Losses of over $1bn and a disappointing Winterthur outcome have not swayed XL's unstinting confidence in its future performance, reports Nigel Allen

"We will restore our historically strong balance sheet," asserted Brian O'Hara, president and chief executive of XL Capital, following the announcement that the company had incurred net losses for the third quarter of over $1bn. There are not many company CEOs that could make such a confident assertion after such a financial drubbing. But while there is little doubt that XL will be able to rebuild its financial base, the question is how quickly this restoration process will be completed and how radical will the changes be that bring it about?

Damage assessment

XL reported net losses for the third quarter of $1.05bn, due almost solely to the astronomical catastrophe losses experienced during the three months, which were estimated at $1.47bn, with Katrina and Rita accounting for $1.16bn and $263.6m respectively. While Wilma's impact will not be felt until the fourth quarter, estimated net losses have so far been put at $210m. Drilling down specifically into the Katrina loss, the hurricane resulted in a net loss on the insurance side of $497m, of which some 60% was from commercial property (compared to $40m from the Florida storms), while on the reinsurance side the hit was put at $628m.

While these figures are clearly significant, particularly when compared to the combined insurance and reinsurance catastrophe losses for the third quarter of 2004 which totalled $445.9m, it should be noted that XL has based these third quarter figures on a total market loss of $60bn-$72bn, higher than the industry average. The bottom line however remains that such a colossal financial loss equates to a hit of some $7.53 per ordinary share and a combined ratio of 182.2%.

The process begins

XL has moved quickly to try and shore up confidence in its underwriting strategy by announcing the implementation of three risk management measures designed to reduce volatility and produce enhanced risk-adjusted returns in 2006. The largest prong of the trident is the decision to establish a reinsurance quota share counterparty, Cyrus Re, in Bermuda. The recently licensed Class 3 entity, with initial funding of $500m, will reinsure XL's property catastrophe and retrocession business. While the time period for the entity is intended to be "flexible", Henry Keeling, CEO of XL Re, confirmed that it would exist for a minimum of two years.

Describing the decision to set up the quota share agreement as a "win-win" for both shareholders and investors, Jerry de St Paer, executive vice president and chief financial officer, explained that when they compared the economics of the cost of capital relative to the cost of raising capital, the former was considered more appealing. "This is a very attractive risk profile," he commented, "which is shared between the new vehicle and XL Capital." XL have been at pains to emphasise that the company will be keeping "a substantial catastrophe exposure" on its books, and are not looking to reduce involvement in this volatile sector. The property cat book has long proved profitable for XL, and the company believes it will remain so in 2006, but Keeling's comments reflected the fact that this market has undergone a fundamental change and the concerns regarding the potential impact of the new rating capital adequacy requirements for catastrophe exposed books. "There is a new reality in terms of capital requirements and volatility that we have to address both for ourselves and our shareholders."

On the property risk book, efforts are underway to significantly reduce catastrophe exposures, which will involve either reducing participation on catastrophe exposed property risk accounts or cancelling them. Keeling is confident that catastrophe pricing and exposure adjusted rates will see significant upwards pressure on a global basis, and will be pushing for improved terms and conditions, "especially with tighter restatement provisions and occurrence limits."

It is perhaps on the marine side, though, that XL's strategy will undergo the most significant rethink. XL's market share on the marine excess of loss side is markedly higher than on the property catastrophe side, and with the well-documented deficiencies in the performance of the models particularly evident on the marine accounts, it is not surprising the company believes that this sector requires "fundamental" change in the way in which reinsurance programmes are constructed and purchased. "This new paradigm," believes Keeling, "will increase rates, segregate lines of coverage, control cat exposures and require more diligent risk management and underwriting by primary cedants."

Counting on capital

XL detailed the structure of its capital-raising exercise on 1 December, which involved the sale of almost 34 million ordinary shares, with a further five million additional optional shares, plus the sale of $745m of equity security units for a total expected gross proceeds figure of $2.9bn. Days after this announcement, the company confirmed that the underwriters on the capital-raising measures had exercised the option to purchase the extra 5 million shares, raising the expected proceeds to $3.2bn.

