We are a specialty insurance group with offices in the United States, the United Kingdom, Spain and Ireland, underwriting business in approximately 180 countries. Our shares trade on the New York Stock Exchange and closed at $31.90 on February 18, 2011, resulting in market capitalization of $3.7 billion.
We underwrite a variety of relatively non-correlated specialty lines of business, including property and casualty, accident and health, surety, credit and aviation. Insurance products are marketed through a network of independent agents and brokers, managing general agents and directly to consumers. In addition, we assume insurance written by other insurance companies. We manage our businesses through five underwriting segments and our Investing segment. Our underwriting segments are U.S. Property & Casualty, Professional Liability, Accident & Health, U.S. Surety & Credit and International.
Key facts about our consolidated group as of and for the year ended December 31, 2010 are as follows:
We generated net earnings of $345.1 million, or $2.99 per diluted share.
We purchased $35.1 million of our common stock at an average cost of $26.99 per share. At year-end, we had $265.3 million shares remaining under our $300.0 million share buyback authorization.
In connection with our resegmentation, we changed the presentation of our consolidated income statement and redefined the calculation of our expense ratio. We previously presented reinsurance ceding commissions that exceeded policy acquisition costs as a component of fee and commission income, within total revenue. We now present all ceding commissions as an offset to policy acquisition costs, within total expense.
In late 2009, we began to write property treaty reinsurance business that covers catastrophic risks worldwide. In 2010, we wrote $59.9 million of net premium, which generated $47.6 million of earned premium. This line, which is susceptible to catastrophic events and large losses such as those described in the next paragraph, had a net loss ratio of 58.2% for 2010.
These items are discussed in greater detail below and in the following “Segment Operations” section.
recurring, but less frequent, transaction-based revenues, primarily related to various financial products in our U.S. Property & Casualty segment, and
Total revenue decreased $16.3 million in 2010, compared to 2009, primarily due to lower other operating income, partially offset by increased investment income from growth in our investment portfolio. Other operating income in 2009 included $25.0 million related to dissolution of a reinsurance contract with Mortgage Guarantee Insurance Company (MGIC), which is discussed below. Total revenue increased $111.9 million in 2009, compared to 2008, due to higher net earned premium, increased investment income and the $25.0 million MGIC fee. In addition, there were losses in 2008 on fixed income investments, alternative investments and trading securities, mainly due to the credit crisis.
Net investment income, which is included in our Investing segment, increased 6% in 2010 and 17% in 2009, primarily due to higher income from fixed income securities. Our fixed income securities portfolio increased 12% in 2010 and 9% in 2009, from $4.3 billion at December 31, 2008 to $4.6 billion at December 31, 2009 and $5.2 billion at December 31, 2010. The growth in fixed income securities resulted primarily from cash flow from operations and reinvestment of funds that were held in short-term investments during 2009 and in alternative investments during 2008. Short-term investment income declined due to lower average short-term investment balances in 2010 and significantly lower short-term market interest rates in 2009 and 2010. In 2008, we experienced $30.8 million of losses on alternative investments (primarily fund-of-fund hedge fund investments), which we redeemed in late 2008 and reinvested in fixed income securities.
As discussed above under “Reporting Segment Changes”, we made certain changes to our presentation of other operating income in connection with our resegmentation. The table below, which details the components of other operating income, reflects these presentation changes in all periods.
Fee and commission income related to third party agency and broker commissions decreased year-over-year, primarily in our International segment due to reduced brokerage volume following the sale of our U.K. reinsurance broker in late 2009. We sold 100% of the stock of Rattner Mackenzie Limited and realized a loss of $4.7 million, which is included in Other above. Strategic investments included gains of $2.4 million in 2009 and $9.2 million in 2008 related to sales of such investments. In 2008, trading securities included losses from the decline in the market value of these securities, which we sold in late 2008.
The financial instruments line, related to two derivative contracts denominated in British pound sterling, includes the effect of foreign currency fluctuations compared to the U.S. dollar. In 2010, financial instruments also included an $8.0 million gain related to commutation of one of these derivative contracts. In 2009, the contract using deposit accounting included a $25.0 million fee we received for dissolving all of our liability, loss-free, under the MGIC reinsurance contract. This contract provided reinsurance coverage for certain residential mortgage guaranty contracts. We had been recording revenue under this contract using the deposit method of accounting because we determined the contract did not transfer significant underwriting risk. Our $25.0 million fee was partially offset by $9.9 million of expenses for reinsurance and other direct costs, which were included in other operating expense. The income from dissolving the derivative contract and the MGIC contract is included in our U.S. Property & Casualty segment.
