The fair value of certain financial assets, including privately placed corporate securities, Auction Rate Securities ("ARS") backed by student loans, equity-indexed notes, and certain free-standing derivatives, where our valuation service providers or brokers do not provide fair value determinations, is determined using valuation methods and models widely accepted in the financial services industry. Internally developed valuation models, which include inputs that may not be market observable and as such involve some degree of judgment, are considered appropriate for each class of security to which they are applied.
Reserves are the difference between the estimated ultimate cost of losses incurred and the amount of paid losses as of the reporting date. Reserves are estimated for both reported and unreported claims, and include estimates of all expenses associated with processing and settling all incurred claims. We update the majority of our reserve estimates quarterly and as new information becomes available or as events emerge that may affect the resolution of unsettled
Reserves are reestimated quarterly, by combining historical results with current actual results to calculate new development factors. This process incorporates the historic and latest actual trends, and other underlying changes in the data elements used to calculate reserve estimates. New development factors are likely to differ from previous development factors used in prior reserve estimates because actual results (claims reported or settled, losses paid, or changes to case reserves) occur differently than the implied assumptions contained in the previous development factor
The following table shows net claims and claims expense reserves by operating segment and line of business as of December 31:
Potential reserve estimate variability The aggregation of numerous micro-level estimates for each business segment, line of insurance, major components of losses (such as coverages and perils), and major states or groups of states for reported losses and IBNR forms the reserve liability recorded in the Consolidated Statements of Financial Position. Because of this detailed approach to developing our reserve estimates, there is not a single set of assumptions that determine our reserve estimates at the consolidated level. Given the numerous micro-level estimates for reported losses and IBNR, management does not believe the processes that we follow will produce a statistically credible or reliable actuarial reserve range that would be meaningful. Reserve estimates, by their very nature, are very complex to determine and subject to significant judgment, and do not represent an exact determination for each outstanding claim. Accordingly, as actual claims, and/or paid losses, and/or case reserve results emerge, our estimate of the ultimate cost to settle will be different than previously estimated.
Adequacy of reserve estimates We believe our net claims and claims expense reserves are appropriately established based on available methodology, facts, technology, laws and regulations. We calculate and record a single best reserve estimate, in conformance with generally accepted actuarial standards, for each line of insurance, its components (coverages and perils) and state, for reported losses and for IBNR losses, and as a result we believe that no
•Improving customer loyalty and retention •Broadening customer product relationships •Improving competitive position through pricing sophistication, claims efficiency and expense management •Investing in the effectiveness and reach of our multiple distribution channels •Maintaining a strong capital foundation through risk management and effective resource allocation
•Implemented rate increases where indicated •Strengthened underwriting guidelines •Revised renewal down payment requirements •Terminated relationships with certain independent agencies • Non-renewal of underperforming business segments •Discontinued writing the Special Value product (middle market auto product focused on segment auto) in certain states
Rate increases that are indicated based on loss trend analysis to achieve a targeted return will continue to be pursued. The following table shows the rate changes that were approved for standard auto during 2009 and 2008. These rate changes do not reflect initial rates filed for insurance subsidiaries initially writing business in a state. The following table does not include rating plan enhancements, including the introduction of discounts and surcharges, that result in no change in the overall rate level in the state.
We define a "catastrophe" as an event that produces pre-tax losses before reinsurance in excess of $1 million and involves multiple first party policyholders, or an event that produces a number of claims in excess of a preset, per-event threshold of average claims in a specific area, occurring within a certain amount of time following the event. Catastrophes are caused by various natural events including high winds, winter storms, tornadoes, hailstorms, wildfires, tropical storms, hurricanes, earthquakes and volcanoes. We are also exposed to man-made catastrophic events, such as certain acts of terrorism or industrial accidents. The nature and level of catastrophes in any future period cannot be reliably predicted.
We continue to take actions to maintain an appropriate level of exposure to catastrophic events, including the following:
$ (14 ) $ (264 ) $ (89 ) $ (172 )
Discontinued Lines and Coverages We conduct an annual review in the third quarter of each year to evaluate and establish asbestos, environmental and other discontinued lines reserves. Reserves are recorded in the reporting period in which they are determined. Using established industry and actuarial best practices and assuming no change in the regulatory or economic environment, this detailed and comprehensive grounds up methodology determines reserves based on assessments of the characteristics of exposure (e.g. claim activity, potential liability, jurisdiction, products versus non-products exposure) presented by policyholders.
