The following tables set forth our selected historical consolidated financial information for the last five years. Refer to Item 1, “Our Business Strategy” for a discussion of our business expansion over this period. This data should also be read in conjunction with the Consolidated Financial Statements and the accompanying notes presented under Item 8 and with the Management’s Discussion and Analysis of Financial Condition and Results of Operations under
Consolidated Results of Operations: Years ended December 31, 2007, 2006 and 2005
Results by Segment: Years ended December 31, 2007, 2006 and 2005
The following is a discussion and analysis of our results of operations for the years ended December 31, 2007, 2006 and 2005 and our financial condition at December 31, 2007 and 2006. This should be read in conjunction with the Consolidated Financial Statements and related notes included in Item 8 of this report. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.
Return on average common equity (“ROACE”): ROACE represents the level of net income available to common shareholders generated from the average of the opening and closing common shareholders’ equity during the period. Our objective is to generate superior returns on capital that appropriately reward our common shareholders for the risks we assume and to grow revenue only when we deem the returns meet or exceed our requirements. ROACE was 24.6% for 2007 compared to 26.7% and 2.9% for 2006 and 2005, respectively.
2006 versus 2005: Net income available to common shareholders for 2006 increased 928% from 2005, primarily reflecting additional underwriting income from our segments, higher investment income and positive changes in foreign exchanges gains/losses. The increase in segmental underwriting income was attributable to an absence of major loss activity in 2006 compared to 2005 when we incurred significant losses from Hurricanes Katrina, Rita and Wilma (“KRW”). The increase in investment income was driven by a 28% increase in our average cash and investment balances, an increase in our effective yield and increased income from other investments.
Gross Premiums Written: Gross premiums written by segment were as follows:
2006 versus 2005: Gross premiums written in 2006 increased 6% over 2005, primarily reflecting growth in our insurance segment. This was largely generated by additional underwriting resource and the targeting of new opportunities in our political risk book as well as significant rate increases within parts of our property book. In our reinsurance segment, growth in our liability and professional lines business was offset by lower reinstatement premiums on our catastrophe line. In 2005, we recorded significant reinstatement premiums following KRW. Excluding these reinstatement premiums, gross premiums written in our reinsurance segment increased 8% in 2006.
Net Premiums Written: Net premiums written by segment were as follows:
2007 versus 2006: The 4% reduction in net premiums written in 2007 was primarily due to an increase in premiums ceded in our insurance segment. This increase was partially due to a change in business mix towards lines with higher levels of ceded premium. We also purchased additional quota share reinsurance on our professional lines business and expanded our worldwide property program during the year.
Net Premium Earned: Net premiums earned by segment were as follows:
Loss ratio: The table below shows the components of our net loss and loss expense ratio (“loss ratio”):
Favorable development on our short tail lines has primarily been due to there being significantly fewer late reported claims than we anticipated in our reserving process. The deviation between expected and actual claims experience is often greater for a company like ours that has a limited operating history and therefore relies more heavily upon industry based loss development profiles. Given the inherent limitations of this, our estimate of ultimate losses in prior years have included a provision for reporting delays and other uncertainties specific to our business. These include the inherent delays we expect to arise from obtaining loss information on excess layers of business across our diverse worldwide exposures. As it has transpired, our actual claims experience in the last three years has been better than we projected, with late reporting being less prevalent than we anticipated.
Acquisition costs relate to the commissions, taxes and other fees paid to obtain business offset by commissions received on ceded premiums. Typically, our acquisition costs are based on a percentage of the premium written and vary by each line of business that we underwrite.
2007 versus 2006: Our general and administrative ratio in 2007 of 11.1%, increased by 1.1 ratio points over 2006, primarily reflecting the costs associated with growing the infrastructure of our business. In particular, we incurred higher staffing costs in 2007 relating to the expansion of our insurance operations in the U.S., including those related to our acquisition of the Media Pro business in the second quarter.
2006 versus 2005: Our general and administrative ratio in 2006 of 10.0%, increased by 1.7 ratio points over 2005, primarily reflecting an increase in incentive compensation costs which are tied to our operating results.
2007 versus 2006: Net investment income in 2007 increased 19% versus 2006 reflecting larger investment balances and higher effective yields. The 21% increase in average cash and investment balances primarily reflects positive operating cash flows during the year. Our annualized effective yield on invested assets (assets under management by external investment managers) was 4.9% in 2007 compared to 4.6% in 2006. The increase was principally due to higher U.S. interest rates at the short and intermediate parts of the yield curve. Partially offsetting this increase was a reduction in investment income from our other investments. This mainly resulted from the net sale of $138 million of CLO’s during the year which reduced interest income thereon, coupled with unrealized losses from our credit related funds which was associated with the broad widening of credit spreads in the fixed income markets during the second half of 2007. Refer to the Cash and Investments section below for further discussion.
2006 versus 2005: Net investment income in 2006 increased 59% versus 2005 reflecting larger investment balances, higher effective yields and increased income from our other investments. The 28% increase in average cash and investment balances primarily reflects positive operating cash flows during 2006 and capital raising activity in late 2005. Our annualized effective yield on invested assets was 4.6% in 2006 compared to 3.9% in 2005. The increase was principally due to higher U.S. interest rates at the short end of the yield curve. The increase in investment income from our other investments was principally the result of higher allocations combined with better returns in 2006 from those investments.
Foreign exchange gains/losses: Some of our business is written in currencies other than U.S. dollars. The gains in 2007 were principally made on the remeasurement of net asset balances denominated in Euro, the Australian dollar and the Canadian dollar, following an appreciation of these currencies against the U.S. dollar of 11.4%, 11.7% and 16.8%, respectively. The gains in 2006 were principally made on the remeasurement of net asset balances denominated in Sterling and Euro, following an appreciation of these currencies against the U.S. dollar, while in 2005, the depreciation of these same currencies against the U.S. dollar, drove the foreign exchange losses that year.
