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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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** **

**FORM 10-K**

 

| **(Mark One)** | ** **                                                                                                   |
|----------------|--------------------------------------------------------------------------------------------------------------|
| x              | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**     |
| ** **     | ** **                                                                                                   |
| ** **     | **For the fiscal year ended  December 31, 2008**                                                        |
| ** **     | ** **                                                                                                   |
| ** **     | **OR**                                                                                                       |
|           | ** **                                                                                                   |
| o              | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

** **

**For the transition periodfrom         to**

** **

**Commissionfile number 333-73012-04**

 

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**ONEBEACON U.S. HOLDINGS, INC.**

(Exact name of Registrant asspecified in its charter)

 

| **Delaware**  (State or other jurisdiction of  incorporation or organization)            | ** ** | **52-2272489**  (I.R.S. Employer  Identification No.) |
|------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|
| ** **                                                                               | ** ** | ** **                                            |
| **601 Carlson Parkway  Minnetonka, Minnesota**  (Address of principal executive offices) | ** ** | **55305**  (Zip Code)                                 |

 

Registrant’s telephone number, including areacode: **(952) 852-2431**

 

Securities registered pursuant to Section 12(b) ofthe Act:

 

| **Title  of each class** | ** ** | **Name  of each exchange on which registered** |
|--------------------------|------------|------------------------------------------------|
| None                     |       | None                                           |

 

Securitiesregistered pursuant to Section 12(g) of the Act

 

**5.875% Senior Unsecured Notes due 2013 of OneBeacon U.S.Holdings, Inc.**

 

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Indicate by check mark if the Registrant is a well-known seasonedissuer, as defined in Rule 405 of the Act. Yes o  No x

 

Indicate by check mark if the Registrant is not required to filereports pursuant to Section 13 or Section 15(d) of the ExchangeAct. Yes o  No x

 

Indicate by check mark whether the Registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the ExchangeAct during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of the Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

 

Indicate by check mark whether the Registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer,”and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer x(Do not check if a smaller reporting company) |   | Smaller reporting company o |
|---------------------------|--------|--------------------------|--------|---------------------------------------------------------------------------|--------|----------------------------------|

 

Indicate by check mark whether the Registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes o  No x

 

The aggregate market value of voting shares of Common Stock held bynon-affiliates of the registrant as of June 30, 2008 was $0, because allof the outstanding shares of Common Stock were owned by OneBeacon U.S.Enterprises Holdings, Inc., an indirect wholly-owned subsidiary ofOneBeacon Insurance Group, Ltd.

 

As of March 13, 2009, there were 505 outstanding shares of CommonStock, $1.00 par value per share, of the registrant.

 

The registrant meets the conditions set forth in GeneralInstruction (I) (1) (a) and (b) of Form 10-K andis therefore filing this Form with reduced disclosure format.

 

 

 

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Table of Contents

 
| ** ** | ** **                                                                                                           | **Page** |
|------------|----------------------------------------------------------------------------------------------------------------------|----------|
|       | **PART I**                                                                                                      |     |
| ITEM 1.    | Business*                                                                                                            | 1        |
|       | Overview                                                                                                             | 1        |
|       | Primary  Insurance Operations                                                                                        | 3        |
|       | Affiliate Quota Shares                                                                                               | 16       |
|       | Other Operations                                                                                                     | 16       |
|       | Investments                                                                                                          | 17       |
|       | Regulatory Matters                                                                                                   | 18       |
|       | Ratings                                                                                                              | 21       |
|       | Employees                                                                                                            | 21       |
|       | Available Information                                                                                                | 21       |
| ITEM 1A.   | Risk Factors                                                                                                         | 22       |
| ITEM 1B.   | Unresolved Staff  Comments                                                                                           | 31       |
| ITEM 2.    | Properties*                                                                                                          | 31       |
| ITEM 3.    | Legal Proceedings                                                                                                    | 31       |
| ITEM  4.   | **                                                                                                                   |     |
|       | **PART II**                                                                                                     |     |
| ITEM 5.    | Market for the  Company’s Common Equity, Related Shareholder Matters and Issuer Purchases of  Equity Securities | 32       |
| ITEM  6.   | **                                                                                                                   |     |
| ITEM 7.    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations*                         | 33       |
|       | Non-GAAP  Financial Measures                                                                                         | 53       |
|       | Liquidity and Capital Resources                                                                                      | 54       |
|       | Critical  Accounting Estimates                                                                                       | 60       |
|       | Forward-Looking  Statements                                                                                          | 78       |
| ITEM 7A.   | Quantitative  and Qualitative Disclosures About Market Risk                                                          | 79       |
| ITEM 8.    | Financial  Statements and Supplementary Data                                                                         | 81       |
| ITEM 9.    | Changes in and  Disagreements With Accountants on Accounting and Financial Disclosure                                | 81       |
| ITEM 9A.   | Controls and  Procedures                                                                                             | 81       |
| ITEM 9B.   | Other Information                                                                                                    | 81       |
|       | **PART III**                                                                                                    |     |
| ITEM  10.  | **                                                                                                                   |     |
| ITEM  11.  | **                                                                                                                   |     |
| ITEM  12.  | **                                                                                                                   |     |
| ITEM  13.  | **                                                                                                                   |     |
| ITEM 14.   | Principal  Accountant Fees and Services                                                                              | 81       |
|       | **PART IV**                                                                                                     |     |
| ITEM 15.   | Exhibits and  Financial Statement Schedules                                                                          | 82       |

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*                                         Item prepared in accordancewith General Instruction I (2) of Form 10-K

 

**                                  Item omitted inaccordance with General Instruction I (2) of Form 10-K

 

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**PART I**

 

**ITEM1.  BUSINESS**

 

**Overview**

 

OneBeacon U.S. Holdings, Inc., (OBH or the Company, andcollectively with its subsidiaries, OB Holdings, we, us, or our), formerlyknown as Fund American Companies, Inc., was created in 2000 by WhiteMountains Insurance Group, Ltd. (White Mountains) to acquire andsubsequently be the immediate holding company for OneBeacon InsuranceGroup LLC (together with its subsidiaries, OneBeacon). White Mountains isa holding company whose businesses provide property and casualty insurance,reinsurance and certain other products. On June 1, 2001, OBH acquiredOneBeacon from Aviva plc (Aviva, formerly CGNU), (the OneBeaconAcquisition).

 

During 2006, White Mountains undertook an internal reorganization andformed OneBeacon Insurance Group, Ltd. (OBIG) for the purpose of holdingcertain of its property and casualty insurance businesses. As part of thisreorganization, certain of White Mountains’ businesses that were historicallyindirect wholly-owned subsidiaries of White Mountains, including OBH, becameindirect wholly-owned subsidiaries of OBIG. During the fourth quarter of 2006,White Mountains sold 27.6 million or 27.6% of OBIG’s common shares in aninitial public offering. As of December 31, 2008, White Mountains owned75.5% of OBIG’s common shares.

 

We are a property and casualty insurance writer that provides a rangeof specialty insurance products as well as a variety of segmented commercialand personal insurance products. With roots dating back to 1831, we have beenoperating for more than 175 years and have many long-standingrelationships with independent agencies, which constitute our primarydistribution channel. Our headquarters are located at 1 Beacon Lane, Canton,Massachusetts 02021 and our principal executive office is located at 601Carlson Parkway, Minnetonka, Minnesota 55305.

 

Our reportable segments are Primary Insurance Operations, AffiliateQuota Shares and Other Operations. We manage our Primary Insurance Operationssegment through three major underwriting units: specialty lines, commerciallines and personal lines. Our Affiliate Quota Shares segment reflects theresults of two quota share reinsurance agreements we entered into withsubsidiaries of White Mountains primarily for White Mountains’ capitalmanagement purposes. These agreements were commuted in the fourth quarter of2006 in connection with OBIG’s initial public offering. Certain otheractivities are conducted through our holding company, OBH, and are included inour Other Operations segment.

 

Our specialty lines businesses are national in scope, while ourcommercial lines business is produced in select territories throughout theUnited States. Personal lines business is concentrated in the NortheasternUnited States. We have added, and expect to continue to add, new specialtybusinesses both organically and through acquisition. With licenses in 50 statesand the District of Columbia, we have selectively expanded our commercial linesbusiness into new territories that align well with our targeted approach tospecific customer segments. As we expand, we are guided by our focus onprofitable growth while prudently managing underwriting risk.

 

Our principal operating subsidiaries are rated “A” (Excellent, thethird highest of fifteen ratings) by A.M. Best Company, Inc. (A.M.Best), “A” (Strong, the sixth highest of twenty-one ratings) by Standard &Poor’s Rating Service (Standard & Poor’s), “A2” (Good, the sixthhighest of twenty-one ratings) by Moody’s Investors Service, Inc. (Moody’s)and “A” (Strong, the sixth highest of twenty-one ratings) by Fitch, Inc.(Fitch).

 

In 2008, our net written premiums totaled approximately$2.0 billion and we had total assets of approximately $7.9 billionand total common shareholder’s equity of approximately $1.1 billion at December 31,2008.

 

**Our Business Focus**

 

We are a specialty company as demonstrated by our heightened focus oncertain customer groups and/or geographic territories where we believe ourtargeted products, pricing and expertise deliver a competitive advantage.Besides our dedicated specialty lines businesses, we additionally pursue aspecialized approach to commercial lines through our focus on specific businesssegments with corresponding customized products and services that address theunique needs of these customer groups. In personal lines, our flagship packageproduct provides a specialized approach to the market by bundling automobile,home, liability, watercraft and other coverages in a single policy. We believethat our proprietary knowledge regarding our targeted industries, classes andrisk characteristics provides us with a competitive edge for our terms andconditions on individual accounts. We believe specialization will result insuperior returns as compared to a more “generalist” underwriting approach.

 

 

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**Our Operating Principles**

 

We strive to operate within the spirit of four operating principles.These are:

 

**Underwriting Comes First.**  An insurance enterprise must respect thefundamentals of insurance. There must be a realistic expectation ofunderwriting profit on all business written, and demonstrated fulfillment ofthat expectation over time, with focused attention to the loss ratio and to allthe professional insurance disciplines of pricing, underwriting and claimsmanagement.

 

**Maintain a Disciplined Balance Sheet.**  The first concern here is that insuranceliabilities must always be fully recognized. Loss reserves and expense reservesmust be solid before any other aspect of the business can be solid. Pricing,marketing and underwriting all depend on informed judgment of ultimate losscosts and that can be managed effectively only with a disciplined balancesheet.

 

**Invest for Total Return.**  Historical insurance accounting tends to hideunrealized gains and losses in the investment portfolio and over-reward reportedinvestment income (interest and dividends). Regardless of the accounting, wemust invest for the best growth in after tax value over time. In addition toinvesting our bond portfolios for total after tax return, that will also meanprudent investment in a balanced portfolio consistent with leverage andinsurance risk considerations.

 

**Think Like Owners.**  Thinking like owners has a value all its own.There are stakeholders in a business enterprise and doing good work requiresmore than this quarter’s profit. But thinking like an owner embraces all thatwithout losing the touchstone of a capitalist enterprise.

 

**Property and Casualty Insurance Overview**

 

Generally, property and casualty insurance companies write insurancepolicies in exchange for premiums paid by their customers (the insured). Aninsurance policy is a contract between the insurance company and the insuredwhere the insurance company agrees to pay for losses suffered by the insuredthat are covered under the contract. Such contracts often are subject tosubsequent legal interpretation by courts, legislative action and arbitration.Property insurance generally covers the financial consequences of accidentallosses to the insured’s property, such as a home and the personal property init, or a business’ building, inventory and equipment. Casualty insurance (oftenreferred to as liability insurance) generally covers the financial consequencesof a legal liability of an individual or an organization resulting fromnegligent acts and omissions causing bodily injury and/or property damage to athird party. Claims on property coverage generally are reported and settled ina relatively short period of time, whereas those on casualty coverage can takeyears, even decades, to settle.

 

We derive substantially all of our revenues from earned premiums,investment income and net realized and unrealized gains and losses oninvestment securities. Earned premiums represent premiums received frominsureds, which are recognized as revenue over the period of time thatinsurance coverage is provided (i.e., ratably over the life of thepolicy). A significant period of time normally elapses between the receipt ofinsurance premiums and the payment of insurance claims. During this time,investment income is generated, consisting primarily of interest earned onfixed maturity investments and dividends earned on equity securities. Netrealized investment gains and losses result from sales of securities andother-than-temporary impairments from our investment portfolio. Effective January 1,2008, we elected to report unrealized gains and losses on investments throughincome as a component of revenues. Prior to that, unrealized gains and losseswere recorded directly to shareholder’s equity as a component of othercomprehensive income.

 

Insurance companies incur a significant amount of their total expensesfrom policyholder losses, which are commonly referred to as claims. In settlingpolicyholder losses, various loss adjustment expenses (LAE) are incurred suchas insurance adjusters’ fees and litigation expenses. In addition, insurancecompanies incur policy acquisition expenses, such as commissions paid to agentsand premium taxes, and other expenses related to the underwriting process,including their employees’ compensation and benefits.

 

The key measure of relative underwriting performance for an insurancecompany is the combined ratio. An insurance company’s combined ratio underaccounting principles generally accepted in the United States (GAAP) iscalculated by adding the ratio of incurred loss and LAE to earned premiums (theloss and LAE ratio) and the ratio of policy acquisition and other underwritingexpenses to earned premiums (the expense ratio). A combined ratio under 100%indicates that an insurance company is generating an underwriting profit.However, when considering investment income and investment gains or losses,insurance companies operating at a combined ratio of greater than 100% can beprofitable.

 

 

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**PrimaryInsurance Operations**

 

Our Primary Insurance Operations segment provides specialty linesinsurance products, a variety of segmented commercial lines insurance productsfor businesses and personal lines insurance products for individuals. ThePrimary Insurance Operations segment also includes run-off business whichprimarily consists of national accounts, certain specialty programs andregional agency business transferred to Liberty Mutual Insurance Group (LibertyMutual) effective November 1, 2001. See “Business—Run-off”.

 

Forthe twelve months ended December 31, 2008, 2007 and 2006, our net writtenpremiums by line of business were as follows:

 

| ** ** | ** ** | **Year ended December 31, (1)** | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** ** | ** ** | **($ in millions)**             | ** ** |
| Specialty  |       | $                                    | 621.9      |   | $ | 440.3 |   | $ | 433.9 |   |
| Commercial |       | 722.1                                |       | 733.4 |   | 722.0 |   |
| Personal   |       | 618.7                                |       | 690.4 |   | 800.6 |   |
| Total(2)   |       | $                                    | 1,963.1    |   | $ | 1,864.4 |   | $ | 1,957.6 |   |

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(1)                                  In the firstquarter of 2008, we began to include Community Banks within commercial lines.Community Banks was formerly reported in specialty lines. The reporting changewas undertaken to better align the reported results of our underwriting unitswith their product and management structure. Prior periods have beenreclassified to conform to the current presentation.

 

(2)                                  Includesrun-off business. See “Business—Run-off.”

 

***Specialty lines***

 

Our specialty lines underwriting unit is a collection of nichebusinesses that focus on solving the unique needs of particular customer groupson a national scale. We provide distinct products and offer tailored coveragesand services, managed by seasoned teams of market specialists. Our specialtylines businesses currently include:

 

·                  *OneBeaconProfessional Partners**(OBPP)*:  Formed in 2002, OBPP specializes inprofessional liability insurance products for an increasingly broad range ofindustry groups. OBPP’s original focus on health-care related liabilityinsurance continues while expansion into non-health-care related liabilityinsurance segments has increased over the last four years. Medical liabilityinsurance for health-care industry segments, including hospitals, physiciangroups, managed care organizations, long-term care facilities and othernon-hospital medical facilities, represents the most significant share of OBPP’sbusiness. Additionally, OBPP offers stop loss insurance to certain health-careproviders through its provider excess insurance and HMO reinsurance products.Errors and omissions liability insurance coverage is also provided to businesssegments including law firms, in-house counsel, realtors and mediaorganizations. Management liability coverage, specifically directors andofficers and employment practices insurance, is offered on a limited basis to someof the business segments noted above. Underwriting, claims and risk controlservices are managed internally. OBPP’s policies are primarily issued on a “claimsmade” basis, which covers losses reported during the time period when aliability policy is in effect, regardless of when the event causing the claimactually occurred.

 

·                  *InternationalMarine Underwriters**(IMU)*:  A leading provider of marine insurance, thisbusiness traces its roots back to the early 1900s. IMU coverages includephysical damage or loss and general liability for cargo and commercial hull,both at primary and excess levels. IMU also offers coverage for marinas,including a “package” product with comprehensive property and liabilitycoverage, and yachts, the offerings for which were strengthened by IMU’sacquisition in October 2006 of yacht-specialist National MarineUnderwriters, Inc., a yacht insurance managing general agency. IMU doesnot offer offshore energy products. Target customers include ferry operatorsand charter boats (hull), marina operators and boat dealers (package product)and private-pleasure yachts with hull values of less than $1 million.

 

·                  *A.W.G.Dewar**(Dewar)*:  A leadingprovider of tuition reimbursement insurance since 1930, Dewar’s productprotects both schools and parents from the financial consequences of a student’swithdrawal or dismissal from 

 

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school. The tuition refund plan reimburses parents up to 100% oftuition, room and board fees when a student is obliged to leave school due tocovered reasons, such as medical or expulsion. Dewar provides customizedpolicies to independent schools and colleges in North America.

 

·                  *SpecialtyAccident and Health (A&H): *Formed in November 2006,this group provides accident insurance principally to employer groups (mid-sized organizations to Fortune 1000companies), associations and other affinity groups. A&H’s products includecorporate accident, travel accident and occupational accident coverage which isprimarily targeted to the trucking industry. In the fourth quarter of 2008,A&H launched OneBeacon Services to provide employer and other affinitygroups with access to a suite of services to help manage today’s emergingissues. Services include a discounted prescription drug program, identity theftresolution services and travel assistance services. The A&H groupdistributes products through independent agents and brokers and selectivelymarkets directly to customers.

 

·                  *OneBeacon**Government Risks (OBGR): *Formed in March 2007,this group offers property and casualty products for government entities. Theproducts include automobile, property, general liability and professional liabilitycoverages. The professional liability offerings consist of law enforcement,public officials and employment practice coverage. Markets served includecities, towns, townships, counties, transit authorities, government agencies,special districts and pools (groups of public entities). OBGR strategicallydistributes its products through agents and brokers.

 

·                  *Specialty**Collectors Program: *Inthe second quarter of 2008, we began to provide property and casualty insurancesolutions through an exclusive partnership with Hagerty Insurance Agency andHagerty Classic Marine Insurance Agency (Hagerty), the nation’s premiercollector car and classic boat agencies. Hagerty’s specialty services includecollector car and wooden boat insurance, vehicle valuation, financing androadside assistance, as well as a variety of useful information resources. ItsHagerty Plus community of collector-car enthusiasts has over 280,000 members.Hagerty works proactively on hobby advocacy and supports the CollectorsFoundation, a nonprofit organization formed by Hagerty and dedicated to thepreservation of the hobby.

 

·                  *EntertainmentBrokers International Insurance Services (EBI):*  Acquired in the third quarter of 2008, EBIprovides specialized commercial insurance products, including professionalliability coverages, for the entertainment, sports and leisure industries. EBIcontinues to operate as a managing agency with a network of 500 independentagents and brokers. EBI also operates a brokerage operation offering excessworkers compensation coverages and a high value homeowners product.

 

Each of these businesses maintains stand-alone operations anddistribution channels targeting their specific customer groups. Our specialtylines include several businesses focused on smaller property-casualty insurancesegments where particular expertise and relationships with similarly focuseddistribution partners has resulted historically in strong operating results.These businesses maintain their competitive advantage through a deep knowledgeof their respective customers and markets.

 

For the years ended December 31, 2008, 2007, and 2006, ourspecialty lines net written premiums were as follows:

 

| ** **                       | ** ** | **Year ended December 31, (1)** | ** ** |
|----------------------------------|------------|--------------------------------------|------------|
| ** **                       | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                       | ** ** | **($ in millions)**             | ** ** |
| OBPP                             |       | $                                    | 239.9      |   | $ | 213.9 |   | $ | 179.3 |   |
| IMU                              |       | 157.0                                |       | 158.6 |   | 139.9 |   |
| Specialty collectors program (2) |       | 110.0                                |       | — |   | — |   |
| Other specialty lines (3)        |       | 115.0                                |       | 67.8 |   | 114.7 |   |
| Total specialty lines            |       | $                                    | 621.9      |   | $ | 440.3 |   | $ | 433.9 |   |

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(1)                                  As describedabove, in the first quarter of 2008, we began to include Community Banks withincommercial lines. Community Banks was formerly reported in specialty lines.Prior periods have been reclassified to conform to the current presentation.

 

(2)                                  Representspremiums from our specialty collector car and boat business which we beganwriting in the second quarter of 2008.

 

 

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(3)                                  Net writtenpremiums for the year ended December 31, 2006 include $64.7 million fromour Agri business which was sold to a third party on September 29, 2006.See “Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Other Acquisitions and Dispositions”.

 

***Commercial lines***

 

Our specialized approach to commercial lines features a suite ofcustomized products and services that target certain industry groups supportedby teams of seasoned underwriting, risk control and claims specialists. Thistargeted industry focus has resulted in favorable loss ratios and strongcustomer retention levels. In recent years, we have continued to selectivelyexpand into new geographic territories that align well with our targetedapproach.

 

Our commercial lines products include:

 

                        *Multi-peril:* a packagepolicy sold to small to mid-sized insureds or to members of trade associationsor other groups that includes general liability and property insurance.

 

                        *Automobile:* physicaldamage and liability coverage. Automobile physical damage insurance covers lossor damage to vehicles from collision, vandalism, fire, theft or other causes.Automobile liability insurance covers bodily injury of others, damage to theirproperty and costs of legal defense resulting from a collision caused by theinsured.

 

                        *Workerscompensation:* covers an employer’s liability for injuries,disability or death of employees, without regard to fault, as prescribed bystate workers compensation law and other statutes.

 

                        *Inlandmarine:* covers property that may be in transit or held by a bailee at a fixedlocation, movable goods that are often stored at different locations or propertywith an unusual antique or collector’s value.

 

                        *Property:* covers lossesto a business’ premises, inventory and equipment as a result of weather, fire,theft and other causes.

 

                        *Excess andsurplus property:* provides excess property coverage against certaindamages over and above those covered by primary policies or a largeself-insured retention.

 

                        *GeneralLiability:* covers businesses for any liability resulting frombodily injury and property damage arising from general business operations,accidents on a premises and the products manufactured or sold.

 

                        *Umbrella:* supplementsexisting insurance policies by covering losses from a broad range of insurancerisks in excess of coverage provided by the primary insurance policy up to aspecified limit.

 

                Our commerciallines underwriting unit is comprised of middle market and small businessdivisions.

 

·                  *Middlemarket:* Ourcommercial lines middle market business division targets select industrysegments through our suite of @vantage products. Our middle market customerstypically produce annualized gross premiums ranging from $25,000 to $1,000,000and principally purchase “package” policies (combination policies offeringproperty and liability coverage). We target 15 distinct customer groupswith a primary focus on technology and financial services, as well as propertyand inland marine product offerings and excess property solutions. We alsoproduce some standard commercial business that is not targeted to a specificindustry group. By partnering with our specialty lines businesses, our middlemarket business can deliver a seamless, comprehensive OneBeacon solution, whichwe believe is a competitive advantage for us and for our agents. Middle marketbusiness is produced through regional and national agencies and brokers, andalso provides excess property solutions primarily through surplus lineswholesalers.

 

                We place particular emphasis onthe following target segments and products:

 

—           *Technology:*Our target technologycustomer groups include hardware manufacturers, software companies, andtelecommunications service providers with annual revenues up to $1 billion andfewer than 500 employees. Our custom @vantage for Technology policies providecoverage for technology customers’ unique needs including specializedprofessional liability such as data privacy, communications and errors 

 

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and omissions liability, both domestically and internationally. Withinthe technology segment we specialize further with a product tailored formedical technology customers available on a claims-made or occurrence basis andthat also provides protection worldwide. Within this class we target medicaldevice manufacturers and operations.

 

—           *Financial services:*****This segmenttargets a broad range of financial services companies including credit unions,investment advisors, securities broker/dealers, insurance companies andcommercial banks. Through our @vantage for Financial Services product we provide customers withbroad property and general liability protection. For community banks with under $3 billion in assets, we augment our property and generalliability protection with specialized professional liability coverages.

 

—           *Property and inland marine:*In this segment, we offer a broadselection of products and services with a concentration in three key areas:construction, fine arts and transportation. Our approach is to providesolutions that are creative and tailored to fit our customers’ needs with broad coverage forms, specialized risk controland claims handling. Our target customers additionally benefit from our partnerships with job site and equipmenttheft prevention firms and fine arts appraisal and risk managementorganizations.

 

—           *OneBeacon Specialty Property (OBSP): *OBSP provides excessproperty protection against certain damages over and above those covered byprimary policies or a large self-insured retention. Target classes includeapartments and condominiums, commercial real estate, small-to-mediummanufacturing, retail/wholesale and public entity and educational institutions.OBSP has a well-defined preference for low catastrophe-exposed risks. Ourexcess property solutions are provided primarily through surplus lineswholesalers in all 50 states and the District of Columbia.

 

·                  *Smallbusiness: *Our commerciallines small business division focuses on certain industry classes through ourcomprehensive businessowners OnePac policy. We target 14 general industrygroups as well as some association and affinity group businesses that provide ahighly competitive solution for select agents. Coverages include automobile,workers compensation and umbrella augmented with customized coverages andlimits aligned to our target classes. Small business customers typicallygenerate annualized premiums ranging from $500 to $25,000. Small business isproduced through regional and national agencies as well as aggregatorsrepresenting smaller local agencies. Our proprietary web platform thatexpedites underwriting at the point of sale has enabled growth in our newerterritories while limiting the need for much incremental infrastructure. Oursmall business service center provides customer administration for enrolledagents.

 

For the years ended December 31,2008, 2007 and 2006, commercial lines net written premiums were as follows:

 

| ** **             | ** ** | **Year ended December 31, (1)** | ** ** |
|------------------------|------------|--------------------------------------|------------|
| ** **             | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **             | ** ** | **($ in millions)**             | ** ** |
| Middle market          |       | $                                    | 566.6      |   | $ | 595.6 |   | $ | 619.7 |   |
| Small business         |       | 155.5                                |       | 137.8 |   | 102.3 |   |
| Total commercial lines |       | $                                    | 722.1      |   | $ | 733.4 |   | $ | 722.0 |   |

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(1)                                  As describedabove, in the first quarter of 2008, we began to include Community Banks withincommercial lines. Community Banks was formerly reported in specialty lines.Prior periods have been reclassified to conform to the current presentation.

 

***Personal lines***

 

Our personal lines underwriting unit provides a comprehensive suite ofpersonal insurance products sold through select independent agents with anexclusive focus on eight Northeastern states (the New England states, New Yorkand New Jersey).  Our personal linesproducts include:

 

·                  *Automobile:* consists ofphysical damage and liability coverage. Automobile physical damage insurancecovers loss or damage to vehicles from collision, vandalism, fire, theft orother causes. Automobile liability insurance covers bodily injury of others,damage to their property and costs of legal defense resulting from a collisioncaused by the insured.

 

 

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·                  *Homeowners:* covers lossesto an insured’s home, including its contents, as a result of weather, fire,theft and other causes, and losses resulting from liability for acts ofnegligence by the insured or the insured’s immediate family. We also offeridentity theft resolution assistance and identity theft expense reimbursementcoverage as part of our homeowners policies.

 

·                  *Package:* consists ofcustomized combination policies offering home and automobile coverage withoptional umbrella and boatowners coverage.

 

Our personal lines underwriting unit is comprised of traditionalpersonal lines and AutoOne Insurance (AutoOne).

 

·                  *Traditional personal lines:*Withintraditional personal lines, in addition to automobile, homeowners and packagepolicy offerings, we also include management services provided to reciprocalinsurance exchanges and the consolidation of the reciprocal insurance exchangesdescribed below.

 

—           *Traditional personal lines excluding reciprocals:* To maintain ahigh degree of flexibility, in 2004 we created a highly segmented productsuite, called OneChoice, under which we offer risk-adjusted product and pricingto our customers. OneChoice is a multi-tiered product suite that enables us tooffer a broader range of coverages to a full spectrum of customers through moresophisticated pricing models that have a greater statistical correlationbetween historical loss experience and price than traditional pricing models.This product suite offers both automobile and homeowners coverages as well aspackage policies such as OneChoice CustomPac, our flagship package policy.OneChoice products rely on multiple, objective pricing tiers and rules-basedunderwriting that enable agents to offer OneBeacon solutions to a broad arrayof their customers and increase our market penetration. We regularly refine ourproduct features and rating plans to optimize target market production. Ease ofuse is a critical aspect of this business. Investments in technology haveprovided opportunities for agents to access OneChoice through either ourweb-based proprietary agent portal or through comparative raters. We believethat the availability of multiple channels to access our product offeringsprovides increased opportunities for new business.

 

—           *Reciprocals:*  We provide management services for a fee tothree reciprocal insurance exchanges, which we refer to as reciprocals. Thereciprocals offer the OneChoice product as described above. We have created andcapitalized the reciprocals by lending them funds in exchange for surplus notes.Reciprocals are policyholder-owned insurance carriers organized asunincorporated associations. We have no ownership interest in thesereciprocals. As required by GAAP, our consolidated financial statements reflectthe consolidation of these reciprocals. See Note 16—“Variable InterestEntities” of the accompanying consolidated financial statements. In the longterm, as the reciprocals produce positive operating results and/or as thirdparty capital is invested, we expect to derive value from reduced volatility inour year-to-year underwriting results. Further, we will generate steady feeincome for the various management services we provide to these associations andreceive the repayment of principal and interest on the surplus notes.

 

·                  *AutoOne:*  AutoOne is a market leader in “assigned risk”business in New York. Assigned risk plans provide automobile insurance forindividuals unable to secure coverage in the voluntary market. Insurancecarriers are obliged to accept future assignments from state assigned riskpools as a condition of maintaining a license to write automobile business inthe state. However, carriers may satisfy their assigned risk obligation bybuying out of their assignments through an agreement with an approved AssignedRisk Servicing Company or limit their assignments through the purchase andtransfer of “credits” (for example, take-out, territorial and youthfuldriver credits). AutoOne offers services known as Limited AssignmentDistribution, or LAD, and Commercial Limited Assignment Distribution, or CLAD,and credit programs to insurance carriers. AutoOne provides 28 LAD and CLADprograms in 21 states and the District of Columbia where assigned riskobligations may be assumed by a servicing carrier under a negotiated feearrangement.

 

AutoOne also writes “voluntary take-out business” (policies “taken out”of the assigned risk pool and written in the voluntary market) by selectingpolicies from the assigned risk business it has assumed for its clients andfrom select insurance brokers that replace their clients’ assigned riskpolicies with AutoOne policies. AutoOne receives credits for all premium takenout of the assigned risk plan which it can use either to reduce its futureassigned risk obligations or sell to other carriers that can use the credits toreduce their own quota obligations. In 2008, AutoOne wrote more take-outbusiness than all other carriers in New York combined and all of its take-outcredits were sold to other carriers to reduce their assigned risk quotaobligations.

 

 

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For the years ended December 31, 2008, 2007 and 2006, our personallines net written premiums were as follows:

 

| ** **                                       | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                       | ** ** | **($ in millions)**         | ** ** |
| Traditional personal lines excluding reciprocals |       | $                                | 296.4      |   | $ | 338.0 |   | $ | 492.7 |   |
| Reciprocals                                      |       | 203.2                            |       | 221.3 |   | 93.2 |   |
| Traditional personal lines                       |       | 499.6                            |       | 559.3 |   | 585.9 |   |
| AutoOne                                          |       | 119.9                            |       | 134.6 |   | 222.6 |   |
| Total personal lines(1)                          |       | $                                | 618.7      |   | $ | 690.4 |   | $ | 800.6 |   |

----

(1)                                  Includeselimination between traditional personal lines and AutoOne.

 

***Run-off***

 

Run-off primarily consists of national accounts, certain specialtyprograms and regional agency business transferred to Liberty Mutual effective November 1,2001. Beginning in 2001, national accounts and certain specialty programs werediscontinued. On November 1, 2001, we transferred our regional agencybusiness, agents and operations in 42 states and the District of Columbia toLiberty Mutual pursuant to a renewal rights agreement (the Liberty Agreement).The operating results and cash flows of policies renewed from November 1,2001 through October 31, 2003 pursuant to the Liberty Agreement were sharedbetween Liberty Mutual and OneBeacon. The Liberty Agreement pro-rated resultsso that OneBeacon assumed approximately two-thirds of the operating resultsfrom renewals through October 31, 2002 and approximately one-third of theoperating results from renewals through October 31, 2003. The renewalrights under the Liberty Agreement expired on October 31, 2003. Wecontinue to manage claims from the discontinued national accounts and specialtyprograms business as well as the claims related to the business that wassubject to the Liberty Agreement.

 

**Geographic Concentration**

 

Our net written premiums are derived solely from business produced inthe United States.

 

Business from specialty lines was produced in the following states:

 

| ** **    | ** ** | **Year ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| California    |       | 10.2                                       | %          | 9.0 | % | 13.7 | % |
| New York      |       | 8.2                                        |       | 8.0 |   | 7.3 |   |
| Texas         |       | 7.5                                        |       | 5.0 |   | 7.0 |   |
| Florida       |       | 6.8                                        |       | 9.1 |   | 8.8 |   |
| Massachusetts |       | 4.1                                        |       | 5.7 |   | 5.2 |   |
| Pennsylvania  |       | 4.1                                        |       | 4.2 |   | 3.9 |   |
| Louisiana     |       | 2.9                                        |       | 4.4 |   | 1.8 |   |
| Other(1)      |       | 56.2                                       |       | 54.6 |   | 52.3 |   |
| Total         |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |

----

(1)                                  No individualstate was greater than 4% of net written premiums, except as noted above.

 

                                                Business fromcommercial lines was produced in the following states:

 

| ** **    | ** ** | **Year ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| California    |       | 15.4                                       | %          | 14.2 | % | 13.1 | % |
| Massachusetts |       | 14.3                                       |       | 16.3 |   | 17.7 |   |
| New York      |       | 13.0                                       |       | 13.7 |   | 13.6 |   |
| Maine         |       | 6.5                                        |       | 6.8 |   | 7.8 |   |
| New Jersey    |       | 6.4                                        |       | 6.6 |   | 7.1 |   |
| Connecticut   |       | 5.4                                        |       | 6.0 |   | 6.5 |   |
| Other(1)      |       | 39.0                                       |       | 36.4 |   | 34.2 |   |
| Total         |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |

----

(1)                                  No individualstate was greater than 4% of net written premiums.

 

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Business from personal lines was produced in the following states:

 

| ** **    | ** ** | **Year ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| New York      |       | 41.5                                       | %          | 40.3 | % | 46.6 | % |
| Massachusetts |       | 22.5                                       |       | 23.0 |   | 21.7 |   |
| New Jersey    |       | 13.0                                       |       | 12.0 |   | 11.4 |   |
| Connecticut   |       | 9.1                                        |       | 6.5 |   | 4.6 |   |
| Maine         |       | 7.9                                        |       | 7.7 |   | 7.3 |   |
| Rhode Island  |       | 3.6                                        |       | 3.3 |   | 3.0 |   |
| Other(1)      |       | 2.4                                        |       | 7.2 |   | 5.4 |   |
| Total         |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |

----

(1)                                  No individualstate was greater than 4% of net written premiums.

 

**Marketing and Distribution**

 

We offer our products through a network comprised of independentagents, regional and national brokers and wholesalers. Our distributionrelationships consist of approximately 3,500 select agencies and brokers. Inrecent years, we have expanded our distribution channels to include selectmanaging general agencies (MGAs), either through acquisitions or exclusiverelationships. These MGAs focus on a particular customer group with tailoredproducts and services, and related expertise.

 

Our specialty lines businesses are managed from locations logisticallyappropriate to their target markets. OBPP is based in Avon, Connecticut anddistributes its products through select national and regional brokers andagents. IMU is headquartered in New York City and operates through tenlocations throughout the United States. Its products are distributed through anetwork of select agencies that specialize in marine business. Dewar’saffiliate, A.W.G. Dewar Agency, which is located in Quincy, Massachusetts,distributes tuition refund products to independent schools and collegesthroughout North America. A&H conducts business through independent agentsand brokers and selectively markets directly to customers. OBGR strategicallydistributes its products through agents and brokers. EBI, a recently acquiredMGA, has locations in New York City and California.

 

Commercial lines products are available in select territoriesthroughout the U.S., whereas personal lines are exclusively available in theeight Northeastern states. The majority of our commercial and personal linesproducts are distributed through select independent insurance agents. Weprotect the integrity of our franchise value by selectively appointing agentsthat demonstrate business and geographic profiles that align with our targetmarkets and specialized capabilities. We believe in the added value provided byindependent insurance agents as they conduct more complete assessments of theirclients’ needs, which result in more appropriate coverages and prudent riskmanagement. We also believe that independent agents will continue to be asignificant force in overall industry premium production including facilitatingthe cross-selling of specialty, commercial and personal lines businessproducts.

 

New York-based AutoOne markets its LAD and CLAD services and New Yorktake-out credits directly to insurance carriers seeking assigned risksolutions. AutoOne generates take-out credits by writing policies from selectinsurance brokers that were previously in the New York Automobile InsurancePlan (NYAIP), and sells these credits to insurance companies subject to NYAIPassignments.

 

**Underwriting and Pricing**

 

We believe there must be a realistic expectation of attaining anunderwriting profit on all the business we write, as well as a demonstratedfulfillment of that expectation over time. Consistent with our “underwritingcomes first” operating principle, adequate pricing is a critical component forachieving an underwriting profit. We underwrite our book with a disciplinedapproach towards pricing our insurance products and are willing to forgo abusiness opportunity if we believe it is not priced appropriately to theexposure.

 

We have used tiered rating plans since 2003 in both our commercial andpersonal lines that permit us to offer more tailored price quotes to ourcustomers based on underwriting criteria applicable to each tier. The enhancedaccuracy and 

 

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precisionof our rate plans enable us to more confidently price our products to theexposure, and thereby permit our agency partners to deliver solutions to abroader range of customers.

 

We also actively monitor pricing activity and measure usage of tiers,credits, debits and limits. In addition, we regularly update base rates toachieve targeted returns on capital and attempt to shift writings away fromlines and classes where pricing is inadequate. To the extent changes in premiumrates, policy forms or other matters are subject to regulatory approval (see “RegulatoryMatters—General” and “Risk Factors—Regulation may restrict our ability tooperate”), we proactively monitor our pending regulatory filings to facilitate,to the extent possible, their prompt processing and approval. Lastly, we expendconsiderable effort to measure and verify exposures and insured values.

 

**Claims Management**

 

Effective claims management is a critical factor in achievingsatisfactory underwriting results. We maintain an experienced staff ofappraisers, medical specialists, managers, staff attorneys and field adjustersstrategically located throughout our operating territories. We also maintain aspecial investigative unit designed to detect insurance fraud and abuse andsupport efforts by regulatory bodies and trade associations to curtail fraud.

 

Claims are separately organized by specialty, commercial, personal andrun-off operations. This approach allows us to better identify and manageclaims handling costs. In addition, a shared claims service unit manages costsrelated to both staff and vendors. We also adopted a total claims cost managementapproach that gives equal importance to controlling claims handling expenses,legal expenses and claims payments, enabling us to lower the sum of the three.This approach requires the utilization of a considerable number of conventionalmetrics to monitor the effectiveness of various programs implemented to lowertotal loss cost. The metrics are designed to guard against implementation of anexpense containment program that will cost us more than we expect to save.

 

Our claims department utilizes a claims workstation to record reserves,payments and adjuster activity and, with support from expert tools, assistseach claim handler in the identification of recovery potential, estimatingproperty damage, evaluating claims and identifying fraud. Our commitment andperformance in fighting insurance fraud has reduced claim costs and aided lawenforcement investigations. Under our staff counsel program, our in-houseattorneys defend the majority of new lawsuits, which has resulted in savingswhen compared to the cost of using outside counsel.

 

Calendar year reported claims in our run-off operations were 1,600 in2008 compared to 1,800 in 2007, an 11% reduction, in part due to the lapse oftime and the nature of run-off operations. These levels of reported claims aredown from 2,400 in 2006, 3,400 in 2005 and 5,900 in 2004. Total open claims forrun-off operations were 4,600 at December 31, 2008 compared to 5,500 at December 31,2007, a 16% reduction, which reflects the success of our focus on settlingclaims from our run-off operations. Total open claims for run-off operationswere 7,300 in 2006, 10,200 in 2005 and 14,600 in 2004.

 

In connection with the OneBeacon Acquisition, Aviva caused us topurchase a reinsurance contract with National Indemnity Company (NICO) to helpprotect against potential asbestos and environmental (A&E) claims relatingto the pre-acquisition period prior to 2001 (the NICO Cover). See “Business—ReinsuranceProtection and Catastrophe Management.” NICO has retained a third partyadministrator (TPA), Resolute New England (Resolute), formerly Cavell USA, tomanage the claims processing for A&E claims reinsured under the NICO Cover.Our claims department personnel are consulted by NICO and Resolute on majorclaims. As with all TPAs, claims department personnel continually monitorResolute to ensure its controls, processes and settlements are appropriate. See“Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Critical Accounting Estimates—Asbestos and Environmental Reserves.”

 

**Reinsurance Protection and Catastrophe Management**

 

In the ordinary course of our business, we purchase reinsurance fromhigh-quality, highly rated, third party reinsurers in order to minimize lossfrom large risks or catastrophic events.

 

The timing and size of catastrophe losses are unpredictable and thelevel of losses experienced in any year could be material to our operatingresults and financial position. Examples of catastrophes include losses causedby earthquakes, wildfires, hurricanes and other types of storms and terroristacts. The extent of losses caused by catastrophes is a function of the amountand type of insured exposure in an area affected by the event as well as theseverity of the event. We use models (primarily AIR V.10) to estimate theprobability of the occurrence of a catastrophic event as well as potentiallosses under various scenarios. We use this model output in conjunction withother data to manage our exposure to catastrophe losses through individual riskselection and by limiting our concentration of insurance written incatastrophe-prone areas such as 

 

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coastalregions. In addition, we impose wind deductibles on existing coastal windstormexposures. We believe that our largest single event natural catastropheexposures are Northeastern United States windstorms and California earthquakes.

 

We seek to further reduce our potential loss from catastrophe exposuresthrough the purchase of catastrophe reinsurance. Effective July 1, 2008,we renewed our property catastrophe reinsurance program through June 30,2009. The program provides coverage for our personal and commercial propertybusiness as well as certain acts of terrorism. Under the program, the first$150 million of losses resulting from any single catastrophe are retainedand $650 million of the next $700 million of losses resulting fromthe catastrophe are reinsured. Any loss above $850 million would beretained. In the event of a catastrophe, our property catastrophe reinsuranceprogram is reinstated for the remainder of the original contract term by payinga reinstatement premium that is based on the percentage of coverage reinstatedand the original property catastrophe coverage premium. We anticipate that the$850 million limit is sufficient to cover Northeast windstorm losses witha 0.4%-0.5% probability of occurrence (1-in-250-year event to 1-in-200-year event).

 

Effective January 1, 2009, in an effort to further reduce ourproperty catastrophe exposures in the Northeast, we entered into a quota shareagreement with a select group of reinsurers, under which we will cede 30% ofour Northeast personal lines homeowners business written through OneBeaconInsurance Company (OBIC) and its subsidiary companies, along with AdirondackInsurance Exchange (Adirondack Insurance) and New Jersey Skylands InsuranceAssociation in New York and New Jersey, respectively. The program providessupplemental protection to previously established reinsurance described above.The reinsurers are all rated “A” (Excellent, the third highest of fifteenratings) or better by A.M. Best. The program is expected to result inceded premiums of approximately $65 million in 2009.

 

Our property catastrophe reinsurance program does not cover personal orcommercial property losses resulting from nuclear events or biological,chemical or radiological terrorist attacks or losses resulting from acts ofterrorism as defined under the Terrorism Risk Insurance Act of 2002 (theTerrorism Act or TRIA), as amended, committed by an individual or individualsacting on behalf of any foreign person or foreign interest. See “Business —Terrorism.”

 

We also purchase individual property reinsurance coverage for certainrisks to reduce large loss volatility. The property-per-risk reinsuranceprogram reinsures losses in excess of $10 million up to $100 million.Individual risk facultative reinsurance may be purchased above $100 millionwhere we deem it appropriate. The property-per-risk treaty also provides onelimit of reinsurance protection for losses in excess of $10 million up to$100 million on an individual risk basis for terrorism losses. However,nuclear, biological, chemical and radiological terrorist attacks are notcovered.

 

We also maintain a casualty reinsurance program that providesprotection for individual risk or catastrophe losses involving workerscompensation, general liability, automobile liability, professional liabilityor umbrella liability in excess of $6 million up to $81 million. Thisprogram provides coverage for terrorism losses but does not provide coveragefor losses resulting from nuclear, biological, chemical or radiologicalterrorist attacks.

 

In addition, we have reinsurance contracts with two reinsurancecompanies rated “AAA” (“Extremely Strong”, the highest of twenty-one ratings)by Standard & Poor’s and “A++” (“Superior”, the highest of fifteenratings) by A.M. Best. One is a reinsurance cover with NICO which entitlesus to recover up to $2.5 billion in ultimate loss and LAE incurred relatedprimarily to A&E claims arising from business written by our predecessorprior to 1992 and 1987, respectively and certain other exposures. As of December 31,2008, we have ceded estimated incurred losses of approximately$2.2 billion to the NICO Cover. Net losses paid totaled $1.1 billionas of December 31, 2008, with $108.5 million paid in 2008. The othercontract is a reinsurance cover with General Reinsurance Corporation (GRC) forup to $570 million of additional losses on all claims arising fromaccident years 2000 and prior (the GRC Cover). As of December 31, 2008, wehave ceded estimated incurred losses of $550 million to the GRC Cover.Pursuant to the GRC Cover, we are not entitled to recover losses to the fullcontract limit if such losses are reimbursed by GRC more quickly thananticipated at the time the contract was signed. We intend to only seekreimbursement from GRC for claims which result in payment patterns similar tothose supporting our recoverables recorded pursuant to the GRC Cover. Theeconomic cost of not submitting certain other eligible claims to GRC isprimarily the investment spread between the rate credited by GRC and the rateachieved by us on our own investments. This cost, if any, is expected to benominal.

 

Reinsurance contracts do not relieve us of our obligation to ourpolicyholders. Therefore, collectibility of balances due from reinsurers iscritical to our financial strength. See Note 5—“Reinsurance” of theaccompanying consolidated financial statements.

 

 

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** **

**Terrorism**

 

Since the terrorist attacks of September 11, 2001, we have soughtto mitigate the risk associated with any future terrorist attacks by limitingthe aggregate insured value of policies in geographic areas with exposure tolosses from terrorist attacks. This is accomplished by either limiting thetotal insured values exposed, or, where applicable, through the use ofterrorism exclusions.

 

In December 2007, the United States government extended theTerrorism Act for seven more years until December 31, 2014. The TerrorismAct, originally enacted in 2002, established a federal “backstop” forcommercial property and casualty losses, including workers compensation,resulting from acts of terrorism by or on behalf of any foreign person orforeign interest. As extended, the law now also covers domestic acts ofterrorism. The law limits the industry’s aggregate liability by requiring thefederal government to share 85% of certified losses once a company meets aspecific retention or deductible as determined by its prior year’s directwritten premiums and limits the aggregate liability to be paid by thegovernment and industry without further action by Congress at $100.0 billion.In exchange for this “back-stop,” primary insurers are required to makecoverage available to commercial insureds for losses from acts of terrorism asspecified in the Terrorism Act. The following types of coverage are excludedfrom the program: commercial automobile, burglary and theft, surety, farmownersmulti-peril and all professional liability coverage except directors andofficers coverage.

 

We estimate our individual retention level for commercial policiessubject to the Terrorism Act to be approximately $178 million in 2009. Thefederal government will pay 85% of covered terrorism losses that exceed our orthe industry’s retention levels in 2009, up to a total of $100.0 billion.

 

Our current property and casualty catastrophe reinsurance programsprovide coverage for both “certified” and “non-certified” events as definedunder the Terrorism Act provided such losses are not the result of a nuclear,biological, chemical or radiological terrorist attack, or for “certified” actscommitted by an individual or individuals acting on behalf of any foreignperson or foreign interest. See “Business—Reinsurance Protection andCatastrophe Management.”

 

We closely monitor and manage our concentration of risk by geographicarea. Our guideline is to control our exposures so that our total maximumexpected loss from a likely terrorism event within any half-mile radius in ametropolitan area or around a target risk will not exceed $200 million, or$300 million in all other areas. Reports monitoring our terrorismexposures are generated quarterly, and the exposure of potential new businesslocated in areas of existing concentration or that individually presentsignificant exposure is evaluated during the underwriting process. As a result,we believe that we have taken appropriate actions to limit our exposure tolosses from terrorist attacks and will continue to monitor our terrorismexposure in the future. Nonetheless, risks insured by us, including thosecovered by the Terrorism Act, remain exposed to terrorist attacks and thepossibility remains that losses resulting from future terrorist attacks couldprove to be material.

 

**Loss and LAE Reserves**

 

We establish loss and LAE reserves that are estimates of amounts neededto pay claims and related expenses in the future for insured events that havealready occurred. The process of estimating reserves involves a considerabledegree of judgment by management and, as of any given date, is inherentlyuncertain. See “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Critical Accounting Estimates.”

 

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The following tables summarize our loss and LAE reserve activities forthe years ended December 31, 2008, 2007 and 2006:

 
| **Year ended December 31, 2008**                           | ** ** | **Primary  Insurance  Operations** | ** ** | **Affiliate  Quota Shares** | ** ** | **Other  Operations(1)** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------|------------|
| Gross beginning balance                                         |       | $                                  | 4,718.8    |                        | $          | —                   |       | $                | (238.5     | ) | $ | 4,480.3 |   |
| Less beginning reinsurance recoverable on unpaid losses    |       | (2,850.6                           | )          | —                      |       | 221.1                    |       | (2,629.5         | )          |
| Net loss and LAE reserves                                       |       | 1,868.2                            |       | —                      |       | (17.4                    | )          | 1,850.8          |       |
| Loss and LAE incurred relating to:                              |       |                               |       |                        |       |                     |       |             |       |
| Current year losses                                             |       | 1,188.2                            |       | —                      |       | —                   |       | 1,188.2          |       |
| Prior year losses                                               |       | (62.0                              | )          | —                      |       | —                   |       | (62.0            | )          |
| Total incurred loss and LAE                                     |       | 1,126.2                            |       | —                      |       | —                   |       | 1,126.2          |       |
| Accretion of fair value adjustment to net loss and LAE reserves |       | —                             |       | —                      |       | 12.0                     |       | 12.0             |       |
| Loss and LAE paid relating to:                                  |       |                               |       |                        |       |                     |       |             |       |
| Current year losses                                             |       | (495.1                             | )          | —                      |       | —                   |       | (495.1           | )          |
| Prior year losses                                               |       | (703.2                             | )          | —                      |       | —                   |       | (703.2           | )          |
| Total loss and LAE payments                                     |       | (1,198.3                           | )          | —                      |       | —                   |       | (1,198.3         | )          |
| Net ending balance                                              |       | 1,796.1                            |       | —                      |       | (5.4                     | )          | 1,790.7          |       |
| Plus ending reinsurance recoverable on unpaid losses       |       | 2,708.4                            |       | —                      |       | (205.1                   | )          | 2,503.3          |       |
| Gross ending balance                                            |       | $                                  | 4,504.5    |                        | $          | —                   |       | $                | (210.5     | ) | $ | 4,294.0 |   |

 
| **Year ended December 31, 2007**                           | ** ** | **Primary  Insurance  Operations** | ** ** | **Affiliate  Quota Shares** | ** ** | **Other  Operations(1)** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------|------------|
| Gross beginning balance                                         |       | $                                  | 5,108.2    |                        | $          | —                   |       | $                | (270.5     | ) | $ | 4,837.7 |   |
| Less beginning reinsurance recoverable on unpaid losses    |       | (3,079.7                           | )          | —                      |       | 237.1                    |       | (2,842.6         | )          |
| Net loss and LAE reserves                                       |       | 2,028.5                            |       | —                      |       | (33.4                    | )          | 1,995.1          |       |
| Loss and LAE incurred relating to:                              |       |                               |       |                        |       |                     |       |             |       |
| Current year losses                                             |       | 1,138.1                            |       | —                      |       | —                   |       | 1,138.1          |       |
| Prior year losses                                               |       | (48.3                              | )          | —                      |       | —                   |       | (48.3            | )          |
| Total incurred loss and LAE                                     |       | 1,089.8                            |       | —                      |       | —                   |       | 1,089.8          |       |
| Accretion of fair value adjustment to net loss and LAE reserves |       | —                             |       | —                      |       | 16.0                     |       | 16.0             |       |
| Loss and LAE paid relating to:                                  |       |                               |       |                        |       |                     |       |             |       |
| Current year losses                                             |       | (527.1                             | )          | —                      |       | —                   |       | (527.1           | )          |
| Prior year losses                                               |       | (723.0                             | )          | —                      |       | —                   |       | (723.0           | )          |
| Total loss and LAE payments                                     |       | (1,250.1                           | )          | —                      |       | —                   |       | (1,250.1         | )          |
| Net ending balance                                              |       | 1,868.2                            |       | —                      |       | (17.4                    | )          | 1,850.8          |       |
| Plus ending reinsurance recoverable on unpaid losses       |       | 2,850.6                            |       | —                      |       | (221.1                   | )          | 2,629.5          |       |
| Gross ending balance                                            |       | $                                  | 4,718.8    |                        | $          | —                   |       | $                | (238.5     | ) | $ | 4,480.3 |   |

 

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| **Year ended December 31, 2006**                           | ** ** | **Primary  Insurance  Operations** | ** ** | **Affiliate  Quota Shares** | ** ** | **Other  Operations(1)** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------|------------|
| Gross beginning balance                                         |       | $                                  | 5,713.4    |                        | $          | (41.6                    | )          | $                | (317.5     | ) | $ | 5,354.3 |   |
| Less beginning reinsurance recoverable on unpaid losses    |       | (3,382.0                           | )          | —                      |       | 261.1                    |       | (3,120.9         | )          |
| Net loss and LAE reserves                                       |       | 2,331.4                            |       | (41.6                       | )          | (56.4                    | )          | 2,233.4          |       |
| Loss and LAE incurred relating to:                              |       |                               |       |                        |       |                     |       |             |       |
| Current year losses                                             |       | 1,157.4                            |       | 114.9                       |       | —                   |       | 1,272.3          |       |
| Prior year losses                                               |       | 22.9                               |       | (11.6                       | )          | —                   |       | 11.3             |       |
| Total incurred loss and LAE                                     |       | 1,180.3                            |       | 103.3                       |       | —                   |       | 1,283.6          |       |
| Accretion of fair value adjustment to net loss and LAE reserves |       | —                             |       | —                      |       | 23.0                     |       | 23.0             |       |
| Loss and LAE paid relating to:                                  |       |                               |       |                        |       |                     |       |             |       |
| Current year losses                                             |       | (474.6                             | )          | (114.9                      | )          | —                   |       | (589.5           | )          |
| Prior year losses                                               |       | (1,008.6                           | )          | 53.2                        |       | —                   |       | (955.4           | )          |
| Total loss and LAE payments                                     |       | (1,483.2                           | )          | (61.7                       | )          | —                   |       | (1,544.9         | )          |
| Net ending balance                                              |       | 2,028.5                            |       | —                      |       | (33.4                    | )          | 1,995.1          |       |
| Plus ending reinsurance recoverable on unpaid losses       |       | 3,079.7                            |       | —                      |       | (237.1                   | )          | 2,842.6          |       |
| Gross ending balance                                            |       | $                                  | 5,108.2    |                        | $          | —                   |       | $                | (270.5     | ) | $ | 4,837.7 |   |

 

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(1)                                  In connectionwith purchase accounting for the OneBeacon Acquisition, we were required toadjust to fair value our loss and LAE reserves and the related reinsurancerecoverables by $646.9 million and $346.9 million, respectively, onour acquired balance sheet as of June 1, 2001. This net reduction to lossand LAE reserves of $300.0 million is being accreted through an incomestatement charge ratably with and over the period the claims are settled.

 

The following information presents (1) our reserve developmentover the preceding 10 years and (2) a reconciliation of reserves inaccordance with accounting principles and practices prescribed or permitted byinsurance authorities (statutory basis) to such reserves determined inaccordance with GAAP, each as prescribed by Securities Act Industry Guide No. 6.

 

Section I of the 10 year table shows the estimated liabilitythat was recorded at the end of each of the indicated years for all current andprior accident year unpaid loss and LAE. The liability represents the estimatedamount of loss and LAE for claims that were unpaid at the balance sheet date,including incurred but not reported, or IBNR, reserves. In accordance withGAAP, the liability for unpaid loss and LAE is recorded in the balance sheetgross of the effects of reinsurance with an estimate of reinsurancerecoverables arising from reinsurance contracts reported separately as anasset. The net balance represents the estimated amount of unpaid loss and LAEoutstanding as of the balance sheet date, reduced by estimates of amountsrecoverable under reinsurance contracts.

 

Section II shows the cumulative amount of net loss and LAE paidrelating to recorded liabilities as of the end of each succeeding year. Section IIIshows the re-estimated amount of the previously recorded net liability as ofthe end of each succeeding year. Estimates of the liability for unpaid loss andLAE are increased or decreased as payments are made and more informationregarding individual claims and trends, such as overall frequency and severitypatterns, becomes known. Section IV shows the cumulative net(deficiency)/redundancy representing the aggregate change in the liability fromoriginal balance sheet dates and the re-estimated liability through December 31,2008. Section V shows the re-estimated gross liability and re-estimatedreinsurance recoverables through December 31, 2008. Section VI showsthe cumulative gross (deficiency)/redundancy representing the aggregate changein the liability from original balance sheet dates and the re-estimatedliability through December 31, 2008.

 

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| ** **                                                                                                          | ** ** | **Primary Insurance Operations Loss and LAE (1), (2), (4)  Year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **1998(3)**                                                                               | ** ** | **1999** | ** ** | **2000** | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **                                                                                                          | ** ** | **($ in millions)**                                                                  | ** ** |
| I. Liability for  unpaid loss and LAE:                                                                              |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross balance                                                                                                       |       | $                                                                                         | 6,869.5    |   | $ | 6,276.0 |   | $ | 6,875.4 |   | $ | 8,320.2 |   | $ | 7,507.0 |   | $ | 6,109.0 |   | $ | 5,328.2 |   | $ | 5,713.4 |   | $ | 5,108.2 |   | $ | 4,718.8 |   | $ | 4,504.5 |   |
| Less reinsurance  recoverable on unpaid                                                                             |       | (1,641.0                                                                                  | )          | (1,262.7 | ) | (1,252.1 | ) | (3,591.5 | ) | (3,534.4 | ) | (2,954.8 | ) | (2,670.9 | ) | (3,382.0 | ) | (3,079.7 | ) | (2,850.6 | ) | (2,708.4 | ) |
| Net balance                                                                                                         |       | $                                                                                         | 5,228.5    |   | $ | 5,013.3 |   | $ | 5,623.3 |   | $ | 4,728.7 |   | $ | 3,972.6 |   | $ | 3,154.2 |   | $ | 2,657.3 |   | $ | 2,331.4 |   | $ | 2,028.5 |   | $ | 1,868.2 |   | $ | 1,796.1 |   |
| II. Cumulative  amount of net liability paid through:                                                               |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 1 year later                                                                                                   |       | 1,784.3                                                                                   |       | 1,938.1 |   | 1,965.3 |   | 1,851.6 |   | 1,610.2 |   | 1,421.1 |   | 1,146.7 |   | 1,004.6 |   | 772.0 |   | 700.9 |   |   |   |
| 2 years  later                                                                                                 |       | 2,908.5                                                                                   |       | 3,065.1 |   | 3,153.0 |   | 3,039.5 |   | 2,764.2 |   | 2,274.5 |   | 1,833.5 |   | 1,547.8 |   | 1,227.3 |   |   |   |   |   |
| 3 years  later                                                                                                 |       | 3,643.7                                                                                   |       | 3,824.9 |   | 3,984.7 |   | 3,963.6 |   | 3,489.6 |   | 2,809.9 |   | 2,264.2 |   | 1,897.6 |   |   |   |   |   |   |   |
| 4 years  later                                                                                                 |       | 4,061.7                                                                                   |       | 4,330.3 |   | 4,596.8 |   | 4,529.5 |   | 3,941.0 |   | 3,135.9 |   | 2,536.1 |   |   |   |   |   |   |   |   |   |
| 5 years  later                                                                                                 |       | 4,353.7                                                                                   |       | 4,666.9 |   | 4,957.3 |   | 4,876.0 |   | 4,209.3 |   | 3,347.5 |   |   |   |   |   |   |   |   |   |   |   |
| 6 years  later                                                                                                 |       | 4,555.9                                                                                   |       | 4,887.2 |   | 5,194.4 |   | 5,092.4 |   | 4,385.4 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 7 years  later                                                                                                 |       | 4,701.7                                                                                   |       | 5,044.7 |   | 5,351.0 |   | 5,233.9 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 8 years  later                                                                                                 |       | 4,801.6                                                                                   |       | 5,149.1 |   | 5,461.4 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 9 years  later                                                                                                 |       | 4,875.1                                                                                   |       | 5,228.5 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 10 years  later                                                                                                |       | 4,932.8                                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| III. Net  Liability re-estimated as of:                                                                             |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 1 year later                                                                                                   |       | 5,237.1                                                                                   |       | 5,829.0 |   | 4,730.8 |   | 4,781.3 |   | 4,110.3 |   | 3,253.4 |   | 2,763.2 |   | 2,354.3 |   | 1,980.2 |   | 1,806.2 |   |   |   |
| 2 years later                                                                                                  |       | 5,916.1                                                                                   |       | 4,942.0 |   | 4,824.2 |   | 5,059.4 |   | 4,227.0 |   | 3,380.4 |   | 2,765.5 |   | 2,387.2 |   | 1,932.5 |   |   |   |   |   |
| 3 years  later                                                                                                 |       | 4,929.6                                                                                   |       | 4,927.0 |   | 5,294.3 |   | 5,143.8 |   | 4,344.8 |   | 3,396.2 |   | 2,852.7 |   | 2,350.7 |   |   |   |   |   |   |   |
| 4 years  later                                                                                                 |       | 4,857.5                                                                                   |       | 5,221.8 |   | 5,336.0 |   | 5,222.8 |   | 4,365.1 |   | 3,520.4 |   | 2,835.1 |   |   |   |   |   |   |   |   |   |
| 5 years  later                                                                                                 |       | 5,042.9                                                                                   |       | 5,165.8 |   | 5,383.6 |   | 5,244.3 |   | 4,497.0 |   | 3,521.5 |   |   |   |   |   |   |   |   |   |   |   |
| 6 years  later                                                                                                 |       | 4,929.1                                                                                   |       | 5,197.2 |   | 5,385.8 |   | 5,372.8 |   | 4,501.3 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 7 years  later                                                                                                 |       | 4,936.5                                                                                   |       | 5,169.2 |   | 5,490.1 |   | 5,372.9 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 8 years  later                                                                                                 |       | 4,902.9                                                                                   |       | 5,242.0 |   | 5,492.0 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 9 years  later                                                                                                 |       | 4,951.3                                                                                   |       | 5,335.4 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 10 years  later                                                                                                |       | 5,138.8                                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| IV. Cumulative  net redundancy/ (deficiency) (5)                                                                    |       | $                                                                                         | 89.7       |   | $ | (322.1 | ) | $ | 131.3 |   | $ | (644.2 | ) | $ | (528.7 | ) | $ | (367.3 | ) | $ | (177.8 | ) | $ | (19.3 | ) | $ | 96.0 |   | $ | 62.0 |   |   |   |
| Percent  redundant/(deficient)                                                                                      |       | 1.7                                                                                       | %          | (6.4 | )% | 2.3 | % | (13.6 | )% | (13.3 | )% | (11.6 | )% | (6.7 | )% | (0.8 | )% | 4.7 | % | 3.3 | % |   |   |
| V. Reconciliation  of net liability re-estimated as of the end of the latest re-estimation  period (see III above): |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross unpaid loss  and LAE latest re-estimate                                                                       |       | $                                                                                         | 9,437.0    |   | $ | 9,455.6 |   | $ | 9,673.9 |   | $ | 9,990.9 |   | $ | 9,064.9 |   | $ | 7,401.1 |   | $ | 6,342.7 |   | $ | 5,749.9 |   | $ | 4,999.6 |   | $ | 4,647.6 |   |   |   |
| Reinsurance  recoverable latest re-estimate                                                                         |       | (4,298.2                                                                                  | )          | (4,120.2 | ) | (4,181.9 | ) | (4,618.0 | ) | (4,563.6 | ) | (3,879.6 | ) | (3,507.6 | ) | (3,399.2 | ) | (3,067.1 | ) | (2,841.4 | ) |   |   |
| Net unpaid loss  and LAE latest re-estimate                                                                         |       | $                                                                                         | 5,138.8    |   | $ | 5,335.4 |   | $ | 5,492.0 |   | $ | 5,372.9 |   | $ | 4,501.3 |   | $ | 3,521.5 |   | $ | 2,835.1 |   | $ | 2,350.7 |   | $ | 1,932.5 |   | $ | 1,806.2 |   |   |   |
| VI. Cumulative  Gross (deficiency)/redundancy                                                                       |       | $                                                                                         | (2,567.5   | ) | $ | (3,179.6 | ) | $ | (2,798.5 | ) | $ | (1,670.7 | ) | $ | (1,557.9 | ) | $ | (1,292.1 | ) | $ | (1,014.5 | ) | $ | (36.5 | ) | $ | 108.6 |   | $ | 71.2 |   |   |   |
| Percent  (deficient)/ redundant                                                                                     |       | (37.3                                                                                     | )%         | (50.7 | )% | (40.7 | )% | (20.1 | )% | (20.8 | )% | (21.2 | )% | (19.0 | )% | (0.6 | )% | 2.1 | % | 1.5 | % |   |   |

 

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(1)                                  In 1998, CGU,the predecessor company to OneBeacon, was formed as a result of a pooling ofinterests between Commercial Union Corporation and General Accident Corporationof America. All historical balances have been restated as though the companieshad been merged throughout the periods presented.

 

(2)                                  This tablereflects the effects of the NICO Cover and the GRC Cover as if they had been ineffect for all periods presented.

 

(3)                                  CGU acquiredHouston General Insurance Company (HGIC) in 1998. In 2005, OneBeaconcontributed HGIC to Houston General Insurance Exchange. All liabilities relatedto this entity have been shown from 1998 forward in this table as it is stillconsolidated by OneBeacon.

 

(4)                                  The 10-yeartable is reflective of activity related to our loss and LAE reserves from ourPrimary Insurance Operations segment and does not include the effect of anyreserve activity from the affiliate quota share agreements or other operations.

 

(5)                                  Our December 31,2007 net liability for unpaid loss and LAE for our Primary Insurance Operationssegment re-estimated as of one year later resulted in a net redundancy of$62.0 million.

 

The cumulative net redundancy/(deficiency) in the table above reflectsreinsurance recoverables recorded under the NICO Cover and the GRC Cover. Thesecovers apply to losses incurred in 2000 and prior years. As a result, they havethe effect of significantly increasing our reinsurance recoverables in 2001 andreducing our net reserve deficiency for each of the 

 

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yearspresented prior to 2001 by the amount of the gross reserves ceded at the timethese covers were purchased. See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Critical Accounting Estimates.”

 

In 2005, weincreased our best estimate of gross losses related to the NICO contract by$841 million ($353 million net of other third party reinsurance) as a result ofa study of our A&E exposures. This had the effect of increasing the grossreserve deficiency for calendar years 2004 and prior. During 2008, wecompleted a new study of our A&E exposures. This did not result in asignificant change to our best estimate of gross losses related to the NICOcontract. As a result of the study, we increased our best estimate ofincurred losses ceded to NICO, net of underlying reinsurance, by $83million. See “Management’s Discussion and Analysis of Financial Conditionand Results of Operations—Critical Accounting Estimates.”

 

The following table reconciles loss and LAE reserves for our PrimaryInsurance Operations determined on a statutory basis to loss and LAE reservesdetermined in accordance with GAAP at December 31, as follows:

 
| ** **                                  | ** ** | **December 31,**    | ** ** |
|---------------------------------------------|------------|--------------------------|------------|
| ** **                                  | ** ** | **2008**                 | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                  | ** ** | **($ in millions)** | ** ** |
| Statutory reserves                          |       | $                        | 3,465.0    |   | $ | 3,564.5 |   | $ | 3,863.9 |   |
| Reinsurance recoverable on unpaid losses(1) |       | 1,073.9                  |       | 1,190.9 |   | 1,280.5 |   |
| Other(2)                                    |       | (34.4                    | )          | (36.6 | ) | (36.2 | ) |
| GAAP reserves                               |       | $                        | 4,504.5    |   | $ | 4,718.8 |   | $ | 5,108.2 |   |

----

 

(1)                                  Representsadjustments made to add back reinsurance recoverables on unpaid losses includedwith the presentation of reserves under GAAP.

 

(2)                                  Representslong-term workers compensation loss and LAE reserve discount in excess ofstatutorily defined discount.

 

**AffiliateQuota Shares**

 

Our consolidated financial statements reflect two quota sharereinsurance agreements we entered into with subsidiaries of White Mountains.The affiliate quota shares were commuted during the fourth quarter of 2006 inconnection with OBIG’s initial public offering. Under the Esurance InsuranceCompany (Esurance) Quota Share (the Esurance Quota Share), which was effective January 1,2005, we assumed approximately 85% of business written by Esurance, whichincluded business written by its wholly-owned subsidiary. Under the SiriusInternational Insurance Corporation (Sirius) Quota Share (the Sirius QuotaShare), we ceded between 6% and 12% of business written, effective April 1,2004, to Sirius.