The net loss in 2008 compared to net income in 2007 was primarily the result of higher net realized capital losses and, to a lesser extent, DAC and DSI amortization acceleration for changes in assumptions and additional amortization of DAC that was recorded in connection with a premium deficiency assessment for traditional life insurance and immediate annuities with life contingencies due to revised annuity mortality assumptions.
Contractholder deposits increased 15.7% in 2008 compared to 2007 due primarily to higher deposits on institutional products, and to a lesser extent, higher deposits on fixed annuities and Allstate Bank products. Deposits on fixed annuities increased 4.6% in 2008 compared to 2007 due primarily to increased consumer demand as the attractiveness of fixed annuities relative to competing products improved, partially offset by pricing decisions aimed to increase new business returns.
(1)Income tax benefit for 2009 includes expense of $142 million attributable to an increase in the valuation allowance relating to the deferred tax asset on capital losses recorded in the first quarter of 2009. This valuation allowance was released in connection with the adoption of new OTTI accounting guidance on April 1, 2009; however, the release was recorded as an increase to retained income and therefore did not reverse the amount recorded in income tax benefit. For further discussion of changes in this valuation allowance see the Deferred Taxes section of the MD&A.
Investment spread declined 55.2% or $468 million in 2009 compared to 2008, and 20.7% or $221 million in 2008 compared to 2007. These declines reflect lower net investment income, partially offset by decreased interest credited to contractholder funds.
•Investments as of December 31, 2009 totaled $99.83 billion, an increase of 4.0% from $96.00 billion as of December 31, 2008. •Unrealized net capital losses totaled $2.32 billion as of December 31, 2009, an improvement from $8.81 billion as of December 31, 2008. This resulted from improving fixed income and equity portfolio valuations. The fair value of fixed income securities increased as a result of significant tightening in credit spreads that more than offset a rise in risk-free interest rates. •Net investment income was $4.44 billion in 2009, a decrease of 21.0% from $5.62 billion in 2008. •Net realized capital losses of $583 million in 2009 primarily included $1.92 billion of net realized capital losses from other-than-temporary impairments partially offset by net realized capital gains of $1.27 billion primarily from the sales of fixed income and equity securities. Net realized capital losses were $5.09 billion in 2008. •During 2009, our fixed income and mortgage loan portfolio generated cash flows totaling $11.51 billion which increased our flexibility to take advantage of market opportunities and manage liabilities. •Over the last three quarters of 2009 we deployed approximately $16.6 billion of short-term investments and cash receipts into securities, primarily fixed income and equity securities, to generate income and capital appreciation. INVESTMENTS
Municipal Bonds, including tax exempt, taxable and ARS securities, totaled $21.28 billion as of December 31, 2009 with an unrealized net capital loss of $403 million. Taxable municipal bonds have an unrealized net capital loss of $455 million resulting from wider credit spreads than at initial purchase, which is largely due to the macroeconomic conditions and credit market deterioration that persisted throughout 2009, as well as specific issue or issuer conditions.
ARS totaled $1.69 billion with an unrealized net capital loss of $107 million as of December 31, 2009. Our holdings primarily have a credit rating of Aaa. $1.64 billion of our holdings are collateralized by pools of student loans for which at least 85% of the collateral was insured by the U.S. Department of Education at the time we purchased the security. As of December 31, 2009, $1.09 billion of our ARS backed by student loans was 100% insured by the U.S. Department of Education, $336 million was 90% to 99% insured and $158 million was 80% to 89% insured. All of our student loan ARS holdings are experiencing failed auctions and we receive the failed auction rate or, for those which contain maximum reset rate formulas, we receive the contractual maximum rate. We anticipate that failed auctions may persist and most of our holdings will continue to pay the failed auction rate or, for those that contain maximum rate reset formulas, the maximum rate. Auctions continue to be conducted as scheduled for each of the securities. At December 31, 2009, interest on $111 million of our ARS has reset using the maximum rate reset formula.
The banking, financial services, utilities and consumer goods sectors had the highest concentration of gross unrealized losses in our corporate fixed income securities portfolio at December 31, 2009. While credit spreads have tightened in the last three quarters of 2009 from the historically high levels observed in the fourth quarter of 2008 and the first quarter of 2009, they remain wider than at initial purchase for certain securities in the portfolio.