Interest expense: Interest expense primarily includes interest due on the senior notes we issued in 2004. In 2007, it also included interest costs of $19 million incurred on a $400 million repurchase agreement we entered into in December 2006 to finance our life settlement investment. We terminated this agreement in September, 2007. For further information refer to Item 8, Note 5 (b) of the Consolidated Financial Statements.
2007 versus 2006: In 2007, underwriting income in our insurance segment increased 3% over the prior year, primarily due to higher levels of prior period reserve development. Underwriting income otherwise decreased during 2007, reflecting a reduction in net premiums earned and an increase in our general and administrative expenses. The 7% reduction in net premiums earned was primarily due to an increase in premiums ceded this year, associated with an expansion of our reinsurance coverage and also changes in business mix. The increase in our general and administrative cost ratio was partially related to the reduction in net premiums earned but was also due to the costs of growing our underwriting platform, in particular those costs associated with the Media Pro business we purchased during the year.
2006 versus 2005: Underwriting income in 2006 increased significantly over 2005, reflecting an absence of major catastrophes in 2006 compared to 2005 when we incurred significant losses from KRW. The 9% increase in net premiums earned in 2006 was driven by lower ceded premiums amortized which were significantly higher in 2005 following ceded reinstatements on KRW.
2007 versus 2006: In general, market conditions globally were increasingly competitive during 2007 and, as a result, we experienced increased pricing pressure across many of our insurance lines. The overall stability of gross premiums written in 2007 versus 2006 reflects our breadth of products and markets worldwide, which gives us the flexibility to allocate capacity where we see the best-rated opportunities. Political risk premium can vary considerably between periods depending on the timing of transactions. However, additional underwriters in this line have allowed us to increase the number of contracts written this year, the majority of which were related to emerging market sovereign and corporate credit insurance. The other notable increase in 2007 was on our professional lines book. This was largely associated with renewal rights acquired in the May 2007 purchase of the Media Pro business. Other than U.S. exposed catastrophe property business, which continued to present good opportunities, market conditions in our other lines of business continued to be less favorable during 2007. This largely limited our ability to expand these lines, although we continued to seek out the better priced and structured opportunities.
(1) To facilitate period to period comparisons, certain amounts previously included in our property and liability lines in previous years have been reclassified to our marine line of business to conform to our current presentation.
2007 versus 2006: The 7% decrease in net premiums earned in 2007 largely reflects an 9% reduction in net premiums written in the year, associated with the increase in premiums ceded.
2007 versus 2006: Our current year loss ratio in 2007 was relatively flat compared with 2006. Although changes in business mix increased our current year ratio in 2007, this was largely offset by lower attritional losses in the year, most notably on our energy onshore account. During 2007, we experienced a shift in business mix from aviation and terrorism lines to our professional lines account. Our professional lines business typically has a higher initial expected loss ratio than our aviation and terrorism lines.
2006 versus 2005: Our current year loss ratio in 2006 was 34.3 ratio points lower than in 2005, reflecting an absence of major catastrophe losses in 2006 compared to 2005 when we incurred significant losses on KRW.
The net favorable reserve development on our short tail lines, which we have recognized due to the emergence of better than expected loss experience, is summarized as follows:
2007: The largest component of favorable development in 2007 was on our property lines from accident year 2006. For these lines, accident year 2006 has largely proven to be a benign loss year with limited late reported loss activity and minimal deterioration on previously reported claims. The balance of the favorable development in 2007 was generated from our accident year 2003 and 2004 aviation, marine and property lines. Accident year 2005 included adverse development on claims arising from KRW of approximately $34 million, or 2.8 ratio points. The majority of this development was on our property and energy offshore lines. The nature and extent of KRW resulted in some claims that increased over previously reported damage estimates. We also experienced adverse development of $8 million, or 0.7 ratio points, on our 2006 accident and health business due to a higher than expected emergence of claims.
2006: Favorable development in 2006 was largely generated by our accident year 2003-2005 aviation and property lines and accident year 2003-2004 marine lines. This was partially offset by adverse development of $51 million, or 3.9 ratio points, on claims arising from KRW, and was largely related to losses on our energy offshore account.
2005: In 2005, we generated approximately $107 million, or 8.9 ratio points, of favorable development on our aviation and terrorism lines, predominately from accident year 2004. The majority of this related to changes in our loss development profiles on these lines. Having observed a lack of claim development on our aviation war and terrorism business, we adjusted our reserving assumptions on these lines to incorporate reporting that was more prompt than we had originally expected. The balance of the other favorable development in 2005 was largely generated from our accident year 2002-2004 property and energy accounts.
2007 versus 2006: Gross premiums written in 2007 benefited from a weakened dollar relative to 2006. In particular, the dollar was weaker against the Euro and Sterling at our major reinsurance renewal date of January 1. Excluding this impact, gross premiums written decreased 3% in 2007, reflecting reductions in our property and professional lines business. The decrease in property premiums was primarily due to a large 16-month pro rata contract, written in the fourth quarter of 2006. Our professional lines book was impacted by the non-renewal of several large contracts, driven by cedants opting to increase their retention of business. Our other lines of business all reported an increase in gross premiums written in 2007. These increases were largely generated from our increased participation in the U.S. and European reinsurance markets, mainly during the January 1 renewal season.
The movements in our current year loss ratios primarily reflect changes in business mix and the level of loss activity each year, rather than from any significant changes in our underlying actuarial assumptions.
2007 versus 2006: Our current year loss ratio in 2007 was 2.6 ratio points higher compared with 2006, partially reflecting changes in business mix. We experienced a shift towards liability business, which typically has a higher initial expected loss ratio compared to our other lines. Although there was a higher incidence of mid-sized catastrophes in 2007, most notably European windstorm Kyrill and flood damages in the UK, our exposure to these events did not have a substantial impact on our total estimated current year losses relative to 2006.
2005: Favorable development in 2005 was primarily generated from our accident year 2004 property and catastrophe lines of business. We also removed several event specific IBNR reserves from our accident year 2003 catastrophe line having established that claims on these events did not develop to a sufficient level to reach our attachment points.