 

The affiliate quota shares were entered into primarily for WhiteMountains’ capital management purposes and therefore, financial informationreflected in Primary Insurance Operations are prior to the quota sharereinsurance agreements consistent with how management measures our financialperformance.

 

**OtherOperations**

 

Our Other Operations segment consists of the activities of our holdingcompany, OBH. Our Other Operations segment primarily consists of financingactivities, purchase accounting adjustments relating to the OneBeaconAcquisition and other assets and general and administrative expenses incurredat the holding company level.

 

In May 2003, OBH issued $700.0 million face value of seniorunsecured notes (the Senior Notes) through a public offering, at an issue priceof 99.7%. The Senior Notes bear an annual interest rate of 5.875%, payablesemi-annually in arrears on May 15 and November 15, until maturity onMay 15, 2013. White Mountains currently provides an irrevocable andunconditional guarantee as to the payment of principal and interest (theGuarantee) on the Senior Notes. In consideration of this Guarantee, we haveagreed to pay White Mountains a specified fee in the amount of 25 basis pointsper annum on the outstanding principal amount of the Senior Notes. We havefurther agreed that if White Mountains’ voting interest in OBIG ceases torepresent more than 50% of all OBIG’s voting securities, we will redeem,exchange or otherwise modify the Senior Notes in order to fully and permanentlyeliminate White Mountains’ obligations under the Guarantee. See “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Financing”.

 

As part of the financing for the OneBeacon Acquisition, BerkshireHathaway, Inc. (Berkshire) invested a total of $300 million in cash,of which (1) $225 million was for the purchase of cumulativenon-voting preferred stock of OBH (the Berkshire Preferred Stock), which had a$300 million redemption value; and (2) $75 million was for thepurchase of warrants 

 

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toacquire 1,724,200 common shares of White Mountains. The Berkshire PreferredStock was entitled to a dividend of no less than 2.35% per quarter through May 31,2008. The Berkshire Preferred Stock was redeemed in the second quarter of 2008for $300 million, its redemption value.

 

In connection with OBIG’s initial public offering and as part of thereorganization at White Mountains, we created an irrevocable grantor trust andfunded it with assets sufficient to provide for the remaining dividend andredemption payments for the $300 million Berkshire Preferred Stock. Thecreation and funding of the trust did not legally defease the preferred stocknor create any additional rights for the holder of the preferred stock eitherin the trust or otherwise, although the assets in the trust were segregatedfrom our other general assets and are not available for any use other than thepayment of the Berkshire Preferred Stock. The assets held in trust were used toredeem the Berkshire Preferred Stock in May 2008 for $300 million, itsredemption value. See “Management’s Discussion and Analysis of Financial Conditionand Results of Operations—Economic Defeasance”.

 

**Investments**

 

*Overview*

 

Our long-term investment philosophy has historically been to maximizeour after tax total risk-adjusted return. Under this approach, each dollar ofafter tax investment income and realized and unrealized gains and losses isvalued equally. We recently shifted our investment philosophy from a totalreturn focus to a capital preservation focus in response to the significantdeclines and high volatility in equity markets, the lack of liquidity in thecredit markets and the widening of credit spreads on fixed income securitiesexperienced in the latter half of 2008. In particular, we significantly reducedthe size of our equity portfolio and now have a larger percentage of our investedassets in cash and short-term investments than we have in the past under atotal return approach. We expect to return to our long-term total returninvestment philosophy in the future when conditions are more favorable.

 

Our investment portfolios are managed under agreements with WhiteMountains Advisors, LLC (WM Advisors) a registered investment advisor thatis owned by White Mountains, and Prospector Partners, LLC (Prospector), aregistered investment advisor. See Note 18—“Related Party Disclosures” of theaccompanying consolidated financial statements. Our investment philosophy is tomaximize our after tax total risk-adjusted return over the long term. Underthis approach, each dollar of after tax investment income and realized andunrealized gains and losses is valued equally. Our investment portfolio mix asof December 31, 2008 consisted in large part of high quality, fixedmaturity investments and short-term investments, as well as a smallerallocation to equity investments which are comprised of common stock,convertible bonds and other investments such as hedge funds, limitedpartnerships and private equity interests. Our management believes that prudentlevels of investments in common equity securities, convertible bonds and otherinvestments within our investment portfolio are likely to enhance long termafter tax total returns without significantly increasing the risk profile ofthe portfolio.

 

*Fixed Income and Other Investments*

 

WM Advisors manages our fixed income portfolio, which includes both fixedmaturity and short-term investments, and our other investments portfolio. WMAdvisors’ overall fixed maturity investment strategy is to purchase securitiesthat are attractively priced in relation to credit risks. WM Advisors generallymanages the interest rate risk associated with holding fixed maturityinvestments by actively maintaining the average duration of the portfolio toachieve an adequate after tax total return without subjecting the portfolio toan unreasonable level of interest rate risk.

 

*Common Stock and Convertible Bonds*

 

Prospector manages our common stock and convertible bond portfolios.Prospector’s investment strategy is to maximize absolute total return throughinvestments in a variety of equity, equity-related and convertible bond instruments.Using a value orientation, Prospector invests in relatively concentratedpositions in the United States and other developed markets. Prospector’sphilosophy is to invest for total risk-adjusted return using a bottom-up, valuediscipline. Preservation of capital is of the utmost importance.

 

*SecuritiesLending*

 

Weparticipate in a securities lending program whereby we loan investmentsecurities to other institutions for short periods of time in order to generateadditional investment income on our fixed maturity and common equityportfolios. Under the securities lending arrangements, certain of our fixedmaturity and common equity investments are loaned to other institutions forshort periods of time through a lending agent. We maintain control over thesecurities we lend, retain the 

 

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earningsand cash flows associated with the loaned securities and receive a fee from theborrower for the temporary use of the asset. All securities loaned can beredeemed on short notice. Collateral, in the form of cash and United Statesgovernment securities, is required at a rate of 102% of the fair value of theloaned securities, is controlled by the lending agent and may not be sold orre-pledged. The lending agent manages the investment of the cash collateral.The fair value of the securities lending collateral is recorded as both anasset and liability on the balance sheet, however, other than in the event ofdefault by the borrower, this collateral is not available to us and will beremitted to the borrower by the lending agent upon the return of the loanedsecurities. Because of these restrictions, we consider our securities lendingactivities to be non-cash transactions. An indemnification agreement with thelending agent protects us in the event a borrower becomes insolvent or fails toreturn any of the securities on loan. The total market value of our securitieson loan at December 31, 2008 was $107.7 million with correspondingcollateral of $100.7 million, resulting in an unrealized loss of $7.0million recorded in change in net unrealized gains and losses on investments.The total market value of our securities on loan at December 31, 2007 was$438.9 million with corresponding collateral of $438.9 million.

 

InFebruary 2009, we amended the terms of our securities lending program togive us more control over the investment of borrowers’ collateral and tosegregate the assets supporting that collateral into a segregatedaccount. Pursuant to the amendment, (i) the guidelines for theinvestment of any new cash collateral as well as the reinvestment of cash werenarrowed to permit investment in only cash equivalent securities, (ii) wehave the authority to direct the lending agent to both sell specific collateralsecurities in our segregated account and to not sell certain collateralsecurities which the lending agent proposes to sell, and (iii) we and thelending agent agreed to manage the securities lending program toward an orderlywind-down, which we believe will be completed over an approximately 1 to 2 yearperiod. As of the date of the amendment, the market value of thesecurities on loan was approximately $64.2 million.

 

*Investment in UnconsolidatedAffiliate—Main Street America Holdings, Inc. (MSA)*

 

Our equity in earnings of unconsolidated affiliate represents anoperating investment in MSA in which we had a significant voting and economicinterest but did not control the entity. On October 31, 2006, we receiveda $70 million cash dividend from MSA, a subsidiary of Main Street AmericaGroup Mutual Holdings, Inc., a Florida-domiciled mutual property andcasualty insurance holding company, which insures risks located primarily inNew York, Massachusetts, Connecticut, Pennsylvania, New Hampshire, Virginia andFlorida and whose consolidated insurance subsidiaries are rated “A” (Excellent,the third highest of fifteen ratings) by A.M. Best. Following thistransaction, we sold our 50% common stock investment in MSA to Main StreetAmerica Group, Inc., or the MSA Group, for (i) $70.0 million in9.0% non-voting cumulative perpetual preferred stock of the MSA Group and (ii) 4.9%of the common stock of the MSA Group. These transactions resulted in a netafter tax realized gain of $8.5 million.

 

Prior to the exchange of our common stock investment in MSA, weaccounted for this investment using the equity method of accounting. MSA’s netwritten premiums for the ten months ended October 31, 2006 totaled$424.2 million and its net income totaled $32.3 million. Subsequentto the exchange, our investment in MSA is included in our common stock andfixed income portfolios.

 

**RegulatoryMatters**

 

*General*

 

Our insurance operations are subject to regulation and supervision ineach of the jurisdictions where they are domiciled and licensed to conductbusiness. Generally, state regulatory authorities have broad supervisory andadministrative powers over such matters as licenses, standards of solvency,premium rates, policy forms, investments, security deposits, methods ofaccounting, form and content of the consolidated financial statements, reservesfor unpaid loss and LAE, reinsurance, minimum capital and surplus requirements,dividends and other distributions to shareholders, periodic examinations andannual and other report filings. In general, such regulation is for theprotection of policyholders rather than shareholders.

 

*State Accreditation and Monitoring*

 

Over the last several years most states have implemented laws thatestablish standards for current, as well as continued, state accreditation. Inaddition, the National Association of Insurance Commissioners (NAIC) hasadopted risk-based capital (RBC) standards for property and casualty companies,which are designed to determine minimum capital requirements and to raise thelevel of protection that statutory surplus provides for policyholderobligations. The RBC formula for property and casualty insurance companiesmeasures three major areas of risk facing property and casualty insurers:underwriting, which encompasses the risk of adverse loss developments andinadequate pricing; declines in asset 

 

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valuesarising from market and/or credit risk; and off-balance sheet risk arising fromadverse experience from non-controlled assets, guarantees for affiliates orother contingent liabilities and excessive premium growth. Under laws adoptedby individual states, insurers having less total adjusted capital than thatrequired by the RBC calculation will be subject to varying degrees ofregulatory action, depending on the level of capital inadequacy. Our currentRBC ratios are satisfactory.

 

The NAIC has developed a set of financial relationships or tests knownas the Insurance Regulatory Information System to assist state regulators inmonitoring the financial condition of insurance companies and identifying companiesthat require special attention or action by insurance regulatory authorities.Insurance companies generally submit data annually to the NAIC, which in turnanalyzes the data using prescribed financial data ratios, each with defined “usualranges.” Generally, regulators will begin to investigate or monitor aninsurance company if its ratios fall outside the usual ranges for four or moreof the ratios. If an insurance company has insufficient capital, regulators mayact to reduce the amount of insurance it can issue. We are not aware that anyof our insurance companies are currently subject to regulatory investigationbased on these ratios.

 

State insurance laws require us to analyze the adequacy of our reservesannually. Our actuaries must submit an opinion that our reserves, whenconsidered in light of the assets we hold with respect to those reserves, makeadequate provision for our contractual obligations and related expenses.

 

Many states have laws and regulations that limit an insurer’s ability toexit a market. For example, certain states limit a private passenger automobileinsurer’s ability to cancel or renew policies. Furthermore, certain statesprohibit an insurer from withdrawing from one or more lines of insurancebusiness in the state without the state regulator’s approval. State regulatorsmay refuse to approve withdrawal plans on the grounds that they could lead tomarket disruption.

 

*Mandatory Shared Market Mechanisms*

 

As a condition of our license to do business in certain states, we arerequired to participate in mandatory shared market mechanisms. Each statedictates the types of insurance and the level of coverage that must beprovided. The most common type of shared market mechanism in which we arerequired to participate is an assigned risk plan. Many states operate assignedrisk plans. The NYAIP and New Jersey commercial automobile insurance plans aretwo such shared market mechanisms in which we are required to participate.These plans require insurers licensed within the applicable state to accept theapplications for insurance policies of customers who are unable to obtaininsurance in the voluntary market. The total number of such policies an insureris required to accept is based on its market share of voluntary business in thestate. Underwriting results related to assigned risk plans are typicallyadverse. Accordingly, we may be required to underwrite policies with a higherrisk of loss than we would otherwise accept.

 

Reinsurance facilities are another type of shared market mechanism.Reinsurance facilities require an insurance company to accept all applicationssubmitted by certain state designated agents. The reinsurance facility thenallows the insurer to cede some of its business to the reinsurance facility sothat the facility will reimburse the insurer for claims paid on ceded business.Typically, however, reinsurance facilities operate at a deficit, which isfunded through assessments against the same insurers. The MassachusettsCommonwealth Automobile Reinsurers is one such reinsurance facility in which weare required to participate.

 

*Guaranty Associations*

 

The insurance laws of many states generally provide that property andcasualty insurers doing business in those states belong to a statutory propertyand casualty guaranty association. The purpose of these guaranty associationsis to protect policyholders by requiring that solvent property and casualtyinsurers pay certain insurance claims of insolvent insurers. These guarantyassociations generally pay these claims by assessing solvent insurersproportionately based on the insurer’s share of voluntary written premiums inthe state. While most guaranty associations provide for recovery of assessmentsthrough rate increases, surcharges or premium tax credits, there is noassurance that insurers will ultimately recover these assessments. At December 31,2008, our aggregate reserve for such assessments totaled $17.4 million.

 

*Pricing, Investment and Dividends*

 

Nearly all states have insurance laws requiring property and casualtyinsurers to file price schedules, policy or coverage forms, and otherinformation with the state’s regulatory authority. In most cases, such priceschedules and/or policy forms must be approved prior to use. While pricing lawsvary from state to state, their objectives are generally to ensure that pricesare adequate, not excessive and not discriminatory. For example, Massachusetts,a state where we have a sizable presence, had previously set virtually allaspects of automobile insurance rates, including agent commissions. While thestate 

 

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isnow transitioning to a system of managed competition, existing regulationscontinue to challenge an insurer’s ability to adequately price its product,which often leads to unsatisfactory underwriting results.

 

We are subject to state laws and regulations that require investmentportfolio diversification and that limit the amount of investment in certaincategories. Non-compliance may cause non-conforming investments to benon-admitted in measuring statutory surplus and, in some instances, may requiredivestiture.

 

One of the primary sources of cash inflows for us is dividends receivedfrom our operating subsidiaries. Under the insurance laws of the jurisdictionsunder which our insurance subsidiaries are domiciled, an insurer is restrictedwith respect to the timing or the amount of dividends it may pay without priorapproval by regulatory authorities. During 2008, our first-tier insurancesubsidiaries declared and paid $201.5 million in cash and non-cashdividends to OneBeacon Insurance Group LLC (OneBeacon LLC). Our first tierinsurance subsidiaries have the ability to pay dividends of approximately$136 million to their parent in 2009 without approval of regulatoryauthorities.

 

*Holding Company Structure*

 

We are subject to regulation under certain state insurance holdingcompany acts. These regulations contain reporting requirements relating to ourcapital structure, ownership, financial condition and general businessoperations. These regulations also contain special reporting and prior approvalrequirements with respect to certain transactions among affiliates. Since we arean insurance holding company, the domiciliary states of our insurancesubsidiaries impose regulatory application and approval requirements onacquisitions of common shares which may be deemed to confer control over thosesubsidiaries, as that concept is defined under the applicable state laws.Acquisition of as little as 10% of our common shares may be deemed to confercontrol under the insurance laws of some jurisdictions, and the applicationprocess for approval can be extensive and time consuming.

 

*Terrorism*

 

While the federal government does not directly regulate the insurancebusiness, federal legislation and administrative policies affect the insuranceindustry. The Terrorism Act established a federal “backstop” for commercialproperty and casualty losses, including workers compensation, resulting fromacts of terrorism by or on behalf of any foreign person or foreign interest. Asextended in December 2007, the law also covers domestic acts of terrorism.See “Business—Reinsurance Protection and Catastrophe Management” and “—Terrorism”.We are actively complying with the requirements of the Terrorism Act in orderto ensure our ability to be reimbursed by the federal government for any losseswe may incur as a result of future terrorist acts.

 

*Legislation*

 

In addition, legislation has been introduced in recent years that, ifenacted, could result in the state and federal government assuming a moredirect role in the regulation of the insurance industry. Furthermore, a numberof additional enacted and pending state and federal legislative measures couldlead to increased consolidation and increased competition for business and forcapital in the financial services industry. We cannot predict whether any stateor federal measures will be adopted to change the nature or scope of theregulation of the insurance business or what effect such measures may have onour insurance operations.

 

*Environmental*

 

Both federal and state laws and regulations govern the environmentalcleanup of contaminated sites by, or for the account of, potentiallyresponsible parties (PRPs). Superfund and comparable state statutes can imposeliability for the entire cost of clean-up upon any responsible party,regardless of fault. The insurance industry in general is involved in extensivelitigation regarding coverage issues arising out of the cleanup of such sitesby insured PRPs and as a result has disputed many such claims. From time totime, comprehensive Superfund reform proposals are introduced in Congress, butnone has yet been enacted. At this time, it remains unclear as to whetherSuperfund reform legislation will be enacted or that any such legislation willprovide for a fair, effective and cost-efficient system for settlement ofSuperfund related claims. The NICO Cover includes coverage for such exposuresat our company, however, there can be no assurance that the coverage providedunder the NICO Cover will ultimately prove to be adequate for our incurredenvironmental losses.

 

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** **

**Competition**

 

Property and casualty insurance is highly competitive. Our competitorsinclude numerous national and regional property and casualty insurers. The moresignificant competitive factors for most insurance products we offer are price,product terms and claims service. Our underwriting principles and dedication toindependent agency distribution are unlikely to make us the low-cost providerin most markets. However, while it is often difficult for insurance companiesto differentiate their products to consumers, we believe that our dedication toproviding superior product offerings, expertise and local talent, claimsservice and disciplined underwriting provide a competitive advantage overtypical low-cost providers. However, as the emergence and growth of competitorsthat have lower cost structures, such as direct writers, continues, we willface greater pressure on our pricing which may impact our ability to compete.

 

**Ratings**

 

Insurance companies are evaluated by various rating agencies in orderto measure each company’s financial strength. Higher ratings generally indicatefinancial stability and a stronger ability to pay claims. We believe thatstrong ratings are an important factor in the marketing of insurance productsto agents and consumers. These financial strength ratings do not refer to ourability to meet non-insurance obligations and are not a recommendation topurchase or discontinue any policy or contract issued by us.

 

Thefollowing table presents the financial strength ratings assigned to ourprincipal insurance operating subsidiaries.

 
| ** **  | ** ** | **A.M. Best(1)**           | ** ** | **Standard & Poor’s(2)** | ** ** | **Moody’s(3)**    | ** ** | **Fitch(4)**            | ** ** |
|-------------|------------|----------------------------|------------|----------------------------------------|------------|------------------------|------------|-------------------------|------------|
| **Rating**  |       | “A”  (Excellent) |       | “A”  (Strong)                |       | “A2”  (Good) |       | “A”  (Strong) |       |
| **Outlook** |       | Stable                     |       | Negative                               |       | Stable                 |       | Stable                  |       |

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(1)                                  “A” is thethird highest of fifteen financial strength ratings.

 

(2)                                  “A” is thesixth highest of twenty-one financial strength ratings.

 

(3)                                  “A2” is thesixth highest of twenty-one financial strength ratings.

 

(4)                                  “A” is thesixth highest of twenty-one financial strength ratings.

 

The 5.875% Senior Notes due 2013 of OBH are currently rated “bbb” (“Good”,the ninth highest of twenty-two ratings) with a stable outlook by A.M.Best, “BBB” (“Adequate”, the ninth highest of twenty-two ratings) with a stableoutlook by Standard & Poor’s, “Baa2” (“Medium Grade”, the ninthhighest of twenty-one ratings) with a stable outlook by Moody’s, and “BBB” (“Good”,the ninth highest of twenty-three ratings) with a stable outlook by Fitch.

 

**Employees**

 

As of December 31, 2008, we employed approximately 2,500 persons.We believe that we have satisfactory relations with our employees.

 

**AVAILABLEINFORMATION**

 

In May 2003, OBH issued $700 million of public notes pursuantto a Form S-3 filing made jointly by White Mountains and OBH. Prior toOBIG’s initial public offering, OBH was exempt from filing its own annual andquarterly reports with the Securities and Exchange Commission (SEC). Condensedconsolidating financial information for OBH was included in White Mountains’ Form 10-Kand Form 10-Q filings. Subsequent to OBIG’s initial public offering, OBHis subject to the informational reporting requirements of the SecuritiesExchange Act of 1934. In accordance therewith, we file reports and otherinformation with the SEC. These documents are available free of charge atwww.onebeacon.com as soon as reasonably practicable after such material iselectronically filed with or furnished to the SEC. In addition, the Code of BusinessConduct as well as the charters of the Board Committees of our ultimate parent,OBIG, are available free of charge at www.onebeacon.com.

 

We will provide upon request and without charge, copies of thesedocuments (excluding any applicable exhibits unless specifically requested).Written or telephone requests should be directed to Investor Relations,OneBeacon Insurance 

 

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Group, Ltd.,1 Beacon Lane, Canton, MA 02021, telephone number(877) 248-8765. Additionally, all such documents are physically availableat the Company’s headquarters at 1 Beacon Lane, Canton, MA 02021.

 

**ITEM1A.  RISK FACTORS**

 

The information contained in this report may contain “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934. *See***“FORWARD-LOOKINGSTATEMENTS”** (page 78) *forspecific important factors that could cause actual results to differ materiallyfrom those contained in forward-looking statements.* The Company’sactual future results and trends may differ materially depending on a varietyof factors including, but not limited to, the risks and uncertainties discussedbelow.

 

**Risks Relating to Our Business**

 

***Our loss reserves may be inadequateto cover our ultimate liability for losses and as a result our financialresults could be adversely affected.***

 

We are required to maintain adequate reserves to cover our estimatedultimate liabilities for loss and LAE. Loss and LAE reserves are typicallycomprised of (1) case reserves for claims reported and (2) reservesfor losses that have occurred but for which claims have not yet been reported,referred to as IBNR reserves, which include a provision for expected futuredevelopment on case reserves. These reserves are estimates based on actuarialand statistical projections of what we believe the settlement andadministration of claims will cost based on facts and circumstances then knownto us. Because of the uncertainties that surround estimating loss and LAEreserves, we cannot be certain that our reserves are adequate and actual claimsand claim expenses paid might exceed our reserves due to the uncertainties thatsurround estimating loss and LAE reserves. For example, we have had a largenumber of construction defect claims arising from our general liability andmultiple peril lines of business. Construction defect is a highly uncertainexposure due to issues concerning whether coverage exists, the definition of anoccurrence, the determination of ultimate damages and the allocation of suchdamages to financially responsible parties.

 

We had established gross loss and LAE reserves of $4,294.0 million and$4,480.3 million as of December 31, 2008 and 2007, respectively. Forthe years ended December 31, 2008, 2007, and 2006, we recorded (favorable)or adverse loss reserve development of $(62.0) million, $(48.3) million, and$11.3 million, respectively, net of reinsurance, related to the re-estimationof previously established reserves.

 

If in the future we determine that our reserves are insufficient tocover our actual loss and LAE, we would have to strengthen our reserves, whichcould have a material adverse effect on our financial condition and results ofoperations.

 

For additional information relating to loss and LAE reserverequirements, see “Regulatory Matters.” For further discussion of our loss andLAE reserves, including our A&E reserves, see “Business—Loss and LAEReserves” and “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Critical Accounting Estimates.”

 

***Exposure to asbestos or environmental claims couldmaterially adversely affect our financial condition and results of operations.***

 

Estimating our exposure to A&E claims is subject to a particularlyhigh degree of uncertainty. If we have not established adequate loss and LAEreserves to cover future claims, our financial condition and results ofoperations could be materially adversely affected.

 

To help protect against potential A&E claims relating to the periodprior to 2001, we have a reinsurance contract from NICO, rated “AAA” (ExtremelyStrong, the highest of twenty-one ratings) by Standard & Poor’s and “A++”(Superior, the highest of fifteen ratings) by A.M. Best. We refer to thisreinsurance contract as the NICO Cover. Under the NICO Cover we are entitled torecover up to $2.5 billion from NICO for (1) all asbestos claimsarising from business written by us in 1992 and prior, (2) allenvironmental claims arising from business written by us in 1987 and prior, and(3) certain other latent exposures. In September 2008, we completed astudy of our A&E exposures. Based on the study, we increased our best estimateof incurred losses ceded to NICO, net of underlying reinsurance, by $83 millionto $2.2 billion. See “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Primary Insurance Operations—Year ended December 31,2008 versus year ended December 31, 2007—Asbestos and EnvironmentalExposures”.  As of December 31,2008, we have ceded estimated incurred losses of approximately$2.2 billion to the NICO Cover, leaving remaining protection under theNICO Cover of $320.2 million. Net losses paid totaled $1.1 billion as of December 31,2008, with $108.5 million paid in 2008. Due to exclusions in policy languageand changes in coverages provided, we do not believe that 

 

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wehave significant exposure to asbestos claims arising from business we wroteafter 1992 or to environmental claims arising from business we wrote after1987.

 

As of December 31, 2008, we had established gross loss and LAEreserves for asbestos claims of $1,098.4 million. Approximately 99% ofthese loss and LAE reserves are covered under reinsurance arrangements. Our netloss and LAE reserves for asbestos claims after giving effect to third partyreinsurance other than the NICO Cover was $741.5 million at December 31,2008. Our net loss and LAE reserves for asbestos claims after giving effect toboth third party reinsurance and the NICO Cover was $6.5 million at December 31,2008.

 

Estimating our future exposure to asbestos claims is subject toconsiderable uncertainty due to tort liability reform in various states, thedifficulty of predicting jury awards in such matters and diverging legalinterpretations and rules in different jurisdictions. These uncertaintiesalso include, among other things:

 

·                  the extent of coverage underinsurance policies;

 

·                  whether or not particularclaims are subject to an aggregate limit;

 

·                  the number of occurrencesinvolved in particular claims; and

 

·                  new theories of insured andinsurer liability.

 

The ultimate liability for our asbestos claims remains uncertain andcould exceed the coverage under our reinsurance arrangements and our net lossand LAE reserves.

 

Insurers, including us, experienced an increase in the number of newasbestos-related claims in recent years, in particular in 2002 and 2003. Weexperienced a 12% increase in the number of accounts with asbestos-relatedclaims reported during 2002 as compared to 2001 and another 51% increase in thenumber reported in 2003 from the level reported in 2002. We believe thisincrease was attributable to, among other things, more intensive advertising bylawyers seeking asbestos claimants, the increasing focus by plaintiffs on newand previously peripheral defendants, an acceleration of claims prior to thepotential enactment of U.S. federal asbestos legislation, and an increase inthe number of entities seeking bankruptcy protection as a result ofasbestos-related liabilities. During 2004, we started to experience a decreasein the number of accounts with asbestos-related claims reported with a 37%decrease from the level reported in 2003; however, the number of accounts withasbestos-related claims reported in 2004 was still above levels reported in1999, 2000 and 2001. During 2005, 2006 and 2007, we experienced a 6%, 13% and15% decrease, respectively, in the number of accounts with asbestos-relatedclaims reported when compared to the average of the prior three-year period.During 2008, we experienced a 32% decrease in the number of accounts withasbestos-related claims reported when compared to the average of the priorthree-year period. It is uncertain whether the number of new annual claims andfilings will continue to decrease, remain stable or increase when compared toprior annual periods. Also, in addition to adding new claims, bankruptcyproceedings may have the effect of significantly accelerating and increasingloss payments by insurers, including us.

 

Increasingly, policyholders have been asserting that their claims forasbestos-related insurance are not subject to aggregate limits on coverage andthat each individual bodily injury claim should be treated as a separateoccurrence under a policy. Some policyholders who previously sought paymentfrom us for asbestos claims under their products liability coverages, whichwere subject to aggregate limits, have increasingly sought payment from us forasbestos claims under the premises and operations coverages of their liabilitypolicies, which may not be subject to similar aggregate limits. We expect thistrend to continue. To the extent either issue is resolved in favor ofpolicyholders, our coverage obligations under the relevant policies would bematerially increased and capped only by the applicable per occurrence limitsand the number of asbestos bodily injury claims against the policyholders.Claims in these instances may vary significantly and policyholders may seeklarge amounts, although such claims frequently settle for a fraction of theinitial alleged amount. Accordingly, it is difficult to predict the ultimatesize of the claims for coverage not subject to aggregate limits.

 

From time to time in recent years, the United States Congress has givenconsideration to legislative proposals that would address various issuesconnected with asbestos liability. While it is unclear whether any suchproposals will be passed into law at any time in the near future, if at all, wecannot predict what impact, if any, such adopted legislation would have on ourultimate asbestos liability or on the NICO Cover.

 

As of December 31, 2008, we had established gross loss and LAEreserves for environmental claims of $470.3 million. Approximately 99% ofthese loss and LAE reserves are covered under reinsurance arrangements. Our netreserves for environmental claims after giving effect to third partyreinsurance other than the NICO Cover was 

 

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$261.2 millionat December 31, 2008. Our net loss and LAE reserves for environmentalclaims after giving effect to both third party reinsurance and the NICO Coverwas $5.5 million as of December 31, 2008. Future exposure fromenvironmental claims is uncertain, in part, for reasons similar to thosedescribed above for asbestos claims.

 

As a result of various state and federal laws and regulations relatingto environmental remediation, particularly the Comprehensive EnvironmentalResponse, Compensation, and Liability Act of 1980, which is commonly referredto as Superfund, and related damages claims, the insurance industry continuesto be involved in litigation involving policy coverage and liability issues. Inaddition to regulatory pressures, the results of court decisions affecting theindustry’s coverage positions continue to be inconsistent and have expandedcoverage beyond the industry’s original expectations. Accordingly, the ultimateliability for environmental costs remains uncertain and could exceed thecoverage of our reinsurance arrangements.

 

***We may not be able to successfullyalleviate risk through reinsurance arrangements. Additionally, we may be unableto collect all amounts due from our reinsurers under our existing reinsurancearrangements.***

 

We attempt to limit our risk of loss through reinsurance arrangements.The availability and cost of reinsurance protection is subject to marketconditions, which are outside of our control. In addition, the coverage underour reinsurance contracts may be inadequate to cover our future liabilities. Asa result, we may not be able to successfully alleviate risk through thesearrangements, which could have a material adverse effect on our financialcondition and results of operations.

 

We are not relieved of our obligations to our policyholders bypurchasing reinsurance. Accordingly, we are subject to credit risk with respectto our reinsurance in the event that a reinsurer is unable to pay amounts owedto us as a result of a deterioration in its financial condition. A number ofreinsurers in the industry experienced such deterioration in the aftermath ofthe 2001 terrorist attacks and the active 2005 hurricane season. To mitigatethis risk, we annually review and periodically monitor our reinsurers’financial condition and require at the time of purchase of reinsurance thateach of our reinsurers holds a rating of at least “A-” (Excellent, the fourthhighest of fifteen ratings) by A. M. Best or the equivalent.  While we believe that our reinsurers’financial condition is strong, it is possible that one or more of ourreinsurers will be significantly adversely affected by future significant lossevents, causing them to be unable to pay amounts owed to us. We also may beunable to recover amounts due under our reinsurance arrangements if ourreinsurers choose to withhold payment due to a dispute or other factors beyondour control.

 

***Unpredictable catastrophic events could adverselyaffect our financial condition or results of operations.***

 

We write insurance policies that cover catastrophic events. Ourpolicies cover unpredictable natural and other disasters, such as hurricanes,windstorms, earthquakes, floods, fires, explosions and severe winter weather.In recent years, the frequency of major weather-related catastrophes hasincreased. Our exposure to catastrophic windstorm damage in the NortheasternUnited States is the largest single natural catastrophe risk to our business.Some extremely remote modeled catastrophic events, or series of catastrophicevents, could be of sufficient size to cause us to become insolvent, whichcould adversely affect our financial condition and results of operations. Wealso have significant exposure to a major earthquake in California andwindstorm damage in the United States Atlantic Coast (i.e., Massachusetts toFlorida) and the United States Gulf Coast region (i.e., Florida to Texas). Inaddition, we are exposed to losses from terrorist attacks, such as attacks onthe United States on September 11, 2001.

 

The extent of losses from a catastrophe is a function of both the totalamount of insured exposure in the area affected by the event and the severityof the event. Increases in the value and concentrations of insured property,the effects of inflation and changes in cyclical weather patterns may increasethe severity of claims from catastrophic events in the future. Claims fromcatastrophic events could reduce our earnings and cause substantial volatilityin our results of operations for any fiscal quarter or year and adverselyaffect our financial condition. Our ability to write new insurance policiescould also be impacted as a result of corresponding reductions in our surpluslevels.

 

We manage our exposure to catastrophic losses by limiting the aggregateinsured value of policies in geographic areas with exposure to catastrophicevents, by estimating a probable maximum loss, which we refer to as PML, formany different catastrophe scenarios and by buying reinsurance. To manage andanalyze aggregate insured values and PML, we use a variety of tools, includingcatastrophe modeling software packages. Our estimates of PML are dependent onmany variables, including assumptions about the demand surge and storm surge,loss adjustment expenses, insurance-to-value and storm intensity in theaftermath of weather-related catastrophes utilized to model the event and therelationship of the actual event to the modeled event. Accordingly, if ourassumptions about these variables are incorrect, the losses we might incur froman actual catastrophe could be materially higher than our expectation of lossesgenerated from modeled catastrophe scenarios, and our financial condition andresults of operations could be materially adversely affected.

 

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For example, in 2005, standard industry models for forecasting thelosses resulting from hurricanes Katrina, Rita and Wilma proved to beinadequate. We had losses of $69.1 million in 2005 resulting from thosehurricanes, which exceeded our internal expectations by approximately$24 million. The total industry loss from 2005 catastrophes was over$80 billion with approximately $58 billion related to hurricanesKatrina, Rita and Wilma, which materially exceeded industry models. During theyear ended December 31, 2006, we increased our estimates of ultimateincurred loss and LAE relating to hurricanes Katrina, Rita and Wilma by$19.9 million.

 

***Future insurance and reinsurancecoverage for terrorist acts is uncertain, and we may in the future havesubstantial exposure to such acts.***

 

We are unable to predict the extent to which our future insurancecontracts will cover terrorist acts. We also are unsure how terrorist acts willbe defined in our future contracts. The Terrorism Act, which has been extendedthrough the end of 2014, requires primary commercial insurers to make terrorismcoverage available and provides federal protection for certain losses above bothindividual company retention and industry retention levels. While we know of noreason that the Terrorism Act will not be extended for an additional period oftime, there is no assurance that it will be extended or of the terms of anysuch extension. The following types of coverage are excluded from the program:commercial automobile, burglary and theft, surety, farmowners, multi-peril andall professional liability coverages except directors and officers coverage. Wemanage our exposure to losses resulting from acts of terrorism by limiting ourconcentration of risk by geographic area. We estimate our PML for differentscenarios using computer models in conjunction with other data. We also manageour terrorism exposures by purchasing reinsurance. Our current property andcasualty catastrophe reinsurance programs provide coverage for us for “non-certified”events as defined under the Terrorism Act, provided such losses are not theresult of a nuclear, biological, chemical or radiological terrorist attack. Nonetheless,risks insured by us, including those covered by the Terrorism Act, remainexposed to terrorist attacks and the possibility remains that losses resultingfrom future terrorist attacks could prove to be material to our results ofoperations and financial condition.

 

***Our investment portfolio may sufferreduced returns or losses which could adversely affect our results ofoperations and financial condition. Any adverse changes in interest rates orvolatility in the equity and debt markets could result in significant losses inthe fair value of our investment portfolio.***

 

Our investment portfolio consists of fixed maturity securities,convertible bonds, short-term investments, common equity securities and otherinvestments such as hedge funds, limited partnerships and private equityinterests. Our investment selections are designed to maximize after tax, totalrisk-adjusted return over the long term; however, investing entails substantialrisks. We cannot assure you that we will achieve our investment objectives, andour investment performance may vary substantially over time.

 

Investment returns are an important part of our changes in book value,and fluctuations in the fixed income or equity markets could impair our resultsof operations or financial condition. A significant period of time normallyelapses between the receipt of insurance premiums and the disbursement ofinsurance claims. During this time, we generate investment income, consistingprimarily of interest earned on fixed maturity investments and dividends earnedon equity securities, by investing our capital as well as insurance premiumsallocated to support unpaid loss and LAE reserves. We also recognize unrealizedinvestment gains and losses on the securities we hold in our investment portfolioand we generate investment gains and losses from sales of securities from ourinvestment portfolio.

 

The investment income and fair market value of our investment portfolioare affected by general economic and market conditions, including fluctuationsin interest rates and volatility in the stock market. Interest rates are highlysensitive to many factors, including governmental monetary policies, domesticand international economic and political conditions and other factors beyondour control. Although we attempt to manage the risks of investing in a changinginterest rate environment, we may not be able to effectively mitigate interestrate sensitivity. In particular, a significant increase in interest rates couldresult in significant losses, realized or unrealized, in the fair value of ourinvestment portfolio and, consequently, could have an adverse affect on ourresults of operations.

 

In addition, we are exposed to changes in the level or volatility ofequity prices that affect the value of securities or instruments that derivetheir value from a particular equity security, a basket of equity securities ora stock index. These conditions are outside of our control and could adverselyaffect the value of our investments and our results of operations and financialcondition. During 2008, financial markets experienced an unprecedented level ofvolatility. For the year ended December 31, 2008, we recognized a totalpre-tax investment loss of $589.9 million, primarily due to the downturn in theequities markets. Although we have taken steps to reduce the level of risk inour portfolio by reducing our equity holdings, which are comprised of commonstock, convertible bonds and other investments, from 32% at December 31,2007 to 19% at December 31, 2008, there is no assurance that these stepswill fully protect us from further market downturns and volatility.

 

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We are highly dependent on WM Advisors, which is owned by WhiteMountains, and Prospector, in connection with the management of our investmentportfolio. WM Advisors supervises and directs the fixed income and alternativeinvestment portion of our investment portfolio, and Prospector supervises anddirects the publicly-traded common equity and convertible securities portion ofour investment portfolio. The agreements, entered into in November 2006 inconnection with OBIG’s initial public offering, provided for an initial fixedterm of three years, which was extended by us for an additional year (a fourthyear), and may be extended by us for a second additional year (a fifth year) ator prior to the end of the third year of the term. If we lose our investment relationshipwith WM Advisors or with Prospector, we may not be able to secure an investmentadvisor or advisors who will produce returns on our investments similar tothese produced by WM Advisors and Prospector in the past, or any positivereturns at all.

 

***We may not maintain favorablefinancial strength or creditworthiness ratings, which could adversely affectour ability to conduct business.***

 

Third party rating agencies assess and rate the financial strength,including claims-paying ability, of insurers and reinsurers. These ratings arebased upon criteria established by the rating agencies and are subject torevision at any time at the sole discretion of the agencies. Some of thecriteria relate to general economic conditions and other circumstances outsidethe rated company’s control. These financial strength ratings are used bypolicyholders, agents and brokers as an important means of assessing thesuitability of insurers as business counterparties and have become anincreasingly important factor in establishing the competitive position ofinsurance companies. These financial strength ratings do not refer to ourability to meet non-insurance obligations and are not a recommendation topurchase or discontinue any policy or contract issued by us or to buy, hold orsell our securities. General creditworthiness ratings are used by existing orpotential investors to assess the likelihood of repayment on a particular debtissue. We believe that strong debt ratings are important factors that providebetter financial flexibility when issuing new debt or restructuring existingdebt.

 

Rating agencies periodically evaluate us to confirm that we continue tomeet the criteria of the ratings previously assigned to us. Our currentfinancial strength ratings are “A” (“Excellent,” third highest of 15 ratings)by A. M. Best, “A” (“Strong,” sixth highest of 21 ratings) by Standard &Poor’s, “A2” (“Good,” sixth highest of 21 ratings) by Moody’s and “A” (“Strong,”sixth highest of 21 ratings) by Fitch. We currently have a “Stable” outlookfrom A.M. Best, Moody’s and Fitch. In 2008, Standard & Poor’schanged our outlook from “Stable” to “Negative”. A downgrade, withdrawal ornegative watch/outlook of our financial strength ratings could limit or preventour insurance subsidiaries from writing new insurance policies or renewingexisting insurance policies, which could have a material adverse affect on ourfinancial condition and results of operations. A downgrade, withdrawal ornegative watch/outlook of our creditworthiness ratings could limit our abilityto raise new debt or make new debt more costly and/or have more restrictiveconditions.

 

***Our debt and related service obligations couldadversely affect our business.***

 

As of December 31, 2008, we had $732.8 million face value ofindebtedness. Our ability to meet our debt and related service obligations, aswell as our ability to pay dividends, will depend on our future performance,which will be affected by financial, business, economic, regulatory and otherfactors, many of which are beyond our control. In addition, White Mountains is subject torestrictive financial covenants contained in its revolving credit facility thatrequire White Mountains to pay the principal and interest on its debt andmaintain specified financial ratios and to satisfy financial conditiontests.  A breach of these covenants couldresult in an event of default under White Mountains’ revolving credit facilitywhich would allow lenders to declare all amounts owed under the revolvingcredit facility to be immediately due and payable. A failure to pay principaland interest on White Mountains’ revolving credit facility would trigger crossacceleration provisions contained in the indentures of our Senior Notes. Wecannot be certain that our earnings will be sufficient to allow us to pay theprincipal and interest on our debt and meet our other obligations, or to repayany accelerated indebtedness as a result of the trigger of the crossacceleration provisions in the indentures of the Senior Notes. If we do not haveenough cash, we may be required to refinance all or part of our existing debt,sell assets, borrow more cash or sell equity. We cannot assure you that we willbe able to accomplish any of these alternatives on terms acceptable to us, ifat all. See the risk factor concerning our Senior Notes, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Liquidityand Capital Resources—Financing” and Note 18—“Related Party Disclosures” of theaccompanying consolidated financial statements.

 

We could incur additional indebtedness and issue preferred stock in thefuture. To the extent new debt, preferred stock and other obligations are addedto our and our subsidiaries’ current debt levels, the risks described in theprevious paragraph would increase.

 

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***We are a holding company with nodirect operations, and our insurance subsidiaries’ ability to pay dividends tous is restricted by law.***

 

As a holding company with no direct operations, we rely on netinvestment income and dividends and other permitted payments from oursubsidiaries to pay our expenses. Our subsidiaries may not be able to generatecash flow sufficient to pay a dividend or distribute funds to us. In addition,under the insurance laws of the jurisdictions in which our insurancesubsidiaries are domiciled, an insurer is restricted with respect to the timingor the amount of dividends it may pay without prior approval by regulatoryauthorities. Generally, our regulated operating subsidiaries have the abilityto pay dividends during any 12-month period in an amount equal to the greaterof prior year statutory net income or 10% of prior year statutory surplus,subject to the availability of unassigned funds. As a result, based on 2008statutory surplus, our top tier regulated operating subsidiaries have theability to pay approximately $136 million of dividends during 2009,subject to the availability of unassigned funds. As of December 31, 2008,our top tier regulated operating subsidiaries had $0.9 billion ofunassigned funds available for dividend distribution. Management believes thatour cash balances, cash flows from operations and cash flows from investmentsare adequate to meet expected cash requirements for the foreseeable future onboth a holding company and operating subsidiary level. However, if ourinsurance subsidiaries cannot pay dividends in future periods, we may have difficultyservicing our debt and meeting our holding company expenses. For additionalinformation relating to insurance regulations governing our operations, see “RegulatoryMatters.”

 

***The property and casualty insuranceindustry is highly competitive and we may not be able to compete effectively inthe future.***

 

The property and casualty insurance industry is highly competitive andhas, from time to time, experienced severe price competition. Competition inthe personal automobile insurance business line, for example, is intensifyingand rate pressures in the automobile industry are expected to continue. Wecompete with numerous national and regional insurance companies. Many of ourcompetitors have greater financial, marketing and management resources than wedo and have established long-term and continuing business relationshipsthroughout the insurance industry, which can be a significant competitiveadvantage for them.

 

In addition, we predominantly offer our products through a networkcomprised of independent agents. These agents compete with direct writers ofinsurance, who are often able to offer substantial discounts in pricing ascompared to our insurance products. If our agents experience increasedcompetition from direct writers of insurance, we in turn could be adverselyaffected if they are unable to maintain a competitive position in theirrespective markets. Our agents might also represent our competitors. If we areunable to maintain our competitive position, our financial condition andresults of operations may be adversely affected.

 

***We may suffer losses fromunfavorable outcomes from litigation and other legal proceedings.***

 

In the ordinary course of business, we are subject to litigation andother legal proceedings as part of the claims process, the outcomes of whichare uncertain. We maintain reserves for these legal proceedings as part of ourloss and LAE reserves. We also maintain separate reserves for legal proceedingsthat are not related to the claims process. In the event of an unfavorable outcomein one or more legal matters, our ultimate liability may be in excess ofamounts we have currently reserved for and such additional amounts may bematerial to our results of operations and financial condition. For adescription of our material legal proceedings, see “Business—Legal Proceedings.”

 

As industry practices and legal, judicial, social and other conditionschange, unexpected and unintended issues related to claims and coverage mayemerge. These issues may adversely affect our financial condition and resultsof operations by either extending coverage beyond our underwriting intent or byincreasing the number and size of claims. In some instances, these changes maynot become apparent until some time after we have issued insurance contracts thatare affected by the changes.

 

***Our profitability may be adverselyimpacted by inflation and legislative actions and judicial decisions.***

 

The effects of inflation could cause claim costs to rise in the future.In addition, judicial decisions and legislative actions continue to broadenliability and policy definitions and to increase the severity of claimpayments, such as described above with respect to A&E claims. To the extentinflation and these legislative actions and judicial decisions cause claim coststo increase above reserves established for these claims, we will be required toincrease our loss and LAE reserves with a corresponding reduction in our netincome in the period in which the deficiency is identified.

 

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***Regulation may restrict our abilityto operate.***

 

The insurance industry is subject to extensive regulation under U.S.and state laws. Governmental agencies have broad administrative power toregulate many aspects of the insurance business, which include premium rates,marketing practices, advertising, policy forms and capital adequacy. Thesegovernmental agencies are concerned primarily with the protection ofpolicyholders rather than shareholders. Insurance laws and regulations imposerestrictions on the amount and type of investments, prescribe solvencystandards that must be met and maintained and require the maintenance ofreserves. Premium rate regulation is common across all of our lines of businessand may make it difficult for us to increase premiums to adequately reflect thecost of providing insurance coverage to our policyholders. In our underwriting,we rely heavily upon information gathered from third parties such as creditreport agencies and other data aggregators. The use of this information is alsohighly regulated and any changes to the current regulatory structure couldmaterially affect how we underwrite and price premiums.

 

Changes in laws and regulations may restrict our ability to operateand/or have an adverse effect upon the profitability of our business within agiven jurisdiction. For example, legislation has been passed in Florida thatsignificantly changes reinsurance protection provided by the Florida HurricaneCatastrophe Fund to companies that write business in Florida. The newlegislation also contains a provision that will disallow insurers that writehomeowners insurance elsewhere in the United States to write automobileinsurance in Florida unless they also write homeowners insurance in Florida.The impact of the new legislation, which could be adverse, upon our insuranceoperations in Florida, cannot be determined until regulations interpreting thelegislation are promulgated. In addition, state and federal legislation hasbeen proposed to establish catastrophe funds and underwriting in coastal areaswhich could impact our business.

 

In addition, there are efforts currently underway to federally regulatefinancial services companies, which could include insurance companies,including through the establishment of a federal regulatory body oragency.  This legislation, if enacted,could result in the federal government assuming a more direct role in theregulation of the insurance industry. The current U.S. Congress could address the issue of federal regulationof insurance companies, including issues such as federal preemption of stateinsurance regulations as well as solvency and capital requirements. We cannotpredict whether any federal legislation will be enacted at all, or if it isenacted, what issues it will address. Any such legislation could have an effect on our business and results ofoperations.

 

***We may be unable to collect amounts utilized to capitalize reciprocals.***

 

Since 2002, we have capitalized three member-owned, not-for-profitinsurance associations, which we refer to as reciprocals, by loaning money tothem in exchange for surplus notes. As of December 31, 2008, we haveloaned an aggregate of $125.9 million, including $0.2 million loanedin the form of a security deposit, to the three reciprocals, and accrued$54.0 million in interest. These three associations are currentlyconsolidated in our consolidated financial statements. As a result, the surplusnotes, the security deposit and accrued interest have been eliminated inconsolidation. In the future, depending on their financial success, theseassociations could be deconsolidated. At such time, the surplus notes would bereflected as notes receivable on our balance sheet. Amounts utilized tocapitalize reciprocals can be difficult to extract as repayment of principaland interest is subject to regulatory approval. If any reciprocal is unable tocover its ultimate liability for loss and LAE or is unable to obtain insuranceregulatory approval to repay us, we would be unable to collect amounts owedunder the related surplus note. In addition, while we have no legal obligationto loan further funds to these reciprocals, even in the event their capital becomesdepleted, we may decide that it is in our best interest to provide thereciprocal with additional capital, thereby increasing our loss exposure.

 

***We depend on our key personnel to manage ourbusiness effectively and they may be difficult to replace.***

 

Our performance substantially depends on the efforts and abilities ofour management team and other executive officers and key employees.Furthermore, much of our competitive advantage is based on the expertise,experience and know-how of our key management personnel. We do not have fixedterm employment agreements with any of our key employees nor key man lifeinsurance, and the loss of one or more of these key employees could adverselyaffect our business, results of operations and financial condition. Our successalso depends on the ability to hire and retain additional key personnel.Difficulty in hiring or retaining key personnel could adversely affect ourresults of operation and financial condition.

 

***Our written premiums are heavilyconcentrated in the Northeastern United States.***

 

Our revenues and profitability for the foreseeable future will besubstantially impacted by prevailing regulatory, economic, demographic,competitive, weather and other conditions in the Northeastern United States.Changes in any of 

 

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theseconditions could make it more costly or more difficult to conduct our business.We are particularly exposed to Northeast windstorm risks. In 2008, 51.4% of ourdirect written premiums were derived from our Primary Insurance Operations inNew York, Massachusetts, New Jersey, Maine and Connecticut.

 

***Mandated market mechanisms mayrequire us to underwrite policies with a higher risk of loss and assessmentsand other surcharges for guaranty funds and second-injury funds may reduce ourprofitability.***

 

We are often required to participate directly or indirectly inmandatory shared market mechanisms as a condition of our licenses to dobusiness in certain states. These markets, which are commonly referred to as “residual”or “involuntary” markets, generally consist of risks considered to beundesirable from a standard or routine underwriting perspective. In 2008,approximately 1% of our net written premiums, excluding premiums written byAutoOne, related to our participation in mandatory shared market mechanisms.Underwriting performance related to assigned risk plans, a form of mandatedmarket mechanism, is typically adverse and, as a result, we are required tounderwrite some policies with a higher risk of loss than we would normallyaccept.

 

Each state dictates the level of insurance coverage that is mandatorilyassigned to participating insurers within these markets. Our participation inmandatory shared market mechanisms is principally concentrated in the States ofMassachusetts, New Jersey and New York. In certain states, such as New York,the amount of involuntary policies we are obligated to write in a given year isbased on our historical market share of all voluntary policies written withinthat state. The share of involuntary written premium for policies assigned byNYAIP, a residual insurance plan that obtains personal automobile insurance forindividuals who cannot otherwise obtain insurance in the voluntary insurancemarket, to a particular insurer in a given year is based on the proportion ofthe total voluntary writings in New York two years earlier. We estimate thecost of discharging our obligation for our NYAIP assignments as of December 31,2008 to be $4.8 million and we have recorded this estimate as a liabilityin our consolidated financial statements. Our participation in assigned riskplans may result in greater liabilities than we anticipate and could materiallyadversely affect our financial condition and results of operations.

 

In addition, virtually all states require insurers licensed to dobusiness in their state to bear a portion of the loss suffered by some insuredsas the result of impaired or insolvent insurance companies. These guarantyfunds are funded by assessments that are expected to increase in the future asa result of recent insolvencies. Many states also have laws that establishedsecond-injury funds to provide compensation to injured employees foraggravation of a prior condition or injury which are funded by eitherassessments based on paid losses or premium surcharge mechanisms. The effect ofthese assessments and surcharges or changes in them could reduce our profitabilityin any given period or limit our ability to grow our business.

 

***Cyclicality of the property andcasualty insurance industry may cause fluctuations in our results of operationsand financial condition.***

 

The property and casualty insurance business, especially the commerciallines business, has been historically characterized by periods of intense pricecompetition, which could have an adverse effect on our results of operationsand financial condition. Periods of intense price competition historically havealternated with periods when shortages of underwriting capacity have permittedattractive premium levels. Any significant decrease in the rates we can chargefor property and casualty insurance would adversely affect our results.

 

Our personal lines business is particularly affected by the cyclicalityof loss cost trends. Factors that affect loss cost trends in automobileunderwriting include inflation in the cost of automobile repairs, medical care,litigation of liability claims, improved automobile safety features,legislative changes and general economic conditions. Factors that affect losscost trends in homeowners underwriting include inflation in the cost ofbuilding materials and labor costs and demand caused by weather-relatedcatastrophes. Personal lines insurers, including us, are generally unable toincrease premium rates until some time after the costs associated with thecoverage have increased, primarily as a result of state insurance regulationlaws. Therefore, in a period of increasing loss costs, profit margins decline.

 

We expect to continue to experience the effects of this cyclicalitywhich, during down periods, could materially adversely affect our financialcondition and results of operations.

 

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***We may need additional capital inthe future, which may not be available to us or available to us on favorableterms.***

 

We may need to raise additional funds through public or private debt orequity financings in order to:

 

·                  fund liquidity needs;

 

·                  replace capital lost in theevent of a catastrophe or adverse reserve development or investment losses;

 

·                  refinance $676 millionaggregate principal amount of our Senior Notes;

 

·                  satisfy letter of credit orguarantee bond requirements that may be imposed by our clients or byregulators;

 

·                  acquire new businesses orinvest in existing businesses;

 

·                  expand our business into newregions and countries; or

 

·                  otherwise respond tocompetitive pressures.

 

Any additional financing we may need may not be available on termsfavorable to us, or at all.

 

***We may be unable to adequately maintain our systemsand safeguard the security of our data which may adversely impact our abilityto operate our business and cause reputational harm and financial loss.***

 

Our business and operations rely on secure and efficient processing,storage and transmission of customer and company data, including personallyidentifiable information such as a name together with a social security number,bank account number, driver’s license number, passport number or birthday(PII).  Our ability to effectivelyoperate our business depends upon our ability and the ability of certain thirdparties to access our computer systems to perform necessary business functionssuch as providing quotes and product pricing, billing and processing premiums,administering claims, and reporting our financial results.  Our business and operations also depend uponour ability to safeguard PII and other confidential and proprietary informationbelonging to us and our policyholders. Our systems may be vulnerable to unauthorized access and hackers,computer viruses, and other scenarios in which our data may be vulnerable to abreach.  Specifically, we could beexposed to data breach risk from lost or stolen laptops, other portable mediaor misdirected mailings containing PII.

 

Data incidents could result in reputational harm to us, which couldaffect our business and results of operations. Nearly every state has enacted data breach laws and regulations thatrequire, among other things, notification to affected persons and stateregulatory agencies of a data breach that involves PII. Some U.S. state andfederal laws also require us to implement measures to safeguard PII. Forexample, new Massachusetts regulations will require our employees to encryptinformation stored on laptops and other portable devices and transmittedthrough electronic media, and take reasonable steps to verify that our thirdparty vendors utilize security procedures to protect PII.

 

We have taken a number of steps to mitigate our risk. We have formed aData Privacy Committee and appointed an Information Privacy and SecurityOfficer. We have implemented policies, procedures, training and education ofemployees, as well as technology solutions to safeguard our information.Although we have taken measures to safeguard our information and that ofpolicyholder and other third parties, and we continually monitor the securityof our systems and information, we could be exposed to data loss. As a result,our ability to conduct our business may be affected, and impact our results ofoperations, financial condition and reputation.

 

**Risks Relating to Our Relationship with WhiteMountains**

 

***Transitional and other arrangementswith White Mountains may not be on arm’s length terms.***

 

In connection with OBIG’s initial public offering, OBIG and certainsubsidiaries of OBIG entered into certain contractual arrangements with WhiteMountains and its affiliates. These agreements were made in the context of aparent-subsidiary relationship. For example, some of our investments aremanaged pursuant to an investment management agreement on a discretionary basisby a registered investment advisor which is owned by White Mountains. We have amulti-year investment management contract with this advisor. While we aresatisfied with the terms of such arrangement, we cannot confirm that such termsare as favorable to us as they might have been had we contracted with anindependent advisor. On the other hand, after the expiration of this agreement,we may not be able to replace these investment services in a timely manner oron terms and conditions, including cost, that are comparable to those wereceive from White Mountains, and we may have to pay higher prices for similarservices from unaffiliated third parties. For more information on these andother arrangements with White Mountains, see Note 18—“Related PartyDisclosures” of the accompanying consolidated financial statements.

 

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*** ***

***Refinancing of our Senior Notes may occur onunfavorable terms.***

 

In connection with OBIG’s initial public offering, OBIG has enteredinto an agreement with White Mountains pursuant to which White Mountainsguarantees the Senior Notes of OBH for a specified fee in the amount of 25basis points per annum on the outstanding principal amount of the Senior Notes.We further agreed that if White Mountains’ voting interest in OBIG’s commonshares ceases to represent more than 50% of all OBIG’s voting securities, wewill seek to redeem, exchange or otherwise modify the Senior Notes in order tofully and permanently eliminate White Mountains’ obligations under itsguarantee. White Mountains and its subsidiaries beneficially own all of OBIG’soutstanding Class B common shares, representing 96.8% of the voting powerof OBIG’s voting securities. If we have not successfully eliminated theguarantee within 180 days upon notice of the triggering of the votinginterest condition, the guarantee fee will increase by 200 basis points. Theguarantee fee will further increase by 100 basis points for each subsequent90 day period thereafter, up to a maximum guarantee fee of 425 basis points,until White Mountains’ obligations under its guarantee have been extinguished.This arrangement could require us to devote significant time and expense tryingto refinance the Senior Notes and we may not be able to do so on commerciallyreasonable terms or at all.

 

White Mountains has a revolving credit facility which provides forborrowing up to a maximum of $442 million and which contains restrictivefinancial covenants. The indenture documents governing the Senior Notes providethat if White Mountains as guarantor of the Senior Notes has a payment defaultin excess of $25 million under a credit agreement, mortgage or similar debtagreement, there is a default under the Senior Notes (commonly referred to as a“cross default”). Therefore, if White Mountains were to breach its financialcovenants in its revolving credit facility, an event of default would result,which would allow lenders to declare all amounts owed under the revolvingcredit facility to be immediately due and payable. A failure to pay the amountsowed under the revolving credit facility would result in a trigger of the crossdefault provisions in the indenture documents governing the Senior Notesresulting in a required repayment of the Senior Notes. While we believe thatWhite Mountains is able to meet its obligations under its revolving creditfacility, there is the potential that adverse market or other conditions whichcannot be controlled could adversely impact White Mountains’ ability to meetits obligations as well as our ability to refinance the Senior Notes in theevent of a cross default. As of December 31, 2008, White Mountains haddrawn $200 million under the facility. See “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Liquidity and CapitalResources—Financing” and Note 18—“Related Party Disclosures” of theaccompanying consolidated financial statements.

 

**ITEM1B.  UNRESOLVED STAFF COMMENTS**

 

As of the date of this report, we had no unresolved written commentsfrom the Commission staff regarding our periodic or current reports under theExchange Act.

 

**ITEM2.  PROPERTIES**

 

Our headquarters are located at 1 Beacon Lane, Canton, Massachusetts02021 and our principal executive office is located at 601 Carlson Parkway,Minnetonka, Minnesota 55305. We also maintain branch offices in various citiesthroughout the United States. Our headquarters are owned by us. Our principalexecutive office and branch offices are leased. Management considers our officefacilities suitable and adequate for our current level of operations.

 

**ITEM3.  LEGAL PROCEEDINGS**

 

OB Holdings, and the insurance industry in general, are subject tolitigation and arbitration in the normal course of business. OB Holdings is nota party to any material litigation or arbitration other than as routinelyencountered in claims activity, none of which is expected by management to havea material adverse effect on OB Holdings’ financial condition and/or cashflows.

 

On July 24,2008, OneBeacon and Liberty Mutual entered into a Confidential SettlementAgreement and Release (the Settlement Agreement) that resolved nearly fouryears of arbitration and litigation.  Thedisputes concerned amounts which Liberty Mutual asserted were due to it underagreements with OneBeacon (the Liberty Agreements) for unallocated lossadjustment expenses and amounts which OneBeacon asserted were due to it relatedto claims administration and reinsurance. The Settlement Agreement represents a full and final resolution of thedisputes related to the Liberty Agreements.

 

In connection with the Settlement Agreement, OneBeacon took a pre-taxcharge in the amount of $9.2 million in the second quarter of 2008,representing a part of the cost of the settlement.  OneBeacon made a cash payment to LibertyMutual in the amount of $16.0 million on July 30, 2008. No further chargesor payments will be made with respect to the disputed matters.

 

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**PART II**

 

**ITEM5.  MARKET FOR THE COMPANY’S COMMONEQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES**

 

All of the Company’s outstanding shares are owned by OneBeacon U.S.Enterprises Holdings, Inc. (OBEH), formerly known as Fund AmericanEnterprises Holding, Inc., the Company’s parent and an indirect,wholly-owned subsidiary of OBIG. As of March 13, 2009, the Companyhad 505 shares of common stock, par value $1.00 per share, issued andoutstanding. There is no established public trading market for the Company’scommon stock.

 

For a discussion regarding the Company’s payment of dividends, and therestrictions related thereto, see “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Dividend Capacity”.

 

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**ITEM7.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*The following discussion contains “forward-lookingstatements.” Statements that are not historical in nature are forward-lookingstatements. OB Holdings cannot promise that our expectations in suchforward-looking statements will turn out to be correct. OB Holdings’ actualresults could be materially different from and worse than our expectations. See“Forward-Looking Statements” on page 78 for specific important factorsthat could cause actual results to differ materially from those contained inforward-looking statements.*

 

*The following discussion also includes two non-GAAPfinancial measures, loss and loss adjustment expenses ratio prior to reservereallocation and total combined ratio prior to reserve reallocation that havebeen reconciled to the most comparable GAAP financial measures (see pages 42and 53). OB Holdings believes these measures to be a useful supplement tothe comparable GAAP measures in evaluating OB Holdings’ financial performance.*

 

**Overview**

 

We are a property and casualty insurance writer that provides a rangeof specialty insurance products as well as a variety of segmented commercialand personal insurance products. With roots dating back to 1831, we have beenoperating for more than 175 years and have many long-standing relationshipswith independent agencies, which constitute our primary distribution channel.We consist of a group of operating companies which are U.S.-based property andcasualty insurance writers, most of which operate in a multi-company pool.Pooling arrangements permit the participating companies to rely on the capacityof the entire pool’s capital and surplus rather than just on its own capitaland surplus. Under such arrangements, the members share substantially allinsurance business that is written, and allocate the combined premiums, lossesand expenses. In the year ended December 31, 2008, our net writtenpremiums totaled $2.0 billion and we had total assets of $7.9 billionand total common shareholder’s equity of $1.1 billion at December 31,2008.

 

***Our Historical Consolidated Financial Information***

 

Prior to OBIG’s initial public offering, we consolidated certain otherbusinesses of White Mountains for GAAP financial reporting and U.S. taxpurposes that are no longer held by us (the Internal Reorganization). These otherbusinesses are therefore reflected in our historical consolidated financialstatements in this report as discontinued operations. Furthermore, on August 24,2006, we exchanged our investment in the common shares of Montpelier ReHoldings, Ltd. (Montpelier), for an agreed-upon portfolio of common equityand fixed maturity securities of equal value owned by White Mountains. (See “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Montpelier Investment”.) In the fourth quarter of 2006, we commutedour two quota share reinsurance arrangements with other subsidiaries of WhiteMountains.

 

***Our Segments***

 

Our reportable segments are Primary Insurance Operations, AffiliateQuota Shares and Other Operations.

 

*Primary Insurance Operations.*  Our Primary Insurance Operations segmentincludes the results of substantially all of our insurance operations, with theexception of certain quota share arrangements with affiliates of WhiteMountains as described below. Our Primary Insurance Operations segment alsoincludes run-off business which primarily consists of national accounts,certain specialty programs and regional agency business transferred to LibertyMutual effective November 1, 2001. See “Business—Run-off”.

 

*Affiliate Quota Shares.*  During 2004 and 2005, we entered into twoquota share reinsurance arrangements with other subsidiaries of WhiteMountains, primarily for White Mountains’ capital management purposes. Thesearrangements were commuted in the fourth quarter of 2006 in connection withOBIG’s initial public offering. Under the Sirius Quota Share, we ceded between6% and 12% of business written, effective April 1, 2004, to Sirius. Underthe Esurance Quota Share, effective January 1, 2005, we assumedapproximately 85% of business written by Esurance, which includes businesswritten by its wholly-owned subsidiary.

 

*Other Operations.*  Our Other Operations segment consists of theactivities of our holding company, OBH.

 

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***Revenues***

 

We account for insurance policies that we write in accordance withFinancial Accounting Standards Board (FASB) Statement of Financial AccountingStandards (SFAS) No. 60, “Accounting and Reporting by InsuranceEnterprises,” (SFAS 60). Premiums written are recognized as revenues andare earned ratably over the term of the related policy. Unearned premiumsrepresent the portion of premiums written that are applicable to futureinsurance coverage provided by policies. AutoOne, one of our subsidiaries,which acts as a LAD servicing carrier, enters into contractual arrangementswith insurance companies to assume private passenger and commercial automobileassigned risk exposures in 21 states and the District of Columbia. AutoOnereceives LAD and CLAD servicing fees from these other companies for assumingthese risks. In addition, AutoOne chooses to write certain policies voluntarilyby taking risks out of the NYAIP. These policies generate takeout credits whichcan be sold for fees, which we refer to as take-out fees, to other carriers.These other carriers in turn can use such credits to reduce their obligationsto write assigned risk business. AutoOne’s LAD and CLAD servicing and take-outfees are recorded as written premium when billed and are earned ratably overthe term of the related policy to which the fee relates.

 

***Deferred Acquisition Costs***

 

Deferred acquisition costs represent commissions, premium taxes,brokerage expenses and other costs that are directly attributable to and varywith the production of new business. These costs are deferred and amortizedover the applicable premium recognition period. Deferred acquisition costs arelimited to the amount expected to be recovered from future earned premiums andanticipated investment income.

 

***Loss and Loss Adjustment Expenses***

 

Loss and LAE are charged against income as incurred. Unpaid loss andLAE reserves are based on estimates (generally determined by claims adjusters,legal counsel and actuarial staff) of the ultimate costs of settling claims,including the effects of inflation and other societal and economic factors.Unpaid loss and LAE reserves represent management’s best estimate of ultimateloss and LAE, net of estimated salvage and subrogation recoveries, ifapplicable. Such estimates are reviewed and updated on a quarterly basis andany adjustments resulting therefrom are reflected in current operations. Theprocess of estimating loss and LAE involves a considerable degree of judgmentby management and the ultimate amount of expense to be incurred could beconsiderably greater than or less than the amounts currently reflected in theconsolidated financial statements.

 

***Reinsurance***

 

Our insurance subsidiaries enter into ceded reinsurance contracts fromtime to time to protect their businesses from losses due to concentration ofrisk and to limit losses arising from catastrophic events. The majority of suchreinsurance contracts are executed through excess-of-loss treaties andcatastrophe contracts under which a third party reinsurer indemnifies ourinsurance subsidiaries for a specified part or all of certain types of lossesover stipulated amounts arising from any one occurrence or event. We also haveentered into quota share treaties with reinsurers under which all risks meetingprescribed criteria are ceded to third party reinsurers on a pro rata basis.The amount of each risk ceded by us is subject to maximum limits that vary byline of business and type of coverage. Amounts related to reinsurance contractsare recorded in our consolidated financial statements in accordance with SFAS No. 113,“Accounting and Reporting for Reinsurance of Short-Duration and Long-DurationContracts” (SFAS 113) and Emerging Issues Task Force Topic No. D-54(EITF Topic D-54), as applicable.

 

Amounts recoverable from reinsurers are estimated in a mannerconsistent with the claim liability associated with the reinsured policies. Ourability to collect our reinsurance recoverables is subject to the solvency ofthe reinsurers with whom we have entered into reinsurance contracts. We areselective in regard to our reinsurers, principally placing reinsurance withthose reinsurers with strong financial condition, industry ratings and underwritingability. Management monitors the financial condition and ratings of ourreinsurers on an ongoing basis.

 

Reinsurance premiums, commissions, expense reimbursements and reservesrelated to reinsured business are accounted for on a basis consistent with thoseused in accounting for the original policies issued and the terms of thereinsurance contracts. Premiums ceded to other companies are reported as areduction of premiums written. Expense allowances received in connection withreinsurance ceded have been accounted for as a reduction of the related policyacquisition costs.

 

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***Mandatorily Redeemable Preferred Stock***

 

We had mandatorily redeemable preferred stock which was redeemed in theyear ended December 31, 2008. This instrument was classified as aliability and carried at its historical carrying value. All dividends andaccretion on our mandatorily redeemable preferred stock have been recorded asinterest expense. See Note 11—“Mandatorily Redeemable Preferred Stock” ofthe accompanying consolidated financial statements.

