Given the changing economic environment that has been experienced throughout 2008 and early 2009 due to the global economic and financial crises and following the significant impacts to the Company during 2008, including the downgrade of the financial strength ratings of the Company’s core insurance and reinsurance subsidiaries by leading rating agencies, the Company plans to focus on those lines of business within its insurance and reinsurance operations that provide the best return on capital over the pricing cycle. As such, the Company will be highly selective on new business, emphasize short-tail lines, where applicable, in the Company’s reinsurance operations, exit other businesses (e.g., Casualty facultative business), non-renew certain insurance programs, as well as continue to reduce long-term agreements (within the insurance operations) in order to capture the benefit of improving pricing. While certain of these decisions as well as any lost business as a result of rating agency downgrades will result in a reduction to both gross and net premiums written in 2009, the Company expects such negative impacts to be partially offset by the positive impact of hardening rates across most lines of business as described below.
impact of the closing of the Master Agreement (defined below) in August 2008 and the impact in 2007 of the Company’s investment in and relationships with Syncora;
The following table provides the realized and unrealized impact related to the Topical Assets during the year ended December 31, 2008:
Net prior year favorable loss development occurs when there is a decrease to loss reserves recorded at the beginning of the year, resulting from actual or reported loss development for prior years that is less than expected loss development. Net prior year adverse loss development occurs when there is an increase to loss reserves recorded at the beginning of the year, resulting from actual or reported loss development for prior years exceeding expected loss development.
Due to the financial market and economic events that occurred in the fourth quarter of fiscal 2008, the Company performed an interim impairment test for goodwill subsequent to its annual testing date of June 30. The interim impairment test resulted in a non-cash goodwill impairment charge of $990.0 million. The charge relates primarily to certain reinsurance units’ goodwill associated with the merger of Mid Ocean Limited (“Mid Ocean”) in 1998. The fair value of the Mid Ocean reporting unit was calculated using the methodologies as described within “Critical Accounting Policies and Estimates” below, and by comparison with similar companies using their publicly traded price multiples as the basis for valuation. For further information, see Item 8, Note 7 to the Consolidated Financial Statements, “Goodwill and Other Intangible Assets” and see further discussion under “Critical Accounting Policies and Estimates”.
Reduction of Expenses to Reflect Simplified Business: In light of the changes in business strategy noted above and in response to expense pressure from softening market conditions and other significant market events which impacted the Company throughout 2008, the Company implemented in the third quarter of 2008 and subsequently in the first quarter of 2009, expense reduction initiatives designed to streamline certain of its processes and functions and reduce the Company’s expense across all major geographic locations, with primary emphasis on corporate functions. The Company recorded restructuring charges totaling $50.8 million during the year ended December 31, 2008. In 2009, the Company expects to record an additional $1.9 million of restructuring charges associated with the restructuring efforts announced in the third quarter of 2008 and approximately $60 million to $80 million associated with the restructuring efforts announced in the first quarter of 2009. Restructuring charges relate mainly to employee termination benefits as well as certain asset writeoffs and ceasing to use certain leased property.
In 2008, the Company announced the commencement of a multiple year operational transformation program (the “Program”) within the Company’s Insurance segment that involved the planned transformation of numerous business processes and technology systems into a unified global architecture. However, in January 2009, following a review of this initiative and in light of the current economic climate, the Company refined the scope of the Program to focus on enhancing claims capabilities to strengthen and support the Insurance segment’s global claims operations.
Evaluation of the Impact of Credit Market Volatility on Core Underwriting Operations
Claims and expenses for individual policies within these annuity reinsurance contracts are projected over the lifetime of the contract to calculate a net present value of future cash flows. Assumptions for each element of the basis (mortality, expenses and interest) are determined at the issue of the contract and these assumptions are locked-in throughout the term of the contract unless a premium deficiency exists. The assumptions are best estimate assumptions plus provisions for adverse deviations on the key risk elements (i.e., mortality and interest). Provisions for adverse deviation are designed to cover reasonable deviations from the best estimate outcome of the contract. As the experience on the contracts emerges, the assumptions are reviewed. This occurs at least annually and includes both an analysis of experience and review of likely future experience. If such review would produce reserves in excess of those currently held then lock-in assumptions will be revised and a loss recognized. During the years ended December 31, 2008, 2007 and 2006, there were no adjustments to the locked-in assumptions for these annuity reinsurance contracts.