Our 2008 treaty reinsurance renewals are progressing well and we are satisfied with the quality, diversity and balance of the portfolio we reassembled at January 1, 2008. Typically, approximately 50% of our reinsurance gross premiums written within any calendar year renews on this date. Although we have not yet finalized all the business we expect to bind, we anticipate that our first quarter treaty reinsurance renewals in 2008 will represent a modest decline in premium relative to the same period in 2007. Although overall discipline throughout the global reinsurance marketplace continues, our reinsurance portfolio continues to be impacted by an ongoing trend of cedants retaining more business. Also, as expected, modest catastrophe claims for the reinsurance market has led to some decreases in margins for property reinsurance business, in most, if not all, geographic regions. However, overall returns generally remain above acceptable levels, in particular, business with major U.S. perils. Although we are experiencing increased competition and pricing pressure on our non-property lines in the U.S. and Europe, terms and conditions have generally held firm, and we continue to identify opportunities in attractively priced areas.
At December 31, 2007 and 2006, total cash and investments, including accrued interest receivable and net receivable/payable for investments sold/purchased were $10.5 billion and $9.7 billion, respectively. Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize investment return through a high quality, diversified portfolio. In this regard, at December 31, 2007 and 2006, our investment portfolio consisted primarily of fixed maturity investments and cash and cash equivalents. The composition of our investment portfolio is summarized as follows:
The amortized cost and fair values of our fixed maturity investments was as follows:
The increase in the gross unrealized losses of $17 million was due to various changes in yield in the fixed income market. During the first half of the year, there was a general increase in yields that negatively impacted prices to varying degrees across all fixed income sectors. In the second half of 2007, a broad re-pricing of risk dramatically increased spreads in the corporate, mortgage and asset-backed sectors, which negatively impacted the pricing of these securities, but resulted in an increase in demand for U.S. Treasuries, which favorably impacted pricing in this sector.
During the year, increasing delinquencies in the U.S. sub-prime residential mortgage collateral triggered increased volatility and decreased liquidity across financial markets as a whole, particularly in the area of structured credit assets.
We define sub-prime related risk as any security that is backed by or contains sub-prime collateral even if that sub-prime component is incidental. We do not invest directly in sub-prime loans nor do we have any direct sub-prime investment commitments. Our exposure to the sub-prime sector is within our fixed maturity portfolio as part of the collateral in our mortgage-backed and asset-backed securities. We also have exposure to Alternative-A mortgages which are considered riskier than prime but less risky than sub-prime. The following table summarizes our holdings in these investment types at December 31, 2007:
Our consolidated sources of funds consist primarily of net premiums written, reinsurance recoverable, net investment income and proceeds from sales and maturities of investments. Funds are primarily used to pay claims, operating expenses, dividends and to service our debt obligations. After satisfying our cash requirements, excess cash flows are generally invested. Our insurance and reinsurance operations provide liquidity in that premiums are received in advance, sometimes substantially in advance, of the time claims are paid. The following is a discussion of our cash flows for the years ended December 31, 2007 and 2006:
Our consolidated net cash flows used for investing activities were $1,417 million in 2007, compared with $1,166 million in 2006. In 2007, net cash flows used for investing activities were related principally to net purchases of fixed maturities, while in 2006 these also included significant purchases of other investments. These investing activities have resulted in a substantial increase in our average investment balances over the last two years.
Long-term debt: Long-term debt represents senior notes we issued during 2004. For further information refer to Item 8, Note 9 (a) of the Consolidated Financial Statements.
Common equity: Our common equity increased by $746 million during 2007. The following table is a summary of this movement:
Shelf registrations: On August 6, 2004, we filed an unallocated universal shelf registration statement with the SEC that was declared effective on August 27, 2004. Under the shelf registration statement, we may issue up to $750 million of equity, debt, trust preferred securities or a combination of these securities. On November 15, 2004, we completed a public offering of $500 million of senior notes. In addition, the shelf registration statement also registered for possible future sales up to 68,216,017 common shares held by certain of our founding shareholders. The registration of the founding shareholders’ common shares did not obligate these shareholders to offer or sell any of the securities held by them. As of December 31, 2007, there remained one founding shareholder with 20,930,928 common shares (including warrants) potentially available for sale.
AXIS Capital and our insurance subsidiaries are assigned debt and financial strength (insurance) ratings from internationally recognized rating agencies, including S&P, A.M. Best and Moody’s Investors Service. The ratings issued on our companies by these agencies are announced publicly and are available directly from the agencies.
Financial strength ratings represent the opinions of the rating agencies on the financial strength of a company and its capacity to meet the obligations of insurance policies. Independent ratings are one of the important factors that establish our competitive position in the insurance markets. The rating agencies consider many factors in determining the financial strength rating of an insurance company, including the relative level of statutory surplus necessary to support the business operations of the company.
“Best’s Financial Strength Ratings provide an opinion of an insurer’s financial strength and ability to meet ongoing obligations to policyholders.”
The “A” rating is the third highest out of fifteen rating levels.
The “A2” rating is the sixth highest out of twenty-one ratings.
In addition, our $500 million of senior notes were assigned a senior unsecured debt rating of Baa1 (stable) by Moody’s Investors Service and BBB+ (positive) by Standard & Poor’s. Our Series A and B preferred shares are rated Baa3 (stable) by Moody’s Investors Service and BBB- by Standard and Poor’s. These ratings are subject to periodic review by, and may be revised downward or revoked, at the sole discretion of the rating agencies.
4. Insurance-related derivative payment: based on an estimated undiscounted indemnity payment due in September 2017 (refer to Item 8, Note 8(c)); actual indemnity payment may differ significantly.
