The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the Company’s consolidated financial statements and related notes included elsewhere in this Annual Report.
Endurance Specialty Insurance Ltd. (“Endurance Bermuda”), domiciled in Bermuda with branch offices in Zurich and Singapore;
In addition to determining the applicable risk period, the Company’s estimate of its reinsurance premiums written is based on the type of reinsurance contracts underwritten. For excess of loss reinsurance contracts, the deposit premium, as defined in the contract, is generally considered to be the best estimate of the reinsurance contract’s written premium at inception. The Company earns reinstatement premiums upon the occurrence of a loss under the reinsurance contract. Reinstatement premiums are calculated in accordance with the contract terms based upon the ultimate loss estimate associated with each contract. Excess of loss reinsurance contracts accounted for approximately 24%, 23%, and 23% of the Company’s gross premiums written during the years ended December 31, 2010, 2009, and 2008, respectively. For proportional reinsurance contracts, the Company estimates premiums, commissions and related expenses based on broker and ceding company estimates. In addition to ceding company estimates, the Company also utilizes its judgment in establishing proportional reinsurance contract premium estimates after considering the following factors:
Other than Temporary Impairment. Following a determination of fair value, the Company reviews its fixed income portfolio to determine whether any declines in the fair value below the amortized cost basis of its fixed income portfolio are other-than-temporary. If the Company determines that a decision to sell the security has been made or that it is more likely than not that the Company will be required to sell the security, the Company deems the security to be other-than-temporarily impaired and writes it down to fair value, thereby establishing a new cost basis. The amount of the write-down is recognized in earnings as an other-than-temporary impairment (“OTTI”) loss.
The annualized net earned yield, total return of the investment portfolio for the years ended December 31, 2010, 2009 and 2008 and market yield and portfolio duration as of December 31, 2010 and 2009 were as follows:
Includes only cash and cash equivalents and fixed income portfolio held by the Company’s investment managers.
As of December 31, 2010, the Company maintained an investment portfolio with an average credit rating of AA. The Company’s investment portfolio consists of both mortgage-backed and asset-backed securities, which comprised 32.8% of total invested assets, including pending securities transactions, fixed maturity investments, short-term investments, preferred equity securities, cash and cash equivalents and Other Investments, at December 31, 2010. The Company, along with its investment managers, monitors the nature and type of assets underlying these types of securities. At December 31, 2010, the Company’s portfolio held no sub-prime mortgage exposure and the Company’s Alt-A exposure represented 1.0% of the Company’s fixed income portfolio. Of the Company’s Alt-A exposure, 78.8% are fixed rate securities.
A decline in workers’ compensation premiums written as a result of the Company’s exit from this line of business in the first quarter of 2009.
Net Losses and Loss Expenses. The net loss ratio in the Company’s Insurance segment in 2010 was comparable to 2009. The 2010 net loss ratio was characterized by a lower accident year loss ratio driven by the agriculture line, which experienced more favorable growing conditions in the current year than in 2009, offset by lower levels of favorable prior year loss reserve development in 2010. The net loss ratio in the Company’s Insurance segment in 2010 was lower than the 2008 net loss ratio due to the absence of severe weather that led to worse than expected growing conditions for major crops in the U.S. and declines in commodity prices experienced in 2008.
Corporate Securities. Corporate securities are comprised of bonds issued by corporations, primarily rated A-/A3 or higher and are diversified across a wide range of issuers and industries. Corporate securities also include high yield securities comprised of bonds issued by corporations rated below BBB-. The principal risk of corporate securities is the potential loss of income and potential realized and unrealized principal losses due to insolvencies or deteriorating credit. The largest corporate security in our portfolio represented less than 0.88% of the fixed income portfolio at December 31, 2010. We had minimal realized credit related losses during 2010.
The Company’s investments in (i) hedge funds and private equity funds that generally invest in senior secured bank debt, high yield securities, distressed debt, distressed real estate, derivatives and equity long/short strategies (“alternative funds”) and (ii) high yield loan funds are recorded on the Company’s balance sheet as “Other Investments”. As of December 31, 2010, our Board of Directors had approved investments in alternative funds at the time of commitment of capital of up to the lesser of (x) 15% of total shareholders’ equity, or (y) $350 million. This restriction does not apply to investments in high yield loan funds. Of Other Investments, alternative funds represented $269.2 million or approximately 71.5% and high yield loan funds represented $107.5 million or approximately 28.5%. As of December 31, 2010, our $376.7 million of Other Investments represented 6.1% of the Company’s invested assets including cash and cash equivalents, fixed maturity investments, short-term investments, preferred equity securities, Other Investments and net pending securities transactions.
