Will XL Sell Off Financial Guaranty Unit?

Unfavorable arbitration ruling draws mixed reaction from analysts, prompts speculation

Could XL Capital's well-documented troubles turn out to be a blessing very well disguised, as one leading property-casualty analyst suggested last week?

The Nov. 28 downgrade of Bermuda-based XL Capital Ltd. by Standard & Poor's–stemming from an unfavorable acquisition-related arbitration award–could lead to the Bermuda-based carrier shedding its financial guaranty business through either a sale or IPO spinoff, according to Bank of America p-c analyst Brian Meredith.

The resulting redeployment of an estimated $900 million to more profitable and less capital-intensive lines of businesses could sweeten returns on equity for years to come, he asserted.

Nonetheless, to many analysts, the fact that XL Capital will be receiving $575 million instead of an anticipated $1.45 billion as a result of an arbitration finding on the value of certain recoverables connected to XL's acquisition of Winterthur Swiss Insurance Company in 2001 was not a cause for celebration.

Even Mr. Meredith said that the action in the short term will “further damage the already damaged credibility of XL's management. XL's management was confident that they would win arbitration, and spent a lot of time and money on consultants to come up with their estimate.”

Bear Stearns p-c analyst David Small said “investors will likely be shocked by this news,” noting that management had repeatedly expressed confidence it would win the arbitration. “Most investors we have spoken with over the past several months had handicapped XL's chances of prevailing at 70 percent to 90 percent,” he wrote.

On Nov. 25, XL Capital Chief Executive Officer Brian O'Hara said he had received a draft actuarial report from an independent actuary in connection with the arbitration over the disputed value of reinsurance recoverables relating to its acquisition in 2001 of certain Winterthur Swiss Insurance Company subsidiaries. XL said the actuary's report indicates Winterthur's seasoned net reserve and net premium recoverable amounts are closer to the independent actuary's estimate than to XL's.

“Since last February, management had repeatedly stated they expected to win and had reflected their estimate of approximately $1.45 billion in recoverables on the balance sheet,” Mr. Small wrote.

Instead, Winterthur is expected to pay XL $575 million (including interest) for the net losses and unearned premium balances relating to the acquired business. That lower payment is expected to result in XL recording a net charge of about $830 million for the fourth quarter, Mr. O'Hara said.

Mr. Small said such a charge would wipe out about 13 percent of book value and call into question XL's underwriting capacity as the renewal season approaches. XL might have to cut back on underwriting unless it can complete some multibillion-dollar equity-raising effort in short order, he added.

(Indeed, on Dec. 1, XL Capital announced plans to sell approximately $2.15 billion in ordinary shares. In addition, the company plans to raise some $650 million in capital from an offering of equity security units. The money is being raised for “the replenishment of the capital base of certain…subsidiaries” following XL's third-quarter catastrophe losses, estimated losses related to Hurricane Wilma, and the Winterthur decision, the company said.

(“This action is being recommended as part of the company's previously announced capital planning initiatives to maintain XL's sound financial footing and to take full advantage of current property and casualty market conditions,” said Mr. O'Hara.)

Mr. Meredith said the arbitration developments could jeopardize the triple-A rating of XL's financial guaranty business if the entire operation is downgraded below the double-A level.

That is where the “blessing” might come into play. Mr. Meredith said that any spinning off of the financial guaranty business necessitated by that unit's failing to receive a triple-A rating could result in nearly $900 million of capital deployed to the carrier's traditional property insurance and reinsurance business. As an added bonus, he noted, XL would not have to meet some of the costly capital requirements for ratings that are not needed for that line.

“Bottom line, the transaction would increase XL's ROE, afford it some financial flexibility, and enable it to take advantage of current opportunities in the insurance and reinsurance marketplace,” he wrote.

He is still maintaining his “buy” recommendation since “the loss should not impact its business prospects in its traditional insurance and reinsurance business. XL still stands to be a major beneficiary of the firming property insurance and reinsurance market.”

Mr. Small, however, sees the share price–currently at around $73–losing 15-to-20 percent of its value, and is maintaining his “Underperform” valuation. Mr. Small has previously written that the hardening market everyone expects next year could be a disappointment to the insurance industry.

Mr. O'Hara tried to put the best face on the announcement and did not resort to potential blessings to do so.

“While extremely disappointing, the IA's draft report removes the uncertainty that has existed since the process began,” he said, asserting the acquisition was both a strategic and financial success.

“While extremely disappointing, the [independent actuary's] draft report removes the uncertainty that has existed since the process began.”

Brian O'Hara, CEO

XL Capital Ltd.

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Will XL Sell Off Financial Guaranty Unit?

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