See also Note 13 to our Consolidated Financial Statements included in this Form 10-K.
We had net earnings of $353.9 million, or $3.11 per diluted share.
We produced $2.4 billion of total revenue, which was $94.5 million, or 4%, higher than in 2008.
Our loss ratio was 59.7% and our combined ratio was 84.9%. Profitability from our underwriting operations remains at acceptable levels.
We declared dividends of $0.52 per share and paid $57.4 million of dividends.
Our $575.0 million Revolving Loan Facility, which expires in December 2011, had no borrowings outstanding at December 31, 2009. The facility has an interest rate of 30-day LIBOR plus 25 basis points.
Our major domestic and international insurance companies have a financial strength rating of “AA (Very Strong)” from Standard & Poor’s Corporation. Our major domestic insurance companies have a financial strength rating of “AA (Very Strong)” from Fitch Ratings, “A1 (Good Security)” from Moody’s Investors Service, Inc., and “A+ (Superior)” by A.M. Best Company, Inc.
See the “Results of Operations” section below for additional discussion about the comparative effect of these items year-over-year.
During the past several years, we substantially increased our shareholders’ equity by retaining most of our earnings. With this additional equity, we increased the underwriting capacity of our insurance companies and made strategic acquisitions, adding new lines of business or expanding those with favorable underwriting
Net earnings were $353.9 million ($3.11 per diluted share) in 2009, compared to $302.1 million ($2.61 per diluted share) in 2008 and $391.6 million ($3.35 per diluted share) in 2007. The increase in net earnings for 2009 compared to 2008 primarily resulted from: 1) the 2009 commutation of a reinsurance contract that had been accounted for using the deposit method of accounting, 2) catastrophic losses in 2008 from the 2008 hurricanes, and 3) investment-related losses in 2008, as described more fully below. The decrease in net earnings for 2008 compared to 2007 primarily resulted from: 1) the investment-related losses in 2008 compared to income from these same investments in 2007, 2) the 2008 hurricane losses, and 3) the gain from sale of a strategic investment in 2007. Diluted earnings per share in 2009 and 2008 benefited from the repurchase of 1.7 million shares of our common stock in 2009 and 3.0 million shares of our common stock in 2008. The share repurchases reduced our diluted weighted-average shares outstanding, which were 113.1 million in 2009 and 115.5 million in 2008, compared to 117.0 million in 2007.
The following items affected pretax earnings in 2009, 2008 and 2007:
In 2008, we incurred gross losses of $98.2 million from Hurricanes Gustav and Ike (referred to herein as “the 2008 hurricanes”). Our pretax loss after reinsurance was $22.3 million, which included
$19.4 million of losses reported in loss and loss adjustment expense and $2.9 million of premiums to reinstate our excess of loss reinsurance protection, which reduced net earned premium.
In 2008 and 2007, we held alternative investments that generated $30.8 million of market-related losses and $23.9 million of income, respectively. We redeemed the investments in late 2008 and received $94.1 million of cash in 2009, which we reinvested in fixed income securities.
In 2008 and 2007, our former trading portfolio had losses of $11.7 million and gains of $3.9 million, respectively. We sold the final two positions in 2008.
realized investment gains and losses and other-than-temporary impairment credit losses related to our fixed income securities portfolio.
Gross written premium, net written premium and net earned premium are detailed below. In 2009, written premium reflects growth in our diversified financial products and London market account lines of business and from our 2008 acquisitions. Written premium also reflects reductions due to the discontinuance, in 2008, of an assumed quota share agreement and our U.K. motor business. Premium increased in 2008 principally from growth in our diversified financial products and other specialty lines of business and from acquisitions. Net written premium and net earned premium increased for the same reasons, as well as from higher retentions and lower reinsurance costs. See the “Insurance Company Segment” section below for additional discussion about the relationships and changes in premium revenue by line of business.
The table below shows the source of our fee and commission income. The 17% decrease in 2009 primarily related to: 1) lower third party agency and broker commissions, 2) the sale of our reinsurance broker in the fourth quarter of 2009, 3) the sale of the operations of our commercial marine agency business in the second quarter of 2009 and 4) lower income from reinsurance overrides and profit commissions on quota share treaties, partially offset by 5) the $5.0 million termination payment in 2009 for commutation of a reinsurance contract that had been accounted for using the deposit method of accounting. The lower fee and commission income in 2008 resulted from a higher percentage of business being written directly by our insurance companies rather than being underwritten on behalf of third party insurance companies by our underwriting agencies, and higher retentions on certain lines of business.
