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XL > SEC Filings for XL > Form 10-Q on 7-Nov-2012All Recent SEC Filings

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Form 10-Q for XL GROUP PLC


7-Nov-2012

Quarterly Report


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

GENERAL

On July 1, 2010, XL Group plc, an Irish public limited company ("XL-Ireland"), and XL Group Ltd. (now known as XLIT Ltd.), a Cayman Islands exempted company ("XL-Cayman"), completed a redomestication transaction in which all of the ordinary shares of XL-Cayman were exchanged for all of the ordinary shares of XL-Ireland (the "Redomestication"). As a result, XL-Cayman became a wholly owned subsidiary of XL-Ireland. Prior to July 1, 2010, unless the context otherwise indicates, references in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" to the "Company" are to XL-Cayman and its consolidated subsidiaries. On and subsequent to July 1, 2010, unless the context otherwise indicates, references herein to the "Company" are to XL-Ireland and its consolidated subsidiaries.

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

This "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains forward-looking statements that involve inherent risks and uncertainties. Statements that are not historical facts, including statements about the Company's beliefs and expectations, are forward-looking statements. These statements are based upon current plans, estimates and expectations. Actual results may differ materially from those projected in such forward-looking statements, and therefore undue reliance should not be placed on them. See "Cautionary Note Regarding Forward-Looking Statements" for a list of additional factors that could cause actual results to differ materially from those contained in any forward-looking statement, as well as Item 1, "Risk Factors," included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

This discussion and analysis should be read in conjunction with the "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the audited Consolidated Financial Statements and Notes thereto, presented under Item 7 and Item 8, respectively, of the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

EXECUTIVE OVERVIEW

See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Overview," included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011. That discussion is updated with the disclosures set forth below.

RESULTS OF OPERATIONS AND KEY FINANCIAL MEASURES

Results of Operations

     The following table presents an analysis of the Company's net income
available to ordinary shareholders and other financial measures (described
below) for the three and nine months ended September 30, 2012 and 2011:


                                                  Three Months Ended         Nine Months Ended
(U.S. dollars in thousands, except share and         September 30,             September 30,
per share amounts)                                 2012         2011         2012         2011
                                                ----------    ---------    ---------    ---------
Net income (loss) attributable to ordinary
shareholders                                    $  171,902    $  42,398    $ 569,686    $  40,777
Earnings (loss) per ordinary share - basic      $     0.57    $    0.14    $    1.84    $    0.13
Earnings (loss) per ordinary share - diluted    $     0.56    $    0.14    $    1.82    $    0.13
Weighted average number of ordinary shares
and ordinary share equivalents - basic             304,199      311,714      309,675      310,793
Weighted average number of ordinary shares
and ordinary share equivalents - diluted           307,764      313,848      312,602      314,842


Key Financial Measures

     The following are some of the financial measures management considers
important in evaluating the Company's operating performance in the Company's P&C
operations:


                                           Three Months Ended                   Nine Months Ended
                                              September 30,                       September 30,
(U.S. dollars in thousands,         ---------------------------------    -------------------------------
except ratios)                           2012               2011              2012             2011
                                    ---------------    --------------    --------------    -------------
Underwriting profit (loss) - P&C
operations                          $       114,203    $      (22,200 )  $      306,815    $    (283,215 )
Combined ratio - P&C operations                92.2 %           101.6 %            92.7 %          107.2 %
Net investment income - P&C
operations (1)                      $       166,001    $      209,757    $      544,203    $     627,492
Annualized return on average
ordinary shareholders' equity
(2)                                             6.8 %             1.7 %             7.7 %            0.6 %

                                                                               September 30, 2012
                                                                         -------------------------------
                                     September 30,      December 31,         Change           Change
(U.S. dollars)                           2012               2011          Three Months      Nine Months
                                    ---------------    --------------    --------------    -------------
Book value per ordinary share
(3)                                 $         34.63    $        29.81    $         2.36    $        4.82
Fully diluted book value per
ordinary share (4)                  $         34.16    $        29.59    $         2.20    $        4.57



