The following is a discussion and analysis of our results of operations for the years ended December 31, 2008, 2007 and 2006 and our financial condition at December 31, 2008 and 2007. This should be read in conjunction with the Consolidated Financial Statements and related notes included in Item 8 of this report. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.
Results of Operations Overview: Years ended December 31, 2008, 2007 and 2006
Results by Segment: Years ended December 31, 2008, 2007 and 2006
Return on average common equity (“ROACE”): ROACE represents the level of net income available to common shareholders generated from the average of the opening and closing common shareholders’ equity during the period. Our objective is to generate superior returns on capital that appropriately reward our common shareholders for the risks we assume and to grow revenue only when we deem the returns meet or exceed our requirements. Although we recognize that the underwriting cycle is such that short-term excess profitability may be difficult to achieve, our current objective is to achieve an average ROACE of 15% or greater over the underwriting cycles.
2007 versus 2006: Total underwriting income in 2007 increased $63 million compared to 2006. There was an absence of major loss activity in both years and the increase in income was primarily due to additional prior period reserve development within both segments.
Interest expense: Interest expense primarily includes interest due on the senior notes we issued in 2004. In 2007, it also included interest costs of $19 million incurred on a $400 million repurchase agreement we entered into in December 2006 to finance a life settlement investment. We terminated this agreement in September, 2007.
The following table provides our group underwriting results for the periods indicated:
(1) Refer to Item 8, Note 3 to the Consolidated Financial Statements, for a reconciliation of underwriting income to net income available to common shareholders for the periods indicated above.
2008 versus 2007: The 6% reduction in consolidated gross premiums emanates from our insurance segment, reflecting the reduction of business due to deteriorating market conditions across most of our property and casualty insurance lines of business. In addition, our credit and political risk insurance line was negatively impacted by a reduction in available transactions associated with a slow down in the capital flows amidst the ongoing global financial crisis. Gross premiums
written in our reinsurance segment in 2008 were largely unchanged from 2007. Although market conditions deteriorated moderately during the year, the impact of this was largely offset by some growth opportunities.
2008 versus 2007: The reduction in net premiums earned in 2008 as compared with 2007 primarily emanates from our insurance segment, reflecting lower net premiums written this year, partially offset by the impact of growth in certain lines of business in prior years. Refer to the insurance segment results below for further information.
Other Insurance Related Income / Loss: In 2008, we recorded an increase of $41 million, relating to the change in fair value of our insurance derivative contract liability primarily attributable to adverse longevity experience to date. For further information refer to our “Critical Accounting Estimate - Fair Value Measurements.”
On September 1, Hurricane Gustav made landfall on the Louisiana Gulf coast as a category 2 hurricane. The hurricane and tropical storm force winds of Hurricane Gustav as well as spin-off tornadoes caused damage in our coverage areas of Louisiana, Mississippi and Alabama. The industry losses estimated by Risk Management Solutions, a risk modeling agency, currently stand at $4 billion to $10 billion, and include wind-related damages, flood-related damages and business interruption. Our estimate of net losses from Hurricane Gustav is $31 million, of which $28 million emanates from our insurance segment and $3 million from our reinsurance segment. Our estimate at December 31, 2008 was primarily based on reported loss information from our clients, brokers and loss adjusters, supplemented by our review of in-force contracts, the output of industry models and a market share analysis.
The balance of our loss estimates for Hurricane Ike were primarily based on reported loss information from our clients, brokers and loss adjusters, supplemented by our review of in-force contracts, the output of industry models and a market share analysis.
On December 11, 2008, Bernard Madoff, Chairman of Bernard L. Madoff Investment Securities LLC, was charged with perpetrating a substantial investor fraud within the asset management division of the firm. Based on our assessment of the precautionary notifications received to date in our financial institutions insurance lines, together with our preliminary review of other potential exposure within our insurance and reinsurance professional lines business, we currently estimate losses relating to this event will be contained within our loss ratios.
Adverse development of $48 million on our accident year 2007 professional lines reserves. During the year, a number of large financial institutions incurred significant financial losses and, in some cases, bankruptcy precipitated by the continued deterioration in the U.S. sub-prime residential mortgage market and the ensuing dislocation in the credit markets. These market driven events triggered claims against directors and officers of impacted institutions as well as providers of professional services of these institutions. As part of our reserving process, we considered the potential impact of market events on our financial institutions insurance portfolio. This included a review for exposure to known notifications of potential loss, as well as a review of accounts that may have exposure in this area, but have not yet provided notice of a claim. We also performed a similar review in our reinsurance segment, where potential exposure primarily exists within financial institution classes underwritten by our cedants. As a result, we strengthened our accident year 2007 reserves by $37 million in our insurance segment and by $11 million in our reinsurance segment. Although our reserves provide for potential future deterioration in our exposure to the credit crisis, while the crisis prevails and as new information is reported, actual losses may ultimately differ materially from our current estimates.