The ability of Endurance Bermuda to pay dividends is dependent on its ability to meet the requirements of applicable Bermuda law and regulations. Under Bermuda law, Endurance Bermuda may not declare or pay a dividend if there are reasonable grounds for believing that Endurance Bermuda is, or would after the payment be, unable to pay its liabilities as they become due, or the realizable value of Endurance Bermuda’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. Further, Endurance Bermuda, as a regulated insurance company in Bermuda, is subject to additional regulatory restrictions on the payment of dividends or distributions. As of December 31, 2010, Endurance Bermuda could pay a dividend or return additional paid-in capital totaling approximately $640.4 million without prior regulatory approval based upon the Bermuda Insurance and Companies Acts regulations. In addition, in December 2009, Endurance Holdings loaned Endurance Bermuda $300 million which was repaid by Endurance Bermuda in January 2011.
The 2007 Credit Facility also contains customary event of default provisions, including failure to pay principal or interest under the facility, insolvency of the Company, a change in control of the Company, a breach of the Company’s representations or covenants in the facility or a default by the Company under its other indebtedness. Upon the occurrence of an event of default under the 2007 Credit Facility, the lenders can terminate their commitments under the credit facility, require repayment of any outstanding revolving loans, give notice of termination of any outstanding letters of credit in accordance with their terms, require the delivery of cash collateral for outstanding letters of credit and foreclose on any security held by the lenders under the 2007 Credit Facility.
In order to capture the key dynamics of loss development and expected volatility that may arise within the disclosed amounts for the reserve for losses and loss expenses, the key lines of business within each business segment are aggregated based on their potential expected length of loss emergence. The period over which loss emergence occurs is typically referred to as the tail. The Company has classified its lines of business as either having a “short,” “long” or “other” tail pattern. The Company views short tail business as that for which development typically emerges within a period of several quarters while long tail business would emerge over many years. The Company’s short tail lines of business in the Insurance segment includes property; long tail lines of business include casualty, healthcare liability, workers’ compensation and professional lines; and other tail lines of business include certain specialty lines of business for which loss emergence is considered unique in nature, such as the Company’s agriculture insurance business. The Company’s short tail lines of business in the Reinsurance segment include catastrophe, property, aerospace and marine and surety while the long tail line of business is casualty related business. Within the Company’s Reinsurance segment, the Company writes certain specialty lines of business for which the loss emergence is considered unique in nature and thus, has been included as “other” in the table below.
We have audited Endurance Specialty Holdings Ltd.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Endurance Specialty Holdings Ltd.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
Notes to the Consolidated Financial Statements for the years ended December 31, 2010, 2009 and 2008
Reporting entities are required to provide fair values for each class of assets and liabilities. The previous guidance required separate fair value for each major category of assets and liabilities.
Activity in the reserve for losses and loss expenses for the years ended December 31, 2010, 2009 and 2008 is summarized as follows:
During the year ended December 31, 2010, the Company recorded ceded losses of $139.1 million (2009 - $299.0 million; 2008 - $574.4 million). At December 31, 2010, the Company has an allowance for estimated uncollectible premiums receivable of $4.9 million (2009 - $12.8 million) and no allowance for estimated uncollectible losses recoverable (2009 - Nil).
The following table reconciles total segment results to income before income tax (expense) benefit for the years ended December 31, 2010, 2009 and 2008:
Major production sources. The following table shows the percentage of gross premiums written generated through the Company’s largest brokers for the years ended December 31, 2010, 2009 and 2008:
At December 31, 2010 and 2009, 2,985,527 and 2,995,527 warrants were outstanding, respectively. Such warrants are exercisable for ordinary and class A shares as follows:
Pyramis Global Advisors, a subsidiary of FMR, LLC (“Fidelity”), provides investment management services to the Company. Fidelity and its affiliates owned 4.8 million or 10.1% of Endurance Holdings’ ordinary shares outstanding at December 31, 2010 and were therefore considered a related party. The Company incurred investment management fees totaling $2.0 million (2009: $0.3 million; 2008: $0.2 million) to this investment manager of which $0.4 million was accrued at December 31, 2010 (2009: $0.1 million).