We lease office space in Hamilton, Bermuda and Dublin, Ireland for use by our property and casualty and life and annuity segments, although the life and annuity segment operates solely from our Bermuda office. Max UK and its subsidiaries lease or license office space in the UK, Denmark and Japan.
The following table of selected financial data should be read in conjunction with our audited consolidated financial statements and the notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” each contained herein.
Our results for the year ended December 31, 2008 reflect three major themes: profitable results in our underwriting activities, significant platform expansion and unprecedented investment volatility.
Gross premiums written of $1,012.1 million on property and casualty business, an increase of 30.4% compared to $776.3 million in 2007;
Net favorable prior year loss reserve development on property and casualty business of $107.0 million;
We believe our diverse underwriting portfolio and balanced business mix helped to limit our net losses from Hurricanes Gustav and Ike to $50.0 million, net of reinstatement premiums, or approximately 3.2% of shareholders’ equity at the start of 2008. Our loss estimates for Hurricanes Gustav and Ike continue to develop within our originally projected range and demonstrates our underwriting risk assessment competency in a year that set some new records for the number and frequency of catastrophe property losses.
Overshadowing the positive operating fundamentals of our underwriting activities were our net investment losses for the year, which were comprised mostly of net losses on our alternative investments. The return on our alternative investments was negative 19.27% for the year ended December 31, 2008, which compares to the negative 20.97% return on the HFRI Fund of Funds Composite Index, which we believe to be the most comparable benchmark, during the same period. With our alternative investments at approximately 20% of invested assets for most of 2008, this return resulted in a net loss of $233.0 million for the year. While our relative performance was better than our primary benchmark, the
We expect to continue to adapt our investment strategy going forward to better complement our growing underwriting platforms. Our fixed maturities investment strategy is expected to remain unchanged. We intend to reduce our alternative investment portfolio as a proportion of our invested assets but expect that it will remain an important component of our asset mix. With the relative attractiveness of current investment market conditions for some non-traditional asset classes, we expect to diversify our alternative investments into asset classes beyond hedge funds.
Acquisition costs consist principally of ceding commissions paid to ceding clients and brokerage expenses. These typically represent a negotiated percentage of the premiums on reinsurance and insurance contracts written. Acquisition costs are stated net of ceding commissions associated with premiums ceded to our quota share partners on our reinsurance and insurance business. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers. We defer and amortize these costs over the period in which the related premiums are earned.
Our life and annuity reinsurance premiums are recorded at the inception of the contract based on actual premiums received and are fully earned at that time. We may periodically receive additional premiums which are recorded and earned when received. Additional premium receipts are generally not material.
offset in the contract terms. Since commencing our operations, premiums receivable written off have not been material and, currently, no material premiums receivable are significantly beyond their due dates or in dispute.
We believe the provision for outstanding losses and benefits will be adequate to cover the ultimate net cost of losses incurred to the balance sheet date but the provision is necessarily an estimate and may ultimately be settled for a significantly greater or lesser amount. These estimates are reviewed regularly and any adjustments to the estimates are recorded in the period they are determined.
Expected Loss Ratio Method. To estimate ultimate losses under the expected loss ratio method, we multiply earned premiums by an expected loss ratio. The expected loss ratio is selected utilizing industry data, historical client data, frequency-severity and rate level forecasts and professional judgment.
The table below breaks our reserves as of December 31, 2008 into these components by segment.
Development of our prior period incurred losses for each of the three years ended December 31, 2008 is reported in Note 6-“Property and casualty losses and loss adjustment expenses” to our consolidated financial statements on page. After adjusting 2006 prior period incurred losses for contractual additional premiums received related to the recording of losses on two contracts, our development of prior period loss reserves has been less than 6.0% in each of the three years ending December 31, 2008 and an average of 3.7% over the past seven years. Based on this experience, we currently believe it reasonably likely that loss reserves could change 3.5% from currently reported amounts. This change could be higher or lower depending on our client reported data and potential future commutation of reserves. As at December 31, 2008, we estimate that a 3.5% change in loss reserves would impact our net income and shareholders’ equity by $102.8 million. Depending on whether the reasonably likely adjustments to loss reserves are on contracts ceded to one of our various reinsurance arrangements, there may also be a partially offsetting change in the losses recoverable, net income and shareholders’ equity.
We establish and review our Bermuda/Dublin reinsurance loss reserves on a quarterly basis. The process for establishing our Bermuda/Dublin reinsurance loss reserves is based
upon actuarial analysis of exposure loss data provided by clients. We use a variety of actuarial techniques and methods in estimating our ultimate liability for Bermuda/Dublin reinsurance losses and loss expenses, together with management judgment. These methods include expected loss ratio, paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency-severity methods. This actuarial data is analyzed by product, type of risk, coverage and accident or policy year, as appropriate. Industry loss experience is also used to supplement our own data in selecting development factors in areas where our own data or the clients’ data is limited.
With respect to our reinsurance products, we rely on loss data reported by our clients when calculating our reserves. The quality of the loss data varies from client to client. On a periodic basis, the clients’ loss data is analyzed by our actuarial and claims management teams to ascertain its quality and credibility. This process may involve comparisons with submission data and industry loss data, claim audits and inquiries about the methods of establishing case reserves or reserves associated with large industry events. There is often a time lag between our clients establishing case reserves and re-estimating their reserves, and notifying us of the new or revised case reserves. On casualty reinsurance transactions, the reporting lag will generally be 60-90 days after the end of a reporting period, but can be longer in some cases. Appropriate selection of loss development factors is used to mitigate these problems. We utilize the latest information received from our clients and work to ensure that the loss data is current. However, due to the varying quality of data from our reinsureds and the inherent reporting delays, our Bermuda/Dublin reinsurance reserves will have more uncertainty than our Bermuda/Dublin insurance reserves, where we receive loss information directly from our insureds.
Mitigating the uncertainty inherent in the reserves of our Bermuda/Dublin reinsurance portfolio is the fact that a large portion of our recorded reinsurance reserves are attributable to contracts that are recorded at contractual aggregate limits. As of December 31, 2008 and December 31, 2007, approximately 30% and 33%, respectively, of the total Bermuda/Dublin reinsurance reserves are on contracts that are recorded at contractual aggregate limits.
When determining reserves, we also consider additional historical data, industry loss trends, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. Rapidly changing economic conditions will increase the inherent uncertainty of the reserve estimates. As additional data becomes available and is reviewed, we revise our Bermuda/Dublin reinsurance reserve estimates to reflect this additional data, which may result in increases or decreases to reserves for insured events of prior years. These adjustments are recorded in the period they are determined. The table below breaks our Bermuda/Dublin reinsurance reserves as of December 31, 2008 and 2007 into casualty (long claim-tail) and property (short claim-tail) components.
In connection with our ongoing analysis of our Bermuda/Dublin insurance loss reserves, we review loss reports received from our clients to confirm that submitted claims are covered under the contract terms and take into account industry loss activity and industry loss trends. We also consider historical data, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. As additional data becomes available and is reviewed, we may revise our Bermuda/Dublin insurance reserve estimates to reflect this additional data, which may result in increases or decreases to reserves for insured events of prior years. These adjustments are recorded in the period they are determined.
We establish and review our Bermuda/Dublin insurance loss reserves on a quarterly basis. The process for adjusting our Bermuda/Dublin insurance loss reserves is based upon loss reports received from clients, which are input into actuarial models. We use a variety of actuarial techniques and methods in estimating our ultimate liability for property and casualty insurance losses and loss expenses, together with management judgment. As noted above, these methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency-severity methods. This actuarial data is analyzed by product, type of risk, coverage and accident or policy year. Industry loss experience is also used to supplement our own data in selecting long term trend and development factors and in areas where our own data or the insureds’ data is limited. The table below breaks our insurance reserves as of December 31, 2008 and 2007 into casualty (long claim-tail) and property (short claim-tail) components.
Our Max at Lloyd’s casualty insurance loss reserves, which include case reserves, amounts for IBNR reserves and loss adjustment expenses, are compiled on a portfolio basis and are computed on an undiscounted basis. Historically, losses associated with casualty business have had a long claim-tail, which is the time period between the occurrence of a loss and the time it is settled by the insurer. Casualty losses are also generally more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. Due to the long claim-tail nature of casualty business, a high degree of judgment is involved in establishing loss reserves.
The loss reserving process involves the use of external actuarial consultants to assist management in the estimation of IBNR reserves and loss adjustment expenses. Loss reserves are established and reviewed on a quarterly basis. The process for adjusting the loss reserves is based upon loss reports received from clients, which are input into actuarial models. A variety of actuarial techniques and methods are used in estimating our ultimate liability for property and casualty insurance and reinsurance losses and loss expenses, together with management judgment. As noted above, these methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency-severity methods. This actuarial data is analyzed by product, type of risk, coverage and accident or policy year. Industry loss experience is also used to supplement our own data in selecting long term trend and development factors and in areas where our own data or the insureds’ data is limited.
In connection with our ongoing analysis of our Max at Lloyd’s loss reserves, we review loss reports received from our clients to confirm that submitted claims are covered under the contract terms and take into account industry loss activity and industry loss trends. We also consider historical data, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. As additional data becomes available and is reviewed, we may revise our Max at Lloyd’s reserve estimates to reflect this additional data, which may result in increases or decreases to reserves for insured events of prior years. These adjustments are recorded in the period they are determined.
In connection with our ongoing analysis of our Bermuda/Dublin insurance, Bermuda/Dublin reinsurance, U.S. specialty, and Max at Lloyd’s loss reserves, we review loss notifications and reports received from our clients to confirm that submitted claims are covered under the contract terms. Disputes with clients arise in the ordinary course of business due to coverage issues such as classes of business covered and interpretation of contract wording. We typically resolve any disputes through negotiations that could vary from a simple exchange of email correspondence to arbitration with a panel of experts. Our contracts generally provide for dispute resolution through arbitration. We are not currently involved in any coverage disputes that would, individually or in the aggregate, be material to us.
(4) Gross and net reserve for property and casualty losses includes, for the first time, Max America, which we acquired in June 2008.
During 2008 our re-estimated balance sheet reserves for 2001 and each subsequent balance sheet decreased as a result of net favorable development on a large number of contracts with varied underwriting years and lines of business. The more significant development included:
Net favorable development for our Bermuda/Dublin reinsurance segment of $56.4 million, excluding the development associated with changes in reinsurance premium estimates described below. Of the $56.4 million of net favorable development, $47.7 million was recognized on the long tail lines of business on the 2006 and prior years, including $25.8 million from professional liability reinsurance, largely on the 2005 and prior years. In addition, we had favorable development of $15.1 million on whole account, where information from the cedants indicate better than expected results. We recorded net positive development of $22.1 million on property reinsurance, primarily from the 2007 year, offset by adverse development of $13.5 million on the marine and energy lines of business. The adverse development originated primarily from one marine contract which covered a number of separate individual risk losses at the end of 2007.
The final settlement of prior period reinsurance reserves on a number of contracts resulting in a net favorable development of $11.7 million.
Net favorable development for our Bermuda/Dublin insurance segment of $22.6 million arising from the re-estimation of liabilities principally on property business.
Changes in loss estimates principally arise from changes in underlying reported, incurred and paid claims data on contracts. Other assumptions used in our process, such as inflation, change infrequently in the reserving process and we do not perform a sensitivity analysis of changes in these assumptions. Given the variety of assumptions and judgments involved in establishing reserves for losses and benefits on our insurance and reinsurance and U.S. specialty portfolios, we have not designed and maintained a system to capture and quantify the financial impact of changes in each of our underlying individual assumptions and judgments.
For additional information on our reserves, including a reconciliation of losses and loss adjustment expense reserves for the years ended December 31, 2008, 2007 and 2006, please refer to Note 6 of our audited consolidated financial statements included herein.
basis using standard actuarial techniques and cash flow models. We establish and review our life and annuity reinsurance reserves regularly based upon cash flow projection models utilizing data provided by clients and actuarial models. We establish and maintain our life and annuity reinsurance reserves at a level that we estimate will, when taken together with future premium payments and investment income expected to be earned on associated premiums, be sufficient to support all future cash flow benefit and third party servicing obligations as they become payable.
We own a trading portfolio and an available for sale portfolio of fixed maturities securities. The trading portfolio comprises the fixed maturities securities held by our Max at Lloyd’s segment. We record both investment portfolios at fair value on our balance sheet. For our trading portfolio, the unrealized gain or loss associated with the difference between the fair value and the amortized cost of the investments is recorded in net income as a realized gain or loss. For our available for sale portfolio, the unrealized gain or loss is recorded in other comprehensive income in the equity section of our balance sheet. Fixed maturities are subject to fluctuations in fair value due to changes in interest rates, changes in issuer specific circumstances such as credit rating and changes in industry specific circumstances such as movements in credit spreads based on the markets perception of industry risks. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolio is to tailor the maturities of the portfolio to the timing of expected loss and benefit payments. At maturity, fixed maturities’ amortized cost will equal their fair value and no realized gain or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell any available for sale investments before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period.
In order to reduce the likelihood of needing to sell our available for sale investments before maturity, especially given the unpredictable and potentially significant cash flow requirements of our property catastrophe business, we maintain significant cash and cash equivalent balances and can access our credit facility, which is described in Note 17 of our audited consolidated financial statements. We believe we have the ability to hold those available for sale securities in an unrealized loss position until such time as they reach maturity or the fair value increases. The only time we would expect to realize an other than temporary impairment on an available for sale security is if there were concern about receiving the interest payments and the maturity value of the investment. We perform regular reviews of our available for sale fixed maturities portfolio and utilize a process that considers numerous indicators in order to identify investments that are showing signs of potential other than temporary impairments. The indicators include the issuer’s financial condition and ability to make future scheduled interest and principal payments, benchmark yield spreads, the nature of collateral or other credit support and significant economic events that have occurred that affect the industry in which the issuer participates. As a result of this process, we recognized other than temporary impairment charges through net income of $16.9 million, $1.1 million and $nil during the years ended December 31, 2008, 2007 and 2006, respectively.
We utilize dynamic financial analysis to determine our overall asset and liability risk and the potential for adverse scenarios producing projected losses and potential adverse cash flow. This analysis is accomplished through a stochastic simulation of future periods with each asset and liability cash flow individually modeled. This 5000 path stochastic simulation utilizes the expected volatility of each of our individual asset and liability cash flows. We construct our asset portfolio based on the expected cash flows from our liability portfolio. Fixed maturities securities are purchased to meet cash flows along the entire maturity spectrum of the liabilities. In our dynamic financial analysis modeling we assume that alternative investments will liquidate in years five through ten, so fixed maturities securities are purchased to meet liability cash flows in years one through five and for liability cash flows beyond ten years. Our liability cash flows are highly variable. Because of this risk, we maintain a significant cash balance, which has consistently exceeded $250.0 million. We have also generated over $250.0 million of positive operating cash flow in each of the five years ended December 31, 2008.
As required by FAS 157, when the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 and 2) and unobservable (Level 3).
Our investments in alternative investments comprise a portfolio of limited partnerships and stock investments in trading entities, or funds, which invest in a wide range of financial products. Investments in the funds are carried at fair value. The change in fair value is included in net gains on alternative investments and recognized in net income. The units of account that we fair value are our interests in the funds and not the underlying holdings of such funds. Thus, the inputs we use to value our investments in each of the funds may differ from the inputs used to value the underlying holdings of such funds. These funds are stated at fair value which ordinarily will be the most recently reported net asset value as advised by the fund manager or administrator, where the fund’s underlying holdings can be in various quoted and unquoted investments. We believe the reported net asset value represents the fair value market participants would apply to an interest in the fund. These funds are classified as Level 3 in the FAS 157 hierarchy. The fund managers value their underlying investments at fair value in accordance with policies established by each fund, as described in each of their financial statements and offering memoranda. Based upon information provided by the fund managers, at December 31, 2008, we estimate that over 87.0% of the underlying assets in the funds are publicly traded securities or have broker quotes available.
by management, a reduction of $2.0 million was made to the net asset values reported by the fund managers as at December 31, 2008 to adjust the carrying value of the funds to our best estimate of fair value.
Alternative investments classified as Level 3 total $749.2 million, or 99.4% of our total alternative investments, and 13.4% of total invested assets as of December 31, 2008.
Additional information about the fair values of alternative investments can be found in Note 3 to our audited consolidated financial statements included herein.
Investments in reinsurance private equities, where we have a meaningful ownership position and the ability to exercise significant influence over operating and financial policies of the investee, are carried under the equity method of accounting. Under this method, we initially record the investments at cost and periodically adjust the carrying values to recognize our proportionate share of income or loss and dividends from these investments. Future adverse changes in general market, global and economic conditions, changes to the interest and currency rate environment or poor operating results by our investments carried under the equity method of accounting could result in losses. At December 31, 2008, our total investment in reinsurance private equity was an interest in Grand Central Re of $4.5 million.
Max at Lloyd’s-This segment generally offers property, personal accident, financial institutions, and professional liability coverage through the Syndicates. This segment comprises our proportionate share of the underwriting results of those Lloyd’s syndicates and the results of our managing agent, Max at Lloyd’s.
Life and annuity reinsurance-This segment operates out of Bermuda only and generally offers reinsurance products focusing on existing blocks of business, which take the form of co-insurance transactions. In co-insurance transactions, risks are reinsured on the same basis as the original policies.
of investment returns from this consolidated portfolio are allocated to our corporate function for the purposes of segment reporting. The investment returns for our strategic private equity reinsurance investment are allocated entirely to the corporate function.
Gross premiums written. Gross premiums written for the year ended December 31, 2008 were in line with our plan for the year. We believe our diversified product line provides us with flexibility to take advantage of the opportunities available in the market. In 2008, we saw attractive opportunities in the agriculture, medical malpractice and property and property catastrophe lines. The $79.5 million increase in agriculture business written was the result of a combination of attractive opportunities and strong agriculture market conditions, which may not continue in future periods. The decrease in excess liability and marine and energy premiums were consistent with our plan and is principally a consequence of maintaining our underwriting discipline in a softer market. We believe market conditions for 2009 are pointing towards improvements in pricing for short tail lines of business and then as the year progresses, improvements in longer tail casualty lines of business.
Gross premiums written for the year ended December 31, 2008 include premium estimate adjustments on prior year contracts, which decreased gross premiums written by $46.0 million, compared to a decrease of $9.3 million in 2007. The largest adjustments were due to cedants writing less business than originally expected due to a change in market conditions. For quota share or proportional property and casualty reinsurance contracts, gross premiums written are normally estimated at inception based on information provided by cedants and/or brokers. We believe that the ceding clients’ estimate of the volume of business they expect to cede to us represents the best estimate of gross premium written at the beginning of the contract. As the contract progresses, we continue to monitor actual premium received in conjunction with correspondence from the ceding client and we obtain further client estimates. Gross premiums written also include reinstatement premiums of $10.8 million principally triggered by property catastrophe losses incurred during the year ended December 31, 2008.
For the year ended December 31, 2007, gross premiums written decreased by 18.5% compared to the same period in 2006. Gross premiums written for excess liability, professional liability, whole account and workers compensation lines decreased in total by $115.1 million largely as a result of the non-renewal of four contracts and the restructuring of two reinsurance contracts at renewal. In addition, there was a reduction of $9.3 million in premium estimates on contracts written in prior periods. This reduction included a $15.2 million adjustment to previously recognized additional premiums on one contract where we are entitled to additional premiums should losses exceed pre-determined, contractual thresholds. Based on updated information received from the client in 2007, our estimate of losses was adjusted downwards, resulting in a corresponding adjustment to premiums. These decreases were partially offset by growth in property and property catastrophe and marine and energy business where pricing remained at levels satisfactory to us.
We continue to monitor pricing and market trends closely and changes to our premium mix reflect the risk types where we believe our price requirements and terms and conditions are being met. As a result, our gross reinsurance premium volume and mix may vary from period to period. In addition, changes in client appetite for risk retentions will vary with reinsurance market conditions and general economic conditions, and may also cause fluctuations in our premium volume and mix.
The increase in premiums ceded for the year ended December 31, 2007 compared to the same period in 2006 was principally attributable to a reinsurance quota share treaty that is utilized to manage our retained exposure on our property business. We also purchased additional excess of loss protection for our property and aviation reinsurance business in the year ended December 31, 2007.
Favorable development of $17.0 million arising from changes in reinsurance premium estimates of $46.0 million. This favorable development was more than offset by decreases in earned premium net of acquisition costs of $24.2 million, and resulted in a $7.2 million reduction in net income; and
An increase of approximately 5.0 percentage points to the current year accident year loss ratio due to the soft market conditions and higher than expected agriculture losses.
The decrease in both net losses and the loss ratio in 2007 compared to 2006 was principally attributable to no property catastrophe losses, partly offset by a greater amount of favorable prior year loss reserve development compared to 2006. Net losses were $173.3 million for the year ended December 31, 2007 compared to $296.0 million for the year ended December 31, 2006, a decrease of 41.5%. The principal components of the net loss for 2007 were the following:
A decrease in net premiums earned of $109.9 million resulting in a corresponding decrease in net losses of $76.9 million at a 70.0% loss ratio;
Net favorable development of $36.0 million arising from the re-estimation of liabilities from our quarterly and annual actuarial review process. There were no individual contracts or lines of business with significant development. Marine, medical malpractice, professional liability and workers’ compensation all had between $5.0 million and $10.0 million in favorable development, with most other lines of business having between $nil and $5.0 million in favorable development;
Adverse development of $20.0 million on a marine reinsurance quota share contract that had losses in relation to the 2005 hurricanes. As a result of this development, the contract has reached the aggregate limit; and
Acquisition costs. The decrease in acquisition costs for the year ended December 31, 2008 compared to the year ended December 31, 2007, is principally attributable to changes in our business mix, with the largest impact resulting from lower acquisition costs in our agriculture product line. Acquisition costs vary from contract to contract depending on characteristics such as the type of business, the clients’ cost to administer the underlying contracts and the involvement of a broker. These factors may result in differences in the ratio of acquisition costs to net premiums earned from period to period.
Interest expense. Interest expense for the year ended December 31, 2008 includes $4.9 million on the funds withheld on the variable quota share retrocession agreement with Grand Central Re compared to $9.3 million of expense for the year ended December 31, 2007. The interest expense on the Grand Central Re funds withheld is based on the average of two total return fixed maturity indices.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2008 remained stable compared to the 2007 year, contributing to the decline in our combined ratio as net premiums earned increased.
Income before taxes. The $111.9 million decrease in income before taxes between the year ended December 31, 2008 and the year ended December 31, 2007 is principally attributable to the year-over-year decrease in gains on alternative investments of $104.1 million and the 3.5 percentage point increase in the segment’s combined ratio.
Income before taxes increased $43.9 million for the year ended December 31, 2007 compared to the same period in 2006. Major components of the increase were $15.2 million release of net loss reserves related to an agreement to settle a large block of prior period reserves and the net favorable development of $16.0 million on various lines of business. Additionally, the 16.97% return on alternative investments for the year ended December 31, 2007 compared to a 6.96% return in the year ended December 31, 2006, accounted for $32.8 million of the increase. Partially offsetting these increases was the increase in interest expense of $15.7 million compared to the prior year.
Gross premiums written. Premium volume in this segment for the year ended December 31, 2008 was consistent with our plan and has remained stable compared to the years ended December 31, 2007 and 2006. As a result of increased competition on our excess liability business, we did not renew a number of our excess liability contracts where pricing fell below our risk/return requirements, resulting in the downwards trend of excess liability since 2006. This trend has been partly offset by growth in our aviation and professional liability business in each of 2007 and 2008. Typically, insurance business is written on an individual risk excess of loss basis with contractually defined premiums rather than estimates, which results in no material premium adjustments.
Net investment income and net (losses) gains on alternative investments. The overall performance of our fixed maturities portfolio and alternative investment portfolio is discussed within the corporate function results of operations as we manage investments for this segment on a consolidated basis with the Bermuda/Dublin reinsurance and life and annuity reinsurance segments.
The loss ratio is calculated by dividing losses (shown as (b)) by net premium earned (shown as (a)). The combined ratio is calculated by dividing total losses and expenses (shown as (c)) by net premiums earned (shown as (a)). For the 2007 year, due to the start-up nature of the segment, the calculated combined ratio does not provide a meaningful result and is therefore shown as N/A.
Gross and net premiums written and earned. Gross premiums written and ceded increased substantially in 2008 compared to 2007 and reflect the growth of this segment in
its first full year of operations. Our gross premiums written exceeded our plan for the year ended December 31, 2008, with strong growth in the last quarter of the year as we continue to expand and diversify our client base. The mix of business written by type of risk in 2008 was in line with our expectations. Reinsurance premiums ceded for the U.S. specialty segment reflect the purchase of quota share and excess of loss reinsurance coverage to manage our retained exposure for risks underwritten. We continue to purchase substantial reinsurance protection while we build out this operation. However, assuming gross premiums written are in line with our plan, we anticipate that the ratio of premiums ceded to gross premiums written will continue on a downwards trend for the next several years.
We wrote three life and annuity contracts during the year ended December 31, 2008 with gross premiums written totaling $239.6 million, each covering a closed block of pension annuities for existing clients. For the year ended December 31, 2007, we wrote six reinsurance contracts, each covering closed blocks of pension annuities, compared to one contract written in 2006. Of the gross premiums written in 2007, $207.9 million was from new clients and $91.4 million was from existing clients.
Apart from the components related to the contracts incepting during the years ended December 31, 2008, 2007 and 2006, gross premiums written, reinsurance premiums ceded, net premiums earned, acquisition costs and general and administrative expenses represent ongoing premium receipts or adjustments and related administration expenses on existing contracts. Interest expense relates to interest on funds withheld on the variable quota share retrocession agreement with Grand Central Re and on certain deposit liabilities. The interest expense on funds withheld from Grand Central Re is based on the average of two total return fixed maturity indices, which varies from period to period.
(Loss) income before taxes. Loss before taxes for the year ended December 31, 2008 was $130.3 million compared to income before taxes of $39.5 million for the year ended December 31, 2007. The results are primarily driven by the spread between the actual rate of return on our investments and the rate of return assumption used when pricing the business that we write, together with no material unexpected changes in our estimates of life and annuity benefit reserves. As a result, the principal contributor to the $169.8 million decrease in income before taxes for the year ended December 31, 2008 compared to the year ended December 31, 2007, was the $161.6 million year-over-year decrease in net gains on alternative investments. Similarly, the principal contributor to the $31.0 million increase in income before taxes for the year ended December 31, 2007 compared to the year ended December 31, 2006 was the $37.8 million year-over-year increase in net gains on alternative investments.
The results of operations for the corporate function discussed below include the net investment income, net losses and gains on alternative investments, and net realized losses on fixed maturities for all of our segments, including amounts which are allocated to the segments and included in the segment discussions above. These investment results are presented below on a consolidated basis for purposes of ease of discussion.
The return for Max Diversified was negative 19.38% for the year ended December 31, 2008, compared to the HFRI Fund of Funds Composite Index returning negative 20.97%. The year ended December 31, 2008 experienced a continuation of tight credit conditions, a slumping U.S. housing market and slowing economic growth, culminating in unprecedented U.S. and foreign government intervention in the financial markets. These highly volatile market conditions had a greater than anticipated negative impact on our Max Diversified portfolio. The investment environment was challenging across a broad range of industries and particularly hard on equity asset classes, with the S&P 500 Index experiencing a negative 37.0% rate of return for the year ended December 31, 2008.
slowed the pace of rebalancing the portfolio. The increase in market volatility, the increased volatility of alternative investments in general, as well as the decrease in market liquidity has led to a higher risk of a large decline in value in any given time period.
We intend to continue rebalancing the portfolio in 2009, to reduce our allocation to alternative investments to within a target range of 10% to 15% of total investable assets, and to move towards a more market neutral/absolute return portfolio, with increased diversification by strategy and underlying Fund. These actions will be made in accordance with new investment guidelines adopted in October 2008, which may be amended from time to time. A market neutral strategy strives to generate consistent returns in both up and down markets by selecting long and short positions with a total net exposure of zero. Returns are derived from the long/short spread, or the amount by which long positions outperform short positions. The objective of an absolute return strategy is to provide stable performance regardless of market conditions, with minimal correlation to market benchmarks. In the current investment environment, the process of rebalancing the portfolio may take longer as redemption requests may take longer to be realized. See “Business-Alternative Investments.”
Net gains on the alternative investment portfolio for the year ended December 31, 2007, were $186.7 million, or a 16.97% rate of return, including a gain of $2.4 million from our private equity reinsurance investment, compared to $84.8 million, or a 6.96% rate of return, including a gain of $10.0 million from our private equity reinsurance investments, for the year ended December 31, 2006. For 2007, the return from our Max Diversified portfolio was 16.78%. This return compares to the returns available in the capital markets as represented by the Merrill Lynch Master Bond Index returning 7.17%, the Standard & Poor’s 500 Index returning 5.49% and the HFRI Fund of Funds Composite Index returning 10.25% in 2007.
Each alternative investment strategy we employed was profitable during the year ended December 31, 2007. Alternative investment strategies principally contributing to the gains in the 2007 year were the event-driven arbitrage and long/short equity strategies, which returned 36.14% and 26.94%, respectively. Contributing to the returns were meaningful gains from a variety of long and short sub-prime mortgage positions taken by several of the underlying funds in our Max Diversified portfolio. As at December 31, 2007, 16.1% and 25.4% of our alternative investments were allocated to the event-driven arbitrage and long/short equity strategies, respectively.
Net realized losses on fixed maturities. As of December 31, 2008, our total fixed maturities portfolio is split into two portfolios: the first is a trading portfolio that was acquired as part of our Max UK acquisition; the second is our available for sale portfolio which remains the same portfolio that was previously known as our fixed maturities portfolio. Our trading portfolio is recorded at fair value with unrealized gains and losses recorded in net income as net realized gains or losses, all of which are reported within our Max UK segment. Our available for sale portfolio is recorded at fair value with unrealized gains and losses recorded in other comprehensive income as part of total shareholders’ equity. Our available for sale fixed maturities investment strategy is not intended to generate significant realized gains and losses as more fully discussed under Financial Condition below. Net realized losses on our fixed maturities portfolios for the years ended December 31, 2008, 2007 and 2006, were $18.9 million, $4.0 million and $5.8 million, respectively.
Included in net realized losses for the years ended December 31, 2008, 2007 and 2006, were other than temporary impairment charges of $16.9 million, $1.1 million and $nil, respectively, on securities for which we believe there is significant doubt over the ultimate recoverability of the maturity value. We perform regular reviews of our available for sale fixed maturities portfolio in order to identify investments that are showing signs of potential other than temporary impairments. The indicators include the issuer’s financial condition and ability to make future scheduled interest and principal payments, the nature of collateral or other credit support and significant economic events that have occurred that affect the industry in which the issuer participates.
Included in net realized losses for the year ended December 31, 2008 was a $3.8 million realized loss on a futures transaction that was initiated and fully settled in September 2008. This transaction was initiated as an economic hedge on a portion of our holdings of U.S. government securities. Net realized losses for the year ended December 31, 2007 includes $1.7 million of gross realized losses resulting from the sale of fixed maturities triggered by an agreement to settle a block of prior period reserves.
General and administrative expenses. The increase in general and administrative expense for the year ended December 31, 2008 compared to 2007 was principally related to professional fees associated with acquisition activity during the year. The decrease in general and administrative expenses during the year ended December 31, 2007 compared to 2006 was principally related to a decrease in professional fees.
In order to reduce the likelihood of needing to sell investments before maturity, especially given the unpredictable and potentially significant cash flow requirements of our property catastrophe business, we maintain significant cash and cash equivalent balances. We believe we have the ability to hold those securities in an unrealized loss position until such time as they reach maturity or the fair value increases.
The only time we would expect to realize an other than temporary impairment on a fixed maturity security is if we believed there was significant uncertainty about receiving the interest payments and the maturity value of the investment. We perform regular reviews of our fixed maturities portfolio and utilize a process that considers numerous indicators in order to identify investments that are showing signs of potential other than temporary impairments. The indicators include the issuer’s financial condition and ability to make future scheduled interest and principal payments, benchmark yield spreads, the nature of collateral or other credit support and significant economic events that have occurred that affect the industry in which the issuer participates. As a result of this process, we recognized an other than temporary impairment charge through net income of $16.9 million during the year ended December 31, 2008.
The following table summarizes the amortized cost and fair value of our fixed maturities securities with exposure to sub-prime or Alt-A mortgages as of December 31, 2008.
As described in Note 3 of our audited consolidated financial statements, our fixed maturities investments and our alternative investments are carried at fair value.
The independent pricing services used by our investment custodian and investment managers obtain actual transaction prices for securities that have quoted prices in active markets. Each pricing service has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing service uses observable market inputs including, but not limited to, reported trades, benchmark yields, broker/dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from market sources to determine a reasonable fair value. In addition, pricing services use valuation models, such as an Option Adjusted Spread model, to develop prepayment and
interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage-backed and asset-backed securities. The ability to obtain quoted market prices is reduced in periods of decreasing liquidity, which generally increases the use of matrix pricing methods and generally increases the uncertainty surrounding the fair value estimates.
Our investment in alternative investments comprise a portfolio of limited partnerships and stock investments in trading entities, or funds, which invest in a wide range of financial products. The units of account that we value are our interests in the funds and not the underlying holdings of such funds. Thus, the inputs we use to value our investments in each of the funds may differ from the inputs used to value the underlying holdings of such funds. These funds are stated at fair value which ordinarily will be the most recently reported net asset value as advised by the fund manager or administrator, where the fund’s underlying holdings can be in various quoted and unquoted investments. We believe the reported net asset value represents the fair value market participants would apply to an interest in the fund. The fund managers value their underlying investments at fair value in accordance with policies established by each fund, as described in each of their financial statements and offering memoranda.
Certain funds may have a lock-up period. A lock-up period refers to the initial amount of time an investor is contractually required to invest before having the ability to redeem. Funds that do provide for periodic redemptions may, depending on the funds’ governing documents, have the ability to deny or delay a redemption request, called a gate. The fund may implement this restriction because the aggregate amount of redemption requests as of a particular date exceeds a specified level, generally ranging from 15% to 25% of the fund’s net assets. The gate is a method for executing an orderly redemption process which allows for redemption requests to be executed in a timely manner to reduce the possibility of adversely affecting the remaining investors in the fund. In the current financial market environment, we have experienced an increase in the number of funds which have imposed gates, and the Company believes it is likely that this trend will continue.
Certain funds may be allowed to invest a portion of their assets in illiquid securities, such as private equity and convertible debt. In such cases, a common mechanism used is a side-pocket, whereby the illiquid security is assigned to a separate memorandum capital account or designated account. Typically, the investor loses its redemption rights to the designated account. Only when the illiquid security is sold, or otherwise deemed liquid by the fund, may investors redeem their interest. As at December 31, 2008, the fair value of our alternative investments held in side-pockets is $113.4 million. Due to the uncertainty surrounding the timing of the sale of the underlying assets within side-pockets, the estimated timing of liquidity presented in the table below is subject to change.
Liabilities for property and casualty losses. Property and casualty losses totaled $2,938.2 million at December 31, 2008 compared to $2,333.9 million at December 31, 2007, an increase of 25.9%. The increase in property and casualty losses was principally attributable to estimated losses associated with premiums earned during the year ended December 31, 2008, and the acquisition of Max UK, partially offset by amounts paid on property and casualty losses and releases of reserves on prior period contracts. During the year ended December 31, 2008, we paid $279.1 million in property and casualty losses and recorded gross favorable development on prior period reserves of $118.0 million.
At December 31, 2008, 81.2% of our losses recoverable were with reinsurers rated “A” or above by A.M. Best Company and a further 4.6% are rated “A-”. The remaining 14.2% of losses recoverable are with “NR-not rated” reinsurers. Grand Central Re, a Bermuda domiciled reinsurance company in which Max Bermuda has a 7.5% equity investment, is our largest “NR-not rated” retrocessionaire and accounted for 12.5% of our losses recoverable at December 31, 2008. As security for outstanding loss obligations, we retain funds from Grand Central Re amounting to 119.8% of its loss recoverable obligations.
Bank loans. In February 2003, Max Bermuda completed a sale of 127,549 shares of its subsidiary, Max Diversified, to a third party financial institution, or the Bank, for a fair value of $150.0 million, or the notional amount. Simultaneous with the sale, Max Bermuda entered into a total return swap with the Bank whereby Max Bermuda receives the return earned on the Max Diversified shares in exchange for the payment of a variable rate of interest based on LIBOR plus a spread. The terms of the share sale obligate the Bank to sell the shares to Max Bermuda and give Max Bermuda the right to repurchase the shares at fair value at termination of the total return swap. On February 28, 2007, Max Bermuda amended the swap transaction. The notional amount under the swap was increased to $235.0 million, and the number of shares sold to the Bank was increased to 143,952. In addition, the amendment, among other things: (i) extended the termination date under the swap to February 28, 2010; (ii) increased the maximum notional amount under the swap to $300.0 million; (iii) decreased the monthly excess collateral requirement under the swap from 50% to 33% of the notional amount; and (iv) permits Max Bermuda to accelerate the swap termination date to a business day no earlier than February 28, 2009. Max Bermuda pledged cash and Max Diversified shares with a combined fair value of $123.9 million at December 31, 2008 to the Bank as collateral and is thus exposed to credit risk. The swap transaction contains provisions for earlier termination at Max Bermuda’s option or in the event that Max Bermuda fails to comply with certain covenants, including maintaining a minimum financial strength rating and a minimum Max Diversified net asset value.
On April 2, 2007, Max USA completed the acquisition of Max Specialty. On April 3, 2007, Max Capital borrowed $50.0 million and Max USA borrowed $100.0 million under their revolving credit facility, in connection with the acquisition and capitalization of Max Specialty. Max USA repaid the $100.0 million borrowed under their revolving credit facility with the proceeds of the issuance of $100.0 million of senior notes. As of December 31, 2008, the $50.0 million loan to Max Capital remains outstanding. This loan renews at intervals of 1 to 6 months at Max Capital’s option, at which time the interest rate is reset to LIBOR plus a premium based on Max Capital’s current debt rating. As of December 31, 2008, the interest rate was 4.56% and resets on April 10, 2009.
indebtedness of Max USA. The senior notes are fully and unconditionally guaranteed by Max Capital. The effective interest rate related to the senior notes, based on the net proceeds received, was approximately 7.27%. The net proceeds from the sale of the senior notes were $99.5 million, and they were used to repay the $100.0 million short-term borrowing of Max USA under the revolving credit facility. On December 30, 2008, Max USA repurchased $8.5 million principal amount of these notes, leaving a principal amount of $91.5 million outstanding as of December 31, 2008.
Shareholders’ equity. Our shareholders’ equity decreased to $1,280.3 million at December 31, 2008 from $1,583.9 million at December 31, 2007, a decrease of 19.2%, principally due to the net loss of $175.3 million, the repurchase of common shares of $109.8 million, a decrease in accumulated other comprehensive income of $25.1 million, and payments of dividends of $20.4 million during the year ended December 31, 2008.
Liquidity. We generated $508.7 million of cash from operations during the year ended December 31, 2008 compared to $252.5 million for the year ended December 31, 2007. The increase in cash from operations is principally due to gross premiums written during the year ended December 31, 2008. The two principal factors that impact our operating cash flow are premium collections and timing of loss and benefit payments.
While we tailor our fixed maturities portfolios to match the duration of expected loss and benefit payments, increased loss amounts or settlement of losses and benefits earlier than anticipated can result in greater cash needs. We maintain a significant working cash balance and have generated positive cash flow from operations in each of our last eight years of operating history. In recent quarters our cash balance has increased as we have elected to maintain a larger cash position in the current investment environment. Our cash and cash equivalents balance is $949.4 million at December 31, 2008. We believe that we currently maintain sufficient liquidity to cover existing requirements and provide for contingent liquidity. Nonetheless, it is possible that significant deviations in expected loss and benefit payments can occur, potentially requiring us to liquidate a portion of our fixed maturities portfolios. If we need to liquidate our fixed maturities securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated at December 31, 2008. We believe that most of our portfolio has sufficient liquidity to mitigate this risk, and we believe that we can continue to hold any potentially illiquid position until we can initiate an appropriately priced transaction.
As a holding company, Max Capital’s principal assets are its investments in the common shares of its principal subsidiary, Max Bermuda, and its other subsidiaries. Max Capital’s principal source of funds is from interest income on cash balances and cash dividends from its subsidiaries, including Max Bermuda. The payment of dividends is limited under Bermuda insurance laws. In particular, Max Bermuda may not declare or pay any dividends if it is in breach of its minimum solvency or liquidity levels under Bermuda law or if the declaration or payment of the dividends would cause it to fail to meet the minimum solvency or liquidity levels under Bermuda law. At December 31, 2008, Max Bermuda had
In the ordinary course of business, we are required to provide letters of credit or other regulatory approved security to certain of our clients to meet contractual and regulatory requirements. As of December 31, 2008, we have three letter of credit facilities totaling $695.0 million with an additional $200.0 million available subject to certain conditions. On that date, we had $490.3 million in letters of credit and a $150.0 million unsecured loan outstanding under these facilities. We also have a GBP 90.0 million letter of credit facility supporting our funds at Lloyd’s commitments, of which GBP 63.6 million is utilized as of December 31, 2008. Each of our credit facilities requires that we comply with certain covenants, which may include a minimum consolidated tangible net worth, a minimum insurer financial strength rating and restrictions on the payment of dividends. We were in compliance with all the covenants of each of our credit facilities at December 31, 2008.
The amount which Max Capital provides as FAL is not available for distribution for the payment of dividends. Our corporate members may also be required to maintain funds under the control of Lloyd’s in excess of their capital requirements and such funds also may not be available for distribution of the payment of dividends.
In April 2007, Max USA sold $100.0 million aggregate principal amount of 7.20% senior notes due April 14, 2017, of which $91.5 million remains outstanding at December 31, 2008. The senior notes are guaranteed by Max Capital. As of December 31, 2008, the senior notes had a senior unsecured debt rating of “Baa2” by Investors Service, Inc. or Moody’s, “bbb-” by A.M. Best, “BBB+” by Fitch, Inc., or Fitch, and “BBB-” by Standard & Poor’s Ratings Services, or S&P, all with a stable outlook, except S&P which has a positive outlook. The ratings assigned by rating agencies to reinsurance and insurance companies are based upon factors and criteria established independently by each rating agency. They are not an evaluation directed to investors in our senior notes, and are not a recommendation to buy, sell or hold our senior notes. These ratings are subject to periodic review by the rating agencies or may be revised downward or revoked at the sole discretion of the rating agencies.
On February 12, 2008, May 5, 2008, August 5, 2008 and October 31, 2008, Max Capital’s board of directors declared a shareholder dividend of $0.09 per share payable on March 11, 2008, May 30, 2008, September 2, 2008 and December 1, 2008 respectively, to shareholders of record on February 26, 2008, May 16, 2008, August 19, 2008 and November 17, 2008, respectively. On February 10, 2009, Max Capital’s board of directors declared a dividend of $0.09 per share payable on March 10, 2009 to shareholders of record on February 24, 2009. Continuation of cash dividends in the future will be at the discretion of the board of directors and will be dependent upon our results of operations and cash flows, and our financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends and other factors the board of directors deems relevant.
The reserves for losses and benefits together with deposit liabilities represent management’s estimate of the ultimate cost of settling losses, benefits and deposit liabilities. As more fully discussed in our “Critical Accounting Policies-Losses and benefits” above, the estimation of losses and benefits is based on various complex and subjective judgments. Actual losses and benefits paid may differ, perhaps significantly, from the reserve estimates reflected in our financial statements. Similarly, the timing of payment of our estimated losses and benefits is not fixed and there may be significant changes in actual payment activity. The assumptions used in estimating the likely payments due by period are based on our historical claims payment experience and industry payment patterns, but due to the inherent uncertainty in the process of estimating the timing of such payments, there is a risk that the amounts paid in any such period can be significantly different than the amounts disclosed above.
The amounts in this table represent our gross estimates of known liabilities as of December 31, 2008 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts paid out in the time periods shown will be greater than that indicated in the table.
In February 2007, the FASB issued Financial Accounting Standard No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” or FAS 159. FAS 159 permits an entity to choose, at specified election dates, to measure eligible financial instruments and certain other items at fair value that are not currently required to be measured at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Upfront costs and fees related to items for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. FAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. At the effective date, an entity may elect the fair value option for eligible items that exist at that date. The entity shall report the effect of the first re-measurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. We elected not to apply the fair value option to any eligible assets or liabilities held as of December 31, 2007.
Financial Accounting Standard No. 161-Disclosures about Derivative Instruments and Hedging Activities
In May 2008, the FASB issued Financial Accounting Standard No. 163 “Accounting for Financial Guarantee Insurance Contracts-an Interpretation of FASB Statement No. 60,” or FAS 163. FAS 163 prescribes the accounting for premium revenue and claims liabilities by insurers of financial obligations, and requires expanded disclosures about financial guarantee insurance contracts. FAS 163 applies to financial guarantee insurance and reinsurance contracts issued by insurers subject to FAS 60, “Accounting and Reporting by Insurance Enterprises.” FAS 163 does not apply to insurance contracts that are similar to financial guarantee insurance contracts such as mortgage guaranty or trade-receivable insurance, financial guarantee contracts issued by noninsurance entities or financial guarantee contracts that are derivative instruments within the scope of FAS 133. FAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years, except for certain disclosure requirements about the risk-management activities of the insurance enterprise that are effective for the first quarter beginning after the statement was issued. Except for those disclosures, early application is prohibited. We do not expect the adoption of FAS 163 will have a material impact on our consolidated financial statements.