Other operating expense, of which approximately 62% relates to compensation and benefits of our employees, decreased 1% in 2010 and increased 11% in 2009. We had 1,883 employees at December 31, 2010, compared to 1,864 at December 31, 2009 and 2008. In 2009, we sold our U.K. reinsurance broker and our commercial marine agency business, which reduced our other operating expense in 2010. Our other operating expense included $3.0 million in 2010 and $9.9 million in 2009 of direct costs related to dissolving the derivative contract and the MGIC reinsurance contract, respectively, discussed above. In addition, our 2009 other operating expense was higher than 2008 due to compensation and other operating expenses related to businesses acquired in late 2008 and 2009, as well as higher profit-related bonuses for our underwriters. The 2009 expense was partially offset by a $5.6 million benefit from reversal of a reserve for uncollectible reinsurance that was collected. We recognized $1.6 million of expense in 2010, compared to gains of $0.6 million in 2009 and $1.9 million in 2008, related to foreign currency conversion.
Our income taxes are due to U.S. Federal, state, local and foreign jurisdictions. Our effective income tax rate was 29.5% for 2010, compared to 31.8% for 2009 and 30.1% for 2008. The lower effective rate in 2010 related to: 1) a benefit in 2010 from adjusting our tax accruals to the actual amount of taxes paid for 2009, compared to expense in 2009 for a related adjustment of our 2008 tax accruals, 2) the reversal of certain liabilities for uncertain tax positions due to the expiration of various tax statutes and 3) the increased benefit from tax-exempt investment income relative to a lower pretax income base, which also lowered the effective rate in 2008.
Each of our insurance segments bears risk for insurance coverage written within its portfolio of insurance products. Each segment generates income from premium written by our underwriting agencies, through third party agents and brokers, or on a direct basis. The insurance segments also write facultative or individual account reinsurance, as well as treaty reinsurance business. In some cases, we purchase reinsurance to limit the segments’ net losses from both individual and catastrophic risks. Our segments maintain disciplined expense management and a streamlined management structure, which results in favorable expense ratios. The following provides operational information about our five underwriting segments and our Investing segment.
Our U.S. Property & Casualty segment writes specialty lines of insurance such as aviation, small account errors and omissions liability (E&O), public risk, employment practices liability, title, residual value, disability, contingency, kidnap and ransom, difference in conditions, occupational accident and brown water marine. The products are written through our underwriting agencies, third party agents and brokers, or on a direct basis in the United States. The majority of the business is primary coverage, with reinsurance on certain product lines. Certain products, including aviation, public risk and difference in conditions, have catastrophic exposure. Claims for most products are reported and settled on a short to medium-term basis.
The following tables summarize the operations of the U.S. Property & Casualty segment.
The U.S. Property & Casualty segment pretax earnings declined 34% in 2010 primarily due to: 1) lower net earned premium, primarily related to pricing competition and 2) the year-over-year impact of a pretax gain of $5.0 million in 2010 and $15.6 million in 2009 related to the dissolution of two contracts discussed below. Segment earnings increased 15% in 2009 compared to 2008, primarily due to the $15.6 million pretax gain.
Our U.S. Surety & Credit segment includes surety products written in the United States and credit insurance managed in the United States. Our surety book includes contract surety bonds, commercial surety bonds, and bail bonds written by independent agents. Our credit insurance covers payments for export trade and structured trade transactions, political risk insurance and letters of credit. Surety bonds serve as financial protection to a third party in the event a principal is unable to honor an obligation, rather than as an insurance policy that pays on behalf of a policyholder. Claims for surety and credit products are reported quickly, but subrogation recovery frequently takes extended periods of time, resulting in medium-tailed business.
The U.S. Surety & Credit segment pretax earnings increased 27% in 2010 compared to 2009 due to higher net earned premium and favorable accident year loss experience in 2010, partially offset by higher expenses. Segment earnings decreased 26% in 2009 compared to 2008 due to increased losses and substantially higher expenses, which more than offset the increase in net earned premium.