 

***Share-Based Compensation***

 

*CompensationPhilosophy*

 

Our executive compensation policies are designed with one goal in mind,namely, the maximization of shareholder value over long periods of time. Webelieve that this goal is best pursued by utilizing a pay-for-performanceprogram that serves to attract and retain superior executive talent and providemanagement with performance-based incentives to maximize shareholder value.Through this compensation program, we seek to maximize shareholder value byaligning closely the financial interests of management with those of ourshareholder and ultimately OBIG’s shareholders. The cost of all incentivecompensation is fully accrued and expensed.

 

Compensation of our senior management team, including our namedexecutive officers, consists primarily of three components: base salary, annualbonus and long-term incentive awards. Base salaries have been capped at$500,000. Annual bonus targets for all senior executives are 50%, with theexception of the Chief Executive Officer at 75%, of base salary. Long-termincentives for senior executives have in the past been comprised of performanceshares and/or performance units. Under these instruments, payouts areexplicitly tied to White Mountains’, OBIG’s or OneBeacon’s performance over athree-year period and are highly variable (the actual number of shares/unitspaid out at the end of the cycle will range from 0% to 200% of target dependingon performance against established goals). See Note 10—“EmployeeShare-Based Incentive Compensation Plans” of the accompanying consolidatedfinancial statements.

 

*Share-BasedCompensation—Primary Insurance Operations*

 

**2003—2005through 2006—2008 performance cycles**

 

For these cycles, OneBeacon revised the design of its long-termincentive plans from prior plan designs principally to use OneBeaconperformance units instead of White Mountains performance shares, withperformance targets primarily tied to OneBeacon’s adjusted combined ratio. Eachunit is initially valued at $100 and compounds in value over the performanceperiod by the underwriting return on capital achieved by OneBeacon. In the caseof certain senior officers of our Primary Insurance Operations segment, aportion of their long-term incentive compensation in these periods had beendenominated in White Mountains performance shares. As a result of the shiftfrom White Mountains performance shares to OneBeacon performance units, OBHoldings’ incentive compensation expense associated with these performancecycles is no longer significantly impacted by changes in the market price ofWhite Mountains common shares. Prior to February 2007, the value ofOneBeacon’s performance shares was based upon the market price of an underlyingWhite Mountains common share (WTM Performance Shares). In February 2007,the Compensation Committee of OBIG’s Board of Directors (the CompensationCommittee) canceled all of OneBeacon’s WTM Performance Shares outstanding (forthe 2005-2007 and 2006-2008 performance cycles) and replaced the awards withtwo performance share grants, a one-year 2007 performance cycle and a two-year2007-2008 performance cycle, whose value is based upon the market price of anunderlying OBIG common share (OB Performance Shares). In the 2007 performancecycle, a total of 117,363 performance shares were earned based upon aperformance factor of 63%. As of December 31, 2008, 137,400 performanceshares were outstanding with respect to the 2007—2008 performance cycle.

 

**2007—2009performance cycle**

 

In February 2007, the Compensation Committee approved theprincipal performance share goal of the OneBeacon Long-Term Incentive Plan (theIncentive Plan) to be growth in its intrinsic business value per share(GIBVPS). GIBVPS is defined by the Compensation Committee with respect to eachaward cycle. For the 2007-2009 performance cycle, the Compensation Committeedefined GIBVPS to be a weighted measure comprised of growth in OBIG’s adjustedbook value per share, underwriting return on equity and growth in OBIG’s priceper common share. As of December 31, 2008, 763,748 performance shares wereoutstanding with respect to the 2007—2009 performance cycle.

 

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**2008—2010performance cycle**

 

In February 2008, the Compensation Committee defined GIBVPS forthe 2008-2010 performance to be a weighted measure comprised of growth in OBIG’sadjusted book value per share and underwriting return on equity. As of December 31,2008, 1,367,379 performance shares were outstanding with respect to the 2008—2010performance cycle.

 

*Compensation—OtherOperations*

 

In connection with the Internal Reorganization, on August 3, 2006,all employees of our Other Operations segment became employees of WhiteMountains. Therefore, we will no longer incur significant compensation expensein our Other Operations segment.

 

*Share-BasedCompensation Recognition*

 

Our share-based compensation plans consist of performance shares whichare typically settled in cash. Effective January 1, 2006, we account forthese share-based compensation plans in accordance with SFAS No. 123R, “Share-BasedPayment” (SFAS 123R). Compensation cost is measured and recognized basedon the current market price of the underlying common shares and on the numberof shares that are expected to vest. Prior to adoption of SFAS 123R, weaccounted for these plans in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25),whereby we recognized compensation cost based on the current market price ofthe underlying common shares and on the assumption that all shares awardedwould vest. Prior to adoption of SFAS 123R, compensation cost gave effect onlyto actual rather than assumed forfeitures.

 

***Purchase Accounting***

 

In connection with purchase accounting for the OneBeacon Acquisition,we were required to adjust to fair value our loss and LAE reserves and therelated reinsurance recoverables by $646.9 million and$346.9 million, respectively, on our balance sheet as of June 1,2001. This net change to loss and LAE reserves of $300.0 million is beingaccreted through an income statement charge ratably with and over the periodthe claims are settled. Accordingly, we recognized $12.0 million,$16.0 million and $23.0 million of such charges, recorded asaccretion of fair value adjustment to loss and LAE reserves in the years ended December 31,2008, 2007 and 2006, respectively. As of December 31, 2008, theoutstanding pre-tax unaccreted adjustment was $5.4 million.

 

***Income taxes***

 

The income tax (benefit) provision related to pre-tax income or lossfrom continuing operations for the years ended December 31, 2008, 2007 and2006 represented an effective tax rate of (32.6)%, 41.2% and 31.3%,respectively. Our effective tax rate for the year ended December 31, 2008was lower than the U.S. statutory rate of 35% due to a pre-tax loss fromoperations and non-deductible dividends and accretion on the BerkshirePreferred Stock, partially offset by tax exempt interest and dividend income.Our effective tax rate for the year ended December 31, 2007 was higherthan the U.S. statutory rate of 35% primarily due to non-deductible dividendsand accretion on the Berkshire Preferred Stock, partially offset by tax exemptinterest and dividend income. Our effective tax rate for the year ended December 31,2006 was lower than the U.S. statutory rate of 35% primarily due to thesettlement of the federal income tax audits related to tax years prior to 2003,the tax benefits recognized on the exchange of our investment in MSA and taxexempt interest and dividend income, partially offset by non-deductibledividends and accretion on the Berkshire Preferred Stock. Due to the redemptionof the Berkshire Preferred Stock in May 2008, the impact of this item hasbeen eliminated for 2009 and subsequent years.

 

**Discontinued Operations**

 

In 2006, as part of the Internal Reorganization, we sold certainconsolidated subsidiaries to White Mountains at GAAP book value. We did notrecognize a gain or a loss on these sales. These subsidiaries which were soldon August 3, 2006 are included in discontinued operations and comprise thefollowing entities:

 

·                  White MountainsAdvisors, LLC (WM Advisors)—an investment management subsidiary;

 

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·                  White Mountains ManagementCompany, Inc. and White Mountains Capital, Inc.—both servicecompanies;

 

·                  White Mountains ServicesHoldings, Inc. and White Mountains Services, LLC—these companiescontain the remainder of mortgage banking run-off assets following the sale ofsubstantially all the mortgage banking assets of White Mountains ServicesCorporation (formerly Source One Mortgage Services Corporation) to CitibankMortgage, Inc. in 1999;

 

·                  Tuckerman Capital, L.P.and Tuckerman Capital II, L.P.—both private equity fund investments; and

 

·                  International AmericanGroup—primarily consisted of American Centennial Insurance Company and BritishInsurance Company of Cayman, two run-off insurance companies.

 

Net income from continuing operations for the year ended December 31,2006 excludes the results of operations for the above entities. Net income fromdiscontinued operations has been presented separately and is shown net ofrelated income taxes.

 

Cash flows associated with the operating and investing activities ofdiscontinued operations are aggregated and presented under separate captions inour consolidated statements of cash flows. There were no cash flows associatedwith financing activities for the discontinued operations.

 

**Other Acquisitions and Dispositions**

 

During the fourthquarter of 2008, we sold one of our inactive licensed subsidiaries, Farmers andMerchants Insurance Company (FMIC), to Pride Holdings LLC for $7.8 million incash and recorded a pre-tax gain of $1.1 million through net other revenues.

 

During the thirdquarter of 2008, we acquired EBI, an insurance agency specializing in theentertainment, sports and leisure industries, for $8.0 million in cash. Inconnection with the purchase of EBI, which was accounted for as an acquisitionunder the purchase method of accounting in accordance with SFAS No. 141, “BusinessCombinations,” we recorded the identifiable assets and liabilities of EBI attheir fair value at acquisition date. Significant assets and liabilitiesacquired include premiums and commissions receivable of $16.6 million andpremiums and commissions payable of $16.1 million. After allocating thepurchase price to identifiable tangible assets and liabilities, we alsorecorded an intangible asset of $9.5 million which represents the value ofbusiness in force at the acquisition date. The amortization associated with the intangible asset will be amortizedover a 10-year period in proportion to the timing of the discounted cash flowsused to value the business.

 

During the firstquarter of 2008, we sold one of our inactive licensed subsidiaries, MidwesternInsurance Company (MWIC), to National Guaranty Insurance Company for $4.2million in cash and recorded a pre-tax gain of $1.0 million through net otherrevenues.

 

During the third quarter of 2007, we sold one of our inactive licensedsubsidiaries, American Employers’ Insurance Company (AEIC) to Sparta InsuranceHoldings, Inc. (Sparta) for $47.7 million in cash, gross of salescosts, and recorded a pre-tax gain of $11.3 million through net otherrevenues.

 

On October 31, 2006, we restructured our investment in MSA. Wereceived a $70 million cash dividend from MSA following which we sold our50% common stock investment in MSA to Main Street America Group, Inc. (the MSA Group) for (i) $70.0 million in 9.0% non-voting cumulativeperpetual preferred stock of the MSA Group and (ii) 4.9% of the commonstock of the MSA Group. (See Note 3—“Acquisitions and Dispositions” of theaccompanying consolidated financial statements.) Effective October 31,2006 and prior to the adoption of SFAS No. 159, “The Fair Value Option forFinancial Assets and Liabilities” (SFAS 159), we accounted for our remaininginvestment in the MSA Group in accordance with SFAS No. 115, “Accountingfor Certain Investments in Debt and Equity Securities”. Prior to the sale, weowned 50% of the total common shares outstanding of MSA and accounted for thisinvestment using the equity method of accounting. These transactions resultedin a net after tax realized gain of $8.5 million.

 

On September 29, 2006 we sold certain assets and the right torenew existing policies of Agri, a division of OB Holdings that providedcommercial farm and ranch and commercial agricultural insurance products, for$32.0 million in cash to QBE Insurance Group, Ltd. (QBE) and recorded apre-tax gain of $30.4 million through net other revenues in 2006. In 

 

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connectionwith this sale, we have entered into agreements under which, at the option ofQBE, we will write the policies of Agri on a direct basis and cede 100% of thisbusiness to QBE.

 

During the third quarter of 2006, we sold one of our inactive licensedsubsidiaries, Homeland Central Insurance Company (HCIC), to a subsidiary ofWhite Mountains. In connection with the sale of HCIC, we recorded a$6.0 million gain as additional paid in capital.

 

**Results of Operations**

 

*Review of Consolidated Results*

 

A summary of our consolidated financial results for the years ended December 31,2008, 2007 and 2006 is as follows:

 
| ** **                                                                                              | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                              | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                                              | ** ** | **($ in millions)**         | ** ** |
| Net written premiums                                                                                    |       | $                                | 1,963.1    |   | $ | 1,864.4 |   | $ | 2,007.0 |   |
| **Revenues**                                                                                            |       |                             |       |   |   |   |   |
| Earned premiums                                                                                         |       | $                                | 1,879.0    |   | $ | 1,873.6 |   | $ | 2,075.9 |   |
| Net investment income                                                                                   |       | 162.1                            |       | 202.4 |   | 187.6 |   |
| Net realized investment (losses) gains                                                                  |       | (318.6                           | )          | 173.1 |   | 163.7 |   |
| Change in net unrealized investment gains and losses                                                    |       | (447.4                           | )          | — |   | — |   |
| Net other revenues                                                                                      |       | 13.8                             |       | 17.2 |   | 27.4 |   |
| Total revenues                                                                                          |       | 1,288.9                          |       | 2,266.3 |   | 2,454.6 |   |
| **Expenses**                                                                                            |       |                             |       |   |   |   |   |
| Loss and LAE                                                                                            |       | 1,126.2                          |       | 1,089.8 |   | 1,283.6 |   |
| Policy acquisition expenses                                                                             |       | 368.3                            |       | 318.9 |   | 379.9 |   |
| Other underwriting expenses                                                                             |       | 290.8                            |       | 329.4 |   | 360.1 |   |
| General and administrative expenses                                                                     |       | 12.9                             |       | 3.2 |   | 9.8 |   |
| Accretion of fair value adjustment to loss and LAE reserves                                             |       | 12.0                             |       | 16.0 |   | 23.0 |   |
| Interest expense on debt                                                                                |       | 44.9                             |       | 45.2 |   | 45.5 |   |
| Interest expense—dividends and accretion on preferred stock subject  to mandatory redemption       |       | 33.4                             |       | 64.4 |   | 56.6 |   |
| Total expenses                                                                                          |       | 1,888.5                          |       | 1,866.9 |   | 2,158.5 |   |
| **Pre-tax (loss) income from continuing operations**                                                    |       | (599.6                           | )          | 399.4 |   | 296.1 |   |
| Income tax benefit (provision)                                                                          |       | 195.3                            |       | (164.5 | ) | (92.6 | ) |
| **Net (loss) income from continuing operations  before equity in earnings of unconsolidated affiliate** |       | (404.3                           | )          | 234.9 |   | 203.5 |   |
| Equity in earnings of unconsolidated affiliate                                                          |       | —                           |       | — |   | 10.3 |   |
| **Net (loss) income from continuing operations**                                                        |       | (404.3                           | )          | 234.9 |   | 213.8 |   |
| Net income from discontinued operations                                                                 |       | —                           |       | — |   | 1.2 |   |
| **Net (loss) income**                                                                                   |       | (404.3                           | )          | 234.9 |   | 215.0 |   |
| Other comprehensive (loss) income                                                                       |       | (25.6                            | )          | (3.9 | ) | 30.6 |   |
| **Comprehensive net (loss) income**                                                                     |       | $                                | (429.9     | ) | $ | 231.0 |   | $ | 245.6 |   |

 

**ConsolidatedResults—Year ended December 31, 2008 versus year ended December 31,2007**

 

Our comprehensive net loss was $429.9 million in the year ended December 31,2008, compared to comprehensive net income of $231.0 million in the year ended December 31,2007. Comprehensive net loss for the year ended December 31, 2008 includedthe impact of a $19.5 million (after tax) decrease in our pension plansprimarily related to a decrease in the over-funded status of our qualifiedpension plan driven by investment results and a $5.7 million (after tax)decrease in our interest rate swap relating to the mortgage note.

 

Net loss was $404.3million in the year ended December 31, 2008, compared to net income of$234.9 million in the year ended December 31, 2007. As described below,effective January 1, 2008, we adopted SFAS 159 and elected to record thechanges in net unrealized gains and losses from our available-for-salesecurities and our investments in limited 

 

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partnerships, hedge fundsand private equity interests in revenues in arriving at net income. In priorperiods, these changes have been included in other comprehensive income.Accordingly, net (loss) income and pre-tax (loss) income for the year ended December 31,2008 are not directly comparable to such measures for the year ended December 31,2007. See “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Summary of Investment Results” for further discussion.

 

Our total revenues decreased43.1% to $1,288.9 million in the year ended December 31, 2008, compared to$2,266.3 million in the year ended December 31, 2007. The decrease wasmainly due to a $491.7 million decrease in net realized investment (losses)gains to $(318.6) million and the inclusion of a $(447.4) million change in netunrealized investment gains and losses in the year ended December 31,2008. During the year ended December 31, 2008, we recognized realizedlosses of $239.8 million for declines in fair value deemed to beother-than-temporary. These realized losses were comprised primarily of $136.8million of losses related to common equity securities, $58.4 million of lossesrelated to fixed maturity investments, $14.7 million related to convertiblebonds and $29.9 million of losses related to other investments. The loss incommon equity securities included $20.9 million of losses within the energysector, $29.5 million within the utilities sector, $35.6 million within thefinancial sector, $30.3 million within the materials sector and $13.5 millionwithin the consumer discretionary sector. The year ended December 31, 2007included the sale of certain convertible fixed maturity and equity securitiesin industry sectors that experienced significant appreciation in the first halfof 2007. Net investment income decreased 19.9% to $162.1 million in the yearended December 31, 2008. Net other revenues decreased 19.8% to $13.8million in the year ended December 31, 2008, compared to $17.2 million inthe year ended December 31, 2007. The year ended December 31, 2008included a $1.0 million gain from the sale of MWIC and a $1.1 million gain fromthe sale of FMIC. The year ended December 31, 2007 included an $11.3million gain from the sale of AEIC.

 

Our total expensesincreased 1.2% in the year ended December 31, 2008 to $1,888.5 million,compared to $1,866.9 million in the year ended December 31, 2007. Loss andLAE increased by 3.3% to $1,126.2 in the in the year ended December 31,2008 primarily due to $57.4 million of current accident year catastrophelosses, compared to $16.4 million in the year ended December 31, 2007,partially offset by a $13.7 million increase in favorable loss reservedevelopment compared to the year ended December 31, 2007 as describedbelow. Policy acquisition expenses increased by 15.5% to $368.3 million in theyear ended December 31, 2008 mainly due to higher acquisition costsassociated with our newer specialty lines businesses and the change in mix ofbusiness at OBPP. In addition, in the year ended December 31, 2007,insurance acquisition expenses were lower due to an increase in the deferralrate of commercial lines’ policy acquisition costs related to the expansioninto new states and the benefit of a $7.6 million state premium tax refund inpersonal lines. These increases were slightly offset by a decrease in otherunderwriting expenses. General and administrative expenses increased 303.1% to$12.9 million primarily related to operating expenses of EBI which was acquiredin the third quarter of 2008.

 

Our income tax(benefit) provision related to pre-tax income or loss for the years ended December 31,2008 and 2007 represented effective tax rates of (32.6)% and 41.2%,respectively. Our effective tax rate for the year ended December 31, 2008was lower than the U.S. statutory rate of 35% due to a pre-tax loss fromoperations and non-deductible dividends and accretion on the BerkshirePreferred Stock, partially offset by tax exempt interest and dividend income.Our effective tax rate for the year ended December 31, 2007 was higherthan the U.S. statutory rate of 35% primarily due to non-deductible dividendsand accretion on the Berkshire Preferred Stock, partially offset by tax exemptinterest and dividend income. Due to the redemption of the Berkshire PreferredStock in May 2008, the impact of this item has been eliminated for 2009and subsequent years.

 

Our GAAP combinedratio for the year ended December 31, 2008 increased to 95.0% from 92.8%for the year ended December 31, 2007. The loss and LAE ratio increased 1.7points to 59.9% while the expense ratio increased 0.5 points to 35.1%. Theincrease in the loss and LAE ratio was due to 3.1 points of current accidentyear catastrophe losses mainly from hurricane Ike primarily within ourspecialty and commercial lines, and winter weather in the southeastern UnitedStates experienced in commercial lines in the first quarter of 2008. The lossand LAE ratio was also higher due to large losses at IMU in specialty lines andin the middle market division in commercial lines. These increases werepartially offset by $62.0 million or 3.3 points of favorable loss reservedevelopment due primarily to lower than expected severity on non-catastrophelosses. The favorable non-catastrophe loss reserve development was primarilyrelated to professional liability in specialty lines and package business incommercial lines partially offset by adverse loss reserve development atAutoOne and in run-off. The year ended December 31, 2007 included $48.3million or 2.6 points of favorable loss reserve development due to lower thanexpected frequency for professional liability in specialty lines and lower thanexpected severity for automobile liability in personal lines partially offsetby adverse loss reserve development for multiple peril and workers compensationprimarily for accident years 2001 and prior. The increase in the expense ratiowas from an increase in policy acquisition expenses, offset by a decrease inother underwriting expenses as described above. The year ended December 31,2007 included a 1.0 point benefit from the partial settlement of our qualifiedpension plan and a 0.4 point benefit from a state premium tax refund, partiallyoffset by 0.7 points of office consolidation costs.

 

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** **

**Consolidated Results—Year ended December 31, 2007 versus yearended December 31, 2006**

 

Our comprehensive net income was $231.0 million in the year ended December 31,2007, compared to comprehensive net income of $245.6 million in the yearended December 31, 2006. The decrease in comprehensive net income wasmainly due to a $34.5 million decrease in other comprehensive income whichincluded a $20.3 million decrease in the change in net unrealized investmentgains and losses and a $12.6 million decrease in the change in foreign currencytranslation adjustments primarily related to our foreign investment securities.

 

                Net income was $234.9 million inthe year ended December 31, 2007, compared to $215.0 million in the yearended December 31, 2006. Our total revenues decreased 7.7% for the yearended December 31, 2007 to $2,266.3 million, compared to$2,454.6 million in the year ended December 31, 2006, due principallyto a 9.7% decrease in earned premiums for 2007. The year ended December 31,2006 included $309.9 million of business assumed from the affiliate quotashare agreement with Esurance, which was commuted in the fourth quarter of2006, in connection with our initial public offering. Net realized investmentgains increased to $173.1 million in the year ended December 31,2007, compared with $163.7 million in the year ended December 31,2006. Net investment income increased to $202.4 million in the year ended December 31,2007, compared with $187.6 million in the year ended December 31, 2006.Net other revenues decreased 37.2% for the year ended December 31, 2007 to$17.2 million, compared to $27.4 million in the year ended December 31,2006, which included a $30.4 million gain on the sale of renewal rights ofAgri to QBE. Partially offsetting the Agri gain was a $12.6 millionpre-tax loss on the sale of our investment in MSA. This pre-tax loss was offsetby tax benefits recognized on the exchange of our investment in MSA describedabove. Net other revenues in the year ended December 31, 2007 included an$11.3 million gain from the sale of AEIC.

 

                Out total expenses decreased13.5% for the year ended December 31, 2007 to $1,866.9 million, comparedto $2,158.5 million in the year ended December 31, 2006, primarily due toa $193.8 million decrease in loss and LAE. As described below, our results forthe year ended December 31, 2007 included $48.3 million of favorable lossreserve development compared to $11.3 million of adverse loss reservedevelopment in the year ended December 31, 2006. Also described below, ourresults for the year ended December 31, 2007 included the benefit ofone-time non-recurring items including the partial settlement of our qualifiedpension plan which reduced loss and LAE by $6.3 million and reduced otherunderwriting expenses by $19.2 million and the benefit of a state premium taxrefund which reduced policy acquisition expenses by $7.6 million. Our generaland administrative expenses decreased $6.6 million mainly due to the inclusionof $4.1 million of incentive compensation in our other operations segment inthe year ended December 31, 2006 related to employees associated withholding company operations at White Mountains prior to our initial publicoffering, which were transferred to White Mountains.

 

During the year ended December 31, 2007, we reallocated reservesof our primary insurance operations from ongoing lines of business to run-offclaims, particularly reserves for construction defect and workers compensationrelated to accident years 2001 and prior. The reallocation shifted$116.7 million of our reserves from specialty lines ($87.4 million),commercial lines ($6.0 million) and personal lines ($23.3 million) torun-off claims. This adjustment had no impact on our total combined ratio forthe year ended December 31, 2007.

 

The income tax provision related to pre-tax income from continuingoperations for the years ended December 31, 2007 and 2006 representedeffective tax rates of 41.2% and 31.3%, respectively. Our effective tax ratefor the year ended December 31, 2007 was higher than the U.S. statutoryrate of 35% primarily due to non-deductible dividends and accretion on theBerkshire Preferred Stock, partially offset by tax exempt interest and dividendincome. Our effective tax rate for the year ended December 31, 2006 waslower than the U.S. statutory rate of 35% primarily due to the settlement offederal income tax audits related to tax years prior to 2003, the tax benefitsrecognized on the exchange of our investment in MSA and tax exempt interest anddividend income, partially offset by non-deductible dividends and accretion onthe Berkshire Preferred Stock.

 

Our GAAP combined ratio was 92.8% for the year ended December 31,2007, compared to 97.4% for the year ended December 31, 2006. The decreaseto our GAAP combined ratio was due to decreases in both our loss and LAE ratioand expense ratio. Our results for the year ended December 31, 2007included $48.3 million or 2.6 points of favorable loss reservedevelopment due to lower than expected frequency for professional liability inspecialty lines and lower than expected severity for automobile liability inpersonal lines partially offset by adverse loss reserve development for multipleperil and workers compensation primarily for accident years 2001 andprior. The prior year period included $11.3 million or 0.5 points ofadverse loss reserve development mainly due to adverse loss reserve developmenton catastrophe losses, primarily related to hurricanes Katrina and Wilma andtwo 2004 catastrophes, partially offset by favorable loss reserve developmenton non-catastrophe losses in specialty lines and commercial lines. Our expenseratio for the year ended December 31, 2007 decreased due to the benefit ofone-time, non-recurring items including the partial settlement of our 

 

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qualifiedpension plan liabilities and the benefit of a state premium tax refund whichreduced our expense ratio by 1.0 point and 0.4 points, respectively, partiallyoffset by 0.7 points of office consolidation costs. Our results for the yearended December 31, 2006 included 3.9 points related to incentivecompensation expense which was 1.0 point higher than in the year ended December 31,2007 and 1.0 point of office consolidation costs.

 

***Summary of Operations By Segment***

 

Our segments consist of the following: (1) Primary InsuranceOperations, (2) Affiliate Quota Shares and (3) Other Operations. Asdescribed above, in the first quarter of 2008, within our PrimaryInsurance Operations segment, we began to include Community Banks withincommercial lines. Community Banks was formerly reported in specialty lines.Prior periods have been reclassified to conform to the current presentation.The affiliate quota share agreements were commuted in the fourth quarter of2006 in connection with OBIG’s initial public offering.

 

Our investments are managed by our affiliate, WM Advisors, and byProspector. A discussion of our consolidated investment operations is includedafter the discussion of operations by segment. Our segment information ispresented in Note 14—“Segment Information” of the accompanyingconsolidated financial statements.

 

*Primary Insurance Operations*

 

Financial results for our Primary Insurance Operations segment for theyears ended December 31, 2008, 2007 and 2006, were as follows:

 
| ** **                                           | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                           | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                           | ** ** | **($ in millions)**         | ** ** |
| Net written premiums                                 |       | $                                | 1,963.1    |   | $ | 1,864.4 |   | $ | 1,957.6 |   |
| Earned premiums                                      |       | 1,879.0                          |       | 1,873.6 |   | 1,944.0 |   |
| Net investment income                                |       | 152.8                            |       | 184.5 |   | 182.3 |   |
| Net realized investment (losses) gains               |       | (317.9                           | )          | 174.5 |   | 165.3 |   |
| Change in net unrealized investment gains and losses |       | (442.6                           | )          | — |   | — |   |
| Net other revenues                                   |       | 14.0                             |       | 19.2 |   | 21.8 |   |
| Total revenues                                       |       | 1,285.3                          |       | 2,251.8 |   | 2,313.4 |   |
| Loss and LAE                                         |       | 1,126.2                          |       | 1,089.8 |   | 1,180.3 |   |
| Policy acquisition expenses                          |       | 368.3                            |       | 318.9 |   | 332.3 |   |
| Other underwriting expenses                          |       | 290.8                            |       | 329.4 |   | 360.1 |   |
| General and administrative expenses                  |       | 12.2                             |       | 2.9 |   | 3.3 |   |
| Interest expense on debt                             |       | 3.5                              |       | 3.2 |   | 2.9 |   |
| Total expenses                                       |       | 1,801.0                          |       | 1,744.2 |   | 1,878.9 |   |
| Pre-tax (loss) income                                |       | $                                | (515.7     | ) | $ | 507.6 |   | $ | 434.5 |   |

 

The following tables provide ratios, net written premiums and earnedpremiums by underwriting units for the years ended December 31, 2008, 2007and 2006:

 
| ** **             | ** ** | **Year ended December 31, 2008** | ** ** |
|------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **Specialty**                         | ** ** | **Commercial** | ** ** | **Personal** | ** ** | **Total(1)** | ** ** |
| ** **             | ** ** | **($ in millions)**              | ** ** |
| *Ratios: (2)(3)(4)(5)* |       |                                  |       |   |   |   |   |   |   |
| Loss and LAE           |       | 51.1                                  | %          | 59.7 | % | 64.0 | % | 59.9 | % |
| Expense                |       | 36.4                                  |       | 36.7 |   | 31.9 |   | 35.1 |   |
| Total GAAP combined    |       | 87.5                                  | %          | 96.4 | % | 95.9 | % | 95.0 | % |
| Net written premiums   |       | $                                     | 621.9      |   | $ | 722.1 |   | $ | 618.7 |   | $ | 1,963.1 |   |
| Earned premiums        |       | 512.7                                 |       | 725.2 |   | 640.8 |   | 1,879.0 |   |
|                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                                      | ** ** | **Year ended December 31, 2007** | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                      | ** ** | **Specialty**                         | ** ** | **Commercial** | ** ** | **Personal** | ** ** | **Total(1)** | ** ** |
| ** **                                      | ** ** | **($ in millions)**              | ** ** |
| *Ratios: (2)(3)(4)(5)*                          |       |                                  |       |   |   |   |   |   |   |
| Loss and LAE prior to reserve reallocation(6)   |       | 57.9                                  | %          | 51.5 | % | 60.4 | % | 58.2 | % |
| Impact of reserve reallocation(6)               |       | (20.2                                 | )          | (0.8 | ) | (3.2 | ) | — |   |
| Loss and LAE                                    |       | 37.7                                  |       | 50.7 |   | 57.2 |   | 58.2 |   |
| Expense                                         |       | 30.3                                  |       | 37.4 |   | 33.6 |   | 34.6 |   |
| Total GAAP combined                             |       | 68.0                                  | %          | 88.1 | % | 90.8 | % | 92.8 | % |
| Total combined prior to reserve reallocation(6) |       | 88.2                                  | %          | 88.9 | % | 94.0 | % | 92.8 | % |
| Net written premiums                            |       | $                                     | 440.3      |   | $ | 733.4 |   | $ | 690.4 |   | $ | 1,864.4 |   |
| Earned premiums                                 |       | 433.3                                 |       | 715.2 |   | 725.0 |   | 1,873.6 |   |
|                                                 |            |                                       |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **             | ** ** | **Year ended December 31, 2006** | ** ** |
|------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **Specialty**                         | ** ** | **Commercial** | ** ** | **Personal** | ** ** | **Total(1)** | ** ** |
| ** **             | ** ** | **($ in millions)**              | ** ** |
| *Ratios: (2)(3)(4)(5)* |       |                                  |       |   |   |   |   |   |   |
| Loss and LAE           |       | 54.6                                  | %          | 56.0 | % | 63.5 | % | 60.7 | % |
| Expense                |       | 33.8                                  |       | 39.4 |   | 32.4 |   | 35.6 |   |
| Total GAAP combined    |       | 88.4                                  | %          | 95.4 | % | 95.9 | % | 96.3 | % |
| Net written premiums   |       | $                                     | 433.9      |   | $ | 722.0 |   | $ | 800.6 |   | $ | 1,957.6 |   |
| Earned premiums        |       | 431.7                                 |       | 689.9 |   | 822.3 |   | 1,944.0 |   |
|                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |

----

 

(1)          Includesresults from run-off. For the years ended December 31, 2008, 2007 and2006, includes net written premiums of $0.4 million, $0.3 million and$1.1 million, respectively, from run-off and earned premiums of $0.3million, $0.1 million and $0.1 million, respectively, from run-off.

 

(2)          Asdescribed above, in the first quarter of 2008, within our Primary InsuranceOperations segment, we began to include Community Banks within commerciallines. Community Banks was formerly reported in specialty lines. Prior periodshave been reclassified to conform to the current presentation.

 

(3)          Includesour long-term incentive compensation expense. For the years ended December 31,2008, 2007 and 2006, long-term incentive compensation expense increased ourtotal GAAP combined ratio by 0.7 points, 1.6 points and 2.3 points,respectively.

 

(4)          Includesloss and LAE relating to catastrophes. For the years ended December 31,2008, 2007 and 2006, total calendar year incurred loss and LAE relating tocatastrophes increased our loss and LAE and total combined ratios by 2.8points, 0.8 points and 2.8 points, respectively, including development on prioraccident year catastrophes which (decreased) increased our loss and LAE andtotal combined ratios by (0.3) points, (0.1) point and 1.3 points,respectively.

 

(5)          Prioraccident year development, including development on catastrophes, for the yearsended December 31, 2008, 2007 and 2006 (decreased) increased our loss andLAE and total combined ratios by (3.3) points, (2.6) points and 1.2 points,respectively.

 

(6)          Representsa non-GAAP financial measure. During 2007, we reallocated reserves from ourongoing lines of business to run-off which had the effect of lowering the lossand LAE ratios and combined ratios of our ongoing businesses. The reallocationhad no impact on total primary insurance operations. For further discussion,see “Consolidated Results—Year ended December 31, 2007 versus year ended December 31,2006.” The tables above for the year ended December 31, 2007 reflect ourloss and LAE ratios and total combined ratios prior to the reserve reallocationand reconciles these non-GAAP financial measures to their most comparable GAAP measures.

 

**PrimaryInsurance Operations—Year ended December 31, 2008 versus year ended December 31,2007**

* *

*Specialty lines.* Net written premiums forspecialty lines increased by 41.2% to $621.9 million in the year ended December 31,2008 from $440.3 million in the year ended December 31, 2007. The increasewas primarily due to $110.0 

 

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millionin net written premiums from our specialty collector car and boat business thatwe began writing in the second quarter of 2008. The increase compared to prioryear was also due to writings from EBI which we acquired in the third quarterof 2008, as well as growth in A&H and OBGR. In addition, net writtenpremiums at OBPP increased $26.0 million.

 

The specialty lines combined ratio for the year ended December 31,2008 decreased to 87.5% from 88.2% for the year ended December 31, 2007.The loss and LAE ratio decreased 6.8 points to 51.1% while the expense ratioincreased 6.1 points to 36.4%. The decrease in the loss and LAE ratio wasmainly due to 10.2 points of favorable loss reserve development in the yearended December 31, 2008 primarily related to lower than expected severity inprofessional liability, compared with 2.8 points in the year ended December 31,2007 primarily related to professional liability. Partially offsetting thisdecrease was higher current accident year catastrophe losses in the year ended December 31,2008 which included 2.3 points primarily related to hurricane Ike, compared to0.5 points of current accident year catastrophe losses in the year ended December 31,2007. The increase in the expense ratio was mainly due to changes in mix ofbusiness within the specialty lines businesses and the mix of products offeredwithin those businesses. Our specialty collector car and boat business and someof our other new specialty lines businesses pay higher agent commissions thanthe previous mix of business. Also, at OBPP, our increased writings of ourlong-term care product and decreased writings of our provider excess insuranceproduct carry a higher and lower commission ratio, respectively, and shiftedthe expense ratio upward. In addition, during the year ended December 31,2008, we incurred additional transition costs associated with the newmanagement team at OBPP. The expense ratio for the year ended December 31,2007 included a 0.6 point favorable impact from the partial settlement of ourqualified pension plan liabilities, partially offset by 0.3 points of officeconsolidation costs.

 

*Commercial lines.* Net written premiums forcommercial lines decreased by 1.5% to $722.1 million in the year ended December 31,2008 from $733.4 million in the year ended December 31, 2007. Thedecrease was primarily due to a $29.0 million decrease in the middle marketdivision, reflecting the more competitive marketplace, partially offset byan  increase of $17.7 million in thesmall business division, principally driven by our small business packageproducts.

 

The commercial lines combined ratio for the year ended December 31,2008 increased to 96.4% from 88.9% for the year ended December 31, 2007.The loss and LAE ratio increased 8.2 points to 59.7%, while the expense ratiodecreased 0.7 points to 36.7%. The increase in the loss and LAE ratio was duein part to a 5.1 point increase in non-catastrophe losses in the year ended December 31,2008 mainly due to higher large losses including losses in our middle marketdivision related to winter weather in the northeastern United Statesexperienced in the first quarter and large property losses in the thirdquarter, compared with an unusually low level of large losses experienced inthe year ended December 31, 2007. Additionally, the loss and LAE ratioincreased due to 5.3 points of current accident year catastrophe losses in theyear ended December 31, 2008 primarily related to hurricane Ike in ourmiddle market and small business divisions and losses from tornados in thesoutheastern United States in our middle market division in the first quarter,compared to 1.2 points of catastrophe losses in the year ended December 31,2007. Expenses for the year ended December 31, 2008 were essentially flatcompared to the prior year. The year ended December 31, 2007 included a0.8 point benefit from the partial settlement of our qualified pension planliabilities, which was offset by 0.9 points of office consolidation costs.

 

*Personal lines.*  Net written premiums for personal linesdecreased by 10.4% to $618.7 million in the year ended December 31,2008 from $690.4 million in the year ended December 31, 2007. Intraditional personal lines, net written premiums decreased $59.6 million due tothe decision to cease writing business in Houston General Insurance Exchange(Houston General) in late 2007, lower new business associated with coastalrestrictions implemented at Adirondack Insurance and higher reinsurance costsat Adirondack Insurance, lower premium volume from the involuntary market inMassachusetts, and the discontinuation of surplus lines business. In January 2008,Houston General entered into a reinsurance agreement with Universal Holdings ofNorth America (Universal) under which Houston General ceded $6.6 million ofunearned premiums to Universal. Further, net written premiums at AutoOnedecreased $14.7 million due to significant declines in New York’s assigned riskpool. With respect to the New York assigned risk pool, market trends indicatethat assigned risk volumes are expected to decline to approximately $150million in 2009, which was consistent with 2008 and down from $179 millionin 2007 and $253 million in 2006. Assigned risk volumes in New Jersey arealso expected to decline in 2009. Market trends indicate that the assigned riskpool in New Jersey is expected to decline to approximately $35 million in 2009,down from $61 million in 2008, $77 million in 2007 and $141 millionin 2006. We expect a reduction in AutoOne’s 2009 premium volume reflective ofthese trends.

 

The personal lines combined ratio for the year ended December 31,2008 increased to 95.9% from 94.0% for the year ended December 31, 2007.The loss and LAE ratio increased 3.6 points to 64.0%, while the expense ratiodecreased by 1.7 points to 31.9%. The increase in the loss and LAE ratio wasprimarily due to 1.2 points of adverse loss reserve development in the yearended December 31, 2008, mainly on personal automobile liability atAutoOne compared with 3.3 points of favorable loss reserve development in theyear ended December 31, 2007, primarily related to automobile liabilitylosses in traditional personal lines and at AutoOne. The decrease in theexpense ratio was primarily due to decreased other 

 

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underwritingexpenses as a result of the decision to cease writing business in HoustonGeneral and actions taken in 2007 to better align personal lines staffing withour business needs. The expense ratio for the year ended December 31, 2007also included a 1.0 point benefit from a state premium tax refund, a 0.9 pointbenefit related to the partial settlement of our qualified pension planliabilities and 0.8 points of office consolidation costs.

 

Effective January 1, 2009, in an effort to further reduce ourproperty catastrophe exposure in the Northeast, we entered into a quota shareagreement with a select group of reinsurers, under which we will cede 30% ofour Northeast homeowners business written through OBIC and its subsidiarycompanies, along with Adirondack Insurance and New Jersey Skylands InsuranceAssociation in New York and New Jersey, respectively. The program providessupplemental protection to previously established reinsurance. The reinsurersare all rated “A” (Excellent, the third highest of fifteen) or better by A.M.Best. The program is expected to result in ceded premiums of approximately $65million in 2009.

 

*Run-off.*  Run-off business generated an underwritingloss of $21.9 million in the year ended December 31, 2008, compared to anunderwriting loss of $155.6 million ($38.9 million excluding a$116.7 million increase to loss and LAE reserves resulting from thereserve reallocation) in the year ended December 31, 2007. The year ended December 31,2008 includes incurred loss and LAE of $20.5 million ($9.2 million of incurredunallocated loss adjustment expenses (ULAE) related to the Liberty Mutualsettlement described in Part I, Item 3—“Legal Proceedings”), compared with$33.1 million (excluding the reserve reallocation) in the year ended December 31,2007. The year ended December 31, 2007 also includes a $5.1 millionbenefit from the partial settlement of our qualified pension plan liabilities.

 

*Asbestos and Environmental Exposures*

 

Asdescribed in “Critical Accounting Estimates,” we have a reinsurance contractwith NICO for up to $2.5 billion in old A&E claims and certain otherexposures. Under the terms of the NICO Cover, NICO receives the economicbenefit of reinsurance recoverables from certain of our third party reinsurersin existence at the time the NICO Cover was executed (Third PartyRecoverables). As a result, the Third Party Recoverables serve to protect the$2.5 billion limit of NICO coverage for our benefit.

 

In September 2008,we completed a study of our A&E exposures. This study considered, amongother items, (i) facts, such as policy limits, deductibles and availablethird party reinsurance, related to reported claims; (ii) current law; (iii) pastand projected claim activity and past settlement values for similar claims; (iv) industrystudies and events, such as recent settlements and asbestos-relatedbankruptcies; and (v) collectibility of third party reinsurance. Based onthe study, we increased our best estimate of our incurred losses ceded to NICO,net of underlying reinsurance, by $83 million to $2.2 billion, which is withinthe $2.5 billion coverage provided by the NICO Cover. The increase in theestimate of incurred A&E losses was principally driven by raisedprojections for claims related to asbestos. Based on the results of the study,we believe that, under all reasonable scenarios, ultimate incurred losses willnot exceed the NICO Cover. Approximately $1.1 billion of the estimated $2.2billion of incurred losses have been paid by NICO through December 31,2008. Due to the NICO Cover, there was no impact to income or equity from thechange in estimate.

 

The ratio of reserves netof Third Party Recoverables for A&E losses at December 31, 2008 totrailing three year average paid loss and allocated LAE (known in the industryas the “survival ratio”) is 12.7 years including the remaining availableprotection under the NICO Cover.

 

Our reserves forA&E losses at December 31, 2008 represent management’s best estimateof our ultimate liability based on information currently available. However,significant uncertainties, including but not limited to case law developments,medical and clean-up cost increases and industry settlement practices, limitour ability to accurately estimate ultimate liability and we may be subject toA&E losses beyond currently estimated amounts. In addition, we remainliable for risks reinsured in the event that a reinsurer does not honor itsobligations under reinsurance contracts. To the extent that actual experiencediffers from our estimate of incurred A&E losses and Third PartyRecoverables, future losses could exceed the $320.2 million of protectionremaining under the NICO Cover.

 

**PrimaryInsurance Operations—Year ended December 31, 2007 versus year ended December 31,2006**

 

*Specialty lines.* Net written premiums forspecialty lines increased by 1.5% to $440.3 million in the year ended December 31,2007 from $433.9 million in the year ended December 31, 2006.Excluding the Agri business, to which the renewal rights were sold in the thirdquarter of 2006, net written premiums increased by 19.2% in the year ended December 31,2007, compared to the year ended December 31, 2006. The increase wasprimarily due to an increase in net written premiums of $34.6 million inspecialty liability products at OBPP, an increase of $18.7 million at IMUand $14.9 million in A&H which commenced operations in 2007.

 

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The specialty lines combined ratio for the year ended December 31,2007 decreased to 88.2% from 88.4% for the year ended December 31,2006.  The loss and LAE ratio increased3.3 points to 57.9% while the expense ratio decreased 3.5 points to 30.3%. Theincrease in the loss and LAE ratio was primarily due to large losses in theAgri run-off business. The decrease in the expense ratio was primarily due to a3.3 point reduction of commission expense from fees received from frontingservices in the year ended December 31, 2007 from QBE on renewals of Agribusiness, as well as a 0.6 point favorable impact from the partial settlementof our qualified pension plan liabilities, partially offset by 0.3 points ofoffice consolidation costs

 

*Commercial lines.* Net written premiums forcommercial lines increased by 1.6% to $733.4 million in the year ended December 31,2007 from $722.0 million in the year ended December 31, 2006. Theincrease was due to a $35.5 million increase in the small businessdivision, principally driven by our small business package products. Partiallyoffsetting this increase was a $24.1 million decrease in the middle marketdivision primarily due to lower premiums at OBSP as a result of our strategy tomanage our exposure to potential catastrophe losses.

 

The commercial lines combined ratio for the year ended December 31,2007 decreased to 88.9% from 95.4% for the year ended December 31, 2006.The loss and LAE ratio decreased by 4.5 points to 51.5%, while the expenseratio decreased 2.0 points to 37.4%. The decrease in the loss and LAE ratio wasprimarily due to 3.0 points of favorable loss reserve development for the yearended December 31, 2007 primarily related to property and generalliability claims, partially offset by 0.9 point increase in the currentaccident year loss ratio driven in part by the pricing environment in the yearended December 31, 2007. The loss and LAE for the year ended December 31,2006 included 2.4 points of adverse loss reserve development mainly due to 3.8points of adverse loss reserve development on catastrophes primarily at OBSP,related to hurricanes Katrina and Wilma and two 2004 catastrophes. The decreasein the expense ratio was primarily due to lower policy acquisition expenses asa result of an increase to the deferral rate of commercial lines’ policyacquisition costs related to the expansion into new states, as well as a 0.8point favorable impact from the partial settlement of our qualified pensionplan liabilities. Partially offsetting the impact of these favorable items was0.9 points of office consolidation costs in the year ended December 31,2007, compared to 1.3 points in the year ended December 31, 2006.

 

*Personal lines.* Net written premiums forpersonal lines decreased by 13.8% to $690.4 million in the year ended December 31,2007 from $800.6 million in the year ended December 31, 2006. Intraditional personal lines, net written premiums decreased due to anincreasingly competitive auto market, Massachusetts state-mandated ratedecreases and the decision to cease writing business in Houston General in late2007. Net written premiums for Houston General were $15.1 million in theyear ended December 31, 2007, compared to $3.8 million in the yearended December 31, 2006. Further, net written premiums at AutoOnedecreased due to significant declines in New York’s and New Jersey’s assignedrisk pools, as described above. The reduction in AutoOne’s premium volume isreflective of these trends.

 

The personal lines combined ratio for the year ended December 31,2007 decreased to 94.0% from 95.9% for the year ended December 31, 2006.The loss and LAE ratio decreased 3.1 points to 60.4% while the expense ratioincreased by 1.2 points to 33.6%. The increase in the loss and LAE ratio wasprimarily due to 3.2 points of favorable loss reserve development in automobileliability in traditional personal lines and at AutoOne, compared to 0.7 pointsof adverse development for the year ended December 31, 2006. Partiallyoffsetting this decrease was higher than average large loss activityexperienced in the first half of 2007. The increase in the expense ratio wasprimarily due to the adverse effect of a lower earned premium base compared tothe year ended December 31, 2006. The expense ratio for the year ended December 31,2007 included a 1.0 point benefit from a state premium tax refund, 0.9 pointbenefit related to the partial settlement of our qualified pension planliabilities and 0.8 points of office consolidation costs. In addition, theexpense ratio for the year ended December 31, 2007 included 0.5 points ofexpenses related to the decision to cease writing business in Houston Generaland actions taken to better align personal lines staffing with our businessneeds.

 

*Run-off.*  Run-off business generated an underwritingloss of $155.6 million ($38.9 million excluding a $116.7 millionincrease to loss and LAE reserves resulting from the reserve reallocation) inthe year ended December 31, 2007, compared to an underwriting loss of$44.1 million in the year ended December 31, 2006. The year ended December 31,2007 includes incurred loss and LAE of $33.1 million (excluding the reservereallocation), compared with $35.7 million in the year ended December 31,2006. The year ended December 31, 2007 includes a $5.1 million benefitfrom the partial settlement of our qualified pension plan liabilities.

 

*Affiliate Quota Shares*

 

During 2004 and 2005, we entered into two quota share reinsurancearrangements with other subsidiaries of White Mountains. Under the EsuranceQuota Share, which was effective on January 1, 2005, we assumedapproximately 85% of 

 

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businesswritten by Esurance, which includes business written by its wholly-ownedsubsidiary. Under the Sirius Quota Share, we ceded between 6% and 12% ofbusiness written, effective April 1, 2004, to Sirius.

 

The affiliate quota shares were entered into primarily for WhiteMountains’ capital management purposes and were therefore excluded from theinformation used by White Mountains’ Board of Directors to measure ourfinancial performance. The affiliate quota share agreements were commuted inthe fourth quarter of 2006 in connection with our initial public offering.

 

A summary of results from our Affiliate Quota Shares segment for theyear ended December 31, 2006 is as follows:

 

| ** **                  | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2006**                         | ** ** |
| ** **                  | ** ** | **Esurance  Quota  Share**       | ** ** | **Sirius  Quota  Share** | ** ** |
| ** **                  | ** ** | **($ in millions)**         | ** ** |
| Net written premiums        |       | $                                | 227.4      |   | $ | (178.0 | ) |
| Earned premiums             |       | 309.9                            |       | (178.0 | ) |
| Total revenues              |       | 309.9                            |       | (178.0 | ) |
| Loss and LAE                |       | 195.5                            |       | (92.2 | ) |
| Policy acquisition expenses |       | 114.4                            |       | (66.8 | ) |
| Total expenses              |       | 309.9                            |       | (159.0 | ) |
| Pre-tax income (loss)       |       | $                                | —     |   | $ | (19.0 | ) |

 

*Other Operations*

 

Our Other Operations segment consists of our holding company, OBH,which primarily consists of financing activities, purchase accountingadjustments relating to the OneBeacon Acquisition and other assets and generaland administrative expenses incurred at the holding company level. This segmentalso includes entities that prior to OBIG’s initial public offering employedpersons associated with White Mountains’ holding company operations.Accordingly, in 2006, Other Operations incentive compensation expense included$4.1 million associated with these persons transferred to White Mountainsfrom these entities.

 

The purchase accounting adjustments relating to the OneBeaconAcquisition were made to reflect the estimated fair value of our assetsacquired and liabilities assumed on the date of the acquisition. The purchaseaccounting adjustments were primarily comprised of an adjustment to our lossand LAE reserves and related reinsurance recoverables to record them at fairvalue, an adjustment to record the cost of our investments at fair value and anallocation of the excess of acquired net assets over the purchase price to ournon-current, non-financial assets, primarily our property, plant and equipment.

 

The Other Operations segment results are affected by purchaseaccounting over time as the fair value adjustments made at our acquisitionunwind. Fair value adjustments other than those related to loss and LAE reservesand  related reinsurance recoverables havebeen fully recognized in our financial statements in periods prior to thosepresented below. The fair value adjustment to net loss and LAE reserves isexpensed through income as our net loss and LAE reserves at the time of theOneBeacon Acquisition are settled.

 

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As described above, effective January 1, 2008, we adopted SFAS159. Accordingly, pre-tax loss for 2008 is not directly comparable to suchmeasures for 2007 and 2006. A summary of results from our Other Operationssegment for the years ended December 31, 2008, 2007 and 2006 are asfollows:

 
| ** **                                                       | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                       | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                       | ** ** | **($ in millions)**         | ** ** |
| Net investment income                                            |       | $                                | 9.3        |   | $ | 17.9 |   | $ | 5.3 |   |
| Net realized investment losses                                   |       | (0.7                             | )          | (1.4 | ) | (1.6 | ) |
| Change in net unrealized investment gains and losses             |       | (4.8                             | )          | — |   | — |   |
| Net other (expenses) revenues                                    |       | (0.2                             | )          | (2.0 | ) | 5.6 |   |
| Total revenues                                                   |       | 3.6                              |       | 14.5 |   | 9.3 |   |
| General and administrative expenses                              |       | 0.7                              |       | 0.3 |   | 6.5 |   |
| Accretion of fair value adjustment to loss and LAE reserves      |       | 12.0                             |       | 16.0 |   | 23.0 |   |
| Interest expense on debt                                         |       | 41.4                             |       | 42.0 |   | 42.6 |   |
| Interest expense—dividends and accretion on preferred stock |       | 33.4                             |       | 64.4 |   | 56.6 |   |
| Total expenses                                                   |       | 87.5                             |       | 122.7 |   | 128.7 |   |
| Pre-tax loss                                                     |       | $                                | (83.9      | ) | $ | (108.2 | ) | $ | (119.4 | ) |

 

**OtherOperations Results—Year ended December 31, 2008 versus year ended December 31,2007**

 

Our Other Operations segment reported a pre-tax loss of$83.9 million in the year ended December 31, 2008, compared to apre-tax loss of $108.2 million in the year ended December 31, 2007. Thedecrease in loss was primarily due to a decrease in interest expense related tothe preferred stock which was redeemed in the second quarter of 2008. Thedecrease in interest expense was partially offset by a decrease in netinvestment income to $9.3 million in the year ended December 31, 2008,compared to $17.9 million in the prior year. Net investment income in the yearended December 31, 2008 included $6.2 million related to assets held intrust whereas the year ended December 31, 2007 included $15.4 million  related to assets held in trust.

 

**OtherOperations Results—Year ended December 31, 2007 versus year ended December 31,2006**

 

Our Other Operations segment reported a pre-tax loss of $108.2 millionin the year ended December 31, 2007, compared to a pre-tax loss of $119.4million in the year ended December 31, 2006. The decrease in loss was primarilydue to an increase in net investment income to $17.9 million in the year endedDecember 31, 2007, compared to $5.3 million in the prior year. Net investmentincome in the year ended December 31, 2007 included $15.4 million related toassets held in trust whereas the year ended December 31, 2006 included $2.1million related to assets held in trust. Total expenses decreased to $122.7million in the year ended December 31, 2007, compared to $128.7 million in theyear ended December 31, 2006.

 

**Summary of Investment Results**

 

***Investment Returns***

 

A summary of our consolidated pre-tax investment results for the yearsended December 31, 2008, 2007 and 2006 is as follows:

 
| ** **                                                  | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                  | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                  | ** ** | **($ in millions)**         | ** ** |
| Gross investment income (1)                                 |       | $                                | 176.1      |   | $ | 218.4 |   | $ | 201.1 |   |
| Net realized investment (losses) gains                      |       | (318.6                           | )          | 173.1 |   | 163.7 |   |
| Change in net unrealized investment gains and losses (2)(3) |       | (447.4                           | )          | (4.9 | ) | 46.5 |   |
| Total GAAP pre-tax investment results                       |       | $                                | (589.9     | ) | $ | 386.6 |   | $ | 411.3 |   |

----

(1)                                  Includes $6.2million, $15.4 million and $2.1 million of net investment income forassets held in trust for the years ended December 31, 2008, 2007 and 2006,respectively.

 

(2)                                  Does notinclude results of our investment in MSA during the period it was recordedunder the equity method.

 

(3)                                  The year ended December 31,2006 includes the impact of the adoption of SFAS No. 155.

 

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Grossinvestment returns versus typical benchmarks for the years ended December 31,2008, 2007 and 2006 are as follows. For purposes of discussing rates of return,all percentages are presented gross of management fees and trading expenses inorder to produce a more relevant comparison to benchmark returns.

 

| ** **                                                                | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **2008(1)**                      | ** ** | **2007(1)** | ** ** | **2006(1)** | ** ** |
| Fixed maturity investments                                                |       | (2.8                             | )%         | 6.4 | % | 5.8 | % |
| Short-term investments                                                    |       | 1.9                              |       | 4.9 |   | 4.6 |   |
| Total fixed income                                                        |       | (2.1                             | )          | 6.1 |   | 5.8 |   |
| Barclays U.S. Aggregate Index (formerly the Lehman U.S. Aggregate  Index) |       | 5.2                              |       | 7.0 |   | 4.3 |   |
| Montpelier common stock                                                   |       | —                           |       | — |   | (7.9 | ) |
| Core common stock (2)                                                     |       | (53.8                            | )          | 12.6 |   | 25.6 |   |
| Convertible bonds                                                         |       | (9.1                             | )          | 4.6 |   | 6.6 |   |
| Total common stock and convertible bonds                                  |       | (40.3                            | )          | 9.9 |   | 18.1 |   |
| Other investments                                                         |       | (35.7                            | )          | 14.4 |   | 15.3 |   |
| Total common stock, convertible bonds and other investments               |       | (39.3                            | )          | 10.8 |   | 17.5 |   |
| S&P 500 Index (total return)                                     |       | (37.0                            | )          | 5.5 |   | 15.8 |   |
| Total consolidated portfolio                                              |       | (13.4                            | )%         | 7.6 | % | 8.9 | % |

----

(1)                                  Includes $6.2million, $15.4 million and $2.1 million of net investment income forassets held in trust for the years ended December 31, 2008, 2007 and 2006,respectively.

 

(2)                                  Represents allcommon stock holdings other than Montpelier, which was transferred to WhiteMountains on August 24, 2006, in exchange for an agreed-upon portfolio ofcommon equity and fixed maturity securities with an equal value.

 

During the third and fourth quarters of 2008, therewere significant declines and high volatility in the equity markets, a lack ofliquidity in the credit markets and a widening of credit spreads on debtsecurities. These factors had a significant adverse effect on the performanceof our investment portfolio.

 

*Investment Returns—Year ended December 31, 2008versus year ended December 31, 2007*

 

**Overview**

 

Our total pre-tax investment results were $(589.9) million, areturn of (13.4)% for the year ended December 31, 2008, compared to$386.6 million, a return of 7.6%, for the year ended December 31,2007. Gross investment income in the year ended December 31, 2008 was$176.1 million, a decrease of 19.4%, compared to $218.4 million inthe year ended December 31, 2007. The decrease was principally due to alower average invested asset base and lower investment yields. Gross investmentincome in the year ended December 31, 2008 included $6.2 million relatedto assets held in trust whereas the year ended December 31, 2007 included$15.4 million related to assets held in trust. Net realized investment (losses)gains were $(318.6) million in the year ended December 31, 2008, adecrease of $491.7 million, compared to $173.1 million in the year ended December 31,2007, mainly due to $239.8 million of impairment charges taken in the yearended December 31, 2008 and $96.3 million of realized losses on sales ofequity investments, compared to realized gains on sales in the year ended December 31,2007 of certain convertible fixed maturity and equity securities in industrysectors that experienced significant appreciation, principally energy andnatural resources. The $239.8 million of realized losses fromother-than-temporary impairments recognized during the year ended December 31,2008 were comprised primarily of $136.8 million of losses related to commonequity securities, $58.4 million of losses related to fixed maturityinvestments, $14.7 million related to convertible bonds and $29.9 million oflosses related to other investments. The loss in common equity securitiesincluded $20.9 million of losses within the energy sector, $29.5 million withinthe utilities sector, $35.6 million within the financial sector, $30.3 millionwithin the materials sector and $13.5 million within the consumer discretionarysector. Impairment charges taken in the year ended December 31, 2008 werereclassified from change in net unrealized investment gains and losses to netrealized investment (losses) gains. The change in net unrealized investmentgains and losses was a decrease of $447.4 million in the year ended December 31,2008, compared to a decrease of $4.9 million in the year ended December 31,2007. Losses reflected in the change in net unrealized investment gains andlosses are a result of the crisis that occurred in the financial markets duringthe third and fourth quarters of 2008 as described above.  We recorded a pre-tax decrease in the changein net unrealized investment gains and losses in our fixed income portfolio of$174.2 million, mainly driven by a general widening of credit spreads.  We recorded a pre-tax decrease in the changein net unrealized investment gains and 

 

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lossesin our common stock portfolio of $156.9 million; the majority of this declinewas driven by investments within the financials, utilities and materialssectors.

 

**Fixedincome**

 

Our fixed income portfolio, which includes both fixed maturity andshort-term investments, returned (2.1)% for the year ended December 31,2008, compared to 6.1% for the year ended December 31, 2007. As previouslydiscussed, the performance was primarily driven by pre-tax losses reflected inthe change in net unrealized investment gains and losses of $174.2 million as aresult of a general widening of credit spreads. We recorded $40.9 million innet realized losses in the year ended December 31, 2008, which included$58.4 million of impairment charges, primarily in the financials sector. Ourfixed income portfolio had minimal exposure to adverse credit events occurringin the last half of 2008. Our short duration mortgage-backed and asset-backedsecurities have also performed relatively well in difficult times. During theyear ended December 31, 2008, we maintained a high quality fixed maturityportfolio with a relatively short duration of approximately 2 years includingshort-term investments and 3 years excluding short-term investments, ascompared with approximately 3 years and 3 years, respectively, for the yearended December 31, 2007, which performed consistent with itscharacteristics and worse than the longer-duration Barclays U.S. AggregateIndex benchmark.

 

**Commonstock, convertible bonds and other investments**

 

Our total common stock, convertible bond and other investmentsportfolio returned (39.3)% for the year ended December 31, 2008 comparedto 10.8% for the year ended December 31, 2007. Our common stock andconvertible bond portfolios returned (40.3)% and 9.9% for the years ended December 31,2008 and 2007, respectively, or 3.3 percentage points worse and4.4 percentage points better than the S&P 500 benchmark, respectively.We recorded $258.9 million in net realized losses in the year ended December 31,2008, which included $151.5 million of impairment charges related toinvestments in the common stock and convertible bond portfolios and $107.4million of net realized losses on the sale of common stocks and convertiblebonds in 2008. Our other investment portfolio returned (35.7)% for the yearended December 31, 2008, compared to 14.4% for the year ended December 31,2007. Approximately 59.7% of our other investment portfolio is invested inhedge funds; these hedge funds experienced decreases in asset values during theyear ended December 31, 2008 as a result of the volatility in thefinancial markets.

 

*Investment Returns—Year ended December 31, 2007versus year ended December 31, 2006*

 

**Overview**

 

Our total pre-tax investment results were $386.6 million, a returnof 7.6% for the year ended December 31, 2007 compared to$411.3 million, a return of 8.9% for the year ended December 31,2006. Gross investment income in the year ended December 31, 2007 was$218.4 million, an increase of 8.6%, compared to $201.1 millionduring the year ended December 31, 2006. Gross investment income for theyear ended December 31, 2007 included $15.4 million related to assets heldin trust whereas the year ended December 31, 2006 included $2.1 millionrelated to assets held in trust. Net realized investment gains were$173.1 million in the year ended December 31, 2007, an increase of5.7%, compared to $163.7 million in the year ended December 31, 2006,mainly due to the sale of certain convertible bonds and equity securitiesduring the first half of 2007, in industry sectors that experienced significantappreciation during the period of our ownership, principally energy and naturalresources. The change in net unrealized investment gains and losses of $(4.9)million during the year ended December 31, 2007 reflected the portfolio’slow duration as well as the effect of the weakening dollar against ourforeign-denominated securities, mostly in British pounds and Australiandollars.

 

**Fixedincome**

 

Our fixed income portfolio, which includes both fixed maturity andshort-term investments, returned 6.1% for the year ended December 31, 2007versus 5.8% for the year ended December 31, 2006. During the year ended December 31,2007, we maintained a high quality fixed maturity portfolio with a relativelyshort duration of approximately 3 years including short-term investmentsand 3 years excluding short-term investments which performed consistent withits characteristics and below the longer-duration Barclays U.S. Aggregate Indexbenchmark by 90 basis points.

 

**Commonstock, convertible bonds and other investments**

 

Our total common stock, convertible bond and other investmentsportfolio returned 10.8% for the year ended December 31, 2007 versus 17.5%for the year ended December 31, 2006. Our total common stock and convertiblebond portfolios returned 9.9% and 18.1%, respectively, for the years ended December 31,2007 and 2006, or 4.4 percentage points 

 

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and2.3 percentage points better than the S&P 500 benchmark, respectively. Ourcommon stock portfolio returned 12.6% during the year ended December 31,2007 and 25.6% for the year ended December 31, 2006, or 7.1 and9.8 percentage points better than the S&P 500 benchmark,respectively, as we benefited from our investments in the energy, commoditiesand utility sectors. Our other investment portfolio returned 14.4% for the yearended December 31, 2007, compared to 15.3% for the year ended December 31,2006.

 

***Portfolio Composition***

 

The following table presents the composition of our trading investmentportfolio as of December 31, 2008 and our available-for-sale andheld-to-maturity portfolios as of December 31, 2007:

 

| ** **                       | ** ** | **As of December 31,** | ** ** |
|----------------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **2008**                    | ** ** | **2007** | ** ** |
| **Type of Investment**           | ** ** | **$ in  millions**     | ** ** | **% of  total** | ** ** | **$ in  millions** | ** ** | **% of  total** | ** ** |
| Available-for-sale investments:  |       |                        |       |   |   |   |   |   |   |
| Fixed maturity investments       |       | $                           | 2,134.8    |   | 57.3 | % | $ | 2,913.0 |   | 58.2 | % |
| Common stock                     |       | 276.7                       |       | 7.4 |   | 788.4 |   | 15.7 |   |
| Convertible bonds                |       | 241.2                       |       | 6.5 |   | 371.4 |   | 7.4 |   |
| Short-term investments           |       | 875.4                       |       | 23.5 |   | 278.9 |   | 5.6 |   |
| Held-to-maturity investments:(1) |       |                        |       |   |   |   |   |   |   |
| Fixed maturity investments       |       | —                      |       | — |   | 305.5 |   | 6.1 |   |
| Short-term investments           |       | —                      |       | — |   | 0.1 |   | — |   |
| Other investments(2)             |       | 196.6                       |       | 5.3 |   | 348.6 |   | 7.0 |   |
| Total                            |       | $                           | 3,724.7    |   | 100.0 | % | $ | 5,005.9 |   | 100.0 | % |

----

(1)                                  Representsassets held in trust to economically defease our preferred stock subject tomandatory redemption. See “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Economic Defeasance”.

 

(2)                                  Includesinvestments such as hedge funds, limited partnerships and private equityinterests.

 

The breakdown of our fixed maturity portfolio, including convertiblebonds, at December 31, 2008 by credit class, based upon issue creditratings provided by Standard & Poor’s, or if unrated by Standard &Poor’s, long-term obligation ratings provided by Moody’s, is as follows:

 

| **Ratings**                            | ** ** | **Cost or  Amortized Cost** | ** ** | **% of Total** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|----------------|------------|
| ** **                             | ** ** | **($ in millions)**    | ** ** |
| U.S. government and agency obligations |       | $                           | 417.3      |           | 16.7       | % |
| AAA/Aaa                                |       | 838.0                       |       | 33.5           |       |
| AA/Aa                                  |       | 66.9                        |       | 2.7            |       |
| A/A                                    |       | 525.2                       |       | 21.0           |       |
| BBB/Baa                                |       | 438.3                       |       | 17.5           |       |
| Other/not rated                        |       | 215.7                       |       | 8.6            |       |
| Total                                  |       | $                           | 2,501.4    |           | 100.0      | % |

 

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The weighted average duration of our fixed maturity portfolio,including convertible bonds, at December 31, 2008 is approximately 3 years.The maturity distribution for fixed maturity investments, including convertiblebonds, held at December 31, 2008 is as follows:

 

| **Maturity**                     | ** ** | **Amortized Cost**       | ** ** | **Carrying Value** | ** ** |
|----------------------------------|------------|--------------------------|------------|--------------------|------------|
| ** **                       | ** ** | **($ in millions)** | ** ** |
| Due within one year              |       | $                        | 222.2      |               | $          | 214.4 |   |
| Due after one through five years |       | 1,092.6                  |       | 1,045.0            |       |
| Due after five through ten years |       | 117.5                    |       | 115.7              |       |
| Due after ten years              |       | 205.7                    |       | 189.5              |       |
| Asset-backed securities          |       | 791.9                    |       | 758.9              |       |
| Preferred stocks                 |       | 71.5                     |       | 52.5               |       |
| Total                            |       | $                        | 2,501.4    |               | $          | 2,376.0 |   |

 

***Asset-backed Securities***

 

In the past several years, many originators of residential mortgage andhome equity loans relaxed their underwriting standards and issued loans tocustomers with weak credit profiles. This practice is often referred to assub-prime mortgage lending. The slowing U.S. housing market has causedmany sub-prime mortgage customers to be unable to refinance their mortgageloans, particularly those customers who had adjustable rate mortgages thatreset at a higher rate than the rate at the origination of their mortgage. As aresult, there have been significantly higher delinquency and foreclosure ratesin the United States.

 

We purchase commercial and residential mortgage-backed securities tomaximize our fixed income portfolio’s risk adjusted returns and diversify theportfolio risk from primarily corporate credit risk to a mix of credit and cashflow risk. We are not an originator of residential mortgage loans and did nothold any mortgage-backed securities categorized as sub-prime as of December 31,2008. In addition, our investments in hedge funds, limited partnerships andprivate equity interests contain negligible amounts of sub-primemortgage-backed securities as of December 31, 2008. We consider sub-primemortgage-backed securities to be those that are issued from dedicated sub-primeshelves, dedicated second-lien shelves (i.e., we consider investmentsbacked primarily by second-liens to be a sub-prime risk regardless of creditscore or other metrics) or otherwise have underlying loan pools that exhibitweak credit characteristics.

 

There are also mortgage-backed securities that we categorize as “non-prime”(also called “Alt A” or “A—“) that are backed by collateral that hasoverall credit quality between prime and sub-prime, as determined based on areview of the characteristics of their underlying mortgage loan pools, such ascredit scores and financial ratios. As of December 31, 2008,$10.9 million of our mortgage-backed securities were classified asnon-prime. All of these non-prime securities have the highest rating ascribedby Moody’s (“Aaa”) or Standard & Poor’s (“AAA”). We did not own any collateralizeddebt obligations, including residential mortgage-backed collateralized debtobligations.

 

Our investments in asset-backed securities are generally valued usingmatrix and other pricing models. Key inputs in a typical valuation arebenchmark yields, benchmark securities, reported trades, issuer spreads, bids,offers, credit ratings and prepayment speeds. At December 31, 2008, themarket for our investments in asset-backed securities remained active and,accordingly, we did not adjust the fair value estimates for the effect ofilliquidity.