Favorable prior period reserve development of $57 million on our accident year 2003 and 2004 professional lines business, of which $32 million was generated from our insurance segment and $25 million from our reinsurance segment. The favorable development was due to the fact that we began to incorporate more of our own claims experience into our loss ratios, with less weighting on our initial expected loss ratios derived from industry benchmarks. We believe that for these more mature accident years, for this claims-made line of business, our loss experience is sufficiently developed, and therefore more statistically reliable.
Net adverse development of $7 million on our accident year 2003 liability reserves in our reinsurance segment. This was driven by adverse claims experience on a specific stop loss contract.
2008 versus 2007: The global property and casualty insurance markets continued to be highly competitive during 2008 with surplus capacity and price deterioration remaining prevalent. Gross premiums written declined in most of our lines of business reflecting declining rates for new and renewal business and the non-renewal of business that did not meet our underwriting requirements. The reduction in property premiums also reflects our decision to reduce our overall risk exposure to this business while unfavorable market conditions persist. Our credit and political risk premium also decreased reflecting the reduction in available transactions associated with a slow down in capital flows amidst the global financial crisis.
2008 versus 2007: Premiums ceded in 2008 were $708 million, or 38.4% of gross premiums written, compared with $713 million, or 34.9%, in 2007. The increase in our ceded premium ratio primarily reflects the purchase of additional quota share coverage within our casualty and professional lines business this year. The increase also partially reflects the impact of business mix, in particular the growth of our professional lines business this year together with the reduction in credit and political risk premiums, a line for which we do not purchase reinsurance cover.
2007 versus 2006: The 7% decrease in net premiums earned in 2007 largely reflects a 9% reduction in net premiums written in 2007, associated with the increase in premiums ceded.
The 11.0 ratio point increase in our current year loss ratio was the net result of several factors, the most significant of which were as follows:
A reduction in our credit and political risk loss ratio relative to 2007. This was primarily due to accelerating the loss development profile of our credit related classes based on our historical loss experience. Although we experienced an increase in loss activity from these classes during the second half of 2008, stemming from the economic downturn, these losses remained within our initial loss ratios.
Net adverse development of $6 million from our professional lines business. This was driven by adverse development of $37 million from accident year 2007 stemming from the credit crisis, partially offset by favorable development of $32 million on accident years 2003 and 2004.
$202 million of net favorable prior period reserve development on our property ($112 million), marine ($44 million), aviation lines ($37 million) and terrorism ($9 million) lines of business. This development was primarily generated from accident year 2006 ($127 million), 2004 ($44 million) and 2003 ($26 million). Our accident year 2005 reserves were adversely impacted by the strengthening of our KRW loss estimates by approximately $34 million.
We experienced net favorable prior period reserve development in 2006 of $168 million, or 12.8 ratio points, the principal movements of which were as follows:
$181 million of net favorable prior period reserve development on our property ($106 million), aviation ($65 million) and terrorism ($10 million) lines of business. This development was primarily generated from accident year 2005 ($80 million), 2004 ($73 million) and 2003 ($27 million).
are critical. We expect competition in the liability market to abate gradually as the impact of rising reinsurance costs take affect and as clients move more business to insurers with stronger financial strength.
The opportunity for growth within our reinsurance portfolio was generally limited this year, reflecting a modest deterioration in global market conditions. In addition, we experienced an ongoing trend of higher risk retention by our clients, particularly on our liability lines. These factors were partially offset by growth opportunities within our engineering and crop line of business this year. We also recorded $28 million of reinstatement premiums in connection with Hurricanes Ike and Gustav on our catastrophe line of business. Our property premiums in 2008 benefited from the renewal of a significant 16-month pro-rata contract, which previously renewed in 2006.
Our initial expected loss ratios in 2008 were mostly higher than in 2007, reflecting the impact of pricing deterioration across many of our lines of business. The impact of this was partially offset by the incorporation of more of our own historical loss experience in our loss picks, which has generally been better than the industry benchmarks that we also incorporate. During 2008, we increased the expected loss ratios on our credit and bond lines of business, relative to 2007, to reflect increased loss activity within the deteriorating economic environment.