(1) Net investment income relating to P&C operations includes the net investment income related to the net results from structured products.
(2) Annualized return on average ordinary shareholders' equity ("ROE") is a non-GAAP financial measure and is calculated by dividing the net income
(loss) for the year by the average of the opening and closing ordinary shareholders' equity. See "Annualized Return on Ordinary Shareholders' Equity Calculation" at the end of this Item 2 for a reconciliation of ROE to average ordinary shareholders' equity.
(3) Book value per ordinary share, a non-GAAP financial measure, is calculated by dividing ordinary shareholders' equity (total shareholders' equity less non-controlling interest in equity of consolidated subsidiaries) by the number of outstanding ordinary shares at the applicable period end. Book value per ordinary share is affected primarily by the Company's net income
(loss), by any changes in the net unrealized gains and losses on its investment portfolio, by currency translation adjustments and also by the impact of any share buyback or issuance activity. Ordinary shareholders' equity was $10.4 billion and $9.4 billion and the number of ordinary shares outstanding was 300.6 million and 315.7 million at September 30, 2012 and December 31, 2011, respectively. Ordinary shares outstanding include all ordinary shares legally issued and outstanding (as disclosed on the face of the balance sheet) as well as all director share units outstanding.
(4) Fully diluted book value per ordinary share, a non-GAAP financial measure, represents book value per ordinary share combined with the dilutive impact of potential future share issuances at period end. The Company believes that book value per share and fully diluted book value per ordinary share are financial measures important to investors and other interested parties. However, these measures may not be comparable to similarly titled measures used by companies either outside or inside of the insurance industry.

Underwriting profit - property and casualty ("P&C") operations

One way that the Company evaluates the performance of its insurance and reinsurance operations is by underwriting profit or loss. The Company does not measure performance based on the amount of gross premiums written. Underwriting profit or loss is calculated from premiums earned less net losses incurred and expenses related to underwriting activities. The Company's underwriting profit for the three and nine months ended September 30, 2012 was consistent with the combined ratio discussed below.

Combined ratio - P&C operations

The combined ratio for P&C operations is used by the Company and many other insurance and reinsurance companies as another measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company's insurance and reinsurance operations. A combined ratio of less than 100% indicates an underwriting profit and greater than 100% reflects an underwriting loss. The Company's combined ratio for the three and nine months ended September 30, 2012 is lower than for the same periods in the previous year, as a result of a decrease in the loss and loss expense ratio partially offset by a marginal increase in the underwriting expense ratio. The loss and loss expense ratio, which is the ratio of losses and loss expenses incurred to net premiums earned, has decreased as a result of overall lower levels of catastrophe losses and other large loss events for the three and nine months ended September 30, 2012 as compared to the same periods of 2011. The increased underwriting expense ratio, which is the ratio of the sum of acquisition expenses and operating expenses to the net premiums earned, is reflective of the additional costs incurred from strategic initiatives and compensation costs.

Net investment income - P&C operations

Net investment income related to P&C operations is an important measure that affects the Company's overall profitability. The largest liability of the Company relates to its unpaid loss reserves, and the Company's investment portfolio provides liquidity for claims settlements of these reserves as they become due. As a result, a significant part of the investment portfolio is invested in fixed income securities. Net investment income is influenced by a number of factors, including the amounts and timing of inward and outward cash flows, the level of interest rates and credit spreads and changes in overall asset allocation.