Net investment income increased 17% in 2009 and decreased 20% in 2008. The 2009 increase was due to higher income from fixed income securities in 2009, generated from an increased level of investments, combined with the effect of the losses on alternative investments (primarily fund-of-fund hedge fund investments) in 2008. This increase was partially offset by our earning less income on short-term investments in 2009, due to significantly lower short-term market interest rates. The 2008 decrease in net investment income was primarily due to the effect of our alternative investments, which generated $30.8 million of losses in 2008 compared to $23.9 million of income in 2007. These investments were impacted by the severe decline in the equity and debt markets. We eliminated our exposure to alternative investments by notifying the fund managers in late 2008 that we planned to liquidate these investments. At December 31, 2008, our alternative investment portfolio was $46.0 million and we also had a $52.6 million receivable for redemption proceeds in the process of liquidation. During 2009, we collected substantially all of the redeemed funds and reinvested the proceeds in fixed income securities. Our 2007 investment expense was higher due to the cost of managing the alternative investment portfolio.
The 2009 increase is due to a $20.0 million termination payment in 2009 to commute a reinsurance contract written in 2008 that had been accounted for using the deposit method of accounting. We entered into this agreement to provide reinsurance coverage for certain residential mortgage guaranty contracts. We recorded this contract using the deposit method of accounting, whereby all consideration received was initially recorded as a deposit liability and the changes in the deposit liability were recorded as a component of other operating income. The income from strategic investments relates to gains from selling different strategic investments in each year. The 2008 other operating income included losses from the decline in the market value of our trading securities, which we sold in 2008. The change in income from financial instruments was due to the effect on their value of foreign currency fluctuations in the British pound sterling compared to the U.S. dollar. In 2009, we sold 100% of the stock of our reinsurance broker, Rattner Mackenzie Limited, and realized a loss of $4.7 million, primarily from related transaction costs. Period to period comparisons of our other operating income may vary substantially, depending on the earnings generated by new transactions or investments, income or loss related to changes in the market values of certain investments, and gains or losses related to any disposition.
In 2009, we sold certain fixed income securities and realized a $12.1 million net gain, compared to a $16.8 million net realized loss on the sale of securities in 2008. We had $5.4 million of other-than-temporary impairment losses recorded through earnings in 2009, compared to $11.1 million of other-than-temporary impairment losses in 2008. There were no other-than-temporary impairment losses in 2007. See the “Critical
insurance claims paid or payable to policyholders, as well as expenses to adjust and settle the claims, and potential liability for incurred but not reported claims (collectively referred to as “loss and loss adjustment expense”),
other operating expense, of which approximately 65% relates to compensation and benefits of our employees,
Other operating expense, which includes compensation expense, increased 11% in 2009 and decreased 3% in 2008. Excluding the effect of the $13.4 million charge in 2007 that is described below, other operating expense increased 2% in 2008. The 2009 increase in other operating expense primarily was due to compensation and other operating expenses of businesses acquired in late 2008 and 2009, as well as higher bonus expense for profit-related bonus programs for our underwriters. In addition, the 2009 other operating expense included $9.9 million of expenses for costs directly related to the 2009 commutation of a reinsurance contract that had been accounted for using the deposit method of accounting. The 2009 other operating expense was partially offset by a $5.6 million benefit from the reversal of a reserve for uncollectible reinsurance for previously reserved recoverables that now are expected to be collected.
In 2007, we had a $13.4 million charge to correct the accounting for embedded currency conversion gains on certain fixed income securities classified as available for sale. Between 2005 and 2007, we used certain available for sale fixed income securities, denominated in British pound sterling, to economically hedge foreign currency exposure on certain insurance reserves and other liabilities, denominated in the same currency. We had incorrectly recorded the unrealized exchange rate fluctuations on these securities through earnings as an offset to the opposite fluctuations in the liabilities they hedged, rather than through other comprehensive income within shareholders’ equity. In 2007, to correct our accounting, we reversed
Other operating expense includes $16.0 million, $13.7 million and $12.0 million in 2009, 2008 and 2007, respectively, of stock-based compensation expense, after the effect of the deferral and amortization of policy acquisition costs, related to stock-based compensation for our underwriters. At December 31, 2009, there was approximately $22.9 million of total unrecognized compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 2.6 years. In January 2010, we granted $12.2 million of restricted stock awards, with a weighted-average life of 7.9 years, to key employees. In 2010, we expect to recognize $13.2 million of compensation expense, including the amortization of deferred policy acquisition costs, for all stock-based awards outstanding at December 31, 2009 plus the newly-granted 2010 awards.
We had 1,864 employees at December 31, 2009 and 2008 and 1,685 employees at December 31, 2007. The number of new employees hired in 2009 was offset by the loss of employees due to the sale of two businesses in June and October 2009.
