The following table sets forth the calculation of return on equity for the years ended December 31, 2012, 2011 and 2010, respectively ($ in thousands):
The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes thereto included in this Form 10-K. This Form 10-K contains forward-looking statements that involve risks and uncertainties. Please see the “Note on Forward-Looking Statements” on page 1 of this Form 10-K. Our consolidated financial statements have been prepared in accordance with U.S. GAAP. Management has included certain schedules containing financial measures that are not calculated under standards and rules that comprise U.S. GAAP, see Item 6. for additional information.
The reinsurance industry has historically been cyclical, characterized by periods of price competition due to excessive underwriting capacity as well as periods of favorable pricing due to shortages of underwriting capacity. Cyclical trends in the industry and the industry’s profitability can be significantly affected by volatile developments, including natural and other catastrophes. To the extent that actual claim liabilities are higher than anticipated, the industry’s capacity to write new business diminishes. The reinsurance industry is also affected by changes in the propensity of courts to expand insurance coverage and grant large liability awards. A changing regulatory environment also may impact the industry’s underwriting capacity. Fluctuations in interest rates, credit spreads, liquidity, inflation and other changes in the economic environment can also affect the fair values of investments and impact the industry’s underwriting capacity. These factors influence the total supply of underwriting capacity in the market which tends to drive the cyclical nature of the industry.
Traditional as well as new capital market participants from time to time produce alternative products (such as reinsurance securitizations, catastrophe bonds and various derivative instruments, such as swaps) that may compete with certain types of reinsurance, such as property catastrophe. Moreover, government-backed entities also represent competition for the coverages that we provide directly, or for the business of our customers, reducing the potential amount of third party private protection our clients might need or desire. Over time, these numerous initiatives could significantly affect supply, pricing and competition in our industry and partially displace our traditional reinsurance products.
Recent global catastrophe activity will help support risk adjusted pricing which we expect will be flat or marginally up in all lines of business that have not recently experienced significant losses. We generally expect property catastrophe exposed reinsurance rates for peak zones and perils will remain reasonably attractive for the balance of the year. Absent a major loss producing event in global insurance or capital markets, we believe that reinsurers generally remain well-capitalized and that competitive pressure will keep property catastrophe reinsurance rates from rising significantly. Accordingly, we currently expect that the portfolio of business we write in our Property and Marine segment during 2013 will be similar to our current in-force book of business. We expect that our Property and Marine segment will continue to represent a large proportion of our overall book of business, which could result in significant volatility in our results of operations.
In the Casualty segment, we currently expect that insurance and reinsurance capacity will remain abundant for the rest of 2013 and that competition will continue to limit the potential for significant increases in risk-adjusted rates. Although certain casualty rate increases appear to exceed trends in loss costs, we believe that the expected profitability of many casualty reinsurance contracts will not improve due to lower investment yields. We expect that select casualty reinsurance contracts will continue to offer adequate returns and that the portfolio of business we write in our Casualty segment during 2013 will be similar to our current in-force book of business.
We will continue with our strategy of responding to changes in market conditions, underwriting for profitability, not market share.
Based on our current reserve position, portfolio of in-force business, asset portfolio, and underwriting prospects for the near term, we believe that we are well capitalized with an adequate margin above the rating agency targets for a company with our ratings. If our business performs as expected, we anticipate that we may generate excess capital over time. Under those conditions, we would have the financial flexibility to expand our underwriting, hold riskier assets, or repurchase our common shares or debt securities. While we will consider the risk adjusted pricing prevailing in the reinsurance and financial markets at the time, we currently view share repurchase as a relatively attractive use of excess capital.
Assumed reinsurance premiums earned are recognized as revenues in the consolidated statements of operations, net of any ceded premiums for retrocessional coverage purchased. Both assumed and ceded premiums written are earned generally on a basis proportionate with the coverage period. Assumed premiums written not yet recognized as revenue are recorded on the consolidated balance sheets as unearned premiums. Ceded premiums written not yet earned are recorded on the consolidated balance sheets as prepaid reinsurance premiums.
The following table sets forth our estimated and reported premiums receivable and unearned premiums as of December 31, 2012 and 2011, respectively ($ in thousands):
Certain of our reinsurance contracts include provisions that adjust premiums based upon the loss experience of the contracts. We take these provisions into account when determining our estimates of premiums written and unearned premiums. Reinstatement premiums are the premiums charged for the restoration of the reinsurance limit of a reinsurance contract to its full amount, generally coinciding with the payment by the reinsurer of losses. These premiums relate to and are earned over the remaining coverage period of the reinsurance contract. Any unearned premiums existing at the time a contract limit is exhausted or reinstated is earned immediately. Additional premiums are premiums that are triggered by losses and are earned immediately. Premiums written and unearned premiums include estimates of reinstatement premiums and additional premiums based on reinsurance contract provisions and loss experience and rely on the estimates of unpaid losses and LAE.