 

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The following table summarizes the carrying value of our mortgage-backedand other asset-backed securities holdings as of December 31, 2008 and2007:

 

| ** **                           | ** ** | **December 31,**    | ** ** |
|--------------------------------------|------------|--------------------------|------------|
| ** **                           | ** ** | **2008**                 | ** ** | **2007** | ** ** |
| ** **                           | ** ** | **($ in millions)** | ** ** |
| Mortgage-backed securities:          |       |                     |       |   |   |
| Agency: (1)                          |       |                     |       |   |   |
| GNMA                                 |       | $                        | 367.3      |   | $ | 288.9 |   |
| FNMA                                 |       | 28.5                     |       | 27.0 |   |
| FHLMC                                |       | 84.9                     |       | 93.4 |   |
| Non-agency:                          |       |                     |       |   |   |
| Residential                          |       | 111.9                    |       | 393.7 |   |
| Commercial                           |       | 126.8                    |       | 137.7 |   |
| Total mortgage-backed securities (2) |       | 719.4                    |       | 940.7 |   |
| Other asset-backed securities:       |       |                     |       |   |   |
| Credit card                          |       | 39.5                     |       | 93.3 |   |
| Auto                                 |       | —                   |       | 8.4 |   |
| Total other asset-backed securities  |       | 39.5                     |       | 101.7 |   |
| Total asset-backed securities (3)    |       | $                        | 758.9      |   | $ | 1,042.4 |   |

----

(1)                                  Representspublicly traded residential mortgage-backed securities which carry the fullfaith and credit guaranty of the U.S. government.

 

(2)                                  Approximately 97% and 94% of ourmortgage-backed securities as of December 31, 2008 and 2007, respectively,have the highest ratings ascribed by Moody’s (“Aaa”) or Standard &Poor’s (“AAA”). The remainder are investment grade.

 

(3)                                  Of our total asset-backed securities,approximately 97% and 95% as of December 31, 2008 and 2007, respectively,have the highest ratings ascribed by Moody’s (“Aaa”) or Standard &Poor’s (“AAA”). The remainder are investment grade.

 

***Montpelier Investment***

 

In order to reduce our exposure to certain insurance risks outside ofour own underwriting competencies, on August 24, 2006, we exchanged ourinvestment in the common shares of Montpelier, a global property catastrophereinsurer, for an agreed-upon portfolio of common equity and fixed maturitysecurities of equal value that was owned by White Mountains. As a result,Montpelier is no longer included in our investment results. The following tabledetails the book value effect of our total investment in Montpelier for theyear ended December 31, 2006.

 

| ** **                                                      | ** ** | **Year ended  December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                      | ** ** | **2006**                          | ** ** |
| ** **                                                      | ** ** | **($ in millions)**          | ** ** |
| Net investment income, pre-tax                                  |       | $                                 | 1.0        |   |
| Net realized investment losses, pre-tax                         |       | (5.8                              | )          |
| Total losses, pre-tax                                           |       | (4.8                              | )          |
| Tax benefit on total losses                                     |       | 1.7                               |       |
| Total losses, after tax                                         |       | (3.1                              | )          |
| Change in net unrealized investment gains and losses, after tax |       | (0.7                              | )          |
| Net after tax change in book value from Montpelier investment   |       | $                                 | (3.8       | ) |

 

At the time of the exchange, our investment in the common shares ofMontpelier was in an unrealized loss position of $6.9 million. This losswas deferred at the time of the exchange as sales of investments between us andentities under White Mountains’ common control are deferred. Subsequent to theexchange, White Mountains sold 5.4 million common shares of Montpeliertriggering the recognition of $5.8 million in realized investment lossesin 2006. During the second quarter of 2007, we recognized the remainingdeferred loss on the exchange of $1.1 million. For the year ended December 31,2006, we recorded an aggregate of $1.0 million in pre-tax investment incomefrom Montpelier’s regular quarterly dividends.

 

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** **

**Non-GAAPFinancial Measures**

 

This report includes two non-GAAP financial measures that have beenreconciled to the most comparable GAAP financial measures. OB Holdings believesthese measures to be a useful supplement to the comparable GAAP measures inevaluating OB Holdings’ financial performance.

 

**Loss and loss adjustment expense ratio prior toreserve reallocation and total combined ratio prior to reserve reallocation** are non-GAAPfinancial measures which are derived by excluding the impact of thereallocation of loss and loss adjustment expense reserves from the loss andloss adjustment expense ratio and the GAAP combined ratio. During 2007, OBHoldings reallocated loss and loss adjustment expense reserves from ongoinglines of business to run-off which reduced the loss and loss adjustment expenseratios and the GAAP combined ratios for OB Holdings’ specialty, commercial andpersonal lines of business but had no impact on the ratios for OB Holdings’total primary insurance operations. OB Holdings believes that a presentationexcluding the effect of the reserve reallocation on the loss and lossadjustment expense ratios and combined ratios for specialty, commercial andpersonal lines is a meaningful supplement for investors to understand theperformance of its underwriting units. The reconciliation of these non-GAAPfinancial measures to the loss and loss adjustment expense ratio and GAAPcombined ratio, the most closely comparable GAAP measures, is included on page 42.

 

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** **

**Liquidityand Capital Resources**

 

***Operating cash and short-term investments***

 

Our sources and uses of cash are as follows:

 

*Holding company level.*  The primary sources of cash for OBH areexpected to be dividends and tax sharing payments received from our insuranceoperating subsidiaries, financing activities and net investment income andproceeds from sales and maturities of holding company investments. The primaryuses of cash are expected to be interest payments on our debt obligations,repurchases of debt, purchases of investments, tax payments and holding companyoperating expenses.

 

*Operating subsidiary level.*  The primary sources of cash for our operatingsubsidiaries are expected to be premium collections, financing activities, netinvestment income and proceeds from sales and maturities of investments. Theprimary uses of cash are expected to be claim payments, policy acquisitioncosts, debt obligations, operating expenses, purchases of investments and dividendsand tax sharing payments made to parent holding companies.

 

Insurance companies typically collect premiums on policies that theywrite prior to paying claims made under those policies. During periods ofpremium growth, insurance companies typically experience positive cash flowfrom operations, as premium receipts typically exceed claim payments. When thishappens, positive cash flow from operations is usually offset by negative cashflow from investing activities, as the positive operating cash flow is used topurchase investments. Conversely, during periods of premium decline, insurancecompanies typically experience negative cash flow from operations, even duringperiods in which they report GAAP net income, as the claims that they payexceed the premiums that they collect. When this happens, negative cash flowfrom operations is typically offset by positive cash flow from investingactivities, as invested assets are sold to fund current claim payments.

 

Both internal and external forces influence our financial condition,results of operations and cash flows. Claim settlements, premium levels andinvestment returns may be impacted by changing rates of inflation and othereconomic conditions. In many cases, significant periods of time, ranging up toseveral years or more, may lapse between the occurrence of an insured loss, thereporting of the loss to us and the settlement of the liability for that loss.The exact timing of the payment of claims and benefits cannot be predicted withcertainty. Our operating subsidiaries maintain portfolios of invested assetswith varying maturities and a substantial amount of short-term investments toprovide adequate liquidity for the payment of claims.

 

Management believes that our cash balances, cash flows from operationsand cash flows from investments are adequate to meet expected cash requirementsfor the foreseeable future on both a holding company and operating subsidiarylevel.

 

***CreditFacility***

 

In November 2006,OBH established a $75 million revolving credit facility that would have maturedin November 2011 (the Bank Facility). As of December 31, 2007, theBank Facility was undrawn. The Bank Facility was terminated in December 2008.

 

***Dividend Capacity***

 

Under the insurance laws of the states and jurisdictions under whichour operating subsidiaries are domiciled, an insurer is restricted with respectto the timing or the amount of dividends it may pay without prior approval byregulatory authorities. Accordingly, there can be no assurance regarding theamount of such dividends that may be paid by such subsidiaries in the future.

 

Generally, our regulated insurance operating subsidiaries have theability to pay dividends during any 12-month period in an amount equal to thegreater of prior year statutory net income or 10% of prior year endstatutory surplus, subject to the availability of unassigned funds. Based on2008 statutory surplus of $1.4 billion, our top tier regulated insuranceoperating subsidiaries have the ability to pay approximately $136 millionof dividends during 2009, subject to the availability of unassigned funds. Asof December 31, 2008, OB Holdings’ top tier regulated insurance operatingsubsidiaries had $0.9 billion of unassigned funds. As of December 31,2008, we had approximately $81.5 million of unrestricted net cash and fixedmaturity investments outside of our regulated insurance operating subsidiaries.

 

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During 2008, OB Holdings’ regulated operating subsidiaries paid$197.0 million of dividends to OneBeacon LLC. Also, during 2008, OBHoldings’ unregulated operating subsidiaries declared and paid $6.0 million ofdividends to their immediate parent.

 

OBH’s ability to declare or pay dividends was limited by the terms ofthe Series A Preferred Stock issued to Berkshire. OBH could not, incertain circumstances, declare or pay any dividend or distribution to any otherclass or series of stock without the consent of the holders of a majority ofoutstanding shares of the Berkshire Preferred Stock. Under the terms of aKeep-Well Agreement dated November 30, 2004 between White Mountains andOBH (the Keep-Well), White Mountains had agreed to return to OBH up to approximately$1.1 billion if some or all of that amount is required by OBH to meet itsobligations under the terms of the Berkshire Preferred Stock. As describedbelow, the Keep-Well has expired. Under the Keep-Well, White Mountains had tomake any required contributions to OBH prior to making any distributions to itsshareholders. The aggregate amount of distributions that White Mountains maymake to its shareholders was limited; the limit increased or decreased by anamount equal to White Mountains’ consolidated net income or loss over theremaining life of the Keep-Well. The Keep-Well expired when all obligations ofthe Berkshire Preferred Stock were satisfied upon its redemption in May 2008.See “Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Economic Defeasance” for a discussion of the creation and funding ofan irrevocable grantor trust to economically defease the Berkshire PreferredStock.

 

**Economic Defeasance**

 

In connection with OBIG’s initial public offering, OBH established anirrevocable grantor trust. The assets of the trust were solely dedicated to thesatisfaction of the payment of dividends and redemption amounts on the$300 million liquidation preference of the Berkshire Preferred Stock. OBHfunded the trust with cash and purchased a portfolio of fixed maturitysecurities issued by the U.S. government and government-sponsoredenterprises. The scheduled interest and principal payments were sufficient topay when due all amounts required under the terms of the Berkshire PreferredStock. The creation and funding of the trust did not legally defease thepreferred stock nor create any additional rights for the holders of theBerkshire Preferred Stock in the trust or otherwise, although the assets in thetrust were segregated from the Company’s other general assets and were notavailable to the Company for any use other than the payment of the BerkshirePreferred Stock. The assets held in trust were used to redeem the BerkshirePreferred Stock in May 2008. White Mountains Capital, Inc., asubsidiary of White Mountains, served as the trustee for the irrevocablegrantor trust. The assets held in the trust as of December 31, 2008and 2007 include $0 and $305.5 million, respectively, of fixedmaturity investments and $0 and $0.1 million, respectively, of short-terminvestments. Pre-tax net investment income earned on these investments totaled$6.2 million, $15.4 million and $2.1 million, respectively, for the yearsended December 31, 2008, 2007 and 2006, respectively.

 

**Insurance Float**

 

Insurance float is an important aspect of our insurance operations.Insurance float represents funds that an insurance company holds for a limitedtime. In an insurance operation, float arises because premiums are collectedbefore losses are paid. This interval can extend over many years. During thattime, the insurer invests the funds. When the premiums that an insurer collectsdo not cover the losses and expenses it eventually must pay, the result is anunderwriting loss, which is considered to be the cost of insurance float. Theamount and cost of insurance float for us is affected by underlying marketconditions, as well as acquisitions or dispositions of insurance business.

 

Although insurance float can be calculated using numbers determinedunder GAAP, insurance float is not a GAAP concept and, therefore, there is nocomparable GAAP measure.

 

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We calculate our insurance float by taking our net invested assets andsubtracting our total tangible capital. The following table illustrates ourconsolidated insurance float position as of the years ended December 31,2008 and 2007.

 
| ** **                                                            | ** ** | **December 31,**    | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                            | ** ** | **2008**                 | ** ** | **2007** | ** ** |
| ** **                                                            | ** ** | **($ in millions)** | ** ** |
| Total investments                                                     |       | $                        | 3,724.7    |   | $ | 5,005.9 |   |
| Less: Total held-to-maturity investments(1)                           |       | —                   |       | (305.6 | ) |
| Cash                                                                  |       | 51.6                     |       | 47.2 |   |
| Accounts receivable on unsettled investment sales                     |       | 49.0                     |       | 55.0 |   |
| Accounts payable on unsettled investment purchases                    |       | (6.8                     | )          | (3.9 | ) |
| Net invested assets (1)                                               |       | $                        | 3,818.5    |   | $ | 4,798.6 |   |
| Total common shareholder’s equity                                |       | $                        | 1,133.4    |   | $ | 1,783.2 |   |
| Debt                                                                  |       | 731.9                    |       | 757.7 |   |
| Preferred stock subject to mandatory redemption(1)                    |       | —                   |       | — |   |
| Total tangible capital(1)                                             |       | $                        | 1,865.3    |   | $ | 2,540.9 |   |
| Insurance float                                                       |       | $                        | 1,953.2    |   | $ | 2,257.7 |   |
| Insurance float as a multiple of total tangible capital               |       | 1.0x                     |       | 0.9x |   |
| Net invested assets as a multiple of total tangible capital           |       | 2.0x                     |       | 1.9x |   |
| Insurance float as a multiple of common shareholder’s equity     |       | 1.7x                     |       | 1.3x |   |
| Net invested assets as a multiple of common shareholder’s equity |       | 3.4x                     |       | 2.7x |   |

----

(1)                                  Excludespreferred stock subject to mandatory redemption, having an aggregate accreditedliquidation preference at December 31, 2007 of $278.4 million and$305.6 million of investments held in an irrevocable grantor trust for thepurpose of economically defeasing the preferred stock subject to mandatoryredemption. The creation and funding of this trust did not legally defease thepreferred stock and therefore the preferred stock appeared on our balance sheetuntil it was redeemed in May 2008.

 

**Financing**

 

The following table summarizes our capital structure as of December 31,2008 and 2007:

 
| ** **                                                                                   | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                   | ** ** | **2008**                    | ** ** | **2007** | ** ** |
| ** **                                                                                   | ** ** | **($ in millions)**    | ** ** |
| Senior Notes, carrying value                                                                 |       | $                           | 675.1      |   | $ | 698.9 |   |
| Other debt(1)                                                                                |       | 56.8                        |       | 58.8 |   |
| Total debt                                                                                   |       | 731.9                       |       | 757.7 |   |
| Preferred stock subject to mandatory redemption                                              |       | —                      |       | 278.4 |   |
| Total common shareholder’s equity                                                       |       | 1,133.4                     |       | 1,783.2 |   |
| Total capital                                                                                |       | $                           | 1,865.3    |   | $ | 2,819.3 |   |
| Ratio of debt and preferred stock subject to mandatory redemption to  total capital          |       | 39.2                        | %          | 36.8 | % |
| Ratio of debt to total capital excluding preferred stock subject to  mandatory redemption(2) |       | 39.2                        | %          | 29.8 | % |

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(1)                                  See Note 7—“Debt”of the accompanying consolidated financial statements.

 

(2)                                  The calculationof total capital excludes the preferred stock subject to mandatory redemptionbecause it was economically defeased in connection with OBIG’s initial publicoffering.

 

We believe that we have the flexibility and capacity to obtain fundsexternally as needed through debt or equity financing on both a short-term andlong-term basis. However, given the recent disruptions in the capital markets,we can provide no assurance that, if needed, we would be able to obtainadditional debt or equity financing on satisfactory terms or at all.

 

The 5.875% Senior Notes due 2013 of OBH are currently rated arecurrently rated “Baa2” (“Medium Grade”, the ninth highest of twenty-oneratings) with a stable outlook by Moody’s, “BBB” (“Adequate”, the ninth highestof twenty-two 

 

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ratings)with a stable outlook by Standard & Poor’s, “bbb” (“Good”, the ninthhighest of twenty-two ratings) with a stable outlook by A.M. Best and “BBB”(“Good”, the ninth highest of twenty-three ratings) with a stable outlook byFitch. During the third quarter of 2008, we repurchased $24.0 million of theoutstanding Senior Notes for $22.3 million, which resulted in a $1.6 milliongain on extinguishment of debt.

 

White Mountains currently provides an irrevocable and unconditionalguarantee as to the payment of principal and interest (the Guarantee) on theSenior Notes. In consideration of this Guarantee, we have agreed to pay aspecified fee to White Mountains in the amount of 25 basis points per annum onthe outstanding principal amount of the Senior Notes. We have further agreedthat if White Mountains’ voting interest in us ceases to represent more than50% of all our voting securities, we will redeem, exchange or otherwise modifythe Senior Notes in order to fully and permanently eliminate White Mountains’obligations under the Guarantee (the Guarantee Elimination). White Mountainshas agreed to provide written notice to us when its voting interest in us hasbeen reduced below 50%. We will have 180 days from the receipt of suchnotification to complete the Guarantee Elimination. If the GuaranteeElimination is not completed within the initial 180-day period, the Guaranteefee shall increase by 200 basis points. The Guarantee fee shall furtherincrease by 100 basis points for each subsequent 90-day period thereafter, upto a maximum Guarantee fee of 425 basis points, until the Guarantee Eliminationhas been completed.

 

The Senior Notes were issued under an indenture which containsrestrictive covenants that, among other things, limit the ability of WhiteMountains, OBH and their respective subsidiaries, which includes us, as asubsidiary of White Mountains, to create liens and enter into sale andleaseback transactions and substantially limits the ability of OBH and itsrespective subsidiaries to consolidate, merge or transfer their properties andassets. The indenture does not contain any financial ratios or specified levelsof net worth or liquidity to which White Mountains or OBH must adhere. At December 31,2008, OBH was in compliance with all of the covenants under the Senior Notes.

 

The indenture also contains a cross default provision which providesthat if White Mountains as guarantor has a payment default in excess of $25million under a credit agreement, mortgage or similar debt agreement, thedefault provisions under the indenture to the Senior Notes will be triggered.White Mountains has a revolving credit facility which provides for borrowing upto a maximum of $442 million and which contains restrictive financialcovenants. As of December 31, 2008, White Mountains had drawn $200 millionunder the facility.  See Note 18—”RelatedParty Disclosures” of the accompanying consolidated financial statements.

 

In connection with our December 2005 purchase of land and anoffice building in Canton, Massachusetts, which is now our headquarters, weentered into a $40.8 million, 18-year mortgage note to fund renovations.As of December 31, 2008, we have fully drawn on the facility. Repayment onthe mortgage note commenced in January 2009.

 

In November 2006, OBH established a $75.0 million revolvingcredit facility that would have matured in November 2011. As of December 31,2007, the Bank Facility was undrawn. The Bank Facility was terminated in December 2008.

 

**Off-Balance Sheet Arrangement**

 

*Galileo Guarantees*

 

Beginning in February 2006, one of our subsidiaries, OBIC, agreedto provide guarantees of the obligations of Galileo Weather RiskManagement Ltd. (Galileo) to Galileo’s counterparty in certainweather-related product transactions. Galileo is a subsidiary of WhiteMountains. The guarantees required OBIC to pay the full amount of Galileo’sobligations to the counterparty in the event that Galileo failed to pay theseobligations. In the event of a payment, OBIC would be eligible to exercise allof the rights of the counterparty against Galileo. In the event that the totalguaranteed principal amount exceeded the lesser of 5% of OBIC’s admitted assetsof $3.5 billion at December 31, 2007 or 25% of OBIC’s statutorysurplus of $1.6 billion at December 31, 2007, OBIC would haverequired the approval of the Pennsylvania Department of Insurance in order tomake any further guarantees. OBIC had agreed, at White Mountains’ option, tocontinue to make these guarantees available through October 2008 andreceived from Galileo an annual fee of 25 basis points of the value at risk forproviding the guarantees. Pursuant to a separation agreement we entered intowith White Mountains in connection with OBIG’s initial public offering, WhiteMountains agreed to take appropriate steps to ensure that OBIC would not becalled on to make payment on these guarantees. OBIC assigned its guarantees toWhite Mountains Re Bermuda, Ltd., a subsidiary of White Mountains, as of October 21,2008. Therefore, as of December 31, 2008, there were no outstandingguarantees.

 

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**Contractual Obligations and Commitments**

 

Below is a schedule of our material contractual obligations andcommitments as of December 31, 2008:

 
| ** **                                     | ** ** | **Due in  One Year  or Less** | ** ** | **Due in  Two to Three  Years** | ** ** | **Due in  Four to Five  Years** | ** ** | **Due After  Five  Years** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|-------------------------------|------------|---------------------------------|------------|---------------------------------|------------|----------------------------|------------|-----------|------------|
| ** **                                     | ** ** | **($ in millions)**      | ** ** |
| Debt                                           |       | $                             | 2.8        |                            | $          | 5.6                             |       | $                          | 681.8      |      | $          | 42.6 |   | $ | 732.8 |   |
| Loss and LAE reserves (1)                      |       | 991.0                         |       | 1,126.1                         |       | 630.6                           |       | 1,756.8                    |       | 4,504.5   |       |
| Interest on debt                               |       | 42.8                          |       | 85.2                            |       | 64.8                            |       | 26.4                       |       | 219.2     |       |
| Long-term incentive compensation               |       | 34.1                          |       | 22.1                            |       | 6.0                             |       | 10.6                       |       | 72.8      |       |
| Pension and other benefit plan obligations (2) |       | 23.8                          |       | 9.0                             |       | 8.8                             |       | 35.6                       |       | 77.2      |       |
| Operating leases                               |       | 12.4                          |       | 16.9                            |       | 9.5                             |       | 3.3                        |       | 42.1      |       |
| Total contractual obligations                  |       | $                             | 1,106.9    |                            | $          | 1,264.9                         |       | $                          | 1,401.5    |      | $          | 1,875.3 |   | $ | 5,648.6 |   |

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(1)                                  Representsexpected future cash outflows resulting from loss and LAE payments. The amountspresented are gross of reinsurance recoverables on unpaid losses of$2,503.3 million and include the discount on our workers compensation lossand LAE reserves of $142.1 million as of December 31, 2008. Thesebalances add back the remaining purchase accounting fair value adjustment of$210.5 million related to the OneBeacon Acquisition as it is a non-cashitem.

 

(2)                                  Includesexpected future cash outflows under our non-qualified, non-contributory, definedbenefit pension plan and our 401(k) savings and employee stock ownership plan.Our pension plans were curtailed during the fourth quarter of 2002. As aresult, new participants are no longer added and benefits for existingparticipants are not increased. Non-vested participants continue to vest duringtheir employment. (See Note 9—“Retirement and Postretirement Plans” of theaccompanying consolidated financial statements.)

 

Our loss and LAE reserves do not have contractual maturity dates.However, based on historical payment patterns, the preceding table includes anestimate of when management expects our loss and LAE reserves to be paid. Thetiming of claim payments is subject to significant uncertainty. We maintain aportfolio of marketable investments with varying maturities and a substantialamount of short-term investments to provide adequate cash flows for the paymentof claims.

 

The balances included in the table above regarding our long-termincentive compensation plans include amounts payable for performance shares andunits, as well as deferred compensation balances. Exact amounts to be paidcannot be predicted with certainty, as the ultimate amounts of theseliabilities are based on future performance. The estimated payments reflectedin the table are based on current accrual factors (common share price andpay-out percentage) and assume that all outstanding balances were 100% vestedas of December 31, 2008.

 

There are no provisions within our lease agreements that would triggeracceleration of future lease payments. We do not finance our operations throughthe securitization of trade receivables, special purpose entities or syntheticleases. Further, we have not entered into any material arrangement requiring usto guarantee payment of third party debt, lease payments or to fund losses ofan unconsolidated special purpose entity.

 

We also have future binding commitments to fund certain limitedpartnership and hedge fund investments. These commitments, which total$53.2 million as of December 31, 2008, do not have fixed fundingdates and are therefore excluded from the table above.

 

**Cash Flows**

 

Detailed information concerning our cash flows during the years ended December 31,2008, 2007 and 2006 follows:

 

***For the year ended December 31, 2008***

 

*Financing and Other Capital Activities*

 

During 2008, we declared and paid cash dividends of $219.9 million toOBEH.

 

During 2008, we declared and paid cash dividends of $11.8 millionto holders of the Berkshire Preferred Stock.

 

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During 2008, we paid a total of $43.7 million in interest, including$40.4 million in interest on the Senior Notes.

 

During 2008, we repurchased a portion of the Senior Notes for $22.3million.

 

During the second quarter of 2008, we redeemed the Berkshire PreferredStock for $300.0 million, its redemption value, using funds that had been heldin trust.

 

*Acquisitions and Dispositions*

 

During the fourth quarter of 2008, we sold one of our inactive licensedsubsidiaries, FMIC, for $7.8 million in cash, to a third party.

 

During the third quarter of 2008, we acquired EBI for $8.0 million incash to a third party.

 

During the first quarter of 2008, we sold one of our inactive licensedsubsidiaries, MWIC, for $4.2 million in cash to a third party.

 

*Other Liquidity and Capital Resource Activities*

 

During the first quarter of 2008, we made payments with respect to ourlong-term incentive compensation plans totaling $47.2 million, in cash or bydeferral into certain of our non-qualified compensation plans, to participantsin our long-term incentive compensation plans. These payments were madeprimarily with respect to 117,363 performance shares and 178,006 performanceunits for various performance cycles.

 

***For the year ended December 31, 2007***

 

*Financing and Other Capital Activities*

 

During 2007, we declared and paid cash dividends of $93.4 millionto OBEH.

 

During 2007, we declared and paid cash dividends of $28.3 millionto holders of the Berkshire Preferred Stock.

 

During 2007, we paid a total of $44.3 million in interest, including$41.1 million in interest on the Senior Notes.

 

*Acquisitions and Dispositions*

 

During the third quarter of 2007, we sold one of our inactive licensedsubsidiaries, AEIC, for $47.7 million in cash, gross of sales costs, to athird party.

 

*Other Liquidity and Capital Resource Activities*

 

During 2007, we reported net decreases in our loss and LAE reserves andreinsurance recoverables on paid and unpaid losses, primarily due to thedecline of our business exposures related to run-off.

 

During the first quarter of 2007, we made payments primarily withrespect to the 2004-2006 performance cycle totaling $39.8 million, in cashor by deferral into certain of our non-qualified compensation plans, toparticipants in our long-term incentive compensation plans. These payments weremade with respect to 4,400 performance shares and 160,470 performance units.

 

***For the year ended December 31, 2006***

 

*Financing and Other Capital Activities*

 

During 2006, we declared and paid cash dividends of $4.5 millionto OBEH.

 

During 2006, we declared and paid cash dividends of $28.3 millionto holders of the Berkshire Preferred Stock.

 

During 2006, we paid a total of $43.4 million in interest, including$41.1 million in interest on the Senior Notes.

 

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During 2006, we drew down the remaining $22.4 million on an18-year mortgage note that we entered into in connection with our purchase ofland and home office building. As of December 31, 2006, we had drawn thefull $40.8 million limit on the mortgage note.

 

During the fourth quarter of 2006, we fully repaid our$8.0 million loan with Dowling & Partners Connecticut FundIII, LP.

 

*Acquisitions and Dispositions*

 

On September 29, 2006, we sold certain assets and the right torenew existing policies of Agri, a division of OB Holdings, for$32.0 million in cash to a third party.

 

On August 24, 2006, we exchanged our investment in Montpeliercommon shares for an agreed-upon portfolio of common equity and fixed maturitysecurities of an equal value owned by White Mountains, resulting in a pre-taxrealized loss of $5.8 million.

 

*Other Liquidity and Capital Resource Activities*

 

During 2006, we reported net decreases in our loss and LAE reserves andreinsurance recoverables on paid and unpaid losses, primarily due to claimpayments (and related collections of reinsurance recoverables) related torun-off reserves.

 

During the first quarter of 2006, we made payments primarily withrespect to the 2003-2005 performance cycle totaling $39.7 million, in cashor by deferral into certain of our non-qualified compensation plans, toparticipants in our long-term incentive compensation plans. These payments weremade with respect to 156,105 performance units.

 

During the first quarter of 2006, we made payments in respect of the2003-2005 performance cycle totaling $3.8 million, in cash or by deferralinto certain of our non-qualified compensation plans, to participants in ourlong-term incentive compensation plans.

 

**Related Party Disclosures**

 

See Note 18—“Related Party Disclosures” of the accompanyingconsolidated financial statements.

 

**CriticalAccounting Estimates**

 

Management’s Discussion and Analysis of Financial Condition and Resultsof Operations discusses our consolidated financial statements, which have beenprepared in accordance with GAAP. The consolidated financial statementspresented herein include all adjustments considered necessary by management tofairly present our financial position, results of operations and cash flows.The preparation of financial statements in conformity with GAAP requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities as of the date of the historical consolidatedfinancial statements and the reported amounts of revenues and expenses duringthe reporting period.

 

In the current year presentation of financial information, certainamounts in the prior period historical consolidated financial statements havebeen reclassified to conform to the current presentation. We have completednumerous significant transactions during the periods presented that haveaffected the comparability of the historical consolidated financial statementinformation presented herein.

 

On an ongoing basis, management evaluates its estimates, includingthose related to fair value measurements of investments, loss and LAE reserves,reinsurance transactions and purchase accounting. Management bases itsestimates on historical experience and on various other factors that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources.

 

Management believes that its critical accounting policies affect itsmore significant estimates used in the preparation of its historicalconsolidated financial statements. The descriptions below are summarized andhave been simplified for clarity.

 

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***1.******             ******Fair Value Considerations***

 

On January 1,2008, we adopted SFAS No. 157, “Fair Value Measurements” (SFAS 157).SFAS 157 provides a revised definition of fair value, establishes a frameworkfor measuring fair value and expands financial statement disclosurerequirements for fair value information. Under SFAS 157, fair value is definedas the price that would be received to sell an asset or paid to transfer aliability in an orderly transaction between market participants (an “exit price”).The Statement establishes a fair value hierarchy that distinguishes between inputsbased on market data from independent sources (“observable inputs”) and areporting entity’s internal assumptions based upon the best informationavailable when external market data is limited or unavailable (“unobservableinputs”). The fair value hierarchy in SFAS 157 prioritizes fair valuemeasurements into three levels based on the nature of the inputs. Quoted pricesin active markets for identical assets or liabilities have the highest priority(“Level 1”), followed by observable inputs other than quoted prices,including prices for similar but not identical assets or liabilities (“Level 2”)and unobservable inputs, including the reporting entity’s estimates of theassumptions that market participants would use, having the lowest priority (“Level 3”).

 

Effective January 1,2008, we adopted SFAS 159 for our available-for-sale securities and ourinvestments in limited partnerships, hedge funds and private equity interests.Consistent with the guidance in SFAS 159, in conjunction with the adoption, thesesecurities are now reported as trading securities. Upon adoption, we recordedan adjustment of $182.4 million to reclassify net unrealized gains, after tax,and net unrealized foreign currency translation gains, after tax, related toinvestments from accumulated other comprehensive income to opening retainedearnings. Subsequent to adoption, we report changes in fair value in revenuesbefore the effect of tax.

 

We use brokers andoutside pricing services to assist in determining fair values. For investmentsin active markets, we use the quoted market prices provided by the outsidepricing services to determine fair value. The outside pricing services used byus have indicated that they will only provide prices where observable inputsare available. In circumstances where quoted market prices are unavailable, weutilize fair value estimates based upon other observable inputs includingmatrix pricing, benchmark interest rates, market comparables and other relevantinputs. In circumstances where observable inputs are adjusted to reflectmanagement’s best estimate of fair value, such fair value measurements areconsidered a lower level measurement in the SFAS 157 fair value hierarchy.

 

Ourprocess to validate the market prices obtained from the outside pricing sourcesinclude, but are not limited to, periodic evaluation of model pricingmethodologies and analytical reviews of certain prices. We also periodicallyperform back-testing of selected sales activity to determine whether there areany significant differences between the market price used to value the securityprior to sale and the actual sale price.

 

For investments inlimited partnerships, hedge funds and private equity interests which areincluded in other investments, net asset value is deemed to approximate fairvalue. These investments are not publicly traded and accordingly, quoted marketprices are not available. In circumstances where the secondary market for suchinvestments is not active, our policy is to adjust net asset value to reflectthe effect of illiquidity. Where appropriate, the fair value of assets andliabilities measured at fair value would be adjusted for the effect ofcounterparty credit risk.

 

As of December 31,2008, approximately 92% of the investment portfolio recorded at fair value waspriced based upon observable inputs.

 

As of December 31,2008, other investments represented approximately 5% of the investmentportfolio recorded at fair value. At December 31, 2008, we did not adjustthe net asset values used to determine the fair value.

 

The fair valuemeasurements at December 31, 2008 for assets for which we adopted SFAS 159and any related Level 3 inputs are as follows:

 
| ** **                 | ** ** | **Fair value at  December 31, 2008** | ** ** | **Level 3 Inputs** | ** ** | **Level 3   Percentage** | ** ** |
|----------------------------|------------|--------------------------------------|------------|--------------------|------------|--------------------------|------------|
| ** **                 | ** ** | **($ in millions)**        | ** ** | ** **         | ** ** |
| Fixed maturity investments |       | $                                    | 2,134.8    |               | $          | 79.3                     |       | 3.7 | % |
| Common equity securities   |       | 276.7                                |       | 26.2               |       | 9.5                      | %          |
| Convertible bonds          |       | 241.2                                |       | —             |       | —                   | %          |
| Short-term investments     |       | 875.4                                |       | —             |       | —                   | %          |
| Other investments          |       | 196.6                                |       | 196.6              |       | 100.0                    | %          |
| Total SFAS 159 assets      |       | $                                    | 3,724.7    |               | $          | 302.1                    |       | 8.1 | % |

 

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Thechanges in Level 3 fair value measurements for the year ended December 31,2008 are as follows:

 
| ** **                                       | ** ** | **Fixed  maturity  investments** | ** ** | **Common  equity  securities** | ** ** | **Convertible  bonds** | ** ** | **Other  investments** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                       | ** ** | **($ in millions)**         | ** ** |
| Balance at January 1, 2008                  |       | $                                | 168.9      |                           | $          | 70.3                   |       | $                      | 19.3       |      | $          | 348.6 |   | $ | 607.1 |   |
| Total net realized and unrealized gains (losses) |       | (39.2                            | )          | (8.8                           | )          | —                 |       | (105.4                 | )          | (153.4    | )          |
| Purchases and sales, net                         |       | (24.2                            | )          | 0.5                            |       | —                 |       | (46.6                  | )          | (70.3     | )          |
| Transfers in (out) of Level 3, net               |       | (26.2                            | )          | (35.8                          | )          | (19.3                  | )          | —                 |       | (81.3     | )          |
| Balance at December 31, 2008                |       | $                                | 79.3       |                           | $          | 26.2                   |       | $                      | —     |      | $          | 196.6 |   | $ | 302.1 |   |

 

The majority of thetransfers out of Level 3 within fixed maturity investments for the year ended December 31,2008 represent securities for which observable inputs were unavailable as of December 31,2007 mainly because the securities were relatively new issuances and/or limitedmarket data was available. Such securities were manually priced using acombination of market inputs such as benchmark interest rates, marketcomparables and/or broker quotes. With respect to common equity securities, asa result of efforts to adopt SFAS 157 and 159, we were able to obtainadditional information on the underlying common equity securities for a limitedpartnership that we consolidate in our financial statements. These commonequity securities which are priced based on quoted prices were transferred outof Level 3 into Level 1 during the year ended December 31, 2008.

 

In addition to theinvestment portfolio described above, we have $20.2 million of liabilitiesrecorded at fair value in accordance with SFAS 157 and included in otherliabilities.  These liabilities relate tosecurities that have been sold short by a limited partnership that we invest inand we are required to consolidate under generally accepted accountingprinciples.  All of the liabilitiesincluded in the $20.2 million have been deemed to have a Level 1 designation.

 

***2.******             ******Loss and LAE***

 

*Reserves other than Asbestos and EnvironmentalReserves and Construction Defect Claim Reserves*

 

We establish loss and LAE reserves that are estimates of amounts neededto pay claims and related expenses in the future for insured events that havealready occurred. The process of estimating reserves involves a considerabledegree of judgment by management and, as of any given date, is inherentlyuncertain.

 

Loss and LAE reserves are typically comprised of (1) case reservesfor claims reported and (2) reserves for losses that have occurred but forwhich claims have not yet been reported, referred to as IBNR reserves, whichinclude a provision for expected future development on case reserves. Casereserves are estimated based on the experience and knowledge of claims staffregarding the nature and potential cost of each claim and are adjusted asadditional information becomes known or payments are made. IBNR reserves arederived by subtracting paid loss and LAE and case reserves from estimates ofultimate loss and LAE. Actuaries estimate ultimate loss and LAE using variousgenerally accepted actuarial methods applied to known losses and other relevantinformation. Like case reserves, IBNR reserves are adjusted as additionalinformation becomes known or payments are made.

 

Ultimate loss and LAE are generally determined by extrapolation ofclaim emergence and settlement patterns observed in the past that canreasonably be expected to persist into the future. In forecasting ultimate lossand LAE with respect to any line of business, past experience with respect tothat line of business is the primary resource, but cannot be relied upon inisolation. Our own experience, particularly claims development experience, suchas trends in case reserves, payments on and closings of claims, as well aschanges in business mix and coverage limits, is the most important informationfor estimating our reserves. External data, available from organizations suchas statistical bureaus, consulting firms and reinsurance companies, issometimes used to supplement or corroborate our own experience, and can beespecially useful for estimating costs of new business. For some lines ofbusiness, such as “long-tail” coverages discussed below, claims data reportedin the most recent accident year is often too limited to provide a meaningfulbasis for analysis due to the typical delay in reporting of claims. For thistype of business, we use a selected loss ratio method for the initial accidentyear or years. This is a standard and accepted actuarial reserve estimationmethod in these circumstances in which the loss ratio is selected based uponinformation used in pricing policies for that line of business, as well as anypublicly available industry data, such as industry pricing, experience andtrends, for that line of business.

 

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Uncertainties in estimating ultimate loss and LAE are magnified by thetime lag between when a claim actually occurs and when it is reported andsettled. This time lag is sometimes referred to as the “claim-tail”. Theclaim-tail for most property coverages is typically short (usually a few daysup to a few months). The claim-tail for liability/casualty coverages, such asautomobile liability, general liability, products liability, multiple perilcoverage, and workers compensation, can be especially long as claims are oftenreported and ultimately paid or settled years, even decades, after the relatedloss events occur. During the long claims reporting and settlement period,additional facts regarding coverages written in prior accident years, as wellas about actual claims and trends may become known and, as a result, we mayadjust our reserves. If management determines that an adjustment isappropriate, the adjustment is booked in the accounting period in which suchdetermination is made in accordance with GAAP. Accordingly, should reserves needto be increased or decreased in the future from amounts currently established,future results of operations would be negatively or positively impacted,respectively.

 

In determining ultimate loss and LAE, the cost to indemnify claimants,provide needed legal defense and other services for insureds and administer theinvestigation and adjustment of claims are considered. These claim costs areinfluenced by many factors that change over time, such as expanded coveragedefinitions as a result of new court decisions, inflation in costs to repair orreplace damaged property, inflation in the cost of medical services andlegislated changes in statutory benefits, as well as by the particular, uniquefacts that pertain to each claim. As a result, the rate at which claims arosein the past and the costs to settle them may not always be representative ofwhat will occur in the future. The factors influencing changes in claim costsare often difficult to isolate or quantify and developments in paid andincurred losses from historical trends are frequently subject to multiple andconflicting interpretations. Changes in coverage terms or claims handlingpractices may also cause future experience and/or development patterns to varyfrom the past. A key objective of actuaries in developing estimates of ultimateloss and LAE, and resulting IBNR reserves, is to identify aberrations andsystemic changes occurring within historical experience and accurately adjustfor them so that the future can be projected reliably. Because of the factorspreviously discussed, this process requires the use of informed judgment and isinherently uncertain.

 

Our actuaries use several generally accepted actuarial methods toevaluate our loss and LAE reserves, each of which has its own strengths andweaknesses. We place more or less reliance on a particular method based on thefacts and circumstances at the time the reserve estimates are made. Thesemethods generally fall into one of the following categories or are hybrids ofone or more of the following categories:

 

·                  *Historicalpaid loss development methods: *These methodsuse historical loss payments over discrete periods of time to estimate futurelosses. Historical paid loss development methods assume that the ratio oflosses paid in one period to losses paid in an earlier period will remainconstant. These methods necessarily assume that factors that have affected paidlosses in the past, such as inflation or the effects of litigation, will remainconstant in the future. Because historical paid loss development methods do notuse case reserves to estimate ultimate losses, they can be more reliable thanthe other methods discussed below that look to case reserves (such as actuarialmethods that use incurred losses) in situations where there are significantchanges in how case reserves are established by a company’s claims adjusters.However, historical paid loss development methods are more leveraged, meaningthat small changes in payments have a larger impact on estimates of ultimatelosses, than actuarial methods that use incurred losses because cumulative losspayments take much longer to equal the expected ultimate losses than cumulativeincurred amounts. In addition, and for similar reasons, historical paid lossdevelopment methods are often slow to react to situations when new or differentfactors arise than those that have affected paid losses in the past.

 

·                  *Historicalincurred loss development methods: *These methods,like historical paid loss development methods, assume that the ratio of lossesin one period to losses in an earlier period will remain constant in thefuture. However, instead of using paid losses, these methods use incurredlosses (i.e., the sum of cumulative historical loss payments plusoutstanding case reserves) over discrete periods of time to estimate futurelosses. Historical incurred loss development methods can be preferable tohistorical paid loss development methods because they explicitly take intoaccount open cases and the claims adjusters’ evaluations of the cost to settleall known claims. However, historical incurred loss development methodsnecessarily assume that case reserving practices are consistently applied overtime. Therefore, when there have been significant changes in how case reservesare established, using incurred loss data to project ultimate losses can beless reliable than other methods.

 

·                  *Expectedloss ratio methods: *These methodsare based on the assumption that ultimate losses vary proportionately withpremiums. Expected loss ratios are typically developed based upon theinformation used in pricing, and are multiplied by the total amount of premiumswritten to calculate ultimate losses. Expected loss 

 

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ratio methods are useful for estimating ultimate losses in the earlyyears of long-tailed lines of business, when little or no paid or incurred lossinformation is available.

 

·                  *Adjustedhistorical paid and incurred loss development methods: *These methods taketraditional historical paid and incurred loss development methods and adjustthem for the estimated impact of changes from the past in factors such asinflation, the speed of claim payments or the adequacy of case reserves.Adjusted historical paid and incurred loss development methods are often morereliable methods of predicting ultimate losses in periods of significantchange, provided the actuaries can develop methods to reasonably quantify theimpact of changes.

 

We perform an actuarial review of our recorded reserves each quarter.Our actuaries compare the previous quarter’s estimates of paid loss and LAE,case reserves and IBNR to amounts indicated by actual experience. Differencesbetween previous estimates and actual experience are evaluated to determinewhether a given actuarial method for estimating loss and LAE should be reliedupon to a greater or lesser extent than it had been in the past. While somevariance is expected each quarter due to the inherent uncertainty in loss andLAE, persistent or large variances would indicate that prior assumptions and/orreliance on certain reserving methods may need to be revised going forward.

 

In its selection of recorded reserves, our management historically gavegreater weight to adjusted paid loss development methods, which are notdependent on the consistency of case reserving practices, over methods thatrely on incurred losses. In recent years, the amount of weight given to methodsbased on incurred losses has increased with management’s confidence that ourcase reserving practices have been more consistently applied.

 

Upon completion of each quarterly review, our actuaries selectindicated reserve levels based on the results of the actuarial methodsdescribed previously, which are the primary consideration in determiningmanagement’s best estimate of required reserves. However, in making its bestestimate, management also considers other qualitative factors that may lead toa difference between held reserves and actuarially recommended levels in thefuture. Typically, these factors exist when management and our actuariesconclude that there is insufficient historical incurred and paid lossinformation or that trends included in the historical incurred and paid lossinformation are unlikely to repeat in the future. Such factors include, amongothers, recent entry into new markets or new products, improvements in theclaims department that are expected to lessen future ultimate loss costs andlegal and regulatory developments. At December 31, 2008 and 2007, totalcarried reserves were 7.3% and 2.7% above the actuarial point estimate,respectively.

 

*Construction Defect Claims Reserves*

 

Construction defect claims are a non-A&E exposure that has provento have a greater degree of uncertainty when estimating loss and LAE usinggenerally accepted actuarial methods. Our general liability and multiple perillines of business have been significantly impacted by a large number of constructiondefect claims. Construction defect is a liability allegation relating todefective work performed in the construction of structures such as apartments,condominiums, single family dwellings or other housing, as well as the sale ofdefective building materials. Such claims seek recovery due to damage caused byalleged deficient construction techniques or workmanship. Much of the recentclaims activity has been generated by plaintiffs’ lawyers who approach newhomeowners, and in many cases homeowner associations with large numbers ofhomeowners in multi-residential complexes, about defects or other flaws intheir homes. Claims for construction defects began with claims relating toexposures in California. Then, as plaintiffs’ lawyers organized suits in otherstates with high levels of multi-residential construction, construction defectclaims were reported in nearby western states, such as Colorado and Nevada, andeventually throughout the country. The reporting of such claims can be quitedelayed as the statute of limitations can be up to ten years. Court decisionshave expanded insurers’ exposure to construction defect claims as well. Forexample, in 1995 California courts adopted a “continuous trigger” theory inwhich all companies that had ever insured a property that was alleged to havebeen damaged must respond to the claimant, even if evidence of the allegeddamage did not appear until after the insurance period had expired. As aresult, construction defect claims may be reported more than ten years after aproject has been completed as litigation can proceed for several years beforean insurance company is identified as a potential contributor. Claims have alsoemerged from parties claiming additional insured status on policies issued toother parties (e.g., such as contractors seeking coverage on asub-contractor’s policy). Further, in reserving for these claims, there isadditional uncertainty due to the potential for further unfavorable judicialrulings and regulatory actions. The primary actuarial methods that are used toestimate loss and LAE reserves for construction defect claims are frequency andseverity methods. These methods separately project the frequency of futurereported claims and the average cost or severity of individual claims. Thereserve is the product of the projected number of reported claims and theseverity.

 

A large number of construction defect claims have been identifiedrelating to coverages that we had written in the past through Commercial UnionCorporation and General Accident Corporation of America, which we refer to asour legacy companies, and their subsidiaries in California, Colorado, Nevada,Washington and Oregon. Management has sought to 

 

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mitigatefuture construction defect risks in all states by no longer providing insuranceto certain residential general contractors and sub-contractors involved inmulti-habitational projects. Mitigating actions also included initiating thewithdrawal from problematic sub-segments within our construction book ofbusiness, such as street and road construction, water, sewer and pipelineconstruction. As a result of these actions, management believes that the numberof reported construction defect claims relating to coverages written in thepast peaked in 2004 and will continue to decline.

 

*Asbestos and Environmental Reserves*

 

Our reserves include provisions made for claims that assert damagesfrom asbestos and environmental, or A&E, related exposures. Asbestos claimsrelate primarily to injuries asserted by those who allegedly came in contactwith asbestos or products containing asbestos. Environmental claims relateprimarily to pollution and related clean-up cost obligations, particularly asmandated by federal and state environmental protection agencies. In addition tothe factors described above under “Non-Asbestos and Environmental Reserves”regarding the reserving process, we estimate our A&E reserves based upon,among other factors, facts surrounding reported cases and exposures to claims,such as policy limits and deductibles, current law, past and projected claimactivity and past settlement values for similar claims, as well as analysis ofindustry studies and events, such as recent settlements and asbestos-relatedbankruptcies. The cost of administering A&E claims, which is an importantfactor in estimating loss and LAE reserves, tends to be higher than in the caseof non-A&E claims due to the higher legal costs typically associated withA&E claims.

 

A large portion of our A&E losses resulted from the operations ofthe Employers Group, an entity acquired by one of the legacy companies in 1971.These operations, including business of Employers Surplus Lines InsuranceCompany and Employers Liability Assurance Corporation, provided primary andexcess liability insurance for commercial insureds, including Fortune 500-sizedaccounts, some of whom subsequently experienced claims for A&E losses. Westopped writing such coverage in 1984.

 

Our liabilities for A&E losses from business underwritten in therecent past are substantially limited by the application of exclusionaryclauses in the policy language that eliminated coverage for such claims. After1987 for pollution and 1992 for asbestos, most liability policies containedindustry-standard absolute exclusions of such claims. In earlier years, variousexclusions were also applied, but the wording of those exclusions was lessstrict and subsequent court rulings have reduced their effectiveness.

 

We also incurred A&E losses via our participation in industry poolsand associations. The most significant of these pools was Excess CasualtyReinsurance Association, or ECRA, which provided excess liability reinsuranceto U.S. insurers from 1950 until the early 1980s. ECRA incurred significantliabilities for A&E, of which we bear approximately a 4.7% share at December 31,2008 and 2007, or $40.0 million and $59.5 million at December 31,2008 and 2007, respectively, which is fully reflected in our loss and LAEreserves.

 

More recently, since the 1990s, we have experienced an influx of claimsfrom commercial insureds, including many non-Fortune 500-sized accounts writtenduring the 1970s and 1980s, who are named as defendants in asbestos lawsuits.As a number of large well-known manufacturers of asbestos andasbestos-containing products have gone into bankruptcy, plaintiffs have soughtrecoveries from peripheral defendants, such as installers, transporters orsellers of such products, or from owners of premises on which the plaintiffs’exposure to asbestos allegedly occurred. At December 31, 2008, 474policyholders had asbestos-related claims against us. In 2008, 80 new insuredswith such peripheral involvement presented asbestos claims under prior policieswe had written.

 

Historically, most asbestos claims have been asserted as productliability claims. Recently, insureds who have exhausted the available productsliability limits of their insurance policies have sought from insurers such asus payment for asbestos claims under the premises and operations coverage oftheir liability policies, which may not be subject to similar aggregate limits.We expect this trend to continue. However, to date there have been fewer ofthese premises and operations coverage claims than product liability coverageclaims. This may be due to a variety of factors, including that it may be moredifficult for underlying plaintiffs to establish losses as stemming frompremises and operations exposures, which requires proof of the defendant’snegligence, rather than products liability under which strict legal liabilityapplies. Premises and operations claims may vary significantly andpolicyholders may seek large amounts, although such claims frequently settlefor a fraction of the initial alleged amount. Accordingly, there is a greatdeal of variation in damages awarded for the actual injuries. As of December 31,2008, there were approximately 242 active claims by insureds against us withoutproduct liability coverage asserting operations or premises coverage, which maynot be subject to aggregate limits under the policies.

 

Immediately preceding the OneBeacon Acquisition, we purchased areinsurance contract with NICO under which we are entitled to recover from NICOup to $2.5 billion in the future for asbestos claims arising from businesswritten by us 

 

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in1992 and prior, environmental claims arising from business written by us in1987 and prior, and certain other exposures. Under the terms of the NICO Cover,NICO receives the economic benefit of reinsurance recoverables from certain ofour third party reinsurers in existence at the time the NICO Cover wasexecuted, or Third Party Recoverables. As a result, the Third PartyRecoverables serve to protect the $2.5 billion limit of NICO coverage forthe benefit of us. Any amounts uncollectible from third party reinsurers due todispute or the reinsurers’ financial inability to pay are covered by NICO underits agreement with us. Third Party Recoverables are typically for the amount ofloss in excess of a stated level each year. Of claim payments from 1998 through2008, approximately 48% of A&E losses have been recovered under thehistorical third party reinsurance.

 

In September 2008, we completed a study of our A&E exposures.This study considered, among other items, (1) facts, such as policy limits,deductibles and available third party reinsurance, related to reported claims; (2) currentlaw; (3) past and projected claim activity and past settlement values forsimilar claims; (4) industry studies and events, such as recentsettlements and asbestos-related bankruptcies; and (5) collectibility ofthird party reinsurance. Based on the study, we increased our best estimate ofour incurred losses ceded to NICO, net of underlying reinsurance, by$83 million to $2.2 billion, which is within the $2.5 billioncoverage provided by the NICO Cover. The increase in the estimate of incurredA&E losses was principally driven by raised projections for claims relatedto asbestos. Based on the results of the study, we believe that, under allreasonable scenarios, ultimate incurred losses will not exceed the NICO Cover.Due to the NICO Cover, there was no impact to income or equity from the changein estimate.

 

As part of our previously described actuarial review process, we reviewA&E activity each quarter and compare that activity to what was assumed inthe most recently completed study. As of December 31, 2008, we noted nochange in the range of reasonable outcomes around our best estimate describedabove.

 

As noted above, we have ceded estimated incurred losses of approximately$2.2 billion to the NICO Cover at December 31, 2008. Since enteringinto the NICO Cover, $44.7 million of the $2.2 billion of utilizedcoverage relates to uncollected amounts from third party reinsurers through December 31,2008. Net losses paid totaled $1.1 billion as of December 31, 2008, with$108.5 million paid in 2008. Asbestos payments during 2008 reflectpayments resulting from intensified efforts by claimants to resolve asbestosclaims prior to the potential enactment of U.S. federal asbestos legislation.To the extent that actual experience differs from our estimate of incurredA&E losses and Third Party Recoverables, future losses could exceed the$320.2 million of protection remaining the NICO Cover.

 

Our reserves for A&E losses, net of Third Party Recoverables butprior to NICO recoveries, were $1.0 billion at December 31, 2008. Anindustry benchmark of reserve adequacy is the “survival ratio”, computed as acompany’s reserves divided by its historical average yearly loss payments. Thisratio indicates approximately how many more years of payments the reserves cansupport, assuming future yearly payments are equal to historical levels. Oursurvival ratio was 12.7 at December 31, 2008. This was computed as theratio of A&E reserves, net of Third Party Recoverables prior to the NICOCover of $1.0 billion plus the remaining unused portion of the NICO Coverof $320.2 million, to the average A&E loss payments over thethree-year period ended December 31, 2008, net of Third PartyRecoverables. Our survival ratio was 14.2 at December 31, 2007. We believethat as a result of the NICO Cover and our historical third party reinsuranceprograms, we should not experience material financial loss from A&Eexposures under current coverage interpretations and that our survival ratiocompares favorably to industry survival ratios. However, the survival ratio isa simplistic measure estimating the number of years it would be before the currentending loss reserves for these claims would be paid using recent annual averagepayments. Many factors, such as aggressive settlement procedures, mix ofbusiness and coverage provided, have a significant effect on the amount ofA&E reserves and payments and the resultant survival ratio. Thus, cautionshould be exercised in attempting to determine reserve adequacy for theseclaims based simply on this survival ratio.

 

Our reserves for A&E losses at December 31, 2008 representmanagement’s best estimate of its ultimate liability based on informationcurrently available. However, significant uncertainties, including but notlimited to case law developments, medical and clean-up cost increases andindustry settlement practices, limit our ability to accurately estimateultimate liability and we may be subject to A&E losses beyond currentlyestimated amounts. In addition, we remain liable for risks reinsured in theevent that a reinsurer does not honor its obligations under reinsurancecontracts. See Note 4—“Reserves for Unpaid Loss and LAE—Asbestos andenvironmental loss and LAE reserve activity” of the accompanying consolidatedfinancial statements for more information regarding our A&E reserves.

 

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*Primary Insurance Operations A&E Claims Activity*

 

Our A&E claims activity, which is all in our Primary InsuranceOperations segment, for the last two years is illustrated in the table below:

 
| ** **                                                         | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                         | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| **Asbestos**                                                       |       |                             |       |   |   |
| Accounts with asbestos claims at the beginning of the year         |       | 491                              |       | 542 |   |
| Accounts reporting asbestos claims during the year                 |       | 80                               |       | 102 |   |
| Accounts on which asbestos claims were closed during the year      |       | (97                              | )          | (153 | ) |
| Accounts with asbestos claims at the end of the year               |       | 474                              |       | 491 |   |
| ** **                                                         |       |                             |       |   |   |
| **Environmental**                                                  |       |                             |       |   |   |
| Accounts with environmental claims at the beginning of the year    |       | 382                              |       | 443 |   |
| Accounts reporting environmental claims during the year            |       | 109                              |       | 135 |   |
| Accounts on which environmental claims were closed during the year |       | (113                             | )          | (196 | ) |
| Accounts with environmental claims at the end of the year          |       | 378                              |       | 382 |   |
| ** **                                                         |       |                             |       |   |   |
| **Total**                                                          |       |                             |       |   |   |
| Total accounts with A&E claims at the beginning of the year    |       | 873                              |       | 985 |   |
| Accounts reporting A&E claims during the year                  |       | 189                              |       | 237 |   |
| Accounts on which A&E claims were closed during the year       |       | (210                             | )          | (349 | ) |
| Total accounts with A&E claims at the end of the year          |       | 852                              |       | 873 |   |

 

*Primary Insurance Operations Reserve Estimation byLine of Business*

 

The process of establishing loss reserves is complex and imprecise asit must consider many variables that are subject to the outcome of futureevents. As a result, informed subjective estimates and judgments as to ourultimate exposure to losses are an integral component of our loss reservingprocess. We, like other insurance companies, categorize and track our insurancereserves by “line of business”, such as automobile liability, multiple perilpackage business, and workers compensation. Furthermore, we regularly reviewthe appropriateness of reserve levels at the line of business level,considering the variety of trends that impact the ultimate settlement of claimsfor the subsets of claims in each particular line of business.

 

For loss and allocated loss adjustment expense reserves, excludingA&E, the key assumption as of December 31, 2008 was that the impact ofthe various reserving factors, as described below, on future paid losses wouldbe similar to the impact of those factors on the historical loss data with thefollowing exceptions:

 

·                  Recent increases in paidloss trends were inflated due to changes in claim handling procedure thatdecreased the settlement time for claims. This resulted in some increases inpaid loss activity that we believe will not continue into the future.

 

·                  Increases in case reserveadequacy over the 2001-2004 calendar periods have resulted in trends in caseincurred activity that we believe will not continue into the future. Caseincurred activity can be the result of underlying changes in expected claimcosts or changes in the adequacy of the case reserves relative to theunderlying expected claim cost. If the activity is the result of underlyingchanges in expected costs, it is more likely to repeat in the future, and wouldlikely result in prior year reserve development, as the change in ultimateclaim costs would not have been considered when making the previous selectionof IBNR reserves. If the activity is the result of changes in case reserveadequacy, it would not indicate any change in the ultimate claim costs andwould not be expected to repeat in the future. In these cases, it is unlikelythat prior year reserve development would occur, as the change in case reserveswould be offset by a corresponding change in IBNR reserves(i.e., deficiency or redundancy in case reserves was implicitly capturedwhen making the previous selection of IBNR reserves).

 

·                  In 2004, we established aseparate claim group to manage run-off claims. Due to the nature of this event,we do not believe that the impacts of this group on future losses have beenreflected in historical losses. Therefore, we have given considerable weight tothe most recent loss experience for this segment.

 

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The major causes of material uncertainty (“reserving factors”)generally will vary for each product line, as well as for each separatelyanalyzed component of the product line. The following section details reservingfactors by product line. There could be other reserving factors that may impactultimate claim costs. Each reserving factor presented will have a differentimpact on estimated reserves. Also, reserving factors can have offsetting orcompounding effects on estimated reserves. For example, in workerscompensation, the use of expensive medical procedures that result in medicalcost inflation may enable workers to return to work faster, thereby loweringindemnity costs. Thus, in almost all cases, it is impossible to discretelymeasure the effect of a single reserving factor and construct a meaningfulsensitivity expectation. Actual results will likely vary from expectations foreach of these assumptions, resulting in an ultimate claim liability that isdifferent from that being estimated currently.

 

*Workers compensation*

 

Workers compensation is generally considered a long-tail coverage, asit takes a relatively long period of time to finalize claims from a givenaccident year. While certain payments such as initial medical treatment ortemporary wage replacement for the injured worker are made quickly, some otherpayments are made over the course of several years, such as awards forpermanent partial injuries. In addition, some payments can run as long as theinjured worker’s life, such as permanent disability benefits and ongoingmedical care. Despite the possibility of long payment tails, the reporting lagsare generally short, settlements are generally not complex, and most of theliability can be considered high frequency with moderate severity. The largestreserve risk generally comes from the low frequency, high severity claimsproviding lifetime coverage for medical expense arising from a worker’s injury.

 

Examples of common reserving factors that can change and, thus, affectthe estimated workers compensation reserves include:

 

*General workers compensation reserving factors*

 

·*                 *Mortalitytrends of injured workers with lifetime benefits and medical treatment ordependents entitled to survivor benefits

 

·                  Degree of cost shiftingbetween workers compensation and health insurance

 

·                  Changes in claim handlingphilosophies (e.g., case reserving standards)

 

*Indemnity reserving factors*

 

·*                 *Time requiredto recover from the injury

 

·                  Degree of availabletransitional jobs

 

·                  Degree of legal involvement

 

·                  Changes in theinterpretations and processes of various workers compensation bureaus’oversight of claims

 

·                  Future wage inflation forstates that index benefits

 

·                  Changes in theadministrative policies of second injury funds

 

·                  Re-marriage rate for spousein instances of death

 

*Medical reserving factors*

 

·*                 *Changes in thecost of medical treatments, including prescription drugs, and underlying feeschedules

 

·                  Frequency of visits tohealth providers

 

·                  Number of medical proceduresgiven during visits to health providers

 

·                  Types of health providersused

 

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·                  Type of medical treatmentsreceived

 

·                  Use of preferred providernetworks and other medical cost containment practices

 

·                  Availability of new medicalprocesses and equipment

 

·                  Changes in the use ofpharmaceutical drugs

 

·                  Degree of patientresponsiveness to treatment

 

*Workers compensation book of business reservingfactors*

 

·*                 *Product mix

 

·                  Injury type mix

 

·                  Changes in underwritingstandards

 

*Personal automobile liability*

 

The personal automobile product line is a mix of property and liabilitycoverages and, therefore, includes both short- and long-tail coverages. Thepayments that are made quickly typically pertain to auto physical damage (property)claims and property damage (liability) claims. The payments that take longer tofinalize and are more difficult to estimate relate to bodily injury claims.Personal automobile reserves are typically analyzed in three components: bodilyinjury liability, property damage liability, and collision/comprehensiveclaims. This last component has minimum reserve risk and fast payouts and,accordingly, separate factors are not presented. Reporting lags are relativelyshort and the claim settlement process for personal automobile liabilitygenerally is the least complex of the liability products. It is generallyviewed as a high frequency, low to moderate severity product line.

 

Examples of common reserving factors that can change and, thus, affectthe estimated personal automobile liability reserves include:

 

*Personal automobile liability reserving factors*

 

·*                 *Trends in juryawards

 

·                  Changes in the underlyingcourt system and its philosophy

 

·                  Changes in case law

 

·                  Litigation trends

 

·                  Frequency of claims with paymentcapped by policy limits

 

·                  Change in average severityof accidents, or proportion of severe accidents

 

·                  Subrogation opportunities

 

·                  Degree of patientresponsiveness to treatment

 

·                  Changes in claim handlingphilosophies (e.g., case reserving standards)

 

*Personal automobile liability book of businessreserving factors*

 

·*                 *Changes inpolicy provisions (e.g., deductibles, policy limits, or endorsements)

 

·                  Changes in underwritingstandards

 

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*Multiple peril*

 

Commercial multiple peril provides a combination of property andliability coverage typically for small businesses and, therefore, includes bothshort- and long-tail coverages. For property coverage, it generally takes arelatively short period of time to close claims, while for the other coverages,generally for the liability coverages, it takes a longer period of time toclose claims. The reserving risk for this line is dominated by the liabilitycoverage portion of this product, except occasionally in the event ofcatastrophic or large single losses.

 

Multiple peril liability reserves here are generally analyzed as twocomponents: bodily injury and property damage. Bodily injury payments reimbursethe claimant for damages pertaining to physical injury as a result of thepolicyholder’s legal obligation arising from non-intentional acts such asnegligence, subject to the insurance policy provisions. In some cases thedamages can include future wage loss (which is a function of future earningspower and wage inflation) and future medical treatment costs. Property damagepayments result from damages to the claimant’s private property arising fromthe policyholder’s legal obligation for non-intentional acts. In most cases,property damage losses are a function of costs as of the loss date, or soonthereafter. Defense costs are also a part of the insured costs covered byliability policies and can be significant, sometimes greater than the cost ofthe actual paid claims, though for some products this risk is mitigated bypolicy language such that the insured portion of defense costs erodes theamount of policy limit available to pay the claim.

 

Multiple peril liability is generally considered a long-tail line, asit takes a relatively long period of time to finalize and settle claims from agiven accident year. The speed of claim reporting and claim settlement is afunction of the specific coverage provided and the jurisdiction, among otherfactors. There are numerous components underlying the multiple peril liabilityproduct line. Some of these have relatively moderate payment patterns (withmost of the claims for a given accident year closed within 5 to 7 years),while others can have extreme lags in both reporting and payment of claims(e.g., a reporting lag of a decade for “construction defect” claims).

 

Examples of common reserving factors that can change and, thus, affectthe estimated multiple peril liability reserves include:

 

*Multiple peril liability reserving factors*

 

·*                 *Changes inclaim handling philosophies (e.g., case reserving standards)

 

·                  Changes in policy provisionsor court interpretations of such provisions

 

·                  New theories of liability

 

·                  Trends in jury awards

 

·                  Changes in the propensity tosue, in general with specificity to particular issues

 

·                  Changes in statutes oflimitations

 

·                  Changes in the underlyingcourt system

 

·                  Distortions from lossesresulting from large single accounts or single issues

 

·                  Changes in tort law

 

·                  Shifts in law suit mixbetween federal and state courts

 

·                  Changes in settlementpatterns

 

*Multiple peril liability book of business reservingfactors*

 

·*                 *Changes inpolicy provisions (e.g., deductibles, policy limits, or endorsements)

 

·                  Changes in underwritingstandards

 

·                  Product mix (e.g., sizeof account, industries insured, or jurisdiction mix)

 

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*Commercial automobile liability*

 

The commercial automobile product line is a mix of property andliability coverages and, therefore, includes both short- and long-tailcoverages. The payments that are made quickly typically pertain to auto physicaldamage (property) claims and property damage (liability) claims. The paymentsthat take longer to finalize and are more difficult to estimate relate tobodily injury claims. Commercial automobile reserves are typically analyzed inthree components; bodily injury liability, property damage liability, andcollision/comprehensive claims. This last component has minimum reserve riskand fast payouts and, accordingly, separate reserving factors are notpresented. In general, claim reporting lags are minor, claim complexity is nota major issue, and the line is viewed as high frequency, low to moderateseverity.

 

Examples of common reserving factors that can change and, thus, affectthe estimated commercial automobile liability reserves include:

 

*Bodily injury and property damage liability reservingfactors*

 

·*                 *Trends in juryawards

 

·                  Changes in the underlyingcourt system

 

·                  Changes in case law

 

·                  Litigation trends

 

·                  Frequency of claims withpayment capped by policy limits

 

·                  Change in average severityof accidents, or proportion of severe accidents

 

·                  Subrogation opportunities

 

·                  Changes in claim handlingphilosophies (e.g., case reserving standards)

 

·                  Frequency of visits tohealth providers

 

·                  Number of medical proceduresgiven during visits to health providers

 

·                  Types of health providersused

 

·                  Types of medical treatmentsreceived

 

·                  Changes in cost of medicaltreatments

 

·                  Degree of patientresponsiveness to treatment

 

*Commercial automobile liability book of businessreserving factors*

 

·*                 *Changes inpolicy provisions (e.g., deductibles, policy limits, or endorsements)

 

·                  Changes in mix of insuredvehicles (e.g., long-haul trucks versus local and smaller vehicles, orfleet risks versus non-fleet risks)

 

·                  Changes in underwritingstandards

 

*General liability*

 

See the above discussions under the liability product lines with regardto reserving factors for multiple peril.

 

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*Homeowners/Farmowners*

 

Homeowners/Farmowners is generally considered a short-tail coverage.Most payments are related to the property portion of the policy, where theclaim reporting and settlement process is generally restricted to the insuredand the insurer. Claims on property coverage are typically reported soon afterthe actual damage occurs, although delays of several months are not unusual.The resulting settlement process is typically fairly short term, althoughexceptions do exist. The liability portion of the homeowners/farmowners policygenerates claims which take longer to pay due to the involvement of litigationand negotiation, but with generally small reporting lags. Overall, the line isgenerally high frequency, low to moderate severity (except for catastrophes),with simple to moderate claim complexity.

 

Examples of common reserving factors that can change and, thus, affectthe estimated homeowners/farmowners reserves include:

 

*Non-catastrophe reserving factors*

 

·*                 *Salvageopportunities

 

·                  Amount of time to returnproperty to residential use

 

·                  Changes in weather patterns

 

·                  Local building codes

 

·                  Litigation trends

 

·                  Trends in jury awards

 

*Catastrophe reserving factors*

 

·*                 *Physicalconcentration of policyholders

 

·                  Availability and cost oflocal contractors

 

·                  Local building codes

 

·                  Quality of construction ofdamaged homes

 

·                  Amount of time to returnproperty to residential use

 

·                  For the more severecatastrophic events, “demand surge” inflation, whereby the greatly increaseddemand for building materials such as plywood far surpasses the immediatesupply, leading to short-term material increases in building material costs

 

*Homeowners/Farmowners book of business reservingfactors*

 

·*                 *Policyprovisions mix (e.g., deductibles, policy limits, or endorsements)

 

·                  Degree of concentration ofpolicyholders

 

·                  Changes in underwritingstandards

 

*Primary Insurance Operations Loss and LAE Development*

 

*Loss andLAE development—2008*

 

In 2008, we experienced $62.0 million of favorable loss and LAEreserve development on prior accident year loss reserves. The favorable lossreserve development was primarily related to lower than expected severity onnon-catastrophe losses.  The favorablenon-catastrophe loss reserve development was primarily related to professionalliability in specialty lines and package business in commercial lines partiallyoffset by adverse loss reserve development at AutoOne and in run-off.