Interest expense decreased $4.2 million in 2009 and increased $4.1 million in 2008. During the three-year period until the fourth quarter of 2009, we had $124.7 million of 1.30% Convertible Notes outstanding and we borrowed and repaid our Revolving Loan Facility, as needed. The year-over-year changes in total interest expense primarily related to the borrowing levels on our Revolving Loan Facility. Interest on the facility was based on 30-day LIBOR (0.23%, 0.44% and 4.60% at December 31, 2009, 2008 and 2007, respectively) plus 25 basis points, but the effective interest on a portion of the facility was 4.60% due to interest rate swap agreements. In the fourth quarter of 2009, we issued $300.0 million of 6.30% Senior Notes due 2019, with an effective interest rate of 6.37%, and redeemed the Convertible Notes. Our 2009 interest expense includes $2.4 million for the Senior Notes. Our future annual interest expense on the Senior Notes will be approximately $19.0 million. See the “Liquidity and Capital Resources” section below for additional information about our debt structure.
We operate our businesses in three segments: insurance company, agency and other operations. Our Chief Executive Officer, as chief decision maker, monitors and evaluates the individual financial results of key subsidiaries in the insurance company and agency segments. Each subsidiary provides monthly reports of its
actual and budgeted results, which are aggregated on a segment basis for management review and monitoring. The operating results of our insurance company, agency, and other operations segments are discussed below.
Gross written premium increased 2% in each of the past two years to $2.6 billion in 2009 and $2.5 billion in 2008. Our net written premium in 2009 was essentially flat at $2.0 billion, while our net earned premium increased 1% to $2.0 billion. In 2008, net written premium increased 4% and net earned premium increased 1%. Our gross written premium grew in 2009 due to additional writings in our diversified financial products and London market account lines of business and in our recently acquired businesses, offset by lower writings of aviation business and the discontinuance, in 2008, of both an assumed quota share contract and our U.K. motor business. Premium increased in 2008 due to our 2008 acquisitions.
In both years, higher demand and increased prices in certain products moderated the effect of decreased writings and lower prices in lines impacted by competitive market pressures. We wrote more business in our diversified financial products lines, particularly in our directors’ and officers’ liability and credit businesses, as prices increased in late 2008 and the market reacted to financial issues with other insurance companies. We elected to write less premium in certain lines, such as domestic aviation, that were affected by competition. Net written premium decreased in 2009 because we elected to reinsure more directors’ and officers’ liability business and the cost for reinsurance in our London market account was higher. The overall percentage of retained premium, as measured as the percent of net written premium to gross written premium, decreased slightly to 80% in 2009 from 82% in 2008 and 81% in 2007.
Group life, accident and health - Our medical stop-loss business grew in 2009 from a medical stop-loss agency acquired in late 2008. The 2009 increase in net earned premium and the 2008 increase in premium were due to our acquisition of an agency in early 2008, which writes short-term medical insurance using one of our managed Lloyd’s syndicates as the issuing carrier. We retain most of our medical stop-loss and short-term medical business because the business traditionally has been non-volatile and has little catastrophic exposure.
Aviation - We wrote less aviation business in 2009 and 2008 due to continuing competition on U.S. business and lack of growth in the general aviation industry. Pricing on this line remains competitive, although we saw price increases on the international portion of this business in 2009. Our underwriting margins on both U.S. and international business continue to be at expected levels.
London market account - This line of business has the most exposure to catastrophic losses from hurricanes and earthquakes. Rates can change quickly, leading to higher premium volatility than our other lines of business. Gross written premium increased in 2009 due to writing more property business. Net written and net earned premium were lower in 2009 due to increased spending on reinsurance. Written premium decreased in 2008 due to increased competition and lower rates. Also, in 2008, we discontinued writing our marine excess of loss book of business due to unacceptable pricing. We expect premium volume to increase in 2010, as we recently hired an underwriting team to write property reinsurance.
Other specialty lines - Premium in our public risk businesses increased in 2009 due to acquisitions in late 2008. Premium decreased in our HCC Lloyd’s line in 2009 and 2008 due to discontinuance of our U.K. motor business in mid-2008. Premium also decreased in 2009 and 2008 due to expiration of an assumed quota share contract in the first half of 2008. The decrease in the retention percentages in 2009 and 2008 was due to the change in mix of business in this line.
Annually, we analyze our threshold for risk in each line of business and on an overall consolidated basis, based on a number of factors, including market conditions, pricing, competition and the inherent risks associated with each business type, and then we structure our reinsurance programs. Based on our analysis of these factors, we may determine not to purchase reinsurance for some lines of business. We generally purchase reinsurance to reduce our net liability on individual risks and to protect against catastrophe losses and volatility. We retain underwriting risk in certain lines of business in order to retain a greater proportion of expected underwriting profits. We have chosen not to purchase any reinsurance on businesses where volatility or catastrophe risks are considered remote and limits are within our risk tolerance.
net profits generated under such treaties with the reinsurers. Various reinsurance brokers arrange for the placement of this proportional and other reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers.
The table below shows the composition of gross incurred loss and loss adjustment expense.