We believe the most significant judgment made by management is the estimation of our reserve for losses and loss expenses, which we also refer to as loss reserves. We are required by U.S. GAAP to establish loss reserves for the estimated unpaid portion of the ultimate liability for losses and loss expenses (“ultimate losses”) under the terms of our policies and agreements with our insured and reinsured customers. Our loss reserves comprise the following components:
Loss reserves also include an estimate of the expense associated with settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. The following table shows our net loss reserves segregated between case reserves and IBNR at December 31, 2007 and 2006:
Reserves for incurred but not reported (“IBNR”) claims are necessary due to time lags between when a loss occurs and when it is actually reported and settled. This is often referred to as the “claim-tail”. Reporting lags arise from the use of intermediaries to provide loss reports, complexities in the claims adjusting process and other related factors. IBNR reserves are calculated by projecting our ultimate losses on each class of business and subtracting paid losses and case reserves.
The evaluation process to determine our ultimate losses involves the collaboration of our underwriting, claims, internal actuarial, legal and finance departments, consultation with an independent external actuarial firm, and includes various segmental committee meetings, culminating with the approval of a single point best estimate by senior management in our Group Reserving Committee. Further, we compare our estimated claims and claim expense reserves to those estimated by the independent actuarial firm as part of our overall assessment of reasonableness.
On an annual basis, our independent actuarial firm performs work for the purpose of issuing an actuarial opinion for each of our operating subsidiaries on the reasonableness of our loss reserves, which are prepared in compliance with the requirements of each related jurisdiction. The actuarial opinions are required to meet various insurance regulatory requirements. The actuarial firm discusses its opinions with management and the Audit Committee of our Board of Directors.
Chain Ladder: This method uses the historical development profile of claims experienced on older accident years to project the more recent, less developed accident years to their ultimate position. The chain ladder method does not incorporate any information regarding market conditions or pricing. This method is more appropriate for homogeneous and low volatility lines under stable economic conditions.
The basis of our selected single point best estimate on a particular line of business is often a blend of the results from two or more methods (e.g. weighted averages). Our estimate is highly dependant on actuarial and management judgment as to which method (s) is most appropriate for a particular accident year and class of business. Our methodology changes over time as new information emerges regarding underlying loss activity and other data issues.
Medium and long-tail business describes lines of business for which specific losses may not be known for some period and claims can take significant time to emerge and subsequently settle. Our medium-tail exposures include certain classes within our political risk insurance lines and credit and bond, motor and engineering reinsurance business. Our long-tail exposures include most of our professional lines and liability classes of business in both our insurance and reinsurance segments. On these longer tailed exposures, we primarily use the IELR method, across all accident years.
For our reinsurance business, the current accident year IELRs are based on a contract by contract review which incorporates information provided by clients together with estimates provided by our underwriters and actuaries concerning the impact of changes in pricing, terms and conditions and coverage. Our estimate of the impact of these changes includes assumptions which consider, among other things, the market experience of our independent external actuarial firm.
In addition to our limited loss experience, our current reliance on industry development patterns is driven by the substantial growth of our business in recent years, which, overall has had the effect of reducing the degree to which we can rely upon our own development trends from older accident years.
The uncertainty in our reserve estimate is particularly pronounced for a company like ours that has a limited operating history and therefore relies more upon industry benchmarks. To reduce some of the uncertainty, management performs an analysis of additional factors to be considered when establishing our IBNR, intended to enhance our best estimate beyond quantitative techniques. At December 31, 2007, we recorded additional IBNR for uncertainties relating to the timing of the emergence of claims. Although time lags are incorporated within the actuarial methods discussed above, these rely on industry experience which may not be indicative of our business. For example, the low frequency, high severity nature of much of our business, together with the vast and diverse expanse of our worldwide exposures, may limit the usefulness of claims experience of other insurers and reinsurers for similar types of business.
The above is informational only and should not be considered projections of future events. For a summary of cumulative redundancies on our loss reserves since inception refer to “Reserves” in Item 1 of this report.
To estimate this valuation provision, we begin by applying case-specific valuation allowances against any reinsurance recoverable balances that we deem unlikely to collect in full. We also perform a default analysis based on the financial strength rating of the reinsurer using A.M. Best credit ratings. These percentages are based on historical industry default statistics developed by rating agencies. Lastly, we evaluate the overall adequacy of the valuation allowance for the total reinsurance recoverable balances based on qualitative and judgmental factors. Based on this process, at December 31, 2007, we recorded a valuation provision against reinsurance recoverable balances of $34 million (2006: $34 million). We have not written off any significant reinsurance recoverable balances in the last three years.
See Item 8, Note 7 to the Consolidated Financial Statements for an analysis of reinsurance recoverable and valuation provision by segment. For an analysis of credit risk with respect our reinsurance recoverable balances at December 31, 2007, refer to Item 8, Note 10 (a), to the Consolidated Financial Statements.
Our revenue is generated primarily by gross premiums written from our underwriting operations. The basis for the amount of gross premiums recognized varies by the type of contract we write.
We also write business on a line slip basis, under which we assume a fixed percentage of the premiums and losses on a particular risk or group of risks along with numerous other unrelated insurers. Statement of Financial Accounting Standard No. 60 Accounting and Reporting By Insurance Enterprises requires that if the ultimate premium is reasonably estimable, the estimated ultimate premium should be recognized as revenue over the period of the contract. Although a premium estimate is not contractually stated for business written on a line slip basis, we believe that the premium is reasonably estimable because we receive an initial estimate of the expected premium written from the client via the broker. This estimate has been derived by reference to one or more of the following: the historical premium volume experienced by the line slip; historical premium volume of similar line slips; and industry information on the underlying business. We may, if we believe appropriate, adjust the initial estimates provided by the broker to reflect management’s best judgments and expectations. This is most likely where the underwriter believes that the estimate is not prudent. Under these circumstances, we will generally recognize as revenue a lower than advised premium written estimate. We actively monitor the development of actual reported premium to the estimates made.
For business written under a proportional contract, similar to our line slip business, we are able to reasonably estimate the premium written by reference to an initial estimate of expected ceded premium received from our clients. In most cases, the treaties are not new and the client can use historical experience to estimate the amount of premium. We may adjust the initial estimate of premium, and any adjustment is usually a result of the underwriter’s prior experience with a client.