Annualized return on average ordinary shareholders' equity ("ROE")

ROE is another non-GAAP financial measure that management considers important in evaluating the Company's operating performance. ROE is calculated by dividing the net income attributable to ordinary shareholders for any period by the average of the opening and closing ordinary shareholders' equity. The Company establishes minimum target ROEs for its total operations, segments and lines of business. If the Company's minimum ROE targets over the longer term are not met with respect to any line of business, the Company seeks to modify and/or exit this line. In addition, among other factors, the Company's compensation of its senior officers is dependent on the achievement of the Company's performance goals to enhance ordinary shareholder value as measured by ROE (adjusted for certain items considered to be "non-operating" in nature). For the nine months ended September 30, 2012, annualized ROE was 7.7%, which is 7.1 percentage points higher than the same period in the prior year, due primarily to the lower net income attributable to ordinary shareholders in the prior period as a result of natural catastrophe losses. See "Annualized Return on Ordinary Shareholders' Equity Calculation" herein for the calculation of annualized ROE to average ordinary shareholders' equity.

Book value per ordinary share

Management also views the change in the Company's book value per ordinary share as an additional measure of the Company's performance. Book value per ordinary share, a non-GAAP financial measure, is calculated by dividing ordinary shareholders' equity (total shareholders' equity less non-controlling interest in equity of consolidated subsidiaries) by the number of outstanding ordinary shares at the applicable period end. Book value per ordinary share is affected primarily by the Company's net income (loss), by any changes in the net unrealized gains and losses on its investment portfolio, by currency translation adjustments and by the impact of any share buyback or issuance activity. Ordinary shareholders' equity was $10.4 billion and $9.4 billion and the number of ordinary shares outstanding was 300.6 million and 315.7 million at September 30, 2012 and December 31, 2011, respectively. Ordinary shares outstanding include all ordinary shares legally issued and outstanding (as disclosed on the face of the balance sheet) as well as all director share units outstanding.

Book value per ordinary share increased by $2.36 in the three months ended September 30, 2012 and by $4.82 in the nine months ended September 30, 2012. These increases were due to the net income in both periods, an increase in net unrealized gains on investments and the benefit of share buyback activity. In the three months ended September 30, 2011 book value per share decreased by $0.53 as compared to the comparable period of 2010, primarily due to the issuance of ordinary shares in connection with the settlement of the forward purchase contracts associated with the 10.75% Units, partially offset by the benefit of share buyback activity, the net income attributable to ordinary shareholders and an increase in net unrealized gains on available for sale investments. In the nine months ended September 30, 2011 book value per share increased by $0.64 mainly due to the net income attributable to ordinary shareholders, an increase in net unrealized gains on available for sale investments, and the benefit of share buyback activity, partially offset by the settlement of the forward purchase contracts associated with the 10.75% Units.

Fully diluted book value per ordinary share

Fully diluted book value per ordinary share, a non-GAAP financial measure, represents book value per ordinary share combined with the dilutive impact of potential future share issuances at period end. In the three and nine months ended September 30, 2012, fully diluted book value per ordinary share increased by $2.20 and $4.57, respectively, as a result of the factors contributing to the increase in book value per share noted above. In the three months ended September 30, 2011 fully diluted book value per ordinary share decreased by $0.07 and in the nine months ended September 30, 2011, fully diluted book value per ordinary share increased by $1.02 as compared to the same periods in the prior year, as a result of the factors contributing to the three month decrease and nine month increase in book value per share noted above.


SIGNIFICANT ITEMS AFFECTING THE RESULTS OF OPERATIONS

The Company's net income and other financial measures as shown above for the three and nine months ended September 30, 2012 have been affected by, among other things, the following significant items:

1) the impact of significant large loss events;

2) market movement impacts on the Company's investment portfolio; and

3) continuing competitive factors impacting the underwriting environment.

1) The impact of significant large loss events

The Company had a P&C underwriting profit of $114.2 million and $306.8 million for the three and nine months ended September 30, 2012, respectively, compared to P&C underwriting losses of $22.2 and $283.2 million for the same periods of 2011, respectively. The increase in underwriting profit in the three and nine months ended September 30, 2012 was primarily due to lower levels of natural catastrophe losses and lower non-catastrophe large loss activity in energy, property and marine business units as explained further below.

Natural Catastrophe Losses

For the three months ended September 30, 2012, natural catastrophe losses net of reinsurance recoveries and reinstatement premiums were $32.0 million, compared to $110.6 million in the same period of 2011.