Our gross redundant reserve development relating to prior years’ losses was $90.4 million in 2009, $72.0 million in 2008 and $90.6 million in 2007. The other reserve redundancies resulted primarily from our review and reduction of gross reserves where the anticipated development was considered to be less than the recorded reserves. Redundancies and deficiencies also occur as a result of claims being settled for amounts different from recorded reserves, or as claims exposures change. The other gross reserve redundancies in all three years related primarily to reserve reductions from the 2002-2006 underwriting years in: 1) our diversified financial products line of business, primarily in our directors’ and officers’ liability, U.K. professional indemnity and U.S. surety products, 2) our London market account, which includes redundancies on the 2005 hurricanes and 3) for an assumed quota share program in our other specialty line of business. These products, with a duration of either medium or medium to long tailed, were new products for us in 2002-2004. Because we lacked sufficient internal data, we used industry, prior carrier and/or ceding company information to estimate our ultimate incurred losses for these products. Our actual experience in subsequent years, as claims were reported and matured, was better than expected due, in part, to better than expected market conditions and lower than expected severity and frequency of claims. As part of our 2009 reserve review, we re-estimated our exposure in our directors’ and officers’ liability business, which resulted in redundant reserve development in the 2004-2006 underwriting years that was substantially offset by an increase in reserves for the 2007 underwriting year. As part of our 2008 reserve review, we also increased the accident year 2008 losses for our directors’ and officers’ liability business due to increased claims activity, primarily from financial institutions. The largest portion of this increase was for policies written in 2007.
Loss reserves on international medical malpractice business, in run-off since shortly after we acquired the subsidiary in 2002 that wrote this business, were strengthened in 2009 due to recent negative court rulings, and in 2007 in response to a deteriorating legal and settlement environment at that time. These claims, with a medium to long tailed duration, have had a higher than expected severity and frequency due to unexpected rulings by Spanish courts.
The table below shows the composition of net incurred loss and loss adjustment expense.
Diversified financial products - The total net loss ratios for this line of business reflect redundant net reserve development of $31.0 million in 2009, compared to $43.8 million in 2008 and $51.9 million in 2007. The 2009 and 2008 redundancies primarily related to our directors’ and officers’ liability and U.K. professional indemnity businesses for 2006 and prior underwriting years. The 2009 development included $70.3 million of additional loss reserves on our directors’ and officers’ liability business for policies written in 2007. Offsetting the redundant reserve development in 2008 was an increase of $50.1 million in our loss estimates on the 2008 accident year affecting business written in the 2007 and 2008 underwriting years, primarily for our directors’ and officers’ liability and credit businesses. Our U.S. surety business had favorable loss development in 2008 and 2007, but the 2009 accident year
losses were higher than the 2008 accident year losses due to the impact of the current economic environment on the construction industry.
Aviation - Redundant development in 2009 was higher than in 2008, but was partially offset by higher accident year losses in 2009. The 2008 hurricanes increased the 2008 losses by $1.4 million and the 2008 loss ratio by 1.0 percentage point.
London market account - The 2009 net loss ratios included $12.9 million of redundant reserve development, of which $12.7 million related to the 2005 hurricanes. The redundancy reduced the 2009 total net loss ratio by 12.5 percentage points. The 2008 hurricanes increased the 2008 losses by $12.1 million and the 2008 loss ratio by 11.3 percentage points. There was also $21.4 million of redundant reserve development in 2008, mostly from our property and energy businesses, which included a $5.4 million reduction of the 2005 hurricane losses. The loss ratio in 2007 was slightly higher than expected due to adverse development in our London accident and health and energy businesses.
Discontinued lines - This line of business was adversely affected in 2009 and 2007 by the strengthening of the net loss reserves on our international medical malpractice business.
The net paid loss ratio is the percentage of losses paid, net of reinsurance, divided by net earned premium for the year. The net paid loss ratio has increased due to a variety of factors. In 2009, we commuted certain loss reserves related to excess workers’ compensation business that is in runoff for $43.9 million. This commutation had no material effect on net earnings but increased our net paid loss ratio by 2.1 percentage points in 2009. In 2008, we experienced an increase in payments on certain lines of business due to shortening the required reporting period, bringing claims processing in-house and responding to faster reporting of claims by insureds.
Regulatory guidelines suggest that a property and casualty insurer’s annual statutory gross written premium should not exceed 900% of its statutory policyholders’ surplus and net written premium should not exceed 300% of its statutory policyholders’ surplus. However, industry and rating agency guidelines place these ratios at 300% and 200%, respectively. Our property and casualty insurance companies have maintained premium to surplus ratios lower than such guidelines. For 2009, our statutory gross written premium to policyholders’ surplus was 112.1% and our statutory net written premium to policyholders’ surplus was 97.5%. At December 31, 2009, each of our domestic insurance companies’ total adjusted capital significantly exceeded the authorized control level risk-based capital level prescribed by the National Association of Insurance Commissioners.