At December 31, 2007, we have not entered into any off-balance sheet arrangements, as defined by Item 303 (a) (4) of Regulation S-K.
We have audited the accompanying consolidated balance sheets of AXIS Capital Holdings Limited and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of AXIS Capital Holdings Limited and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.
The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant estimates reflected in our consolidated financial statements are:
Investments that are considered to be “available for sale” under the definition included in FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, are reported at fair value at the balance sheet date. The fair value of investments is based upon quoted market values where available or by reference to broker or underwriter bid indications. The net unrealized gain or loss on investments, net of tax, is included as accumulated other comprehensive income (loss) in shareholders’ equity. Purchases and sales of investments are recorded on a trade date basis. Realized gains or losses on sales of investments are determined based on the specific identification method.
We invest in both senior debt and equity tranches of CLOs. The fair value of senior debt tranches is based on available market prices; whereas, the fair value of equity tranches is derived by amortizing the invested amounts at rates which incorporate certain assumptions such as market default rates, weighted average spread earned and recovery rates over the expected life of the security. Any adjustments required due to the change in effective yields and maturities are recognized on a prospective basis through yield adjustments.
Investment funds include a short duration high yield fund, credit funds and hedge funds. The fair value for these investment funds is determined by management incorporating the net asset value provided by the third party administrators of these funds. The valuation for credit funds is reported on a one month lag.
We elected to use the fair value method to account for all of the life settlement contracts under FASB Staff Position No. FTB 85-4-1, Accounting for Life Settlement Contracts by Third Party Investors. The fair value of the life settlement contracts is based on discounting the estimated cash flows of the life insurance policies, as calculated by a financial institution and reviewed by management. The discount factor is calculated by deriving a risk yield curve which incorporates the USD LIBOR swap rates, credit spreads for the life insurance companies and a spread for longevity risk as observed in the secondary market. Changes in the fair value of life settlement contracts, life insurance proceeds and life premium payments are included in net investment income. The cash flows relating to the life settlement contracts are included in investing activities in the Consolidated Statements of Cash Flows.
We assess quarterly whether declines in fair value of our investments represent impairments that are other than temporary. There are several factors that are considered in the assessment of a security, which include (i) the time period during which there has been a significant decline below cost, (ii) the extent of the decline below cost, (iii) our intent and ability to hold the security, (iv) the potential for the security to recover in value, (v) an analysis of the financial condition of the issuer and (vi) an analysis of the collateral structure and credit support of the security, if applicable. Where we have determined that there is an other than temporary impairment in the fair value of the security, the cost of the security is written down to the fair value and the unrealized loss at the time of the determination is charged to net realized investment gains (losses) in the Consolidated Statement of Operations.
Cash equivalents include money-market funds and fixed interest deposits placed with a maturity of under 90 days when purchased. At December 31, 2007, cash and cash equivalents included restricted cash of $60 million, primarily for collateralizing certain reinsurance agreements.
Reinstatement premiums for our insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and earned on a pro-rata basis over the remaining risk period. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment, as described in Note 2 (e) below.
In the normal course of business, we seek to reduce the loss that may arise from events that could cause unfavorable underwriting results by reinsuring certain levels of risk in various lines of business with other reinsurers. Reinsurance premiums ceded are expensed over the period the reinsurance coverage is provided. Prepaid reinsurance premiums represent the portion of premiums ceded on the unexpired term of the policies in force. Reinstatement premiums ceded are recorded at the time a loss event occurs where coverage limits for the remaining life of a contract are reinstated under pre-defined contract terms and are expensed over the remaining risk period.
The reserve for uncollectible reinsurance is based on an estimate of the amount of the reinsurance recoverable balance that will ultimately not be recovered due to reinsurer insolvency, contractual disputes or some other reason. The valuation of this reserve includes several processes including a review of the credit ratings of the reinsurance recoverables by reinsurer, an analysis of default probabilities as well as coverage issues. These factors require considerable management judgment and the factors are reviewed in detail on a regular basis with any resulting adjustments reflected in losses and loss expenses in our Consolidated Statement of Operations in the period that collection issues are identified.
Reserves for losses and loss expenses are established by management and represent an estimate of the total cost of claims that are reported but not yet paid (“case reserves”) and the anticipated cost of claims incurred but not reported (“IBNR”).
Management also performs an analysis of additional factors to be considered when establishing our IBNR, intended to enhance our best estimate beyond quantitative techniques and reflect uncertainties specific to our business. These uncertainties may vary over time, but generally contemplate matters such as the timing and emergence of claims or short term market trends. While we believe that our reserves for losses and loss expenses are sufficient to pay losses that fall within the coverages we assume, actual losses and loss expenses may be materially greater or less than the reserve provided. Due to the limited length of time we have been operating, actual loss experience is limited; this increases the potential for material deviation from currently estimated amounts. The methods of determining such estimates and establishing the resulting reserve are reviewed quarterly and any adjustments are reflected in income in the period in which they become known.
Prior to January 1, 2006, we accounted for stock-based awards under the fair value recognition and measurement provisions of FAS No. 123, Accounting for Stock-Based Compensation (“FAS No. 123”). Effective January 1, 2006, we adopted FAS No. 123 (revised 2004), Share Based Payment (“FAS No. 123(R)”) using the modified prospective approach. We determine the fair value of the stock-based award at the date of grant and recognized the share-based compensation expense over the period the award is earned by the employee, net of our best estimate of forfeiture benefits. The adoption of FAS 123(R) did not have a significant impact on net income and basic and diluted earnings per share for 2006.
