An important part of our strategy is to form new operating units to capitalize on various business opportunities, with 21 of our 45 units formed since 2006. These newer units are focused on important parts of the economy in the U.S., including healthcare, energy and agriculture, and on growing international markets, including Norway, Australia, the Asia-Pacific region and South America. As a result, our international operations have become an increasingly important part of our business.
The profitability of the Company’s insurance business is affected primarily by the adequacy of premium rates. The ultimate adequacy of premium rates is not known with certainty at the time a property casualty insurance policy is issued because premiums are determined before claims are reported. The ultimate adequacy of premium rates is affected mainly by the severity and frequency of claims, which are influenced by many factors, including natural and other disasters, regulatory measures and court decisions that define and change the extent of coverage and the effects of economic inflation on the amount of compensation for injuries or losses. General insurance prices are also influenced by available insurance capacity, i.e., the level of policyholders’ surplus employed in the industry, and the industry’s willingness to deploy that capital.
The Company’s profitability is also affected by its investment income. The Company’s invested assets, which are derived from its own capital and cash flow from its insurance business, are invested principally in fixed maturity securities. The return on fixed maturity securities is affected primarily by general interest rates, which are at historically low levels, as well as the credit quality and duration of the securities. The Company also invests in equity securities, merger arbitrage, private equity investments, investment funds and real estate.
The risk and complexity of estimating loss reserves have increased under the current financial market conditions. It is especially difficult to estimate the impact of inflation on loss reserves given the current economic environment and related government actions. Whereas a slowing economy would generally lead to lower inflation or even deflation, increased government spending would generally lead to higher inflation. A change in our assumptions regarding inflation would result in reserve increases or decreases that would be reflected in our operations in periods in which such assumptions are changed.
and assumptions it makes in the reserving process provide the best estimate of the ultimate cost of settling claims and related expenses with respect to insured events which have occurred; however, different assumptions and variables could lead to significantly different reserve estimates.
Our net reserves for losses and loss expenses of approximately $8.2 billion as of December 31, 2011 relate to multiple accident years. Therefore, the impact of changes in frequency or severity for more than one accident year could be higher or lower than the amounts reflected above.
Following is a summary of the Company’s reserves for losses and loss expenses by business segment as of December 31,
Following is a summary of the Company’s net reserves for losses and loss expenses by major line of business as of December 31, 2011 and December 31, 2010:
(1) Represents portion of reserve development offset by additional or return premiums on retrospectively rated insurance policies and reinsurance agreements.
Reinsurance - The favorable development for the reinsurance segment during 2011 was related to umbrella and professional liability treaty business, facultative business and to business written through Lloyd’s of London. The favorable development for the segment was spread across underwriting years 2005 through 2010 and resulted from lower than expected reported losses.
Loss Reserve Discount - The Company discounts its liabilities for excess and assumed workers’ compensation business because of the long period of time over which losses are paid. Discounting is intended to appropriately match losses and loss expenses to income earned on investment securities supporting the liabilities. The expected losses and loss expense payout pattern subject to discounting was derived from the Company’s loss payout experience. For non-proportional business, reserves for losses and loss expenses have been discounted using risk-free discount rates determined by reference to the U.S. Treasury yield curve. For proportional business, reserves for losses and loss expenses have been discounted at the statutory rate permitted by the Department of Insurance of the State of Delaware of 2.3%. As of December 31, 2011, the aggregate blended discount rates ranged from 2.3% to 6.5%, with a weighted average discount rate of 4.3%. The aggregate net discount, after reflecting the effects of ceded reinsurance, was $892 million and $898 million as of December 31, 2011 and December 31, 2010, respectively.
The following table provides a summary of all fixed maturity securities in an unrealized loss position as of December 31, 2011:
The Company has evaluated its fixed maturity securities in an unrealized loss position and believes the unrealized losses are due primarily to temporary market and sector-related factors rather than to issuer-specific factors. None of these securities are delinquent or in default under financial covenants. Based on its assessment of these issuers, the Company expects them to continue to meet their contractual payment obligations as they become due and does not consider any of these securities to be OTTI.