During the years ended December 31, 2012, 2011 and 2010, we recorded net written premiums of $565.0 million, $651.5 million and $760.6 million. In those years, we recorded increases in prior year net written premiums of $44.8 million, $23.9 million and $23.2 million, respectively. Substantially all of the change in prior year net premiums written relates to the two most recent underwriting years and were primarily the result of updated premiums reported by our ceding companies. During the years ended December 31, 2012, 2011 and 2010, we recorded increases in prior year net premiums earned of $30.4 million, $15.3 million and $15.7 million, respectively. We do not believe that the increases in prior year premium estimates in 2012, 2011 and 2010 are indicative of prospective net premium adjustments in future years because conditions and trends that affected prior years’ premium estimates may not exist in the future.
We receive information from ceding companies regarding our liability for unpaid losses and LAE. This information varies but typically includes information regarding the ceding company’s paid losses and case reserves and may include a ceding company’s estimate of IBNR. We may increase or decrease case reserves based on receipt of additional information from the ceding companies. Adjustments that we make to reported case reserves are generally referred to as “additional case reserves”.
Includes $403.3 million and $607.1 million of reserves related to major catastrophes as of December 31, 2012 and 2011, respectively.
The determination of when reported losses are sufficient and credible to warrant selection of an ultimate loss ratio different from initial expected loss ratio also requires judgment. We generally make adjustments for reported loss experience indicating unfavorable variances from initial expected loss ratios sooner than reported loss experience indicating favorable variances. This is because the reporting of losses in excess of expectations tends to have greater credibility than an absence or lower than expected level of reported losses. While we continue with this approach, in the fourth quarter of 2012 we began reflecting favorable variances in reported losses in our selection of ultimate loss ratios at an earlier point in the loss development pattern than we had in the past. For further discussion, see our “Independent Actuarial Review” below.
In the North American casualty excess-of-loss classes, the loss development patterns are primarily based on our historical reported loss data and that of our predecessor, both of which are supplemented by industry data from the Reinsurance Association of America (“RAA”) and Insurance Services Offices, Inc. Due to the long loss development pattern in general liability, various sources are used to estimate the end of the loss development pattern referred to as the “tail”. To estimate the tail, we supplement our historical data, and the data available from our predecessor, with industry data, generally from the RAA, and data received from external actuarial firms.
We analyze historical loss development patterns and may adjust them for observed anomalies. For example, we observed that loss development patterns were much slower in Underwriting Years that were characterized by especially intense competition, known as the “soft market,” particularly in the North American excess-of-loss claims made class. We believe this is due to multiple year policies written by ceding companies and the deterioration in underwriting standards during these periods. In determining our loss development patterns for certain classes, we may exclude certain historical data from the soft market years. However, one of the risks of excluding some of the years is that we could be obscuring trends in loss development patterns. Our actuaries consider this when determining the credibility of indications that use these patterns. For certain reinsurance contracts, appropriate historical loss development patterns may be developed from ceding company data or other sources.
Our underwriters will typically prepare an initial estimate of our ultimate losses for a catastrophe event on a contract-by-contract basis. This estimate is typically based on the Company’s portfolio modeling, discussions with brokers and clients, market share analysis and a review of the Company’s in-force contracts, as well as claims information and analysis, if any, received from brokers and clients. Information is typically updated as it becomes available. Our actuaries and underwriters will also consider a variety of factors, including: (1) the credibility of ceding company estimates, (2) whether the ceding company estimates include IBNR and (3) whether the ceding company information is current. After reviewing loss estimates and other information with our underwriters, our actuaries make an estimate of ultimate loss.
In addition to the above major catastrophe events we have established specific reserves for other major catastrophes events. For additional information on major catastrophe events in 2012, 2011 and 2010 see the “Results of Operations” set forth below in this Form 10-K.
Our estimates are based on assumptions that historical loss development and trends are reasonably predictive of how losses will develop in the future when reported. New or updated information or loss data may impact our selection of ultimate loss ratios in subsequent periods. There are various elements of updated loss data and related information that may result in a materially different estimate of ultimate losses. The four most significant inputs to our loss estimation process are: (1) the initial expected loss ratio, (2) reported losses to date, (3) the loss development patterns and (4) earned premiums.
As part of their 2006 and 2009 reviews, the independent actuarial firms also provided low and high loss development patterns by reserving class. The Company’s actuarial staff applied these low and high loss development patterns for certain of our North American casualty excess-of-loss classes to develop alternative indications of ultimate losses. We considered these alternative indications, along with the indications developed using loss development patterns determined by the Company’s own actuaries, in the selection of ultimate loss ratios.