For the nine months ended September 30, 2012, natural catastrophe losses net of reinsurance recoveries and reinstatement premiums were $112.5 million, compared to $566.3 million in the same period of 2011. Natural catastrophe losses in the nine months ended September 30, 2011 included the March 11, 2011 earthquake and tsunami in Japan, the earthquake that struck Christchurch, New Zealand on February 22, 2011, the 2011 flooding events in Australia, the severe weather occurrences, including tornado activity, in the United States over the periods April 22 - 28 and May 20 - 23, 2011 and the Atlantic Hurricanes (Hurricane Irene and Tropical Storm Lee).

Large Loss Events

In the nine months ended September 30, 2012, the results from operations were impacted by significant losses from large non-catastrophe loss events in both the Insurance and Reinsurance segments. In 2012, the impact was mainly related to a single large marine loss during the first quarter. Management's preliminary loss estimate for this large marine loss at September 30, 2012, net of reinsurance recoveries and reinstatement premiums, was $46.6 million, of which $24.3 million was attributable to the Insurance segment and $22.3 million to the Reinsurance segment. In addition, the results from operations during the nine months ended September 30, 2012 were affected by crop losses attributable to the severe drought conditions in the U.S. in 2012. Management's preliminary loss estimate for these drought and crop losses net of reinsurance recoveries and reinstatement premiums was $26.1 million, all attributable to the Company's Reinsurance segment.

See "Income Statement Analysis," herein for further information regarding these large loss events within each of the Company's operating segments.

Subsequent Event

In late October 2012, Post-Tropical Cyclone Sandy made landfall in the United States. Given its recent occurrence and the limited information available, it is too early for the Company to arrive at a reasonable estimate of the amount of any possible losses from this event. The impact of this event will be reflected in our fourth quarter 2012 results.



2) Market movement impacts on the Company's investment portfolio

During the three months ended September 30, 2012, credit spreads tightened combined with decreasing interest rates. The net impact of the market conditions on the Company's investment portfolio for the three months was favorable and resulted in an increase of $512.0 million in net unrealized gains on available for sale investments as compared to June 30, 2012. This represents an approximately 1.1% appreciation in average assets for the three months ended September 30, 2012.

The following table provides further detail regarding the movements in relevant credit markets, as well as in government interest rates using selected market indices:

                       Interest Rate Movement for     Credit Spread Movement for
                            the three months               the three months
                        ended September 30, 2012       ended September 30, 2012
                                   (1)                            (2)
                           ('+'/'-' represents            ('+'/'-' represents
                          increases / decreases          widening / tightening
                           in interest rates)             of credit spreads)
                       ---------------------------    ---------------------------
United States          -9 basis points (5 year        -48 basis points (US
                       Treasury)                      Corporate A rated)
                                                      -56 basis points (US
                                                      Mortgage Master Index)
                                                      -51 basis points (US CMBS,
                                                      AAA rated)
United Kingdom         -1 basis points (10 year       -41 basis points (UK
                       Gilt)                          Corporate, AA rated)
Euro-zone              -10 basis points (5 year       -54 basis points (Europe
                       Bund)                          Corporate, A rated)



(1) Source: Bloomberg Finance L.P.
(2) Source: Merrill Lynch Global Indices.

Net realized losses on investments in the three months ended September 30, 2012 totaled $5.5 million, including net realized losses of approximately $12.6 million related to OTTI charges on certain of the Company's fixed income investments. For further analysis of this, see "Results of Operations" below.

During the nine months ended September 30, 2012, credit spreads tightened combined with decreasing interest rates. The net impact of the market conditions on the Company's investment portfolio for the nine-month period was favorable and resulted in an increase of $881.9 million in net unrealized gains on available for sale investments as compared to December 31, 2011. This represents an approximately 2.0% appreciation in average assets for the nine months ended September 30, 2012.