 

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Specifically, at December 31, 2007, management had revised itsexpectations downward with respect to future loss emergence in the professionalliability business, which is included in the general liability line ofbusiness, which had initially been based on market analysis when this businesswas initiated in 2002 and 2003. However, during 2008, losses continued to besignificantly lower than these revised expectations. As a result, managementlowered its selected reserves on the earliest years which affected more recentyears as total loss expectations for those years are based in part on prioryears’ results. The impact of this revised estimate was a decrease toprofessional liability reserves of $50.5 million.

 

AtDecember 31, 2007, management had estimated that future payments frompersonal injury protection (PIP) litigation from our NYAIP business would beapproximately $14.0 million.  During2008, the legal expenses related to this litigation were higher than expectedas the 2002 accident year neared conclusion. As a result, management increased estimates of all accident years forNYAIP and other similar business in New York. The total increase in estimate was $10.8 million.

 

At December 31, 2007, based on actuarial techniques describedabove, managementestimated that IBNR related to multiple peril liability was $137.0 million, orapproximately 64% of case reserves of $212.8 million for 2002 and subsequentaccident years. During 2008, case incurred loss and allocated LAE (ALAE) was$16.2 million, which was less than expected for this line of business. As aresult of the lower than expected case incurred loss and ALAE during 2008, theactuarial methods based on case incurred losses produced lower estimated ultimatelosses for these accident years. As a result, at December 31, 2008, theIBNR was determined to be $86.9 million, or approximately 64% of the remainingcase reserves. The impact of this revised estimate was a decrease to multipleperil liability reserves of $33.8 million.

 

At December 31, 2007, based on actuarial techniques describedabove, managementestimated that IBNR related to workers compensation was $41.1 million, orapproximately 96% of case reserves of $43.0 million for 2005 and subsequent accidentyears. During 2008, case incurred loss and ALAE was $20.2 million, which wasgreater than expected for this line of business. As a result of the higher thanexpected case incurred loss and ALAE during 2008, the actuarial methods basedon case incurred losses produced higher estimated ultimate losses for theseaccident years. As a result, at December 31, 2008, the IBNR was determinedto be $34.8 million, or approximately 81% of the remaining case reserves. Theimpact of this revised estimate was an increase to workers compensationreserves of $13.9 million.

 

In addition to the development described for the lines of businessabove, management also recorded a $2.4 million net decrease in IBNR in otherlines of business as a result of its review of loss reserves at December 31,2008. The change in IBNR for each other line of business was not individuallysignificant.

 

*Loss andLAE development—2007*

 

In 2007, we experienced $48.3 million of favorable loss reservedevelopment on prior accident year loss reserves. The favorable loss reservedevelopment was primarily related to lower than expected frequency forprofessional liability in specialty lines and lower than expected severity forautomobile liability in personal lines, partially offset by adverse loss reservedevelopment for multiple peril and workers compensation, primarily for accidentyears 2001 and prior.

 

Specifically, at December 31, 2006, management continued to expectlosses to emerge in the professional liability business, which is included in ourgeneral liability line of business, in line with initial expectations based onmarket analysis when this business was initiated in 2002 and 2003. During 2007,losses continued to be significantly lower than initial expectations. As aresult, management lowered its selected reserves on the earliest years whichaffected more recent years as total loss expectations for those years are basedin part on prior years’ results. The impact of this revised estimate was adecrease to professional liability reserves of $79.6 million.

 

At December 31, 2006, based on actuarial techniques describedabove, management estimated that IBNR related to personal automobile liabilitywas $137.6 million, or approximately 49% of case reserves of $278.7 million for2002 and subsequent accident years. During 2007, case incurred loss and ALAEwas $38.4 million, which was less than expected for this relatively short-tailline of business. At December 31, 2007, based on actuarial techniquesdescribed above, management estimated that IBNR was $66.1 million, orapproximately 49% of the remaining case reserves. The actuarial methods thatmanagement relied upon to estimate IBNR at December 31, 2007 were similarto those used at December 31, 2006. The impact of this revised estimatewas a decrease to personal automobile liability reserves of $33.0 million.

 

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At December 31, 2006, based on actuarial techniques describedabove, management estimated that IBNR related to workers compensation andmultiple peril liability was $95.6 million, or approximately 15% of casereserves of $621.5 million for 2001 and prior accident years. During 2007, caseincurred loss and ALAE was $44.7 million, which was greater than expected forthese long-tail lines of business. As a result of the higher than expected caseincurred loss and ALAE during 2007, management gave greater weight to actuarialtechniques that are based on historical incurred loss development during itsreview of loss reserves at December 31, 2007. As a result, at December 31,2007, the IBNR was determined to be $149.4 million, or approximately 28%relative to the remaining case reserves. The impact of this revised estimatewas an increase to workers compensation and multiple peril liability reservesof $98.5 million.

 

In addition to the development described for the lines of businessabove, management also recorded a $34.2 million net decrease in IBNR in otherlines of business as a result of its review of loss reserves at December 31,2007. The change in IBNR for each other line of business was not individuallysignificant.

 

*Loss andLAE development—2006*

 

In 2006, we experienced $11.3 million of adverse loss reservedevelopment on prior accident year loss reserves, primarily due to developmenton losses related to hurricane events impacting our excess property policies.

 

Specifically at December 31, 2005, management had reviewed allknown losses related to hurricane events impacting our excess propertypolicies. Based on information at that time, management established reservesfor those losses which were expected to reach our coverage layers. During 2006,several individual claims experienced adverse development resulting in morelosses penetrating our coverage layers. As a result, management increased heldreserves as of December 31, 2006 to reflect the actual adverse claimdevelopment as well as a provision for future adverse development on theseclaims.

 

*Primary Insurance Operations Case and IBNR Reservesby Line of Business*

 

Loss and LAE reserves, net of reinsurance recoverables on unpaidlosses, by line of business at December 31, 2008 and 2007 for our PrimaryInsurance Operations were as follows:

 
| ** **                      | ** ** | **December 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|---------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                      | ** ** | **Case**                   | ** ** | **IBNR**                   | ** ** | **Total** | ** ** | **Case** | ** ** | **IBNR** | ** ** | **Total** | ** ** |
| ** **                      | ** ** | **($ in millions)**   | ** ** |
| Workers compensation(1)         |       | $                          | 160.2      |                       | $          | 132.7 |   | $ | 292.9 |   | $ | 81.3 |   | $ | 95.8 |   | $ | 177.1 |   |
| Personal automobile liability   |       | 271.3                      |       | 110.3                      |       | 381.6 |   | 305.2 |   | 139.3 |   | 444.5 |   |
| Multiple peril(1)(2)            |       | (4.9                       | )          | 238.5                      |       | 233.6 |   | 247.0 |   | 206.1 |   | 453.1 |   |
| Commercial automobile liability |       | 90.9                       |       | 66.2                       |       | 157.1 |   | 99.7 |   | 61.8 |   | 161.5 |   |
| General liability(2)(3)         |       | 112.1                      |       | 362.7                      |       | 474.8 |   | 80.2 |   | 305.3 |   | 385.5 |   |
| Homeowners/Farmowners           |       | 55.1                       |       | 23.0                       |       | 78.1 |   | 71.5 |   | 22.8 |   | 94.3 |   |
| Other(1)(4)                     |       | 116.5                      |       | 61.5                       |       | 178.0 |   | 95.9 |   | 56.3 |   | 152.2 |   |
| Total                           |       | $                          | 801.2      |                       | $          | 994.9 |   | $ | 1,796.1 |   | $ | 980.8 |   | $ | 887.4 |   | $ | 1,868.2 |   |

----

(1)                                  Includes lossand LAE reserves related to A&E.

 

(2)                                  Includes lossand LAE reserves related to construction defect claims.

 

(3)                                  Includes lossand LAE reserves related to professional liability.

 

(4)                                  Includes lossand LAE reserves related to marine liability.

 

*PrimaryInsurance Operations Range of Reserves by Line of Business*

 

Our range of reserve estimates at December 31, 2008 was evaluatedto consider the strengths and weaknesses of the actuarial methods appliedagainst our historical claims experience data. The following table shows therecorded reserves and the high and low ends of our range of reasonable loss andLAE reserve estimates at December 31, 2008. The high and low ends of ourrange of reserve estimates in the table below are based on the results ofvarious actuarial methods described above.

 

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| ** **                      | ** ** | **December 31, 2008** | ** ** |
|---------------------------------|------------|----------------------------|------------|
| ** **                      | ** ** | **Low**                    | ** ** | **Recorded** | ** ** | **High** | ** ** |
| ** **                      | ** ** | **($ in millions)**   | ** ** |
| Workers compensation            |       | $                          | 242        |   | $ | 292.9 |   | $ | 356 |   |
| Personal automobile liability   |       | 367                        |       | 381.6 |   | 422 |   |
| Multiple peril                  |       | 162                        |       | 233.6 |   | 265 |   |
| Commercial automobile liability |       | 139                        |       | 157.1 |   | 160 |   |
| General liability               |       | 345                        |       | 474.8 |   | 479 |   |
| Homeowners/Farmowners           |       | 75                         |       | 78.1 |   | 83 |   |
| Other                           |       | 165                        |       | 178.0 |   | 181 |   |
| Total                           |       | $                          | 1,495      |   | $ | 1,796.1 |   | $ | 1,946 |   |

 

The recorded reserves represent management’s best estimate of unpaidloss and LAE by line of business. We use the results of several differentactuarial methods to develop our estimate of ultimate reserves. While we havenot determined the statistical probability of actual ultimate paid lossesfalling within the range, management believes that it is reasonably likely thatactual ultimate paid losses will fall within the ranges noted above because theranges were developed by using several different generally accepted actuarialmethods.

 

The probability that ultimate losses will fall outside of the ranges ofestimates by line of business is higher for each line of business individuallythan it is for the sum of the estimates for all lines taken together due to theeffects of diversification. The diversification effects result from the factthat losses across our different lines of business are not completelycorrelated. Although management believes our reserves are reasonably stated,ultimate losses may deviate, perhaps materially, from the recorded reserveamounts and could be above the high end of the range of actuarial projections.This is because ranges are developed based on known events as of the valuationdate, whereas the ultimate disposition of losses is subject to the outcome ofevents and circumstances that may be unknown as of the valuation date.

 

The percentages shown in the following table represent the linearinterpolation of where our recorded loss and LAE reserves are within the rangeof reserves estimates by line of business at December 31, 2008 and 2007,where the low end of the range equals zero, the middle of the range equals 50%and the high end of the range equals 100%.

 
| ** **                      | ** ** | **December 31,**                         | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                      | ** ** | **2007** | ** ** |
| ** **                      | ** ** | **(expressed as a  percentage of the range)** | ** ** |
| Workers compensation            |       | 45                                            | %          | 42 | % |
| Personal automobile liability   |       | 26                                            |       | 51 |   |
| Multiple peril                  |       | 69                                            |       | 47 |   |
| Commercial automobile liability |       | 88                                            |       | 47 |   |
| General liability               |       | 97                                            |       | 72 |   |
| Homeowners/Farmowners           |       | 37                                            |       | 91 |   |
| Other                           |       | 80                                            |       | 82 |   |
| Total                           |       | 67                                            | %          | 57 | % |

 

During 2008, management saw the actuarial methods which were used todevelop the range of reserves for certain long-tailed lines of business producelower estimated losses. However, due to the nature of these lines and theinherent risks in estimating the longer tailed lines of business, managementchose to record losses higher in the range for commercial automobile,commercial multiple peril and general liability. Additionally in 2008,management began to see higher than anticipated paid loss and LAE for personalautomobile which has resulted in increases in the methods used to develop theranges. However, management believes that the ultimate losses will not increaseas much as the models have suggested. As a result, management has chosen torecord reserves lower in the range for personal automobile. In general,management continues to select somewhat higher in the range for newer and/orgrowing segments and as those reserves have become an increasing proportion ofour total reserves, our overall selected reserves have moved up in the range.

 

*Sensitivity Analysis*

 

The following discussion includes disclosure of possible variationsfrom current estimates of loss reserves due to a change in certain keyassumptions. Each of the impacts described below is estimated individually,without consideration for 

 

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anycorrelation among key assumptions or among lines of business. Therefore, itwould be inappropriate to take each of the amounts described below and add themtogether in an attempt to estimate volatility for our reserves in total. It isimportant to note that the variations discussed are not meant to be aworst-case scenario, and therefore, it is possible that future variations maybe more than amounts discussed below.

 

·                  *Workerscompensation: *Recordedreserves for workers compensation were $292.9 million at December 31,2008. The two most important assumptions for workers compensation reserves areloss development factors and loss cost trends, particularly medical costinflation. Loss development patterns are dependent on medical cost inflation.Approximately half of the workers compensation net reserves are related tofuture medical costs. Across the entire reserve base, a 0.5 point change incalendar year medical inflation would have changed the estimated net reserve byapproximately $48 million at December 31, 2008, in either direction.

 

·                  *Personalautomobile liability: *Recordedreserves for personal automobile liability were $381.6 million across alllines at December 31, 2008. Personal automobile liability reserves areshorter-tailed than other lines of business (such as workers compensation) and,therefore, less volatile. However, the size of the reserve base means thatfuture changes in estimates could be material to our results of operations inany given period. A key assumption for personal automobile liability is theimplicit loss cost trend, particularly the severity trend component of losscosts. A 2.0 point change in assumed annual severity for the two most recentaccident years would have changed the estimated net reserve by$10.5 million at December 31, 2008, in either direction. Assumedannual severity for accident years prior to the two most recent accident yearsis likely to have minimal variability.

 

·                  *Multipleperil liability and general liability: *Recordedreserves for multiple peril and general liability combined were $708.4 millionat December 31, 2008. Reported loss development patterns are a keyassumption for these lines of business, particularly for more mature accidentyears. Historically, assumptions on reported loss development patterns havebeen impacted by, among other things, emergence of new types of claims(e.g. construction defect claims) or a shift in the mixture betweensmaller, more routine claims and larger, more complex claims. If the severitytrend for construction defect claims changed by 3.0 points this would havechanged the estimated net reserve by $4.7 million at December 31,2008, in either direction. Separately, if case reserve adequacy fornon-construction defect claims changed by 10.0 points this would have changedthe estimated net reserve by $22.3 million at December 31, 2008, ineither direction.

 

***3.******             ******Reinsurance Transactions***

 

Our insurance subsidiaries purchase reinsurance from time to time toprotect their businesses from losses due to exposure aggregation, to managetheir operating leverage ratios and to limit ultimate losses arising fromcatastrophic events. Amounts recoverable from reinsurers are estimated in amanner consistent with the claim liability associated with the reinsuredpolicies. Amounts related to reinsurance contracts are recorded in accordancewith SFAS 113.

 

In connection with the OneBeacon Acquisition, Aviva caused us topurchase reinsurance contracts with two reinsurance companies rated “AAA” (“ExtremelyStrong”, the highest of twenty-one ratings) by Standard & Poor’s and “A++”(“Superior”, the highest of fifteen ratings) by A.M. Best. One is areinsurance cover with NICO which entitles us to recover up to$2.5 billion in ultimate loss and LAE incurred related to asbestos claimsarising from business written by our predecessor prior to 1992, environmentalclaims arising from business written by our predecessor prior to 1987 andcertain other latent exposures. As of December 31, 2008, we have cededestimated incurred losses of approximately $2.2 billion to NICO under theNICO Cover. The other contract is a reinsurance cover with GRC for up to$570 million of additional losses on all claims arising from accidentyears 2000 and prior. As of December 31, 2008, we have ceded estimatedincurred losses of $550.0 million to GRC under the GRC Cover. The NICOCover and GRC Cover, which were contingent on and occurred contemporaneouslywith the OneBeacon Acquisition, were put in place in lieu of a seller guaranteeof loss and LAE reserves and are therefore accounted for as a seller guaranteeunder GAAP in accordance with EITF Topic D-54. NICO and GRC are wholly-ownedsubsidiaries of Berkshire Hathaway.

 

The collectibility of reinsurance recoverables is subject to thesolvency and willingness to pay of the reinsurer. We are selective in choosingour reinsurers, placing reinsurance principally with those reinsurers with astrong financial condition, industry ratings and underwriting ability.Management monitors the financial condition and ratings of our reinsurers on anongoing basis. See Note 5—“Reinsurance” of the accompanying consolidatedfinancial statements for additional information on our reinsurance programs.

 

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***4.******             ******PurchaseAccounting***

 

When we acquire another company, our management must estimate the fairvalues of the assets and liabilities acquired, as prescribed by SFAS No. 141,“Business Combinations.” (We adopted SFAS No. 141 (Revised 2007), “BusinessCombinations” effective January 1, 2009. See Note 1—“Nature of Operationsand Summary of Significant Accounting Policies—Recent Accounting Pronouncements”of the accompanying consolidated financial statements.) Certain assets andliabilities require little judgment to estimate their fair values, particularlythose that are quoted on a market exchange, such as publicly-traded investmentsecurities. Other assets and liabilities, however, require a substantial amountof judgment to estimate their fair values. The most significant of these is theestimation required to fair value loss and LAE reserves. We estimate the fairvalue of loss and LAE reserves obtained in an acquisition following theprinciples contained within FASB Statement of Financial Accounting Concepts No. 7:“Using Cash Flow Information and Present Value in Accounting Measurements”, orCON 7. Under CON 7, the fair value of a particular asset or liability essentiallycontains five elements: (1) an estimate of the future cash flows; (2) expectationsabout possible variations in the amount or timing of those cash flows; (3) thetime value of money, represented by the risk-free rate of interest; (4) theprice for bearing the uncertainty inherent in the asset or liability; and (5) other,sometimes unidentifiable, factors including illiquidity and marketimperfections.

 

Our actuaries estimate the fair value of loss and LAE reserves obtainedin an acquisition by taking the acquired company’s recorded reserves anddiscounting them based on expected reserve payout patterns using the currentrisk-free rate of interest. Then, our actuaries develop additional cash flowscenarios that use different payout and ultimate reserve assumptions deemed tobe reasonably possible based upon the inherent uncertainties present indetermining the amount and timing of payment of such reserves. In eachscenario, the risk-free rate of interest is used to discount future cash flows.These scenarios are put in a statistical model that assigns a probability toeach cash flow scenario. Our actuaries then choose the scenario that bestrepresents the price for bearing the uncertainty inherent within the acquiredcompany’s recorded reserves. The “price” for bearing the uncertainty inherentwithin the acquired company’s reserves is measured as the difference betweenthe selected cash flow scenario and the expected cash flow scenario. Thescenario selected has typically been between 1.5 and 2 standard deviations fromthe expected cash flow outcome. The fair value of the acquired company’s lossand LAE reserves is determined to be the sum of the expected cash flow scenario(i.e., the acquired company’s discounted loss and LAE reserves) and theuncertainty “price.”

 

The difference between an acquired company’s loss and LAE reserves andour best estimate of the fair value of such reserves at the acquisition date isamortized ratably over the payout period of the acquired loss and LAE reserves.Historically, the fair value of an acquired company’s loss and LAE reserves hasbeen less than its nominal reserves at acquisition. Accordingly, theamortization has been and will continue to be recorded as an expense on ourincome statement until fully amortized.

 

In connection with purchase accounting for the OneBeacon Acquisition,we were required to adjust to fair value our loss and LAE reserves and therelated reinsurance recoverables by $646.9 million and$346.9 million, respectively, on OneBeacon’s acquired balance sheet as of June 1,2001. This net reduction to loss and LAE reserves of $300.0 million isbeing accreted through an income statement charge ratably with and over theperiod the claims are settled. The outstanding pre-tax unaccreted adjustment asof December 31, 2008 was $5.4 million.

 

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**FORWARD-LOOKINGSTATEMENTS**

 

The information contained in this report may contain “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934. Allstatements, other than statements of historical facts, included or referencedin this report that address activities, events or developments which we expector anticipate will or may occur in the future are forward-looking statements.The words “will,” “believe,” “intend,” “expect,” “anticipate,” “project,” “estimate,”“predict” and similar expressions are also intended to identify forward-lookingstatements. These forward-looking statements include, among others, statementswith respect to our:

 

·                  change in bookvalue per share or return on equity;

 

·                  businessstrategy;

 

·                  financial andoperating targets or plans;

 

·                  incurred lossand loss adjustment expenses and the adequacy of our loss and loss adjustmentexpense reserves and related reinsurance;

 

·                  projections ofrevenues, income (or loss), earnings (or loss) per share, dividends, marketshare or other financial forecasts;

 

·                  expansion andgrowth of our business and operations; and

 

·                  future capitalexpenditures.

 

These statements are based on certain assumptions and analyses made byus in light of our experience and perception of historical trends, currentconditions and expected future developments, as well as other factors believedto be appropriate in the circumstances. However, whether actual results anddevelopments will conform with its expectations and predictions is subject to anumber of risks and uncertainties that could cause actual results to differmaterially from expectations, including:

 

·                  the risksdiscussed beginning on page 22 of this Form 10-K;

 

·                  recorded lossand loss adjustment expense reserves subsequently proving to have beeninadequate;

 

·                  claims arisingfrom catastrophic events, such as hurricanes, earthquakes, floods or terroristattacks;

 

·                  competitiveforces, including the conduct of other property and casualty insurers andreinsurers;

 

·                  changes indomestic or foreign laws or regulations, or their interpretation, applicable tous, our competitors or our clients;

 

·                  the continuedavailability of capital and financing;

 

·                  generaleconomic, market or business conditions;

 

·                  an economicdownturn or other economic conditions adversely affecting our financialposition;

 

·                  businessopportunities (or lack thereof) that may be presented to us and pursued; and

 

·                  other factors,most of which are beyond our control.

 

Consequently, all of the forward-looking statements made in this reportare qualified by these cautionary statements, and there can be no assurancethat the actual results or developments anticipated by us will be realized or,even if substantially realized, that they will have the expected consequencesto, or effects on, us or our business or operations. We assume no obligation toupdate publicly any such forward-looking statements, whether as a result of newinformation, future events or otherwise.

 

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**ITEM7A.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Our consolidated balance sheet includes a substantial amount of assetsand liabilities whose fair values are subject to market risk. The term marketrisk refers to the risk of loss arising from adverse changes in interest ratesand other relevant market rates and prices. Due to our sizable balances ofinterest rate sensitive instruments, market risk can have a significant effecton our consolidated financial position.

 

***Interest Rate Risk***

 

*Fixed Maturity and Convertible Bond Portfolios.*  In connection with our consolidated insurancesubsidiaries, we invest in interest rate sensitive securities, primarily debtsecurities. Our strategy is to purchase fixed maturity investments andconvertible bonds that are attractively priced in relation to perceived creditrisks. Upon adoption of SFAS 159 on January 1, 2008, our portfolio offixed maturity investments held for general investment purposes werereclassified as trading securities which are reported at fair value as of thebalance sheet date as determined by quoted market prices when available.  Realized and unrealized investment gains andlosses on trading securities are reported pre-tax in revenues. Prior toadoption of SFAS 159, our fixed maturity investments were held as available-for-salein accordance with SFAS No. 115, “Accounting for Certain Investments inDebt and Equity Securities,” or SFAS 115, whereby these investments arecarried at fair value on the balance sheet with net unrealized gains or lossesreported net of tax as a separate component of common shareholder’s equity.

 

Upon adoption of SFAS 159, our convertible bonds are carried at fairvalue with changes therein recorded in revenues as unrealized investment gainsor losses. Prior to adoption of SFAS 159, our convertible bonds were held asavailable-for-sale and were carried at fair value with changes in fair valuerecorded through income as realized investment gains or losses in accordancewith SFAS No. 155, “Accounting for Certain Hybrid Instruments,” orSFAS 155.

 

We generally manage our interest rate risk associated with ourportfolio of fixed maturity investments and convertible bonds by monitoring theaverage duration of the portfolio, which allows us to achieve an adequate yieldwithout subjecting the portfolio to an unreasonable level of interest raterisk. Our fixed maturity and convertible bond portfolios are comprised ofprimarily investment grade corporate securities, U.S. government and agencysecurities, municipal obligations and mortgage-backed securities(e.g., those receiving an investment grade rating from Standard &Poor’s or Moody’s).

 

Increases and decreases in prevailing interest rates generallytranslate into decreases and increases in fair values of fixed maturity andconvertible bond investments, respectively. Additionally, fair values ofinterest rate sensitive instruments may be affected by the creditworthiness ofthe issuer, prepayment options, relative values of alternative investments, theliquidity of the instrument and other general market conditions.

 

The table below summarizes the estimated effects of hypotheticalincreases and decreases in market interest rates on our fixed maturity andconvertible bond investments and pension fixed maturity investments:

 
| ** **                                      | ** ** | **Fair value at  December 31,  2008** | ** ** | **Assumed change  in relevant  interest rate** | ** **       | **Estimated fair value  after change in  interest rate** | ** ** | **After tax increase  (decrease) in  carrying value** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------------|------------------|----------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                      | ** ** | **($ in millions)**                   | ** ** |
| Fixed maturity and convertible bond investments |       | $                                          | 2,376.0    |                                           | 100  bp decrease |                                                     | $          | 2,420.4                                               |       | $ | 28.9 |   |
|                                            |       |                                       |       | 50  bp decrease                                |             | 2,397.9                                                  |       | 14.2                                                  |       |
|                                            |       |                                       |       | 50  bp increase                                |             | 2,345.5                                                  |       | (19.8                                                 | )          |
|                                            |       |                                       |       | 100  bp increase                               |             | 2,317.9                                                  |       | (37.8                                                 | )          |
| Pension fixed maturity investments              |       | $                                          | 55.0       |                                           | 100  bp decrease |                                                     | $          | 56.3                                                  |       | $ | 0.8 |   |
|                                            |       |                                       |       | 50  bp decrease                                |             | 55.7                                                     |       | 0.5                                                   |       |
|                                            |       |                                       |       | 50  bp increase                                |             | 54.3                                                     |       | (0.5                                                  | )          |
|                                            |       |                                       |       | 100  bp increase                               |             | 53.7                                                     |       | (0.8                                                  | )          |

 

*Long-term obligations.*  As of December 31, 2008, our interestand dividend bearing long-term obligations consisted primarily of the SeniorNotes which have a fixed interest rate. As a result, our exposure to interestrate risk resulting from variable interest rate obligations is insignificant.

 

The Senior Notes were issued in 2003 and mature on May 15, 2013.At December 31, 2008, the fair value of the Senior Notes was$483.3 million, which compared to a carrying value of $675.1 million.The fair value of this obligation was estimated by discounting future cashflows using current market rates for similar obligations or using quoted marketprices.

 

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*Mortgage Note on Real Estate Owned.*  In connection with our purchase of land andan office building in 2005 that became our headquarters in the fourth quarterof 2006, we entered into a $40.8 million, 18-year mortgage note which hasa variable interest rate based upon the lender’s 30 day LIBOR rate. As of December 31,2008, we had fully drawn on the mortgage note. Repayment commenced in January 2009.

 

*Cash Flow Hedge.*  Concurrent with entering into the mortgagenote in 2005, we also entered into an interest rate swap to hedge our exposureto the variability in the interest rate on the mortgage note. The notionalamount of the swap is equal to the debt outstanding on the mortgage note andwill be adjusted to match the drawdowns and repayments on the mortgage note sothat the principal amount of the mortgage note and the notional amount of theswap are equal at all times. Under the terms of the swap, we pay a fixedinterest rate of approximately 6% and receive a variable interest rate based onthe same LIBOR index used for the mortgage note. Interest paid or received onthe swap is reported in interest expense. In accordance with SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities”, orSFAS 133, we have accounted for the swap as a cash flow hedge and haverecorded the interest rate swap at fair value on the balance sheet in otherassets or liabilities depending on the value as of the balance sheet date.Changes in the fair value of the interest rate swap, which was a$5.7 million loss, after tax, for the year ended December 31, 2008,is reported as a component of other comprehensive income. We monitor continuedeffectiveness of the hedge by monitoring the changes in the terms of theinstruments as described above as compared to the actual changes in principaland notional amount in the mortgage note and interest rate swap, respectively.

 

***Credit SpreadRisk***

 

*Fixed Maturity and Convertible Bond Portfolios.*  Our overall fixed maturityinvestment strategy is to purchase securities that are attractively priced inrelation to credit risks. Widening and tightening of credit spreads generallytranslate into decreases and increases in fair values of fixed maturity investments,respectively. The table below summarizes the estimated effects ofhypothetical widening and tightening of credit spreads on our fixed maturityand convertible bond investments and pension plan fixed maturity investments.

 
| ** **                                      | ** ** | **Fair value at  December 31,  2008** | ** ** | **Assumed change  in credit spread** | ** **       | **Estimated fair value  after change in  credit spread** | ** ** | **After tax increase  (decrease) in  carrying value** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------|------------------|----------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                      | ** ** | **($ in millions)**                   | ** ** |
| Fixed maturity and convertible bond investments |       | $                                          | 2,376.0    |                                 | 100  bp decrease |                                                     | $          | 2,416.3                                               |       | $ | 26.2 |   |
|                                            |       |                                       |       | 50  bp decrease                      |             | 2,397.3                                                  |       | 13.8                                                  |       |
|                                            |       |                                       |       | 50  bp increase                      |             | 2,354.0                                                  |       | (14.3                                                 | )          |
|                                            |       |                                       |       | 100  bp increase                     |             | 2,331.5                                                  |       | (28.9                                                 | )          |
| Pension fixed maturity investments              |       | $                                          | 55.0       |                                 | 100  bp decrease |                                                     | $          | 56.0                                                  |       | $ | 0.7 |   |
|                                            |       |                                       |       | 50  bp decrease                      |             | 55.5                                                     |       | 0.3                                                   |       |
|                                            |       |                                       |       | 50  bp increase                      |             | 54.4                                                     |       | (0.4                                                  | )          |
|                                            |       |                                       |       | 100  bp increase                     |             | 53.8                                                     |       | (0.8                                                  | )          |

 

***Equity Price Risk***

 

The carrying values of our common equity securities and our otherinvestments are based on quoted market prices or management’s estimates of fairvalue (which is based, in part, on quoted market prices) as of the balancesheet date. Market prices of common equity securities, in general, are subjectto fluctuations which could cause the amount to be realized upon sale orexercise of the instruments to differ significantly from the current reportedvalue. The fluctuations may result from perceived changes in the underlyingeconomic characteristics of the investee, the relative price of alternativeinvestments, general market conditions and supply and demand imbalances for aparticular security.

 

***Foreign Currency Exchange Rates***

 

Our investments denominated in foreign currencies are valued usingperiod-end exchange rates and our net investment income on foreign-denominatedsecurities are valued using average exchange rates. Foreign currency exchangerate risk is the risk that we will incur losses on a U.S. dollar basis due toadverse changes in foreign currency exchange rates.

 

At December 31, 2008, we held $84.0 million in bondsdenominated in foreign currencies, mostly in British pounds and Australian dollars.Assuming a hypothetical 10% increase or decrease in the rate of exchange fromthe British pound and Australian dollar to the U.S. dollar as of December 31,2008, the carrying value of our foreign currency-denominated bond portfoliowould have respectively decreased or increased by $8.4 million.

 

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**ITEM8.  FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The financial statements and supplementary data have been filed as apart of this Annual Report on Form 10-K as indicated in the Index toConsolidated Financial Statements and Financial Statement Schedules appearingon page F-1 of this report.

 

**ITEM9.  CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM9A.  CONTROLS AND PROCEDURES**

 

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in the reports that we file orsubmit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer (CEO) and Chief FinancialOfficer (CFO), as appropriate, to allow timely decisions regarding requiredfinancial disclosure.

 

Our CEO and the CFO (the principal executive officer and principalfinancial officer, respectively) have evaluated the effectiveness of ourdisclosure controls and procedures (as defined in Rule 13a-1 5(e) ofthe Securities Exchange Act of 1934, as amended) as of December 31, 2008.Based on this evaluation, the CEO and CFO have concluded that as of December 31,2008, our disclosure controls and procedures are adequate and effective toprovide reasonable assurance that material information required to be includedin our periodic SEC reports is recorded, processed, summarized and reportedwithin the time periods specified in rules and forms.

 

The CEO and the CFO have evaluated the effectiveness of our internalcontrol over financial reporting as of December 31, 2008. Based on thatevaluation, the CEO and CFO have concluded that our internal control overfinancial reporting is effective. Management’s annual report on internalcontrol over financial reporting is included on page F-53 of this report.This annual report does not include an attestation report of our registeredpublic accounting firm regarding internal control over financial reporting.Management’s report was not subject to attestation by our registered publicaccounting firm pursuant to temporary rules of the Securities and ExchangeCommission that permit us to provide only management’s report in this annualreport.

 

There were no significant changes with respect to our internal controlover financial reporting or in other factors that materially affected, or arereasonably likely to materially affect, internal control over financialreporting during the quarter ended December 31, 2008.

 

**ITEM9B.  OTHER INFORMATION**

 

None.

 

**PART III**

 

**ITEM14.  PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 

The following table presents fees for professional services rendered byPricewaterhouseCoopers LLP for the audit of the Company’s annual financialstatements, audit-related services, tax services and all other services for theyears ended December 31, 2008 and 2007.

 

81

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| ** **            | ** ** | **Year ended  December 31,** | ** ** |
|-----------------------|------------|-----------------------------------|------------|
| ** **            | ** ** | **2008**                          | ** ** | **2007** | ** ** |
| ** **            | ** ** | **($ in millions)**          | ** ** |
| Audit fees(1)         |       | $                                 | 1.7        |   | $ | 1.9 |   |
| Audit-related fees(2) |       | 0.2                               |       | 0.2 |   |
| Tax fees(3)           |       | —                            |       | 0.1 |   |
| Total(4)              |       | $                                 | 1.9        |   | $ | 2.2 |   |

----

(1)                                  The fees inthis category were for professional services rendered in connection with (i) theaudits of the Company’s annual financial statements set forth in the Company’sAnnual Report on Form 10-K, (ii) the review of the Company’squarterly financial statements as set forth in its Quarterly Reports on Form 10-Q,(iii) audits of the Company’s subsidiaries that are required by statute orregulation, and (iv) services that generally only the Company’sindependent registered public accounting firm reasonably can provide.

 

(2)                                  The fees inthis category were for professional services rendered in connection with (i) employeebenefit plans, (ii) agreed upon procedures, (iii) a consent inconnection with the filing of the Company’s shelf registration statement on Form S-3in 2008, and (iv) other regulatory requirements.

 

(3)                                  The fees inthis category were for professional services rendered in connection with taxstrategy assistance and tax compliance services.

 

(4)                                  These fees area component of the total accountant fees incurred by OBIG during 2008 and 2007.

 

**PART IV**

 

**ITEM15.  EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

 

**a.****                                      ****Documents Filed as Part of the Report**

 

The financial statements and financial statement schedules and reportof independent auditors have been filed as part of this Annual Report on Form 10-Kas indicated in the Index to Consolidated Financial Statements and FinancialStatement Schedules appearing on page F-1 of this report. A listing ofexhibits filed as part of the report appears on page 82 of this report.

 

**b.****                                      ****Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                         |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 23.1*                |       | Consent  of PricewaterhouseCoopers LLP.                                                                                                                            |
| 31.1*                |       | Certification  of T. Michael Miller pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                          |
| 31.2*                |       | Certification  of Paul H. McDonough pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                          |
| 32.1**               |       | Certification  of T. Michael Miller pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2**               |       | Certification  of Paul H. McDonough pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

----

*                                         Filed Herewith

 

**                                  FurnishedHerewith

 

**c.****                                      ****Financial Statement Schedules**

 

The financial statement schedules and report of independent registeredpublic accounting firm have been filed as part of this Annual Report on Form 10-Kas indicated in the Index to Consolidated Financial Statements and FinancialStatement Schedules appearing on page F-1 of this report.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereto duly authorized.

 
|                       | **ONEBEACON U.S. HOLDINGS, INC.** |
|----------------------------|-----------------------------------|
| ** **                 |                              |   |
| ** **                 |                              |   |
| ** **                 | By:                               | /s/  T. MICHAEL MILLER |
|                       |                              | T.  Michael Miller |
| Date:  March 13, 2009 |                              | *President and Chief Executive Officer* |

 

Pursuant to the requirements of the Securities Act of 1934, this reporthas been signed by the following persons in the capacities and on the dateindicated.

 
| **Signature**         | ** ** | **Title**                                             | ** ** | **Date**            |
|-----------------------|------------|-------------------------------------------------------|------------|---------------------|
| ** **            | ** ** | ** **                                            | ** ** | ** **          |
| /s/ T. MICHAEL MILLER |       | Director,  Chairman of the Board, President and Chief |       | March 13, 2009 |
| T. Michael Miller     |       | Executive  Officer                                    |       |                |
|                  |       |                                                  |       |                |
|                  |       |                                                  |       |                |
| /s/ PAUL H. MCDONOUGH |       | Director  and Chief Financial Officer                 |       | March 13, 2009 |
| Paul H. McDonough     |       |                                                  |       |                |
|                  |       |                                                  |       |                |
|                  |       |                                                  |       |                |
| /s/ ANN MARIE ANDREWS |       | Chief  Accounting Officer                             |       | March 13, 2009 |
| Ann Marie Andrews     |       |                                                  |       |                |

 

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**ONEBEACONU.S. HOLDINGS, INC.**

 

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**

 
| ** **                                                                                                                         | **Form 10-K  Pages**                                                  |
|------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------|
| **Audited Consolidated Financial Statements**                                                                                      |                                                                       |
| Consolidated Balance Sheets:  As of December 31, 2008 and 2007                                                                | F-2                                                                        |
| Consolidated Statements of Operations and  Comprehensive (Loss) Income:  For the years ended December 31, 2008, 2007 and 2006 | F-3                                                                        |
| Consolidated Statements of Common Shareholder’s  Equity:  For the years ended December 31, 2008, 2007 and 2006           | F-4                                                                        |
| Consolidated Statements of Cash Flows:  For the years ended December 31, 2008, 2007 and 2006                                  | F-5                                                                        |
| Notes to Consolidated Financial Statements                                                                                         | F-6                                                                        |
| ** **                                                                                                                         |                                                                       |
| **Other Financial Information:**                                                                                                   |                                                                       |
| Management’s Annual Report on Internal Control Over  Financial Reporting                                                      | F-53                                                                       |
| Report of Independent Registered Public Accounting  Firm                                                                           | F-54                                                                       |
| Selected Quarterly Financial Data (Unaudited)                                                                                      | F-55                                                                       |
| ** **                                                                                                                         |                                                                       |
| **Financial Statement Schedules:**                                                                                                 |                                                                       |
| I.                                                                                                                                 | Summary of investments—other than  investments in related parties     | S-1 |
| II.                                                                                                                                | Condensed financial information of the  Registrant                         | S-2 |
| III.                                                                                                                               | Supplementary insurance information                                        | S-4 |
| IV.                                                                                                                                | Reinsurance                                                                | S-5 |
| V.                                                                                                                                 | Valuation and qualifying accounts                                          | S-6 |
| VI.                                                                                                                                | Supplemental information for property  and casualty insurance underwriters | S-7 |

 

F-1

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Tableof Contents

 

**ONEBEACONU.S. HOLDINGS, INC.**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                | ** ** | **December 31,**                                          | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2008**                                                       | ** ** | **2007** | ** ** |
| ** **                                                                                                                | ** ** | **($ in millions, except  share and per share  amounts)** | ** ** |
| **Assets**                                                                                                                |       |                                                           |       |   |   |
| Investment Securities:                                                                                                    |       |                                                           |       |   |   |
| Fixed maturity investments, at fair value (amortized cost $2,246.4  and $2,861.9)                                         |       | $                                                              | 2,134.8    |   | $ | 2,913.0 |   |
| Common equity securities, at fair value (cost $284.6 and $641.7)                                                          |       | 276.7                                                          |       | 788.4 |   |
| Convertible bonds, at fair value (amortized cost $255.0 and $362.7)                                                       |       | 241.2                                                          |       | 371.4 |   |
| Short-term investments, at amortized cost (which approximates fair  value)                                                |       | 875.4                                                          |       | 278.9 |   |
| Held-to-maturity investments (assets held in trust):                                                                      |       |                                                           |       |   |   |
| Fixed maturity investments, at amortized cost (estimated fair value $—  and $306.9)                                  |       | —                                                         |       | 305.5 |   |
| Short-term investments, at amortized cost (which approximates fair  value)                                                |       | —                                                         |       | 0.1 |   |
| Other investments, at fair value (cost $178.6 and $292.7)                                                                 |       | 196.6                                                          |       | 348.6 |   |
| Total investments                                                                                                         |       | 3,724.7                                                        |       | 5,005.9 |   |
| Cash                                                                                                                      |       | 51.6                                                           |       | 47.2 |   |
| Reinsurance recoverable on unpaid losses                                                                                  |       | 859.4                                                          |       | 958.9 |   |
| Reinsurance recoverable on unpaid losses—Berkshire  Hathaway, Inc.                                              |       | 1,643.9                                                        |       | 1,670.6 |   |
| Reinsurance recoverable on paid losses                                                                                    |       | 21.7                                                           |       | 21.9 |   |
| Premiums receivable                                                                                                       |       | 527.6                                                          |       | 506.2 |   |
| Securities lending collateral                                                                                             |       | 100.7                                                          |       | 438.9 |   |
| Deferred acquisition costs                                                                                                |       | 225.5                                                          |       | 200.0 |   |
| Net deferred tax asset                                                                                                    |       | 269.4                                                          |       | 48.3 |   |
| Investment income accrued                                                                                                 |       | 25.7                                                           |       | 32.9 |   |
| Ceded unearned premiums                                                                                                   |       | 66.5                                                           |       | 68.1 |   |
| Accounts receivable on unsettled investment sales                                                                         |       | 49.0                                                           |       | 55.0 |   |
| Other assets                                                                                                              |       | 296.3                                                          |       | 313.1 |   |
| Total assets                                                                                                              |       | $                                                              | 7,862.0    |   | $ | 9,367.0 |   |
| **Liabilities**                                                                                                           |       |                                                           |       |   |   |
| Loss and LAE reserves                                                                                                     |       | $                                                              | 4,294.0    |   | $ | 4,480.3 |   |
| Unearned premiums                                                                                                         |       | 1,088.2                                                        |       | 1,005.9 |   |
| Debt                                                                                                                      |       | 731.9                                                          |       | 757.7 |   |
| Securities lending payable                                                                                                |       | 107.7                                                          |       | 438.9 |   |
| Preferred stock subject to mandatory redemption—Berkshire  Hathaway, Inc. (redemption value $— and $300.0) |       | —                                                         |       | 278.4 |   |
| Ceded reinsurance payable                                                                                                 |       | 70.5                                                           |       | 79.8 |   |
| Accounts payable on unsettled investment purchases                                                                        |       | 6.8                                                            |       | 3.9 |   |
| Other liabilities                                                                                                         |       | 429.5                                                          |       | 538.9 |   |
| Total liabilities                                                                                                         |       | 6,728.6                                                        |       | 7,583.8 |   |
| **Common shareholder’s equity**                                                                                      |       |                                                           |       |   |   |
| Common shares and paid-in surplus (par value $1, issued and  outstanding, 505 shares)                                     |       | 970.5                                                          |       | 970.5 |   |
| Retained earnings                                                                                                         |       | 187.9                                                          |       | 629.7 |   |
| Accumulated other comprehensive (loss) income, after tax:                                                                 |       |                                                           |       |   |   |
| Net unrealized gains on investments                                                                                       |       | —                                                         |       | 169.9 |   |
| Net unrealized foreign currency translation (losses) gains                                                                |       | (0.6                                                           | )          | 12.3 |   |
| Other comprehensive income and loss items                                                                                 |       | (24.4                                                          | )          | 0.8 |   |
| Total common shareholder’s equity                                                                                    |       | 1,133.4                                                        |       | 1,783.2 |   |
| Total liabilities and common shareholder’s equity                                                                    |       | $                                                              | 7,862.0    |   | $ | 9,367.0 |   |

 

See Notes to ConsolidatedFinancial Statements including Note 19—“Commitments and Contingencies.”

 

F-2

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**ONEBEACONU.S. HOLDINGS, INC.**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE (LOSS) INCOME**

 
| ** **                                                                                              | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                              | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                                              | ** ** | **($ in millions)**         | ** ** |
| **Revenues**                                                                                            |       |                             |       |   |   |   |   |
| Earned premiums                                                                                         |       | $                                | 1,879.0    |   | $ | 1,873.6 |   | $ | 2,075.9 |   |
| Net investment income                                                                                   |       | 162.1                            |       | 202.4 |   | 187.6 |   |
| Net realized investment (losses) gains                                                                  |       | (318.6                           | )          | 173.1 |   | 163.7 |   |
| Change in net unrealized investment gains and losses                                                    |       | (447.4                           | )          | — |   | — |   |
| Net other revenues                                                                                      |       | 13.8                             |       | 17.2 |   | 27.4 |   |
| Total revenues                                                                                          |       | 1,288.9                          |       | 2,266.3 |   | 2,454.6 |   |
| **Expenses**                                                                                            |       |                             |       |   |   |   |   |
| Loss and LAE                                                                                            |       | 1,126.2                          |       | 1,089.8 |   | 1,283.6 |   |
| Policy acquisition expenses                                                                             |       | 368.3                            |       | 318.9 |   | 379.9 |   |
| Other underwriting expenses                                                                             |       | 290.8                            |       | 329.4 |   | 360.1 |   |
| General and administrative expenses                                                                     |       | 12.9                             |       | 3.2 |   | 9.8 |   |
| Accretion of fair value adjustment to loss and LAE reserves                                             |       | 12.0                             |       | 16.0 |   | 23.0 |   |
| Interest expense on debt                                                                                |       | 44.9                             |       | 45.2 |   | 45.5 |   |
| Interest expense—dividends on preferred stock subject to mandatory  redemption                     |       | 11.8                             |       | 28.3 |   | 28.3 |   |
| Interest expense—accretion on preferred stock subject to mandatory  redemption                     |       | 21.6                             |       | 36.1 |   | 28.3 |   |
| Total expenses                                                                                          |       | 1,888.5                          |       | 1,866.9 |   | 2,158.5 |   |
| **Pre-tax (loss) income**                                                                               |       | (599.6                           | )          | 399.4 |   | 296.1 |   |
| Income tax benefit (provision)                                                                          |       | 195.3                            |       | (164.5 | ) | (92.6 | ) |
| **Net (loss) income from continuing operations  before equity in earnings of unconsolidated affiliate** |       | (404.3                           | )          | 234.9 |   | 203.5 |   |
| Equity in earnings of unconsolidated affiliate                                                          |       | —                           |       | — |   | 10.3 |   |
| **Net (loss) income from continuing operations**                                                        |       | (404.3                           | )          | 234.9 |   | 213.8 |   |
| Net income from discontinued operations                                                                 |       | —                           |       | — |   | 1.2 |   |
| **Net (loss) income**                                                                                   |       | (404.3                           | )          | 234.9 |   | 215.0 |   |
| Change in net unrealized gains and losses for investments held                                          |       | —                           |       | 105.1 |   | 102.1 |   |
| Recognition of net unrealized gains and losses for investments sold                                     |       | —                           |       | (108.3 | ) | (85.0 | ) |
| Change in foreign currency translation                                                                  |       | (0.4                             | )          | 0.5 |   | 13.1 |   |
| Change in other comprehensive income and loss items                                                     |       | (25.2                            | )          | (1.2 | ) | 0.4 |   |
| **Comprehensive net (loss) income**                                                                     |       | $                                | (429.9     | ) | $ | 231.0 |   | $ | 245.6 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

F-3

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**ONEBEACONU.S. HOLDINGS, INC.**

 

**CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDER’S EQUITY**

 
| ** **                                                                      | ** ** | **Common  shareholder’s  equity** | ** **  | **Common  shares and  paid-in  surplus** | ** ** | **Retained  earnings** | ** ** | **Accum. other  comprehensive  income (loss),  after tax** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------------|-------------|------------------------------------------|------------|------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **($ in millions)**               | ** **  |
| Balances at January 1, 2006                                                |       | $                                      | 1,483.8     |                                     | $          | 920.1                  |       | $                                                          | 406.0      |   | $ | 157.7 |   |
| Adjustment to adopt SFAS No. 155, after tax                                |       | —                                 |        | —                                   |       | 7.1                    |       | (7.1                                                       | )          |
| Net income                                                                      |       | 215.0                                  |        | —                                   |       | 215.0                  |       | —                                                     |       |
| Dividends to OneBeacon U.S. Enterprises Holdings, Inc.                     |       | (38.0                                  | )           | —                                   |       | (38.0                  | )          | —                                                     |       |
| Capital contributions received from White Mountains Insurance  Group, Ltd. |       | 50.4                                   |        | 50.4                                     |       | —                 |       | —                                                     |       |
| Adjustment to adopt SFAS No. 158, after tax                                |       | 5.7                                    |        | —                                   |       | —                 |       | 5.7                                                        |       |
| Other comprehensive income (loss) items, after tax:                             |       |                                   |        |                                     |       |                   |       |                                                       |       |
| Change in net unrealized gains and losses on investments                        |       | 17.1                                   |        | —                                   |       | —                 |       | 17.1                                                       |       |
| Change in foreign currency translation                                          |       | 13.1                                   |        | —                                   |       | —                 |       | 13.1                                                       |       |
| Change in interest rate swap                                                    |       | 0.6                                    |        | —                                   |       | —                 |       | 0.6                                                        |       |
| Change in additional pension liability                                          |       | (0.2                                   | )           | —                                   |       | —                 |       | (0.2                                                       | )          |
| Other comprehensive income, after tax                                           |       | 30.6                                   |        | —                                   |       | —                 |       | 30.6                                                       |       |
| Balances at December 31, 2006                                              |       | $                                      | 1,747.5     |                                     | $          | 970.5                  |       | $                                                          | 590.1      |   | $ | 186.9 |   |
| Adjustment to adopt FIN 48                                                 |       | (0.3                                   | )           | —                                   |       | (0.3                   | )          | —                                                     |       |
| Net income                                                                      |       | 234.9                                  |        | —                                   |       | 234.9                  |       | —                                                     |       |
| Dividends to OneBeacon U.S. Enterprises Holdings, Inc.                     |       | (195.0                                 | )           | —                                   |       | (195.0                 | )          | —                                                     |       |
| Other comprehensive income (loss) items, after tax:                             |       |                                   |        |                                     |       |                   |       |                                                       |       |
| Change in net unrealized gains and losses on investments                        |       | (3.2                                   | )           | —                                   |       | —                 |       | (3.2                                                       | )          |
| Change in foreign currency translation                                          |       | 0.5                                    |        | —                                   |       | —                 |       | 0.5                                                        |       |
| Change in interest rate swap                                                    |       | (1.1                                   | )           | —                                   |       | —                 |       | (1.1                                                       | )          |
| Change in additional pension liability                                          |       | (0.1                                   | )           | —                                   |       | —                 |       | (0.1                                                       | )          |
| Other comprehensive loss, after tax                                             |       | (3.9                                   | )           | —                                   |       | —                 |       | (3.9                                                       | )          |
| Balances at December 31, 2007                                              |       | $                                      | 1,783.2     |                                     | $          | 970.5                  |       | $                                                          | 629.7      |   | $ | 183.0 |   |
| Adjustment to adopt SFAS No. 159, after tax                                |       | —                                 |        | —                                   |       | 182.4                  |       | (182.4                                                     | )          |
| Net loss                                                                        |       | (404.3                                 | )           | —                                   |       | (404.3                 | )          | —                                                     |       |
| Dividends to OneBeacon U.S. Enterprises Holdings, Inc.                     |       | (219.9                                 | )           | —                                   |       | (219.9                 | )          | —                                                     |       |
| Other comprehensive loss items, after tax:                                      |       |                                   |        |                                     |       |                   |       |                                                       |       |
| Change in foreign currency translation                                          |       | (0.4                                   | )           | —                                   |       | —                 |       | (0.4                                                       | )          |
| Change in interest rate swap                                                    |       | (5.7                                   | )           | —                                   |       | —                 |       | (5.7                                                       | )          |
| Change in additional pension liability                                          |       | (19.5                                  | )           | —                                   |       | —                 |       | (19.5                                                      | )          |
| Other comprehensive loss, after tax                                             |       | (25.6                                  | )           | —                                   |       | —                 |       | (25.6                                                      | )          |
| **Balances at December 31, 2008**                                          | ** ** | **$**                                  | **1,133.4** | ** **                               | **$**      | **970.5**              | ** ** | **$**                                                      | **187.9**  | ** ** | **$** | **(25.0** | **)** |

 

See Notes to ConsolidatedFinancial Statements.

 

F-4

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Tableof Contents

 

**ONEBEACONU.S. HOLDINGS, INC.**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                           | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                           | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                                           | ** ** | **($ in millions)**         | ** ** |
| Cash flows from operations:                                                                          |       |                             |       |   |   |   |   |
| Net (loss) income                                                                                    |       | $                                | (404.3     | ) | $ | 234.9 |   | $ | 215.0 |   |
| Charges (credits) to reconcile net (loss) income to cash flows  provided from (used for) operations: |       |                             |       |   |   |   |   |
| Income from discontinued operations                                                                  |       | —                           |       | — |   | (1.2 | ) |
| Net realized investment losses (gains)                                                               |       | 318.6                            |       | (173.1 | ) | (163.7 | ) |
| Change in net unrealized investment gains and losses                                                 |       | 447.4                            |       | — |   | — |   |
| Net realized gains from sale of common stock of subsidiaries                                         |       | (2.1                             | )          | (11.3 | ) | — |   |
| Dividends paid on mandatorily redeemable preferred stock                                             |       | 11.8                             |       | 28.3 |   | 28.3 |   |
| Deferred income tax (benefit) provision                                                              |       | (207.3                           | )          | 29.8 |   | 96.9 |   |
| Other operating items:                                                                               |       |                             |       |   |   |   |   |
| Net change in loss and LAE reserves                                                                  |       | (186.3                           | )          | (357.4 | ) | (516.6 | ) |
| Net change in unearned premiums                                                                      |       | 82.3                             |       | 20.7 |   | (57.6 | ) |
| Net change in ceded reinsurance payable                                                              |       | (9.3                             | )          | 30.9 |   | (5.2 | ) |
| Net change in premiums receivable                                                                    |       | (21.4                            | )          | (12.1 | ) | 88.0 |   |
| Net change in reinsurance recoverable on paid and unpaid losses                                      |       | 126.4                            |       | 223.6 |   | 270.2 |   |
| Net change in other assets and liabilities                                                           |       | (140.1                           | )          | (37.5 | ) | 190.6 |   |
| Net cash provided from (used for) operating activities of continuing  operations                     |       | 15.7                             |       | (23.2 | ) | 144.7 |   |
| Net cash used for operating activities of discontinued operations                                    |       | —                           |       | — |   | (22.0 | ) |
| Net cash provided from (used for) operations                                                         |       | 15.7                             |       | (23.2 | ) | 122.7 |   |
| Cash flows from investing activities:                                                                |       |                             |       |   |   |   |   |
| Net maturities, purchases and sales of short-term investments                                        |       | (597.4                           | )          | (25.0 | ) | (73.8 | ) |
| (Purchases) maturities of short-term held-to-maturity investments                                    |       | (7.1                             | )          | 13.4 |   | (13.3 | ) |
| Maturities of fixed maturity investments                                                             |       | 644.3                            |       | 137.9 |   | 468.2 |   |
| Maturities (purchases) of held-to-maturity  investments                                              |       | 312.6                            |       | 13.4 |   | (303.3 | ) |
| Sales of fixed maturity investments                                                                  |       | 893.4                            |       | 1,889.7 |   | 1,610.7 |   |
| Sales of common equity securities                                                                    |       | 446.5                            |       | 327.6 |   | 433.5 |   |
| Sales of convertible bonds                                                                           |       | 225.3                            |       | 241.3 |   | 154.1 |   |
| Distributions and redemptions from other investments                                                 |       | 76.6                             |       | 50.5 |   | 17.8 |   |
| Purchases of fixed maturity investments                                                              |       | (992.6                           | )          | (1,853.0 | ) | (1,777.6 | ) |
| Purchases of common equity securities                                                                |       | (338.6                           | )          | (291.9 | ) | (413.4 | ) |
| Purchases of convertible bonds                                                                       |       | (101.0                           | )          | (251.9 | ) | (338.9 | ) |
| Contributions for other investments                                                                  |       | (30.1                            | )          | (78.9 | ) | (72.0 | ) |
| Sales of common stock of subsidiaries, net of sales costs                                            |       | 12.0                             |       | 47.2 |   | — |   |
| Sales of consolidated and unconsolidated affiliate, net of cash sold                                 |       | —                           |       | — |   | 11.1 |   |
| Sale of renewal rights                                                                               |       | —                           |       | — |   | 32.0 |   |
| Sale of discontinued operations                                                                      |       | —                           |       | — |   | 94.7 |   |
| Purchase of subsidiary                                                                               |       | (7.3                             | )          | — |   | — |   |
| Net change in unsettled investment purchases and sales                                               |       | 8.9                              |       | (55.6 | ) | 5.5 |   |
| Net acquisitions of property and equipment                                                           |       | (0.8                             | )          | (12.0 | ) | (8.0 | ) |
| Net cash provided from (used for) investing activities of continuing  operations                     |       | 544.7                            |       | 152.7 |   | (172.7 | ) |
| Net cash provided from investing activities of discontinued  operations                              |       | —                           |       | — |   | 19.8 |   |
| Net cash provided from (used for) investing activities                                               |       | 544.7                            |       | 152.7 |   | (152.9 | ) |
| Cash flows from financing activities:                                                                |       |                             |       |   |   |   |   |
| Issuance of debt                                                                                     |       | —                           |       | — |   | 22.4 |   |
| Repayment of debt                                                                                    |       | (2.0                             | )          | (2.0 | ) | (8.0 | ) |
| Repurchases of debt                                                                                  |       | (22.3                            | )          | — |   | — |   |
| Cash dividends paid to OneBeacon U.S. Enterprises Holdings, Inc.                                |       | (219.9                           | )          | (93.4 | ) | (4.5 | ) |
| Capital contributions received from White Mountains Insurance  Group, Ltd.                      |       | —                           |       | — |   | 46.1 |   |
| Redemption of mandatorily redeemable preferred stock.                                                |       | (300.0                           | )          | — |   | — |   |
| Dividends paid on mandatorily redeemable preferred stock                                             |       | (11.8                            | )          | (28.3 | ) | (28.3 | ) |
| Net cash (used for) provided from financing activities of continuing  operations                     |       | (556.0                           | )          | (123.7 | ) | 27.7 |   |
| Net increase (decrease) in cash during year                                                          |       | 4.4                              |       | 5.8 |   | (2.5 | ) |
| Cash balance at beginning of year                                                                    |       | 47.2                             |       | 41.4 |   | 43.9 |   |
| Cash balance at end of year                                                                          |       | $                                | 51.6       |   | $ | 47.2 |   | $ | 41.4 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

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** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**NOTE 1.  Natureof Operations and Summary of Significant Accounting Policies**

 

The accompanyingconsolidated financial statements include the accounts of OneBeacon U.S.Holdings, Inc. (the “Company” or “OBH”), formerly known as Fund AmericanCompanies, Inc., and its subsidiaries (collectively, “OB Holdings”) andhave been prepared in accordance with generally accepted accounting principlesin the United States of America (“GAAP”). The OB Holdings operating companiesare U.S.-based property and casualty insurance writers, most of which operatein a multi-company pool. OB Holdings offers a wide range of specialty,commercial and personal products and services sold through select independentagencies and brokers and managing general agencies.

 

OBH was created in 2000 byWhite Mountains Insurance Group, Ltd. (“White Mountains”) to acquire andsubsequently be the holding company for OneBeacon Insurance Group LLC(together with its subsidiaries, “OneBeacon”). On June 1, 2001, OBHacquired OneBeacon from Aviva plc (“Aviva”, formerly CGNU), (the “OneBeaconAcquisition”). During 2006, White Mountains undertook an internal reorganizationand formed OneBeacon Insurance Group, Ltd. (“OBIG”) for the purpose ofholding certain of its property and casualty insurance businesses. As part ofthis reorganization, certain of White Mountains’ businesses that werehistorically indirect wholly-owned subsidiaries of White Mountains, includingOBH, became indirect wholly-owned subsidiaries of OBIG. During the fourthquarter of 2006, White Mountains sold 27.6 million or 27.6% of OBIG’scommon shares in an initial public offering. As of December 31, 2008,White Mountains owned 75.5% of OBIG’s common shares. Within this report, theterm “OB Holdings” is used to refer to one or more entities within theconsolidated organization, as the context requires. The Company is a U.S.-basedcompany with its headquarters located at 1 Beacon Lane, Canton, Massachusetts02021 and its principal executive office located at 601 Carlson Parkway,Minnetonka, Minnesota 55305.

 

OB Holdings’ reportablesegments are Primary Insurance Operations, Affiliate Quota Shares and Other Operations.OB Holdings’ Primary Insurance Operations segment includes the results ofsubstantially all of its insurance operations, with the exception of certainquota share arrangements with affiliates of White Mountains as described below.

 

During 2004 and 2005, OBHoldings entered into two quota share reinsurance arrangements with othersubsidiaries of White Mountains. These quota share agreements were commutedduring the fourth quarter of 2006 in connection with OBIG’s initial publicoffering. Under the Sirius International Insurance Corporation (“Sirius”) QuotaShare (the “Sirius Quota Share”), OB Holdings ceded between 6% and 12% ofbusiness written, effective April 1, 2004, to Sirius. Under the EsuranceInsurance Company (“Esurance”) Quota Share (the “Esurance Quota Share”),effective January 1, 2005, OB Holdings assumed approximately 85% ofbusiness written by Esurance, which included business written by itswholly-owned subsidiary, Esurance Property and Casualty Insurance Company.

 

OB Holdings’ OtherOperations segment consists of the activities of the Company.

 

All significant intercompanytransactions have been eliminated in consolidation. The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities as of the date of the financial statements and the reported amountsof revenues and expenses during the reporting period. Actual results coulddiffer from those estimates. Certain amounts in the prior period financialstatements have been reclassified to conform to the current presentation.

 

As discussed in furtherdetail in Note 2, OB Holdings sold certain consolidated subsidiaries toWhite Mountains on August 3, 2006 at GAAP book value as part of areorganization immediately preceding OBIG’s initial public offering. The soldsubsidiaries have been classified as discontinued operations. Accordingly, theresults of operations for the sold subsidiaries are presented net of tax, asincome from discontinued operations in the consolidated statements ofoperations and comprehensive (loss) income. Cash flows associated with theoperating and investing activities of discontinued operations are aggregatedand presented under separate captions in the consolidated statements of cashflows. There were no cash flows associated with financing activities for thediscontinued operations.

 

***Basis of presentation***

 

*Investment Securities*

 

In accordance with itsadoption of Financial Accounting Standards Board (“FASB”) Statement ofFinancial Accounting Standards (“SFAS”) No. 159, “The Fair Value Optionfor Financial Assets and Financial Liabilities” (“SFAS 159”) on January 1,2008, OB Holdings classifies its portfolio of fixed maturity investments andcommon equity securities, 

 

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excluding convertible bonds, held for generalinvestment purposes as trading. Trading securities are reported at fair valueas of the balance sheet date as determined by quoted market prices whenavailable. Realized and unrealized investment gains and losses on tradingsecurities are reported, pre-tax in revenues. See *RecentlyAdopted Changes in Accounting Principles*of Note 1 for furtherdiscussion. Prior to adoption of SFAS 159, OB Holdings’ fixed maturityinvestments and common equity securities, held for general investment purposes,excluding convertible bonds which are described below, were classified asavailable-for-sale and reported at fair value. Net unrealized investment gainsand losses on available-for-sale securities were reported net, after tax, as aseparate component of common shareholder’s equity. Changes in net unrealizedinvestment gains and losses, after tax, were reported as a component of othercomprehensive income.

 

OB Holdings owns convertiblebonds with embedded derivatives. OB Holdings has elected the fair value optionunder SFAS 159 for its investments in convertible bonds effective January 1,2008. Convertible bonds are carried at fair value with changes therein reportedin revenues as unrealized investment gains or losses. See *RecentlyAdopted Changes in Accounting Principles*of Note 1 for furtherdiscussion. Prior to adoption of SFAS 159, OB Holdings recorded its convertiblebonds in accordance with SFAS No. 155, “Accounting for Certain HybridInstruments, an amendment to Statements No. 133 and 140” (“SFAS 155”).Under SFAS 155, OB Holdings had accounted for convertible bonds on a fairvalue basis with changes in fair value recorded through revenues as realizedinvestment gains or losses. SFAS 155 eliminated the requirement to bifurcatefinancial instruments with embedded derivatives if the holder of the instrumentelected to account for the entire instrument on a fair value basis with changesin fair value of the entire instrument recorded through income as realizedinvestment gains or losses. Prior to adoption of SFAS 155, OB Holdings hadrecorded $143.6 million related to the host instruments in fixed maturityinvestments and $73.6 million for the equity conversion options in otherinvestments. Upon adoption of SFAS 155, OB Holdings recorded an after taxadjustment of $7.1 million to reclassify net unrealized gains on investments(gross gains of $11.0 million and gross losses of $0 million) toopening retained earnings to reflect the cumulative effect of adoption. At December 31,2008 and 2007, OB Holdings had $241.2 million and $371.4 million,respectively, of convertible bonds.

 

Short-term investmentsconsist of money market funds, certificates of deposit and other securitieswhich, at the time of purchase, mature or become available for use within oneyear. Short-term investments are carried at amortized cost, which approximatedfair value as of December 31, 2008 and 2007.

 

In connection with OBIG’sinitial public offering and as part of the reorganization described above, OBHoldings created an irrevocable grantor trust and funded it with assetssufficient to make the remaining dividend and redemption payments for$300 million of preferred stock that was redeemed in May 2008. See *Mandatorily Redeemable Preferred Stock*section of this note and Note 11 for further discussion of preferred stocksubject to mandatory redemption. The cash contributed to fund this trust wasused to purchase a portfolio of fixed maturity securities. This portfolio offixed maturity investments was classified as held-to-maturity and reported atamortized cost as the creation and funding of the trust did not legally defeasethe preferred stock or create any additional rights for the holders ofpreferred stock, although the assets in the trust remained segregated from OBHoldings’ other general assets as OB Holdings had the ability and intent tohold the investments in this portfolio to maturity. Certain of the investmentspurchased to fund the trust matured within one year and were thereforereflected as short-term investments. In addition, some of the interest paymentson the assets in the trust were reinvested in short-term investments.Consistent with the basis of presentation described above, these short-terminvestments were carried at amortized cost, which approximated fair value as ofDecember 31, 2007. These investments are referred to herein as “assetsheld in trust”.

 

Other investments includelimited partnerships, hedge funds and private equity interests. Prior to January 1,2008, changes in OB Holdings’ interest in other investments accounted for usingthe equity method were included in net realized investment gains (losses).Changes in OB Holdings’ interest in other investments not accounted for underthe equity method are reported, net of tax, as a component of commonshareholder’s equity with changes therein reported, after tax, as a componentof other comprehensive (loss) income. Upon adoption of SFAS 159 on January 1,2008, OB Holdings measures its investments in limited partnerships, hedge fundsand private equity interests at fair value with changes therein reported inrevenues on a pre-tax basis. See *Recently Adopted Changesin Accounting Principles*of Note 1 for further discussion.

 

Investment securities areregularly reviewed for impairment based on criteria that include the extent towhich cost exceeds market value, the duration of the market decline, thefinancial health of and specific prospects for the issuer and the ability andintent to hold the investment to recovery. Investment losses that aredetermined to be other-than-temporary are recognized in revenues through netrealized investment gains (losses). Realized gains and losses resulting fromsales of investment securities are accounted for using the specificidentification method. Premiums and discounts on fixed maturity investments areaccreted to income over the anticipated life of the investment.

 

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*Securities Lending*

 

OB Holdings participates ina securities lending program as a mechanism for generating additionalinvestment income on its fixed maturity and common equity portfolios. Under thesecurity lending arrangements, certain of its fixed maturity and common equityinvestments are loaned to other institutions for short periods of time througha lending agent. OB Holdings maintains control over the securities it lends,retains the earnings and cash flows associated with the loaned securities andreceives a fee from the borrower for the temporary use of the asset.Collateral, in the form of cash and United States government securities, isrequired at a rate of 102% of the fair value of the loaned securities, iscontrolled by the lending agent and may not be sold or re-pledged. The lendingagent manages the investment of the cash collateral. The fair value of thesecurities lending collateral is recorded as both an asset and liability on thebalance sheet, however, other than in the event of default by the borrower,this collateral is not available to OB Holdings and will be remitted to theborrower by the lending agent upon the return of the loaned securities. Becauseof these restrictions, OB Holdings considers its securities lending activitiesto be non-cash transactions. An indemnification agreement with the lendingagent protects OB Holdings in the event a borrower becomes insolvent or failsto return any of the securities on loan.

 

*Cash*

 

Cash includes amounts onhand and demand deposits with banks and other financial institutions. Amountspresented in the statements of cash flows are shown net of balances acquiredand sold in the purchase or sale of the Company’s consolidated subsidiaries.

 

*Insurance Operations*

 

OB Holdings accounts forinsurance policies that it writes in accordance with SFAS No. 60, “Accountingand Reporting by Insurance Enterprises” (“SFAS 60”). Premiums written arerecognized as revenues and are earned ratably over the term of the relatedpolicy. Unearned premiums represent the portion of premiums written that areapplicable to future insurance coverage provided by policies. AutoOne Insurance(“AutoOne”), which acts as a limited assignment distribution (“LAD”) servicingcarrier, enters into contractual arrangements with insurance companies toassume private passenger and commercial automobile assigned risk exposures in21 states and the District of Columbia. AutoOne receives LAD and commerciallimited assignment distribution (“CLAD”) servicing fees from these othercompanies for assuming these risks. LAD and CLAD servicing fees are typically apercentage of the total premiums that AutoOne must write to fulfill theobligation of the transferor company. In addition, LAD servicing carriers maychoose to write certain policies voluntarily by taking risks out of the NewYork Automobile Insurance Plan (“NYAIP”). These policies generate takeoutcredits which can be “sold” for fees (“takeout fees”) to other carriers. Theseother carriers in turn can use such credits to reduce their obligations towrite assigned risk business. AutoOne’s LAD and CLAD servicing and takeout feesare recorded as written premium when billed and are earned ratably over theterm of the related policy to which the fee relates. Fees charged oninstallment premiums are recorded as a reduction to other underwritingexpenses.