We believe incorporating earlier recognition of favorable variances may result in more volatility in our reserve for unpaid losses and loss adjustment expenses than we have previously experienced.
During the years ended December 31, 2012, 2011 and 2010, we experienced net favorable loss development of $235.5 million, $113.0 million, and $158.9 million, respectively. The net favorable loss development was attributable primarily to a level of cumulative losses reported to us by our ceding companies that was lower than expected and that, in our judgment, resulted in sufficient credibility in the loss experience to change our previously selected loss ratios and reduce estimated ultimate losses, as discussed further in Item 1, “Business - Unpaid Losses and Loss Adjustment Expenses,” in this Form 10-K.
Initial expected loss ratios and loss development patterns are two key inputs to our loss estimation process. We exercise judgment in establishing key inputs at the beginning of an underwriting year and also as we modify the key inputs, as appropriate, throughout the loss development period. During the years ended December 31, 2012, 2011 and 2010, changes in the initial expected loss ratio and the loss development patterns resulted in net favorable loss development of $26.0 million, $5.6 million and $13.2 million, respectively.
We have selected the initial expected loss ratio and the loss development patterns for sensitivity analysis. Ultimate loss estimates for the North American casualty excess-of-loss classes of business, which generally have the longest loss development patterns, have a higher degree of uncertainty than other reserving classes. IBNR for these classes as of December 31, 2012 was $742.5 million, which was 64% of the total IBNR at that date. The estimates of unpaid losses and LAE related to North American casualty excess-of-loss classes of business have a higher degree of uncertainty and, consequently, reasonable alternatives to our selected initial expected loss ratios and loss development patterns could vary significantly.
For example, if we increased the initial expected loss ratio for these classes by 5% from 69% to 74%, we would increase the IBNR for these classes by $56.4 million, which represents approximately 5% of unpaid losses and LAE for these classes as of December 31, 2012, or if we increased the initial expected loss ratio for these classes by 10% from 69% to 79%, we would increase the IBNR for these classes by $102.6 million, which represents approximately 10% of unpaid losses and LAE for these classes as of December 31, 2012.
As another example of key assumption sensitivity, if we shortened the estimated loss development patterns related to North American casualty excess-of-loss classes by 5%, we would decrease the IBNR for these classes by $54.5 million, which represents approximately 5% of unpaid losses and LAE for these classes as of December 31, 2012, or if we shortened the loss development patterns by 10%, we would decrease the IBNR for these classes by $99.7 million, which is approximately 10% of unpaid losses and LAE for these classes as of December 31, 2012.
The sensitivity analysis illustrates how a reasonable alternative assumption could affect the current estimate of our ultimate loss liability. The sensitivity analysis is not intended to present a range of reasonable possible settlement values in the future. Over time, changes to the initial expected loss ratio and loss development patterns may vary by more than the sensitivity analysis above as new loss information and data emerges. Also, other inputs and judgments that impact unpaid losses and LAE may change. Actual settlement values could be materially different from the current estimates.
Valuations are based on prices obtained from independent pricing vendors, index providers or broker-dealers using observable inputs for financial assets and liabilities; and
Valuations are based on unobservable inputs for assets and liabilities where there is little or no market activity. Management’s assumptions and internal valuation pricing models may be used to determine the fair value of financial assets or liabilities.
The fair value of our fixed maturity securities and short-term investments is based on prices primarily obtained from pricing vendors, index providers, or broker-dealers using observable inputs. Pricing vendors collect, edit, maintain, evaluate and model data on a large number of securities utilizing primarily market data and observable inputs. Index providers utilize external sources and pricing models to value index-eligible securities across numerous sectors and asset classes. Broker-dealers value securities through proprietary trading desks primarily based on observable inputs. As of December 31, 2012, we valued approximately 51% of our investment securities using prices obtained from pricing vendors, 45% using prices obtained from index providers and 4% using prices obtained from broker-dealers.
Generally, pricing sources determine prices by maximizing the use of observable inputs to determine the fair value measurement. The inputs used by pricing vendors may include, but are not limited to, benchmark yields, reported trades, broker-dealer quotes, issuer spreads, bids, offers and industry and economic events. The inputs used by index providers may include, but are not limited to, benchmark yields, transactional data, broker-dealer quotes, security cash flows and structures, credit ratings, prepayment speeds, loss severities, credit risks and default rates. The inputs used by broker-dealers may include, but are not limited to, trade data, bids or offers and other corresponding market data.
We believe that the estimated fair value of our investments is representative of the securities in our portfolio. However, our estimate of fair value on a particular security may differ from the amount that could be realized if the security was sold immediately. In addition, when financial markets experience a reduction in liquidity, we may obtain prices for a specific security that have a larger dispersion across price sources and our ability to conduct orderly investment transactions may be limited.