We currently use foreign currency forward contracts as part of our process to manage foreign currency exposures in the balance sheet. Foreign currency forward contracts are purchased as economic hedges to minimize the effect of fluctuating foreign currencies but are not specifically identifiable against cash, any single security or any groups of securities, insurance and reinsurance premium balances receivable or the reserve for losses and loss expenses and, therefore, do not qualify and are not designated as a hedge for financial reporting purposes. Realized and unrealized gains (losses) on foreign currency forward contracts that are purchased as economic hedges of our net foreign exposure are recognized in foreign exchange losses (gains) in the Consolidated Statements of Operations.
We do not amortize identifiable intangible assets with indefinite lives and goodwill. We test these intangible assets and goodwill for impairment on a yearly basis, or whenever changes in circumstances warrant an analysis of the recoverability of these assets. If we determine that an impairment exists, we adjust the carrying value of these assets to fair value and record the impairment charge in income.
We have certain subsidiaries which operate in jurisdictions where they are subject to taxation. Current and deferred income taxes are provided based upon enacted tax laws and rates applicable in the relevant jurisdictions. Deferred income taxes are provided on all temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance against deferred tax assets is recorded when our assessment indicates that it is more likely than not that a portion of the deferred tax asset will not be realized in the foreseeable future. We adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109” (“FIN 48”) on January 1, 2007. Under FIN 48, the tax benefits of uncertain tax positions may only be recognized when the position is more-likely-than-not to be sustained upon audit by the relevant taxing authorities.
In September 2006, the FASB issued FAS No. 157, Fair Value Measurement (“FAS 157”). This Statement provides guidance for using fair value to measure assets and liabilities. Under this standard, the definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). FAS 157 clarifies that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets and the lowest priority to unobservable data. Further, FAS 157 requires tabular disclosures of the fair value measurements by level within the fair value hierarchy. FAS 157 was effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will adopt FAS 157 on January 1, 2008, and we do not anticipate any cumulative-effect adjustment to beginning retained earnings or any material adjustment prospectively to our earnings and other comprehensive income.
In February 2007, the FASB issued FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”). This standard permits an entity to irrevocably elect fair value on a contract-by-contract basis as the initial and subsequent measurement attribute for many financial instruments and certain other items including insurance contracts. An entity electing the fair value option would be required to recognize changes in fair value in earnings and provide disclosure that will assist investors and other users of financial information to more easily understand the effect of the company’s choice to use fair value on its earnings. Further, the entity is required to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. This standard does not eliminate the disclosure requirements about fair value measurements included in FAS 157 and FAS 107, Disclosures about Fair Value of Financial Instruments. FAS 159 was effective for fiscal years beginning after November 15, 2007. We will adopt FAS 159 on January 1, 2008, and have no current plans to elect fair value option for our financial assets and liabilities.
Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Re and therefore we have determined that we have two reportable segments, insurance and reinsurance. Except for goodwill and intangible assets, we do not allocate our assets by segment as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.
Our insurance segment provides insurance coverage on a worldwide basis. In January 2007, we reorganized AXIS Insurance to further strengthen the global operations of the segment. This reorganization reflects the management of AXIS Insurance along global product lines rather than by geographical location. The new structure enables us to design insurance programs on a global basis in alignment with the global needs of many of our clients. The product lines in this segment are property, marine, terrorism, aviation, political risk, professional lines, liability and accident and health.
The following table presents our gross premiums written by the geographical location of our subsidiaries:
We participate in a securities lending program whereby our securities, which are included in investments, are loaned to third parties, primarily major brokerage firms for short periods of time through a lending agent. We maintain control over the securities loaned, retain the earnings and cash flows associated with the loaned securities and receive a fee from the borrower for the temporary use of the securities. Collateral in the form of cash, government securities and letters of credit is required at a rate of 102.0% of the market value of the loaned securities and is monitored and maintained by the lending agent. At December 31, 2007, we had $848 million (2006: $774 million) in securities on loan. We consider our securities lending activities to be non-cash investing and financing activities.
The following table represents a reconciliation of our beginning and ending gross losses and loss expenses:
The amounts above were almost entirely generated from our short-tail lines of business. For our long tail lines, our loss experience from older accident years is generally considered too immature as yet to recognize deviations from our initial expectations.
We purchase treaty and facultative reinsurance to reduce exposure to a large loss or a series of large losses. Facultative reinsurance provides for all or a portion of the insurance provided by a single policy and each policy reinsured is individually negotiated. Treaty reinsurance provides for a specified type or category of risks. The reinsurance agreements are written on either an excess of loss or quota share basis. Excess of loss covers provide a contractually set amount of cover after an excess point has been reached. This excess point can be based on the size of an industry loss or a fixed monetary amount. These covers can be purchased on a package policy basis, which provide cover for a number of lines of business within one contract. Quota share covers provide a proportional amount of coverage from the first dollar of loss. All of these reinsurance covers provide for recovery of a portion of losses and loss expenses from reinsurers. Under our reinsurance security policy, we predominantly cede our business to reinsurers rated A- or better by Standard & Poor’s and/or A.M. Best. We remain liable to the extent that reinsurers do not meet their obligations under these agreements either due to solvency issues, contractual disputes or some other reason.
* Ratings as assigned by Standard & Poor’s and/or A.M. Best. At December 31, 2007, 9.2% of the total reinsurance recoverable balance was collateralized (2006: 13.8%).
During 2007, we recorded a negligible amount of realized and unrealized losses on foreign currency forward contracts in our investment portfolio (2006: $1 million loss; 2005: $7 million gain). At December 31, 2007, the net contractual amount of these foreign currency forward contracts was $45 million (2006: $3 million; 2005: $27 million) with a negligible unrealized loss in each of the three years. During 2007, we recorded realized and unrealized losses on mortgage-backed securities that were accounted for as derivatives of $1 million (2006: $3 million; 2005: negligible). At December 31, 2007 and 2006, we did not hold any mortgage-backed securities in our investment portfolio that are accounted for as derivatives.