 

Deferred acquisition costs representcommissions, premium taxes, brokerage expenses and other costs which aredirectly attributable to and vary with the production of business. These costsare deferred and amortized over the applicable premium recognition period aspolicy acquisition expenses. Deferred acquisition costs are limited to theamount expected to be recovered from future earned premiums and anticipatedinvestment income. This limitation is referred to as a premium deficiency. Apremium deficiency is recognized if the sum of expected loss and lossadjustment expenses (“LAE”), unamortized acquisition costs, and maintenancecosts exceeds related unearned premiums. A premium deficiency is recognized bycharging any unamortized acquisition costs to expense to the extent required inorder to eliminate the deficiency. If the premium deficiency exceedsunamortized acquisition costs then a liability is accrued for the excessdeficiency. For the years ended December 31, 2008, 2007 and 2006, nodeferred acquisition costs were charged to expense based on the determinationof a premium deficiency.

 

Loss and LAE are chargedagainst income as incurred. Unpaid insurance loss and LAE are based onestimates (generally determined by claims adjusters, legal counsel andactuarial staff) of the ultimate costs of settling claims, including theeffects of inflation and other societal and economic factors. Unpaidreinsurance loss and LAE are based primarily on reports received from cedingcompanies and actuarial projections. Unpaid loss and LAE reserves representmanagement’s best estimate of ultimate loss and LAE, net of estimated salvageand subrogation recoveries, if applicable. Such estimates are regularlyreviewed and updated and any adjustments resulting therefrom are reflected incurrent operations. The process of estimating loss and LAE involves aconsiderable degree of judgment by management and the ultimate amount ofexpense to be incurred could be considerably greater than or less than theamounts currently reflected in the financial statements.

 

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OB Holdings discountscertain of its long-term workers compensation loss and LAE reserves when suchliabilities constitute unpaid but settled claims under which the paymentpattern and ultimate costs are fixed and determinable on an individual claimbasis. OB Holdings discounts these reserves using an average discount ratewhich is determined based on various assumptions including consideration ofwhen the claims will be settled (5.5% at December 31, 2008 and 2007). Asof December 31, 2008 and 2007, the discount on OB Holdings’ workerscompensation loss and LAE reserves amounted to $142.1 million and$156.9 million, respectively.

 

In connection with purchaseaccounting for the OneBeacon Acquisition, OB Holdings was required to adjust tofair value its loss and LAE reserves and the related reinsurance recoverablesby $646.9 million and $346.9 million, respectively, on the acquiredbalance sheet as of June 1, 2001. This net reduction to loss and LAEreserves of $300.0 million is being accreted through an income statementcharge ratably with and over the period the claims are settled. SeeNote 4.

 

OB Holdings’ insurancesubsidiaries enter into ceded reinsurance contracts from time to time toprotect their businesses from losses due to concentration of risk, to managetheir operating leverage ratios and to limit losses arising from catastrophicevents. The majority of such reinsurance contracts are executed through excessof loss treaties and catastrophe contracts under which the reinsurerindemnifies for a specified part or all of certain types of losses overstipulated amounts arising from any one occurrence or event. OB Holdings hasalso entered into quota share treaties with reinsurers under which all risksmeeting prescribed criteria are covered on a pro rata basis. The amount of eachrisk ceded by OB Holdings is subject to maximum limits which vary by line of businessand type of coverage. Amounts related to reinsurance contracts are recorded inaccordance with SFAS No. 113, “Accounting and Reporting for Reinsurance ofShort-Duration and Long-Duration Contracts” (“SFAS 113”) and EmergingIssues Task Force (“EITF”) Topic No. D-54 (“EITF Topic D-54”) asapplicable.

 

Amounts recoverable fromreinsurers are estimated in a manner consistent with the claim liabilityassociated with the reinsured policies. The collectibility of reinsurancerecoverables is subject to the solvency of the reinsurers. OB Holdings isselective in regard to its reinsurers, principally placing reinsurance withthose reinsurers with strong financial condition, industry ratings andunderwriting ability. Management monitors the financial condition and ratingsof its reinsurers on an ongoing basis.

 

Reinsurance premiums,commissions, expense reimbursements and reserves related to reinsured businessare accounted for on a basis consistent with those used in accounting for theoriginal policies issued and the terms of the reinsurance contracts. Premiumsceded to other companies are reported as a reduction of premiums written.Expense allowances received in connection with reinsurance ceded have beenaccounted for as a reduction of the related policy acquisition costs and aredeferred and amortized accordingly. Funds held by ceding companies representamounts due to OB Holdings in connection with certain assumed reinsuranceagreements in which the ceding company retains a portion of the premium toprovide security against future loss payments. The funds held by the cedingcompanies are generally invested by the ceding company and a contractuallyagreed interest amount is credited to OB Holdings and recognized as investmentincome. Funds held under reinsurance treaties represent contractual paymentsdue to the reinsurer that OB Holdings has retained to secure obligations of thereinsurer. Such amounts are recorded as liabilities in the consolidatedfinancial statements.

 

*Accounting for Mandatory Shared Market Mechanisms*

 

As a condition to itslicenses to do business in certain states, OB Holdings’ insurance operationsmust participate in various mandatory shared market mechanisms commonlyreferred to as “residual” or “involuntary” markets. These markets generallyconsist of risks considered to be undesirable from a standard or routineunderwriting perspective. Each state dictates the levels of insurance coveragethat are mandatorily assigned to participating insurers within these markets.The total amount of such business an insurer must accept in a particular stateis generally based on that insurer’s market share of voluntary business writtenwithin that state. In certain cases, OB Holdings is obligated to write businessfrom shared market mechanisms at a future date based on its historical marketshare of all voluntary policies written within that state. Involuntary businessgenerated from mandatory shared market mechanisms is accounted for inaccordance with SFAS 60 or as assumed reinsurance under SFAS 113, dependingupon the structure of the mechanism.

 

OB Holdings’ marketassignments are typically required to be written in the current period,although, in certain cases OB Holdings is required to accept policy assignmentsat a future date. OB Holdings’ residual market assignments to be written in thefuture primarily relate to private passenger automobile assigned risk exposureswithin the State of New York where several of OB Holdings’ insurancesubsidiaries write voluntary automobile insurance. The share of involuntarywritten premium for policies assigned by the NYAIP to a particular insurer in agiven year is based on the proportion of the total voluntary writings in NewYork two years prior. Anticipated losses associated with future marketassignments are recognized 

 

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in accordance with SFAS No. 5, “Accountingfor Contingencies” (“SFAS 5”), when the amount of such anticipated losses isdetermined to be probable and can be reasonably estimated.

 

*Accounting for Insurance Related Assessments*

 

Under existing guaranty fundlaws in all states, insurers licensed to do business in those states can beassessed for certain obligations of insolvent insurance companies topolicyholders and claimants. In accordance with Statement of Position (“SOP”)97-3, “Accounting by Insurance and Other Enterprises for Insurance RelatedAssessments” (“SOP 97-3”), OB Holdings’ insurance subsidiaries recordguaranty fund assessments when such assessments are billed by the respectiveguaranty funds. In addition, each insurance subsidiary’s policy is to accruefor any significant insolvencies when the loss is probable and the assessmentamount can be reasonably estimated.

 

*Deferred Software Costs*

 

OB Holdings capitalizescosts related to computer software developed for internal use during theapplication development stage of software development projects in accordancewith SOP 98-1, “Accounting for the Costs of Computer Software Developed orObtained for Internal Use.” These costs generally consist of certain external,payroll and payroll related costs. OB Holdings begins amortization of thesecosts once the project is completed and ready for its intended use.Amortization is on a straight line basis and over a useful life of three tofive years. At December 31, 2008 and 2007, OB Holdings had deferredsoftware costs of $22.1 million and $27.8 million, respectively.

 

*Federal and State Income Taxes*

 

The Company and itssubsidiaries join in the filing of a federal consolidated tax return. Theconsolidated parent, which is not included in these financial statements, isOneBeacon U.S. Financial Services, Inc. (“OBFS”), formerly known as FundAmerican Financial Services, Inc. OBFS is an indirect, wholly-ownedsubsidiary of OBIG.

 

Deferred tax assets andliabilities are recorded when a difference between the carrying amounts ofassets and liabilities for financial reporting purposes and the amounts for taxpurposes exists, and for other temporary differences as defined by SFAS No. 109,“Accounting for Income Taxes” (“SFAS 109”). The deferred tax asset orliability is recorded based on tax rates expected to be in effect when thedifference reverses. The deferred tax asset is recognized when it is morelikely than not that it will be realized.

 

*Foreign Currency Exchange*

 

The U.S. dollar is thefunctional currency for all of OB Holdings’ businesses. OB Holdings is subjectto foreign currency fluctuations primarily associated with its foreigninvestment securities. Assets recorded in foreign currencies are translatedinto U.S. dollars at exchange rates in effect at the balance sheet date. Priorto the adoption of SFAS 159, net foreign exchange gains and losses arising fromthe translation were generally reported in common shareholder’s equity, inaccumulated other comprehensive income or loss, net of tax. As of December 31,2007, OB Holdings had after tax net unrealized foreign currency translationgains on its foreign investment securities of $12.7 million. Upon adoptionof SFAS 159, net foreign exchange gains and losses arising from the translationare generally reported in revenues in change in net unrealized investment gainsand losses.

 

*Cash Flow Hedge*

 

Contemporaneously withentering into a variable rate mortgage note during 2005, as further describedin Note 7, OB Holdings entered into an interest rate swap agreement underwhich it pays a fixed rate and receives a variable rate to hedge its exposureto interest rate fluctuations. The notional amount of the swap is equal to theoutstanding principal of the mortgage note it hedges and is adjusted at thesame time as the mortgage note principal changes for drawdowns and repayments.The underlying index used to determine the variable interest paid under theswap is the same as that used for OB Holdings’ variable rate mortgage note. Inaccordance with SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities”, OB Holdings has accounted for the swap as a cash flowhedge and has recorded the interest rate swap at fair value on the balancesheet in other assets or other liabilities depending on the value as of thebalance sheet date. Changes in the fair value of the interest rate swap, aftertax, are reported as a component of other comprehensive income. OB Holdingsmonitors continued effectiveness of the hedge by monitoring the changes in theterms of the instruments as described above as compared to the actual changesin principal and notional amount in the mortgage note and interest rate swap,respectively.

 

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*Variable Interest Entities*

 

OB Holdings records the reciprocals,as defined in Note 16, in accordance with FASB Interpretation (“FIN”) No. 46(R),“Consolidation of Variable Interest Entities” (“FIN 46R”). FIN 46Raddresses consolidation issues surrounding special purpose entities and certainother entities, collectively termed variable interest entities (“VIE”), towhich previous accounting guidance on consolidation does not apply. A VIE is anentity in which the equity investors do not have the characteristics of acontrolling interest or do not have sufficient equity at risk for the entity tofinance its activities without additional subordinated financial support fromother parties. Under FIN 46R, the primary beneficiary of a VIE is requiredto consolidate the VIE in its financial statements. The primary beneficiary isan entity that has a variable interest that will absorb the majority of the VIE’sexpected losses if they occur, receive a majority of the entity’s expectedresidual returns if they occur, or both. See Note 16.

 

*Mandatorily Redeemable Preferred Stock*

 

OB Holdings had mandatorilyredeemable preferred stock which was considered a noncontrolling interest andhad been recorded as a liability at its historical carrying value in accordancewith SFAS No. 150, “Accounting for Certain Financial Instruments WithCharacteristics of Both Liability and Equity.” Dividends and accretion on OBHoldings’ mandatorily redeemable preferred stock were recorded as interestexpense. See Note 11.

 

*Defined Benefit Plans*

 

In September 2006, theFASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans, an amendment to Statements No. 87,88, 106 and 132R” (“SFAS 158”). The Statement requires an employer thatsponsors a defined benefit plan to recognize the funded status of a benefitplan, measured as the difference between plan assets at fair value and theprojected benefit obligation (for defined benefit pension plans) or theaccumulated benefit obligation (for other postretirement benefit plans) in itsstatement of financial position. The Statement also requires recognition ofamounts previously deferred and amortized under SFAS No. 87, “Employers’Accounting for Pensions” and SFAS No. 106, “Employers’ Accounting forPostretirement Benefits Other Than Pensions” in other comprehensive income inthe period in which they occur. Under SFAS 158, plan assets andobligations must be measured as of the fiscal year end. OB Holdings adoptedSFAS 158 effective December 31, 2006. See Note 9.

 

***Recently Adopted Changes inAccounting Principles***

 

*FairValue Measurements*

 

On January 1, 2008,OB Holdings adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).SFAS 157 provides a revised definition of fair value, establishes a frameworkfor measuring fair value and expands financial statement disclosurerequirements for fair value information. Under SFAS 157, fair value is definedas the price that would be received to sell an asset or paid to transfer aliability in an orderly transaction between market participants (an “exit price”).The Statement establishes a fair value hierarchy that distinguishes betweeninputs based on market data from independent sources (“observable inputs”) anda reporting entity’s internal assumptions based upon the best informationavailable when external market data is limited or unavailable (“unobservableinputs”). The fair value hierarchy in SFAS 157 prioritizes fair valuemeasurements into three levels based on the nature of the inputs. Quoted pricesin active markets for identical assets or liabilities have the highest priority(“Level 1”), followed by observable inputs other than quoted prices,including prices for similar but not identical assets or liabilities (“Level 2”)and unobservable inputs, including the reporting entity’s estimates of theassumptions that market participants would use, having the lowest priority (“Level 3”).See Note 6 for further financial statement disclosure required pursuant to SFAS157.

 

OB Holdings uses brokersand outside pricing services to assist in determining fair values. Forinvestments in active markets, OB Holdings uses the quoted market pricesprovided by the outside pricing services to determine fair value. The outsidepricing services used by OB Holdings have indicated that they will only provideprices where observable inputs are available. In circumstances where quotedmarket prices are unavailable, OB Holdings utilizes fair value estimates basedupon other observable inputs including matrix pricing, benchmark interestrates, market comparables and other relevant inputs.

 

OBHoldings’ process to validate the market prices obtained from the outsidepricing sources include, but are not limited to, periodic evaluation of modelpricing methodologies and analytical reviews of certain prices. OB Holdingsalso periodically performs back-testing of selected sales activity to determinewhether there are any significant differences between the market price used tovalue the security prior to sale and the actual sale price.

 

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For investments inlimited partnerships, hedge funds and private equity interests, net asset valueis deemed to approximate fair value. In circumstances where the secondarymarket for such investments is not active, OB Holdings’ policy is to adjust netasset value to reflect the effect of illiquidity. Where appropriate, the fairvalue of assets and liabilities measured at fair value would be adjusted forthe effect of counterparty credit risk.

 

*FairValue Option*

 

OnJanuary 1, 2008, OB Holdings adopted SFAS 159 which allows companies tomake an election, on an individual instrument basis, to report financial assetsand liabilities at fair value. The election must be made at the inception of atransaction and may not be reversed. The election may also be made for existingfinancial assets and liabilities at the time of adoption. Unrealized gains andlosses on assets or liabilities for which the fair value option has beenelected are reported in revenues.

 

OBHoldings has made the fair value election for its portfolio ofavailable-for-sale securities and its investments in limited partnerships,hedge funds and private equity interests. See Note 6 for further discussion. Upon adoption, OB Holdings recordedan adjustment of $182.4 million to reclassify net unrealized gains, after tax,and net unrealized foreign currency translation gains, after tax, related toinvestments from accumulated other comprehensive income to opening retainedearnings.  Subsequent to adoption, OBHoldings’ portfolio of available-for-sale securities was reclassified astrading and changes in fair value are reported in revenues before the effect oftax. See Note 6 for further discussion. The Company believes that making theelection results in reporting its investment results on a basis consistent withone of its operating principles, namely to manage investments for total return.

 

***Recent Accounting Pronouncements***

 

*BusinessCombinations and Non-controlling Interests*

 

In December 2007,the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141R”)and SFAS No. 160, “Noncontrolling Interests—an amendment to ARB 51” (“SFAS 160”).SFAS 141R requires the acquiring company to recognize all assets acquiredand liabilities assumed at their fair values at the acquisition date, withcertain exceptions including income taxes which will continue to be accountedfor under SFAS 109. This represents a basic change in approach from the oldcost allocation method originally described in SFAS 141. In addition,SFAS 141R changes the accounting for step acquisitions since it requiresrecognition of all assets acquired and liabilities assumed, regardless of theacquirer’s percentage of ownership in the acquiree. This means that theacquirer will measure and recognize all of the assets, liabilities andgoodwill, not just the acquirer’s share. Assets and liabilities arising fromcontractual contingencies are to be recognized at the acquisition date, at fairvalue. Non-contractual contingencies are to be recognized when it is morelikely than not that they meet the Statement of Financial Accounting Concepts No. 6,“Elements of Financial Statements (A Replacement of FASB Concepts Statement No. 3—Incorporatingan Amendment of FASB Concepts Statement No. 2)” criteria for an asset orliability. Previously under SFAS 141, recognition of preacquisitioncontingencies was deferred until the criteria in SFAS 5 had been met. Changesin the amount of deferred taxes arising from a business combination are to berecognized in either income or through a change in contributed capital,depending on the circumstances. Previously under SFAS 109, such changeswere recognized through goodwill. Acquisition related costs, such as legal feesand due diligence costs would be expensed and would not be recognized as partof goodwill. The classification of insurance and reinsurance contracts isre-evaluated at the acquisition date only if their terms were changed inconnection with the acquisition.

 

SFAS 160 requiresall companies to account for minority interests in subsidiaries as equity,clearly identified and presented separately from parent company equity. Once acontrolling interest has been acquired, any subsequent acquisitions or dispositionsof noncontrolling interest that do not result in a change of control are to beaccounted for as equity transactions. Assets and liabilities acquired aremeasured at fair value only once; at the original acquisition date,i.e., the date at which the acquirer gained control. When a subsidiary isdeconsolidated, any retained noncontrolling equity investment is to be measuredat fair value with the gain or loss on the deconsolidation being measured usingfair value rather than the carrying amount of the retained ownership interest.

 

SFAS 141R andSFAS 160 are effective for fiscal years beginning after December 15,2008 and shall be applied prospectively. OB Holdings has adopted SFAS 141R andSFAS 160 effective January 1, 2009. SFAS 141R did not impact OB Holdings’previous transactions involving purchase accounting. SFAS 160 did not impactthe OB Holdings’ consolidated financial statements.

 

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*Derivativesand Hedging Activities*

 

In March 2008, theFASB issued SFAS No. 161, “Disclosures about Derivative Instruments andHedging Activities — an Amendment of FASB Statement No. 133” (“SFAS 161”).SFAS 161 requires disclosure of the following: objectives for using derivative instruments in terms of underlying riskand accounting designation, the fair values of derivative instruments and theirgains and losses in a tabular format, and information about credit-risk-relatedcontingent features. SFAS 161 is effective for fiscal years and interim periodsbeginning after November 15, 2008. OB Holdings has adopted SFAS 161effective January 1, 2009.

 

*Participating Securities Granted in Share-Based PaymentTransactions*

 

In June 2008, the FASBissued FASB Staff Position (“FSP”) EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Transactions areParticipating Securities.” The FSP addresses whether instruments grantedin share-based payment transactions should be considered participatingsecurities prior to vesting. The FSP requires that such instruments that holdunforfeitable rights to dividends or dividend equivalents, regardless ofwhether paid or unpaid, should be considered participating securities and accordinglyshould be included in the calculation of earnings per share under the two-classmethod instead of the treasury stock method. Unvested restricted stock issuedunder employee incentive compensation plans containing such dividendparticipation features would be considered participating securities. This FSPis effective for financial statements issued for fiscal years beginning after December 15,2008 and interim periods within those years. Upon adoption, all prior periodearnings per share data must be adjusted retrospectively to conform to theprovisions of the FSP. Early application is not permitted. OB Holdings iscurrently evaluating the potential impact of adopting this FSP.

 

*Disclosures about Postretirement Benefit Plan Assets*

 

In December 2008, theFASB issued FSP SFAS 132(R)-1, “Employers’ Disclosures about PostretirementBenefit Plan Assets.” The FSPrequires additional disclosures regarding plan assets of a defined benefitpension or other postretirement plan. The disclosures are to provide users offinancial statements with an understanding of how investment allocationdecisions are made, the major categories of plan assets, the inputs andvaluation techniques used to measure the fair value of plan assets, the effectof fair value measurements using significant unobservable inputs on changes inplan assets for the period and significant concentrations of risk within planassets. This FSP is effective for fiscal years ending after December 15,2009 with earlier adoption permitted. OB Holdings is currently evaluating thepotential impact of adopting this FSP.

 

**NOTE 2. Discontinued Operations**

 

In 2006, OB Holdings soldcertain consolidated subsidiaries at GAAP book value to White Mountains. OBHoldings did not recognize a gain or a loss on these sales. These subsidiaries whichwere sold on August 3, 2006 are included in discontinued operations andcomprise the following entities:

 

·***                 ***White MountainsAdvisors, LLC (“WM Advisors”)—an investment management subsidiary;

 

·                  White MountainsManagement Company, Inc. and White Mountains Capital, Inc.—bothservice companies;

 

·                  White MountainsServices Holdings and White Mountains Services, LLC—these companiescontain the remainder of mortgage banking run-off assets from the sale ofsubstantially all the mortgage banking assets of White Mountains ServicesCorporation (formerly Source One Mortgage Services Corporation) to CitibankMortgage, Inc. in 1999;

 

·                  TuckermanCapital, L.P. and Tuckerman Capital II, L.P.—both private equity fundinvestments;

 

·                  InternationalAmerican Group—primarily consisted of American Centennial Insurance Company andBritish Insurance Company of Cayman, two run-off insurance companies.

 

OB Holdings’ net income fromcontinuing operations for the year ended December 31, 2006 excludes the resultsof operations for the above entities. Net income from discontinued operationshas been presented separately and is shown net of related income taxes.

 

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**NOTE 3. Acquisitions and Dispositions**

 

During the fourth quarter of2008, OB Holdings sold one of its inactive licensed subsidiaries, Farmers andMerchants Insurance Company, to Pride Holdings LLC for $7.8 million in cash andrecorded a pre-tax gain of $1.1 million through net other revenues.

 

During the third quarterof 2008, OB Holdings acquired Entertainment Brokers International InsuranceServices (“EBI”), an insurance agency specializing in the entertainment, sportsand leisure industries, for $8.0 million. In connection with the purchase ofEBI, which was accounted for as an acquisition under the purchase method ofaccounting in accordance with SFAS No. 141, “Business Combinations,” OBHoldings recorded the identifiable assets and liabilities of EBI at their fairvalue at acquisition date.  Significantassets and liabilities acquired include premiums and commissions receivable of$16.6 million and premiums and commissions payable of $16.1 million. After allocatingthe purchase price to identifiable tangible assets and liabilities, OB Holdingsalso recorded an intangible asset of $9.5 million which represents the value ofbusiness in force at the acquisition date. The amortization associated with the intangible asset will be amortizedover a 10-year period in proportion to the timing of the discounted cash flowsused to value the business.

 

During the first quarterof 2008, OB Holdings sold one of its inactive licensed subsidiaries, MidwesternInsurance Company, to National Guaranty Insurance Company for $4.2 million incash and recorded a pre-tax gain of $1.0 million through net other revenues.

 

During the third quarterof 2007, OB Holdings sold one of its inactive licensed subsidiaries, AmericanEmployers’ Insurance Company to Sparta Insurance Holdings, Inc. for$47.7 million in cash, gross of sales costs, and recorded a pre-tax gainof $11.3 million through net other revenues.

 

On October 31, 2006, OBHoldings restructured its investment in Main Street America Holdings, Inc.(“MSA”). OB Holdings received a $70 million cash dividend from MSAfollowing which OB Holdings sold its 50% common stock investment in MSA to MainStreet America Group, Inc. (“the MSA Group”) for (i) $70.0 millionin 9.0% non-voting cumulative perpetual preferred stock of the MSA Group and (ii) 4.9%of the common stock of the MSA Group. Effective October 31, 2006 and priorto the adoption of SFAS 159, OB Holdings accounted for its remaining investmentin the MSA Group in accordance with SFAS No. 115, “Accounting for CertainInvestments in Debt and Equity Securities.” See Note 1 for a discussion ofOB Holdings’ accounting for investment securities. Prior to the sale, OBHoldings owned 50% of the total common shares outstanding of MSA and accountedfor this investment using the equity method of accounting. These transactionsresulted in a net after tax realized gain of $8.5 million. SeeNote 15.

 

On September 29, 2006,OB Holdings sold certain assets and the right to renew existing policies ofAgri, a division of OB Holdings that provided commercial farm and ranch andcommercial agricultural insurance products, for $32.0 million in cash toQBE Insurance Group, Ltd. (“QBE”) and recorded a pre-tax gain of$30.4 million through net other revenues. In connection with this sale, OBHoldings entered into agreements under which, at the option of QBE, it willwrite the policies of Agri on a direct basis and cede 100% of this business toQBE.

 

During the third quarter of2006, OB Holdings sold one of its inactive licensed subsidiaries, HomelandCentral Insurance Company (“HCIC”) to a subsidiary of White Mountains. Inconnection with the sale of HCIC, OB Holdings recorded a $6.0 million gainassociated with the sale as additional paid in capital.

 

**NOTE 4. Reserves for Unpaid Loss and LAE**

 

OB Holdings’ insurancesubsidiaries establish loss and LAE reserves that are estimates of amountsneeded to pay claims and related expenses in the future for insured events thathave already occurred. The process of estimating reserves involves aconsiderable degree of judgment by management and, as of any given date, isinherently uncertain.

 

Reserves are typicallycomprised of (1) case reserves for claims reported and (2) reservesfor losses that have occurred but for which claims have not yet been reported,referred to as incurred but not reported (“IBNR”) reserves, which include aprovision for expected future development on case reserves. Case reserves areestimated based on the experience and knowledge of claims staff regarding thenature and potential cost of each claim and are adjusted as additionalinformation becomes known or payments are made. IBNR reserves are derived bysubtracting paid loss and LAE and case reserves from estimates of ultimate lossand LAE. Actuaries estimate ultimate loss and LAE using various generallyaccepted actuarial methods applied to known losses and other relevantinformation. Like case reserves, IBNR reserves are adjusted as additional informationbecomes known or payments are made.

 

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Ultimateloss and LAE are generally determined by extrapolation of claim emergence andsettlement patterns observed in the past that can reasonably be expected topersist into the future. In forecasting ultimate loss and LAE with respect toany line of business, past experience with respect to that line of business isthe primary resource, but cannot be relied upon in isolation. OB Holdings’ ownexperience, particularly claims development experience, such as trends in casereserves, payments on and closings of claims, as well as changes in businessmix and coverage limits, is the most important information for estimating itsreserves. External data, available from organizations such as statisticalbureaus, consulting firms and reinsurance companies, is sometimes used tosupplement or corroborate OB Holdings’ own experience, and can be especiallyuseful for estimating costs of new business. For some lines of business, suchas “long-tail” coverages discussed below, claims data reported in the mostrecent accident year is often too limited to provide a meaningful basis foranalysis due to the typical delay in reporting of claims. For this type ofbusiness, OB Holdings uses a selected loss ratio method for the initialaccident year or years. This is a standard and accepted actuarial reserveestimation method in these circumstances in which the loss ratio is selectedbased upon information used in pricing policies for that line of business, aswell as any publicly available industry data, such as industry pricing,experience and trends, for that line of business.

 

Uncertainties in estimatingultimate loss and LAE are magnified by the time lag between when a claimactually occurs and when it is reported and settled. This time lag is sometimesreferred to as the “claim-tail”. The claim-tail for most property coverages istypically short (usually a few days up to a few months). The claim-tail forliability/casualty coverages, such as automobile liability, general liability,products liability, multiple peril coverage, and workers compensation, can beespecially long as claims are often reported and ultimately paid or settledyears, even decades, after the related loss events occur. During the longclaims reporting and settlement period, additional facts regarding coverageswritten in prior accident years, as well as about actual claims and trends maybecome known and, as a result, OB Holdings may adjust its reserves. If managementdetermines that an adjustment is appropriate, the adjustment is booked in theaccounting period in which such determination is made in accordance with GAAP.Accordingly, should reserves need to be increased or decreased in the futurefrom amounts currently established, future results of operations would benegatively or positively impacted, respectively.

 

In determining ultimate lossand LAE, the cost to indemnify claimants, provide needed legal defense andother services for insureds and administer the investigation and adjustment ofclaims are considered. These claim costs are influenced by many factors thatchange over time, such as expanded coverage definitions as a result of newcourt decisions, inflation in costs to repair or replace damaged property,inflation in the cost of medical services and legislated changes in statutorybenefits, as well as by the particular, unique facts that pertain to eachclaim. As a result, the rate at which claims arose in the past and the costs tosettle them may not always be representative of what will occur in the future.The factors influencing changes in claim costs are often difficult to isolateor quantify and developments in paid and incurred losses from historical trendsare frequently subject to multiple and conflicting interpretations. Changes incoverage terms or claims handling practices may also cause future experienceand/or development patterns to vary from the past. A key objective of actuariesin developing estimates of ultimate loss and LAE, and resulting IBNR reserves,is to identify aberrations and systemic changes occurring within historicalexperience and accurately adjust for them so that the future can be projectedreliably. Because of the factors previously discussed, this process requiresthe use of informed judgment and is inherently uncertain.

 

OB Holdings’ actuaries use several generally acceptedactuarial methods to evaluate its loss reserves, each of which has its ownstrengths and weaknesses. OB Holdings places more or less reliance on a particularmethod based on the facts and circumstances at the time the reserve estimatesare made. These methods generally fall into one of the following categories orare hybrids of one or more of the following categories:

 

·                  *Historical paid lossdevelopment methods:*    These methods use historical loss payments overdiscrete periods of time to estimate future losses. Historical paid lossdevelopment methods assume that the ratio of losses paid in one period tolosses paid in an earlier period will remain constant. These methodsnecessarily assume that factors that have affected paid losses in the past,such as inflation or the effects of litigation, will remain constant in thefuture. Because historical paid loss development methods do not use casereserves to estimate ultimate losses, they can be more reliable than the othermethods discussed below that look to case reserves (such as actuarial methodsthat use incurred losses) in situations where there are significant changes inhow case reserves are established by a company’s claims adjusters. However,historical paid loss development methods are more leveraged, meaning that smallchanges in payments have a larger impact on estimates of ultimate losses, thanactuarial methods that use incurred losses because cumulative loss paymentstake much longer to equal the expected ultimate losses than cumulative incurredamounts. In addition, and for similar reasons, historical paid loss developmentmethods are often slow to react to situations when new or different factorsarise than those that have affected paid losses in the past.

 

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·                  *Historical incurred lossdevelopment methods:*    These methods, like historical paid loss developmentmethods, assume that the ratio of losses in one period to losses in an earlierperiod will remain constant in the future. However, instead of using paidlosses, these methods use incurred losses (i.e., the sum of cumulativehistorical loss payments plus outstanding case reserves) over discrete periodsof time to estimate future losses. Historical incurred loss development methodscan be preferable to historical paid loss development methods because theyexplicitly take into account open cases and the claims adjusters’ evaluationsof the cost to settle all known claims. However, historical incurred lossdevelopment methods necessarily assume that case reserving practices areconsistently applied over time. Therefore, when there have been significantchanges in how case reserves are established, using incurred loss data toproject ultimate losses can be less reliable than other methods.

 

·                  *Expected loss ratio methods:*     These methodsare based on the assumption that ultimate losses vary proportionately withpremiums. Expected loss ratios are typically developed based upon theinformation used in pricing, and are multiplied by the total amount of premiumswritten to calculate ultimate losses. Expected loss ratio methods are usefulfor estimating ultimate losses in the early years of long-tailed lines ofbusiness, when little or no paid or incurred loss information is available.

 

 

·                  *Adjusted historical paid andincurred loss development methods:     *These methods take traditional historicalpaid and incurred loss development methods and adjust them for the estimatedimpact of changes from the past in factors such as inflation, the speed ofclaim payments or the adequacy of case reserves. Adjusted historical paid andincurred loss development methods are often more reliable methods of predictingultimate losses in periods of significant change, provided the actuaries candevelop methods to reasonably quantify the impact of changes.

 

OB Holdingsperforms an actuarial review of its recorded reserves each quarter. OB Holdings’actuaries compare the previous quarter’s estimates of paid loss and LAE, casereserves and IBNR to amounts indicated by actual experience. Differencesbetween previous estimates and actual experience are evaluated to determinewhether a given actuarial method for estimating loss and LAE should be reliedupon to a greater or lesser extent than it had been in the past. While somevariance is expected each quarter due to the inherent uncertainty in loss andLAE, persistent or large variances would indicate that prior assumptions and/orreliance on certain reserving methods may need to be revised going forward.

 

***Loss and LAE reserve summary***

 

The following tablesummarizes the loss and LAE reserve activities of OB Holdings’ insurancesubsidiaries for the years ended December 31, 2008, 2007 and 2006:

 
| ** **                                                      | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                      | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                      | ** ** | **($ in millions)**         | ** ** |
| Gross beginning balance                                         |       | $                                | 4,480.3    |   | $ | 4,837.7 |   | $ | 5,354.3 |   |
| Less beginning reinsurance recoverable on unpaid losses         |       | (2,629.5                         | )          | (2,842.6 | ) | (3,120.9 | ) |
| Net loss and LAE reserves                                       |       | 1,850.8                          |       | 1,995.1 |   | 2,233.4 |   |
| Loss and LAE incurred relating to:                              |       |                             |       |   |   |   |   |
| Current year losses                                             |       | 1,188.2                          |       | 1,138.1 |   | 1,272.3 |   |
| Prior year losses                                               |       | (62.0                            | )          | (48.3 | ) | 11.3 |   |
| Total incurred loss and LAE                                     |       | 1,126.2                          |       | 1,089.8 |   | 1,283.6 |   |
| Accretion of fair value adjustment to net loss and LAE reserves |       | 12.0                             |       | 16.0 |   | 23.0 |   |
| Loss and LAE paid relating to:                                  |       |                             |       |   |   |   |   |
| Current year losses                                             |       | (495.1                           | )          | (527.1 | ) | (589.5 | ) |
| Prior year losses                                               |       | (703.2                           | )          | (723.0 | ) | (955.4 | ) |
| Total loss and LAE payments                                     |       | (1,198.3                         | )          | (1,250.1 | ) | (1,544.9 | ) |
| Net ending balance                                              |       | 1,790.7                          |       | 1,850.8 |   | 1,995.1 |   |
| Plus ending reinsurance recoverable on unpaid losses            |       | 2,503.3                          |       | 2,629.5 |   | 2,842.6 |   |
| Gross ending balance                                            |       | $                                | 4,294.0    |   | $ | 4,480.3 |   | $ | 4,837.7 |   |

 

*Loss and LAE development—2008*

 

In 2008, OB Holdingsexperienced $62.0 million of favorable loss and LAE reserve development onprior accident year loss reserves. The favorable loss reserve development wasprimarily related to lower than expected severity on non-catastrophelosses.  The favorable non-catastropheloss reserve development was primarily related to professional liability in 

 

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specialty lines and package business incommercial lines partially offset by adverse loss reserve development atAutoOne and in run-off.

 

Specifically, at December 31,2007, management had revised its expectations downward with respect to futureloss emergence in the professional liability business, which is included in thegeneral liability line of business, which had initially been based on marketanalysis when this business was initiated in 2002 and 2003. However, during2008, losses continued to be significantly lower than these revisedexpectations. As a result, management lowered its selected reserves on theearliest years which affected more recent years as total loss expectations forthose years are based in part on prior years’ results. The impact of thisrevised estimate was a decrease to professional liability reserves of $50.5million.

 

At December 31, 2007, management hadestimated that future payments from personal injury protection (PIP) litigationfrom OB Holdings’ NYAIP business would be approximately $14.0 million.  During 2008, the legal expenses related tothis litigation were higher than expected as the 2002 accident year nearedconclusion.  As a result, managementincreased estimates of all accident years for NYAIP and other similar businessin New York.  The total increase inestimate was $10.8 million.

 

At December 31, 2007,based on actuarial techniques described above, management estimated that IBNR related to multiple peril liability was $137.0million, or approximately 64% of case reserves of $212.8 million for 2002 andsubsequent accident years. During 2008, case incurred loss and allocated LAE (“ALAE”)was $16.2 million, which was less than expected for this line of business. As aresult of the lower than expected case incurred loss and ALAE during 2008, theactuarial methods based on case incurred losses produced lower estimatedultimate losses for these accident years. As a result, at December 31,2008, the IBNR was determined to be $86.9 million, or approximately 64% of theremaining case reserves. The impact of this revised estimate was a decrease tomultiple peril liability reserves of $33.8 million.

 

At December 31, 2007,based on actuarial techniques described above, management estimated that IBNR related toworkers compensation was $41.1 million, or approximately 96% of case reservesof $43.0 million for 2005 and subsequent accident years. During 2008, case incurredloss and ALAE was $20.2 million, which was greater than expected for this lineof business. As a result of the higher than expected case incurred loss andALAE during 2008, the actuarial methods based on case incurred losses producedhigher estimated ultimate losses for these accident years. As a result, at December 31,2008, the IBNR was determined to be $34.8 million, or approximately 81% of theremaining case reserves. The impact of this revised estimate was an increase toworkers compensation reserves of $13.9 million.

 

                In addition to thedevelopment described for the lines of business above, management also recordeda $2.4 million net decrease in IBNR in other lines of business as a result ofits review of loss reserves at December 31, 2008. The change in IBNR foreach other line of business was not individually significant.

 

*Loss and LAE development—2007*

 

In 2007, OB Holdingsexperienced $48.3 million of favorable loss reserve development on prioraccident year loss reserves. The favorable loss reserve development wasprimarily related to lower than expected frequency for professional liabilityin specialty lines and lower than expected severity for automobile liability inpersonal lines, partially offset by adverse loss reserve development for multipleperil and workers compensation, primarily for accident years 2001 and prior.

 

Specifically, at December 31,2006, management continued to expect losses to emerge in the professionalliability business, which is included in the general liability line of business, in linewith initial expectations based on market analysis when this business wasinitiated in 2002 and 2003. During 2007, losses continued to be significantlylower than initial expectations. As a result, management lowered its selectedreserves on the earliest years which affected more recent years as total lossexpectations for those years are based in part on prior years’ results. Theimpact of this revised estimate was a decrease to professional liabilityreserves of $79.6 million.

 

At December 31, 2006, based on actuarialtechniques described above, management estimated that IBNR related to personal automobile liabilitywas $137.6 million, or approximately 49% of case reserves of $278.7 million for2002 and subsequent accident years. During 2007, case incurred loss and ALAEwas $38.4 million, which was less than expected for this relatively short-tailline of business.  At December 31,2007, based on actuarial techniques described above, management estimated thatIBNR was $66.1 million, or approximately 49% of the remaining case reserves. The actuarial methods that managementrelied upon to estimate IBNR at December 31, 2007 were similar to thoseused at December 31, 2006. The impact of this revisedestimate was a decrease to personal automobile liability reserves of $33.0million.

 

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At December 31, 2006,based on actuarial techniques described above, management estimated that IBNR related toworkers compensation and multiple peril liability was $95.6 million, orapproximately 15% of case reserves of $621.5 million for 2001 and prioraccident years. During 2007, case incurred loss and ALAE was $44.7 million,which was greater than expected for these long-tail lines of business. As aresult of the higher than expected case incurred loss and ALAE during 2007,management gave greater weight to actuarial techniques that are based onhistorical incurred loss development during its review of loss reserves at December 31,2007. As a result, at December 31, 2007, the IBNR was determined to be$149.4 million, or approximately 28% of the remaining case reserves. The impactof this revised estimate was an increase to workers compensation and multipleperil liability reserves of $98.5 million.

 

In addition to thedevelopment described for the lines of business above, management also recordeda $34.2 million net decrease in IBNR in other lines of business as a result ofits review of loss reserves at December 31, 2007. The change in IBNR foreach other line of business was not individually significant.

 

*Loss and LAE development—2006*

 

In 2006, OB Holdingsexperienced $11.3 million of adverse loss reserve development on prioraccident year loss reserves, primarily due to development on losses related tohurricane events impacting OB Holdings’ excess property policies.

 

Specifically at December 31,2005, management had reviewed all known losses related to hurricane eventsimpacting its excess property policies. Based on information at that time,management established reserves for those losses which were expected to reachthe coverage layers. During 2006, several individual claims experienced adverseloss reserve development resulting in more losses penetrating the coveragelayers. As a result, management increased held reserves as of December 31,2006 to reflect the actual adverse claim development as well as a provision forfuture adverse loss reserve development on these claims.

 

*Fair value adjustment*

 

In connection with purchaseaccounting for the OneBeacon Acquisition, OB Holdings was required to adjust tofair value OB Holdings’ loss and LAE reserves and the related reinsurancerecoverables by $646.9 million and $346.9 million, respectively, onOB Holdings’ acquired balance sheet as of June 1, 2001. This net reductionto loss and LAE reserves of $300.0 million is being accreted through anincome statement charge ratably with and over the period the claims aresettled. Accordingly, OB Holdings recognized $12.0 million, $16.0 millionand $23.0 million of such charges, recorded as accretion of fair valueadjustment to loss and LAE reserves in the years ended December 31, 2008,2007 and 2006, respectively. As of December 31, 2008, the outstandingpre-tax unaccreted adjustment was $5.4 million.

 

The fair values of OBHoldings’ loss and LAE reserves and related reinsurance recoverables acquiredon June 1, 2001 were based on the present value of their expected cashflows with consideration for the uncertainty inherent in both the timing of,and the ultimate amount of, future payments for losses and receipts of amountsrecoverable from reinsurers. In estimating fair value, management adjusted thenominal loss reserves of OB Holdings (net of the effects of reinsuranceobtained from the NICO Cover, as defined below, and the GRC Cover, as definedin Note 5) and discounted them to their present value using an applicablerisk-free discount rate. The series of future cash flows related to such losspayments and reinsurance recoveries were developed using OB Holdings’historical loss data. The resulting discount was reduced by the “price” forbearing the uncertainty inherent in OB Holdings’ net loss reserves in order toestimate fair value. This was approximately 11% of the present value of theexpected underlying cash flows of the loss reserves and reinsurancerecoverables of OB Holdings, which is believed to be reflective of the cost OBHoldings would incur if they had attempted to reinsure the full amount of itsnet loss and LAE reserves with a third party reinsurer.

 

***Asbestos and environmental loss andLAE reserve activity***

 

OB Holdings’ reservesinclude provisions made for claims that assert damages from asbestos andenvironmental (“A&E”) related exposures. Asbestos claims relate primarilyto injuries asserted by those who came in contact with asbestos or productscontaining asbestos. Environmental claims relate primarily to pollution andrelated clean-up costs obligations, particularly as mandated by federal andstate environmental protection agencies. In addition to the factors describedabove regarding the reserving process, OB Holdings estimates its A&Ereserves based upon, among other factors, facts surrounding reported cases andexposures to claims, such as policy limits and deductibles, current law, pastand projected claim activity and past settlement values for similar claims, aswell as analysis of industry studies and events, such as recent settlements andasbestos-related bankruptcies. The cost of administering A&E claims, whichis an important factor in estimating loss 

 

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reserves, tends to be higher than in the caseof non-A&E claims due to the higher legal costs typically associated withA&E claims.

 

In connection with theOneBeacon Acquisition, Aviva caused OneBeacon to purchase a reinsurancecontract with National Indemnity Company (“NICO”) under which OB Holdings isentitled to recover from NICO up to $2.5 billion in the future forasbestos claims arising from business written by OB Holdings in 1992 and prior,environmental claims arising from business written by OB Holdings in 1987 andprior, and certain other exposures (the “NICO Cover”). Under the terms of theNICO Cover, NICO receives the economic benefit of reinsurance recoverables fromcertain of OB Holdings’ third party reinsurers in existence at the time theNICO Cover was executed (“Third Party Recoverables”). As a result, the ThirdParty Recoverables serve to protect the $2.5 billion limit of NICOcoverage for the benefit of OB Holdings. Any amounts uncollectible from thirdparty reinsurers due to dispute or the reinsurers’ financial inability to payare covered by NICO under its agreement with OB Holdings. Third PartyRecoverables are typically for the amount of loss in excess of a stated leveleach year. Of claim payments in the past 11 years, approximately 48% of A&Elosses have been recovered under the historical third party reinsurance.

 

In September 2008, OB Holdings completed a studyof its A&E exposures. This study considered, among other items, (i) facts,such as policy limits, deductibles and available third party reinsurance,related to reported claims; (ii) current law; (iii) past andprojected claim activity and past settlement values for similar claims; (iv) industrystudies and events, such as recent settlements and asbestos-relatedbankruptcies; and (v) collectibility of third party reinsurance. Based onthe study, OB Holdings increased its best estimate of its incurred losses cededto NICO, net of underlying reinsurance, by $83 million to $2.2 billion, whichis within the $2.5 billion coverage provided by the NICO Cover. The increase inthe estimate of incurred A&E losses was principally driven by raisedprojections for claims related to asbestos. Due to the NICO Cover, there was noimpact to income or equity from the change in estimate.

 

As noted above, OB Holdingsestimates that on an incurred basis it has used approximately $2.2 billionof the coverage provided by NICO at December 31, 2008. Since entering intothe NICO Cover, $44.7 million of the $2.2 billion of utilizedcoverage relates to uncollected amounts from third party reinsurers through December 31,2008. Net losses paid totaled approximately $1.1 billion as of December 31,2008, with $108.5 million paid in 2008. Asbestos payments during 2008reflect payments resulting from intensified efforts by claimants to resolveasbestos claims prior to enactment of potential U.S. federal asbestoslegislation. To the extent that actual experience differs from OB Holdings’estimate of ultimate A&E losses and Third Party Recoverables, future lossescould exceed the $320.2 million of protection remaining under the NICO Cover atDecember 31, 2008.

 

OB Holdings’ reserves forA&E losses at December 31, 2008 represent management’s best estimateof its ultimate liability based on information currently available. However, significantuncertainties, including but not limited to case law developments, medical andclean up cost increases and industry settlement practices, limit OB Holdings’ability to accurately estimate ultimate liability and OB Holdings may besubject to A&E losses beyond currently estimated amounts. In addition, OBHoldings remains liable for risks reinsured in the event that a reinsurer doesnot honor its obligations under reinsurance contracts. OB Holdings cannotreasonably estimate at the present time loss reserve additions arising from anysuch future adverse loss reserve developments and cannot be sure that allocatedloss reserves, plus the remaining capacity under the NICO Cover and otherreinsurance contracts, will be sufficient to cover additional liability arisingfrom any such adverse loss reserve developments.

 

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The following tablessummarize reported A&E loss and LAE reserve activities (gross and net ofreinsurance) for OB Holdings for the years ended December 31, 2008, 2007and 2006, respectively.

 
| ** **                            | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | **Gross**                        | ** ** | **Pre-NICO  Net(1)** | ** ** | **Net** | ** ** | **Gross** | ** ** | **Pre-NICO  Net(1)** | ** ** | **Net** | ** ** | **Gross** | ** ** | **Pre-NICO  Net(1)** | ** ** | **Net** | ** ** |
| ** **                            | ** ** | **($ in millions)**         | ** ** |
| **Asbestos:**                         |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Beginning balance                     |       | $                                | 1,155.9    |   | $ | 699.7 |   | $ | 7.2 |   | $ | 1,227.6 |   | $ | 766.6 |   | $ | 6.8 |   | $ | 1,323.4 |   | $ | 845.9 |   | $ | 7.4 |   |
| Incurred loss and LAE                 |       | 37.8                             |       | 114.5 |   | — |   | 14.7 |   | — |   | — |   | (4.0 | ) | (1.6 | ) | — |   |
| Paid loss and LAE                     |       | (95.3                            | )          | (72.7 | ) | (0.7 | ) | (86.4 | ) | (66.9 | ) | 0.4 |   | (91.8 | ) | (77.7 | ) | (0.6 | ) |
| Ending balance                        |       | $                                | 1,098.4    |   | $ | 741.5 |   | $ | 6.5 |   | $ | 1,155.9 |   | $ | 699.7 |   | $ | 7.2 |   | $ | 1,227.6 |   | $ | 766.6 |   | $ | 6.8 |   |
| **Environmental:**                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Beginning balance                     |       | $                                | 577.1      |   | $ | 342.5 |   | $ | 6.0 |   | $ | 678.0 |   | $ | 394.6 |   | $ | 10.6 |   | $ | 729.7 |   | $ | 421.5 |   | $ | 6.5 |   |
| Incurred loss and LAE                 |       | (74.3                            | )          | (56.2 | ) | 2.6 |   | (18.3 | ) | — |   | — |   | (8.6 | ) | (7.8 | ) | — |   |
| Paid loss and LAE                     |       | (32.5                            | )          | (25.1 | ) | (3.1 | ) | (82.6 | ) | (52.1 | ) | (4.6 | ) | (43.1 | ) | (19.1 | ) | 4.1 |   |
| Ending balance                        |       | $                                | 470.3      |   | $ | 261.2 |   | $ | 5.5 |   | $ | 577.1 |   | $ | 342.5 |   | $ | 6.0 |   | $ | 678.0 |   | $ | 394.6 |   | $ | 10.6 |   |
| **Total asbestos and environmental:** |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Beginning balance                     |       | $                                | 1,733.0    |   | $ | 1,042.2 |   | $ | 13.2 |   | $ | 1,905.6 |   | $ | 1,161.2 |   | $ | 17.4 |   | $ | 2,053.1 |   | $ | 1,267.4 |   | $ | 13.9 |   |
| Incurred loss and LAE                 |       | (36.5                            | )          | 58.3 |   | 2.6 |   | (3.6 | ) | — |   | — |   | (12.6 | ) | (9.4 | ) | — |   |
| Paid loss and LAE                     |       | (127.8                           | )          | (97.8 | ) | (3.8 | ) | (169.0 | ) | (119.0 | ) | (4.2 | ) | (134.9 | ) | (96.8 | ) | 3.5 |   |
| Ending balance                        |       | $                                | 1,568.7    |   | $ | 1,002.7 |   | $ | 12.0 |   | $ | 1,733.0 |   | $ | 1,042.2 |   | $ | 13.2 |   | $ | 1,905.6 |   | $ | 1,161.2 |   | $ | 17.4 |   |

----

(1)                                  RepresentsA&E reserve activity, net of third party reinsurance, but prior to the NICOCover.

 

**NOTE 5. Reinsurance**

 

In the normal course ofbusiness, OB Holdings’ insurance subsidiaries seek to limit losses that mayarise from catastrophes or other events by reinsuring with third partyreinsurers. OB Holdings remains liable for risks reinsured even if thereinsurer does not honor its obligations under reinsurance contracts. Theeffects of reinsurance (including the quota share reinsurance agreements withaffiliates) on OB Holdings’ insurance subsidiaries’ written and earned premiumsand on loss and LAE were as follows:

 
| ** **            | ** ** | **Year ended December 31,** | ** ** |
|-----------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **            | ** ** | **($ in millions)**         | ** ** |
| **Written premiums:** |       |                             |       |   |   |   |   |
| Direct(1)             |       | $                                | 2,154.0    |   | $ | 2,041.3 |   | $ | 2,028.0 |   |
| Assumed               |       | 60.0                             |       | 50.6 |   | 287.8 |   |
| Ceded(1)              |       | (250.9                           | )          | (227.5 | ) | (308.8 | ) |
| Net written premiums  |       | $                                | 1,963.1    |   | $ | 1,864.4 |   | $ | 2,007.0 |   |
| **Earned premiums:**  |       |                             |       |   |   |   |   |
| Direct                |       | $                                | 2,078.0    |   | $ | 2,017.3 |   | $ | 2,007.5 |   |
| Assumed               |       | 53.6                             |       | 54.7 |   | 375.3 |   |
| Ceded                 |       | (252.6                           | )          | (198.4 | ) | (306.9 | ) |
| Net earned premiums   |       | $                                | 1,879.0    |   | $ | 1,873.6 |   | $ | 2,075.9 |   |
| **Loss and LAE:**     |       |                             |       |   |   |   |   |
| Direct                |       | $                                | 1,262.1    |   | $ | 1,172.0 |   | $ | 1,245.1 |   |
| Assumed               |       | 34.2                             |       | (11.1 | ) | 249.5 |   |
| Ceded                 |       | (170.1                           | )          | (71.1 | ) | (211.0 | ) |
| Net loss and LAE      |       | $                                | 1,126.2    |   | $ | 1,089.8 |   | $ | 1,283.6 |   |

----

(1)                                  Includespolicies written for Agri on a direct basis which were then ceded 100% to QBEas a result of the sale of the renewal rights of the Agri business to QBE on September 29,2006.

 

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Through the quota share withEsurance, in 2006 OB Holdings assumed premiums of $227.4 million, loss andLAE of $195.5 million and expenses of $114.4 million. The quota shareagreement with Esurance was commuted during the fourth quarter of 2006 inconnection with OBIG’s initial public offering. At commutation, cash andinvestments were used to settle the assets and liabilities assumed under thisagreement.

 

Consistent with the terms ofthe quota share agreement with Sirius, OB Holdings ceded between 6% and 12% ofbusiness written, effective April 1, 2004, to Sirius. OB Holdings cededpremiums of $178.0 million, loss and LAE of $92.2 million, andexpenses of $66.8 million for the year ended December 31, 2006. Thequota share agreement with Sirius was commuted during the fourth quarter of2006 in connection with OBIG’s initial public offering. At commutation, cashand investments were used to settle the assets and liabilities ceded under thisagreement.

 

In the ordinary course ofits business, OB Holdings purchases reinsurance from high-quality, highly ratedthird party reinsurers in order to minimize loss from large risks orcatastrophic events.

 

The timing and size ofcatastrophe losses are unpredictable and the level of losses experienced in anyyear could be material to OB Holdings’ operating results and financialposition. Examples of catastrophes include losses caused by earthquakes,wildfires, hurricanes and other types of storms and terrorist acts. The extentof losses caused by catastrophes is a function of the amount and type ofinsured exposure in an area affected by the event and the severity of theevent. OB Holdings continually assesses and implements programs to manage itsexposure to catastrophe losses through individual risk selection and bylimiting its concentration of insurance written in catastrophe-prone areas,such as coastal regions. In addition, OB Holdings imposes wind deductibles onexisting coastal windstorm exposures. OB Holdings’ largest single event naturalcatastrophe exposures are Northeastern United States windstorms and Californiaearthquakes. OB Holdings uses probable maximum loss (“PML”) forecasting toquantify its exposure to catastrophic losses. PML is a statistical modelingtechnique that measures a company’s catastrophic exposure as the maximumprobable loss in a given time period.

 

Since the terrorist attacksof September 11, 2001, OB Holdings has sought to mitigate the riskassociated with any future terrorist attacks by limiting the aggregate insuredvalue of policies in geographic areas with exposure to losses from terroristattacks. This is accomplished by either limiting the total insured valuesexposed, or, where applicable, through the use of terrorism exclusions.

 

In December 2007, theUnited States government extended the Terrorism Risk Insurance Act (the “TerrorismAct” or “TRIA”) for seven more years until December 31, 2014. TheTerrorism Act, originally enacted in 2002, established a federal “backstop” forcommercial property and casualty losses, including workers compensation,resulting from acts of terrorism by or on behalf of any foreign person orforeign interest. As extended, the law now also covers domestic acts ofterrorism. The law limits the industry’s aggregate liability by requiring thefederal government to share 85% of certified losses once a company meets aspecific retention or deductible as determined by its prior year’s directwritten premiums and limits the aggregate liability to be paid by thegovernment and industry without further action by Congress at$100.0 billion. In exchange for this “back-stop,” primary insurers arerequired to make coverage available to commercial insureds for losses from actsof terrorism as specified in the Terrorism Act. The following types of coverageare excluded from the program: commercial automobile, burglary and theft,surety, farmowners multi-peril and all professional liability coverage exceptdirectors and officers coverage.

 

OB Holdings estimates itsindividual retention level for commercial policies subject to the Terrorism Actto be approximately $178 million in 2009. The federal government will pay85% of covered terrorism losses that exceed OB Holdings’ or the industry’sretention levels in 2009, up to a total of $100.0 billion.

 

OB Holdings seeks to furtherreduce its potential loss from catastrophe exposures through the purchase ofcatastrophe reinsurance. Effective July 1, 2008, OB Holdings renewed itsproperty catastrophe reinsurance program through June 30, 2009. Theprogram provides coverage for OB Holdings’ personal and commercial propertybusiness as well as certain acts of terrorism. Under the program, the first$150 million of losses resulting from any single catastrophe are retainedand $650 million of the next $700 million of losses resulting fromthe catastrophe are reinsured. Any loss above $850 million would beretained. In the event of a catastrophe, OB Holdings’ property catastrophereinsurance program is reinstated for the remainder of the original contractterm by paying a reinstatement premium that is based on the percentage ofcoverage reinstated and the original property catastrophe coverage premium.

 

OB Holdings’ propertycatastrophe reinsurance program does not cover personal or commercial propertylosses resulting from nuclear events or biological, chemical or radiologicalterrorist attacks or losses resulting from acts of terrorism as defined underthe Terrorism Act, as amended, committed by an individual or individuals actingon behalf of any foreign person or foreign interest.

 

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OB Holdings also purchasesindividual property reinsurance coverage for certain risks to reduce large lossvolatility. The property-per-risk reinsurance program reinsures losses inexcess of $10 million up to $100 million. Individual risk facultativereinsurance may be purchased above $100 million where OB Holdings deems itappropriate. The property-per-risk treaty also provides one limit of reinsuranceprotection for losses in excess of $10 million up to $100 million onan individual risk basis for terrorism losses. However, nuclear, biological,chemical and radiological terrorist attacks are not covered.

 

OB Holdings also maintains acasualty reinsurance program that provides protection for individual risk orcatastrophe losses involving workers compensation, general liability,automobile liability or umbrella liability in excess of $6 million up to$81 million. This program provides coverage for terrorism losses but doesnot provide coverage for losses resulting from nuclear, biological, chemicaland radiological terrorist attacks.

 

In connection with theOneBeacon Acquisition, Aviva caused OneBeacon to purchase two reinsurancecontracts: the NICO Cover, a reinsurance contract from NICO for up to$2.5 billion in old A&E claims and certain other exposures and anadverse loss reserve development cover from General Reinsurance Corporation (“GRC”)for up to $570.0 million, comprised of $400.0 million of adverse lossreserve development occurring in years 2000 and prior (the “GRC Cover”) inaddition to $170.0 million of reserves ceded as of the date of theOneBeacon Acquisition. The NICO Cover and GRC Cover, which were contingent onand occurred contemporaneously with the OneBeacon Acquisition, were put inplace in lieu of a seller guarantee of loss and LAE reserves and are thereforeaccounted for as a seller guarantee under GAAP in accordance with EITF TopicD-54. NICO and GRC are wholly-owned subsidiaries of Berkshire Hathaway, Inc (“Berkshire”).

 

Pursuant to the GRC Cover,OB Holdings is not entitled to recover losses to the full contract limit ifsuch losses are reimbursed by GRC more quickly than anticipated at the time thecontract was signed. OB Holdings intends to only seek reimbursement from GRCfor claims which result in payment patterns similar to those supporting itsrecoverables recorded pursuant to the GRC Cover. The economic cost of notsubmitting certain other eligible claims to GRC is primarily the investmentspread between the rate credited by GRC and the rate achieved by OneBeacon onits own investments. This cost, if any, is expected to be nominal.

 

Reinsurance contracts do notrelieve OB Holdings of its obligation to its insureds. Therefore, collectibilityof balances due from its reinsurers is critical to OB Holdings’ financialstrength. The following table provides a listing of OB Holdings’ top reinsurersfor its primary insurance operations, excluding industry pools and associationsand affiliates of OB Holdings, based upon recoverable amounts, the percentageof total reinsurance recoverables and the reinsurer’s A.M. Best Company, Inc.(“A.M. Best”) rating.

 
| **($ in millions)**                                          | ** ** | **Balance at  December 31, 2008** | ** ** | **% of total** | ** ** | **A.M. Best Rating(1)** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------|------------|----------------|------------|-------------------------|------------|
| National Indemnity Company and General Reinsurance Corporation(2) |       | $1,964.1                               |       | 72             | %          | A++                     |       |
| Tokio Marine and Nichido Fire (3)                                 |       | 55.9                                   |       | 2              | %          | A++                     |       |
| QBE Insurance Corporation                                         |       | 45.3                                   |       | 2              | %          | A                       |       |
| Munich Reinsurance America                                        |       | 44.6                                   |       | 2              | %          | A+                      |       |
| Swiss Re                                                          |       | 25.6                                   |       | 1              | %          | A+                      |       |

----

(1)                                  A.M. Bestratings as detailed above are: “A++” (Superior, which is the highest of fifteenratings), “A+” (Superior, which is the second highest of fifteen ratings) and “A”(Excellent, which is the third highest of fifteen ratings).

 

(2)                                  Includes$320.2 million of Third Party Recoverables, which NICO would pay under theterms of the NICO Cover if they are unable to collect from third partyreinsurers. OB Holdings also has an additional $277.6 million of ThirdParty Recoverables from various reinsurers, the majority of which are rated “A”or better by A.M. Best.

 

(3)                                  Excludes $45.7million of reinsurance recoverables from various reinsurers that are guaranteedby Tokio Marine and Nichido Fire under the terms of a 100% quota sharereinsurance agreement between Houston General Insurance Company and TokioMarine and Nichido Fire.

 

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** **

**NOTE 6. Investment Securities**

 

OB Holdings’ net investmentincome is comprised primarily of interest income associated with OB Holdings’fixed maturity investments, dividend income from its equity investments andinterest income from its short-term investments. Net investment income for theyears ended December 31, 2008, 2007 and 2006 consisted of the following:

 

| ** **                     | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                     | ** ** | **($ in millions)**         | ** ** |
| **Investment income:**         |       |                             |       |   |   |   |   |
| Fixed maturity investments     |       | $                                | 143.2      |   | $ | 179.9 |   | $ | 159.7 |   |
| Short-term investments         |       | 8.6                              |       | 14.1 |   | 13.2 |   |
| Common equity securities       |       | 15.3                             |       | 14.8 |   | 20.4 |   |
| Convertible bonds              |       | 6.3                              |       | 6.7 |   | 2.3 |   |
| Other investments              |       | 2.7                              |       | 2.9 |   | 5.5 |   |
| Total investment income        |       | 176.1                            |       | 218.4 |   | 201.1 |   |
| Less investment expenses       |       | (14.0                            | )          | (16.0 | ) | (13.5 | ) |
| Net investment income, pre-tax |       | $                                | 162.1      |   | $ | 202.4 |   | $ | 187.6 |   |

 

For the year ended December 31,2006, OB Holdings recorded an aggregate of $1.0 million in pre-taxinvestment income from regular quarterly dividends from Montpelier Re Holdings,Ltd. (“Montpelier”).

 

The composition of netrealized investment (losses) gains consisted of the following:

 

| ** **                                                        | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                        | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                        | ** ** | **($ in millions)**         | ** ** |
| Fixed maturity investments                                        |       | $                                | (41.0      | ) | $ | 17.5 |   | $ | 11.5 |   |
| Common equity securities                                          |       | (246.5                           | )          | 108.5 |   | 104.6 |   |
| Convertible bonds                                                 |       | (12.4                            | )          | 12.2 |   | 27.8 |   |
| Other investments                                                 |       | (18.7                            | )          | 34.9 |   | 19.8 |   |
| Net realized investment (losses) gains, pre-tax                   |       | (318.6                           | )          | 173.1 |   | 163.7 |   |
| Income taxes attributable to realized investment gains and losses |       | 111.5                            |       | (60.6 | ) | (57.3 | ) |
| Net realized investment (losses) gains, after tax                 |       | $                                | (207.1     | ) | $ | 112.5 |   | $ | 106.4 |   |

 

OB Holdings recognized grossrealized investment gains of $104.3 million, $208.8 million and$189.3 million and gross realized investment losses of $422.9 million,$35.7 million and $25.6 million on sales and other-than-temporaryimpairment charges of investment securities during the years ended December 31,2008, 2007 and 2006, respectively.

 

As of January 1, 2006,OB Holdings owned 6.3 million common shares of Montpelier, with a fairvalue of $115.7 million. On August 24, 2006, OB Holdings exchangedits investment in the common shares of Montpelier for an agreed-upon portfolioof common equity and fixed maturity securities of equal value that was owned byWhite Mountains. At the time of the exchange, OB Holdings’ investment in thecommon shares of Montpelier was in an unrealized loss position of$6.9 million. This loss was deferred at the time of the exchange as salesof investments between OB Holdings and entities under White Mountains’ commoncontrol are deferred. Subsequent to the exchange, White Mountains sold5.4 million common shares of Montpelier triggering the recognition of$5.8 million in realized investment losses in 2006. During the secondquarter of 2007, OB Holdings recognized the remaining deferred loss on theexchange of $1.1 million.

 

OB Holdings recognizesdeclines in fair value deemed to be other-than-temporary impairments asrealized losses. During the year ended December 31, 2008 OB Holdingsrecognized realized losses of $239.8 million for declines in fair value deemedto be other-than-temporary. These realized losses were comprised primarily of$136.8 million of losses related to common equity securities, $58.4 million oflosses related to fixed maturity investments, $14.7 million related toconvertible bonds and $29.9 million of losses related to other investments. Theloss in common equity securities included $20.9 million of losses within theenergy sector, $29.5 million within the utilities sector, $35.6 million withinthe financial sector, $30.3 million within the materials sector and $13.5million within the consumer discretionary sector. Effective January 1,2008, upon adoption of SFAS 159, for all investment securities for which thefair value election has been made, all changes in fair value are included inrevenues. During the years ended December 31, 2007 and 2006, OB Holdingsrecognized $12.7 million and $5.4 million, respectively, of pre-taxother-than-temporary impairment charges as realized losses included in revenues

 

As of December 31, 2008and 2007, OB Holdings reported $6.8 million and $3.9 million,respectively, in accounts payable on unsettled investment purchases and $49.0million and $55.0 million, respectively, in accounts receivable onunsettled investment sales.

 

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The components of OBHoldings’ change in net unrealized investment gains and losses, after tax, andchange in net unrealized foreign currency gains and losses, after tax, on itsavailable-for-sale portfolio, as recorded in the statements of operations andcomprehensive (loss) income prior to adopting SFAS 159 were as follows:

 
| ** **                                                                                       | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                       | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| ** **                                                                                       | ** ** | **($ in millions)**         | ** ** |
| Net change in pre-tax unrealized gains and losses for investment  securities (1)                 |       | $                                | 160.7      |   | $ | 163.6 |   |
| Net change in pre-tax unrealized gains and losses from investments in  unconsolidated affiliates |       | —                           |       | (6.7 | ) |
| Net change in pre-tax unrealized investment gains and losses for  investments                    |       | 160.7                            |       | 156.9 |   |
| Income taxes attributable to investments                                                         |       | (55.6                            | )          | (54.8 | ) |
| Net change in unrealized gains and losses for investments, after tax                             |       | 105.1                            |       | 102.1 |   |
| Recognition of pre-tax net unrealized gains and losses for investments  sold (1)                 |       | (166.5                           | )          | (130.7 | ) |
| Income taxes attributable to investments sold                                                    |       | 58.2                             |       | 45.7 |   |
| Recognition of net unrealized gains and losses for investments sold,  after tax                  |       | (108.3                           | )          | (85.0 | ) |
| Change in net unrealized investment gains and losses, after tax                                  |       | $                                | (3.2       | ) | $ | 17.1 |   |

----

(1)                                  Includes thechange in deferred gains and losses on sales of investments between OB Holdingsand entities under White Mountains’ common control.

 
| ** **                                                                               | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                               | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| ** **                                                                               | ** ** | **($ in millions)**         | ** ** |
| Net change in unrealized foreign currency gains and losses for  investment securities(1) |       | $                                | 1.0        |   | $ | 20.2 |   |
| Income taxes attributable to foreign currency gains and losses                           |       | (0.3                             | )          | (7.1 | ) |
| Change in net unrealized foreign currency gains and losses, after tax                    |       | $                                | 0.7        |   | $ | 13.1 |   |

----

(1)                                  Includes thechange in deferred foreign currency gains and losses on sales of investmentsbetween OB Holdings and entities under White Mountains’ common control.Excludes change in unrealized foreign currency gains and losses on funds heldunder reinsurance agreements in foreign banks for the year ended December 31,2007 of $(0.2) million, after tax.