The fair value measurements of our investments classified as Level 3 were approximately 0.3% of our total investments as of December 31, 2012. Specifically, the fair value measurements of our commercial mortgage-backed securities, non-agency residential mortgage-backed securities and sub-prime asset-backed securities classified as Level 3 used significant unobservable inputs that include probability of default and loss severity in the event of default. We also considered prepayment rates when fair valuing our Level 3 non-agency mortgage-backed securities and sub-prime asset-backed securities. The prices we obtained to determine these measurements were based upon unadjusted third party pricing sources.
Investments we own that we may not have the positive intent to hold until maturity are classified as available-for-sale and reported at fair value, with related net unrealized gains or losses excluded from net income or loss and included in shareholders’ equity as a component of accumulated other comprehensive income or loss, net of deferred taxes. Investments we own and have the intent to sell prior to maturity, or securities for which we have elected the fair value option are classified as trading securities. Trading securities are reported at fair value, with mark-to-market adjustments included in net realized gains on investments and the related deferred income tax included in income tax expense or benefit in the consolidated statements of operations.
For further discussion on fair values of investments see “Financial Condition - Liquidity - Sources of Liquidity”.
Reinsurance accounting is used for assumed and ceded transactions when risk transfer requirements have been met. Reinsurance contracts that do not transfer sufficient insurance risk are accounted for as deposits.
2012 versus 2011: Net underwriting income was $212.2 million for the year ended December 31, 2012, which compares with a net underwriting loss of $296.7 million for the year ended December 31, 2011. The change in the net underwriting result was due primarily to a significant decrease in net losses from major catastrophes in 2012 and an increase in net favorable development.
Net losses from major catastrophes were $68.9 million and $510.0 million for the years ended December 31, 2012 and 2011, respectively. Net favorable development was $234.0 million and $104.4 million for the years ended December 31, 2012 and 2011, respectively.
The following table summarizes underwriting results, ratios and the change year over year for the Property and Marine segment for the years ended December 31, 2012, 2011 and 2010 ($ in thousands):
2011 versus 2010: The Property and Marine segment underwriting result decreased by $330.4 million for the year ended December 31, 2011 as compared with the year ended December 31, 2010, primarily due to an increase in net losses from major catastrophes. Net losses from major catastrophes were $510.0 million and $214.8 million for the years ended December 31, 2011 and 2010, respectively. Net losses from major catastrophes for the year ended December 31, 2010 were primarily attributable to earthquakes in Chile and New Zealand.
2011 versus 2010: Gross premiums written decreased by $51.1 million for the year ended December 31, 2011 as compared with the year ended December 31, 2010 and by $64.6 million when considering reinstatement premiums related to major catastrophes of $31.1 million and $17.6 million for the years ended December 31, 2011 and 2010, respectively. The decrease in gross premiums written, excluding reinstatement premiums, was due to decreases across most classes of business, most significantly in the catastrophe excess-of-loss classes as compared with 2010 and resulted from fewer opportunities that met our underwriting standards and our desire to reduce our exposure to catastrophe events. The increase in ceded premiums written for the year ended December 31, 2011 was due to an increase in our purchase of retrocessional coverage on catastrophe business that resulted from our desire to reduce our exposure to catastrophe events. Net premiums earned decreased by $61.8 million for the year ended December 31, 2011 as compared with 2010, primarily as a result of decreases in net premiums written in current and prior periods. Net premiums written and earned were also impacted by changes in the mix of business and the structure of the underlying reinsurance contracts.
2011 versus 2010: Net losses and LAE increased by $284.6 million for the year ended December 31, 2011 as compared with the year ended December 31, 2010, primarily due to an increase in net losses from major catastrophes.
The above table excludes any favorable or unfavorable development subsequent to December 31, 2011. Any material development is discussed below under Prior Year Loss Development.
The following table sets forth the components of pre-tax net losses for 2010 major catastrophes for the year ended December 31, 2010 ($ in thousands):
2011 versus 2010: Net favorable loss development was $41.4 million and $36.9 million for the years ended December 31, 2011 and 2010, respectively. Net favorable loss development and related premium adjustments decreased the net loss and LAE ratio by 11.2 points and 9.2 points for the years ended December 31, 2011 and 2010, respectively. Net favorable loss development for the years ended December 31, 2011 and 2010 was primarily attributable to a level of cumulative losses reported by our ceding companies that was lower than expected and that, in our judgment, resulted in sufficient credibility in the loss experience to change our previously selected loss ratios.
