Fitch Affirms XL Subsidiaries IFS Ratings

Fitch Ratings announced that it has affirmed the “AAA” insurer financial strength (IFS) ratings of XL Capital Assurance Inc. (XLCA), its subsidiary XL Capital Assurance (U.K.) Limited and affiliate XL Financial Assurance Ltd (XLFA). XLCA is wholly owned by XL Capital Ltd (XL Capital, senior debt ‘A’). XLFA is 87 percent owned by XL Insurance (Bermuda) Ltd (XLI; ‘AA’ IFS rating) and 13 percent ultimately owned by Financial Security Assurance Holdings Ltd. (FSA Holdings; ‘AA’ long-term debt rating). The rating outlook for all ratings is stable.

Fitch’s analysis of the various rating factors is as follows:

The ‘AAA’ IFS ratings reflect each company’s committed long-term ownership from XL Capital, strong credit quality of the insured portfolio, the arm’s length reinsurance treaty between XLCA and XLFA, a stable and growing revenue stream, and adequate capital resources. Ongoing concerns include a less diversified portfolio than more established peers, improving but relatively low profitability compared to industry peers and XLCA’s continuing challenge to establish a recognized brand name in the primary financial guaranty market during a time of increased industry competition.

XLCA is a direct writer of structured finance, municipal bonds and international project financings. XLCA maintains significantly less capital resources than its industry competitors, but it offsets this concern by ceding up to 90% of its premium and exposure to affiliate XLFA. XLFA is a Bermuda-based monoline financial guaranty reinsurer that derives the majority of its business from XLCA, but also assumes business from Financial Security Assurance Inc. (FSA), and other third party financial guarantors. From a ratings perspective, the non-XLCA assumed business has typically been lower than exposure insured by XLCA. While this business has been underwritten to standards reflective of an ‘AAA’ IFS rating, it is concentrated in lower-rated structured finance transactions and non-proportional layered loss reinsurance, the majority of which was assumed from FSA.

Because of the interdependent nature of XLCA and XLFA, as well as their majority ownership by XL Capital, Fitch views their ratings as closely linked and analyzes their operational and capital strength on a reported aggregate basis. At June 30, 2004, aggregate in force par for XLCA and XLFA was $49.6 billion. The weighted average credit quality of the aggregated portfolio for XLFA and XLCA was ‘A’ at June 30, 2004, stable with prior year and in line with the more established ‘AAA’ primary financial guarantors. Like its competitors, XLCA and XLFA have exposure to some impaired credits but Fitch believes these are manageable at the present time. Backing the insured portfolio is aggregate statutory capital of $662.2 million. On an aggregated basis, XLCA and XLFA net par leverage (net in force par / total statutory capital) was 75:1 as of June 30, 2004, which is conservative relative to an industry average of 100:1. In addition to the hard capital resources discussed above, in December 2004 XLFA issued $200 million of soft capital pass-through trust securities, rated ‘AA’ by Fitch.

Aggregated reported earnings for XLCA and XLFA have shown improvement, but return on equity (ROE) continues to lag the major players in the industry, demonstrating that the companies have not fully emerged from a start-up mode. For the first six months of 2004, aggregated core net income (which backs out from net income preferred dividends, the impact of unrealized marks to market on the credit default swap portfolio, and includes revenues and expenses on credit default swaps or CDS) for XLCA and XLFA was $27.5 million which produced a return on aggregated reported equity of 10 percent, which while improved, is below expected industry returns of 12 to 14 percent. Fitch expects returns to continue to improve over time, aided by growth in insured production.