$162 million of net favorable prior period reserve development on our property ($84 million) and catastrophe lines of business ($78 million). This development was generated from accident years 2007 ($62 million), 2006 ($46 million), 2005 ($28 million) and 2004 and prior ($26 million).
$10 million of favorable prior period reserve development on our accident year 2007 and 2006 crop reserves.
$7 million adverse development on our accident year 2003 liability reserves related to higher than expected loss emergence on a stop loss contract.
$104 million of net favorable prior period reserve development on our catastrophe ($78 million) and property lines of business ($26 million). This development was primarily generated from accident years 2006 ($94 million).
We experienced net favorable prior period reserve development in 2006 of $49 million, or 3.5 points, the principal movements of which were as follows:
Refer to “Prior Period Reserve Development” within our Group Underwriting Results, above, for discussion on the underlying reasons for these movements.
Outside of the U.S., European and Caribbean property catastrophe placement were up approximately 5% but all other non-U.S. geographies were down. In the U.S. property catastrophe market, small regional covers with no loss experience renewed flat to up modestly. Larger regional and super regional placements saw rate increases closer to 10% and more if loss-affected. Nationwide placements or placements with heavier southeast exposures were up 15% to 20% and even more in some cases. We believe several of these major placements did not get fully placed. The number of shortfall covers and private deals that seemed to abound in the market was a very good indication of relative market discipline and a lack of new capacity. We believe that rates will continue to strengthen in peak zones. We have also observed some upward movement in U.S. earthquake driven property catastrophe treaties in January 2009. Continued dislocations in the Florida market are likely to add more upward pressure on pricing for Florida exposed risk. Overall, our property catastrophe reinsurance premium was relatively stable at the January 1, 2009 versus the prior year. However, we reduced our exposure to European windstorm due to the less attractive risk-reward profile relative to other peak zones. More broadly, we are also attaching higher in a number of programs.
In recent months, we have witnessed unprecedented global government interventions to stabilize the financial markets and restore credit availability, liquidity and confidence. We have also witnessed a coordinated global action to significantly reduce short-term interest rates. Although these actions are intended to stimulate inter-bank lending and the commercial paper markets in order to bring an end to the current credit crisis, there is no assurance that these actions will be effective. Accordingly, our investment results and investment portfolio could continue to be materially and adversely impacted in the near term. For further analysis of these market risks, refer to
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 24, 2009 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
The terms “FAS” and “FASB” used in these notes refer to Statements of Financial Accounting Standards issued by the Financial Accounting Standards Board, a United States based accounting standard setter. These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). All significant inter-company accounts and transactions have been eliminated.
fair value measurement for certain fixed maturities, other investments and derivatives.
Effective January 1, 2008, we partially adopted FAS 157, Fair Value Measurements (“FAS 157”), with no cumulative effect upon adoption. FAS 157 defines fair value as the price to sell an asset or transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants. Additionally, FAS 157 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. The hierarchy is broken down into three levels based on the reliability of inputs as follows:
Examples of assets and liabilities utilizing Level 3 inputs include: insurance and reinsurance derivative contracts; hedge and credit funds with partial transparency; and collateralized loan obligation (“CLO”) - equity tranche securities that are traded in less liquid markets.
In October 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active (“FSP FAS 157-3”), which clarifies the application of FAS 157 in a market that is not active. The key considerations highlighted in the FSP FAS 157-3 include the use of an entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates, appropriate risk adjustments for non-performance and liquidity risks, and the reliance that an entity should place on quotes that do not reflect the result of market transactions. FSP FAS 157-3 was effective upon issuance.
Purchases and sales of investments are recorded on a trade date basis. Realized gains or losses on sales of investments are determined based on the specific identification method. Net investment income is recognized when earned and includes interest and dividend income together with amortization of market premiums and discounts using the effective yield method and is net of investment management fees and other expenses. For mortgage-backed securities and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Any adjustments required due to the change in effective yields and maturities are recognized on a prospective basis through yield adjustments.
We account for our other investments at fair value, with the change in fair value and realized gains and losses reported in net investment income.
For hedge, credit and short duration high yield funds, we measure fair value by obtaining the net asset value as advised by the external fund manager, or third party administrator. Certain of these funds have lock-up and other redemption provisions which limit our ability to liquidate these funds in the short term. As these contractual provisions are common in the alternative investment industry, we do not apply a discount factor to the reported net asset value.
Cash equivalents include money-market funds and fixed interest deposits placed with a maturity of under 90 days when purchased. Restricted cash and cash equivalents, which have been previously reported as part of cash and cash equivalents, are now separately reported in the Consolidated Balance Sheets at December 31, 2008 and 2007. Accordingly, changes in restricted cash and cash equivalents are now reported as an investing activity in our Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007 and 2006.