The following table sets forth the net favorable (unfavorable) development for the year ended December 31, 2012 by class of business ($ in thousands):
Net favorable development in the catastrophe excess-of-loss (non-major events) class arose primarily from the 2010 and 2011 underwriting years. Net favorable development in the property per risk excess-of-loss class arose primarily from the 2007 through 2011 underwriting years. Net favorable development in the major catastrophes class arose primarily from the 2011 earthquake in Japan. Net favorable development in the property proportional class arose primarily from the 2009 through 2011 underwriting years. Changes to loss development patterns contributed $0.4 million to the net favorable development. Net favorable development in the marine, aviation and satellite class arose primarily from the 2006 through 2008 underwriting years with changes to loss development patterns contributed $1.1 million to the net favorable development.
The following table sets forth the net favorable (unfavorable) development for the year ended December 31, 2010 by class of business ($ in thousands):
2012 versus 2011: The calendar year loss ratios, excluding major catastrophes and prior years’ loss development, were 41.6% and 39.5% for the years ended December 31, 2012 and 2011, respectively. Underwriting losses on our 2012 underwriting year North American crop business as a result of the severe drought conditions in the United States were $17.6 million for year ended December 31, 2012 compared with a $1.5 million underwriting loss on our 2011 underwriting year North American crop business for the year ended December 31, 2011. The loss ratio was also impacted by improved results in the catastrophe excess-of-loss (non-major events) class in 2012 as compared with 2011.
2011 versus 2010: Net acquisition expenses and related net acquisition expense ratios were $49.3 million and 13.8%, respectively, for the year ended December 31, 2011 and $60.2 million and 14.4%, respectively, for the year ended December 31, 2010. The decrease in net acquisition expenses was primarily due to the decrease in net premiums earned and a decrease in commissions related to prior years’ loss development as compared with the same period in 2010. The decrease in acquisition expense ratio for the year ended December 31, 2011 was primarily due to a decrease in commissions related to prior years’ loss development as compared with the same period in 2010. The commissions related to prior years’ loss development was $0.2 million and $5.4 million for the years ended December 31, 2011 and 2010, respectively. The commissions related to prior years’ loss development increased the net acquisition expense ratio by 0.1 points and 1.2 points for the years ended December 31, 2011 and 2010, respectively. Net acquisition expenses and related net acquisition expense ratios were also impacted by changes in the mix of business.
2012 versus 2011: Other underwriting expenses were $31.1 million and $27.6 million for the years ended December 31, 2012 and 2011, respectively. The increase was primarily the result of an increase in performance-based compensation accruals in 2012 versus 2011.
2011 versus 2010: Other underwriting expenses were $27.6 million and $32.7 million for the years ended December 31, 2011 and 2010, respectively. The decrease was primarily the result of a decrease in performance-based compensation accruals in 2011 versus 2010.
The following table summarizes underwriting results, ratios and the change year over year for the Casualty segment for the years ended December 31, 2012, 2011 and 2010 ($ in thousands):
The Casualty segment generated 50.8%, 45.6% and 43.3% of our net premiums written for the years ended December 31, 2012, 2011 and 2010, respectively.
2012 versus 2011: Net premiums written decreased by $9.9 million for the year ended December 31, 2012 as compared with the year ended December 31, 2011. Net premiums written in the years ended December 31, 2012 and 2011 were impacted by increases to prior years’ premium estimates of $34.8 million and $21.5 million, respectively. Excluding the impact of increases to prior years’ premium estimates, net premiums written decreased by $23.2 million primarily due to fewer opportunities that met our underwriting standards across most classes. The net premiums earned in the years ended December 31, 2012 and 2011 were impacted by increases to prior years’ premium estimates of $23.0 million and $11.7 million, respectively. Excluding the impact of increases to prior years’ premium estimates, net premiums earned decreased by $35.9 million. Net premiums earned decreased as a result of the decreases in net premiums written in current and prior periods. Net premiums written and earned were also impacted by changes in the mix of business and the structure of the underlying reinsurance contracts.
2011 versus 2010: Net premiums written decreased by $32.4 million for the year ended December 31, 2011 as compared with the year ended December 31, 2010 primarily due to decreases in the North American casualty excess-of-loss, international casualty and financial lines classes as a result of fewer opportunities that met our underwriting standards. The net premiums written in the years ended December 31, 2011 and 2010 were impacted by increases to prior years’ premium estimates of $21.5 million for both years. The net premiums earned in the years ended December 31, 2011 and 2010 were also impacted by increases to prior years’ premium estimates of $11.7 million and $16.2 million, respectively. Excluding the impact of increases to prior years’ premium estimates, net premiums earned decreased by $20.6 million. Net premiums earned decreased as a result of the decreases in net premiums written in current and prior periods. Net premiums written and earned were also impacted by changes in the mix of business and the structure of the underlying reinsurance contracts.
2011 versus 2010: Net losses and LAE increased by $59.0 million for the year ended December 31, 2011 as compared with the year ended December 31, 2010, primarily due to a decrease in net favorable loss development.