•The credit loss evaluation for non-agency RMBS securities, including Prime, Alt-A and Subprime securities, primarily relies on projections of losses based on future collateral performance, taking into account security specific delinquency and loss severity trends on the underlying mortgage collateral to date. The expected performance of each transaction considers projected collateral losses and credit enhancement levels, as well as an assessment of the origination practices of the transaction sponsor, geographic diversification, overall transaction structure, collateral type and quality, transaction vintage year and other considerations that may be of concern. Our default estimates on the underlying mortgage collateral are forward looking and generally based upon security specific performance trends to date as well as our overall economic outlook, with a focus on housing, unemployment and GDP expectations, and consider other factors that may influence future
(1)The difference between par value and amortized cost of $1.50 billion at December 31, 2009 and $2.00 billion at December 31, 2008 is primarily attributable to write-downs. Par value has been reduced by principal payments. (2)Bank loans are reflected at amortized cost. (3)Cumulative write-downs recognized only reflects impairment write-downs related to investments within the problem, potential problem and restructured categories.
We performed a sensitivity analysis on OTC derivative collateral requirements by assuming a hypothetical reduction in our S&P insurance financial strength ratings from AA- to A and a 100 basis point decline in interest rates. The analysis indicated that we would have to post an estimated $327 million in additional collateral with 67.3% attributable to Allstate Financial. The selection of these hypothetical scenarios should not be construed as our prediction of future events, but only as an illustration of the estimated potential effect of such events. We also actively manage our counterparty credit risk exposure by monitoring the level of collateral posted by our counterparties with respect to our receivable positions.
To the extent that conditions differ from the assumptions we used in these calculations, duration and rate shock measures could be significantly impacted. Additionally, our calculations assume that the current relationship between short-term and long-term interest rates (the term structure of interest rates) will remain constant over time. As a result, these calculations may not fully capture the effect of non-parallel changes in the term structure of interest rates and/or large changes in interest rates.
Foreign currency exchange rate risk is the risk that we will incur economic losses due to adverse changes in foreign currency exchange rates. This risk primarily arises from our foreign equity investments, including real estate funds and private equity funds, and our Canadian operations. We also have certain funding agreement programs and fixed income securities that are denominated in foreign currencies; however, derivatives are used to hedge the foreign currency risk of these funding agreements and approximately 82% of the fixed income securities. At both December 31, 2009 and 2008, we had $713 million in funding agreements denominated in foreign currencies.
$ (111 ) $ (32 ) $ (4 ) $ (78 ) $
Funds from investment repurchase agreements, securities lending, commercial paper and line of credit agreements
ALIC by a subsidiary of ALIC. In 2008, Allstate Financial cash flows were also impacted by funds paid by AIC to ALIC totaling $1.41 billion. The $1.41 billion includes capital contributions paid in cash totaling $607 million and the issuance of two surplus notes, each with a principal sum of $400 million, to AIC in exchange for cash totaling $800 million. Allstate Financial cash flows in 2008 exclude capital contributions to ALIC comprising the transfer to ALIC from AIC of non-cash assets totaling $342 million and the transfer of a $50 million surplus note to Kennett Capital Inc. from ALIC in exchange for a note receivable with a principal sum equal to that of the surplus note, which was originally issued to ALIC by a subsidiary of ALIC. One of the surplus notes issued to AIC in 2008 was subsequently canceled and forgiven by AIC resulting in the recognition of a capital contribution equal to the outstanding principal balance of the surplus note of $400 million. There were no capital contributions to ALIC in 2007.
Short-term investments, including money market funds, commercial paper and other short-term investments, are carried at fair value. Other investments consist primarily of policy loans and bank loans. Policy loans are carried at the respective unpaid principal balances. Bank loans are comprised primarily of senior secured corporate loans which are carried at amortized cost.
A rollforward of the amount recognized in earnings related to credit losses for fixed income securities is presented in the following table.
For each fixed income security in an unrealized loss position, the Company assesses whether management with the appropriate authority has made a decision to sell or whether it is more likely than not the Company will be required to sell the security before recovery of the amortized cost basis for reasons such as liquidity, contractual or regulatory purposes. If a security meets either of these criteria, the security's decline in fair value is deemed other than temporary and is recorded in earnings.
