Last week's announcement that XL Capital Ltd. would sever its financial commitments to Security Capital Assurance Ltd. is not sitting well with rating agencies, as the insurer also announced it will be going through a companywide realignment.

The news from the Bermuda-based firm comes as it reported that net income for the second quarter fell 57 percent.

All four major rating agencies--A.M. Best, Fitch, Moody's and Standard & Poor's--reacted negatively to the deal, which will have XL Capital end its relationship with SCA in a transaction where XL would pay the bond insurer $2 billion in cash and stock to terminate reinsurance agreements between them and commutate six existing contracts.

XL said the agreement eliminates $64.6 billion in exposure it had with SCA and its subsidiaries, XL Capital Assurance Inc. and XL Financial Assurance Ltd., which were once owned by XL.

The move makes SCA a solvent company, according to New York Insurance Superintendent Eric Dinallo, who said the operation had been in danger of going into receivership if the deal with XL had not been struck.

The chief executive officer of the Bermuda Monetary Authority, Matthew Elderfied, said in a statement: "We welcome this agreement, as it lifts a shadow of uncertainty from SCA and XL Capital and provides greater stability for the bond insurance industry."

However, XL will now have to raise money, and announced it plans to offer $2.5 billion in securities. XL said it will have to record a charge of between $1.4 billion and $1.5 billion during the third quarter because of the SCA deal.

After the announcement:

o A.M. Best put under review the "A (Excellent)" financial strength rating of XL with negative implications.

o Moody's also put the company's "A1" rating on review for possible downgrade.

Both Best and Moody's cited the capital-raising position the company is now placed in, as well as concerns over completing the deal in the current economic climate.

o Fitch downgraded the financial strength rating of SCA's XL insurance subsidiaries from "double-B" to "triple-C," citing uncertainty over completion of the deal.

o Standard & Poor's kept SCA's subsidiaries under credit watch with negative implications, noting the same concerns as Fitch.

As it announced the deal, XL also reported its second-quarter results.

Net income in the second quarter fell 57 percent ($317 million) to $238 million, or $1.34 a share, from $3 a share for the comparable period a year ago. Revenues dropped 18 percent ($472 million) to $2.12 billion. The combined ratio in the period jumped six points, from 86.3 last year to 92.3 in 2008.

For the first half, net income also dropped 57 percent ($635 million) to $482 million--translating to $2.54 a share, off $3.52 a share. Revenues dropped 15 percent ($781 million) to $4.3 billion. For the first half, the combined ratio deteriorated 4.7 points to 92.9.

The results were blamed by XL on the combination of strict underwriting and soft market pressures.

In a statement, XL CEO Michael S. McGavick announced several executive changes and other moves--including eventual reduction of the workforce.

He said the company would eliminate between $110 million and $120 million in operating expense to reduce its expense rate $70 million from current levels. He said the company would record a charge between $50 million and $60 million for the remainder of this year.

The reduction would affect all parts of the organization, "but the primary emphasis will be on streamlining corporate functions. This will be achieved through job eliminations, increased outsourcing and the cessation of certain projects and activities," according to Mr. McGavick.

The company said it will explore "strategic opportunities" related to its life insurance operations as part of its capital-raising commitment.

XL also said it is launching a five-year "operational transformation" to streamline operations and technology systems, hiring Accenture to provide consulting and tech services under a multiyear contract.

The insurer also announced the retirement of Henry Keeling, executive vice president and chief operating officer, who Mr. McGavick said will be replaced.

Meanwhile, earlier in the week, in what New York's superintendent called a precedent-setting agreement, the insurance department approved a $2 billion infusion of cash to SCA's XL Capital Assurance Inc., ensuring the bond insurer's solvency.

"It's a good agreement for everyone--for the Main Street municipal bond holders, for Wall Street policy or [credit default swap] holders, for the bond insurance industry," said Superintendent Dinallo.

During a telephone news conference, Mr. Dinallo said SCA has gone from being close to insolvent, to a solvent company with more than $1 billion in surplus.

Under the deal announced last week, Bermuda-based XL Capital Ltd., the former parent company of XLCA, will pay less than $2 billion, in a combination of cash and stock, to XLCA and XL Financial Assurance Ltd.

In return, existing financial guarantee and reinsurance arrangements among SCA and XLCA, XLFA and XL will be terminated, commuted or restructured.

The deal also calls for commutation of credit default swaps between Merrill Lynch, along with others trusts, SCA and XLCA, where eight CDS agreements will be commuted and litigation dismissed in exchange for a cash payment of $500 million.

The deal does not involve any funding from the state, according to Mr. Dinallo, who described this as a good template going forward because it avoids companies going into rehabilitation--something he said might have a negative impact on the bond insurance industry as a whole.

He said XLCA was in the most critical of positions, requiring the attention of the department, characterizing the company as "headed toward rehabilitation."

As for other bond insurers, he said the department is "actively working on other situations," adding there is the potential for another transaction.

Special Reports /

Rating Agencies Wary Of XL-SCA Move

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