Net favorable loss development for the year ended December 31, 2011 was primarily attributable to a level of cumulative losses reported by our ceding companies that was lower than expected and that, in our judgment, resulted in sufficient credibility in the loss experience to change our previously selected loss ratios. Net favorable development of $4.9 million related to changes in loss development patterns.
Net favorable development in the North American claims made class arose primarily from the 2004 through 2009 underwriting years with changes in loss development patterns contributing $6.8 million. Net favorable development in the North American umbrella class arose primarily from the 2003 through 2009 underwriting years with changes in loss development patterns contributing $16.1 million to the net favorable development. Net favorable development in the North American occurrence class arose primarily from the 2002 through 2005 and 2007 through 2009 underwriting years partially offset by net unfavorable development in the 2006, 2010 and 2011 underwriting years. Changes in loss development patterns contributed $5.8 million to the net unfavorable development. Net favorable development in the international casualty class arose primarily from the 2003 through 2007 and 2009 underwriting years. Changes in loss development patterns contributed $5.1 million to the net favorable development. This was partially offset by net unfavorable development on the 2008 underwriting year which was impacted by claims related to the credit crisis arising from the financial institutions business as well as liability arising from Australian wildfires. Net favorable development in the financial lines class arose primarily from the 2006 and 2011 underwriting years. Changes in loss development patterns contributed $1.4 million to the net favorable development. Net favorable development in the North American clash class arose primarily from the 2004 and 2008 underwriting years. Changes in loss development patterns contributed $0.6 million to the net favorable development. Net favorable development in the accident and health class arose from most prior underwriting years.
2012 versus 2011: The calendar year loss ratios, excluding prior years’ loss development, were 77.4% and 74.8% for the years ended December 31, 2012 and 2011, respectively. The loss ratio was impacted by an increase in the financial lines loss ratio as compared with 2011. Calendar year losses and related ratios, excluding prior years’ loss development, were also impacted by changes in the mix of business.
The following table summarizes underwriting activity, ratios and the change year over year for the Finite Risk segment for the years ended December 31, 2012, 2011 and 2010 ($ in thousands):
2012 versus 2011: Net premiums written increased by $11.9 million for the year ended December 31, 2012 as compared with the year ended December 31, 2011. The net premiums written in the year ended December 31, 2012 were impacted by increases to prior years’ premium estimates of $5.8 million compared to decreases to prior years’ premiums estimates of $0.6 million for the year ended December 31, 2011. Excluding the impact of increases to prior years’ premium estimates, net premiums written increased by $5.5 million due to an increase in premium written relating to the one in-force contract. The net premiums earned in the year ended December 31, 2012 were also impacted by increases to prior years’ premium of $2.1 million compared to decreases of $0.6 million for the year ended December 31, 2011. Excluding the impact of increases to prior years’ premium, net premiums earned increased by $2.4 million.
2012 versus 2011: Net realized gains on investments were $88.8 million and $3.9 million for the years ended December 31, 2012 and 2011, respectively. Sales of investments resulted in net realized gains of $90.1 million for the year ended December 31, 2012 and included $68.0 million from the sale of municipal bonds, $9.6 million from the sale of commercial mortgage-backed securities ("CMBS”) and $9.2 million from the sale of corporate bonds. Also included in net realized gains was a net negative impact from mark-to-market adjustments on trading securities of $1.3 million for the year ended December 31, 2012 that was related to non-U.S government securities. Sales of investments resulted in net realized gains of $1.4 million for the year ended December 31, 2011, primarily from U.S. Treasury Inflation-Protected Securities (“TIPS”) and corporate bonds partially offset by realized losses from U.S. Government securities. The net positive impact from mark-to-market adjustments on trading securities of $2.5 million for the year ended December 31, 2011 was related primarily to non-U.S government securities partially offset by insurance-linked securities.
Net impairment losses reflect other-than-temporary impairments attributable to credit losses on impaired securities that relate exclusively to investments in securitized mortgages not guaranteed by U.S. government agencies.
2011 versus 2010: Net impairment losses on investments were $22.4 million and $36.6 million for the years ended December 31, 2011 and 2010, respectively. The net impairment losses recorded for the year ended December 31, 2010 included $17.7 million related to sub-prime ABS, $11.2 million related to non-agency RMBS and $7.7 million related to CMBS.
The following table sets forth other revenues and expenses for the years ended December 31, 2012, 2011 and 2010 ($ in thousands):
2011 versus 2010: Non-underwriting operating expenses were $15.6 million and $25.6 million for the years ended December 31, 2011 and 2010, respectively. The decrease was primarily the result of a decrease in performance-based compensation accruals in 2011 versus 2010.