Common Stocks - At December 31, 2011, the Company owned four common stocks in an unrealized loss position with an aggregate fair value of $47 million and an aggregate unrealized loss of $3 million. The Company does not consider these common stocks to be OTTI.
The following is a summary of pricing sources for the Company's fixed maturity securities available for sale as of December 31, 2011:
Syndicate manager - The Company has a 15% participation in a Lloyd’s syndicate, and the Company’s share of the securities owned by the syndicate is priced by the syndicate’s manager. The majority of the securities are liquid, short duration
Following is a summary of gross and net premiums written, premiums earned, loss ratios (losses and loss expenses incurred expressed as a percentage of premiums earned), expense ratios (underwriting expenses expressed as a percentage of premiums earned) and GAAP combined ratios (sum of loss ratio and expense ratio) for each of our business segments for the years ended December 31, 2011 and 2010. The GAAP combined ratio represents a measure of underwriting profitability, excluding investment income. A GAAP combined ratio in excess of 100 indicates an underwriting loss; a number below 100 indicates an underwriting profit.
Net Income to Common Stockholders. The following table presents the Company’s net income to common stockholders and net income per diluted share for the years ended December 31, 2011 and 2010 (amounts in thousands, except per share data):
The Company reported net income of $395 million in 2011 compared to $449 million in 2010. The decrease in net income was primarily due to a decline in underwriting income partially offset by an increase in net investment gains. The decline in underwriting income was attributable to an increase in catastrophe losses of $72 million and a decrease in favorable prior year reserve development of $52 million. The number of weighted average diluted shares decreased as a result of the Company’s repurchases of its common stock in 2011 and 2010.
Premiums earned increased 9% to $4,161 million in 2011 from $3,836 million in 2010. Insurance premiums (including the impact of rate changes) are generally earned evenly over the policy term. Premiums earned in 2011 are related to business written during both 2011 and 2010.
Net Investment Gains. The Company buys and sells securities on a regular basis in order to maximize its total return on investments. Decisions to sell securities are based on management’s view of the underlying fundamentals of specific securities as well as management’s expectations regarding interest rates, credit spreads, currency values and general economic conditions. Net realized gains on investment sales were $126 million in 2011 compared with $66 million in 2010.
Other-Than-Temporary Impairments. The cost of securities is adjusted where appropriate to include a provision for decline in value which is considered to be other-than-temporary. Other-than-temporary impairments were $0.4 million in 2011 compared with $9.2 million in 2010.
Regional - The loss ratio of 68.0% in 2011 was 7.3 points higher than the loss ratio of 60.7% in 2010. Catastrophe
losses were $85 million in 2011 compared with $73 million in 2010, an increase of 1.1 loss ratio points. Favorable prior year reserve development was $40 million in 2011 compared with $84 million in 2010, a difference of 4.1 loss ratio points. The loss ratio excluding catastrophe losses and favorable prior year reserve development increased 2.1 points to 63.8% in 2011 from 61.7% in 2010 due to earned pricing and loss cost trends.
International - The loss ratio of 60.5% in 2011 was 1.3 points lower than the loss ratio of 61.8% in 2010. Catastrophe losses were $25 million in 2011 compared with $4 million in 2010, an increase of 3.2 loss ratio points. Favorable prior year reserve development was $12 million in 2011 and $1 million in 2010, a difference of 1.7 loss ratio points. The loss ratio excluding catastrophe losses and favorable prior year reserve development decreased 2.8 points to 58.4% in 2011 from 61.2% in 2010 due to improved profitability for our businesses in South America and Australia.
Service expenses, which represent the costs associated with the fee-based businesses, increased 4% to $75 million. The increase was due to an increase in general and administrative expenses.
Other costs and expenses, which represent general and administrative expenses that are not allocated to business segments, increased to $115 million in 2011 from $107 million in 2010 due to an increase in general and administrative expenses.
Results of Operations for the Years Ended December 31, 2010 and 2009
Premiums. Gross premiums written were $4,416 million in 2010, an increase of 4% from $4,253 million in 2009. The increase in gross premiums written was primarily due to growth in international business as a result of expansion into new markets. In 2010 and 2009, approximately 77% of policies expiring were renewed. The average price of policies renewed in 2010 declined 0.3% from the same period in 2009.