Revenue from our agency segment was $182.1 million in 2009, compared to $188.4 million in 2008 and $178.6 million in 2007. Revenue for 2009 included $5.0 million of fee and commission income related to the 2009 commutation of a reinsurance contract that had been accounted for using the deposit method of accounting. The decrease in 2009 revenue was due to the sales of our commercial marine agency business and our reinsurance broker during the year. The increase in 2008 was primarily due to underwriting agencies acquired in 2008.
On June 30, 2009, we sold the assets and licensed the intangibles related to our commercial marine agency business. We entered into a five-year managing general underwriter agreement that allows the purchaser to write that same business utilizing policies issued by one of our insurance companies. We recognized an immaterial gain on the sale transaction. On October 3, 2009, we executed a contract to sell 100% of the stock of our reinsurance broker, Rattner Mackenzie Limited, to an affiliate of Marsh & McLennan Companies, Inc. (MMC). We also executed an agreement with MMC and its affiliates whereby our insurance companies and agencies will continue to utilize MMC and its affiliates to place certain of our reinsurance programs. We recognized a loss on the transaction of $4.7 million, which was included in the other operations segment. Together, in 2009, these two operations contributed 11% and 23% of our agency segment revenue and net earnings, respectively.
The significant drop in revenue and net earnings was due to losses on our trading securities in 2008 and lower gains on the sales of strategic investments. We held a trading portfolio that we began to liquidate in 2006 and completed in 2008. Before their sales in 2008, two remaining positions generated losses due to poor market conditions. We invested the proceeds from all of these sales in fixed income securities. We realized gains of $2.4 million, $9.2 million and $21.6 million from the sales of strategic investments in 2009, 2008 and 2007, respectively. We recognized a loss related to the sale of our reinsurance broker in 2009. Results of this segment may vary substantially period to period depending on our investment in or disposition of strategic investments.
During 2008, there were significant disruptions in the world-wide and U.S. financial markets. A number of large financial institutions failed, received substantial capital infusions and loans from the U.S. and various other governments, or were merged into other companies. The market disruptions resulted in tightening of available sources of credit, increases in the cost of credit and significant liquidity concerns for many companies. Although these conditions continued throughout 2009, we have not been impacted in any material manner by these market conditions. We believe we currently have ample sources of liquidity at a reasonable cost based on the following:
We held $940.1 million of cash and liquid short-term investments at December 31, 2009, which was $415.3 million more than at December 31, 2008. We sold approximately $210.0 million of fixed income securities in the fourth quarter of 2009 and held the funds as short-term investments, pending reinvestment. In addition, we held cash to pay, among other items, $64.5 million of convertible notes in the process of redemption at year-end and $15.5 million for shareholder dividends, which we paid in 2010.
We have averaged over $580.0 million in cash from our operating activities, excluding commutations, during the three years ended December 31, 2009.
Our insurance companies have sufficient resources to pay potential claims in 2010. As shown in the “Contractual Obligations” section below, we project that our insurance companies will pay approximately $1.2 billion of claims in 2010 based on historical payment patterns and claims history. We project that they will collect approximately $314.7 million of reinsurance recoveries in 2010. These subsidiaries have a total $1.2 billion of cash, short-term investments, maturing bonds, and principal payments from asset-backed and mortgage-backed securities in 2010 that will be available to pay these
In November 2009, we used our “Universal Shelf” registration agreement to issue $300.0 million of unsecured 6.30% Senior Notes that are payable on November 15, 2019. The Senior Notes were priced at a discount of $1.5 million, for an effective interest rate of 6.37%. Our future interest expense will increase to approximately $19.0 million, compared to $16.1 million in 2009, which included $2.4 million for the Senior Notes. However, we were able to lock in long-term debt at a very favorable rate in a tight credit market.
We receive substantial cash from premiums, reinsurance recoverables, outward commutations, fee and commission income, proceeds from sales and redemptions of investments and investment income. Our principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, inward commutations, purchases of investments, debt service, policy acquisition costs, operating expenses, taxes and dividends.
Cash provided by operating activities can fluctuate due to timing differences in the collection of premiums and reinsurance recoverables and the payment of losses and premium and reinsurance balances payable and the completion of commutations. Our operating cash flow also exceeds our net earnings due to
Cash provided by operating activities increased $76.8 million in 2009 and decreased $220.5 million in 2008. In 2009, we paid $43.9 million of cash for an inward commutation of certain loss reserves, which reduced our 2009 cash provided by operating activities. In 2008 and 2007, we received $7.5 million and $101.0 million, respectively, of cash from outward commutations, which increased our cash provided by operating activities. Excluding the commutations, cash provided by operating activities was $626.7 million in 2009, $498.5 million in 2008 and $625.4 million in 2007.