The reserve for uncollectible reinsurance is based on an estimate of the amount of the reinsurance recoverable balance that will ultimately not be recovered due to reinsurer insolvency, contractual disputes or some other reason. The valuation of this reserve includes several processes, including a review of case-specific allowances for coverage issues and a default analysis based on the financial strength rating of the reinsurers. These factors require considerable management judgment and the factors are reviewed in detail on a regular basis with any resulting adjustments reflected in losses and loss expenses in our Consolidated Statement of Operations in the period that collection issues are identified.
For reported losses, management primarily establishes case reserves based on amounts reported from insureds or ceding companies. Management may also establish additional case reserves on claims reported which are not considered adequately reserved. Case reserves are established on a case by case basis within the parameters of coverage provided in the insurance and reinsurance contracts. Our general IBNR reserves are calculated by projecting our ultimate losses on each class of business and subtracting paid losses and case reserves. Unlike case reserve, IBNR is generally calculated at an aggregate level and cannot usually be directly identified as reserves for a particular loss or contract.
Within our reserving process, management utilizes the initial expected loss ratio method (“IELR”), Bornhuetter-Ferguson (“BF”) and chain ladder actuarial methods. The IELR method calculates an estimate of ultimate losses by applying an estimated loss ratio to an estimate of ultimate earned premium for each underwriting year. The estimated loss ratio is based on pricing information and industry data and is independent of the current claim experience to date. The BF method uses as a starting point an assumed IELR and blends in the loss ratio implied by the claims experience to date by using benchmark loss development. This method uses actual loss data and the historical development profiles on older accident years to project more recent, less developed years to their ultimate position. The basis of our selected single point best estimate on a particular line of business is often a blend of the results from two or more methods (e.g. weighted averages). Our estimate is highly dependent on management’s judgment as to which method(s) is most appropriate for a particular accident year and class of business. Our methodology changes over time as new information emerges regarding underlying loss activity and other data issues.
Management also performs an analysis of additional factors to be considered when establishing our IBNR, intended to enhance our best estimate beyond quantitative techniques and reflect uncertainties specific to our business. These uncertainties may vary over time, but generally contemplate matters such as the timing and emergence of claims or short term market trends.
Our functional currency is the U.S. dollar. We remeasure monetary assets and liabilities denominated in foreign currencies at year end exchange rates, with the resulting foreign exchange gains and losses recognized in the Consolidated Statements of Operations. Revenues and expenses in foreign currencies are converted at average exchange rates during the year. In the case of foreign currency denominated fixed maturity investments, the change in exchange rates between the local currency and our functional currency at each balance sheet date represents an unrealized appreciation or depreciation in value of these securities, and is included as a component of accumulated other comprehensive income.
Effective January 1, 2006, we adopted FAS No. 123 (revised 2004), Share Based Payment (“FAS No. 123(R)”) using the modified prospective approach, resulting in no significant impact on net income and basic and diluted earnings per share for 2006. We determine the fair value of the stock-based award at the date of grant and recognized the share-based compensation expense over the period the award is earned by the employee, net of our best estimate of forfeiture benefits.
We measure all derivative instruments at fair value (see above (a) Fair Value Measurements) and recognize as either assets or liabilities in the Consolidated Balance Sheets. We record the change in fair value and realized gains or losses on derivative instruments in the Consolidated Statements of Operations.
We have certain subsidiaries which operate in jurisdictions where they are subject to taxation. Current and deferred income taxes are provided based upon enacted tax laws and rates applicable in the relevant jurisdictions. Deferred income taxes are provided on all temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance against deferred tax assets is recorded when our assessment indicates that it is more likely than not that a portion of the deferred tax asset will not be realized in the foreseeable future. On January 1, 2007, we adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109” (“FIN 48”). Under FIN 48, the tax benefits of uncertain tax positions may only be recognized when the position is more-likely-than-not to be sustained upon audit by the relevant taxing authorities.
In December 2008, we have adopted FAS No. 141(R), Business Combinations (“FAS 141(R)”) and FAS No. 160, Noncontrolling Interests in Consolidated Financial Statements - an amendment of Accounting Research Bulletin No. 51 (“FAS 160”). SFAS 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to provide additional disclosures on the nature and financial
effect of the business combination. FAS 141(R) applies to all transactions or other events in which the acquirer obtains control of one or more businesses, even if control is not obtained by purchasing equity interests or net assets. FAS 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. FAS 141(R) will apply to our recent acquisition of the business and operations of the managing general agent Dexta Corporation Pty Ltd (“Dexta”) which closed in January 2009. We do not expect this revised accounting pronouncement will have a material impact to our results of operations, financial condition or liquidity.
We early adopted FASB Staff Position No. FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161, which was issued in September 2008. This Staff Position amends FAS 133 to require a seller of credit derivatives, including credit derivatives embedded in hybrid instruments, to provide certain disclosures for each credit derivative (or group of similar credit derivatives) for each balance sheet presented. These disclosures must be provided even if the likelihood of having to make payments is remote. This FSP also amends FIN 45 to require additional disclosure about the current status of the payment/performance relating to the guarantee. At December 31, 2008, we did not have any credit derivatives or guarantees as defined in FIN 45.
In May 2008, the FASB issued FAS No. 163, Accounting for Financial Guarantee Insurance Contracts (“FAS 163”). This new standard clarifies how FAS No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities. It also requires expanded disclosures about financial guarantee insurance contracts. FAS 163 is effective for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for disclosures about the insurance enterprise’s risk-management activities, which was effective for our quarter ended September 30, 2008. We adopted FAS 163 on January 1, 2009. The applicability of FAS 163 to our existing insurance contracts requires significant judgment and based on our interpretation of its scope this adoption will not have a material impact on our results of operations, financial position or liquidity.
In June 2008, the FASB issued FSP EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (“FSP EITF 03-6-1”). FSP EITF 03-6-1 provides additional guidance in the calculation of earnings per share under FAS No. 128, Earnings Per Share, and requires unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) to be included in the computation of earnings per share pursuant to the two-class method. FSP EITF 03-6-1 is effective beginning January 1, 2009, and we do not expect this will have a material impact to our financial statements upon adoption.
At December 31, 2008, 1202 fixed maturities (2007: 1,440) were in an unrealized loss position with a fair value of $3,434 million (2007: $2,718 million) of which 266 securities (2007: 1,065) have been in continuous unrealized loss position for 12 months or greater and have a fair value of $702 million (2007: $1,422 million). In 2008, we incurred OTTI charges of $71 million (2007: $9 million; 2006: $5 million) relating to fixed maturities. These charges primarily emanated from the financial institutions sector, including $32 million relating to Lehman Brothers corporate bonds. Based on our qualitative and quantitative OTTI review of each asset class within our fixed maturity portfolio, the remaining unrealized losses on fixed maturities at December 31, 2008, were primarily due to widening of credit spreads relating to the market illiquidity, rather than credit events. Because we have the ability and intent to hold these securities until a recovery of fair value to amortized cost, we currently believe it is probable that we will collect all amounts due according to their respective contractual terms. Therefore we do not consider these fixed maturities to be other-than-temporarily impaired at December 31, 2008.
The following provides an analysis of gross and net realized gains/losses and the change in unrealized gains/losses on investments included within accumulated other comprehensive loss:
We participate in a securities lending program whereby our securities, which are included in investments, are loaned to third parties, primarily major brokerage firms for short periods of time through a lending agent. We maintain control over the securities loaned, retain the earnings and cash flows associated with the loaned securities and receive a fee from the borrower for the temporary use of the securities. Collateral in the form of cash, government securities and letters of credit is required at a rate of 102.0% of the fair value of the loaned securities and is monitored and maintained by the lending agent. At December 31, 2008, we had $406 million (2007: $848 million) in securities on loan. We consider our securities lending activities to be non-cash investing and financing activities. As a response to current market conditions, we are currently winding down this lending program to reduce our counterparty credit risk.
The following table presents changes in Level 3 for our financial instruments measured at fair value on a recurring basis for the year ended December 31, 2008:
Observable equity tranche CLO trades in the secondary markets are infrequent, particularly given the illiquidity in the current credit markets. Accordingly, because we were unable to corroborate non-binding quotes from brokers with observable market data, we continued using our internal valuation model based on our assumptions with respect to the expected future cash flows and risk-adjusted discount rates. These include current market inputs such as default and recovery rates, collateral spread, and prepayments. Of these assumptions, the default rate is the most subjective and judgmental input. The current market default rate of approximately 4% (as reported by S&P for speculative-grade securities) is lower than the average default rates assumed in our models; however, we currently believe that a market participant would adjust the current default rates to our assumed average default rates over the life of our CLOs.
the timing of the receipt of death benefits as well as the amount of premiums to be paid to maintain the policies in force, both of which are directly correlated to life expectancy assumptions for a portfolio of 188 lives;
The carrying amount of financial assets and liabilities presented on the Consolidated Balance Sheets as at December 31, 2008 and 2007 are equal to their fair value with the exception of senior notes. Senior notes are recorded at amortized cost with a carrying value of $499,368 (2007: $499,261) and a fair value of $415,000 (2007: $501,815).
The following table represents a reconciliation of our beginning and ending net losses and loss expense reserves:
We write business with loss experience generally characterized as low frequency and high severity in nature, which results in volatility in our financial results. In 2008, we incurred net loss and loss expenses of $408 million relating to Hurricanes Ike and Gustav. Our estimate at December 31, 2008 was primarily based on reported loss information from our clients, brokers and loss adjusters, supplemented by our review of in-force contracts, the output of industry models and a market share analyses. Industry-wide insured losses and our own loss estimates for Hurricanes Gustav and Ike are subject to change as claims continue to be reported and adjusted. Actual losses may ultimately differ materially from current loss estimates.
Net favorable prior period reserve development in each of the last three years was primarily generated from the property, marine, terrorism and aviation lines of our insurance segment and the property and catastrophe lines of our reinsurance segment. The favorable development reflects the recognition of better than expected loss emergence rather than explicit changes to our actuarial assumptions.
We recorded favorable reserve development of $57 million on our accident year 2003 and 2004 professional lines business in 2008, of which $32 million was generated from our insurance segment and $25 million from our reinsurance segment. The favorable development was due to the fact that we began to incorporate more of our own claims experience into our loss ratios, with less weighting on our initial expected loss ratios derived from industry benchmarks. We believe that for these more mature accident years, for this claims-made line of business, our loss experience is sufficiently developed, and therefore more statistically reliable.
At December 31, 2008, 6.2% (2007: 9.2%) of the total reinsurance recoverable balance was collateralized.
The following table summarizes information on the location and amounts of derivative fair values on the consolidated balance sheet as at December 31, 2008:
The following table summarizes information on the location and amounts of derivative fair values on the consolidated balance sheet as at December 31, 2007:
The following table provides the total unrealized and realized gains (losses) recorded in earnings for the years ended December 31, 2008, 2007 and 2006.
gains to offset the gains on the foreign exchange contracts noted in the above table. The difference of $1 million represents the hedge ineffectiveness.
Within our AFS investment portfolio we are exposed to foreign currency risk. Accordingly, the fair values for our AFS investment portfolio are partially influenced by the change in foreign exchange rates. We entered in foreign currency forward contracts to manage the effect of this foreign currency risk. Certain of these foreign currency hedging activities did not meet the criteria for hedge accounting.
At December 31, 2008, we had a $1.5 billion credit facility agreement with a syndicate of lenders. The credit agreement is an unsecured five-year facility that allows us to issue letters of credit up to the full amount of the facility and to borrow up to $500 million for general corporate purposes, with total usage not to exceed $1.5 billion. The credit facility will expire on August 25, 2010. On September 26, 2007, we amended the facility to modify certain definitions in order to permit dividend payments on existing and future preferred and hybrid securities notwithstanding certain events of default. All other terms and conditions remain unchanged.
We were in compliance with all covenants at December 31, 2008 and 2007. At December 31, 2008, we had letters of credit outstanding of $567 million (2007: $306 million). There was no debt outstanding under the credit facility at December 31, 2008 and 2007.
Financial instruments that potentially subject us to concentrations of credit risk consist principally of investments and reinsurance recoverable balances. Our investment portfolio is managed by external investment managers in accordance with our investment guidelines. Specific provisions limit the allowable holdings of a single issue and issuers. Within our fixed income portfolio, we attempt to limit our credit exposure by purchasing fixed income investments rated BBB or higher. In addition, we limit our exposure to any single corporate issuer to 5% or less of our portfolio for securities rated A- or above and 3% or less of our portfolio for securities rated between BBB and BBB+. At December 31, 2008, we did not have an aggregate exposure to any single issuer of 3% or more of our shareholders’ equity, other than with respect to U.S. government and agency securities.
Concentration of credit risk with respect to reinsurance recoverable balances is limited due to the number of reinsurers used on our reinsurance programs. At December 31, 2008, the top ten reinsurers accounted for 71% of reinsurance balances recoverable, one of which accounted for 15% of this balance. Of the 71%, 57 percentage points are with reinsurers rated A+ or better, with the remainder rated A, by A.M Best.