The segment had favorable loss development of $7.2 million in 2010, compared to $10.5 million in 2009 and $3.9 million in 2008. The favorable development was offset by higher accident year losses and lower subrogation in 2010 and 2009, due to the impact of the current economic environment on the construction industry and economic strain on principals on commercial surety bonds. The credit line experienced large losses in 2009 and 2008, due to weak economic conditions in the world credit markets, for which a substantial amount of subrogation was collected in 2010.
In 2010, we recognized gross losses of $44.0 million from numerous catastrophic events, the most significant of which was the Chilean earthquake. After reinsurance, our pretax loss was $22.5 million, which primarily impacted our property treaty and property lines. We also recognized gross losses of $31.7 million for the Deepwater Horizon rig disaster in 2010. Due to significant facultative reinsurance, in addition to treaty reinsurance, our pretax net loss was minimal. In 2008, we incurred gross losses of $88.0 million from the 2008 hurricanes. Our 2008 pretax losses after reinsurance were $12.1 million, which primarily impacted our energy and property lines. The catastrophic losses increased the International segment’s net loss ratio by 7.1 percentage points in 2010 and 5.0 percentage points in 2008.
The segment had favorable loss development of $22.3 million in 2010, compared to $30.9 million in 2009 and $34.8 million in 2008. The 2010 development related to the 2006 - 2007 underwriting years for our energy and U.K. professional liability product (included in Liability), as well as the reduction of reserves for the 2005 and 2008 hurricanes (included in Energy). The 2009 development related to energy reserves for the 2005 hurricanes and to our U.K. professional liability product for the 2004 - 2006 underwriting years. The 2008 development related to our U.K. professional liability product and to the 2005 hurricanes. Our surety and credit businesses incurred higher losses in 2009 and 2008 due to weak macro-economic conditions, particularly in the U.K. and Spanish construction markets. Our jewelers block business (included in Other), which we stopped writing in 2010, had losses in 2010 with minimal net earned premium.
We invest substantially all of our funds in highly-rated fixed income securities, the majority of which are designated as available for sale securities. We held $5.2 billion and $4.6 billion of fixed income securities at December 31, 2010 and 2009, respectively. At year-end 2010, 99% of our fixed income securities were investment grade, of which 83% were rated AAA or AA. The portfolio has a weighted-average life of 7.5 years and a weighted-average duration of 5.5 years.
Our total investments increased $230.9 million principally from operating cash flow that we generated during the year, partially offset by a $21.7 million reduction in the unrealized pretax gain associated with our available for sale fixed income securities. During 2010, we substantially reduced our short-term investments, and re-invested the funds in long-term fixed income securities, in order to maximize our investment return. We continue to focus on reducing our holdings of short-term investments, given the extremely low market interest rates on such funds.
The fluctuations in fair value are somewhat muted by the relatively short duration of our portfolio and our relatively high level of investments in state and municipal obligations. We estimate that a 100 basis point increase in market interest rates would decrease the fair value of our fixed income securities by approximately $285.0 million before tax and a 100 basis point decrease in market interest rates would increase the fair value by a like amount. Fluctuations in interest rates have a minimal effect on the value of our short-term investments due to their very short maturities.
other-than-temporary impairment credit losses through pretax earnings, including $0.4 million in 2010, $5.5 million in 2009 and $11.1 million in 2008.
In 2008, we began holding certain bonds in a held to maturity portfolio. This portfolio includes securities, denominated in currencies other than the functional currency of the investing subsidiary, for which we have the ability and intent to hold the securities to maturity or redemption. We hold these securities to hedge the foreign exchange risk associated with insurance claims that we will pay in foreign currencies. The amortized cost of bonds in our held to maturity portfolio was $193.7 million at December 31, 2010 and $102.8 million at December 31, 2009. Any foreign exchange gain/loss on these bonds will be recorded through income and will substantially offset any foreign exchange gain/loss on the related liabilities.
The average long-term tax equivalent yield of our fixed income securities portfolio was 5.0%, 5.1% and 5.2% in 2010, 2009 and 2008, respectively. These yields reflect general declines in market interest rates over this period, partially offset by longer average duration of our new investments. Realized gains and losses from sales of securities are usually minimal, unless we sell securities for investee credit-related reasons, or because we can reinvest the proceeds at a higher effective yield. We recognized net realized investment gains of $12.1 million in 2010 and 2009 and $16.8 million of net realized investment losses in 2008, due to credit market events in that year.
The table below indicates the expected maturity distribution of our fixed income securities at December 31, 2010. In the table, we allocated the maturities of asset-backed maturities and mortgage-backed securities based on the expected future principal payments. The weighted-average life of our asset-backed and mortgage-backed securities is approximately 4.9 years based on expected future cash flows.
At December 31, 2010, we held a portfolio of residential mortgage-backed securities (MBSs) and collateralized mortgage-obligations (CMOs) with a fair value of $995.1 million and a $12.6 million portfolio of asset-backed securities. In our residential MBS/CMO portfolio, $938.9 million, or 94%, of the securities were issued by the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (GNMA) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which are supported by the U.S. government. For the remaining $56.2 million of securities, 71% are collateralized by prime mortgages. Within our residential MBSs and asset-backed securities, we held $5.9 million of bonds that are collateralized by Alt A and subprime mortgages and have an average rating of BBB+.
A Corporate & Other category includes operations not related to our segments, including unallocable corporate operating expenses, consolidated interest expense and underwriting results of our Exited Lines of business. The Exited Lines include: 1) accident and health business managed by our underwriting agency, LDG Reinsurance, 2) workers’ compensation, 3) provider excess, 4) Spanish medical malpractice, 5) U.K. motor and 6) film completion bonds. We no longer write the Exited Lines and do not expect to write these product lines in the future.
Net earned premium and losses decreased year-over-year because we sold the renewal rights to provider excess in 2009 and we stopped writing film completion bonds and U.K. motor business in 2009 and 2008, respectively. The Exited Lines had adverse loss development of $3.2 million, $11.4 million and $10.9 million
in 2010, 2009 and 2008, respectively, mainly in the accident and health, Spanish medical malpractice and U.K. motor businesses. In 2009, we also incurred larger than expected accident year losses on film completion bonds. The Exited Lines continue to incur minimal operating costs, primarily for claims personnel and facilities.
Our Corporate expenses not allocable to the segments decreased $6.2 million in 2010, principally due to lower expense for corporate bonuses, stock-based compensation and the fair value adjustment on two expired interest rate swap agreements. Corporate expenses not allocable to the segments increased $16.2 million in 2009, compared to 2008, primarily due to higher expense related to salaries and bonuses. Our consolidated interest expense increased in 2010 because we issued long-term debt in late 2009 at a higher fixed rate than the floating rate related to our prior line of credit borrowings. Interest expense decreased in 2009 compared to 2008 due to lower borrowings and interest rates on our Revolving Loan Facility.
During the three years ended December 31, 2010, we have averaged $501.3 million in cash provided by operating activities.
Our long-term debt consists of $300.0 million of unsecured 6.30% Senior Notes due November 15, 2019. Our debt to total capital ratio was 8.3% at December 31, 2010.
We have a committed $575.0 million Revolving Loan Facility at a rate of 30-day LIBOR plus 25 basis points that matures December 19, 2011. Letters of credit issued on behalf of certain of our subsidiaries reduce available borrowing capacity under the facility. At December 31, 2010, we had $556.8 million of unused capacity, which we can draw against at any time at our request.
We have a $90.0 million Standby Letter of Credit Facility, which is used to guarantee our performance in two Lloyd’s of London syndicates, that expires on December 31, 2014.
Our domestic insurance companies have the ability to pay $183.6 million in dividends to HCC, the parent company, in 2011 without obtaining special permission from state regulatory authorities. Our underwriting agencies have no restrictions on the amount of dividends that can be paid. HCC can utilize these dividends for any purpose, including to pay down debt, pay dividends to shareholders, fund acquisitions, purchase common stock and pay operating expenses.
We have a “Universal Shelf” registration statement that provides for the issuance of an aggregate of $1.0 billion of securities, of which we have $700.0 million of remaining capacity. These securities may be debt securities, equity securities, or a combination thereof. The shelf registration statement provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial market.
We generated cash from operations of $415.2 million in 2010, $582.8 million in 2009 and $506.0 million in 2008. The components of our net operating cash flows are summarized in the following table.
Our cash provided by operating activities was lower in 2010, compared to 2009, primarily due to timing differences in the payment of claims and reinsurance balances payable and the collection of fiduciary funds. We paid $80.3 million more for claims payments in 2010 than in 2009. Fiduciary funds, mainly received as collateral against surety losses, for which we earn the interest income, increased $32.7 million in 2010 and $47.0 million in 2009. Our operating cash flow is also impacted by the timing of cash receipts and payments related to commutations. In 2009, we commuted certain loss reserves for $43.9 million of cash, which reduced cash provided by operating activities. In 2010 and 2009, we received special cash receipts of: 1) $8.3 million in 2010 to dissolve a derivatives contract and 2) $25.0 million and $20.3 million in 2009 to dissolve the MGIC reinsurance contract and to partially liquidate the previously mentioned derivatives contract, respectively.
The 6.30% Senior Notes are due in 2019. We pay interest semi-annually on May 15 and November 15, which is included in the above table.
The $575.0 million Revolving Loan Facility expires on December 19, 2011. At December 31, 2010, there were no outstanding borrowings on the Facility, but we pay an annual commitment fee of 10.0 basis points, which is included in the above table.
duration than our other products. We consider these different claims payment patterns in determining the duration of our investment portfolio.
In 2010, we had two free-standing interest rate swaps for $105.0 million, with a fixed rate of 2.94%, which expired in November 2010.
We have a $90.0 million Standby Letter of Credit Facility (Standby Facility), reduced from $152.0 million on November 26, 2010, that is used to guarantee our performance in two Lloyd’s of London syndicates. The Standby Facility expires on December 31, 2014. Letters of credit issued under the Standby Facility are unsecured commitments of HCC. The Standby Facility contains two restrictive financial covenants, with which we were in compliance at December 31, 2010.
We acquired HCC Global Financial Products (HCC Global), which underwrites our U.S. and International D&O business, in 2002. The purchase agreement, as amended, includes a contingency for future earnout payments.
The earnout is based on HCC Global’s pretax earnings from the acquisition date through September 30, 2007, with no maximum amount due to the former owners. Pretax earnings include underwriting results on this long-tailed business, until all related claims are settled. When conditions specified under the purchase agreement are met, we record a net amount owed to or due from the former owners based on our estimate, at that point in time, of how claims will ultimately be settled. This net amount will fluctuate in the future, and the ultimate total net earnout payments cannot be finally determined until all claims are settled or paid. Based on our estimate, as of December 31, 2010, of ultimate claims settlements, we recorded a projected net amount due from the owners of $20.0 million at year-end 2010. This net amount includes approximately $22.7 million due to the former owners in March 2011, according to contractual requirements in the purchase agreement. All adjustments to the net amount due have been, or will be, recorded as an increase or decrease to goodwill.
Our 2008 acquisition of HCC Medical Insurance Services includes an earnout based on achievement of certain underwriting profit levels. At December 31, 2010, the accrued earnout, which will be paid in 2011, totaled $1.8 million.
The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries. HCC’s direct U.S. insurance company subsidiaries can pay an aggregate of $183.6 million in dividends in 2011 without obtaining special permission from state regulatory authorities. In 2010, 2009 and 2008, our insurance companies paid HCC dividends of $285.7 million, $134.0 million and $111.8 million, respectively. The 2010 dividends included $135.4 million of fixed income securities plus the related accrued interest.
A portion of our revenue is related to healthcare insurance and reinsurance products that are subject to the effects of the underlying inflation of healthcare costs. Such inflation in the costs of healthcare tends to generate increases in premiums for medical stop-loss coverage, resulting in greater revenue but also higher claims payments. Inflation also may have a negative impact on insurance and reinsurance operations by causing higher claims settlements than originally estimated, without an immediate increase in premiums to a level necessary to maintain profit margins. We do not specifically provide for inflation when setting underwriting terms and claim reserves, although we do consider trends. We continually review claim reserves to assess their adequacy and make necessary adjustments.
Inflation can also affect interest rates. A significant increase in interest rates could increase our net investment income related to newly invested cash flow and could also have a material adverse effect on the fair value of our investments. The fair value of our fixed income securities was $5.2 billion at December 31, 2010. If market interest rates were to change 100 basis points, the fair value of our fixed income securities would change approximately $285.0 million before tax, based on our year-end portfolio value. The change in fair value was determined using duration modeling assuming no prepayments. In addition, the interest rate payable under our Revolving Loan Facility fluctuates with market interest rates. A significant increase in interest rates could have an adverse effect on our net earnings, if we have outstanding borrowings under the Facility. The interest rate on our 6.30% Senior Notes is fixed and not subject to interest rate changes.
We underwrite risks that are denominated in a number of foreign currencies. As a result, we have receivables and payables in foreign currencies and we establish and maintain loss reserves with respect to our insurance policies in their respective currencies. There could be a negative impact on our net earnings from the effect of exchange rate fluctuations on these assets and liabilities. Our principal area of exposure is related to fluctuations in the exchange rates between the British pound sterling, the Euro and the U.S. dollar. We constantly monitor the balance between our receivables and payables and loss reserves to mitigate the potential exposure should an imbalance be expected to exist for other than a short period of time. Imbalances are generally net liabilities, and we economically hedge such imbalances with cash and short-term investments denominated in the same foreign currency as the net imbalance. We recognized a $1.6 million loss from currency conversion in 2010, compared to gains of $0.6 million in 2009 and $1.9 million in 2008.
The following tables show, as of December 31, 2010 and 2009, our recorded net reserves by segment, as well as the actuarial reserve point estimates, and the high and low ends of the actuarial reserve range as determined by our reserving actuaries.
We are not aware of any material exposure to asbestos claims or environmental pollution losses. Our largest insurance company only began writing business in 1981, and its policies normally contain pollution exclusion clauses that limit pollution coverage to “sudden and accidental” losses only, thus excluding intentional dumping and seepage claims. Policies issued by our other insurance companies do not have significant legacy environmental exposures because of the types of risks covered.
Based on our reserving techniques and past results, we believe that our net reserves are adequate.
In our proportional reinsurance programs, we generally receive a commission on the premium ceded to reinsurers. This compensates our insurance companies for the direct costs associated with production of the business, the servicing of the business during the term of the policies ceded, and the costs associated with placement of the related reinsurance. In addition, certain of our reinsurance treaties allow us to share in any net profits generated under such treaties with the reinsurers. Various reinsurance brokers arrange for the placement of this reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers.
Our reinsurance recoverables decreased in amount and as a percentage of our shareholders’ equity during 2010. The percentage of reinsurance recoverables compared to our shareholders’ equity was 31% and 34% at December 31, 2010 and 2009, respectively. A high percentage of our reinsurance recoverables relates to our D&O business, where it takes longer for claims reserves to result in net paid claims.
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on our history of earnings, expectations for future earnings, taxable income in carryback years and the expected timing of the reversals of existing temporary differences. Although realization is not assured, we believe that, as of December 31, 2010, it is more likely than not that we will be able to realize the benefit of recorded deferred tax assets, with the exception of certain tax loss carryforwards for which valuation allowances have been provided. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions, which could result in a change in the valuation allowance required.
When we complete a business acquisition, goodwill is either allocated to the reporting unit in which the acquired business is included or, if there are synergies with our other businesses, allocated to the different reporting units based on their respective share of the estimated future cash flows.
An indicator of impairment of goodwill exists when the fair value of a reporting unit is less than its carrying amount. We assess our goodwill for impairment annually, or sooner if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. We conducted our 2010 goodwill impairment test as of June 30, 2010, which is consistent with the timeframe for our annual assessment in prior years. This test considered the fair value of our former reporting units, before the change in reporting units discussed below. Based on our June 2010 impairment test, the fair value of each of our reporting units as of that date exceeded its carrying amount.
For our June 2010 impairment test, we considered three valuation approaches (market, income and cost) to determine the fair value of each reporting unit. We utilized the market and income approaches and based our assumptions and inputs on market participant data, rather than our own data. For the income approach, we estimated the present value of expected cash flows to determine the fair value of each reporting unit. We utilized estimated future cash flows, probabilities as to occurrence of these cash flows, a risk-free rate of interest, and a risk premium for uncertainty in the cash flows. We weighted the results of the market and income approaches to determine the calculated fair value of each reporting unit. We utilized our budgets and projection of future operations based on historical and expected industry trends to estimate our future cash flows and their probability of occurring as projected.
At September 30, 2010, in connection with the change to our segment reporting structure in the third quarter of 2010, we allocated our consolidated goodwill to five new reporting units, which are the same as our new insurance underwriting segments. We allocated the goodwill based on the relative fair value of each reporting
unit to the sum of the reporting units’ total fair value at September 30, 2010. The goodwill balances by reportable segment after resegmentation, as of September 30, 2010 were as follows:
To determine the fair value of each reporting unit as of September 30, 2010, we utilized the income and market valuation approaches and based our assumptions and inputs on market participant data, as well as our own data. For the income approach, we estimated the present value of each reporting unit’s expected cash flows to determine its fair value. We utilized estimated future cash flows of the portfolio of products included in each reporting unit, as well as a risk-appropriate rate of return specific to each reporting unit. We utilized our budgets and projection of future operations based on historical and expected industry trends to estimate our future cash flows and their probability of occurring as projected. We also determined fair value of each reporting unit based on market participant data, and used those results to test the reasonableness and validity of the income approach results.
As a result of our resegmentation, we tested goodwill for impairment as of September 30, 2010 using this fair value information. For goodwill impairment purposes only, we allocated the majority of investments and investment income from the Investing segment to the five reporting units. We assigned investments to each reporting unit based on the amount of capital required by the reporting unit to maintain an A+ rating under A.M. Best’s capital allocation model. We assumed the same investment income rate of return for all investments. Based on this impairment test, the fair value of each new reporting unit exceeded its carrying amount. No events have occurred that indicate there is an impairment in our goodwill as of December 31, 2010.
We will conduct our next annual goodwill impairment test as of June 30, 2011, unless other events occur that indicate there is an impairment in our goodwill prior to that date. In future periods, when we complete a business acquisition, we will assign goodwill to the applicable reporting units, based on the reporting unit’s share of the estimated future cash flows of all acquired insurance products.
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. Our available for sale fixed income securities had gross unrealized losses of $35.6 million (0.7% of the aggregate fair value of total available for sale fixed income securities) at December 31, 2010, compared to $18.9 million (0.4% of aggregate fair value) at December 31, 2009. We evaluate the securities in our fixed income securities portfolio for possible other-than-temporary impairment (OTTI) losses at each quarter end.
Prior to April 1, 2009, we assessed our ability and intent to hold an impaired security for a period of time sufficient to allow full recovery or until maturity. If we could not assert this condition, we recorded the difference between fair value and amortized cost as an OTTI loss through earnings in that period. Based on this criteria, we recorded OTTI losses of $3.1 million in the first quarter of 2009 and $11.1 million in 2008. Our quarterly reviews covered all impaired securities where the loss exceeded $0.5 million and the loss either exceeded 10% of cost or the security had been in a loss position for longer than twelve consecutive months.
securities, the impairment is considered an other-than-temporary loss if the net present value of the cash flows expected to be collected from the security is less than its amortized cost basis. Such a shortfall in cash flows is referred to as a “credit loss.” For any such security, we separate the impairment loss into: 1) the credit loss and 2) the amount related to all other factors, such as interest rate changes, market conditions, etc. (the “non-credit” loss). The credit loss is charged to current period earnings and the non-credit loss is charged to other comprehensive income, within shareholders’ equity, on an after-tax basis. We permanently reduce an impaired security’s cost basis by the amount of a credit loss and accrete income over the remaining life of the security based on the interest rate necessary to discount the expected future cash flows to the new basis.
To adopt the new accounting standard, we reviewed all securities with a previous OTTI loss that we still held at April 1, 2009. For each, we determined the credit and non-credit component as of the adoption date. We calculated the net present value of each security by discounting our best estimate of projected future cash flows at the effective interest rate implicit in the security prior to impairment. For our mortgage-backed securities, the estimated cash flows included prepayment assumptions and other assumptions regarding the underlying collateral including default rates, recoveries and changes in value. We recorded a cumulative adjustment of $4.3 million after-tax to reclassify the non-credit portion of the loss from retained earnings to accumulated other comprehensive income as of the adoption date.
See Note 1 to the Consolidated Financial Statements for additional information about new accounting guidance that we adopted in 2010 for the following: 1) consolidation of variable interest entities, 2) fair value measurements and disclosures, and 3) credit risk and the allowance for credit losses related to finance receivables.