Our investment policy is determined by our Board of Directors and our Investment and Finance Committee and is reviewed on a regular basis. We engage an independent investment advisor to oversee our investments, based on the investment policies promulgated by our Investment and Finance Committee, and to make investment recommendations. The majority of our investment assets are held by our insurance companies. The investment policy for each of our domestic insurance company subsidiaries must comply with applicable state and Federal regulations that prescribe the type, quality and concentration of investments. These regulations permit investments, within specified limits and subject to certain qualifications, in U.S. government, state and municipal obligations, corporate bonds, obligations of foreign countries, and preferred and common equity securities. The regulations generally allow certain other types of investments subject to maximum limitations. Investments of our foreign insurance companies must comply with the regulations of their country of domicile.
our normal level, because we liquidated certain fixed income securities in the fourth quarter and the funds were pending reinvestment.
The fair value of our fixed income securities fluctuates depending on general economic and market conditions. As market interest rates increase, the fair value will generally decrease, and as market interest rates decrease, the fair value will generally increase. At December 31, 2009, the net unrealized gain on our available for sale fixed income securities portfolio was $156.3 million, compared to $14.6 million at December 31, 2008. The change in the net unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income and fluctuates with changes in market interest rates. Our general policy has been to hold our available for sale fixed income securities through periods of fluctuating interest rates.
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. The gross unrealized losses of individual securities within our available for sale fixed income securities was $18.9 million at December 31, 2009 and $91.3 million at December 31, 2008. We evaluate the securities in our fixed income securities portfolio for possible other-than-temporary impairment losses at each quarter end. See the “Critical Accounting Policies - Other-than-temporary Impairments in Investments” section below for a description of the accounting policies and procedures that we use to determine our other-than-temporary impairment losses. Over the three-year period of 2007 - 2009, we realized only $16.6 million of other-than-temporary impairment losses through pretax earnings, of which $5.4 million were in 2009 and $11.1 million were in 2008.
At December 31, 2009, we held a corporate bond portfolio with a fair value of $559.8 million, an overall rating of A, and a weighted-average life of approximately 3.0 years. We also held a portfolio of residential mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs) with a fair value of $944.2 million. Within our residential MBS/CMO portfolio, $887.6 million of securities, or 94%, 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 backed by the U.S. government.
Within our residential mortgage-backed and asset-backed securities, we held bonds that are collateralized by prime, Alt A and subprime mortgages. All of these securities were current as to principal and interest. Details of these securities at December 31, 2009 were as follows:
At December 31, 2009, we held a commercial MBS securities portfolio with a fair value of $146.2 million, an average rating of AAA, an average loan-to-value ratio of 69%, and a weighted-average life of approximately 4.7 years. We owned no collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), and we have never been counterparty to any credit default swap transactions.
The fair value of our fixed income securities is sensitive to changing interest rates. As interest rates increase, the fair value will generally decrease, and as interest rates decrease, the fair value will generally increase. 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 1% increase in market interest rates would decrease the fair value of our fixed income securities by approximately $230.0 million before tax and a 1% 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. Higher interest rates would have a positive effect on net earnings and lower interest rates would have a negative effect on net earnings.
We value financial assets and financial liabilities at fair value. In determining fair value, we generally apply the market approach, which uses prices and other relevant data based on market transactions involving identical or comparable assets and liabilities. We classify our financial instruments into the following three-level hierarchy:
Level 1 - Inputs are based on quoted prices in active markets for identical instruments.
Level 2 - Inputs are based on observable market data (other than quoted prices), or are derived from or corroborated by observable market data.
our total assets measured at fair value, respectively. We use quoted prices for identical instruments to measure fair value.
Our Level 3 securities include certain fixed income securities and two insurance contracts that we account for as derivative financial instruments. At December 31, 2009 and 2008, our Level 3 investments totaled $4.7 million and $22.6 million, respectively, and represented less than 1% of our total assets measured at fair value. We determine fair value based on internally developed models that use assumptions or other data that are not readily observable from objective sources. Because we use the lowest level significant input to determine our hierarchy classifications, a financial instrument may be classified in Level 3 even though there may be significant readily-observable inputs. Our exposure with respect to the two insurance contracts is measured based on movement in a specified U.K. housing index. We determine their fair value based on our estimate of the present value of expected future cash flows, modified to reflect specific contract terms. In 2009, we collected $20.3 million to partially liquidate a receivable related to these contracts, which reduced the Level 3 value to $0.4 million at December 31, 2009. The remaining Level 3 value at year-end 2009 related to four commercial mortgage-backed and asset-backed securities. Transfers of investments into Level 3 occur due to our inability to obtain a fair value using inputs based on observable market data. Transfers of investments out of Level 3 occur because we were able to determine their fair value using inputs based on observable market data. Transfers in totaled $6.3 million and transfers out totaled $8.0 million in 2009.
The following table summarizes our total contractual cash payment obligations by estimated payment date at December 31, 2009.
Our interest rate swaps have a notional amount of $105.0 million and expire in November 2010. Under the terms of the swap agreements, we pay 2.94% and receive 30-day LIBOR (0.23% at December 31, 2009), the net of which is included in the above table.
payable and accrued liabilities in the consolidated balance sheet at December 31, 2009. We issued 1.0 million shares of our common stock in conjunction with the conversion.