2011 versus 2010: The net changes in the fair value of derivatives resulted in an expense of $4.3 million and $9.6 million for the years ended December 31, 2011 and 2010, respectively. The net changes in the fair value of derivatives for the year ended December 31, 2010 were attributable to the derivative agreement that was used to manage our exposure to certain underwriting risks.
The income tax expense or benefit rate is driven by the portion of taxable income or loss generated by our U.S.-based subsidiaries relative to the income or loss generated by our Bermuda-based operations, which are non-taxable. Premiums earned by our U.S. and Bermuda-based subsidiaries generally do not bear a proportionate relationship to their respective pre-tax income for a variety of reasons, including the significant impact on pre-tax income of the different mixes of business underwritten by the particular subsidiary, the presence or absence of underwriting income or loss attributable to such business, and the investment results experienced by the particular subsidiary.
2012 versus 2011: Income tax expense was $25.0 million and income tax benefit was $3.1 million for the years ended December 31, 2012 and 2011, respectively. Our effective tax rate was 7.1% and (1.4%) for the years ended December 31, 2012 and 2011, respectively. Income tax expense or benefit is primarily driven by the taxable income or loss generated by our U.S.-based subsidiaries.
Investments with a carrying value of $6.2 million and cash and cash equivalents of less than $0.1 million were also pledged to U.S. regulatory authorities as of December 31, 2012.
Platinum Holdings also may require cash to pay for share repurchases. See “Capital Resources - Share and Debt Repurchases” below for additional discussion of share repurchases.
Platinum Holdings and Platinum Finance’s sources of liquidity include cash and cash equivalents, liquid investments, borrowings from credit facilities, the potential issuance of securities, and dividends and other distributions from subsidiaries. Our reinsurance subsidiaries’ sources of funds consist primarily of cash and cash equivalents, cash flows from operations, proceeds from sales, redemption and maturity of investments and borrowings from our credit facilities.
Net cash flows provided by investing activities were $1.2 billion for the year ended December 31, 2012 and net cash flows used in investing activities were $24.2 million for the year ended December 31, 2011. In 2012, net cash flows provided by investing activities were primarily due to sales and maturities of fixed maturity available-for-sale and short-term investments, partially offset by the acquisition of fixed maturity available-for-sale securities and short-term investments. In 2011, net cash flows used in investing activities were primarily due to an increase in the acquisition of short-term investments partially offset by sales and maturities of fixed maturity available-for-sale and short-term investments. In 2012, we increased our cash balance from investing activities as a result of managing the overall duration of our investment portfolio and in planning for the expected loss payments from major catastrophe activity that has occurred since the beginning of 2010.
Net cash flows used in financing activities were $121.9 million and $153.1 million for the years ended December 31, 2012 and 2011, respectively. Net cash flows used in financing activities in 2012 primarily related to repurchases of common shares of $115.7 million and the payment of dividends to common shareholders of $10.7 million. Net cash flows used in financing activities in 2011 primarily related to repurchases of common shares and the purchase of common share options totaling $142.6 million and the payment of dividends to common shareholders of $11.7 million.
Our investment portfolio consists primarily of diversified, high quality, predominantly investment grade fixed maturity securities. See Note 3 to the “Consolidated Financial Statements” in this Form 10-K for additional discussion of fair values. The following table sets forth the fair values, net unrealized gains and losses and credit quality of our investments as of December 31, 2012 ($ in thousands):
Our investable assets, which consist of investments, cash and cash equivalents, accrued investment income and net balances due to and from brokers, totaled $4.0 billion and $4.2 billion as at December 31, 2012 and 2011, respectively. Investable assets had a weighted average duration of 2.6 and 3.6 years as of December 31, 2012 and 2011, respectively.
As of December 31, 2012, our investable assets had a weighted average credit rating of Aa1, primarily measured by Moody’s. If a particular security did not have a Moody’s rating then a rating from S&P was generally converted to a Moody’s equivalent rating.
Our non-U.S. government bond portfolio, which includes our short-term investments classified as trading, consists of securities issued by governments, provinces, agencies and supranationals.
In addition to the investments noted above, we hold non-U.S. dollar denominated cash and cash equivalents of $145.5 million that are also held for the purpose of hedging our net foreign currency reinsurance liabilities.
The net unrealized gain position of our portfolio of CMBS was $8.4 million as of December 31, 2012 as compared with $9.3 million as of December 31, 2011. The decrease in the net unrealized gain position was the result of sales activities partially offset by the narrowing of interest rate spreads. We analyze our CMBS on a periodic basis using default loss models based on the performance of the underlying loans. Performance metrics include delinquencies, defaults, foreclosures, debt-service-coverage ratios and cumulative losses incurred. The expected losses for a mortgage pool are compared with the current level of credit support, which generally represents the point at which our security would experience losses. We evaluate projected cash flows as well as other factors in order to determine if a credit impairment has occurred. Our portfolio consists primarily of senior tranches of CMBS with high credit ratings and strong credit support.