The increase in the underwriting expense ratio in the year ended December 31, 2007, compared to the same period in 2006 was due to an increase in the operating expense ratio of 1.2 points (16.6% as compared to 15.4%), partially offset by a decrease in the acquisition expense ratio of 0.2 points (11.8% as compared to 12.0%). The increase in the operating expense ratio was due primarily to higher compensation costs associated with higher head count and corporate allocations, and was partially offset by adjustments booked in 2007 relating to previously accrued regulatory costs. The decrease in the acquisition expense ratio resulted primarily from an increase in outward reinsurance profit commissions as well as favorable
With respect to those securities that were sold at a loss during the year ended December 31, 2007, the following is an analysis of the period of time that those securities had been in a continual unrealized loss position, the amount of the realized loss recorded in the Company’s results of operations as of the sale date and the amount of the impairment charge taken in the year:
Interest expense does not include interest expense related structured products as reported within the Insurance and Reinsurance segments.
Net income from other strategic operating affiliates decreased in the twelve months ended December 31, 2008 as compared to the same period in 2007 mainly due to lower earnings reported in 2008 from both an insurance affiliate which writes largely direct U.S. homeowners insurance and the Company’s Brazilian joint venture ITAÚ XL. Offsetting these decreases was earnings from an investment in an affiliate entered into in the second quarter of 2008 that provides reinsurance to certain Lloyd’s syndicates. Net income from other strategic operating affiliates increased in 2007 as compared to 2006, primarily as a result of strong
initial public offering in August 2006 as well as the minority interest ownership in preferred shares of Syncora Guarantee Re.
The primary objectives of the investment strategy are to support the liabilities arising from the operations of the Company, generate stable investment income and to build book value for the Company over the longer term. The strategy strives to balance investment returns against market and credit risks taken. The Company’s overall investment portfolio is structured to take into account a number of variables including local regulatory requirements, business needs, collateral management and risk tolerance.
In addition, the Company’s unsecured Lloyd’s letter of credit facility provides that, in the event that the Company’s insurance and reinsurance rated operating subsidiaries in Bermuda fall below a rating of “A-” from A.M. Best, the facility would then be required to be fully secured by the Company, at which time the Company would be required to either (i) provide an amount in cash to cover an amount equal to the aggregate letters of credit outstanding at that time or (ii) deposit assets in trust securing 105% of the aggregate letters of credit outstanding at that time.
Details on assets and liabilities that have been included under the requirements of FAS 157 to illustrate the bases for determining the fair values of the assets and liabilities held by the Company are detailed in each respective significant accounting policy section of this note.
The following table shows an analysis of intangible assets broken down between goodwill, intangible assets with an indefinite life and intangible assets with a definite life for the years ended December 31, 2008, 2007 and 2006:
Exchange rate effects on net loss reserves in each of the three years ended December 31, 2008 related to the global operations of the Company primarily where reporting units have a functional currency that is not the U.S. dollar. The increase in the value of the U.S. dollar in 2008 combined with the decrease in the value of the U.S. dollar in 2007 and 2006 mainly compared to the Swiss franc, U.K. Sterling and the Euro, gave rise to translation and revaluation exchange movements related to carried loss reserve balances of $(677.7) million, $421.6 million and $355.5 million in 2008, 2007 and 2006, respectively.
The Company utilizes tabular reserving for workers’ compensation (including long-term disability) unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 5% (2007: 5%). The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2008 and 2007 were $755.8 million and $813.7 million, respectively. The related discounted unpaid losses and loss expenses were $346.0 million and $377.0 million as of December 31, 2008 and 2007, respectively.