At December 31, 2008, we had three interest rate swap agreements to exchange 30-day LIBOR (0.44% at December 31, 2008) for a 4.60% fixed rate on $200.0 million of our Revolving Loan Facility. The swaps qualified for cash flow hedge accounting treatment. The three swaps expired in November 2009. As of December 31, 2008, we had entered into two additional swaps for $105.0 million, which began when the original swaps expired and will expire in November 2010. These swaps were entered into with a future effective date to minimize our exposure to expected interest rate increases due to the credit and market conditions in 2008. The fixed rate on these swaps is 2.94%, and they were in a total unrealized loss position of $2.4 million at December 31, 2009. These swaps do not qualify for hedge accounting treatment and the change in value is reported in our consolidated statements of earnings.
Our prior acquisition of HCC Global Financial Products includes a contingency for future earnout payments, as defined in the purchase agreement, as amended. 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 longer-duration business until all future losses are paid. When conditions specified under the purchase agreement are met, we record a net liability for amounts owed to or due from the former owners based on our estimate at that point in time of potential future losses. This net liability will fluctuate in the future, and the ultimate total earnout payments cannot be finally determined, until all claims are paid. We accrued a net liability of $18.0 million at December 31, 2009, with an offset to goodwill. Accrued amounts are paid according to contractual requirements in the purchase agreement, with $38.3 million due to the former owners in 2010.
The principal assets of HCC are the shares of capital stock of its insurance company subsidiaries. HCC’s obligations include servicing outstanding debt and interest, paying dividends to shareholders, repurchasing HCC’s common stock, and paying corporate expenses. Historically, we have not relied on dividends from our insurance companies to meet HCC’s obligations as we have had sufficient cash flow from our underwriting agencies to meet our corporate cash flow requirements. However, as a greater percentage of profit is now being earned in our insurance companies, we may have to increase the amount of dividends paid by our insurance companies in the future to fund HCC’s cash obligations.
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 $217.8 million in dividends in 2010 without obtaining special permission from state regulatory authorities. In 2009, 2008 and 2007, our insurance company subsidiaries paid HCC dividends of $134.0 million, $111.8 million and $22.6 million, respectively.
Inflation can also affect interest rates. A significant increase in interest rates could have a material adverse effect on the fair value of our investments. The fair value of our fixed income securities was $4.6 billion at December 31, 2009. If market interest rates were to change 1%, the fair value of our fixed income securities would have changed approximately $230.0 million before tax at December 31, 2009. 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. Our gain (loss) from currency conversion was $0.6 million in 2009, $1.9 million in 2008 and ($1.8) million in 2007. The 2007 loss excludes a $13.4 million charge to correct the accounting for unrealized cumulative foreign exchange gains related to certain available for sale securities discussed previously. This loss was offset by a $13.4 million realized gain for embedded net foreign currency exchange gains when the securities were sold in 2007.
Our net loss and loss adjustment expense reserves are composed of reserves for reported losses and reserves for incurred but not reported losses (which include provisions for potential movement in reported losses, as well as for claims that have occurred but have not been reported to us), less a reduction for reinsurance recoverables related to those reserves. Reserves are recorded by product line and are undiscounted, except for reserves related to acquisitions.
The process of estimating our loss and loss adjustment expense reserves involves a considerable degree of judgment by management and is inherently uncertain. The recorded reserves represent management’s best estimate of unpaid loss and loss adjustment expense by line of business. Because we provide insurance
To record reserves on our lines of business, we utilize expected loss ratios, which management selects based on the following: 1) information used to price the applicable policies, 2) historical loss information where available, 3) any public industry data for that line or similar lines of business, 4) an assessment of current market conditions and 5) a claim-by-claim review by management, where actuarially homogenous data is unavailable. Management also considers the point estimates and ranges calculated by our actuaries, together with input from our experienced underwriting and claims personnel. Because of the nature and complexities of the specialized types of business we insure, management may give greater weight to the expectations of our underwriting and claims personnel, who often perform a claim by claim review, rather than to the actuarial estimates. However, we utilize the actuarial point and range estimates to monitor the adequacy and reasonableness of our recorded reserves.
The excess of the total recorded net reserves over the actuarial point estimate was 3.6% of recorded net reserves at December 31, 2009, compared to 4.3% at December 31, 2008. The percentage will vary in total and by line depending on current economic events, the potential volatility of the line, the severity of claims reported and of claims incurred but not reported, management’s judgment with respect to the risk of development, the nature of business acquired in acquisitions, and historical development patterns.
Direct insurance is coverage that is originated by our insurance companies and brokers in return for premium. Assumed reinsurance is coverage written by another insurance company, for which we assume all or a portion of the risk in exchange for all or a portion of the premium. Subscription business is direct insurance or assumed reinsurance where we only take a percentage of the total risk and premium and other insurers take their proportionate percentage of the remaining risk and premium. Assumed reinsurance represented 10% of our gross written premium in 2009 and 18% of our gross reserves at December 31, 2009. Approximately 45% of the assumed reinsurance reserves related to business in our discontinued lines, 31% related to assumed reinsurance in our London market account, aviation and diversified financial products lines of business, 15% related to assumed quota share surplus lines business in our other specialty lines, and 7% related to assumed business in our group life, accident and health line of business. The remaining assumed reinsurance reserves covered various other reinsurance programs. The table above recaps the underwriting, claims characteristics and major actuarial assumptions for our assumed reinsurance business.
loss reserves than slower reporting lines, and lines for which reserve volatility is low will have a lower percentage of incurred but not reported loss reserves than high volatility lines.
Diversified financial products - Total net reserves increased $223.4 million from 2008 to 2009 as this line of business continues to grow. The incurred but not reported portion of the total reserves for this line of business is higher than in most of our other lines, since these losses report slower and have a longer duration. This line includes our directors’ and officers’ liability, errors and omissions liability, and fiduciary liability coverages, which have experienced increased notices of claims, primarily from financial institutions, due to market and credit-related issues. The percentage of incurred but not reported reserves has decreased as claims mature.
London market account - Total net reserves decreased and the percentage of incurred but not reported reserves increased due to payment of claims on prior year hurricanes previously reported in case reserves.
Discontinued lines - Total net reserves for our discontinued lines decreased $57.5 million in 2009, primarily due to a $43.9 million commutation of certain loss reserves for run-off assumed accident and health reinsurance business.
During 2008 and 2009, we conducted additional reviews of our potential loss exposures stemming from the U.S. and international economic environment, including subprime lending and trade credit issues. We write directors’ and officers’ liability, errors and omissions liability and fiduciary liability coverages for public and private companies and not-for-profit organizations. Certain of this business is written for financial institutions that have potential exposure to shareholder lawsuits as a result of the economic environment during the past few years. At December 31, 2009, we had 17 “Side A only” and 75 “non-Side A only” directors’ and officers’ liability, errors and omissions liability and fiduciary liability claims related to subprime and credit market issues. This compares to 15 “Side A only” and 57 “non-Side A only” claims at December 31, 2008. In reviewing our exposure, we consider the types of risks we wrote, the industry of our insured, attachment points with respect to excess business, types of coverage, policy limits, actual claims reported, and current legal interpretations and decisions. We also write trade credit business for policyholders who have credit and
political risk exposure. We continue to closely monitor our exposure to subprime and trade credit issues. Based on our present knowledge, we believe our ultimate losses from these coverages will be contained within our current overall loss reserves for this business.
The reserve was $2.9 million at December 31, 2009, compared to $8.4 million at December 31, 2008. During 2009, we wrote off $0.9 million of uncollectible recoverables against the reserve. We also recognized a $4.6 million benefit from reversing a portion of the reserve based on actual or expected cash collections from reinsurers, for which reserves had previously been established. We assessed the collectibility of our year-end recoverables and believe amounts are collectible and any potential losses are adequately reserved based on currently available information.
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 2009 goodwill impairment test as of June 30, 2009, which is consistent
For our 2009 impairment test, we incorporated new accounting guidance, which required us to consider 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. Prior to 2009, we used the expected cash flow approach with assumptions and inputs based on our own internal data to determine the fair value of each reporting unit. In all years, 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.
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. The gross unrealized losses in our available for sale fixed income securities was $18.9 million at December 31, 2009 (0.4% of aggregate fair value of total available for sale fixed income securities) compared to $91.3 million (2.2% of aggregate fair value) at December 31, 2008. We evaluate the securities in our fixed income securities portfolio for possible other-than-temporary impairment losses at each quarter end.
To adopt the new accounting standard, we reviewed all securities with a previous other-than-temporary impairment 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.
impaired security. To assist us in our evaluation, our outside investment advisor also performs detailed credit evaluations of all of our fixed income securities on an ongoing basis. Our quarterly reviews have 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. Our reviews considered various factors including:
stress testing of expected cash flows for mortgage-backed and asset-backed securities under various scenarios.
The new accounting standard also changed the earnings recognition criteria for other-than-temporary impairment losses. We now recognize an other-than-temporary impairment loss in earnings in the period we determine: 1) we intend to sell the security, 2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, or 3) the security has a credit loss. Any non-credit portion of the other-than-temporary impairment loss is recognized in shareholders’ equity. In 2009, we recognized $6.4 million of pretax other-than-temporary impairment losses, of which $5.4 million were recorded in earnings and $1.0 million were recorded in shareholders’ equity. At December 31, 2009, we had $5.0 million of after-tax other-than-temporary impairments, primarily related to mortgage-backed and asset-backed securities, included in shareholders’ equity.