The following table provides further detail regarding the movements in relevant credit markets, as well as in government interest rates using selected market indices:

                        Interest Rate Movement for      Credit Spread Movement for
                             the nine months                 the nine months
                       ended September 30, 2012 (1)    ended September 30, 2012 (2)
                           ('+'/'-' represents         ('+'/'-' represents widening
                          increases / decreases                / tightening
                            in interest rates)              of credit spreads)
                       ----------------------------    ----------------------------
United States          -21 basis points (5 year        -100 basis points (US
                       Treasury)                       Corporate A rated)
                                                       -63 basis points (US
                                                       Mortgage Master Index)
                                                       -109 basis points (US CMBS,
                                                       AAA rated)
United Kingdom         -25 basis points (10 year       -58 basis points (UK
                       Gilt)                           Corporate, AA rated)
Euro-zone              -25 basis points (5 year        -139 basis points (Europe
                       Bund)                           Corporate, A rated)



(1) Source: Bloomberg Finance L.P.
(2) Source: Merrill Lynch Global Indices.

Net realized gains on investments in the nine months ended September 30, 2012 totaled $2.9 million, including net realized losses of approximately $61.8 million related to OTTI charges on certain of the Company's fixed income investments. For further analysis of this, see "Results of Operations" below.

3) Continuing competitive factors impacting the underwriting environment

Insurance

The trading environment for the core lines of insurance business written by the Company remains competitive, although the gradual rate improvement which began in the second half of 2011 has been sustained through the first nine months of 2012. Gross premiums written in the Insurance segment increased in the three months ended September 30, 2012 as compared to the same period in 2011 by 2.5% after adjusting for changes in foreign exchange rates. This premium increase was partly driven by improved pricing and also from new business in NAPC construction and surplus lines, U.S. D&O, as well as growth in the new political risk and trade credit business.

Improved pricing contributed to the premium growth in the third quarter with an overall 3.3% rate increase. Rate improvement occurred in nearly all of the segment's businesses. NAPC rates improved by almost 8% led by double digit increases in excess casualty and surplus lines businesses, Professional increased by over 2% driven by U.S. D&O, architects & engineers and miscellaneous professional liability, and Specialty pricing increased by low single digits. Only IPC was flat to slightly down, driven by competitive conditions in both its property and casualty businesses.

Reinsurance

Gross premiums written in the Reinsurance segment decreased in the three months ended September 30, 2012 as compared to the same period in 2011 by 30.8% after adjusting for changes in foreign exchange rates. This premium decrease was predominantly driven by changes in the structure of a U.S. agricultural program, which renewed as a reinsurance treaty rather than a primary facility with significant ceded premiums. Normalizing for foreign exchange movements and excluding the U.S. agricultural program premiums for both years, gross premiums written increased by 1.6% due to premium increases in the Bermuda and International business groups, partially offset by selected cancelations in the U.S. and Latin America portfolios due to the re-underwriting actions in these regions.

Both the primary and reinsurance markets remain highly competitive with substantial capacity available in both traditional and non-traditional forms. In general, July 1 renewals saw pricing in line with management's expectations, except for the U.S. catastrophe book where the level of risk adjusted improvement was lower than expected due to a relatively benign hurricane season. However, given the likely industry losses relating to Post-Tropical Cyclone Sandy in the United States at the end of October 2012, it is possible that year-end pricing will be impacted.

There can be no assurance, however, that such (re)insurance rate conditions or growth opportunities will be sustained or further materialize, or lead to improvements in our books of business. See "Cautionary Note Regarding Forward-Looking Statements." The Company continues its disciplined underwriting approach to grow on a very selective basis and exit lines where margins are unacceptable.


OTHER KEY FOCUSES OF MANAGEMENT

The Company remains focused on, among other things, managing its capital and enhancing its enterprise risk management capabilities. Details of these and other initiatives are outlined below.

Capital Management

Fundamental to supporting the Company's business model is its ability to underwrite business, which is largely dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company is downgraded, its ability to write business, as well as its financial condition and/or results of . . .

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