Net Investment Income. Following is a summary of net investment income for 2010 and 2009:
Net investment income increased 40% to $531 million in 2010 from $379 million in 2009. The increase in investment income was due to a decrease in losses from investment funds (which are reported on a one quarter lag). Average invested assets, at cost (including cash and cash equivalents) were $13.4 billion in 2010 and $12.9 billion in 2009.
Revenues from Wholly-Owned Investees. Revenues from wholly-owned investees were $214 million in 2010 compared with $189 million in 2009. These revenues were derived from aviation-related businesses that were separately purchased in 2007, 2008 and 2009. These companies provide services to the general aviation market, including fuel and line service, aircraft sales and maintenance, avionics and engineering services and parts fabrication. The increase in 2010 revenues is due to the acquisition of an aviation company in June 2009, partially offset by lower aircraft sales in 2010.
Specialty - The loss ratio of 58.3% in 2010 was 3.6 points lower than the loss ratio of 61.9% in 2009. Favorable prior year reserve development was $99 million in 2010 compared with $69 million in 2009, a difference of 2.6 loss ratio points. The loss ratio excluding favorable prior year reserve development decreased 1.0 points to 66.0% in 2010 from 67.0% in 2009.
Regional - The loss ratio was 60.7% in 2010 was 0.7 points lower than the loss ratio of 61.4% in 2009. Catastrophe losses were $73 million in 2010 compared with $63 million in 2009, an increase of 1.3 loss ratio points. Favorable prior year reserve development was $84 million in 2010 compared with $52 million in 2009, a difference of 3.2 loss ratio points. The loss ratio excluding catastrophe losses and favorable prior year reserve development increased 1.2
Other Operating Costs and Expenses. Following is a summary of other operating costs and expenses for 2010 and 2009:
Underwriting expenses are comprised of commissions paid to agents and brokers, premium taxes and other assessments and internal underwriting costs. The expense ratio (underwriting expenses expressed as a percentage of premiums earned) increased to 34.3% in 2010 from 32.8% in 2009 primarily due to higher expense ratios for certain underwriting units that experienced a significant decline in earned premiums in 2010.
Expenses from Wholly-Owned Investees. Expenses from wholly-owned investees were $208 million in 2010 compared to $183 million in 2009. These expenses represent costs associated with aviation-related businesses that were separately purchased in 2007, 2008 and 2009. These include cost of goods sold related to aircraft and other sales, labor and equipment costs related to repairs and other services and general and administrative expenses. The increase in 2010 expenses is due to the acquisition of an aviation company in June 2009, partially offset by lower cost of aircraft sales in 2010.
Interest Expense. Interest expense increased 21.6% to $107 million primarily due to the issuance of $300 million of 7.375% senior notes in September 2009 and $300 million of 5.375% senior notes in September 2010, partially offset by the repayment of $150 million of 5.125% senior notes in September 2010.
Income Taxes. The effective income tax rate was 25% in 2010 as compared to 19% in 2009. The effective income tax rate differs from the federal income tax rate of 35% primarily because of tax-exempt investment income. Tax exempt investment income comprised a smaller portion of the 2010 pre-tax income and as such had a lower impact on the effective tax rate for 2010 compared with 2009.
The Company also attempts to maintain an appropriate relationship between the average duration of the investment portfolio and the approximate duration of its liabilities (i.e., policy claims and debt obligations). The average duration of the investment portfolio was 3.6 years at December 31, 2011 and 2010. The Company’s investment portfolio and investment-related assets as of December 31, 2011 were as follows:
(1) Supranational represents investments in the North American Development Bank, European Investment Bank and Inter-American Development Bank.
Cash Flow. Cash flow provided from operating activities increased to $670 million in 2011 from $451 million in 2010. The increase in cash flow was due primarily to an increase in premium collections and a decrease in income taxes paid, partially offset by an increase in underwriting expenses paid. Paid losses as a percent of earned premiums were 59.8% in 2011 compared with 64.0% in 2010.