On September 26, 2007, following the sale of the Note (see Note 5 (b)), we entered into an insurance contract with the buyer whereby we agreed to indemnify the buyer in the event of non payment on the principal of its investment in a newly issued $400 million asset-backed note. This security has a 10 year term with the full principal amount due at maturity and is collateralized by a portfolio of life settlement contracts and cash held by the same SPE as disclosed in Note 5 (b). Through our insurance contract, we hold an implicit variable interest in the SPE; but management has determined that we are not its primary beneficiary. We have recorded the insurance contract as a derivative contract.
As there is no active market for this contract, we engaged an independent consultant to assist us in calculating its fair value. The independent consultant developed our valuation model that incorporated all of the significant cash flows relating to the insurance contract. It includes the cash flows relating to the assets supporting the $400 million note, namely life settlement contracts, cash and hedging instruments, as well as associated expenses. The estimated loss payment and risk margin, net of our contractual insurance premiums, were discounted using a risk free yield curve. We exercised significant judgment in deriving this fair value. At December 31, 2007, we recorded a fair value of $16 million for the derivative contract and it was included in other liabilities in our Consolidated Balance Sheets. The change in fair value of the derivative was solely due to collection of insurance premiums and accordingly, there was no income or loss derived from this contract in 2007. At December 31, 2007, our maximum exposure to a loss was $400 million on an undiscounted basis.
Interest expense on our Senior Notes includes interest payable, amortization of the offering discount and amortization of debt offering expenses. The offering discount and debt offering expenses are amortized over the period of time during which the Senior Notes are outstanding. In each of the last three years, we incurred interest expense for the Senior Notes of $29 million.
Financial instruments that potentially subject us to concentrations of credit risk consist principally of investments and reinsurance recoverable balances. Our investment portfolio is managed by external investment managers in accordance with our investment guidelines. Specific provisions limit the allowable holdings of a single issue and issuers. Within our fixed income portfolio, we attempt to limit our credit exposure by purchasing fixed income investments rated BBB or higher. In addition, we limit our exposure to any single corporate issuer to 5% or less of our portfolio for securities rated A- or above and 3% or less of our portfolio for securities rated between BBB and BBB+. At December 31, 2007, we did not have an aggregate exposure to any single issuer of 10% or more of our shareholders’ equity, other than with respect to U.S. government and agency securities.
We produce our business through brokers and direct relationships with insurance companies. During 2007, three brokers accounted for 50% (2006: 52%; 2005: 52%) of our total gross premiums written. Marsh, Inc. (including its subsidiary Guy Carpenter and Company) accounted for 24% (2006: 25%; 2005: 28%), Aon Corporation for 16% (2006: 17%; 2005: 16%) and Willis Group Holdings Ltd. for 10% (2006: 10%; 2005: 8%). No other broker and no one insured or reinsured accounted for more than 10% of our gross premiums written in any of the last three years.
During September 2007, we made an investment commitment of $75 million in an alternative investment fund, of which $36 million was still outstanding at December 31, 2007. We expect to fund this remaining commitment during 2008.
During 2007, we purchased reinsurance coverage for our insurance lines of business. The minimum reinsurance premiums are contractually due on a quarterly basis in advance. Accordingly at December 31, 2007, we have an outstanding reinsurance purchase commitment of $52 million.
On December 6, 2007 the Board of Directors declared a dividend of $0.185 per common share to shareholders of record at December 31, 2007 and payable on January 15, 2008. Additionally, the Board of Directors declared a dividend of $0.453125 per Series A 7.25% Preferred share and a dividend of $1.875 per Series B 7.5% Preferred share. The Series A Preferred share dividend is payable on January 15, 2008, to shareholders of record at December 31, 2007 and the Series B Preferred share dividend is payable on March 3, 2008 to shareholders of record at February 15, 2008.
Our authorized share capital is 800,000,000 common shares, par value of $0.0125 per share.
On December 7, 2006, we announced that our Board had authorized a renewal of our share repurchase plan with authorization to repurchase $400 million of our common shares. This authorization will expire on December 31, 2008. During 2007, under this repurchase plan we repurchased 8,164,378 common shares for a total cost of $305 million, including 5,263,445 shares for $201 million from Trident II, L.P. and affiliated entities. On December 6, 2007, our Board approved a new share repurchase plan authorizing $400 million of share repurchases in addition to the $95 million remaining from the 2006 repurchase plan. This new authorization will expire on December 31, 2009. During 2007, we have repurchased 88,277 (2006: 10,923) common shares from employees for $3 million (2006: negligible) to satisfy withholding tax liabilities upon the vesting of restricted stock awards and the exercise of stock options. These share repurchases are excluded from our repurchase plans.
On October 5, 2005, we issued $250 million of 7.25% series A Preferred shares, par value $0.0125 per share, with a liquidation preference of $25.00 per share. We may redeem the shares on and after October 15, 2010 at a redemption price of $25.00 per share. Dividends on the series A Preferred shares are non-cumulative. Consequently, if the board of directors does not authorize and declare a dividend for any dividend period, holders of the series A Preferred shares will
not be entitled to receive a dividend for such period, and such undeclared dividend will not accumulate and be payable. Holders of series A Preferred shares will be entitled to receive, only when, as and if declared by the board of directors, non-cumulative cash dividends from the original issue date, quarterly in arrears on the fifteenth day of January, April, July and October of each year, commencing on January 15, 2006, without accumulation of any undeclared dividends. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 7.25% of the liquidation preference per annum. For 2007 and 2006, the total dividends declared on series A Preferred share was $1.8125 per share.
The warrants were granted to the founding shareholders as an inducement to purchase our stock and therefore no compensation expense has been recorded in connection with the warrants. The fair value of the warrants at November 20, 2001 of $65 million has been included in additional paid-in capital. This value was calculated using the Black-Scholes option-pricing model. The three significant assumptions used were: risk-free interest rate of 5.1%; expected life of 7 years; and a dividend yield of nil.
We provide retirement benefits to eligible employees through various plans sponsored by us.