We produce our business through brokers and direct relationships with insurance companies. During 2008, three brokers accounted for 58% (2007: 55%; 2006: 57%) of our total gross premiums written. Marsh, Inc. (including its subsidiary Guy Carpenter and Company) accounted for 23% (2007: 23%, 2006: 24%), Aon Corporation for 23% (2007: 21%, 2006: 23%) and Willis Group Holdings Ltd. for 12% (2007: 11%, 2006: 11%). No other broker and no one insured or reinsured accounted for more than 10% of our gross premiums written in any of the last three years.
During 2008, we purchased reinsurance coverage for our insurance lines of business. The minimum reinsurance premiums are contractually due on a quarterly basis in advance. Accordingly at December 31, 2008, we have an outstanding reinsurance purchase commitment of $46 million.
For the year ended December 31, 2008, there were 843,904 restricted shares that were excluded in the computation of diluted earnings per share because the effect would be anti-dilutive (2007: nil and 2006: 881,980).
Our authorized share capital is 800,000,000 common shares, par value of $0.0125 per share. At December 31, 2008, 136,211,956 (2007: 142,520,406) common shares were outstanding, which excludes restricted shares under our stock compensation plans (see Note 15).
On October 5, 2005, we issued $250 million of 7.25% series A Preferred shares, par value $0.0125 per share, with a liquidation preference of $25.00 per share. We may redeem the shares on and after October 15, 2010 at a redemption price of $25.00 per share. Dividends on the series A Preferred shares are non-cumulative. Consequently, if the board of directors does not authorize and declare a dividend for any dividend period, holders of the series A Preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accumulate and be payable. Holders of series A Preferred shares will be entitled to receive, only when, as and if declared by the board of directors, non-cumulative cash dividends from the original issue date, quarterly in arrears on the fifteenth day of January, April, July and October of each year, commencing on January 15, 2006, without accumulation of any undeclared dividends. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 7.25% of the liquidation preference per annum. For 2008 and 2007, the total dividends declared on series A Preferred share was $1.8125 per share.
date at a price of $12.50 per share. The warrants are subject to anti-dilution provisions that adjust in the event of dividends, distributions or stock adjustments. In the event of a dividend, a warrant holder may elect to take either an adjustment to both the exercise price and the number of shares issuable upon exercise of the warrants or to take a cash dividend that is paid upon exercise of the warrant. The anti-dilution provisions ensure that the holder is in the same position as if the warrant had been exercised immediately before the dividend, distribution or stock adjustment.
At December 31, 2008, 19,710,390 common shares (2007: 19,651,329) would be issued pursuant to the warrants, if all warrants were exercised at an average price of $12.40 (2007: $12.42). All warrants were exercisable on November 20, 2001. At December 31, 2008, we accrued $56 million (2007: $43 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.
Following our shareholders’ approval at the Annual General Meeting held in May 2007, we amended our bye-laws to permit common shares repurchased to be held in treasury.
On December 6, 2007, our Board approved a new share repurchase plan authorizing $400 million of share repurchases (the “2007 repurchase plan”), in addition to the $95 million remaining from the 2006 repurchase plan which expired on December 31, 2008. During 2008 and 2007 we made the following share repurchases, which were held in treasury.
At December 31, 2008, we had $212 million remaining of shares that may be repurchased under the 2007 repurchase plan, which will expire on December 31, 2009.
We have SERPs for our two senior executives: Chairman, Mr. Butt, and President and Chief Executive Officer (CEO), Mr. Charman. The SERP for Mr. Butt requires us to make annual payments to him upon retirement, or beginning January 1, 2010, even if he has not retired, for a period of 10 years. The SERP for Mr. Charman requires us to make annual payments to him starting January 1, 2009, even if he has not retired, for a period of 20 years.
If either the CEO or Chairman dies, is disabled or a change of control of the Company occurs, the remaining benefits under their respective SERP are payable by the Company in a lump sum. At December 31, 2008, the total lump sum contingently payable to our CEO and Chairman was $23 million and $4 million, respectively. During 2008, we incurred a pension expense of $3 million (2007 and 2006: $2 million) for the two SERPs. At December 31, 2008, the accrued SERPs obligations were $16 million (2007: $14 million). The weighted-average assumptions used to determine our net periodic pension cost and benefit obligations were as follows:
The rate is fixed at 3% for the duration of the SERPs.
We have granted stock options under the 2003 Plans. The stock options generally become exercisable over a three-year annual vesting period and expire 10 years from the date of grant. We have determined the fair value of each stock option grant at the date of grant.