 

The components of OBHoldings’ ending net unrealized investment gains and losses, excluding theimpact of net unrealized foreign currency translation gains and losses, on itstrading investment portfolio as of December 31, 2008 andavailable-for-sale portfolio as of December 31, 2007 were as follows:

 

| ** **                                                | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| ** **                                                | ** ** | **($ in millions)**         | ** ** |
| **Investment securities:**                                |       |                             |       |   |   |
| Gross unrealized investment gains                         |       | $                                | 74.1       |   | $ | 267.2 |   |
| Gross unrealized investment losses                        |       | (170.6                           | )          | (32.2 | ) |
| Net unrealized (losses) gains from investment securities  |       | (96.5                            | )          | 235.0 |   |
| Income taxes attributable to such losses (gains)          |       | 33.7                             |       | (81.1 | ) |
| Total net unrealized investment (losses) gains, after tax |       | $                                | (62.8      | ) | $ | 153.9 |   |

 

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The cost or amortized cost,gross unrealized investment gains and losses, and carrying values of OBHoldings’ fixed maturity investments as of December 31, 2008 and 2007,were as follows:

 
| ** **                                        | ** ** | **December 31, 2008** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|
| ** **                                        | ** ** | **Cost or amortized cost** | ** ** | **Gross unrealized gains** | ** ** | **Gross unrealized losses** | ** ** | **Net foreign currency losses** | ** ** | **Carrying value** | ** ** |
| ** **                                        | ** ** | **($ in millions)**   | ** ** |
| U.S. Government and agency obligations            |       | $                          | 417.3      |   | $ | 5.3 |   | $ | (13.0 | ) | $ | — |   | $ | 409.6 |   |
| Debt securities issued by industrial corporations |       | 914.9                      |       | 13.2 |   | (39.2 | ) | (18.7 | ) | 870.2 |   |
| Municipal obligations                             |       | 4.8                        |       | 0.2 |   | — |   | — |   | 5.0 |   |
| Asset-backed securities                           |       | 791.9                      |       | 9.3 |   | (42.3 | ) | — |   | 758.9 |   |
| Foreign government obligations                    |       | 46.0                       |       | 0.4 |   | (7.8 | ) | — |   | 38.6 |   |
| Preferred stocks                                  |       | 71.5                       |       | 0.2 |   | (19.2 | ) | — |   | 52.5 |   |
| Total fixed maturity investments                  |       | $                          | 2,246.4    |   | $ | 28.6 |   | $ | (121.5 | ) | $ | (18.7 | ) | $ | 2,134.8 |   |

 
| ** **                                        | ** ** | **December 31, 2007** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|
| ** **                                        | ** ** | **Cost or amortized cost** | ** ** | **Gross unrealized gains** | ** ** | **Gross unrealized losses** | ** ** | **Net foreign currency gains** | ** ** | **Carrying value** | ** ** |
| ** **                                        | ** ** | **($ in millions)**   | ** ** |
| U.S. Government and agency obligations            |       | $                          | 471.1      |   | $ | 17.4 |   | $ | (0.1 | ) | $ | — |   | $ | 488.4 |   |
| Debt securities issued by industrial corporations |       | 1,085.7                    |       | 13.6 |   | (12.8 | ) | 7.9 |   | 1,094.4 |   |
| Municipal obligations                             |       | 8.1                        |       | 0.4 |   | — |   | — |   | 8.5 |   |
| Asset-backed securities                           |       | 1,032.1                    |       | 12.0 |   | (1.7 | ) | — |   | 1,042.4 |   |
| Foreign government obligations                    |       | 133.4                      |       | 0.7 |   | (0.1 | ) | — |   | 134.0 |   |
| Preferred stocks                                  |       | 131.5                      |       | 7.5 |   | (2.1 | ) | 8.4 |   | 145.3 |   |
| Total fixed maturity investments                  |       | $                          | 2,861.9    |   | $ | 51.6 |   | $ | (16.8 | ) | $ | 16.3 |   | $ | 2,913.0 |   |

 

In connection with OBIG’sinitial public offering, an irrevocable grantor trust was established toeconomically defease the Company’s mandatorily redeemable preferred stock. Theassets of the trust were solely dedicated to payments of dividends andredemption amounts on the mandatorily redeemable preferred stock. The assetsheld in the trust included fixed maturity and short-term investments which wereclassified and accounted for as held-to-maturity. During the second quarter of2008, trust assets were utilized to redeem the $300.0 million BerkshireHathaway, Inc. (“Berkshire”) Preferred Stock (“Berkshire Preferred Stock”).The carrying value, gross unrealized investment gains and losses, and estimatedmarket values of OB Holdings’ fixed maturity held-to-maturity investments,carried at amortized cost, as of December 31, 2007 were as follows:

 
| ** **                       | ** ** | **December 31, 2007** | ** ** |
|----------------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | **Carrying Value**         | ** ** | **Gross unrealized gains** | ** ** | **Gross unrealized losses** | ** ** | **Net foreign currency gains** | ** ** | **Estimated Fair Value** | ** ** |
| ** **                       | ** ** | **($ in millions)**   | ** ** |
| U.S. Government obligations      |       | $                          | 305.5      |   | $ | 1.4 |   | $ | — |   | $ | — |   | $ | 306.9 |   |
| Total fixed maturity investments |       | $                          | 305.5      |   | $ | 1.4 |   | $ | — |   | $ | — |   | $ | 306.9 |   |

 

The cost or amortized costand carrying value of OB Holdings’ fixed maturity investments and convertiblebonds at December 31, 2008 is presented below by contractual maturity.Actual maturities could differ from contractual maturities because borrowersmay have the right to call or prepay certain obligations with or without callor prepayment penalties.

 

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| ** **                             | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **Cost or amortized cost** | ** ** | **Carrying value** | ** ** |
| ** **                             | ** ** | **($ in millions)**   | ** ** |
| Due in one year or less                |       | $                          | 222.2      |   | $ | 214.4 |   |
| Due after one year through five years  |       | 1,092.6                    |       | 1,045.0 |   |
| Due after five years through ten years |       | 117.5                      |       | 115.8 |   |
| Due after ten years                    |       | 205.7                      |       | 189.4 |   |
| Asset-backed securities                |       | 791.9                      |       | 758.9 |   |
| Preferred stocks                       |       | 71.5                       |       | 52.5 |   |
| Total                                  |       | $                          | 2,501.4    |   | $ | 2,376.0 |   |

 

Prior to adoption of SFAS159, OB Holdings accounted for convertible bonds on a fair value basis withchanges in fair value recorded through revenues as realized investment gains orlosses. The cost or amortized cost, gross unrealized investment gains andlosses, and carrying values of OB Holdings’ common equity securities,convertible bonds and other investments as of December 31, 2008 and 2007,were as follows:

 

| ** **               | ** ** | **December 31, 2008** | ** ** |
|--------------------------|------------|----------------------------|------------|
| ** **               | ** ** | **Cost or amortized cost** | ** ** | **Gross unrealized gains** | ** ** | **Gross unrealized losses** | ** ** | **Net foreign currency losses** | ** ** | **Carrying value** | ** ** |
| ** **               | ** ** | **($ in millions)**   | ** ** |
| Common equity securities |       | $                          | 284.6      |   | $ | 6.4 |   | $ | (14.2 | ) | $ | (0.1 | ) | $ | 276.7 |   |
| Convertible bonds        |       | $                          | 255.0      |   | $ | 2.4 |   | $ | (16.2 | ) | $ | — |   | $ | 241.2 |   |
| Other investments        |       | $                          | 178.6      |   | $ | 36.7 |   | $ | (18.7 | ) | $ | — |   | $ | 196.6 |   |

 

|                     |   | **December 31, 2007**  |       |
|--------------------------|--------|-----------------------------|------------|
|                     |   | **Cost or  amortized cost** | ** ** | **Gross  unrealized gains** | ** ** | **Gross  unrealized losses** | ** ** | **Net  foreign currency gains** | ** ** | **Carrying  value** |   |
|                     |   | **($ in  millions)**   |       |
| Common equity securities |   | $                           | 641.7      |   | $ | 157.6 |   | $ | (13.3 | ) | $ | 2.4 |   | $ | 788.4 |   |
| Other investments        |   | $                           | 292.7      |   | $ | 58.0 |   | $ | (2.1 | ) | $ | — |   | $ | 348.6 |   |

 

 

The cost of otherinvestments as of December 31, 2007 includes $48.8 million related toequity changes in OB Holdings’ interest in other investments accounted forusing the equity method which, prior to the adoption of SFAS 159, were includedin realized investment gains or losses.

 

Sales and maturities ofinvestments, excluding short-term investments and other investments, totaled$2,522.1 million, $2,609.9 million and $2,666.5 million for the yearsended December 31, 2008, 2007 and 2006, respectively. There were nonon-cash exchanges or involuntary sales of investment securities during theyears ended December 31, 2008, 2007 or 2006.

 

OB Holdings’ consolidatedinsurance operations are required to maintain deposits with certain insuranceregulatory agencies in order to maintain their insurance licenses. The fairvalue of such deposits totaled $281.3 million and $302.7 million as of December 31,2008 and 2007, respectively.

 

*Fair value measurements at December 31,2008*

 

As described above, OBHoldings adopted SFAS 157 on January 1, 2008. SFAS 157 established ahierarchy of fair value measurements based upon the nature of the inputs asfollows:

 

Level 1 — Valuationsbased on quoted prices in active markets for identical assets;

 

Level 2 — Valuationsbased on observable inputs that do not meet the criteria for Level 1, includingquoted prices in inactive 

 

F-26

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markets and quoted pricesin active markets for similar, but not identical instruments; and

 

Level 3 — Valuations basedon unobservable inputs.

 

As of December 31,2008, approximately 92% of the investment portfolio recorded at fair value waspriced based upon observable inputs.

 

Fair values forsecurities for which quoted prices are unavailable are estimated based upon referenceto observable inputs other than quoted prices, such as benchmark interestrates, market comparables, broker quotes and other relevant observable inputs.In circumstances where observable inputs are adjusted to reflect management’sbest estimate of fair value, such fair value measurements are considered alower level measurement in the SFAS 157 fair value hierarchy.

 

Other investments, whichare comprised of limited partnerships, hedge funds and private equity interestsfor which the SFAS 159 fair value option has been elected, are carried at fairvalue based upon OB Holdings’ proportionate interest in the underlyingpartnership’s or fund’s net asset value, which is deemed to approximate fairvalue.  These investments are notpublicly traded and, accordingly, quoted market prices are not available.  In circumstances where the partnership netasset value is deemed to differ from fair value due to illiquidity or otherfactors, net asset value is adjusted accordingly. As of December 31, 2008,other investments represented approximately 5% of the investment portfoliorecorded at fair value.  At December 31,2008, OB Holdings did not adjust the net assets values used to determine fairvalue.

 

The fair valuemeasurements at December 31, 2008 and their related inputs are as follows:

 
| ** **                 | ** ** | **Fair value at December 31, 2008** | ** ** | **Level 1 Inputs** | ** ** | **Level 2 Inputs** | ** ** | **Level 3 Inputs** | ** ** |
|----------------------------|------------|---------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                 | ** ** | **($ in millions)**                                | ** ** |
| Fixed maturity investments |       | $                                                       | 2,134.8    |                         | $          | 429.8                        |       | $                            | 1,625.7    |   | $ | 79.3 |   |
| Common equity securities   |       | 276.7                                                   |       | 249.2                        |       | 1.3                          |       | 26.2                         |       |
| Convertible bonds          |       | 241.2                                                   |       | —                       |       | 241.2                        |       | —                       |       |
| Short-term investments     |       | 875.4                                                   |       | 875.4                        |       | —                       |       | —                       |       |
| Other investments          |       | 196.6                                                   |       | —                       |       | —                       |       | 196.6                        |       |
| Total                      |       | $                                                       | 3,724.7    |                         | $          | 1,554.4                      |       | $                            | 1,868.2    |   | $ | 302.1 |   |

 

The changes in Level 3fair value measurements for the year ended December 31, 2008 are asfollows:

 
| ** **                                       | ** ** | **Fixed maturity investments** | ** ** | **Common equity securities** | ** ** | **Convertible bonds** | ** ** | **Other investments** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------|------------|
| ** **                                       | ** ** | **($ in millions)**       | ** ** |
| Balance at January 1, 2008                  |       | $                              | 168.9      |                         | $          | 70.3                  |       | $                     | 19.3       |      | $          | 348.6 |   | $ | 607.1 |   |
| Total net realized and unrealized gains (losses) |       | (39.2                          | )          | (8.8                         | )          | —                |       | (105.4                | )          | (153.4    | )          |
| Purchases and sales, net                         |       | (24.2                          | )          | 0.5                          |       | —                |       | (46.6                 | )          | (70.3     | )          |
| Transfers in (out) of Level 3, net               |       | (26.2                          | )          | (35.8                        | )          | (19.3                 | )          | —                |       | (81.3     | )          |
| Balance at December 31, 2008                |       | $                              | 79.3       |                         | $          | 26.2                  |       | $                     | —     |      | $          | 196.6 |   | $ | 302.1 |   |

 

                The majority of the transfers out of Level 3 withinfixed maturity investments for the year ended December 31, 2008 representsecurities for which observable inputs were unavailable as of December 31,2007 mainly because the securities were relatively new issuances and/or limitedmarket data was available. Such securities were manually priced using acombination of market inputs such as benchmark interest rates, marketcomparables and/or broker quotes. With respect to common equity securities, asa result of efforts to adopt SFAS 157 and 159, OB Holdings was able to obtainadditional information on the underlying common equity securities for a limitedpartnership that it consolidates in its financial statements. These commonequity securities which are priced based on quoted prices were transferred outof Level 3 into Level 1 during the year ended December 31, 2008.

 

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Thefollowing table summarizes the change in net unrealized gains and losses for assets designatedas Level 3 for the year ended December 31, 2008:

 
| ** **                 | ** ** | **Year ended December 31, 2008** | ** ** |
|----------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **($ in millions)**              | ** ** |
| Fixed maturity investments |       | $                                     | (26.3      | ) |
| Common equity securities   |       | (3.9                                  | )          |
| Convertible bonds          |       | —                                |       |
| Short-term investments     |       | —                                |       |
| Other investments          |       | (93.7                                 | )          |
| Total                      |       | $                                     | (123.9     | ) |

 

The net changes in fairvalue for the year ended December 31, 2008 are as follows:

 
| ** **                 | ** ** | **Changes in net unrealized gains and losses (1)(2)** | ** ** | **Changes in net foreign currency translation gains and  losses (1)** | ** ** | **Total net changes in fair value reflected in revenues  (1)(2)** | ** ** |
|----------------------------|------------|-----------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **($ in millions)**                                        | ** ** |
| Fixed maturity investments |       | $                                                               | (139.4     | )                                                                                    | $          | (35.3                                                                                 | )          | $ | (174.7 | ) |
| Common equity securities   |       | (154.3                                                          | )          | (2.6                                                                                 | )          | (156.9                                                                                | )          |
| Convertible bonds          |       | (22.5                                                           | )          | —                                                                               |       | (22.5                                                                                 | )          |
| Short-term investments     |       | 0.2                                                             |       | 0.3                                                                                  |       | 0.5                                                                                   |       |
| Other investments          |       | (93.8                                                           | )          | —                                                                               |       | (93.8                                                                                 | )          |
| Total                      |       | $                                                               | (409.8     | )                                                                                    | $          | (37.6                                                                                 | )          | $ | (447.4 | ) |

----

(1)                                  Includeschanges in net deferred gains and losses on sales of investments between OBHoldings and entities under White Mountains’ common control of $(11.0) million,pre-tax. 

 

(2)                                  Includesunrealized losses related to OB Holdings’ securities lending program of $7.0million, pre-tax. 

 

In addition to the investment portfolio describedabove, OB Holdings has $20.2 million of liabilities recorded at fair value inaccordance with SFAS 157 and included in other liabilities.  These liabilities relate to securities thathave been sold short by a limited partnership that OB Holdings invests in andis required to consolidate under GAAP. All of the liabilities included in the $20.2 million have been deemed tohave a Level 1 designation.

 

*SecuritiesLending*

 

OBHoldings participates in a securities lending program whereby it loansinvestment securities to other institutions for short periods of time. OBHoldings receives a fee from the borrower in return for the use of its assetsand its policy is to require collateral equal to approximately 102% of the fairvalue of the loaned securities, which is held by a third party. All securitiesloaned can be redeemed on short notice. The total market value of OB Holdings’securities on loan at December 31, 2008 was $107.7 million withcorresponding collateral of $100.7 million, resulting in an unrealizedloss of $7.0 million recorded in change in net unrealized gains and losses oninvestments.  The total market value ofOB Holdings’ securities on loan at December 31, 2007 was $438.9 millionwith corresponding collateral of $438.9 million.

 

**NOTE 7.  Debt**

 

OB Holdings’ debt outstandingas of December 31, 2008 and 2007 consisted of the following:

 

| ** **                                                       | ** ** | **December 31,**    | ** ** |
|------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                       | ** ** | **2008**                 | ** ** | **2007** | ** ** |
| ** **                                                       | ** ** | **($ in millions)** | ** ** |
| Senior unsecured notes (“Senior Notes”), at face value |       | $                        | 676.0      |   | $ | 700.0 |   |
| Unamortized original issue discount                              |       | (0.9                     | )          | (1.1 | ) |
| Senior Notes, carrying value                                     |       | 675.1                    |       | 698.9 |   |
| Mortgage note on real estate owned                               |       | 40.8                     |       | 40.8 |   |
| Atlantic Specialty Note                                          |       | 16.0                     |       | 18.0 |   |
| Total debt                                                       |       | $                        | 731.9      |   | $ | 757.7 |   |

 

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Aschedule of contractual repayments of OB Holdings’ debt as of December 31,2008 follows:

 

| ** **                | ** ** | **December 31,  2008** | ** ** |
|---------------------------|------------|-----------------------------|------------|
| ** **                | ** ** | **($ in millions)**    | ** ** |
| Due in one year or less   |       | $                           | 2.8        |   |
| Due in two to three years |       | 5.6                         |       |
| Due in four to five years |       | 681.8                       |       |
| Due after five years      |       | 42.6                        |       |
| Total                     |       | $                           | 732.8      |   |

 

***Senior Notes***

 

In May 2003, theCompany issued $700.0 million face value of senior unsecured debt througha public offering, at an issue price of 99.7% (the “Senior Notes”). The SeniorNotes bear an annual interest rate of 5.875%, payable semi-annually in arrearson May 15 and November 15, until maturity on May 15, 2013, andare fully and unconditionally guaranteed as to the payment of principal andinterest by White Mountains. The Company incurred $7.3 million in expensesrelated to the issuance of the Senior Notes (including the $4.5 millionunderwriting discount), which have been deferred and are being recognized intointerest expense over the life of the Senior Notes. Taking into effect theamortization of the original issue discount and all underwriting and issuanceexpenses, the Senior Notes have an effective yield to maturity of approximately6.0% per annum. At December 31, 2008, the Company was in compliance withall of the covenants under the Senior Notes. During the third quarter of 2008,the Company repurchased $24.0 million of outstanding Senior Notes for $22.3million, which resulted in a $1.6 million gain on extinguishment of debt.

 

White Mountains has providedand, pursuant to a separation agreement, continues to provide an irrevocableand unconditional guarantee as to the payment of principal and interest on theSenior Notes. See Note 18.

 

***Bank Facility***

 

In November 2006, theCompany established a $75 million revolving credit facility that wouldhave matured in November 2011 (“the Bank Facility”). As of December 31,2007, the Bank Facility was undrawn. The Bank Facility was terminated in December 2008.

 

***Mortgage Note on Real Estate Owned***

 

In connection with its December 2005purchase of land and an office building that is now its headquarters, OBHoldings entered into a $40.8 million, 18-year mortgage note which has avariable interest rate based upon the lender’s 30-day LIBOR rate. As of December 31,2008, OB Holdings had drawn the full amount of $40.8 million on themortgage note. Repayment on the mortgage note commenced in January 2009.

 

Concurrent with enteringinto the mortgage note, OB Holdings also entered into an interest rate swap tohedge its exposure to the variability in the interest rate on the mortgagenote. The notional amount of the swap is equal to the debt outstanding on themortgage note and will be adjusted to match the drawdowns and repayments on themortgage note so that the principal amount of the mortgage note and thenotional amount of the swap are equal at all times. Under the terms of theswap, OB Holdings pays a fixed interest rate of approximately 6% and receives avariable interest rate based on the same LIBOR index used for the mortgagenote. Interest paid or received on the swap is reported in interest expense.The swap was recorded at its fair value of $(10.4) million and $(1.7) millionas of December 31, 2008 and 2007, respectively. Changes in the fair valueof the interest rate swap are reported as a component of other comprehensive(loss) income. The after tax change in the fair value of the interest rate swapwas a (loss) gain of $(5.7) million, $(1.1) million and $0.6 millionfor the years ended December 31, 2008, 2007 and 2006, respectively.

 

***Other Debt of Operating Subsidiaries***

 

In connection with theacquisition of Atlantic Specialty Insurance Company on March 31, 2004, OBHoldings issued a $20.0 million ten-year note to the seller (the “AtlanticSpecialty Note”). OB Holdings is required to repay $2.0 million ofprincipal on the notes per year, commencing in January 2007. The noteaccrues interest at a rate of 5.2% except that the outstanding principal amountin excess of $15.0 million accrues interest at a rate of 3.6%.

 

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***Interest***

 

Total interest expenseincurred by OB Holdings for its indebtedness was $44.9 million,$45.2 million and $45.5 million in 2008, 2007 and 2006, respectively.Total cash interest paid by OB Holdings for its indebtedness was $43.7 million,$44.3 million and $43.4 million in 2008, 2007 and 2006, respectively.

 

**NOTE 8.  IncomeTaxes**

 

OBH and its subsidiaries aredomiciled in the United States. The majority of OB Holdings’ operations aretaxed in the United States.

 

OBH and its subsidiariesjoin in the filing of a federal consolidated tax return. The consolidatedparent, which is not included in these financial statements, is OBFS. For allyears, the companies included within the U.S. consolidated tax return areparties to a tax sharing agreement which provides that each company pays theamount of income taxes or estimated tax or receives refunds that it would haveto make or be entitled to if it filed its own separate tax return. As a result,certain companies have made payments, and received refunds from theconsolidated parent that are different than amounts payable to the InternalRevenue Service (“IRS”). In addition, OB Holdings has a separate agreement withthe consolidated parent which provides that OB Holdings will be paid for theirtax benefits (losses and credits) the earlier of when they would be able toutilize such benefits on a stand-alone basis or when the parent utilizes suchlosses on a consolidated basis.

 

The total income tax benefit(provision) for the years ended December 31, 2008, 2007 and 2006 consistedof the following:

 

| ** **                             | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| ** **                             | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                             | ** ** | **($ in millions)**         | ** ** |
| **Current tax benefit (provision):**   |       |                             |       |   |   |   |   |
| Federal                                |       | $                                | (10.6      | ) | $ | (134.0 | ) | $ | 4.2 |   |
| State                                  |       | (1.2                             | )          | (0.6 | ) | 0.2 |   |
| Non-U.S.                               |       | (0.2                             | )          | (0.1 | ) | (0.1 | ) |
| Total current tax benefit (provision)  |       | (12.0                            | )          | (134.7 | ) | 4.3 |   |
| **Deferred tax benefit (provision):**  |       |                             |       |   |   |   |   |
| Federal                                |       | 207.3                            |       | (29.8 | ) | (96.9 | ) |
| State                                  |       | —                           |       | — |   | — |   |
| Non-U.S.                               |       | —                           |       | — |   | — |   |
| Total deferred tax benefit (provision) |       | 207.3                            |       | (29.8 | ) | (96.9 | ) |
| Total income tax benefit (provision)   |       | $                                | 195.3      |   | $ | (164.5 | ) | $ | (92.6 | ) |

 

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Deferred income taxesreflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts for tax purposes. An outline of the significant components of OBHoldings’ deferred tax assets and liabilities follows:

 

 

| ** **                                           | ** ** | **December 31,**    | ** ** |
|------------------------------------------------------|------------|--------------------------|------------|
| ** **                                           | ** ** | **2008**                 | ** ** | **2007** | ** ** |
| ** **                                           | ** ** | **($ in millions)** | ** ** |
| **Deferred income tax assets related to:**           |       |                     |       |   |   |
| Investment basis differences                         |       | $                        | 92.9       |   | $ | — |   |
| Unearned premiums                                    |       | 70.6                     |       | 64.8 |   |
| U.S. net operating loss and tax credit carryforwards |       | 61.0                     |       | 56.5 |   |
| Discounting of loss and LAE reserves                 |       | 38.8                     |       | 41.5 |   |
| Net unrealized investment losses                     |       | 33.7                     |       | — |   |
| Compensation and bonus accruals                      |       | 22.5                     |       | 37.1 |   |
| Deferred compensation plans                          |       | 15.2                     |       | 23.7 |   |
| Pension and benefit accruals                         |       | 9.9                      |       | 0.9 |   |
| Foreign currency translation on investments          |       | 6.8                      |       | — |   |
| Fixed assets                                         |       | 6.3                      |       | 7.1 |   |
| Allowance for doubtful accounts                      |       | 2.5                      |       | 6.5 |   |
| Other accrued compensation                           |       | 1.9                      |       | 2.3 |   |
| Involuntary pool and guaranty fund accruals          |       | 1.6                      |       | 1.7 |   |
| Other items                                          |       | 9.8                      |       | 9.0 |   |
| Total gross deferred income tax assets               |       | 373.5                    |       | 251.1 |   |
| Less valuation allowance                             |       | (17.1                    | )          | (13.8 | ) |
| Total net deferred income tax assets                 |       | 356.4                    |       | 237.3 |   |
| **Deferred income tax liabilities related to:**      |       |                     |       |   |   |
| Net unrealized investment gains                      |       | —                   |       | 81.1 |   |
| Deferred acquisition costs                           |       | 78.7                     |       | 69.7 |   |
| Investment basis differences                         |       | —                   |       | 14.9 |   |
| Foreign currency translation on investments          |       | —                   |       | 6.4 |   |
| Purchase accounting                                  |       | 1.9                      |       | 6.1 |   |
| Other items                                          |       | 6.4                      |       | 10.8 |   |
| Total deferred income tax liabilities                |       | 87.0                     |       | 189.0 |   |
| Net deferred tax asset                               |       | $                        | 269.4      |   | $ | 48.3 |   |

 

The total net deferred taxasset relates solely to the U.S. consolidated return group.

 

At December 31, 2008and 2007, a valuation allowance of $17.1 million and $13.8 million,respectively, was established for the net deferred tax assets of the threeconsolidated insurance reciprocals which each file their own tax return.

 

OB Holdings believes that,based upon its prior earnings history, expected future earnings and capacityfor carry-back of losses, it is more likely than not that the deferred taxasset balances (net of valuation allowance) carried at December 31, 2008and 2007 will be realized.

 

A reconciliation of taxescalculated using the 35% U.S. statutory rate (the tax rate at which themajority of OB Holdings’ operations are taxed) to the income tax provision onpre-tax earnings follows:

 

| ** **                                               | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                               | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                               | ** ** | **($ in millions)**         | ** ** |
| Tax benefit (provision) at the U.S. statutory rate       |       | $                                | 209.9      |   | $ | (139.8 | ) | $ | (103.6 | ) |
| **Differences in taxes resulting from:**                 |       |                             |       |   |   |   |   |
| Non-deductible preferred stock dividends and accretion   |       | (11.7                            | )          | (22.5 | ) | (19.8 | ) |
| Tax reserve adjustments                                  |       | (1.0                             | )          | (1.2 | ) | 27.1 |   |
| Tax exempt interest and dividends                        |       | 3.6                              |       | 3.6 |   | 19.7 |   |
| Change in valuation allowance                            |       | (3.3                             | )          | (2.5 | ) | (7.6 | ) |
| Other, net                                               |       | (2.2                             | )          | (2.1 | ) | (8.4 | ) |
| Total income tax benefit (provision) on pre-tax earnings |       | $                                | 195.3      |   | $ | (164.5 | ) | $ | (92.6 | ) |

 

At December 31, 2008,there were net operating losses of $17.8 million and capital losscarryforwards of $0.3 million, which will begin to expire in 2011, related tothe three insurance reciprocals which each file their own tax return. 

 

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Under the tax sharing agreement, the Companyand its subsidiaries have net operating loss carryforwards of$156.7 million, which begin to expire in 2021.

 

On January 1, 2007, OBHoldings adopted FASB Interpretation No. 48, “Accounting for Uncertaintyin Income Taxes” (“FIN 48”). FIN 48 prescribes when the benefit of a given taxposition should be recognized and how it should be measured. Under the newguidance, recognition is based upon whether or not a company determines that itis more likely than not that a tax position will be sustained upon examinationbased upon the technical merits of the position. In evaluating themore-likely-than not recognition threshold, OB Holdings must presume that thetax position will be subject to examination by a taxing authority with fullknowledge of all relevant information. If the recognition threshold is met,then the tax position is measured at the largest amount of benefit that is morethan 50% likely of being realized upon ultimate settlement.

 

In connection with theadoption of FIN 48, OB Holdings recognized a $0.3 million increase inthe liability for unrecognized tax benefits, primarily as a result of increasesin its estimates of accrued interest. The effect of adoption was recorded as anadjustment to opening retained earnings on January 1, 2007. Areconciliation of the beginning and ending amount of unrecognized tax benefitsis as follows:

 

| ** **                                  | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|
| ** **                                  | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| ** **                                  | ** ** | **($ in millions)**         | ** ** |
| Beginning of period                         |       | $                                | 12.9       |   | $ | 15.2 |   |
| Increases for tax positions of prior years  |       | 2.3                              |       | — |   |
| Reductions for tax positions of prior years |       | —                           |       | (2.3 | ) |
| End of period                               |       | $                                | 15.2       |   | $ | 12.9 |   |

 

Included in the balance at December 31,2008 are $8.4 million of tax positions for which ultimate deductibility ishighly certain but the timing of deductibility is uncertain. Because of theimpact of deferred tax accounting, other than interest and penalties, thedisallowance of the shorter deductibility period would not affect the effectivetax rate but would accelerate the payment of cash to the taxing authority to anearlier period. The remaining balance of $6.8 million, if recognized,would be recorded as a reduction to income tax expense.

 

FIN 48 also addresseshow interest and penalties should be accrued for uncertain tax positions,requiring that interest expense should be recognized in the first periodinterest would be accrued under the tax law. OB Holdings classifies allinterest and penalties on unrecognized tax benefits as part of income taxexpense. During the years ended December 31, 2008 and 2007, OB Holdingsrecognized $1.0 million of interest expense and $0.3 million of interestincome, respectively, net of federal benefit. The balance of accrued interestat December 31, 2008 and 2007 is $1.6 million and $0.6 million,respectively, net of federal benefit.

 

With few exceptions, OBHoldings is no longer subject to U.S. federal, state or non-U.S. income taxexaminations by tax authorities for years before 2003. The IRS commenced anexamination of OBFS’ U.S. income tax returns for 2003 through 2004 in thesecond quarter of 2006. On January 22, 2009, OBFS received Form 4549-A(Income Tax Examination Changes) from the IRS relating to the audit of taxyears 2003 and 2004 assessing an additional $65.7 million of tax. The portionof the assessment that relates to OB Holdings is $5.9 million of tax. Theestimated total assessment relating to OB Holdings, including interest, is $6.2million. OBFS disagrees with the adjustments proposed by the IRS and intends tovigorously defend its position. The timing of the resolution of these items isuncertain, however, it is reasonably possible that the resolution could occurwithin the next 12 months. An estimate of the range of potential outcomescannot be made at this time. OBFS’ overall liability for tax assessments for2003 and 2004 is limited due to the Tax Make Whole Agreement with WhiteMountains, which fixes the liability for these items at the amount recorded onOBFS’ books. OB Holdings does not expect the resolution of this examination toresult in a material change to its financial position. In October 2008,the IRS commenced examination of OBFS’ U.S. income tax returns for 2005 through2006. As of December 31, 2008, the IRS has not proposed any significantadjustments to taxable income as a result of the 2005 through 2006 audit. Dueto the uncertainty of the outcome of the ongoing IRS examination, OB Holdingscannot estimate the range of reasonably possible changes to its unrecognizedtax benefits at this time. OB Holdings does not expect the resolution of thisexamination to result in a material change to its financial position.

 

Net cash payments (refunds)for federal income taxes, including those made under tax sharing payments,totaled $100.7 million, $172.7 million and $(77.0) million for the yearsended December 31, 2008, 2007 and 2006, respectively.

 

 

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For the years ended December 31,2008 and 2007 OB Holdings had net tax sharing amounts receivable (payable) of$49.8 million and $(42.9) million, respectively.

 

**NOTE 9. Retirement Plans**

 

OneBeacon sponsors qualifiedand non-qualified, non-contributory, defined benefit pension plans coveringsubstantially all employees who were employed as of December 31, 2001 andremain actively employed with OneBeacon. Current plans include a OneBeaconqualified pension plan (the “Qualified Plan”) and a OneBeacon non-qualifiedpension plan (the “Non-qualified Plan”) (collectively the “Plans”). OneBeacon’sPlans were frozen and curtailed in the fourth quarter of 2002. The Plans nolonger add new participants or increase benefits for existing participants.Non-vested plan participants continue to vest during their employment withOneBeacon, which effectively causes the projected benefit obligation to equalthe accumulated benefit obligation.

 

The benefits for the Plansare based primarily on years of service and employees’ compensation through December 31,2002. Participants generally vest after five years of continuous service.OneBeacon’s funding policy is consistent with the funding requirements of U.S.federal laws and regulations.

 

On July 11, 2007,OneBeacon settled approximately 80% of the Qualified Plan liabilities throughthe purchase of two group annuity contracts for $398.5 million fromTransamerica Life Insurance Company (“Transamerica”) and Hartford LifeInsurance Company (“Hartford Life”). In accordance with SFAS No. 88 “Employers’Accounting for Settlements and Curtailments of Defined Benefit Pension Plansand for Termination Benefits”, the Qualified Plan’s obligations werere-measured in connection with this settlement. As a result of the partialsettlement and re-measurement, OneBeacon recognized a gain of$25.6 million through pre-tax income ($6.3 million as a reduction toloss and LAE, allocated to claims department employees, and $19.3 millionas a reduction to other underwriting expenses) and a pre-tax loss of$2.5 million through other comprehensive income in the third quarter of2007. At the time of settlement, the remaining Qualified Plan liabilities wereprimarily attributable to Qualified Plan participants who were actively employedby OneBeacon.

 

During the third quarter of2008, the Qualified Plan received reimbursements from Transamerica and HartfordLife in the amounts of $0.8 million and $0.6 million, respectively, due to thefinal reconciliation of the partial pension settlement. These amountsrepresented changes in participants and benefits between the time of purchaseand the settlement plus any related interest and resulted in a pre-tax gain of$1.4 million recognized in other comprehensive income and loss items.

 

 

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The following tables setforth the obligations and funded status, assumptions, plan assets and cashflows associated with the various pension plans at December 31, 2008 and2007:

 
| ** **                                                                     | ** ** | **2008**                 | ** ** | **2007** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------|------------|----------|------------|
| ** **                                                                     | ** ** | **($ in millions)** | ** ** |
| **Change in projected benefit obligation:**                                    |       |                     |       |     |       |
| Projected benefit obligation at beginning of year                              |       | $                        | 121.6      |     | $          | 534.1 |   |
| Service cost                                                                   |       | 1.1                      |       | 2.1      |       |
| Interest cost                                                                  |       | 6.7                      |       | 16.7     |       |
| Settlement gain                                                                |       | —                   |       | (398.5   | )          |
| Special termination benefit cost                                               |       | 2.4                      |       | 1.8      |       |
| Assumption changes                                                             |       | 1.8                      |       | (4.8     | )          |
| Actuarial loss                                                                 |       | (2.8                     | )          | 1.6      |       |
| Benefits and expenses paid with plan assets, net of participant  contributions |       | (11.4                    | )          | (28.4    | )          |
| Benefits paid directly by OneBeacon                                            |       | (2.9                     | )          | (3.0     | )          |
| **Projected benefit obligation at end of year**                                |       | $                        | 116.5      |     | $          | 121.6 |   |
| **Change in plan assets:**                                                     |       |                     |       |     |       |
| Fair value of plan assets at beginning of year                                 |       | $                        | 145.5      |     | $          | 532.7 |   |
| Actual return on plan assets                                                   |       | (23.1                    | )          | 39.7     |       |
| Employer contributions                                                         |       | —                   |       | —   |       |
| Benefits and expenses paid, net of participant contributions                   |       | (11.4                    | )          | (28.4    | )          |
| Settlement gain                                                                |       | —                   |       | (398.5   | )          |
| **Fair value of plan assets at end of year**                                   |       | $                        | 111.0      |     | $          | 145.5 |   |
| **Funded status at end of year**                                               |       | $                        | (5.5       | )        | $          | 23.9 |   |

 

The funded status of theconsolidated pension plans at December 31, 2008 was $(5.5) million,which represents an over-funding of $20.2 million related to the QualifiedPlan and an under-funding of $(25.7) million related to the Non-qualifiedPlan. The Non-qualified Plan, which is unfunded, does not hold any assets.OneBeacon has set aside $15.2 million in irrevocable rabbi trusts for thebenefit of Non-qualified Plan participants. In accordance with GAAP, the assetsheld in the rabbi trusts are not reflected in the funded status of theconsolidated pension plans as presented.

 

Amounts recognized in thefinancial statements as of December 31, 2008 and 2007 consist of:

 
| ** **                                             | ** ** | **December 31,**    | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|
| ** **                                             | ** ** | **2008**                 | ** ** | **2007** | ** ** |
| ** **                                             | ** ** | **($ in millions)** | ** ** |
| Prepaid benefit cost recorded in other assets          |       | $                        | 20.2       |   | $ | 51.8 |   |
| Accrued benefit cost recorded in other liabilities     |       | (25.7                    | )          | (27.9 | ) |
| **Net amount recognized in the financial  statements** |       | $                        | (5.5       | ) | $ | 23.9 |   |

 

The accumulated benefitobligation for all defined benefit pension plans was $116.5 million and$121.6 million at December 31, 2008 and 2007, respectively.

 

Information for theNon-qualified Plan, which had accumulated benefit obligations in excess of planassets, was as follows:

 
| ** **                     | ** ** | **2008**                 | ** ** | **2007** | ** ** |
|--------------------------------|------------|--------------------------|------------|----------|------------|
| ** **                     | ** ** | **($ in millions)** | ** ** |
| Projected benefit obligation   |       | $                        | 25.7       |     | $          | 27.9 |   |
| Accumulated benefit obligation |       | $                        | 25.7       |     | $          | 27.9 |   |
| Fair value of plan assets      |       | $                        | —     |     | $          | — |   |

 

 

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Information for theQualified Plan, which had accumulated benefit obligations less than planassets, was as follows:

 
| ** **                     | ** ** | **2008**                 | ** ** | **2007** | ** ** |
|--------------------------------|------------|--------------------------|------------|----------|------------|
| ** **                     | ** ** | **($ in millions)** | ** ** |
| Projected benefit obligation   |       | $                        | 90.8       |     | $          | 93.6 |   |
| Accumulated benefit obligation |       | $                        | 90.8       |     | $          | 93.6 |   |
| Fair value of plan assets      |       | $                        | 111.0      |     | $          | 145.5 |   |

 

The incremental effect ofapplying SFAS 158 on individual line items in the statement of financialposition for the year ended December 31, 2006, was as follows:

 
| ** **                                         | ** ** | **Before  Application of  SFAS 158** | ** ** | **Adjustments** | ** ** | **After  Application of  SFAS 158** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|-----------------|------------|------------------------------------------|------------|
| ** **                                         | ** ** | **($ in millions)**                  | ** ** |
| Prepaid benefit cost recorded in other assets      |       | $                                         | 18.6       |            | $          | 8.8                                      |       | $ | 27.4 |   |
| Accrued benefit cost recorded in other liabilities |       | 28.8                                      |       | —          |       | 28.8                                     |       |
| Deferred federal income taxes                      |       | 64.3                                      |       | (3.1            | )          | 61.2                                     |       |
| Accumulated other comprehensive income             |       | 181.2                                     |       | 5.7             |       | 186.9                                    |       |
| Total common shareholder’s equity             |       | 1,741.8                                   |       | 5.7             |       | 1,747.5                                  |       |
|                                                    |            |                                           |            |                 |            |                                          |            |  |  |  |

 

The amounts recognized inaccumulated other comprehensive (loss) income on a before tax basis for theyears ended December 31, 2008 and 2007 were as follows:

 
| ** **                                                      | ** ** | **December 31,**     | ** ** |
|-----------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                      | ** ** | **2008**                  | ** ** | **2007** | ** ** |
| ** **                                                      | ** ** | **($ in  millions)** | ** ** |
| Accumulated other comprehensive income beginning balance        |       | $                         | 3.0        |   | $ | 3.1 |   |
| Increase (decrease) in accumulated other comprehensive income:  |       |                      |       |   |   |
| Amortization of net actuarial losses recognized during the year |       | 0.3                       |       | 0.3 |   |
| Net actuarial losses occurring during the year                  |       | (30.4                     | )          | (0.4 | ) |
| Accumulated other comprehensive (loss) income ending balance    |       | $                         | (27.1      | ) | $ | 3.0 |   |

 

The amount in accumulatedother comprehensive loss, on a before tax basis, that has not yet beenrecognized as a component of net periodic benefit cost for the year ended December 31,2008 is attributable to net losses. During 2009, OneBeacon expects$1.3 million will be amortized from accumulated other comprehensive lossinto net periodic benefit cost.

 

The components of netperiodic benefit costs for the years ended December 31, 2008, 2007 and2006 were as follows:

 

| ** **                                                                                            | ** ** | **Pension Benefits**     | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                            | ** ** | **2008**                 | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                                            | ** ** | **($ in millions)** | ** ** |
| Service cost                                                                                          |       | $                        | 1.0        |   | $ | 2.1 |   | $ | 2.6 |   |
| Interest cost                                                                                         |       | 6.7                      |       | 16.7 |   | 27.7 |   |
| Expected return on plan assets                                                                        |       | (8.2                     | )          | (17.7 | ) | (30.6 | ) |
| Amortization of prior service benefit                                                                 |       | —                   |       | — |   | — |   |
| Amortization of unrecognized loss                                                                     |       | 0.3                      |       | 0.3 |   | 0.3 |   |
| Net periodic pension (income) cost before settlements, curtailments  and special termination benefits |       | (0.2                     | )          | 1.4 |   | — |   |
| Settlement gain                                                                                       |       | —                   |       | (25.6 | ) | — |   |
| Special termination benefits expense(1)                                                               |       | 2.4                      |       | 1.8 |   | 1.6 |   |
| **Total net periodic benefit cost (income)**                                                          |       | $                        | 2.2        |   | $ | (22.4 | ) | $ | 1.6 |   |

----

(1)                                  Specialtermination benefits were additional payments made from the pension plan when avested participant’s employment has been terminated due to a reduction inforce.

 

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** **

**Assumptions**

 

The weighted averageassumptions used to determine benefit obligations at December 31, 2008 and2007 were:

 
| ** **    | ** ** | **December 31,** | ** ** |
|---------------|------------|-----------------------|------------|
| ** **    | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Discount rate |       | 5.665                 | %          | 5.750 | % |

 

The weighted averageassumptions used to determine net periodic benefit cost for the years ended December 31,2008 and 2007 were:

 
| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Discount rate                                    |       | 5.750                 | %          | 5.096 | % |
| Expected long-term rate of return on plan assets |       | 5.750                 | %          | 5.400 | % |

 

OneBeacon’s discount rateassumptions used to account for the Qualified and Non-qualified Plans reflectthe rates at which the benefit obligations could be effectively settled. For2008 and 2007, in addition to consideration of published yields for highquality long-term corporate bonds, U.S. Treasuries and quotes on insurancecompany annuity contracts, consideration was given to a cash flow matchinganalysis utilizing the Citigroup Pension Discount Curve and Liability Index.

 

OneBeacon performed ananalysis of expected long-term rates of return based on the allocation of itspension plan assets at December 31, 2007 and 2006 to develop expectedrates of return for 2008 and 2007 for each significant asset class or economicindicator. A range of returns was developed based both on forecasts and onbroad-market historical benchmarks for expected return, correlation, andvolatility for each asset class.

 

***Plan Assets***

 

OneBeacon’s pension plans’asset allocations at December 31, 2008 and 2007, by asset category were asfollows:

 
| ** **                      | ** ** | **Plan Assets at December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| **Asset Category**              | ** ** | **2008**                             | ** ** | **2007** | ** ** |
| Fixed maturity investments      |       | 7                                    | %          | 19 | % |
| Common equity securities        |       | 38                                   |       | 24 |   |
| Convertible securities          |       | 43                                   |       | 50 |   |
| Cash and short-term investments |       | 12                                   |       | 7 |   |
| Total                           |       | 100                                  | %          | 100 | % |

 

The majority of the Plans’assets are managed by WM Advisors, a subsidiary of White Mountains, andProspector Partners, LLC (“Prospector”), both related parties (seeNote 18). The investment policy places an emphasis on preserving investedassets through a diversified portfolio of high-quality income producinginvestments and equity investments.

 

The investment managementprocess integrates the risks and returns available in the investment arena withthe risks and returns available to the Plans in establishing the properallocation of invested assets. The asset classes include fixed income, equity,convertible securities, and cash and cash equivalents. The factors examined inestablishing the appropriate investment mix include the outlook for risk andreturn in the various investment markets and sectors, and the long-term needfor capital growth.

 

***Cash Flows***

 

OneBeacon does not expect tomake a contribution to its Qualified Plan in 2009. OneBeacon anticipatescontributing $2.7 million to the Non-qualified Plan, for which OneBeacon hasassets held in rabbi trusts.

 

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The following benefit payments,which reflect expected future service, as appropriate, are expected to be paid:

 
| ** ** | ** ** | **Expected Benefit  Payments** | ** ** |
|------------|------------|--------------------------------|------------|
| ** ** | ** ** | **($ in millions)**       | ** ** |
| 2009       |       | $                              | 5.3        |   |
| 2010       |       | 5.7                            |       |
| 2011       |       | 6.1                            |       |
| 2012       |       | 6.5                            |       |
| 2013       |       | 6.9                            |       |
| 2014-2018  |       | 39.6                           |       |
|            |            |                                |            |  |

 

***Other Benefit Plans***

 

OneBeacon sponsors anemployee savings plan (defined contribution plan) covering the majority ofemployees. The contributory plan provides qualifying employees with matchingcontributions of 50% of the first 6% of salary (subject to federal limits onallowable contributions in a given year). Total expense for the plan was $4.7million, $3.7 million and $4.9 million in the years ended December 31,2008, 2007 and 2006, respectively. The employee savings plan includes anemployee stock ownership component. See Note 10.

 

OneBeacon had apost-employment benefit liability of $8.0 million and $9.0 million relatedto its long-term disability plan at December 31, 2008 and 2007,respectively.

 

**NOTE 10. Employee Share-Based Incentive Compensation Plans**

 

OB Holdings’ share-basedcompensation plans consist of performance shares. OB Holdings’ share-basedcompensation plans are designed to maximize shareholder value over long periodsof time by aligning the financial interests of its management with those of itsowners. OBIG’s board of directors (the “Board”) believes that share-basedcompensation for its key employees should be payable in full only if OBIGachieves superior returns for its owners. Performance shares are payable onlyupon achievement of pre-defined business goals and are valued based on themarket value of OBIG’s common shares at the time awards are earned. See “PerformanceShares” below. Performance shares are typically paid in cash, though, in someinstances, they may be paid in common shares or may be deferred in accordancewith the terms of OneBeacon Insurance Company’s (“OBIC”) deferred compensationplans. OB Holdings expenses the full cost of all its share-based compensation.As a result, OB Holdings’ calculation of such return includes the full expenseof all outstanding share-based compensation awards.

 

OB Holdings records itshare-based compensation in accordance with SFAS No. 123(R), “Share-BasedPayment” (“SFAS 123R”), which is a revision to SFAS No. 123, “Accountingfor Stock Based Compensation” (“SFAS 123”) and supersedes AccountingPrinciples Board Opinion (“APB”) No. 25, “Accounting for Stock Issued toEmployees” (“APB 25”). SFAS 123R applies to new grants of share-basedawards, awards modified after the effective date and the remaining portion ofthe fair value of the unvested awards. The unvested portion of OB Holdingsperformance share awards, as well as new awards, are subject to the fair valuemeasurement and recognition requirements of SFAS 123R.

 

***OneBeacon Long-Term Incentive Plan(the “Incentive Plan”)***

 

The Incentive Plan providesfor granting various types of share-based incentive awards includingperformance shares, performance units, options, share appreciation rights andrestricted shares to certain key employees of OB Holdings. The Incentive Planwas adopted by the Board in October 2006. Prior to adoption of theIncentive Plan, share-based awards were granted under the OneBeacon Phantom WTMShare Plan. In 2007, the Board and shareholders approved the 2007 OneBeaconLong-Term Incentive Plan (the “2007 Incentive Plan”). The 2007 Incentive Planprovides for all of the awards referenced above as well as restricted stockunits.  Awards are granted under the 2007Incentive Plan.

 

***Performance Shares &Phantom Performance Shares***

 

Performance shares areconditional grants of a specified maximum number of common shares or anequivalent amount of cash. Phantom shares are much like performance shares butsettle only in cash. In general, grants are earned, subject to the attainmentof pre-specified performance goals, at the end of a three-year period or asotherwise determined by the Compensation Committee of the Board (the “CompensationCommittee”) and are valued based on the market value of 

 

 

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common shares at the time awards are paid.Results that significantly exceed pre-specified targets can result in aperformance share payout of up to 200% of value whereas results significantlybelow target result in no payout.

 

Through 2006, the principalperformance share goal had been White Mountains’ after tax corporate return onequity as measured by growth in its intrinsic value per share. In determiningintrinsic value per share, White Mountains’ Compensation Committee of its boardof directors had considered the White Mountains’ growth in economic value pershare with some attention to growth in tangible book value per share and growthin market value per share. This proprietary measure was viewed by WhiteMountains’ and OB Holdings’ management as being an objective and conservativemeasure of the value of White Mountains’ stock and included the cost of alloutstanding compensation awards.

 

Prior to February 2007,the value of OB Holdings’ performance shares was based upon the market price ofan underlying White Mountains common share (“WTM Performance Shares”). In February 2007,all of OB Holdings’ WTM Performance Shares outstanding were replaced withperformance shares whose value is based upon the market price of an underlyingOBIG common share (“OB Performance Shares”).

 

For awards granted in February 2007,the Compensation Committee defined growth in intrinsic business value per share(“GIBVPS”) to be a weighted measure comprised of growth in OBIG’s adjusted bookvalue per share, underwriting return on equity and growth in OBIG’s commonprice per share.

 

For awards granted in February 2008,the Compensation Committee defined GIBVPS to be a weighted measure comprised ofgrowth in OBIG’s adjusted book value per share and underwriting return onequity.

 

The following summarizesperformance share activity for OB Performance Shares for the years ended December 31,2008 and 2007:

 
| ** **                                        | ** ** | **Year ended December 31,**           | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                        | ** ** | **2007** | ** ** |
| ** **                                        | ** ** | **Target OB  Performance  Shares  outstanding** | ** ** | **Accrued  expense** | ** ** | **Target OB  Performance  Shares  outstanding** | ** ** | **Accrued  expense** | ** ** |
| ** **                                        | ** ** | **($ in millions)**                   | ** ** |
| Beginning of period                               |       | 1,058,194                                       |       | $ | 9.2 |   | — |   | $ | — |   |
| Payments and deferrals (1)                        |       | (117,363                                        | )          | (1.6 | ) | — |   | — |   |
| New awards                                        |       | 1,430,258                                       |       | — |   | 934,131 |   | — |   |
| Forfeitures and net change in assumed forfeitures |       | (158,776                                        | )          | (0.6 | ) | (158,638 | ) | (0.2 | ) |
| Transfers in (2)                                  |       | —                                          |       | — |   | 282,701 |   | 4.1 |   |
| (Income) expense recognized                       |       | —                                          |       | (2.4 | ) | — |   | 5.3 |   |
| End of period                                     |       | 2,212,313                                       |       | $ | 4.6 |   | 1,058,194 |   | $ | 9.2 |   |

----

(1)                                 Performanceshare payments in 2008 for the 2007 performance cycle were based upon aperformance factor of 63%.

 

(2)                                  In February 2007,OB Holdings’  WTM Performance Shares werereplaced with OB Performance Shares of an equivalent value.

 

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The following summarizesperformance share activity for WTM Performance Shares for the years ended December 31,2007 and 2006:

 
| ** **                                        | ** ** | **Year ended December 31,**                   | ** ** |
|---------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                        | ** ** | **2007**                                           | ** ** | **2006** | ** ** |
| ** **                                        | ** ** | **Target   WTM  Performance  Shares  outstanding** | ** ** | **Accrued  expense** | ** ** | **Target   WTM  Performance  Shares  outstanding** | ** ** | **Accrued  expense** | ** ** |
| ** **                                        | ** ** | **($ in millions)**                           | ** ** |
| Beginning of period                               |       | 16,058                                             |       | $ | 7.8 |   | 10,650 |   | $ | 7.1 |   |
| Payments and deferrals (1)(2)                     |       | (4,400                                             | )          | (3.7 | ) | — |   | (3.8 | ) |
| New awards                                        |       | —                                             |       | — |   | 11,360 |   | — |   |
| Forfeitures and net change in assumed forfeitures |       | 412                                                |       | — |   | (412 | ) | (0.1 | ) |
| Transfers out (3)(4)                              |       | (12,070                                            | )          | (4.1 | ) | (5,540 | ) | (1.2 | ) |
| Expense recognized                                |       | —                                             |       | — |   | — |   | 5.8 |   |
| End of period                                     |       | —                                             |       | $ | — |   | 16,058 |   | $ | 7.8 |   |

----

(1)                                  Performanceshare payments in 2007 for the 2004-2006 performance cycle were based upon aperformance factor of 145%.

 

(2)                                  Performanceshare payments in 2006 for the 2003-2005 performance cycle were based upon aperformance factor of 142%.

 

(3)                                  In February 2007,OB Holdings’ WTM Performance Shares were replaced with OB Performance Shares ofan equivalent value.

 

(4)                                  Represents the2006 transfer of employee liabilities associated with business formerly held byOB Holdings that were unrelated to its ongoing operations.

 

The following summarizesperformance shares outstanding and accrued performance share expense at December 31,2008 for each performance cycle:

 
| ** **                      | ** ** | **Target OB  Performance  Shares  outstanding** | ** ** | **Accrued  expense** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|----------------------|------------|
| ** **                      | ** ** | **($ in millions)**                        | ** ** |
| Performance cycle:              |       |                                            |       |                 |       |
| 2007—2008                  |       | 137,400                                         |       | $                    | —     |   |
| 2007—2009                  |       | 763,748                                         |       | —               |       |
| 2008—2010                  |       | 1,367,379                                       |       | 4.7                  |       |
| Sub-total                       |       | 2,268,527                                       |       | 4.7                  |       |
| Assumed forfeitures             |       | (56,214                                         | )          | (0.1                 | )          |
| Total at December 31, 2008 |       | 2,212,313                                       |       | $                    | 4.6        |   |

 

If 100% of the outstandingperformance shares had been vested on December 31, 2008, the totaladditional compensation cost to be recognized would have been$9.3 million, based on current accrual factors (OBIG’s common share priceand payout assumptions).

 

All performance sharesearned for the 2007 and the 2004-2006 performance cycles were settled in cashor by deferral into certain non-qualified deferred compensation plans of theCompany’s subsidiaries.

 

At December 31, 2008,1,367,379, 763,748 and 137,400 performance shares had been granted at targetand remained outstanding under the 2007 Incentive Plan for the performanceperiods 2008-2010, 2007-2009 and 2007-2008, respectively.

 

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The targeted performancegoal for full payment of the outstanding performance shares granted during theyears ended December 31, 2007 and 2006 is the attainment of a GIBVPS of13%. At a GIBVPS of 6% or less, no performance shares would be earned and at aGIBVPS of 20% or more, 200% of performance shares would be earned. The targetedperformance goal for full payment of the outstanding performance shares grantedduring 2008 is the attainment of a GIBVPS of 11%. At a GIBVPS of 4% or less, noperformance shares would be earned and at a GIBVPS of 18% or more, 200% ofperformance shares would be earned.

 

At December 31, 2008,there were 0 phantom performance shares outstanding under the Incentive Plan orthe 2007 Incentive Plan for the three-year performance periods beginning 2007and 2006, respectively. During 2006, no performance shares were earned underthe Incentive Plan.

 

***Other Share-Based Compensation***

 

OBIC, an indirectwholly-owned subsidiary of the Company, sponsors a defined contribution plan,the OneBeacon 401(k) Savings and Employee Stock Ownership Plan (“KSOP”),formerly known separately as the OneBeacon 401(k) Savings Plan (“401(k) Plan”)and the OneBeacon Employee Stock Ownership Plan (“ESOP”). In April 2007,the two plans were merged to form the KSOP. Under the KSOP, participants havethe ability to invest their balances in several different investment options,including the common shares of White Mountains and subsequent to OBIG’s initialpublic offering, the common shares of OBIG.

 

The employee stock ownershipcomponent of the KSOP provides all participants with an annual basecontribution in common shares (common shares of White Mountains prior to 2007,and beginning in 2007, common shares of OBIG) equal to 3% of their salary, upto the applicable Social Security wage base (or $102,500 with respect to 2008).Additionally, those participants not otherwise eligible to receive certainother OneBeacon benefits can earn a variable contribution up to an additional6% of their salary, capped at the annual covered compensation limits ($230,000for 2008), contingent upon OneBeacon’s performance. The variable contributionamounts earned by eligible participants constituted approximately 4%, 6% and 6%of salary for the years ended December 31, 2008, 2007 and 2006,respectively. OneBeacon has recorded $11.5 million, $15.4 million and$15.5 million in compensation expense to pay benefits and allocate commonshares to participants’ accounts for the years ended December 31, 2008,2007 and 2006, respectively.

 

In connection with OBIG’sinitial public offering, four common shares of OBIG’s common stock were awardedto each employee and deposited into participant employee stock ownershipaccounts. A total of 13,292 shares were awarded and an expense of$0.3 million was recognized in 2006.

 

As of December 31, 2008and 2007, the KSOP owned 1% or less of either of the total White Mountainscommon shares outstanding or the total OBIG shares outstanding.

 

As of December 31,2008, there were no outstanding share appreciation rights or restricted shareawards.

 

**NOTE 11. Mandatorily Redeemable Preferred Stock**

 

***Mandatorily Redeemable PreferredStock***

 

OBH held mandatorilyredeemable preferred stock prior to its redemption in May 2008. Thisinstrument was classified as a liability and carried at its historical carryingvalue. Dividends and accretion on OBH’s mandatorily redeemable preferred stockwere recorded as interest expense. During the years ended December 31,2008, 2007 and 2006, OBH recorded $33.4 million, $64.4 million and$56.6 million, respectively, as interest expense on preferred stock (ofwhich $21.6 million, $36.1 million and $28.3 million, respectively,represented accretion of discount).

 

*Berkshire Preferred Stock*

 

As part of the financing forthe OneBeacon Acquisition, Berkshire invested a total of $300 million incash, of which (1) $225 million was for the purchase of cumulativenon-voting preferred stock of OBH (the “Berkshire Preferred Stock”), which hasa $300 million redemption value; and (2) $75 million was for thepurchase of warrants to acquire 1,724,200 common shares of White Mountains. TheBerkshire Preferred Stock was entitled to a dividend of no less than 2.35% perquarter until it was redeemed on May 31, 2008 for $300.0 million, itsredemption value. The Berkshire Preferred Stock was initially recorded at$145.2 million, as the aggregate proceeds received from Berkshire of$300 million were allocated between the Berkshire Preferred Stock and thewarrants, based on their relative fair values in accordance with APB No. 14,

 

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“Accounting for Convertible Debt and DebtIssued with Stock Purchase Warrants”. During the years ended December 31,2008, 2007 and 2006, OBH declared and paid dividends of $11.8 million,$28.3 million and $28.3 million on the Berkshire Preferred Stock andrecorded $21.6 million, $36.1 million and $28.3 million, respectively,of related accretion charges.

 

As described in Note 1,in connection with OBIG’s initial public offering and as part of thereorganization, the Company created an irrevocable grantor trust and funded itwith assets sufficient to make the remaining dividend and redemption paymentsfor the $300 million Berkshire Preferred Stock. The creation and fundingof the trust did not legally defease the preferred stock or create anyadditional rights for the holders of the preferred stock, although the assetsin the trust were segregated from the Company’s other general assets and werenot available for any use other than the payment of the Berkshire PreferredStock. The assets held in trust were used to redeem the Berkshire PreferredStock in May 2008 for $300.0 million, its redemption value.

 

**NOTE 12.  CommonShareholder’s Equity**

 

*Adjustments to Adopt AccountingPronouncements*

 

On January 1, 2008, OBHoldings adopted SFAS 159. See Note 1 for further discussion. Upon adoption, OBHoldings recorded an adjustment of $182.4 million to reclassify net unrealizedgains, after tax, and net unrealized foreign currency translation gains, aftertax, related to investments from accumulated other comprehensive income toopening retained earnings.

 

On January 1, 2007, OBHoldings adopted FIN 48.  See Note 8 forfurther discussion.  Upon adoption, OBHoldings recognized a $0.3 million increase in the liability forunrecognized tax benefits, primarily as a result of increases in its estimatesof accrued interest. The effect of adoption has been recorded as an adjustmentto opening retained earnings.

 

On December 31, 2006,OB Holdings adopted SFAS 158.  SeeNote 1 for further discussion.  As aresult, OB Holdings recognized the over-funded status of its projected benefitobligation related to the Qualified Plan increasing the asset on its balancesheet by $8.8 million and recognizing a $5.7 million after taxadjustment to accumulated other comprehensive (loss) income at December 31,2006.

 

On January 1, 2006, OBHoldings adopted SFAS 155.  See Note 1for further discussion.  Upon adoption ofSFAS 155, OB Holdings recorded an after tax adjustment of$7.1 million to reclassify net unrealized gains on investments (grossgains of $11.0 million and gross losses of $0 million) to openingretained earnings to reflect the cumulative effect of adoption.

 

*Dividends*

 

During 2008, OBH declaredand paid dividends to its immediate parent, OneBeacon U.S. Enterprises Holdings, Inc.(“OBEH”), formerly known as Fund American Enterprises Holdings, Inc.,totaling $219.9 million, all of which was paid in cash. During 2007, OBHdeclared and paid dividends to OBEH totaling $195.0 million, of which$93.4 million was paid in cash. During 2006, OBH declared and paiddividends to OBEH totaling $38.0 million, of which $4.5 million waspaid in cash.

 

*Distributions and Contributions*

 

During 2006, OB Holdingssold one of its inactive licensed subsidiaries, HCIC, to a subsidiary of WhiteMountains. In connection with the sale of HCIC, OB Holdings recorded a$6.0 million gain as additional paid in capital.

 

*AccumulatedOther Comprehensive (Loss) Income*

 

For the years ended December 31,2008, 2007 and 2006, OB Holdings recorded the after tax change in the fairvalue of the interest rate swap related to the mortgage loan of $(5.7) million,$(1.1) million and $0.6 million, respectively as a change to accumulatedother comprehensive (loss) income.  SeeNote 7 for further information.

 

For the years ended December 31,2008, 2007 and 2006, OB Holdings recorded the after tax change in itsadditional pension liability of $(19.5) million, $(0.1) and $(0.2) million,respectively as a change to accumulated other comprehensive (loss) income.  See Note 9 for further information.

 

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Prior to the adoption ofSFAS 159, OB Holdings recorded the change in net unrealized gains and losses oninvestments and the change in foreign currency translation on its foreigninvestment securities as a component of accumulated other comprehensive (loss)income.  For the years ended December 31,2007 and 2006, OB Holdings recorded the after tax change in net unrealizedgains and losses on investments of $(3.2) million and $17.1 million,respectively, and the change in foreign currency translation on its foreigninvestment securities of $0.5 million and $13.1 million, respectively.  See Note 6.

 

**NOTE 13. Statutory Capital and Surplus**

 

OB Holdings’ insurance operationsare subject to regulation and supervision in each of the jurisdictions wherethey are domiciled and licensed to conduct business. Generally, regulatoryauthorities have broad supervisory and administrative powers over such mattersas licenses, standards of solvency, premium rates, policy forms, investments,security deposits, methods of accounting, form and content of financialstatements, reserves for unpaid loss and LAE, reinsurance, minimum capital andsurplus requirements, dividends and other distributions to shareholders,periodic examinations and annual and other report filings. In general, suchregulation is for the protection of policyholders rather than shareholders.Over the last several years most states have implemented laws that establishstandards for current, as well as continued, state accreditation. In addition,the National Association of Insurance Commissioners uses risk-based capital (“RBC”)standards for property and casualty insurers as a means of monitoring certainaspects affecting the overall financial condition of insurance companies. At December 31,2008, OB Holdings’ active insurance operating subsidiaries met their respectiveRBC requirements.

 

OB Holdings’ combinedinsurance subsidiaries’ policyholders’ surplus as reported to variousregulatory authorities as of December 31, 2008 and 2007, was $1.4 billionand $1.9 billion, respectively. OB Holdings’ consolidated combinedstatutory net (loss) income for the years ended December 31, 2008, 2007and 2006 was $(156.5) million, $335.2 million and $372.0 million,respectively. The principal differences between OB Holdings’ combined statutoryamounts and the amounts reported in accordance with GAAP include deferredacquisition costs, deferred taxes, gains recognized under retroactivereinsurance contracts, market value adjustments for debt securities andrecognition of pension plans. OB Holdings’ combined insurance subsidiaries’statutory policyholders’ surplus at December 31, 2008 was in excess of theminimum requirements of relevant state insurance regulations.

 

In December 2008,OneBeacon Insurance Group LLC (“OneBeacon LLC”) contributed$25 million to OBIC.

 

***Dividend Capacity***

 

Under the insurance laws ofthe states and jurisdictions under which OB Holdings’ insurance operating subsidiariesare domiciled, an insurer is restricted with respect to the timing or theamount of dividends it may pay without prior approval by regulatoryauthorities. Accordingly, there can be no assurance regarding the amount ofsuch dividends that may be paid by such subsidiaries in the future.

 

Generally, OB Holdings’regulated insurance operating subsidiaries have the ability to pay dividendsduring any twelve month period in an amount equal to the greater of prior yearstatutory net income or 10% of prior year end statutory surplus, subject to theavailability of unassigned funds. Based upon 2008 statutory surplus OB Holdings’top tier regulated insurance operating subsidiaries have the ability to payapproximately $136 million of dividends during 2009,  subject to the availability of unassignedfunds. As of December 31, 2008, OB Holdings’ top tier regulated insuranceoperating subsidiaries had approximately $0.9 billion of unassigned funds.As of December 31, 2008, OB Holdings had $81.5 million of unrestrictednet cash and fixed maturity investments outside of its regulated insuranceoperating subsidiaries.

 

During the year ended December 31,2008, OB Holdings’ regulated operating subsidiaries paid $197.0 million ofdividends to OneBeacon LLC. Also, during 2008, OB Holdings’ unregulatedoperating subsidiaries declared and paid $6.0 million of dividends totheir immediate parent.

 

 OBH’s ability to declare or pay dividends hadbeen limited by the terms of the Series A Preferred Stock issued toBerkshire. OBH may not, in certain circumstances, declare or pay any dividendor distribution to any other class or series of stock without the consent ofthe holders of a majority of outstanding shares of the Berkshire PreferredStock. Under the terms of a Keep-Well Agreement dated November 30, 2004between White Mountains and OBH (the “Keep-Well”), White Mountains had agreedto return to OBH up to approximately $1.1 billion if some or all of thatamount was required by OBH to meet its obligations under the terms of theBerkshire Preferred Stock. As described below, the Keep-Well has expired. Underthe Keep-Well, White Mountains had to make any required contributions to OBHprior to making any distributions to its shareholders. The aggregate amount ofdistributions that White Mountains could make to its shareholders was limited;the limit increased or decreased by an amount equal to White Mountains’consolidated net income or loss over the remaining life 

 

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of the Keep-Well. The Keep-Well expired whenall obligations of the Berkshire Preferred Stock were satisfied upon itsredemption in May 2008. See Note 1 and Note 11 for discussion ofthe creation and funding of an irrevocable grantor trust to economicallydefease the Berkshire Preferred Stock.