As a holding company, the Company derives cash from its subsidiaries in the form of dividends, tax payments and management fees. Maximum amounts of dividends that can be paid without regulatory approval are prescribed by statute. During 2012, the maximum amount of dividends which can be paid without regulatory approval is approximately $417 million. The ability of the holding company to service its debt obligations is limited by the ability of its insurance subsidiaries to pay dividends. In the event dividends, tax payments and management fees available to the holding company were inadequate to service its debt obligations, the Company would need to raise capital, sell assets or restructure its debt obligations.
Equity. The Company repurchased 5,218,097, 17,017,479 and 6,382,331 shares of its common stock in 2011, 2010 and 2009, respectively. The aggregate cost of the repurchases was $157 million in 2011, $449 million in 2010 and $147 million in 2009. At December 31, 2011, total common stockholders’ equity was $4 billion, common shares outstanding were 137,082,096, and stockholders’ equity per outstanding share was $29.15.
Total Capital. Total capitalization (equity, senior notes and other debt and junior subordinated debentures) was $5.8 billion at December 31, 2011. The percentage of the Company’s capital attributable to senior notes, junior subordinated debentures and other debt was 30% at December 31, 2011 and 32% at December 31, 2010.
The Company follows customary industry practice of reinsuring a portion of its exposures in exchange for, paying reinsurers a part of the premiums received on the policies it writes. Reinsurance is purchased by the Company principally to reduce its net liability on individual risks and to protect it against catastrophic losses. Although reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance coverage. The Company monitors the financial condition of its reinsurers and attempts to place its coverages only with substantial and financially sound carriers.
The following table presents the credit quality of amounts due from reinsurers as of December 31, 2011 (dollars in thousands). Amounts due from reinsurers are net of reserves for uncollectible reinsurance of $3 million in the aggregate.
As of January 1, 2012, the Company's catastrophe excess of loss reinsurance program provides protection for losses between $30 million and $155 million for the majority of the primary business written by its U.S. companies. The Company has separate catastrophe excess of loss reinsurance for business written through Lloyd's. The catastrophe reinsurance agreements are subject to certain limits, exclusions and reinstatement premiums.
The Company utilizes letters of credit to back certain reinsurance payments and obligations. Outstanding letters of credit were $29 million as of December 31, 2011. The Company has made certain guarantees to state regulators that the statutory capital of certain subsidiaries will be maintained above certain minimum levels. In addition, the Company has commitments to invest up to $328 million in certain investment funds.
An off-balance sheet arrangement is any transaction, agreement or other contractual arrangement involving an unconsolidated entity under which a company has (1) made guarantees, (2) a retained or contingent interest in transferred assets, (3) an obligation under derivative instruments classified as equity or (4) any obligation arising out of a material variable interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company, or that engages in leasing, hedging or research and development arrangements with the Company. The Company has no arrangements of these types that management believes may have a material current or future effect on our financial condition, liquidity or results of operations.
We have audited the accompanying consolidated balance sheets of W. R. Berkley Corporation and subsidiaries (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of income, stockholders' equity, comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2011. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We also have 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, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2012 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
Audit premiums are recognized when they are reliably determinable. The change in accruals for earned but unbilled audit premiums increased net premiums written and premiums earned by $1 million in 2011, and decreased net premiums written and premiums earned by $7 million and $23 million in 2010 and 2009, respectively.
Revenues from wholly-owned investees are derived from services provided to the general aviation market, including fuel and line service, aircraft sales and maintenance, avionics and engineering services and parts fabrication. Revenue is recognized upon delivery of aircraft, delivery of fuel, shipment of parts and upon completion of services.
Equity securities that the Company purchased with the intent to sell in the near-term are classified as trading account securities and are reported at estimated fair value. Realized and unrealized gains and losses from trading activity are reported as net investment income and are recorded at the trade date. Short sales and short call options are presented as trading securities sold but not yet purchased. Unsettled trades and the net margin balances held by the clearing broker are presented as a trading account receivable from brokers and clearing organizations.
