Our insurance and reinsurance segments have both experienced a shift in business mix towards longer tail lines in recent years. Because our long tail lines typically have a higher initial expected loss ratio relative to our short tail lines, this resulted in a slight increase in our current year loss ratios in the last two years, when isolated from all other variables.
Our investment portfolio is structured to preserve capital and provide us with a high level of liquidity. Additionally, we invest our portfolio with a focus on total return rather than establishing yield or income targets. The following table provides a breakdown of net investment income and net realized investment gains/losses:
2006 versus 2005: Underwriting income in 2006 increased significantly over 2005, reflecting an absence of major loss activity in 2006, compared to 2005 when we incurred significant losses from KRW. Excluding the impact of reinstatement premiums on KRW in 2005, net premiums earned increased 9% in 2006, reflecting growth of our U.S. and European reinsurance business.
In 2007, net premiums earned increased 10% over 2006, while gross premiums written stayed mostly flat. The correlation between gross premiums written and net premiums earned in a particular calendar year varies depending on normal variability in earning patterns and also period to period changes in business mix. The composition of premiums written in each of our lines of business varies. For example, on our catastrophe and motor accounts, we typically write 12-month non-proportional contracts, largely in the first quarter of the year. Consequently changes in gross premiums written on these lines more closely align to changes in net premiums earned in a given calendar year. In contrast, our professional lines premium is written more evenly throughout the year and includes a higher level of proportional business. Consequently, net premiums earned in a calendar year on this line tend to include a significant amount of premium written in prior years. For example, in 2007, approximately 69% of premium earned on our professional lines business was from prior underwriting years. Overall, the growth in net premiums earned in each of the last two years reflects the expansion of our U.S and European reinsurance operations in the last several years.
Assigned to companies that have, in A.M. Best’s opinion, an excellent ability to meet their ongoing obligations to policyholders.
The following table provides a breakdown of our contractual obligations by period due:
With respect to our insurance operations, we are notified of insured losses by brokers and insureds and record a case reserve for the estimated amount of the ultimate expected liability arising from the claim. The estimate reflects the judgment of our claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel, loss adjusters and other relevant consultants.
Unlike case reserves, IBNR is generally calculated at an aggregate level and cannot usually be directly identified as reserves for a particular loss or contract (see “Specific Reserving Issues - Catastrophe losses” for discussion of specific IBNR provisions). Our loss and premium data is aggregated by exposure class and by accident year (i.e. the year in which losses were incurred).
As discussed above, there is considerable judgment involved in determining our ultimate loss ratios, and therefore we believe the potential variance with actual loss experience could be relatively wide by line of business. On an aggregate basis, we believe it is reasonably likely our net loss reserves could increase or decrease by up to 10% from current amounts based on our more recent claims experience. For the year ended December 31 2007, we experienced net favorable development of 9% (2006: 7%) on our beginning net loss reserves. A 10% change in our net loss reserves at December 31, 2007 equates to $423 million and represents 37% of our income before taxes for 2007.
Reinstatement premiums for our insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment, as described above in “Reserves for Losses and Loss Expenses.”
Under FAS No. 60, Accounting and Reporting by Insurance Enterprises, a company is permitted to book premium as long as it is reasonably estimable. For line slip premiums, we receive an initial estimate of expected premium from the client via the broker. This estimate has been derived by reference to one or more of the following: the historical premium volume experienced by the line slip; historical premium volume of similar line slips; and industry information on the underlying business. We may, if we believe appropriate, adjust the initial estimates provided by the broker to reflect management’s best judgment and expectations. This is most likely where the underwriter believes that the estimate is not prudent. In the case of proportional contracts, similar to our line slip business, we are able to reasonably estimate the premium written by reference to an initial estimate of expected ceded premium received from our clients. In most cases, the treaties are not new and the client can use historical experience to estimate the amount of premium. We may, if we believe appropriate, adjust the initial estimates provided by the broker to reflect management’s best judgments and expectations. This is most likely where the underwriter believes that the estimate is not prudent. We monitor the emergence of actual premium data on line slip policies and proportional reinsurance contracts and adjust our estimates of written premiums to reflect reported premiums on a periodic basis as additional information becomes available.
Treasury shares are common shares repurchased by our Company and not subsequently cancelled. These shares are recorded at cost and result in a reduction of our shareholders’ equity in the Consolidated Balance Sheets.
In 2006, we adopted FAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (“FAS 158”), an amendment of FAS No. 87, 88, 106 and 132 (R). Accordingly, at December 31, 2006, we reclassified the remaining unrecognized prior service cost on the SERPs from intangible assets with a finite life to accumulated other comprehensive income. In 2007, we acquired the assets and operations of the Media Professional Division of MPI Insurance Agency, Inc, which resulted in recording $24 million and $10 million of goodwill and intangible assets with a finite life, respectively.
The following provides an analysis of gross realized gains/losses and the change in unrealized gains/losses on investments included within accumulated other comprehensive loss:
We are required to maintain assets on deposit with various regulatory authorities to support our insurance and reinsurance operations. The assets on deposit are available to settle insurance and reinsurance liabilities. We also utilize trust accounts in certain large transactions for the benefit of ceding companies. These trust accounts generally take the place of Letter of Credit requirements. The assets in trust as collateral are primarily highly rated fixed maturity securities. The fair value of our restricted assets components are as follows:
Net loss and loss expenses incurred include net favorable prior period reserve development of $337 million, $217 million and $383 million for the years ended December 31, 2007, 2006 and 2005, respectively. Prior period development arises from changes to loss estimates recognized in the current year that relate to loss reserves first reported in previous calendar years. The following table summarizes the net favorable reserve development by segment:
At December 31, 2007, 19,651,329 common shares (2006: 19,644,253; 2005: 19,650,509) would be issued pursuant to the warrants, if all warrants were exercised at an average price of $12.42 (2006: $12.44; 2005: $12.46). All warrants were exercisable on November 20, 2001. At December 31, 2007, we had accrued $43 million (2006: $31 million; 2005: $20 million) of cash dividends relating to the anti-dilution provision in respect of the warrants. The expiration date for the warrants is November 20, 2011.
The following table summarizes information about our stock options at December 31, 2007:
The reduction of the valuation allowance for the capital loss carryforwards was recorded in the deferred tax benefit. In addition, the investment portfolio within taxable jurisdictions, was in a net unrealized gain position at December 31, 2007, resulting in a deferred tax liability and eliminating the deferred tax asset and related valuation allowance for unrealized losses. The elimination of the valuation allowance related to net unrealized losses has been recorded as a component of other comprehensive income.