There is potential for significant variation in the development of loss reserves, particularly for the casualty lines of business due to their long-tail nature and high attachment points. The maturing of our casualty segment loss reserves has caused us to reduce what we believe is a reasonably likely variance in the expected loss ratios for older loss years. As of December 31, 2007, we believe a reasonably likely variance in our expected loss ratio for the 2002 and 2003 loss years is six and eight percentage points, respectively. This is a reduction from ten percentage points as of December 31, 2006. We believe the reasonably likely variance in the expected loss ratio for all other loss years continues to be ten percentage points. As a result, we have lowered the reasonably likely variance of our aggregate expected loss ratio for our casualty insurance and casualty reinsurance lines of business from ten percentage points as of December 31, 2006 to nine percentage points as of December 31, 2007. If our final casualty insurance and reinsurance loss ratios vary by nine percentage points from the expected loss ratios in aggregate, our required net reserves after reinsurance recoverable would increase or decrease by approximately $417 million. The $417 million is greater than the reasonably likely variance as of December 31, 2006 due to a larger net earned premium base to which the change in the expected loss ratio was applied. Because we expect a small volume of large claims, it is more difficult to estimate the ultimate loss ratios, so we believe the variance of our loss ratio selection could be relatively wide. This would result in either an increase or decrease to net income and shareholders’ equity of approximately $417 million. As of December 31, 2007, this represented approximately 18.6% of shareholders’ equity. In terms of liquidity, our contractual obligations for reserve for losses and loss expenses would also decrease or increase by $417 million after reinsurance recoverable. If our obligations were to increase by $417 million, we believe we currently have sufficient cash and investments to meet those obligations. We believe showing the impact of an increase or decrease in the expected loss ratios is useful information despite the fact we have realized only net favorable prior year loss development each calendar year. We continue to use industry benchmarks to determine our expected loss ratios, and these industry benchmarks have implicit in them both favorable and unfavorable loss development, which we incorporate into our selection of the expected loss ratios.
The following table sets forth our selected consolidated statement of operations data for each of the periods indicated.
The reduction in acquisition costs was offset slightly by reduced ceding commissions due to us on our general property and energy treaties. The factors that will determine the amount of acquisition costs going forward are the amount
including the elimination of certain classes of business, such as directors and officers as well as errors and omissions and changes in the underwriting guidelines under the agreement.
The net favorable reserve development of $7.1 million for the year ended December 31, 2007 was comprised of the following:
Acquisition costs. Acquisition costs decreased by $11.5 million, or 10.2%, for the year ended December 31, 2007 compared to the year ended December 31, 2006 primarily as a result of the related decrease in net premiums earned. The acquisition cost ratio of 20.2% for the year ended December 31, 2007 was lower than the 21.5% acquisition cost ratio for the year ended December 31, 2006 partially due to more contracts being written on an excess-of-loss basis and less on a proportional basis. Contracts written on a proportional basis typically carry higher acquisition costs than contracts written on an excess-of-loss basis. The acquisition cost ratio also decreased because we no longer pay a 6.5% override commission to IPCUSL as our underwriting agency agreement with them was terminated in December 2006.
In comparison, we were not exposed to any significant catastrophes during the year ended December 31, 2006. However, 2006 losses and loss expenses were impacted by several factors:
On July 21, 2006, we issued $500.0 aggregate principal amount of 7.50% senior notes due August 1, 2016, with interest payable August 1 and February 1 each year, commencing February 1, 2007. We can redeem the senior notes prior to maturity, subject to payment of a “make-whole” premium; however, we currently have no intention of redeeming the notes. The senior notes incorporate certain covenants that include:
The following table shows our aggregate contractual obligations by time period remaining until due date as of December 31, 2007:
As of December 31, 2007, we did not have any off-balance sheet arrangements.