But it is not the amount that is attracting most comment, but rather the fact that XL have waited so long to enter the capital markets. There is a danger that by being later to the market than many of its peers XL may struggle to raise the required capital and have it in place in time to exploit the predicted rate increases in the January renewals, particularly with the spurt of new start-ups vying for capital. However, XL is confident that capital can be raised quickly. "We believe we will have access to the market in a volume sufficient to support our business plan," the company confirmed during the third quarter conference call, "and we have confidence that we can go into the renewals with that capital behind us." Furthermore, going to the market later without any potential "overhang" or financial surprises clearly presents a more attractive front to investors. As the Winterthur issue was still unresolved at that time, with hindsight the decision to hold off appears to have been a wise one following the announcement by the independent actuary that XL would only be receiving $575m as opposed to its original estimate of $1.45bn (see box 1). This confidence in XL's ability to raise capital before the renewals is also echoed in the comments of the rating agencies, with Fitch Ratings affirming XL's ratings at the end of November, despite the Winterthur decision, stating that it had based the action on its "expectation that XL will promptly implement capital-raising actions to offset the impact of this Q4 loss, as well as a substantial portion of recent catastrophe related losses." At the time of going to press Global Reinsurance had received unconfirmed reports that XL had succeeded in its capital-raising excercise.

But while confidence may remain strong in the company, a recent comment by Ron Frank of Citigroup on the Dow Jones Marketwatch, questioned whether there was still confidence in O'Hara, adding that not only were investors pushing for his resignation, but that one "leading rating agency" had also put its shoulder behind the push. XL moved quickly to quash these rumours, with a spokesperson for the company confirming that, "Brian O'Hara has the full support of the company and is totally committed to the stewardship of XL Capital, which is why he is out raising capital at the moment."

Fully restored

XL will restore its balance sheet to historically strong levels. Whether it takes two months, 12 months, 24 months or longer, there is no doubt of this. But while the balance sheet may return to its former state, it is clear that the underwriting strategies and the portfolio of business which underpin the figures will have changed to reflect a new market environment.

"We have laid out a plan of execution," said O'Hara, "that meets our needs to preserve financial strength and ratings, position us for growth with less volatility and increase returns in both the near term and the long term."

- Nigel Allen is editor of Global Reinsurance.


XL's confidence in a positive outcome from the long running financial wrangles relating to the acquisition of Wintherthur has been evident from day one, so the findings of the independent actuary at the beginning of December were clearly a shock to the system.

The acquisition of Winterthur International from Winterthur Swiss Insurance Co was completed in July 2001 for a cash sum put at approximately $405m.

At the time, O'Hara described the move as "a milestone in the company history," providing XL with a strong purchase in the European market.

However, conflict arose between the parties to the sale over the estimated seasoned net reserves amount, with XL and Winterthur each submitting figures to an independent actuary for evaluation. The disparity between the two sums was immense, with XL estimating the amount owed at $1.45bn, while Winterthur's analysis produced a figure of $541m - a difference of over $900m.

The issue was resolved on 6 December following the release of the independent auditor's final report, which will see Winterthur pay $575m plus interest to XL. The financial impact of the decision on XL's fourth quarter results is expected to be in the region of $830m. O'Hara, however, still stands by the decision to acquire the company, describing it as "critical" to XL's global expansion and reminding us that the acquisition was made just prior to a major hardening of the market.


On 28 November, Standard & Poor's announced that it had lowered the financial strength ratings on XL Capital's core companies to "A+" from "AA-" and removed them from CreditWatch. The rating action followed the release of the independent actuary's report on Winterthur and the expected $830m pre-tax charge in the fourth quarter for XL. The stable outlook on the new ratings however reflected the agency's strong belief that the company would be able to exploit hardening market conditions, and also reflected its faith in the company's ability to raise the necessary capital by the end of 2005.