Property, furniture and equipment are carried at cost less accumulated depreciation. Depreciation is calculated using the estimated useful lives of the respective assets. Depreciation expense was $40 million, $41 million and $46 million for 2011, 2010 and 2009, respectively.
Interest payments were $111 million, $103 million and $80 million in 2011, 2010 and 2009, respectively. Income taxes paid were $48 million, $123 million and $16 million in 2011, 2010 and 2009, respectively. Other non-cash items include acquisitions and dispositions, unrealized investment gains and losses and pension expense. (See Note 2, Note 10 and Note 25 of Notes to Consolidated Financial Statements.)
In 2011, the Company acquired a business that owned an office building in London for $251 million in cash and an inactive insurance company for $23 million in cash. Approximately $2 million of the aggregate purchase price for these acquisitions was allocated to intangible assets.
At December 31, 2011 and 2010, investments in fixed maturity securities were as follows:
The amortized cost and fair value of fixed maturity securities at December 31, 2011, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because certain issuers may have the right to call or prepay obligations:
At December 31, 2011 and 2010, there were no investments, other than investments in United States government and government agency securities, which exceeded 10% of common stockholders’ equity. At December 31, 2011, investments with a carrying value of $912 million were on deposit in custodial or trust accounts, of which $664 million was on deposit with state insurance departments, $155 million was on deposit in support of the Company’s underwriting activities at Lloyd’s, $64 million was on deposit as security for reinsurance clients and $29 million was on deposit as security for letters of credit issued in support of the Company’s reinsurance operations.
At December 31, 2011 and 2010, the fair value and carrying value of the arbitrage trading account were $397 million and $359 million, respectively. The primary focus of the trading account is merger arbitrage. Merger arbitrage is the business of investing in the securities of publicly held companies which are the targets in announced tender offers and mergers. Arbitrage investing differs from other types of investing in its focus on transactions and events believed likely to bring about a change in value over a relatively short time period (usually four months or less). The Company believes that this makes arbitrage investments less vulnerable to changes in general financial market conditions.
The Company's six largest loans receivable, which have an aggregate amortized cost of $187 million and an aggregate fair value of $166 million at December 31, 2011, are secured by commercial real estate located primarily in New York City, California, Hawaii and Boston. These loans earn interest at floating LIBOR-based interest rates and have maturities (inclusive of extension options) through March 2016. As part of the evaluation process, the Company reviews certain credit quality indicators for these loans. The Company utilizes an internal risk rating system to assign a risk to each of its commercial loans. The loan rating system takes into consideration credit quality indicators including loan to value ratios, which compare the outstanding loan amount to the estimated value of the property, the borrower's financial condition and performance with respect to loan terms, the Company's position in the capital structure, and the overall leverage in the capital structure. Based on this rating system, three loans with a cost basis of $58 million were considered to be impaired at December 31, 2011 and 2010. For each of these loans, a determination was made as to the amount of loss in the event of a default and whether the loss is probable. The results of the determination were considered in connection with the valuation allowance noted above. An additional credit quality indicator is the debt service coverage ratio, which compares a property's net operating income to the borrower's principal and interest payments. At December 31, 2011, each of the six largest loans referred to above have of debt service coverage ratios greater than 3.0 except one that is lower due to a recent and temporary rate abatement.
Includes change in valuation allowance for loans receivable of $0, $6,082,000 and $12,418,000 for the years ended December 31, 2011, 2010 and 2009, respectively.
The following table summarizes all securities in an unrealized loss position at December 31, 2011 and 2010 by the length of time those securities have been continuously in an unrealized loss position.
Fixed Maturity Securities - A summary of the Company’s non-investment grade fixed maturity securities that were in an unrealized loss position at December 31, 2011 is presented in the table below:
The following tables present the assets and liabilities measured at fair value on a recurring basis as of December 31, 2011 and 2010 by level:
The transfers out of Level 3 for mortgage-backed securities in 2010 were based upon the availability of broker dealer quotations. In certain circumstances, the Company was able to obtain quotations from third party broker dealers.