Platinum Holdings and its subsidiaries are subject to certain legal and regulatory restrictions in their respective jurisdictions of domicile. The legal restrictions generally include the requirement to maintain positive net assets and to be able to pay liabilities as they become due. For more details on our regulations, see Item 1, “Business - Regulation,” in this Form 10-K. Other regulatory restrictions are described below.
There are no regulatory restrictions on retained earnings available for the payment of dividends by Platinum Holdings to its shareholders.
The laws and regulations of Bermuda and the United States include certain restrictions on the amount of statutory capital and surplus that are available for the payment of dividends by Platinum Bermuda and Platinum US to their respective parent companies, Platinum Holdings and Platinum Finance, without the prior approval of the relevant regulatory authorities. For 2013, Platinum Bermuda is generally restricted from declaring and paying dividends of more than 25% of its prior year end statutory capital and surplus. For 2013, Platinum US’s dividend capacity will be limited to its 2012 statutory-basis net investment income. Based on regulatory restrictions, the maximum amount available for payment of dividends by our reinsurance subsidiaries during 2013 without prior regulatory approval is as follows ($ in thousands):
At December 31, 2012, our capital resources of $2.1 billion consisted of $1.9 billion of common shareholders’ equity and $250.0 million of debt obligations. At December 31, 2011, our capital resources of $1.9 billion consisted of $1.7 billion of common shareholders’ equity and $250.0 million of debt obligations. The increase in capital during the year ended December 31, 2012 was primarily attributable to our net income of $327.2 million, partially offset by repurchases of common shares of $115.7 million and dividends of $10.7 million.
We actively manage our capital and may seek to raise additional capital or return capital to our shareholders through common share repurchases and cash dividends (or a combination of such methods). We may also seek to manage our capital through repurchases of our outstanding debt in open market purchases, privately negotiated transactions or otherwise.
To the extent that our existing capital is insufficient to fund our future operating requirements or maintain our financial strength or debt ratings, we may need to raise additional capital through financings, which may be in the form of debt securities, preferred shares, common equity, bank credit facilities providing loans and/or letters of credit, or any combination of these sources. Any equity or debt financing, if available at all, may be on terms that are unfavorable to us or our shareholders. In the case of equity financings, dilution to our shareholders could result, and such securities may have rights, preferences and privileges that are senior to those of our outstanding securities. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by rating agencies to our reinsurance subsidiaries, which could place those reinsurance subsidiaries at a competitive disadvantage compared with higher-rated competitors; (2) reductions in the amount of business that our reinsurance subsidiaries are able to write in order to meet surplus requirements of ceding companies or an increase in the amount of collateral required; (3) reductions in the amount of business that our reinsurance subsidiaries are able to write in order to meet capital adequacy-based tests enforced by regulatory authorities; and (4) increases in the cost of bank credit and letters of credit. We can provide no assurance that, if needed, we would be able to obtain additional funds through financing on satisfactory terms or at all.
The shares we repurchased were canceled. As of December 31, 2012, the remaining amount available under the repurchase program was $224.2 million.
Our Board of Directors has also authorized the repurchase of up to $250.0 million of our outstanding Series B 7.5% Notes due June 1, 2017, issued by Platinum Finance in open market purchases, privately negotiated transactions or otherwise. We have not repurchased any of our Series B 7.5% Notes.
The timing and amount, if any, of repurchase transactions under our repurchase programs, depends on a variety of factors, including prevailing market conditions, our liquidity requirements, contractual restrictions, corporate and regulatory considerations and other factors.
Our contractual obligations as of December 31, 2012 by estimated maturity are presented below ($ in thousands):
There are generally no notional or stated amounts related to unpaid losses and LAE. Both the amounts and timing of future loss and LAE payments are estimates and subject to the inherent variability of legal and market conditions affecting the obligations and make the timing of cash outflows uncertain. The ultimate amount and timing of unpaid losses and LAE could differ materially from the amounts in the table above. Further, the unpaid losses and LAE do not represent all of the obligations that will arise under the contracts, but rather only the estimated liability incurred through December 31, 2012. There are reinsurance contracts that have terms extending into 2013 under which additional obligations will be incurred.
See Note 1 to the “Consolidated Financial Statements” contained elsewhere in this Form 10-K for a discussion of recently issued accounting standards.
Our consolidated financial statements as of December 31, 2012 and 2011 and for each of the years in the three-year period ended December 31, 2012, together with the reports thereon by KPMG Audit Limited, our independent registered public accounting firm for the years ended December 31, 2012, 2011 and 2010, are set forth on pages through hereto.