In 2006, we issued 23,334 modified stock options pursuant to a severance agreement. Under FAS No. 123(R), modified stock options are deemed cancelled and new grants issued at the new terms. We have elected to use the simplified method of calculating the expected life of the options, which is the average of the vesting period and the expiry period. The weighted-average fair value of stock options granted per share in 2006 was $4.48, based on using the Black-Scholes option-pricing model with the following weighted-average assumptions: 1) expected term of the options of 0.3 years; 2) risk free interest rate of 4.6%; 3) expected volatility of 20%; and 4) dividend yield of 1.7%. We have not issued stock options in 2007 and 2008.
* The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between our closing stock price on December 31, 2008, and the exercisable price, multiplied by the number of in-the-money-options) that would have been received by the stock option holders had all stock option holders exercised their stock options on December 31, 2008.
We have granted restricted stock under both our 2003 Plans and the 2007 Plan. The nature and general terms of these plans are materially consistent. Restricted shares are entitled to vote and to receive dividends but may not be transferred during the period of restriction and are forfeited if the employee’s employment terminates prior to vesting. For employees, restricted stock grants generally cliff vest three years after the date of grant or upon the employee’s earlier retirement, death, permanent disability or a change in control of the Company. Prior to 2008, restricted stock and phantom stock units granted to our non-management directors generally vested six months after the date of grant or upon the director’s earlier retirement, death, permanent disability or a change in control of the Company. Starting in 2008, under the 2007 Plan, we granted common stock and phantom stock units with no vesting restriction to our non-management directors.
The collateral manager of four of our CLOs is Blackstone Debt Advisors L.P., who is entitled to management fees payable by the collateralized obligations in the ordinary course of business. We also have investments in three hedge funds and a credit fund that are managed by Blackstone Alternative Asset Management, LP, who is entitled to management fees in the ordinary course of business. During 2008, total management fees to the Blackstone Group were $2 million (2007: $4 million; 2006: $2 million).
Our U.S. subsidiaries are subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The provision for federal income taxes has been determined under the principles of the consolidated tax provisions of the U.S. Internal Revenue Code and Regulations. Should the U.S. subsidiaries pay a dividend outside the U.S. group, withholding taxes will apply. Our U.S. subsidiaries are not under examination but remain subject to examination in the U.S. for tax years 2005-2008. One of our U.S. subsidiaries has a branch operation in Canada, which is subject to the relevant taxes in that jurisdiction. The branch is not under examination in this tax jurisdiction, but remains subject to examination for tax year 2008.
The net deferred assets of $86 million at December 31, 2008 include a $52 million valuation allowance. The valuation allowance has been established against certain U.S. deferred tax assets attributable to realized and unrealized losses, capital loss carryforwards on investments and impairments. At this time, we believe it is necessary to establish a valuation allowance against the deferred tax assets due to insufficient positive evidence regarding the utilization of these losses. During the twelve months ended December 31, 2008, $30 million of the valuation allowance was recorded in the Consolidated Statements of Operations and $22 million recorded as a component of other comprehensive income in shareholders’ equity.
Our U.S. operations required statutory capital and surplus is determined using risk based capital tests, which is the threshold that constitutes the authorized control level. If a company falls below the control level, the commissioner is authorized to take whatever regulatory actions considered necessary to protect policyholders and creditors. The maximum dividend that may be paid by our U.S. insurance subsidiaries is restricted by the regulatory requirements of the domiciliary states. Generally, the maximum dividend that may be paid by each of our U.S. insurance subsidiaries is limited to unassigned surplus (statutory equivalent of retained earnings) and cannot exceed 10% of total statutory capital and surplus. At December 31, 2008, the maximum dividend that our U.S. insurance operations could pay without regulatory approval was approximately $41 million.
Under the Insurance Act 1978, amendments thereto and Related Regulations of Bermuda, our Bermuda subsidiary, AXIS Specialty Bermuda is restricted as to the payment of dividends for amounts greater than 25% of the prior year’s statutory capital and surplus whereby a signed affidavit by at least two members of the Board of Directors attesting that a dividend in excess of this amount would not cause the company to fail to meet its relevant margins is required. At December 31, 2008, the maximum dividend AXIS Specialty Bermuda could pay, without a signed affidavit, having met minimum levels of statutory capital and surplus requirements, was approximately $869 million.
Our Irish subsidiaries, AXIS Specialty Europe and AXIS Re Ltd., are required to maintain minimum levels of statutory and capital surplus. As at 31 December our subsidiaries were in compliance with these requirements. Our Irish subsidiaries may declare dividends out of retained earnings subject to meeting their solvency and capital requirements. At December 31, 2008 the maximum dividend our Irish subsidiaries could pay out of retained earnings, subject to regulatory approval, was $7 million.