We have SERPs for our two senior executives: Chairman, Michael Butt, and President and Chief Executive Officer (CEO), John Charman. The SERP requires our Company to make annual payments upon retirement for a period of 20 years for our CEO and 10 years for our Chairman. If either the CEO or Chairman dies, is disabled or a change of control of the Company occurs, the remaining benefits under their respective plan are payable by the Company in a lump sum. At December 31, 2007, the total lump sum contingently payable to our CEO and Chairman was $22 million and $3 million, respectively. During 2007, the plan assets were invested in money market funds and the pension expense was $2 million (2006: $2 million and 2005: $3 million). At December 31, 2007, the SERPs were fully funded.
In May 2007, our shareholders approved the AXIS Capital Holdings Limited 2007 Long-Term Equity Compensation Plan (“2007 Plan”). The 2007 Plan provides for, among other things, the grant of restricted stock awards and units, non-qualified and incentive stock options, and other equity-based awards to our employees and directors. The maximum number of our common shares that may be delivered under our 2007 Plan is 5,000,000. As a result of the adoption of the 2007 Plan, the 2003 Long-Term Equity Compensation and 2003 Directors Long-Term Equity Compensation Plan were terminated (“2003 Plans”), except that all related outstanding awards will remain in effect. All stock compensation plans are administered by the Compensation Committee of our Board of Directors.
We have granted stock options under the 2003 Plans. These options generally become exercisable over a three-year annual vesting period and expire 10 years from the date of grant. We have determined the fair value of each stock option grant at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
We have not issued stock options under the 2007 Plan. We also have not issued stock options in 2006 except for 23,334 modified stock options pursuant to a severance agreement. Under FAS No. 123(R), modified stock options are deemed cancelled and new grants issued at the new terms. We have elected to use the simplified method of calculating the expected life of the options, which is the average of the vesting period and the expiry period. The weighted-average fair value of stock options granted per share for 2007 was nil (2006: $4.48; 2005: $5.55).
We have granted restricted stock under both our 2003 Plans and the 2007 Plan. The nature and general terms of these plans are materially consistent. For employees, restricted stock grants generally cliff vest three years after the date of grant or upon the employee’s earlier retirement, death, permanent disability or a change in control of the Company. For directors, restricted stock grants generally vest six months after the date of grant or upon the director’s earlier retirement, death, permanent disability or a change in control of the Company. Restricted shares are entitled to vote and to receive dividends but may not be transferred during the period of restriction and are forfeited if the employee’s employment terminates prior to vesting.
During 2007, we realized additional tax benefits for certain vested restricted stocks and exercised stock options of $1 million (2006: negligible; 2005: $3 million). These excess tax benefits are included in our cash flows from financing activities in the Consolidated Statements of Cash Flows.
In addition, our directors may elect to receive their fees in common shares rather than cash. At December 31, 2007, a cumulative total of 52,816 (2006: 44,834; 2005: 40,235) common shares had been granted under the 2003 Plans in lieu of fees. All awards are made at the fair value of the common shares at the time of the grant.
We have an unfunded nonqualified deferred compensation plan for our directors that allows participating directors to elect (i) the amount, if any, of cash or stock as fees for services to be deferred and (ii) the form in which payment is to be made. Directors who choose to defer fees otherwise payable in shares are credited a number of phantom stock units equal in amount to the number of shares of stock deferred. In the event a cash dividend is declared on the stock, the portion of the participant’s deferral account denominated in phantom share units is credited with additional phantom share units (or portions thereof). Directors who choose to defer fees otherwise payable in cash are credited with interest on their cash deferral at a rate for the year of deferral that is 100 basis points above the 12-month LIBOR rate for deposits of U.S. dollars. Generally, benefits are paid upon termination of service as a director. In 2007, we issued 10,331 (2006: 10,324; 2005: 10,360) phantom stock units in lieu of: a) annual cash retainer, b) annual restricted stock grant, c) board and committee fees, and d) cash dividends declared on our common stock. At December 31, 2007, we had 53,463 (2006: 45,805; 2005 38,068) phantom stock units outstanding.
Our U.S. subsidiaries are subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The provision for federal income taxes has been determined under the principles of the consolidated tax provisions of the U.S. Internal Revenue Code and Regulation. Should the U.S. subsidiaries pay a dividend to AXIS Capital, withholding taxes will apply. Our U.S. subsidiaries are not under examination but remain subject to examination in the U.S. for tax years 2004-2007.
Deferred income taxes reflect the tax impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. The significant components of our net deferred tax asset (liability) were as follows:
The valuation allowance in 2006 related to net unrealized losses on our fixed maturity investments and U.S. capital loss carryforwards of $8 million. We believed it was necessary to establish a valuation allowance of $7 million against the deferred tax assets arising from capital loss carryforwards of $1 million and net unrealized losses of $6 million due to insufficient positive evidence regarding the reversal of these losses. The establishment of the valuation allowance relating to net unrealized losses of $6 million was recorded as a component of other comprehensive income, at December 31, 2006, consistent with the treatment of the net unrealized losses.
At December 31, 2007, we determined that a valuation allowance for the deferred tax assets arising from capital loss carryforwards of $10 million ($4 million expire in 2010, $4 million expire in 2011 and $2 million expire in 2012) was not necessary due to sufficient unrealized gains in the investment portfolio which could be used to realize the capital loss carryforwards.
Although realization is not assured, management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized. There were no unrecognized tax benefits at December 31, 2007 and 2006.
Total statutory net income of our operating subsidiaries was $1,137 million, $980 million and $101 million for 2007, 2006, and 2005, respectively. The difference between statutory financial statements and statements prepared in accordance with U.S. GAAP vary by jurisdiction; however, the primary difference is that statutory financial statements do not reflect deferred acquisition costs, certain net deferred tax assets, goodwill and intangible assets, unrealized appreciation on debt securities or certain unauthorized reinsurance recoverables.
We use various financial instruments in the normal course of our business. Fair values of these financial instruments are based on quoted market prices, if available, estimates of fair values of similar instruments or our estimates of fair values. The carrying amounts and fair values of our financial instruments were as follows: