
                                    

Corporate & other:

            

Net realized & unrealized gains (losses) on derivative instruments

           $ (5,648   $ (5,648

Net income (loss) from financial, investment and other operating affiliates (4)

             (1,516,169     (1,516,169

Exchange (gains) losses

             (63,786     (63,786

Corporate operating expenses

             144,686        144,686   

Extinguishment of debt

             22,527        22,527   

Interest expense (5)

             150,719        150,719   

Income taxes & other

             131,976        131,976   
                        

Net Income

           $ (1,964,865   $ (1,134,300
                        

Ratios – P&C operations: (6)

            

Loss and loss expense ratio

     70.7     64.5     68.7      

Underwriting expense ratio

     27.8     29.3     28.2      
                              

Combined ratio

     98.5     93.8     96.9      
                              

 

Notes:

(1) Operating expenses exclude Corporate operating expenses, shown separately.
(2) The net results from P&C and Corporate structured products includes net investment income, interest expense and operating expenses of $86.6 million and $92.2 million, $50.7 million and $66.2 million, and $26.2 million and $8.4, respectively.
(3) Net fee income and other includes operating expenses from the Company’s loss prevention consulting services business
(4) Net loss from investment fund and operating affiliates for the nine months ended September 30, 2008 includes additional losses totaling $1.4 billion related to the reinsurance and guarantee agreements with Syncora.
(5) Interest expense excludes interest expense related to deposit liabilities recorded in the Insurance, Reinsurance, and Corporate segments.
(6) Ratios are based on net premiums earned from property and casualty operations. The underwriting expense ratio excludes exchange gains and losses.

 

27


Table of Contents

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:

 

Three months ended September 30, 2009:

(U.S. dollars in thousands)

(Unaudited)

   Insurance     Reinsurance    Life
Operations
   Total

P&C Operations:

          

Casualty – professional lines

   $ 318,477      $ 46,127    $ —      $ 364,604

Casualty – other lines

     177,349        55,561      —        232,910

Property catastrophe

     (4     85,297      —        85,293

Other property

     110,780        134,802      —        245,582

Marine, energy, aviation and satellite

     143,929        22,397      —        166,326

Other specialty lines (1)

     151,245        —        —        151,245

Other (2)

     3,874        39,482      —        43,356

Structured indemnity

     (300     4,863      —        4,563
                            

Total P&C Operations

   $ 905,350      $ 388,529    $ —      $ 1,293,879
                            

Life Operations:

          

Other Life

   $ —        $ —      $ 117,037    $ 117,037

Annuity

     —          —        34,803      34,803
                            

Total Life Operations

   $ —        $ —      $ 151,840    $ 151,840
                            

Total

   $ 905,350      $ 388,529    $ 151,840    $ 1,445,719
                            

 

Three months ended September 30, 2008:

(U.S. dollars in thousands)

(Unaudited)

   Insurance    Reinsurance    Life
Operations
   Total

P&C Operations:

           

Casualty – professional lines

   $ 340,087    $ 64,157    $ —      $ 404,244

Casualty – other lines

     220,503      105,936      —        326,439

Property catastrophe

     161      72,478      —        72,639

Other property

     131,315      149,233      —        280,548

Marine, energy, aviation and satellite

     157,909      34,849      —        192,758

Other specialty lines (1)

     167,413      —        —        167,413

Other (2)

     7,175      54,214      —        61,389

Structured indemnity

     17,177      2,416      —        19,593
                           

Total P&C Operations

   $ 1,041,740    $ 483,283    $ —      $ 1,525,023
                           

Life Operations:

           

Other Life

   $ —      $ —      $ 129,943    $ 129,943

Annuity

     —        —        39,665      39,665
                           

Total Life Operations

   $ —      $ —      $ 169,608    $ 169,608
                           

Total

   $ 1,041,740    $ 483,283    $ 169,608    $ 1,694,631
                           

 

(1) Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, specie, middle markets and excess and surplus lines.
(2) Other includes employers liability, surety, political risk and other lines.

 

28


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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:

Nine months ended September 30, 2009:

(U.S. dollars in thousands)

(Unaudited)

   Insurance     Reinsurance    Life
Operations
   Total

P&C Operations:

          

Casualty – professional lines

   $ 945,737      $ 156,364    $ —      $ 1,102,101

Casualty – other lines

     492,507        192,896      —        685,403

Property catastrophe

     1,758        231,471      —        233,229

Other property

     325,870        417,898      —        743,768

Marine, energy, aviation and satellite

     431,412        64,011      —        495,423

Other specialty lines (1)

     475,332        —        —        475,332

Other (2)

     14,705        131,519      —        146,224

Structured indemnity

     9,630        6,205      —        15,835
                            

Total P&C Operations

   $ 2,696,951      $ 1,200,364    $ —      $ 3,897,315
                            

Life Operations:

          

Other Life

   $ —        $ —      $ 332,004    $ 332,004

Annuity

     —          —        97,621      97,621
                            

Total Life Operations

   $ —        $ —      $ 429,625    $ 429,625
                            

Total

   $ 2,696,951      $ 1,200,364    $ 429,625    $ 4,326,940
                            
Nine months ended September 30, 2008:           

(U.S. dollars in thousands)

(Unaudited)

   Insurance     Reinsurance    Life
Operations
   Total

P&C Operations:

          

Casualty – professional lines

   $ 1,028,254      $ 194,593    $ —      $ 1,222,847

Casualty – other lines

     645,873        328,581      —        974,454

Property catastrophe

     268        243,988      —        244,256

Other property

     390,081        491,607      —        881,688

Marine, energy, aviation and satellite

     480,527        95,551      —        576,078

Other specialty lines (1)

     492,337        —        —        492,337

Other (2)

     (20,184     159,129      —        138,945

Structured indemnity

     51,336        4,649      —        55,985
                            

Total P&C Operations

   $ 3,068,492      $ 1,518,098    $ —      $ 4,586,590
                            

Life Operations:

          

Other Life

   $ —        $ —      $ 377,752    $ 377,752

Annuity

     —          —        124,373      124,373
                            

Total Life Operations

   $ —        $ —      $ 502,125    $ 502,125
                            

Total

   $ 3,068,492      $ 1,518,098    $ 502,125    $ 5,088,715
                            

 

(1) Other specialty lines within the Insurance segment includes: environmental, programs, equine, warranty, specie, middle markets and excess and surplus lines.
(2) Other includes employers liability, surety, political risk and other lines.

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

5. Restructuring and Asset Impairment Charges

During the third quarter of 2008 and during the first quarter of 2009, expense reduction initiatives were implemented in order to reduce the Company’s operating expenses. The goal of these initiatives was to achieve enhanced efficiency and an overall reduction in operating expenses by streamlining processes across all geographic locations, with a primary emphasis on corporate functions. To date, this has been achieved through redundancies, increased outsourcing and the cessation of certain projects and activities. Charges have been recognized and accrued as restructuring and asset impairment charges and allocated to the Company’s reportable segments in accordance with authoritative guidance over accounting for costs associated with exit or disposal activities and guidance over accounting for the impairment or disposal of long-lived assets. Other costs that do not meet the criteria for accrual are being expensed as restructuring charges as they are incurred. Restructuring charges relate mainly to employee termination benefits as well as costs associated with ceasing to use certain leased property accounted for as operating leases. Asset impairment charges relate primarily to the write-off of certain IT system and equipment costs previously capitalized. The Company recognizes an asset impairment charge when net proceeds expected from disposition of an asset are less than the carrying value of the asset and reduces the carrying amount of the asset to its estimated fair value. Restructuring and asset impairment charges noted above have been recorded in the Company’s income statement under “Operating Expenses”.

Total estimated costs the Company expects to incur in connection with the restructuring initiatives noted above as well as costs incurred during the nine months ended September 30, 2009 and total cumulative costs incurred through September 30, 2009 are as follows:

 

(U.S. dollars in millions)

(Unaudited)

   Total
Expected
Costs
   Costs Incurred
During the Three
Months Ended
September 30,
2009
   Costs Incurred
During the Nine
Months Ended
September 30,
2009
   Cumulative
Costs Incurred
through
September 30,
2009

Employee Termination Benefits

   $ 89.8    $ 6.2    $ 33.7    $ 77.5

Lease Termination and Other Costs

     15.7      1.1      8.1      14.7

Asset Impairment

     22.1      1.4      17.3      17.7
                           

Total

   $ 127.6    $ 8.7    $ 59.1    $ 109.9
                           

These costs are allocated to the Company’s segments as follows:

 

(U.S. dollars in millions)

(Unaudited)

   Total
Expected
Costs
   Costs Incurred
During the Three
Months Ended
September 30,
2009
   Costs Incurred
During the Nine
Months Ended
September 30,
2009
   Cumulative
Costs Incurred
through
September 30,
2009

Insurance (1)

   $ 83.0    $ 6.5    $ 41.7    $ 68.7

Reinsurance (1)

     13.6      1.1      8.3      12.2

Corporate

     31.0      1.1      9.1      29.0
                           

Total

   $ 127.6    $ 8.7    $ 59.1    $ 109.9
                           

 

(1) Includes allocated restructuring charges associated with eliminating the XL Financial Solutions business unit.

Activity related to restructuring and asset impairment charges for the nine months ended September 30, 2009 was as follows:

 

(U.S. dollars in millions)

(Unaudited)

   Accrual at
December 31,
2008
   Costs Incurred
During the Nine
Months Ended

September 30,
2009
   Amounts Paid and
Assets Impaired
During the
Nine Months Ended
September 30, 2009
   Balance of
Liability
at September 30,
2009

Employee Termination Benefits

   $ 4.4    $ 33.7    $ 29.5    $ 8.6

Lease Termination and Other Costs

     5.3      8.1      9.4      4.0

Asset Impairment

     —        17.3      17.3      —  
                           

Total

   $ 9.7    $ 59.1    $ 56.2    $ 12.6
                           

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

6. Investments

The cost (amortized cost for fixed maturities and short-term investments), fair value, gross unrealized gains, gross unrealized (losses), and OTTI recorded in AOCI of the Company’s investments at September 30, 2009 and December 31, 2008 were as follows:

 

          Included in Accumulated Other Comprehensive
Income (“AOCI”)
     
               Gross Unrealized Losses      

September 30, 2009

(U.S. dollars in thousands)

(Unaudited)

   Cost or
Amortized
Cost
   Gross
Unrealized
Gains
   Related to
changes in
estimated
fair value
    OTTI included
in other
comprehensive
income
(Loss)(1)
    Fair Value

Fixed maturities

            

U.S. Government and Government agency

   $ 4,139,385    $ 132,065    $ (19,116   $ —        $ 4,252,334

Corporate (2)

     10,603,610      330,399      (673,444     (126,485     10,134,080

Residential mortgage-backed securities – Agency

     4,079,443      114,724      (6,252     —          4,187,915

Residential mortgage-backed securities – Non-Agency

     2,416,324      11,006      (593,880     (221,276     1,612,174

Commercial mortgage-backed securities

     1,798,103      5,211      (135,583     (17,122     1,650,609

Collateralized debt obligations

     1,042,179      8,499      (486,029     (10,744     553,905

Other asset-backed securities

     1,017,113      20,312      (78,957     (10,983     947,485

U.S. States and political subdivisions of the States

     612,709      23,719      (9,124     —          627,304

Non-U.S. Sovereign Government

     3,876,734      169,149      (46,279     —          3,999,604
                                    

Total fixed maturities

   $ 29,585,600    $ 815,084    $ (2,048,664   $ (386,610   $ 27,965,410
                                    

Total short-term investments

   $ 1,973,189    $ 18,337    $ (1,296   $ —        $ 1,990,230
                                    

Total equity securities

   $ 47,755    $ 7,480    $ (136   $ —        $ 55,099
                                    

 

(1) Represents the amount of OTTI losses in AOCI, which from April 1, 2009 was not included in earnings by authoritative accounting guidance.
(2) Included within Corporate are certain floating rate medium term notes supported primarily by pools of European corporate bonds with varying degrees of leverage. The notes have a fair value of $565.3 million and an amortized cost of $730.5 million. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

6. Investments (Continued)

 

 

          Included in Accumulated Other Comprehensive
Income (“AOCI”)
    
               Gross Unrealized Losses     

December 31, 2008

 

(U.S. dollars in thousands)

(Unaudited)

   Cost or
Amortized
Cost
   Gross
Unrealized
Gains
   Related to
changes in
estimated
fair value
    OTTI included
in other
comprehensive
income
(Loss)
   Fair Value

Fixed maturities

             

U.S. Government and Government agency

   $ 3,649,168    $ 334,302    $ (5,128   $ —      $ 3,978,342

Corporate (1)

     11,187,246      80,049      (1,978,692     —        9,288,603

Residential mortgage-backed securities – Agency

     2,039,783      62,638      (2,466     —        2,099,955

Residential mortgage-backed securities – Non-Agency

     2,873,478      15,975      (951,507     —        1,937,946

Commercial mortgage-backed securities

     2,505,698      1,200      (365,330     —        2,141,568

Collateralized debt obligations

     1,100,358      3,521      (465,100     —        638,779

Other asset-backed securities

     1,895,229      2,504      (189,725     —        1,708,008

U.S. States and political subdivisions of the States

     486,394      5,229      (22,853     —        468,770

Non-U.S. Sovereign Government

     3,253,123      224,094      (102,820     —        3,374,397
                                   

Total fixed maturities

   $ 28,990,477    $ 729,512    $ (4,083,621   $ —      $ 25,636,368
                                   

Total short-term investments

   $ 1,500,767    $ 4,258    $ (38,702   $ —      $ 1,466,323
                                   

Total equity securities

   $ 337,765    $ 31,632    $ (7,578   $ —      $ 361,819
                                   

 

(1) Included within Corporate are certain floating rate medium term notes supported primarily by pools of European corporate bonds with varying degrees of leverage. The notes have a fair value of $491.9 million and an amortized cost of $922.7 million. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.

The Company had gross unrealized losses and OTTI recorded in AOCI totaling $2.4 billion at September 30, 2009. Individual security positions comprising this balance have been evaluated by management, based on specified criteria, to determine if these impairments should be considered other than temporary. These criteria include an assessment of the severity and length of time securities have been impaired, along with management’s assessment as to whether it believes it can continue to hold such securities to recovery, among other factors included below.

At September 30, 2009 and December 31, 2008, approximately 4.9% and 2.5%, respectively, of the Company’s fixed income investment portfolio at fair value was invested in securities which were below investment grade or not rated. The increase in below investment grade or not rated securities is primarily due to rating agency action on residential mortgage-backed securities (“RMBS”) and hybrids. Approximately 34.5% of the unrealized losses in the Company’s fixed income securities portfolio at September 30, 2009 related to securities that were below investment grade or not rated. The information shown below about the unrealized losses on the Company’s investments at September 30, 2009 relates to the potential effect upon future earnings and financial position should management later conclude that some of the current declines in the fair value of these investments are other than temporary declines.

 

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XL CAPITAL LTD

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 

6. Investments (Continued)

 

The following is an analysis of how long each of those securities at September 30, 2009 had been in a continual unrealized loss position:

 

     Less than 12 months    Equal to or greater
than 12 months

September 30, 2009

(U.S. dollars in thousands)

(Unaudited)

   Fair Value    Gross
Unrealized
Losses
   Fair Value    Gross
Unrealized
Losses

Fixed maturities and short-term investments:

           

U.S. Government and Government agency

   $ 523,520    $ 19,065    $ 25,392    $ 968

Corporate (1)

     759,787      121,062      3,490,236      678,939

Residential mortgage-backed securities – Agency

     210,054      6,040      1,334      212

Residential mortgage-backed securities – Non-Agency

     237,295      88,946      1,299,283      726,210

Commercial mortgage-backed securities

     43,513      15,026      1,351,064      137,679

Collateralized debt obligations

     48,829      20,652      505,622      476,121

Other asset-backed securities

     78,958      21,108      456,374      68,832

U.S. States and political subdivisions of the States

     37,139      1,166      57,521      7,958

Non-U.S. Sovereign Government

     319,597      5,206      512,367      41,380
                           

Total fixed maturities and short-term investments

   $ 2,258,692    $ 298,271    $ 7,699,193    $ 2,138,299
                           

Total equity securities

   $ 1,864    $ 136    $ —      $ —  
                           

 

(1) Included within Corporate are certain floating rate medium term notes supported primarily by pools of European corporate bonds with varying degrees of leverage. The notes have a fair value of $569.0 million and an amortized cost of $729.5 million. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.

The following is an analysis of how long each of those securities at December 31, 2008 had been in a continual unrealized loss position:

 

     Less than 12 months    Equal to or greater
than 12 months

December 31, 2008

(U.S. dollars in thousands)

(Unaudited)

   Fair Value    Gross
Unrealized
Losses
   Fair Value    Gross
Unrealized
Losses

Fixed maturities and short-term investments:

           

U.S. Government and Government agency

   $ 103,040    $ 7,214    $ —      $ —  

Corporate (1)

     3,641,376      633,371      4,005,267      1,363,661

Residential mortgage-backed securities – Agency

     32,279      1,276      3,162      1,190

Residential mortgage-backed securities – Non-Agency

     1,036,527      452,246      947,017