Claims occurring during the current year are net of loss reserve discounts of $43,286,000, $67,763,000 and $80,455,000 in 2011, 2010 and 2009, respectively.
The decrease in estimates for claims occurring in prior years is net of loss reserve discount. On an undiscounted basis, the estimates for claims occurring in prior years decreased by $182,937,000, $246,941,000 and $232,040,000 in 2011, 2010 and 2009, respectively.
For certain retrospectively rated insurance polices and reinsurance agreements, reserve development is offset by additional or return premiums. Favorable reserve development, net of additional and return premiums, was $182 million, $234 million and $190 million in 2011, 2010 and 2009, respectively.
Environmental and Asbestos - To date, known environmental and asbestos claims have not had a material impact on the Company’s operations. These claims have not materially impacted the Company because its subsidiaries generally did not insure large industrial companies that are subject to significant environmental or asbestos exposures prior to 1986 when an absolute exclusion was incorporated into standard policy language.
The Company reinsures a portion of its exposures principally to reduce its net liability on individual risks and to protect against catastrophic losses. Estimated amounts due from reinsurers are reported net of reserves for uncollectible reinsurance of $3,169,000, $3,098,000 and $4,430,000 as of December 31, 2011, 2010 and 2009, respectively. The following table presents the amounts due from reinsurers as of December 31, 2011 (dollars in thousands):
(1) Subsidiary debt is due as follows: $4 million in 2012, $1 million in 2013, $26 million in 2014 and $3 million thereafter.
Income before income taxes from domestic operations was $469 million, $574 million and $343 million for the years ended December 31, 2011, 2010 and 2009, respectively. Income before income taxes from foreign operations was $49 million, $29 million and $39 million for the years ended December 31, 2011, 2010 and 2009, respectively.
At December 31, 2011 and 2010, the tax effects of differences that give rise to significant portions of the deferred tax asset and deferred tax liability are as follows:
The National Association of Insurance Commissioners (“NAIC”) has risk-based capital (“RBC”) requirements that require insurance companies to calculate and report information under a risk-based formula which measures statutory capital and surplus needs based on a regulatory definition of risk in a company’s mix of products and its balance sheet. As of December 31, 2011, all of the Company’s insurance subsidiaries had an RBC amount above the authorized control level RBC, as defined by the NAIC. The Company has guaranteed that the RBC levels of certain subsidiaries will remain above their authorized control levels.
The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as of December 31, 2011 and 2010:
Pursuant to the stock incentive plan, the Company may also issue restricted stock units (RSUs) to officers of the Company and its subsidiaries. The RSUs generally vest five years from the award date and are subject to other vesting and forfeiture provisions contained in the award agreement. The following table summarizes RSU information for the three years ended December 31, 2011:
The Company has a Long-Term Incentive Compensation Plan (“LTIP”) that provides for incentive compensation to key executives based on the growth in the Company’s book value per share over a five year period. There are 193,600 units outstanding from the 2011 grant with a maximum value of $48.4 million, of which $5.6 million was earned by December 31, 2011. There are 158,500 units outstanding from the 2008 grant with a maximum value of $39.6 million, of which $17.3 million was earned over the four years ended December 31, 2011. The 2006 grant earned $30.7 million during the five years ended December 31, 2010, and fully paid in 2011.
The Company has an unfunded noncontributory defined benefit plan that covers its chief executive officer and chairman of the board. The plan provides that the benefits payments shall commence on the earliest of (i) January 2, 2014, (ii) the date of death or (iii) a change in control of the Company. The discount rate used to derive the projected benefit obligation and related retirement expense was 4.36% in 2011 and 5.24% in 2010. The discount rate assumption used to determine the benefit obligation is based on a yield curve approach. Under this approach, a weighted average yield is determined from a hypothetical portfolio of AA rated bonds. Following is a summary of the projected benefit obligation as of December 31, 2011 and 2010:
The estimated prior service cost and net actuarial loss that will be amortized from accumulated other comprehensive income (loss) into periodic benefit cost during 2012 are $2,197,000 and $3,023,000, respectively.
The following is a summary of quarterly financial data (in thousands except per share data):