(1)Gross unrealized losses resulting from factors other than credit on fixed income securities with other-than-temporary impairments for which the Company has recorded a credit loss in earnings total $20 million for the less than 12 month category and $729 million for the 12 months or greater category.
As of December 31, 2009, $1.55 billion of unrealized losses are related to securities with an unrealized loss position less than 20% of cost or amortized cost, the degree of which suggests that these securities do not pose a high risk of being other-than-temporarily impaired. Of the $1.55 billion, $1.20 billion are related to unrealized losses on investment grade fixed income securities. Investment grade is defined as a security having a rating of Aaa, Aa, A or Baa from Moody's, a rating of AAA, AA, A or BBB from S&P, Fitch, Dominion or Realpoint, a rating of aaa, aa, a or bbb from A.M. Best, or a comparable internal rating if an externally provided rating is not available, which is consistent with the National Association of Insurance Commissioners ("NAIC") rating. Unrealized losses on investment grade securities are principally related to rising interest rates or changes in credit spreads since the securities were acquired.
As of December 31, 2009, the Company has not made a decision to sell and it is not more likely than not the Company will be required to sell fixed income securities with unrealized losses before recovery of the amortized cost basis. As of December 31, 2009, the Company had the intent and ability to hold the equity securities with unrealized losses for a period of time sufficient for them to recover.
At December 31, 2009, fixed income securities and short-term investments with a carrying value of $267 million were on deposit with regulatory authorities as required by law.
•Fixed income securities: Comprise U.S. Treasuries. Valuation is based on unadjusted quoted prices for identical assets in active markets that the Company can access.
Corporate, including privately placed: Valued based on non-binding broker quotes or based on models that are widely accepted in the financial services industry with certain inputs to the valuation model that are significant to the valuation, but are not market observable. Equity-indexed notes, which are senior unsecured debt obligations of corporate issuers, are categorized as Level 3 as a result of the significance of non-market observable inputs.
The Company undertakes various programs to reduce expenses. These programs generally involve a reduction in staffing levels, and in certain cases, office closures. Restructuring and related charges include employee termination and relocation benefits, and post-exit rent expenses in connection with these programs, and non-cash charges resulting from pension benefit payments made to agents in connection with the 1999 reorganization of Allstate's multiple agency programs to a single exclusive agency program. In 2009, restructuring programs primarily relate to Allstate Protection's claim office consolidations, initiatives to improve efficiency and prioritization of technology operations, and reorganization of Business Insurance, as well as Allstate Financial's initiative to lower operating expenses. The expenses related to these activities are included in the Consolidated Statements of Operations as restructuring and related charges, and totaled $130 million, $23 million and $29 million in 2009, 2008 and 2007, respectively.
Minimum rental commitments under noncancelable capital and operating leases with an initial or remaining term of more than one year as of December 31, 2009 are as follows:
level of $350 million. There is no provision that allows insurers to recover assessments through a premium surcharge or other mechanism. The CEA's projected aggregate claim paying capacity is $9.60 billion as of September 30, 2009 and if an event were to result in claims greater than its capacity, affected policyholders would be paid a prorated portion of their covered losses.
The Internal Revenue Service ("IRS") is currently examining the Company's 2007 and 2008 federal income tax returns. The IRS has completed its examination of the Company's federal income tax returns for 2005-2006 and the case is under consideration at the IRS Appeals Office. The Company's tax years prior to 2005 have been examined by the IRS and the statute of limitations has expired on those years. Any adjustments that may result from IRS examinations of tax returns are not expected to have a material effect on the results of operations, cash flows or financial position of the Company.
The tax benefit realized in 2009, 2008 and 2007 related to tax deductions from stock option exercises and included in shareholders' equity was zero, $3 million and $20 million, respectively. The tax benefit realized in 2009, 2008 and 2007 related to all stock-based compensation and credited directly to shareholders' equity was $(6) million, $3 million and $30 million, respectively.
Allstate Protection sells principally private passenger auto and homeowners insurance in the United States and Canada. Revenues from external customers generated outside the United States were $619 million, $665 million and $668 million for the years ended December 31, 2009, 2008 and 2007, respectively. The Company evaluates the results of this segment based upon underwriting results.