 

**NOTE 14. Segment Information**

 

OB Holdings’ segmentsconsist of the following: (1) Primary Insurance Operations, (2) AffiliateQuota Shares and (3) Other Operations. OB Holdings has made its segmentdetermination based on consideration of the following criteria: (i) thenature of the business activities of each of the Company’s subsidiaries andaffiliates; (ii) the manner in which the Company’s subsidiaries andaffiliates are organized; (iii) the existence of primary managersresponsible for specific subsidiaries and affiliates; and (iv) theorganization of information provided to the Board. Significant intercompanytransactions among OB Holdings’ segments have been eliminated herein. Financialinformation for OB Holdings’ segments follows:

 
| ** **                                                          | ** ** | **Primary  Insurance  Operations** | ** ** | **Affiliate  Quota  Shares(1)** | ** ** | **Other  Operations** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------------|------------|------------------------------------|------------|---------------------------------|------------|-----------------------|------------|-----------|------------|
| ** **                                                          | ** ** | **($ in millions)**           | ** ** |
| **Year ended December 31, 2008**                               |       |                               |       |                            |       |                  |       |      |       |
| Earned premiums                                                     |       | $                                  | 1,879.0    |                            | $          | —                |       | $         | —     |   | $ | 1,879.0 |   |
| Net investment income                                               |       | 152.8                              |       | —                          |       | 9.3                   |       | 162.1     |       |
| Net realized investment losses                                      |       | (317.9                             | )          | —                          |       | (0.7                  | )          | (318.6    | )          |
| Change in net unrealized investment gains and losses                |       | (442.6                             | )          | —                          |       | (4.8                  | )          | (447.4    | )          |
| Net other revenues (expenses)                                       |       | 14.0                               |       | —                          |       | (0.2                  | )          | 13.8      |       |
| Total revenues                                                      |       | 1,285.3                            |       | —                          |       | 3.6                   |       | 1,288.9   |       |
| Loss and LAE                                                        |       | 1,126.2                            |       | —                          |       | —                |       | 1,126.2   |       |
| Policy acquisition expenses                                         |       | 368.3                              |       | —                          |       | —                |       | 368.3     |       |
| Other underwriting expenses                                         |       | 290.8                              |       | —                          |       | —                |       | 290.8     |       |
| General and administrative expenses                                 |       | 12.2                               |       | —                          |       | 0.7                   |       | 12.9      |       |
| Accretion of fair value adjustment to loss and LAE reserves         |       | —                             |       | —                          |       | 12.0                  |       | 12.0      |       |
| Interest expense on debt                                            |       | 3.5                                |       | —                          |       | 41.4                  |       | 44.9      |       |
| Interest expense-on preferred stock subject to mandatory redemption |       | —                             |       | —                          |       | 33.4                  |       | 33.4      |       |
| Total expenses                                                      |       | 1,801.0                            |       | —                          |       | 87.5                  |       | 1,888.5   |       |
| Pre-tax loss                                                        |       | $                                  | (515.7     | )                               | $          | —                |       | $         | (83.9      | ) | $ | (599.6 | ) |
| **Year ended December 31, 2007**                               |       |                               |       |                            |       |                  |       |      |       |
| Earned premiums                                                     |       | $                                  | 1,873.6    |                            | $          | —                |       | $         | —     |   | $ | 1,873.6 |   |
| Net investment income                                               |       | 184.5                              |       | —                          |       | 17.9                  |       | 202.4     |       |
| Net realized investment gains (losses)                              |       | 174.5                              |       | —                          |       | (1.4                  | )          | 173.1     |       |
| Change in net unrealized investment gains and losses                |       | —                             |       | —                          |       | —                |       | —    |       |
| Net other revenues (expenses)                                       |       | 19.2                               |       | —                          |       | (2.0                  | )          | 17.2      |       |
| Total revenues                                                      |       | 2,251.8                            |       | —                          |       | 14.5                  |       | 2,266.3   |       |
| Loss and LAE                                                        |       | 1,089.8                            |       | —                          |       | —                |       | 1,089.8   |       |
| Policy acquisition expenses                                         |       | 318.9                              |       | —                          |       | —                |       | 318.9     |       |
| Other underwriting expenses                                         |       | 329.4                              |       | —                          |       | —                |       | 329.4     |       |
| General and administrative expenses                                 |       | 2.9                                |       | —                          |       | 0.3                   |       | 3.2       |       |
| Accretion of fair value adjustment to loss and LAE reserves         |       | —                             |       | —                          |       | 16.0                  |       | 16.0      |       |
| Interest expense on debt                                            |       | 3.2                                |       | —                          |       | 42.0                  |       | 45.2      |       |
| Interest expense-on preferred stock subject to mandatory redemption |       | —                             |       | —                          |       | 64.4                  |       | 64.4      |       |
| Total expenses                                                      |       | 1,744.2                            |       | —                          |       | 122.7                 |       | 1,866.9   |       |
| Pre-tax income (loss)                                               |       | $                                  | 507.6      |                            | $          | —                |       | $         | (108.2     | ) | $ | 399.4 |   |

 

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| ** **                                                          | ** ** | **Primary  Insurance  Operations** | ** ** | **Affiliate  Quota  Shares(1)** | ** ** | **Other  Operations** | ** ** | **Total**  | ** ** |
|---------------------------------------------------------------------|------------|------------------------------------|------------|---------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                                                          | ** ** | **($ in millions)**           | ** ** |
| **Year ended December 31, 2006**                               | ** ** | ** **                         | ** ** | ** **                      | ** ** | ** **            | ** ** | ** ** | ** ** |
| Earned premiums                                                     |       | $                                  | 1,944.0    |                            | $          | 131.9                 |       | $          | —     |   | $ | 2,075.9 |   |
| Net investment income                                               |       | 182.3                              |       | —                          |       | 5.3                   |       | 187.6      |       |
| Net realized investment gains (losses)                              |       | 165.3                              |       | —                          |       | (1.6                  | )          | 163.7      |       |
| Change in net unrealized investment gains and losses                |       | —                             |       | —                          |       | —                |       | —     |       |
| Net other revenues                                                  |       | 21.8                               |       | —                          |       | 5.6                   |       | 27.4       |       |
| Total revenues                                                      |       | 2,313.4                            |       | 131.9                           |       | 9.3                   |       | 2,454.6    |       |
| Loss and LAE                                                        |       | 1,180.3                            |       | 103.3                           |       | —                |       | 1,283.6    |       |
| Policy acquisition expenses                                         |       | 332.3                              |       | 47.6                            |       | —                |       | 379.9      |       |
| Other underwriting expenses                                         |       | 360.1                              |       | —                          |       | —                |       | 360.1      |       |
| General and administrative expenses                                 |       | 3.3                                |       | —                          |       | 6.5                   |       | 9.8        |       |
| Accretion of fair value adjustment to loss and LAE reserves         |       | —                             |       | —                          |       | 23.0                  |       | 23.0       |       |
| Interest expense on debt                                            |       | 2.9                                |       | —                          |       | 42.6                  |       | 45.5       |       |
| Interest expense-on preferred stock subject to mandatory redemption |       | —                             |       | —                          |       | 56.6                  |       | 56.6       |       |
| Total expenses                                                      |       | 1,878.9                            |       | 150.9                           |       | 128.7                 |       | 2,158.5    |       |
| Pre-tax income (loss)                                               |       | $                                  | 434.5      |                            | $          | (19.0                 | )          | $          | (119.4     | ) | $ | 296.1 |   |
| **December 31, 2008**                                          | ** ** | ** **                         | ** ** | ** **                      | ** ** | ** **            | ** ** | ** ** | ** ** |
| Total investments                                                   |       | $                                  | 3,653.3    |                            | $          | —                |       | $          | 71.4       |   | $ | 3,724.7 |   |
| Reinsurance recoverable on paid and unpaid losses                   |       | 2,730.1                            |       | —                          |       | (205.1                | )          | 2,525.0    |       |
| Total assets                                                        |       | 7,962.7                            |       | —                          |       | (100.7                | )          | 7,862.0    |       |
| Loss and LAE reserves                                               |       | 4,504.5                            |       | —                          |       | (210.5                | )          | 4,294.0    |       |
| Total liabilities                                                   |       | 6,259.0                            |       | —                          |       | 469.6                 |       | 6,728.6    |       |
| Total equity                                                        |       | 1,703.7                            |       | —                          |       | (570.3                | )          | 1,133.4    |       |
| **December 31, 2007**                                          | ** ** | ** **                         | ** ** | ** **                      | ** ** | ** **            | ** ** | ** ** | ** ** |
| Total investments                                                   |       | $                                  | 4,525.9    |                            | $          | —                |       | $          | 480.0      |   | $ | 5,005.9 |   |
| Reinsurance recoverable on paid and unpaid losses                   |       | 2,872.5                            |       | —                          |       | (221.1                | )          | 2,651.4    |       |
| Total assets                                                        |       | 9,114.8                            |       | —                          |       | 252.2                 |       | 9,367.0    |       |
| Loss and LAE reserves                                               |       | 4,718.8                            |       | —                          |       | (238.5                | )          | 4,480.3    |       |
| Total liabilities                                                   |       | 6,843.1                            |       | —                          |       | 740.7                 |       | 7,583.8    |       |
| Total equity                                                        |       | 2,271.7                            |       | —                          |       | (488.5                | )          | 1,783.2    |       |

 

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(1)                                  The affiliatequota share agreements were commuted during the fourth quarter of 2006.

 

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The following tables provideratios, net written premiums and earned premiums for OB Holdings’ PrimaryInsurance Operations segment by major underwriting unit and in total for theyears ended December 31, 2008, 2007, and 2006:

 
| ** **                               | ** ** | **Specialty**            | ** ** | **Commercial** | ** ** | **Personal** | ** ** | **Total(1)** | ** ** |
|------------------------------------------|------------|--------------------------|------------|----------------|------------|--------------|------------|--------------|------------|
| ** **                               | ** ** | **($ in millions)** | ** ** |
| **Year ended December 31, 2008**    | ** ** | ** **               | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** |
| Ratios:                                  |       |                     |       |           |       |         |       |         |       |
| Loss and LAE                             |       | 51.1                     | %          | 59.7           | %          | 64.0         | %          | 59.9         | %          |
| Expense                                  |       | 36.4                     |       | 36.7           |       | 31.9         |       | 35.1         |       |
| Total GAAP combined                      |       | 87.5                     | %          | 96.4           | %          | 95.9         | %          | 95.0         | %          |
| Net written premiums                     |       | $                        | 621.9      |           | $          | 722.1        |       | $            | 618.7      |   | $ | 1,963.1 |   |
| Earned premiums                          |       | 512.7                    |       | 725.2          |       | 640.8        |       | 1,879.0      |       |
| **Year ended December 31, 2007**(2) |       |                     |       |           |       |         |       |         |       |
| Ratios:                                  |       |                     |       |           |       |         |       |         |       |
| Loss and LAE (3)                         |       | 37.7                     | %          | 50.7           | %          | 57.2         | %          | 58.2         | %          |
| Expense                                  |       | 30.3                     |       | 37.4           |       | 33.6         |       | 34.6         |       |
| Total GAAP combined (3)                  |       | 68.0                     | %          | 88.1           | %          | 90.8         | %          | 92.8         | %          |
| Net written premiums                     |       | $                        | 440.3      |           | $          | 733.4        |       | $            | 690.4      |   | $ | 1,864.4 |   |
| Earned premiums                          |       | 433.3                    |       | 715.2          |       | 725.0        |       | 1,873.6      |       |
| **Year ended December 31, 2006**(2) | ** ** | ** **               | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** |
| Ratios:                                  |       |                     |       |           |       |         |       |         |       |
| Loss and LAE                             |       | 54.6                     | %          | 56.0           | %          | 63.5         | %          | 60.7         | %          |
| Expense                                  |       | 33.8                     |       | 39.4           |       | 32.4         |       | 35.6         |       |
| Total GAAP combined                      |       | 88.4                     | %          | 95.4           | %          | 95.9         | %          | 96.3         | %          |
| Net written premiums                     |       | $                        | 433.9      |           | $          | 722.0        |       | $            | 800.6      |   | $ | 1,957.6 |   |
| Earned premiums                          |       | 431.7                    |       | 689.9          |       | 822.3        |       | 1,944.0      |       |

 

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(1)                                 Includesresults from run-off.

 

(2)                                 In the firstquarter of 2008, within its Primary Insurance Operations segment, OB Holdingsbegan to include Community Banks within commercial lines. Community Banks wasformerly reported in specialty lines. The reporting change was undertaken tobetter align the reported results of OB Holdings’ underwriting units with theirproduct and management structure. The prior periods have been reclassified toconform to the current presentation.

 

(3)                                 During thefourth quarter of 2007, OB Holdings reallocated reserves from ongoing lines ofbusiness to run-off. This had the effect of lowering the loss and LAE and GAAPcombined ratios for specialty, commercial and personal lines but had no netimpact on overall results.

 

**NOTE 15. Investment in Unconsolidated Affiliate**

 

OB Holdings’ equity inearnings of an unconsolidated affiliate for the year ended December 31,2006 represents an operating investment in MSA in which OB Holdings had asignificant voting and economic interest but did not control the entity.

 

On October 31, 2006, OBHoldings’ investment in MSA was restructured. OB Holdings received a$70 million cash dividend from MSA following which OB Holdings sold its50% common stock investment in MSA to Main Street America Group, Inc. (“theMSA Group”) for (i) $70.0 million in 9.0% non-voting cumulativeperpetual preferred stock of the MSA Group and (ii) 4.9% of the commonstock of the MSA Group. See Note 3 for discussion. Effective October 31,2006 and prior to the adoption of SFAS 159, OB Holdings accounted for itsremaining investment in the MSA Group in accordance with SFAS 115. Priorto the sale, OB Holdings owned 50% of the total common shares outstanding ofMSA and accounted for this investment using the equity method of accounting.These transactions resulted in a net after tax realized gain of $8.5 million.

 

Prior to the exchange of OBHoldings’ common stock investment in MSA, OB Holdings accounted for thisinvestment using the equity method of accounting. The following table providessummary financial amounts recorded by OB Holdings under the equity method relatingto its investment in MSA common stock.

 

| ** **                                                                               | ** ** | **2006**                 | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                               | ** ** | **($ in millions)** | ** ** |
| **Amounts recorded by OB Holdings:**                                                     | ** ** | ** **               | ** ** |
| Investment in MSA common stock.                                                          |       | $                        | —     |   |
| Equity in earnings from MSA common stock (1)                                             |       | 10.3                     |       |
| Equity in unrealized investment gains (losses) from MSA’s investment  portfolio (2) |       | 0.3                      |       |
|                                                                                          |            |                          |            |  |

 

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(1)                                  Equity inearnings amounts are net of taxes of $5.6 million for the ten months endedOctober 31, 2006.

 

(2)                                  Recordeddirectly to common shareholder’s equity (after tax) as a component of othercomprehensive income.

 

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**NOTE 16. Variable Interest Entities**

 

***Reciprocals***

 

Reciprocals arenot-for-profit, policyholder-owned insurance carriers organized asunincorporated associations. Each policyholder insured by the reciprocal sharesrisk with the other policyholders. Policyholders share profits and losses inthe same proportion as the amount of insurance purchased but are not subject toassessment for net losses of the reciprocal.

 

OB Holdings has capitalizedthree reciprocals by loaning funds to them in exchange for surplus notes. In2002, OB Holdings formed New Jersey Skylands Management LLC (“NJSM”) toprovide management services for a fee to New Jersey Skylands InsuranceAssociation, a reciprocal, and its wholly-owned subsidiary New Jersey SkylandsInsurance Company (together, New Jersey Skylands Insurance). New JerseySkylands Insurance was capitalized with a $31.3 million surplus noteissued to OB Holdings in 2002. New Jersey Skylands Insurance began writingpersonal automobile coverage for new customers in August 2002. In 2004, OBHoldings formed Houston General Management Company to provide managementservices for a fee to another reciprocal, Houston General Insurance Exchange.During 2004, OB Holdings contributed $2.0 million of capital to HoustonGeneral Insurance Exchange. In 2005, OB Holdings contributed one of itssubsidiaries, Houston General Insurance Company with assets of$149.4 million and liabilities of $127.6 million, to Houston GeneralInsurance Exchange (together “Houston General Insurance”). Subsequent to thecontribution of Houston General Insurance Company, Houston General InsuranceExchange issued a surplus note of $23.7 million to OB Holdings. In November 2005,Houston General Insurance commenced writing personal automobile business inArizona. In September 2007, OB Holdings notified agents that it planned toseek regulatory approval of a withdrawal plan to cease writing business in allstates where Houston General Insurance Exchange, a reciprocal insuranceexchange, wrote business. In 2006, Adirondack AIF, LLC, a wholly-ownedsubsidiary of OB Holdings, entered into an agreement to provide management servicesfor a fee to Adirondack Insurance Exchange (“Adirondack Insurance”), areciprocal. Adirondack Insurance was capitalized with a $70.7 millionsurplus note issued to OB Holdings in May 2006. Adirondack Insurance beganwriting personal automobile and homeowners business in August 2006.Principal and interest on the surplus notes are repayable to OB Holdings onlywith regulatory approval. The obligation to repay principal on the notes issubordinated to all other liabilities including obligations to policyholdersand claimants for benefits under insurance policies. OB Holdings has noownership interest in New Jersey Skylands Insurance, Houston General Insuranceor Adirondack Insurance.

 

Under the provisions ofFIN 46R, OB Holdings has determined that each of the reciprocals qualifiesas a VIE. Further, OB Holdings has determined that it is the primarybeneficiary and accordingly, consolidates all three reciprocals. New JerseySkylands Insurance was consolidated on March 31, 2004 upon adoption ofFIN 46R and Houston General Insurance Exchange and Adirondack Insurancewere consolidated upon inception.

 

At December 31, 2008and 2007, consolidated amounts related to New Jersey Skylands Insuranceincluded total assets of $119.0 million and $106.0 million, respectively,and total liabilities of $140.3 million and $124.4 million, respectively.At December 31, 2008, the net amount of capital at risk is equal to thesurplus note of $31.3 million less the accumulated losses as of December 31,2008 of $21.3 million which includes accrued interest on the surplus noteof $20.8 million which eliminates in consolidation.

 

At December 31, 2008and 2007, consolidated amounts related to Houston General Insurance includedtotal assets of $142.4 million and $163.3 million, respectively, and totalliabilities of $157.5 million and $174.0 million, respectively. At December 31,2008 the net amount of capital at risk is equal to the surplus note of$23.7 million less the accumulated losses as of December 31, 2008 of$15.1 million which includes accrued interest on the surplus note of $9.8million which eliminates in consolidation.

 

At December 31, 2008and 2007, amounts related to Adirondack Insurance included total assets of$250.3 million and $241.4 million, respectively, and total liabilities of$264.3 million and $252.9 million, respectively. At December 31, 2008the net amount of capital at risk is equal to the surplus note of$70.7 million less the accumulated losses as of December 31, 2008 of$14.0 million which includes accrued interest on the surplus note of $23.3million which eliminates in consolidation.

 

**NOTE 17.  FairValue of Financial Instruments**

 

SFAS No. 107, “Disclosureabout Fair Value of Financial Instruments” (“SFAS 107”), requiresdisclosure of fair value information of financial instruments. For certainfinancial instruments where quoted market prices are not available, otherindependent valuation techniques and assumptions are used. Because considerablejudgment is used, these estimates are not necessarily indicative of amountsthat could be realized in a current market exchange. SFAS 107 excludescertain 

 

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financial instruments from disclosure,including insurance contracts, other than financial guarantees and investmentcontracts. OB Holdings carries its financial instruments on its balance sheetat fair value with the exception of its fixed-rate, long-term indebtedness andits mandatorily redeemable preferred stock.

 

The fair values of theseobligations were estimated by discounting future cash flows using currentmarket rates for similar obligations or using quoted market prices.Considerable judgment is required to develop such estimates of fair value.Therefore, the estimate provided herein is not necessarily indicative of theamounts that could be realized in a current market exchange.

 

At December 31, 2008and 2007, the fair value of OBH’s Senior Notes (its fixed-rate, long-termindebtedness) was $483.3 million and $703.2 million, respectively, whichcompared to a carrying value of $675.1 million and $698.9 million,respectively.

 

The Berkshire PreferredStock was redeemed in the second quarter of 2008 for $300.0 million, itsredemption value. At December 31, 2007, the fair value of the BerkshirePreferred Stock was $307.0 million, which compared to a carrying value of$278.4 million.

 

In December 2005, OBHoldings entered into a mortgage note with a variable interest rate based on30-day LIBOR. At December 31, 2008 and 2007, the carrying value of thenote of $40.8 million was considered to approximate its fair value.

 

In March 2004, OBHoldings issued the Atlantic Specialty Note. At December 31, 2008 and2007, the carrying value of the note of $16.0 million and $18.0 million,respectively, were considered to approximate its fair value.

 

**NOTE 18. Related Party Disclosures**

 

***White Mountains***

 

During the fourth quarter of2006, White Mountains sold 27.6 million or 27.6% of OBIG’s common sharesin an initial public offering. OBIG is the ultimate parent of OBH. Prior toOBIG’s initial public offering, OBH was a wholly-owned subsidiary of WhiteMountains. As of December 31, 2008, White Mountains owned 75.5% of OBIG’soutstanding common shares.

 

*Separation Agreement*

 

In connection with OBIG’sinitial public offering, OBIG entered into a separation agreement dated November 14,2006 with White Mountains (the “Separation Agreement”) to address a number ofoperational, administrative and financial matters relating to the fact thatOBIG would no longer be a wholly-owned subsidiary of White Mountains. Thesematters included, among others, the administration of payroll, employeebenefits programs, deferred compensation and 401(k) plans, OB Holdings’travel and logistics office, certain information technology assets andfunctions and certain agreements with respect to finance and tax arrangements.Pursuant to the Separation Agreement, White Mountains has agreed to indemnifyOBIG and its subsidiaries, including OB Holdings, as well as their current andformer officers, directors and employees to the extent permitted by law, forany and all claims or actions resulting in losses, expenses or damages relatingto or arising out of the business, operation or ownership of any subsidiarycompany or business owned by OBIG or its subsidiaries that, subsequent to OBIG’sownership, was a subsidiary or business of White Mountains (but no longer asubsidiary or business of OBIG).

 

Included within the SeparationAgreement is a provision that indemnifies OBIG from an increase in income taxeswhich result from certain transactions that took place prior to the initialpublic offering (“Tax Make Whole Arrangements”). This provision also statesthat any excess taxes and interest recorded in the contingency reserve will bepayable to White Mountains if a final determination results in less cashpayment to the government for taxes and interest. As of December 31, 2008,the tax and interest expense recorded by OBIG for these items was$49.1 million, net of federal benefit.

 

Prior to entering into theSeparation Agreement, a number of these matters were governed by informalarrangements between OBIG and White Mountains. For the years ended December 31,2008, 2007 and 2006, OB Holdings recorded expenses of $0.7 million,$1.0 million and $10.0 million, respectively and recorded revenues of$2.1 million, $3.3 million and $2.7 million, respectively, forservices under the Separation Agreement that OB Holdings received from orprovided to White Mountains and its subsidiaries.

 

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*Investment Management Agreement with WM Advisors*

 

Prior to OBIG’s initialpublic offering, WM Advisors managed the majority of OB Holdings’investments, including the investments of the employee benefit plan portfolios.Prospector served as a discretionary advisor with respect to certain assets,specifically publicly-traded common equity and convertible securities, througha sub-advisory agreement with WM Advisors.

 

Subsequent to OBIG’s initialpublic offering, under agreements dated as of November 2006 and November 2007,WM Advisors supervises and directs the fixed income and alternativeinvestment portion of OB Holdings’ investment portfolio in accordance with theinvestment objectives, policies and restrictions described in OB Holdings’investment guidelines (the “Investment Guidelines”), as well as the majority ofthe investments of the employee benefit plan portfolios. Under the agreements,WM Advisors has full discretion and authority to make all investmentdecisions in respect of the fixed income and alternative investment portion ofOB Holdings’ investment portfolio as well as the portfolios of the employeebenefit plans on OB Holdings’ behalf and at OB Holdings’ sole risk, and to doanything which WM Advisors deems is required, appropriate or advisable inconnection with the foregoing, subject to and in accordance with InvestmentGuidelines. The assets of OB Holdings’ portfolio as well as the portfolios ofthe employee benefit plans will be held in one or more separately identifiableaccounts in the custody of a bank or similar entity designated by OB Holdingsand acceptable to WM Advisors. OB Holdings is responsible for custodialarrangements and the payment of all custodial charges and fees. Prospectorcontinues to serve as a discretionary advisor with respect to thepublicly-traded common equity and convertible securities of the employeebenefit plan portfolios, through a sub-advisory agreement withWM Advisors, as well as serving as investment advisor to OB Holdings withrespect to its common equity and convertible securities portion of its portfolio  OB Holdings incurred $8.5 million,$9.4 million and $1.2 million in fees for investment managementservices provided by WM Advisors under this investment managementagreement during the years ended December 31, 2008, 2007 and 2006,respectively.

 

OB Holdings has agreed topay annual investment management fees generally based on the quarter-end marketvalues held under custody as set forth in the table below:

 

| **Assets Under Management**                                    | ** ** | **Annual Fee**                      | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------|------------|
| Investment Grade Fixed Income:                                 |       |                                |       |
| —Up to $999 million                                  |       | 10.0  basis points  (0.1% or 0.001) |       |
| —Next $1—$1.999 billion                         |       | 8.5  basis points                   |       |
| —Amounts over $2 billion                             |       | 7.5  basis points                   |       |
| High Yield Fixed Income                                        |       | 25.0  basis points                  |       |
| Hedge Funds, Limited Partnerships and Private Equity Interests |       | 100.0  basis points                 |       |

 

WM Advisors is paid aquarterly fee for treasury management services computed at the annual rate of1.75 basis points (0.0175%) of the aggregate value of net assets on an annualbasis. OB Holdings incurred $0.6 million, $0.8 million and $0.1 million intreasury management fees during the years ended December 31, 2008, 2007and 2006, respectively.

 

The agreements provided foran initial fixed term of three years, which was extended by OB Holdings for anadditional year (a fourth year), and may be extended by OB Holdings for asecond additional year (a fifth year) at or prior to the end of the third yearof the term. During such term, the WM Advisors Agreement is terminable byOB Holdings only (i) for cause (including material non-performance byWM Advisors), (ii) if there is a change in control ofWM Advisors (for this purpose, a change in control represents 50% orgreater change in voting interest of WM Advisors), or (iii) if WhiteMountains’ voting interest in OBIG falls below 50%. Following the end of theinitial term and any extensions, the agreements may be terminated by eitherparty on 60 days written notice.

 

*OBH Guarantee*

 

White Mountains has providedand, pursuant to the Separation Agreement, continues to provide an irrevocableand unconditional guarantee as to the payment of principal and interest (the “Guarantee”)on the OBH 5.875% Senior Notes due 2013. See Note 7.

 

In consideration of thisGuarantee, OBH has agreed to pay a specified fee to White Mountains in theamount of 25 basis points per annum on the outstanding principal amount of theSenior Notes. Such payment will be made on a semi-annual basis in arrears. OBHhas further agreed that if White Mountains’ voting interest in OBIG falls below50%, OBH will redeem, exchange or otherwise modify the Senior Notes in order tofully and permanently eliminate White Mountains’ 

 

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obligations under the Guarantee (the “GuaranteeElimination”). White Mountains has agreed to provide written notice to OBH whenits voting interest in OBIG has been reduced below 50%. OBH shall have180 days from the receipt of such notification to complete the GuaranteeElimination. If the Guarantee Elimination is not completed within the initial180-day period, the Guarantee fee shall increase by 200 basis points. TheGuarantee fee shall further increase by 100 basis points for each subsequent90-day period thereafter, up to a maximum Guarantee fee of 425 basis points,until the Guarantee Elimination has been completed. All expenses associatedwith the elimination of the Guarantee will be borne by OBH. OBH incurred $1.7million, $1.8 million and $0.2 million, respectively, in fees for the provisionof the Guarantee during the years ended December 31, 2008, 2007 and 2006.

 

White Mountains has arevolving credit facility which provides for borrowing up to a maximum of$442 million and which contains restrictive financial covenants. Theindenture documents governing the Senior Notes provide that if White Mountainsas guarantor of the Senior Notes has a payment default in excess of$25 million under a credit agreement, mortgage or similar debt agreement,there is a default under the Senior Notes (commonly referred to as a “crossdefault”). Therefore, if White Mountains were to breach its financial covenantsin its revolving credit facility, an event of default would result, which wouldallow lenders to declare all amounts owed under the revolving credit facilityto be immediately due and payable. A failure to pay the amounts owed under therevolving credit facility would result in a trigger of the cross defaultprovisions in the indenture documents governing the Senior Notes resulting in arequired repayment of the Senior Notes. As of December 31, 2008, WhiteMountains had drawn $200 million under the facility.

 

*Keep-Well*

 

Under the terms of theKeep-Well described in Note 13, White Mountains had agreed to return toOBH up to approximately $1.1 billion if some or all of that amount wasrequired by OBH to meet its obligations under the terms of the BerkshirePreferred Stock. As described above, the Keep-Well has expired. Under theKeep-Well, White Mountains had to make any required contributions to OBH priorto making any distributions to its shareholders. The aggregate amount ofdistributions that White Mountains could make to its shareholders was limited;the limit increased or decreased by an amount equal to White Mountains’consolidated net income or loss over the remaining life of the Keep-Well. TheKeep-Well expired when all obligations of the Berkshire Preferred Stock weresatisfied upon its redemption in May 2008.

 

*Irrevocable Grantor Trust*

 

In connection with OBIG’sinitial public offering, OBH created an irrevocable grantor trust and funded itwith assets sufficient to make the remaining dividend and redemption paymentsfor $300 million of preferred stock that was redeemed in May 2008.See Note 1 and Note 11. White Mountains Capital, Inc. served asthe trustee for the irrevocable grantor trust and received no fee for theprovision of trustee services.

 

*Galileo Guarantees*

 

Beginning in February 2006,OBIC agreed to provide guarantees of the obligations of Galileo Weather RiskManagement Ltd. (“Galileo”) to Galileo’s counterparty in certainweather-related product transactions. OBIC assigned its guarantees to WhiteMountains Re Bermuda, Ltd. (“WMRE Ltd.”), a subsidiary of White Mountains, asof October 21, 2008. See Note 19.

 

*Esurance Claims Administrations Services*

 

Esurance Insurance Services, Inc.,a subsidiary of White Mountains (“Esurance Insurance”), and NJSM, an indirectsubsidiary of the Company, entered into a Transition Services Agreement (the “TransitionServices Agreement”) dated as of June 28, 2007 and a related TerminationAgreement (the “Termination Agreement”) dated as of the same date. TheTermination Agreement terminated a Claims Administration Agreement (the “ClaimsAdministration Agreement”) dated as of February 1, 2005 between EsuranceInsurance and NJSM pursuant to which NJSM had been providing claimsadministration services to Esurance Insurance in the State of New Jersey. TheTransition Services Agreement provides that NJSM will provide certaintransition services to Esurance Insurance during the period from July 2,2007 through February 28, 2009 plus any extension term to enable EsuranceInsurance to be able to provide such services internally after the transitionperiod. NJSM provides the following services to Esurance Insurance pursuant tothe Transition Services Agreement; facilities and building services (cubicles,office furniture, common space, conference rooms, telecommunications equipmentand services, building management services and mailroom services) and ITservices (network connections and voice and telecom services). For the yearsended December 31, 2008 and 2007, Esurance Insurance paid NJSM $0.3million and $0.1 million under the Transition Services Agreement. For theyears ended December 31, 2007 and 2006, Esurance Insurance paid NJSM$1.2 million and $1.8 million under the Claims AdministrationAgreement.

 

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*Esurance Insurance Claims Counsel Services*

 

From time to time, OneBeaconprovides staff counsel services to Esurance Insurance. OneBeacon’s staffcounsel defends Esurance Insurance policyholders when the policyholders aresued by third party tort plaintiffs arising from automobile accidents. Thehourly cost of the staff counsels’ time is charged to Esurance Insurance. As ofthe years ended December 31, 2008 and 2007, OBIC had billed EsuranceInsurance $0.1 million and $0.1 million, respectively, for counselservices.

 

*Esurance Sublease*

 

OBIC subleases toEsurance approximately 4,200 square feet of an approximately 14,000 square footoffice facility in Brooklyn, NY. The sublease term commenced August 15,2008 and terminates on November 29, 2014. Esurance has the option to subleasean additional 3,000 square feet of the office space if available on the sameterms and conditions as the original sublease except that the monthly rentalpayment shall increase to approximately $24,500 per month until May 2009,at which time the rent will increase to approximately $29,500 per month. Inaddition, Esurance has the right of first refusal on the remainder of theoffice space on terms and conditions to be agreed upon by the parties. Esurancepaid OBIC approximately $14,525 per month, or approximately $65,000, during2008 for the office space. Beginning in May 2009, Esurance will payOBIC approximately $17,500 per month for the office space. Esurance alsopurchased office equipment and furniture from OBIC for approximately $22,000.

 

*EsuranceBrokerage Commission*

 

In2008, AutoOne assisted Esurance with the sale of $6.1 million of excess 2008New York take-out credits and received a fee of $195,200. Various states haveassigned risks pools which provide automobile insurance for individuals unableto secure coverage in the voluntary market. Insurers are obligated toaccept future assignments from state assigned risk pools as a condition ofmaintaining a license to write auto business in the state. However,insurers may satisfy their assigned risk obligations by utilizing variouscredits (including take-out credits).

 

*Sale of HCIC to Esurance Holdings, Inc.*

 

As described in Note 3,during the third quarter of 2006, OB Holdings sold one of its inactive licensedsubsidiaries, HCIC, to Esurance Holdings, Inc. (“Esurance Holdings”), asubsidiary of White Mountains. HCIC was renamed Esurance Insurance Company ofNew Jersey (“Esurance Insurance NJ”). In connection with the sale, EsuranceHoldings agreed to pay $2.9 million of the total purchase price in periodicannual installments based upon a percentage of an annually recognized taxbenefit with respect to premium tax in the state of New Jersey. Because of thelicense held by HCIC in New Jersey, Esurance Insurance NJ is entitled to a taxbenefit that results in a reduction in the amount of annual state premium taxdue on premiums written in New Jersey. In April 2008, after the filing ofits New Jersey premium tax return, Esurance Insurance NJ paid OB Holdingsapproximately $52,000.

 

*Purchase of OBIG Common Shares for Employee StockOwnership Plan*

 

In March 2007, the ESOPpurchased approximately 645,000 OBIG Class B common shares from Lone TreeHoldings Ltd., a subsidiary of White Mountains, to satisfy OB Holdings’funding obligation for the 2006 performance period under the ESOP. The ESOPpurchased the OBIG shares at the fair market value of $25.85 on March 13,2007. Upon purchase, the OBIG Class B common shares automaticallyconverted to OBIG Class A common shares.

 

*Affiliate Quota Shares*

 

During 2005 and 2004, OBHoldings participated in two quota share reinsurance arrangements with othersubsidiaries of White Mountains. These quota share agreements were commutedduring the fourth quarter of 2006 in connection with OBIG’s initial publicoffering. Under the Esurance Quota Share, effective January 1, 2005, OBHoldings assumed approximately 85% of business written by Esurance, whichincludes business written by its wholly-owned subsidiary. Under the SiriusQuota Share, OB Holdings ceded between 6% and 12% of business written,effective April 1, 2004, to Sirius, a subsidiary of White Mountains Re.The affiliate quota shares were entered into primarily for White Mountains’capital management purposes.

 

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***Prospector***

 

*Investment Management Agreement with Prospector*

 

Prior to OBIG’s initial public offering, Prospector managed most of thepublicly-traded common equity and convertible securities in OB Holdings’portfolio, as well as the employee benefit plan portfolios, through asub-advisory agreement with WM Advisors.

 

In connection with OBIG’s initial public offering, OB Holdings enteredinto an investment management agreement with Prospector in November 2006,as amended in November 2007, pursuant to which Prospector supervises anddirects the publicly-traded common equity and convertible securities portion ofOB Holdings’ investment portfolio in accordance with the investment objectives,policies and restrictions described in OB Holdings’ investment guidelines.Under the agreement, Prospector has discretion and authority with respect tothe portfolio it manages for OB Holdings that is substantially similar toWM Advisors’ discretion and authority under its agreements. The assets ofOB Holdings’ portfolio are held in one or more separately identifiable accountsin the custody of a bank or similar entity designated by OB Holdings andacceptable to Prospector. OB Holdings is responsible for custodial arrangementsand the payment of all custodial charges and fees. For the years ended December 31,2008, 2007 and 2006, Prospector earned $4.2 million, $4.3 million and$0.5 million, respectively, in fees with respect to OB Holdings’portfolio.

 

Under the agreement, OB Holdings pays annual management fees toProspector based on aggregate net assets under management according to thefollowing schedule: 1.00% on the first $200 million; 0.50% on the next$200 million; and 0.25% on amounts over $400 million. The agreementhad an initial fixed term of three years, which was extended by OB Holdings foran additional year (a fourth year), and may be extended by OB Holdings for asecond additional year (a fifth year) at or prior to the end of the third yearof the term. The agreement is terminable by OB Holdings only (i) for cause(including material non-performance by Prospector), (ii) if either John D.Gillespie or Richard P. Howard are no longer affiliated with Prospector, (iii) ifthere is a change in control of Prospector (for this purpose, a change incontrol represents 50% or greater change in voting interest of Prospector), or (iv) ifWhite Mountains’ voting interest in OBIG falls below 50%. Following the end ofthe initial term and any extensions, the Prospector Agreement may be terminatedby either party on 60 days written notice. Prospector continues to serveas a discretionary advisor to WM Advisors under the sub-advisory agreementwith respect to specified assets in OneBeacon’s employee benefit planportfolios.

 

Richard P. Howard, a portfolio manager of Prospector, is a director ofOBIG.

 

*Prospector Managed Limited Partnerships*

 

At December 31, 2008 and 2007, OB Holdings had $38.9 million and$39.3 million, respectively, invested in limited partnerships managed byProspector. Under the limited partnership agreements, Prospector serves asgeneral partner and general manager of the funds and is paid a management feeby OB Holdings. In addition, OB Holdings allocates a portion of its earningsfrom OB Holdings’ limited partnership interests to Prospector as an incentivefee. For the years ended December 31, 2008, 2007 and 2006, OB Holdingsincurred $0.4 million, $0.4 million and $0.4 million, respectively,in management fees and $0.1 million, $0.9 million and $0.5 million,respectively, in incentive fees.

 

**NOTE 19. Commitments and Contingencies**

 

OB Holdings leases certain office space under noncancellable operatingleases expiring at various dates through 2016. Rental expense for all of OBHoldings’ locations was approximately $22.3 million, $33.4 million and$40.9 million for the years ended December 31, 2008, 2007 and 2006,respectively. OB Holdings also has various other lease obligations which areimmaterial in the aggregate.

 

OB Holdings’ future annual minimum rental payments required undernoncancellable leases primarily for office space are $12.4 million,$9.2 million, $7.7 million, $6.0 million and $6.8 millionfor 2009, 2010, 2011, 2012 and 2013 and thereafter, respectively.

 

OB Holdings has future binding commitments to fund certain limitedpartnerships and hedge fund investments. These commitments, which do not havefixed funding dates, total $53.2 million as of December 31, 2008.

 

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***Assigned Risks***

 

As a condition of OB Holdings’ license to do business in certainstates, OB Holdings’ insurance operations are required to participate inmandatory shared market mechanisms. Each state dictates the types of insuranceand the level of coverage that must be provided. The total amount of suchbusiness an insurer is required to accept is based on its market share ofvoluntary business in the state. In certain cases, OB Holdings is obligated towrite business from mandatory shared market mechanisms at some time in thefuture based on the market share of voluntary policies it is currently writing.Underwriting results related to assigned risk plans are typically adverse andare not subject to the predictability associated with OB Holdings’ voluntarilywritten business.

 

Under existing guaranty fund laws in all states, insurers licensed todo business in those states can be assessed for certain obligations ofinsolvent insurance companies to policyholders and claimants. In accordancewith SOP 97-3, OB Holdings’ insurance subsidiaries record guaranty fundassessments when such assessments are billed by the respective guaranty funds.In addition, each insurance subsidiary’s policy is to accrue for anysignificant insolvencies when the loss is probable and the assessment amountcan be reasonably estimated. The actual amount of such assessments will dependupon the final outcome of rehabilitation proceedings and will be paid overseveral years. At December 31, 2008, the reserve for such assessments atOB Holdings’ insurance subsidiaries totaled $17.4 million.

 

***Legal Contingencies***

 

OB Holdings, and the insurance industry in general, are subject tolitigation and arbitration in the normal course of business. OB Holdings is nota party to any material litigation or arbitration other than as routinelyencountered in claims activity, none of which is expected by management to havea material adverse effect on OB Holdings’ financial condition and/or cashflows.

 

On July 24, 2008,OneBeacon and Liberty Mutual Insurance Group (“Liberty Mutual”) entered into aConfidential Settlement Agreement and Release (the “Settlement Agreement”) thatresolved nearly four years of arbitration and litigation.  The disputes concerned amounts which LibertyMutual asserted were due to it under agreements with OneBeacon (the “LibertyAgreements”) for unallocated loss adjustment expenses and amounts whichOneBeacon asserted were due to it related to claims administration andreinsurance.  The Settlement Agreementrepresents a full and final resolution of the disputes related to the LibertyAgreements.

 

In connection with the Settlement Agreement, OneBeacon took a pre-taxcharge in the amount of $9.2 million in the second quarter of 2008,representing a part of the cost of the settlement.  OneBeacon made a cash payment to LibertyMutual in the amount of $16.0 million on July 30, 2008. No further chargesor payments will be made with respect to the disputed matters.

 

***Guarantees***

 

Beginning in February 2006, OBIC agreed to provide guarantees ofthe obligations of Galileo to Galileo’s counterparty in certain weather-relatedproduct transactions. Galileo is a subsidiary of White Mountains. Theguarantees required OBIC to pay the full amount of Galileo’s obligations to thecounterparty in the event that Galileo failed to pay these obligations. In theevent of a payment, OBIC would be eligible to exercise all of the rights of thecounterparty against Galileo. In the event that the total guaranteed principalamount exceeded the lesser of 5% of OBIC’s admitted assets of $3.5 billionat December 31, 2007 or 25% of OBIC’s statutory surplus of$1.6 billion at December 31, 2007, OBIC would have require theapproval of the Pennsylvania Department of Insurance in order to make anyfurther guarantees. OBIC had agreed, at White Mountains’ option, to continue tomake these guarantees available through October 2008 and received fromGalileo an annual fee of 25 basis points of the value at risk for providing theguarantees. Pursuant to a separation agreement entered into by OBIG and WhiteMountains in connection with OBIG’s initial public offering, White Mountainsagreed to take appropriate steps to ensure that OBIC would not be called on tomake payment on these guarantees. OBIC assigned its guarantees to WMRE, Ltd., asubsidiary of White Mountains, as of October 21, 2008. Therefore as of December 31,2008, there were no outstanding guarantees.

 

**NOTE 20.  SubsequentEvents**

 

On March 6, 2009, the Company repurchased $10.6 million ofoutstanding Senior Notes for $8.1 million, which resulted in a $2.5 milliongain on extinguishment of debt.

 

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**MANAGEMENT’SRESPONSIBILITY FOR FINANCIAL STATEMENTS**

 

Management is responsible for the preparation and fair presentation ofthe financial statements included in this report. The financial statements havebeen prepared in conformity with GAAP in the United States. The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities as of the date of the financial statements and the reported amountsof revenues and expenses during the reporting period. Actual results coulddiffer from those estimates.

 

**MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIALREPORTING**

 

Management is responsible for establishing and maintaining adequateinternal control over financial reporting as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act of 1934. There are inherentlimitations in the effectiveness of any internal control over financialreporting, including the possibility of human error and the circumvention oroverriding of internal control. Accordingly, even effective internal controlover financial reporting can provide only reasonable assurance with respect tofinancial statement preparation. Further, an effective internal controlenvironment as of a point in time may become inadequate in the future becauseof changes in conditions, or deterioration in the degree of compliance with thepolicies and procedures.

 

We assessed the effectiveness of OB Holdings’ internal control overfinancial reporting as of December 31, 2008. Our assessment did notinclude an assessment of internal control over financial reporting forEntertainment Brokers International Insurance Services which was acquired on July 3,2008. This acquisition represents less than 1% of OB Holdings’ total assets asof December 31, 2008 and less than 1% of OB Holdings’ total revenue forthe year ended December 31, 2008. In making our assessment, we used thecriteria set forth by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO) in *InternalControl-Integrated Framework.* Based on this assessment, we haveconcluded that OB Holdings maintained effective internal control over financialreporting as of December 31, 2008.

 

This annual report does not include an attestation report of theCompany’s registered public accounting firm regarding internal control overfinancial reporting. Management’s report was not subject to attestation by theCompany’s registered public accounting firm pursuant to temporary rules ofthe Securities and Exchange Commission that permit the Company to provide onlymanagement’s report in this annual report.

 

March 13,2009

 

| /s/  T. MICHAEL MILLER                 |   | /s/  PAUL H. MCDONOUGH         |
|----------------------------------------|--------|--------------------------------|
| T.  Michael Miller                     |   | Paul  H. McDonough             |
| President  and Chief Executive Officer |   | Chief  Financial Officer       |
| (Principal  Executive Officer)         |   | (Principal  Financial Officer) |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Tothe Board of Directors and Shareholder of OneBeacon U.S. Holdings, Inc.:

 

Inour opinion, the accompanying consolidated financial statements listed in theaccompanying index appearing on page F-1 present fairly, in all materialrespects, the financial position of OneBeacon U.S. Holdings, Inc. and itssubsidiaries (the “Company”), an indirect wholly-owned subsidiary of OneBeaconInsurance Group, Ltd., at December 31, 2008 and 2007, and the resultsof their operations and their cash flows for each of the three years in theperiod ended December 31, 2008 in conformity with accounting principlesgenerally accepted in the United States of America. In addition, in ouropinion, the financial statement schedules listed in the accompanying indexpresent fairly, in all material respects, the information set forth thereinwhen read in conjunction with the related consolidated financial statements. Thesefinancial statements and financial statement schedules are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements and financial statement schedules based on ouraudits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

Asdiscussed in Note 1 to the consolidated financial statements, the company changed its method of accountingfor certain invested assets in 2008.

 

/s/PRICEWATERHOUSECOOPERS LLP

 

NewYork, New York

March 13,2009

 

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**SELECTED QUARTERLY FINANCIAL DATA**

 

**(Unaudited)**

 

Selected quarterly financial data for 2008 and 2007 is shown in thefollowing table. The quarterly financial data includes, in the opinion ofmanagement, all recurring adjustments necessary for a fair presentation of theresults of operations for the interim periods.

 
| ** **               | ** ** | **2008 Three Months Ended** | ** ** | **2007 Three Months Ended** | ** ** |
|--------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Millions**             | ** ** | **Mar. 31**            | ** ** | **June 30**            | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** | **Mar. 31** | ** ** | **June 30** | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** |
| Revenues                 |       | $                           | 450.0      |                        | $          | 507.7 |   | $ | 162.5 |   | $ | 168.7 |   | $ | 576.5 |   | $ | 577.5 |   | $ | 566.1 |   | $ | 546.2 |   |
| Expenses                 |       | 489.9                       |       | 471.9                       |       | 488.0 |   | 438.7 |   | 488.1 |   | 483.5 |   | 429.8 |   | 465.5 |   |
| Pre-tax (loss)  income   |       | (39.9                       | )          | 35.8                        |       | (325.5 | ) | (270.0 | ) | 88.4 |   | 94.0 |   | 136.3 |   | 80.7 |   |
| Tax benefit  (provision) |       | 12.6                        |       | (17.4                       | )          | 110.0 |   | 90.1 |   | (38.8 | ) | (38.7 | ) | (53.4 | ) | (33.6 | ) |
| Net (loss) income        |       | $                           | (27.3      | )                           | $          | 18.4 |   | $ | (215.5 | ) | $ | (179.9 | ) | $ | 49.6 |   | $ | 55.3 |   | $ | 82.9 |   | $ | 47.1 |   |

 

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** **

**SCHEDULE I**

 

**ONEBEACON U.S. HOLDINGS, INC.**

 

**SUMMARY OF INVESTMENTS—OTHER THAN**

**INVESTMENTS IN RELATED PARTIES**

 

**At December 31, 2008**

 
| ** **                                              | ** ** | **Cost**                 | ** ** | **Fair  Value** | ** ** | **Carrying  Value** | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|-----------------|------------|---------------------|------------|
| ** **                                              | ** ** | **($ in millions)** | ** ** |
| **Investments:**                                        |       |                     |       |            |       |                |       |
| Fixed maturities:                                       |       |                     |       |            |       |                |       |
| Bonds:                                                  |       |                     |       |            |       |                |       |
| U.S. Government and government agencies and authorities |       | $                        | 417.3      |            | $          | 409.6               |       | $ | 409.6 |   |
| Corporate bonds and asset-backed securities             |       | 1,706.8                  |       | 1,629.1         |       | 1,629.1             |       |
| States, municipalities and political subdivisions       |       | 4.8                      |       | 5.0             |       | 5.0                 |       |
| Convertibles and bonds with warrants attached           |       | 255.0                    |       | 241.2           |       | 241.2               |       |
| Foreign governments                                     |       | 46.0                     |       | 38.6            |       | 38.6                |       |
| Redeemable preferred stocks                             |       | 71.5                     |       | 52.5            |       | 52.5                |       |
| Total fixed maturities                                  |       | 2,501.4                  |       | 2,376.0         |       | 2,376.0             |       |
| Short-term investments                                  |       | 875.4                    |       | 875.4           |       | 875.4               |       |
| Common equity securities:                               |       |                     |       |            |       |                |       |
| Banks, trust and insurance companies                    |       | 104.8                    |       | 100.5           |       | 100.5               |       |
| Public utilities                                        |       | 53.7                     |       | 53.6            |       | 53.6                |       |
| Industrial, miscellaneous and other                     |       | 126.1                    |       | 122.6           |       | 122.6               |       |
| Total common equity securities                          |       | 284.6                    |       | 276.7           |       | 276.7               |       |
| Other investments                                       |       | 178.6                    |       | 196.6           |       | 196.6               |       |
| Total investments                                       |       | $                        | 3,840.0    |            | $          | 3,724.7             |       | $ | 3,724.7 |   |

 

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**SCHEDULE II**

 

**ONEBEACON U.S. HOLDINGS, INC.**

**(Registrant Only)**

 

**CONDENSED BALANCE SHEETS**

 
| ** **                                                                          | ** ** | **December 31,**     | ** ** |
|-------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                          | ** ** | **2008**                  | ** ** | **2007** | ** ** |
| ** **                                                                          | ** ** | **($ in  millions)** | ** ** |
| Assets:                                                                             |       |                      |       |   |   |
| Investments                                                                         |       | $                         | 71.3       |   | $ | 480.0 |   |
| Investments in consolidated subsidiaries                                            |       | 1,713.3                   |       | 2,294.7 |   |
| Other assets                                                                        |       | 28.9                      |       | — |   |
| Total assets                                                                        |       | $                         | 1,813.5    |   | $ | 2,774.7 |   |
|                                                                                |       |                      |       |   |   |
| Liabilities:                                                                        |       |                      |       |   |   |
| Long-term debt                                                                      |       | 675.1                     |       | 698.9 |   |
| Preferred stock subject to mandatory redemption—Berkshire  Hathaway, Inc. |       | —                    |       | 278.4 |   |
| Other liabilities                                                                   |       | 5.0                       |       | 14.2 |   |
| Total liabilities                                                                   |       | 680.1                     |       | 991.5 |   |
| Common shareholder’s equity                                                    |       | 1,133.4                   |       | 1,783.2 |   |
| Total liabilities and common shareholder’s equity                              |       | $                         | 1,813.5    |   | $ | 2,774.7 |   |

 

**CONDENSED STATEMENTS OF OPERATIONS AND COMPREHENSIVE(LOSS) INCOME**

 
| ** **                                                                           | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                           | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                           | ** ** | **($ in millions)**         | ** ** |
| Revenues                                                                             |       | $                                | 3.6        |   | $ | 14.5 |   | $ | 9.3 |   |
| Expenses                                                                             |       | 75.5                             |       | 106.7 |   | 105.7 |   |
| Pre-tax loss                                                                         |       | (71.9                            | )          | (92.2 | ) | (96.4 | ) |
| Income tax benefit                                                                   |       | 14.9                             |       | 10.5 |   | 14.0 |   |
| Net loss                                                                             |       | (57.0                            | )          | (81.7 | ) | (82.4 | ) |
| Equity in (loss) earnings from consolidated subsidiaries—continuing  operations |       | (347.3                           | )          | 316.6 |   | 296.2 |   |
| Equity in earnings from consolidated subsidiaries—discontinued  operations      |       | —                           |       | — |   | 1.2 |   |
| Consolidated net (loss) income                                                       |       | (404.3                           | )          | 234.9 |   | 215.0 |   |
| Other comprehensive net (loss) income items, after tax                               |       | (25.6                            | )          | (3.9 | ) | 30.6 |   |
| Consolidated comprehensive net (loss) income                                         |       | $                                | (429.9     | ) | $ | 231.0 |   | $ | 245.6 |   |

 

The condensedfinancial statements should be read in conjunction with the accompanyingconsolidated financial statements and notes thereto. Certain amounts in theprior periods have been reclassified to conform with the current presentation.

 

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**ONEBEACON U.S. HOLDINGS, INC.**

**(Registrant Only)**

 

**CONDENSED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                               | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                               | ** ** | **2008**                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                               | ** ** | **($ in millions)**         | ** ** |
| Net (loss) income                                                                        |       | $                                | (404.3     | ) | $ | 234.9 |   | $ | 215.0 |   |
| Charges (credits) to reconcile net (loss) income to net cash from  operations:           |       |                             |       |   |   |   |   |
| Net realized losses from investment securities                                           |       | 4.1                              |       | 1.4 |   | — |   |
| Undistributed loss (earnings) from consolidated  subsidiaries—continuing operations |       | 347.3                            |       | (316.6 | ) | (296.2 | ) |
| Undistributed earnings from consolidated subsidiaries—discontinued operations       |       | —                           |       | — |   | (1.2 | ) |
| Dividends paid on mandatorily redeemable preferred stock                                 |       | 11.8                             |       | 28.3 |   | 28.3 |   |
| Dividends received from subsidiaries                                                     |       | 203.0                            |       | 99.4 |   | 31.6 |   |
| Other operating items:                                                                   |       |                             |       |   |   |   |   |
| Net change in other assets and liabilities                                               |       | (42.9                            | )          | 21.7 |   | 118.0 |   |
| Net cash provided from operations                                                        |       | 119.0                            |       | 69.1 |   | 95.5 |   |
| Cash flows from investing activities:                                                    |       |                             |       |   |   |   |   |
| Net change in short-term investments held-to-maturity                                    |       | 0.1                              |       | 13.4 |   | (13.3 | ) |
| Net change in short-term investments                                                     |       | (68.2                            | )          | 1.9 |   | 0.6 |   |
| Purchases of fixed maturity investments held-to-maturity                                 |       | —                           |       | — |   | (303.3 | ) |
| Purchases of fixed maturity investments                                                  |       | (33.2                            | )          | (10.2 | ) | (5.9 | ) |
| Maturities of held-to-maturity investments                                               |       | 311.4                            |       | 13.4 |   | — |   |
| Proceeds from the sales of fixed maturity investments                                    |       | 202.5                            |       | 34.1 |   | 118.4 |   |
| Proceeds from sale of discontinued operations                                            |       | —                           |       | — |   | 94.7 |   |
| Net cash provided from (used for) investing activities                                   |       | 412.6                            |       | 52.6 |   | (108.8 | ) |
| Cash flows from financing activities:                                                    |       |                             |       |   |   |   |   |
| Redemption of mandatorily redeemable preferred stock                                     |       | (300.0                           | )          | — |   | — |   |
| Dividends to OBEH                                                                        |       | (219.9                           | )          | (93.4 | ) | (4.5 | ) |
| Contributions of capital from White Mountains                                            |       | —                           |       | — |   | 46.1 |   |
| Dividends paid on mandatorily redeemable preferred stock                                 |       | (11.8                            | )          | (28.3 | ) | (28.3 | ) |
| Net cash (used for) provided from financing activities                                   |       | (531.7                           | )          | (121.7 | ) | 13.3 |   |
| Net change in cash during the year                                                       |       | (0.1                             | )          | — |   | — |   |
| Cash balance at beginning of year                                                        |       | 0.1                              |       | 0.1 |   | 0.1 |   |
| Cash balance at end of year                                                              |       | $                                | —     |   | $ | 0.1 |   | $ | 0.1 |   |

 

The condensedfinancial statements should be read in conjunction with the accompanyingconsolidated financial statements and notes thereto. Certain amounts in theprior periods have been reclassified to conform with the current presentation.

 

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**SCHEDULE III**

 

**ONEBEACONU.S. HOLDINGS, INC.**

 

**SUPPLEMENTARYINSURANCE INFORMATION**

 
| **Column A**                 | ** ** | **Column B**                     | ** ** | **Column C**                                                      | ** ** | **Column D**          | ** ** | **Column E**                                    | ** ** | **Column F**        | ** ** | **Column G**                  | ** ** | **Column H**                                            | ** ** | **Column I**                                       | ** ** | **Column J**                  | ** ** | **Column K**         | ** ** |
|------------------------------|------------|----------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------|------------|-------------------------------------------------|------------|---------------------|------------|-------------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------|------------|-------------------------------|------------|----------------------|------------|
| **Segment**                  | ** ** | **Deferred  acquisition  costs** | ** ** | **Future policy**

**benefits, losses, claims and loss expenses** | ** ** | **Unearned premiums** | ** ** | **Other policy  claims and  benefits  payable** | ** ** | **Premiums earned** | ** ** | **Net  investment income(1)** | ** ** | **Benefits,  claims, losses,  and settlement expenses** | ** ** | **Amortization  of policy  acquisition  expenses** | ** ** | **Other  operating expenses** | ** ** | **Premiums written** | ** ** |
| ** **                   |       | **($ in  millions)**        |       |
| **Years ended:**             |       |                             |       |                                                              |       |                  |       |                                            |       |                |       |                          |       |                                                    |       |                                               |       |                          |       |                 |       |
| **December 31, 2008:**  |       |                             |       |                                                              |       |                  |       |                                            |       |                |       |                          |       |                                                    |       |                                               |       |                          |       |                 |       |
| Primary Insurance Operations |       | $                                | 225.5      |                                                              | $          | 4,504.5               |       | $                                               | 1,088.2    |                | $          | —                        |       | $                                                       | 1,879.0    |                                               | $          | 152.8                         |       | $                    | 1,126.2    |   | $ | 368.3 |   | $ | 290.8 |   | $ | 1,963.1 |   |
| Affiliate Quota Shares       |       | —                           |       | —                                                            |       | —                |       | —                                          |       | —              |       | —                        |       | —                                                  |       | —                                             |       | —                        |       | —               |       |
| Other Operations             |       | —                           |       | (210.5                                                            | )          | —                |       | —                                          |       | —              |       | —                        |       | —                                                  |       | —                                             |       | —                        |       | —               |       |
| **December 31, 2007:**  |       |                             |       |                                                              |       |                  |       |                                            |       |                |       |                          |       |                                                    |       |                                               |       |                          |       |                 |       |
| Primary Insurance Operations |       | $                                | 200.0      |                                                              | $          | 4,718.8               |       | $                                               | 1,005.9    |                | $          | —                        |       | $                                                       | 1,873.6    |                                               | $          | 184.5                         |       | $                    | 1,089.8    |   | $ | 318.9 |   | $ | 329.4 |   | $ | 1,864.4 |   |
| Affiliate Quota Shares       |       | —                           |       | —                                                            |       | —                |       | —                                          |       | —              |       | —                        |       | —                                                  |       | —                                             |       | —                        |       | —               |       |
| Other Operations             |       | —                           |       | (238.5                                                            | )          | —                |       | —                                          |       | —              |       | —                        |       | —                                                  |       | —                                             |       | —                        |       | —               |       |
| **December 31, 2006:**  |       |                             |       |                                                              |       |                  |       |                                            |       |                |       |                          |       |                                                    |       |                                               |       |                          |       |                 |       |
| Primary Insurance Operations |       | $                                | 183.8      |                                                              | $          | 5,108.2               |       | $                                               | 985.2      |                | $          | —                        |       | $                                                       | 1,944.0    |                                               | $          | 182.3                         |       | $                    | 1,180.3    |   | $ | 332.3 |   | $ | 360.1 |   | $ | 1,957.6 |   |
| Affiliate Quota Shares       |       | —                           |       | —                                                            |       | —                |       | —                                          |       | 131.9               |       | —                        |       | 103.3                                                   |       | 47.6                                               |       | —                        |       | 49.4                 |       |
| Other Operations             |       | —                           |       | (270.5                                                            | )          | —                |       | —                                          |       | —              |       | —                        |       | —                                                  |       | —                                             |       | —                        |       | —               |       |

----

(1)                                  The amountsshown exclude net investment income relating to non-insurance operations of$9.3 million, $17.9 million and $5.3 million for the years ended December 31,2008, 2007 and 2006, respectively.

 

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**SCHEDULE IV**

 

**ONEBEACONU.S. HOLDINGS, INC.**

 

**REINSURANCE**

 
| **Column A**                 | ** ** | **Column B**             | ** ** | **Column C**                   | ** ** | **Column D**                       | ** ** | **Column E**    | ** ** | **Column F**                               | ** ** |
|------------------------------|------------|--------------------------|------------|--------------------------------|------------|------------------------------------|------------|-----------------|------------|--------------------------------------------|------------|
| **Premiums earned**          | ** ** | **Gross  amount**        | ** ** | **Ceded to  other  companies** | ** ** | **Assumed  from other  companies** | ** ** | **Net  amount** | ** ** | **Percentage  of amount  assumed to  net** | ** ** |
| ** **                   | ** ** | **($ in millions)** | ** ** |
| **Years ended:**             |       |                     |       |                           |       |                               |       |            |       |                                       |       |
| **December 31, 2008:**  |       |                     |       |                           |       |                               |       |            |       |                                       |       |
| Primary Insurance Operations |       | $                        | 2,078.0    |                           | $          | (252.6                             | )          | $               | 53.6       |                                       | $          | 1,879.0 |   | 2.9 | % |
| Affiliate Quota Shares(1)    |       | —                   |       | —                         |       | —                             |       | —          |       | —                                     |       |
| Other Operations             |       | —                   |       | —                         |       | —                             |       | —          |       | —                                     |       |
| **December 31, 2007:**  |       |                     |       |                           |       |                               |       |            |       |                                       |       |
| Primary Insurance Operations |       | $                        | 2,017.3    |                           | $          | (198.4                             | )          | $               | 54.7       |                                       | $          | 1,873.6 |   | 2.9 | % |
| Affiliate Quota Shares(1)    |       | —                   |       | —                         |       | —                             |       | —          |       | —                                     |       |
| Other Operations             |       | —                   |       | —                         |       | —                             |       | —          |       | —                                     |       |
| **December 31, 2006:**  |       |                     |       |                           |       |                               |       |            |       |                                       |       |
| Primary Insurance Operations |       | $                        | 2,007.5    |                           | $          | (128.9                             | )          | $               | 65.4       |                                       | $          | 1,944.0 |   | 3.4 | % |
| Affiliate Quota Shares(1)    |       | —                   |       | (178.0                         | )          | 309.9                              |       | 131.9           |       | 235.0                                      | %          |
| Other Operations             |       | —                   |       | —                         |       | —                             |       | —          |       | —                                     |       |

----

(1)                                  The affiliatequota share agreements were commuted during the fourth quarter of 2006.

 

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**SCHEDULE V**

 

**ONEBEACONU.S. HOLDINGS, INC.**

 

**VALUATIONAND QUALIFYING ACCOUNTS**

 
| **Column A**                                       | ** ** | **Column B**                         | ** ** | **Column C**                                    | ** ** | **Column D**                               | ** ** | **Column E**                                   | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                         | ** ** | ** **                           | ** ** | **Additions (subtractions)**                    | ** ** | ** **                                 | ** ** | ** **                                     | ** ** |
| **Description**                                    | ** ** | **Balance at  beginning of  period** | ** ** | **Charged  (credited) to  costs and  expenses** | ** ** | **Charged (credited)  to other  accounts** | ** ** | **Other additions (deductions)  described(1)** | ** ** | **Balance at  end of  period** | ** ** |
| ** **                                         | ** ** | **($ in millions)**             | ** ** |
| **Years ended:**                                   |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| **December 31, 2008:**                        |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Reinsurance recoverable on paid and unpaid losses: |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Allowance for reinsurance balances(2)              |       | $                                    | 12.7       |                                            | $          | —                                     |       | $                                              | 5.2        |   | $ | (1.3 | ) | $ | 16.6 |   |
| Premiums receivable:                               |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Allowance for uncollectible accounts(3)            |       | 18.5                                 |       | 2.0                                             |       | (13.1                                      | )          | (0.3                                           | )          | 7.1 |   |
| **December 31, 2007:**                        |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Reinsurance recoverable on paid and unpaid losses: |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Allowance for reinsurance balances                 |       | $                                    | 13.4       |                                            | $          | —                                     |       | $                                              | —     |   | $ | (0.7 | ) | $ | 12.7 |   |
| Premiums receivable:                               |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Allowance for uncollectible accounts               |       | 16.8                                 |       | (1.0                                            | )          | —                                     |       | 2.7                                            |       | 18.5 |   |
| **December 31, 2006:**                        |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Reinsurance recoverable on paid and unpaid losses: |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Allowance for reinsurance balances                 |       | $                                    | 13.2       |                                            | $          | —                                     |       | $                                              | —     |   | $ | 0.2 |   | $ | 13.4 |   |
| Premiums receivable:                               |       |                                 |       |                                            |       |                                       |       |                                           |       |   |   |
| Allowance for uncollectible accounts               |       | 13.6                                 |       | (3.0                                            | )          | —                                     |       | 6.2                                            |       | 16.8 |   |

----

(1)                                  Represents netcollections (charge-offs) of balances receivable.

 

(2)                                  Amount chargedto other accounts represents an increase in the Allowance for uncollectiblereinsurance which was offset by a corresponding increase in Ceded reinsurance,a component of Reinsurance recoverable on unpaid losses.  There was no impact to Reinsurancerecoverable on unpaid losses as presented in the consolidated balance sheets.

 

(3)                                  Amount creditedto other accounts represents a reduction in the Allowance for uncollectiblepremiums receivable which was offset by a corresponding reduction in Grosspremiums receivable. There was no impact to Premiums receivable as presented inthe consolidated balance sheets.

 

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Table ofContents

 

**SCHEDULE VI**

 

**ONEBEACONU.S. HOLDINGS, INC.**

 

**SUPPLEMENTALINFORMATION FOR PROPERTY AND CASUALTY INSURANCE UNDERWRITERS**

 
| **Column A**                      | ** ** | **Column B**             | ** ** | **Column C**   | ** ** | **Column D**      | ** ** | **Column E** | ** ** | **Column F** | ** ** | **Column G**   | ** ** | **Column H**            | ** ** | **Column I**     | ** ** | **Column J**    | ** ** | **Column K**   | ** ** |
|-----------------------------------|------------|--------------------------|------------|----------------|------------|-------------------|------------|--------------|------------|--------------|------------|----------------|------------|-------------------------|------------|------------------|------------|-----------------|------------|----------------|------------|
| ** **                        | ** ** | ** **               | ** ** | **Reserves**   | ** ** | ** **        | ** ** | ** **   | ** ** | ** **   | ** ** | ** **     | ** ** | ** **              | ** ** | ** **       | ** ** | **Paid**        | ** ** | ** **     | ** ** |
| ** **                        | ** ** | ** **               | ** ** | **for unpaid** | ** ** | ** **        | ** ** | ** **   | ** ** | ** **   | ** ** | ** **     | ** ** | **Claims and claims**   | ** ** | **Amortization** | ** ** | **claims**      | ** ** | ** **     | ** ** |
| ** **                        | ** ** | ** **               | ** ** | **claims and** | ** ** | **Discount,**     | ** ** | ** **   | ** ** | ** **   | ** ** | ** **     | ** ** | **adjustment expenses** | ** ** | **of deferred**  | ** ** | **and**         | ** ** | ** **     | ** ** |
| ** **                        | ** ** | **Deferred**             | ** ** | **claims**     | ** ** | **if any,**       | ** ** | ** **   | ** ** | ** **   | ** ** | **Net**        | ** ** | **incurred related to** | ** ** | **policy**       | ** ** | **claims**      | ** ** | ** **     | ** ** |
| ** **                        | ** ** | **acquisition**          | ** ** | **adjustment** | ** ** | **deducted in**   | ** ** | **Unearned** | ** ** | **Earned**   | ** ** | **investment** | ** ** | **(1)**                 | ** ** | **(2)**          | ** ** | **acquisition** | ** ** | **adjustment** | ** ** | **Premiums** | ** ** |
| **Affiliation with registrant**   | ** ** | **costs**                | ** ** | **expenses**   | ** ** | **Column C** | ** ** | **premiums** | ** ** | **premiums** | ** ** | **income(4)**  | ** ** | **Current Year**        | ** ** | **Prior Year**   | ** ** | **costs**       | ** ** | **expenses**   | ** ** | **written** | ** ** |
| ** **                        | ** ** | **($ in millions)** | ** ** |
| **Primary Insurance Operations:** |       |                     |       |           |       |              |       |         |       |         |       |           |       |                    |       |             |       |            |       |           |       |   |   |
| 2008                              |       | $                        | 225.5      |           | $          | 4,504.5           |       | $            | 142.1      | (2)          | $          | 1,088.2        |       | $                       | 1,879.0    |             | $          | 152.8           |       | $              | 1,188.2    |   | $ | (62.0 | ) | $ | 368.3 |   | $ | 1,198.3 |   | $ | 1,963.1 |   |
| 2007                              |       | 200.0                    |       | 4,718.8        |       | 156.9             | (2)        | 1,005.9      |       | 1,873.6      |       | 184.5          |       | 1,138.1                 |       | (48.3            | )          | 318.9           |       | 1,250.1        |       | 1,864.4 |   |
| 2006                              |       | 183.8                    |       | 5,108.2        |       | 190.7             | (2)        | 985.2        |       | 1,944.0      |       | 182.3          |       | 1,157.4                 |       | 22.9             |       | 332.3           |       | 1,483.2        |       | 1,957.6 |   |
| **Affiliate Quota Shares:(1)**    |       |                     |       |           |       |              |       |         |       |         |       |           |       |                    |       |             |       |            |       |           |       |   |   |
| 2008                              |       | $                        | —     |           | $          | —            |       | $            | —     |         | $          | —         |       | $                       | —     |             | $          | —          |       | $              | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| 2007                              |       | —                   |       | —         |       | —            |       | —       |       | —       |       | —         |       | —                  |       | —           |       | —          |       | —         |       | — |   |
| 2006                              |       | —                   |       | —         |       | —            |       | —       |       | 131.9        |       | —         |       | 114.9                   |       | (11.6            | )          | 47.6            |       | 61.7           |       | 49.4 |   |
| **Other Operations:**             |       |                     |       |           |       |              |       |         |       |         |       |           |       |                    |       |             |       |            |       |           |       |   |   |
| 2008                              |       | $                        | —     |           | $          | (210.5            | )          | $            | 210.5      | (3)          | $          | —         |       | $                       | —     |             | $          | —          |       | $              | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| 2007                              |       | —                   |       | (238.5         | )          | 238.5             | (3)        | —       |       | —       |       | —         |       | —                  |       | —           |       | —          |       | —         |       | — |   |
| 2006                              |       | —                   |       | (270.5         | )          | 270.5             | (3)        | —       |       | —       |       | —         |       | —                  |       | —           |       | —          |       | —         |       | — |   |

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(1)                                  The affiliatequota share agreements were commuted during the fourth quarter of 2006 inconnection with OBIG’s initial public offering.

 

(2)                                  The amountsshown represent OB Holdings’ discount on its long-term workers compensationloss and LAE reserves, as such liabilities constitute unpaid but settled claimsunder which the payment pattern and ultimate costs are fixed and determinableon an individual basis. OB Holdings discounts these reserves using an averagediscount rate which is determined based on various assumptions includingconsideration of when the claims will be settled (5.5%, 5.5% and 5.3% at December 31,2008, 2007 and 2006).

 

(3)                                  The amountsshown exclude unamortized fair value adjustments to reserves for unpaid claimsand claims adjustment expenses made in purchase accounting as a result of OBH’spurchase of OneBeacon for the years ended December 31, 2008, 2007 and2006, respectively.

 

(4)                                  The amountsshown exclude net investment income relating to non-insurance operations of$9.3 million, $17.9 million and $5.3 million for the years ended December 31,2008, 2007 and 2006, respectively.

 

S-7

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