The following is a discussion and analysis of our results of operations for the years ended December 31, 2019 and 2018 and our financial condition at December 31, 2019 and 2018. This should be read in conjunction with Item 8 'Consolidated Financial Statements and Supplementary Data' of this report. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.
Results by Segment: Years ended December 31, 2019, 2018 and 2017
Reserve for losses and loss expenses of $12.8 billion and reinsurance recoverable on unpaid and paid losses and loss expenses of $4.2 billion
Consolidated underwriting income (loss) is a non-GAAP financial measure as defined in Item 10(e) of SEC Regulation S-K. The reconciliation to net income (loss), the most comparable GAAP financial measure, is provided in 'Management's Discussion and Analysis of Financial Condition - Executive Summary - Results of Operations' and a discussion of the rationale for its presentation is provided in 'Management’s Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Non GAAP Financial Measures'.
The debt to total capital ratio is calculated by dividing debt by total capital. Total capital represents the sum of total shareholders’ equity and debt.
AXIS Capital, through its operating subsidiaries, is a global provider of specialty lines insurance and treaty reinsurance with operations in Bermuda, the U.S., Europe, Singapore, Canada and the Middle East. Our underwriting operations are organized around our global underwriting platforms, AXIS Insurance and AXIS Re.
continuing to grow a leadership position in the areas of our business with strong potential for profitable growth including U.S. excess and surplus lines, North America professional lines and Lloyd's specialty insurance business;
continuing to improve the effectiveness and efficiency of our operating platforms and processes;
investing in data and technology capabilities, and tools to empower our underwriters and enhance the service we provide to our customers;
We are committed to being a leader in specialty insurance and global reinsurance markets; areas where we have depth of talent and expertise. As a mid-sized player that is both sophisticated and agile, we believe we are well-positioned to succeed in a rapidly evolving industry. Across our business, we continue to emphasize underwriting discipline to actively manage our portfolio. In 2020, we are focused on further growing our most attractive lines to drive an improved risk-adjusted return for our shareholders.
In the reinsurance market, we are seeing variability in pricing across specific lines and geographies. In quota share business, we benefit from improvements in the primary markets. In excess of loss treaties, we observe pricing generally responding to recent loss trends. This remains a competitive market, and at the 1/1/20 renewals, our aggregate estimated premium on renewed treaties was lower than aggregate premiums on expiring treaties. Looking forward, we expect meaningful rate increases at the Japanese Catastrophe renewal period (April), and we will be pushing for increases in Florida Catastrophe (June), and US Casualty business (April-October) in 2020. We expect our reinsurance premium volume in these renewals will be dependent on our view of achievable rate adequacy.
The reconciliation of underwriting-related general and administrative expenses to general and administrative expenses, the most comparable GAAP financial measure, is presented in 'Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Results of Operations'.
Consolidated underwriting income (loss) is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income (losses) as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative expenses as expenses. While this measure is presented in Item 8, Note 3
to the Consolidated Financial Statements 'Segment Information', it is considered a non-GAAP financial measure when presented elsewhere on a consolidated basis.
We evaluate our underwriting results separately from the performance of our investment portfolio. As such, we believe it is appropriate to exclude net investment income and net investment gains (losses) from our underwriting profitability measure.
Interest in income (loss) of equity method investments is primarily driven by business decisions, the nature and timing
Bargain purchase gain, recognized on the acquisition of Compagnie Belge d'Assurances Aviation NV/SA ("Aviabel"), reflects the excess of the fair value of the net identifiable assets acquired over the fair value of consideration transferred and is not indicative of future revenues, therefore, this revenue is excluded from operating income (loss).
We believe that showing net income (loss) available (attributable) to common shareholders exclusive of after-tax net investment gains (losses), foreign exchange losses (gains), transaction and reorganization expenses, interest in income (loss) of equity method investments, revaluation of net deferred tax asset and bargain purchase gain reflects the underlying fundamentals of our business. In addition, we believe that this presentation enables investors and other users of our financial information to analyze performance in a manner similar to how our management analyzes the underlying business performance. We also believe this measure follows industry practice and, therefore, facilitates comparison of our performance with our peer group. We believe that equity analysts and certain rating agencies that follow us, and the insurance industry as a whole, generally exclude these items from their analyses for the same reasons. The reconciliation of operating income (loss) to net income (loss), the most comparable GAAP financial measure, is presented in 'Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Results of Operations'.
We also present operating income (loss) per diluted common share and operating ROACE, which are derived from the operating income (loss) measure and are reconciled to the most comparable GAAP financial measures, earnings (loss) per diluted common share and return on average common equity ("ROACE"), respectively, in 'Management’s Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Results of Operations'.
We present gross premiums written, net premiums written and net premiums earned on a constant currency basis in this MD&A. The amounts presented on a constant currency basis are calculated by applying the average foreign exchange rate from the current year to the prior year amounts. We believe this presentation enables investors and other users of our financial information to analyze growth in gross premiums written, net premiums written and net premiums earned on a constant basis. The reconciliation to gross premiums written, net premiums written and net premiums earned on a GAAP basis is presented in 'Management’s Discussion and Analysis of Financial Condition and Results of Operations - Underwriting Results - Consolidated'.
Pre-tax total return on cash and investments excluding foreign exchange movements measures net investment income (loss), net investments gains (losses), interest in income (loss) of equity method investments, and change in unrealized investment gains (losses) generated by average cash and investment balances. The reconciliation of pre-tax total return on cash and investments excluding foreign exchange movements to pre-tax total return on cash and investments, the most comparable GAAP financial measure, is presented in 'Management’s Discussion and Analysis of Financial Condition and Results of Operations - Net Investment Income and Net Investment Gains (Losses)'. We believe this presentation enables investors and other users of our financial information to analyze the performance of our investment portfolio.
Ex-PGAAP operating income (loss) represents operating income (loss) exclusive of amortization of VOBA and intangible assets, net of tax and amortization of acquisition costs, net of tax associated with Novae's balance sheet at October 2, 2017 (the "closing date" or "acquisition date"). The reconciliation of ex-PGAAP operating income (loss) to net income (loss) available (attributable) to common shareholders, the most comparable GAAP financial measure, is presented in 'Management’s Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Results of Operations'.
We also present ex-PGAAP operating income (loss) per diluted common share and ex-PGAAP operating ROACE, which are derived from the ex-PGAAP operating income (loss) measure and are reconciled to the most comparable GAAP financial measures, earnings (loss) per diluted common share and ROACE, respectively, in 'Management’s Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Results of Operations'.
We believe the presentation of ex-PGAAP operating income (loss), ex-PGAAP operating income (loss) per diluted common share and ex-PGAAP operating ROACE enables investors and other users of our financial information to better analyze the performance of our business.
Tax cost (benefit) of $12 million, $(12) million and $2 million for the years ended December 31, 2019, 2018 and 2017, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the ability to utilize capital losses.
Tax cost (benefit) of $1 million, $(4) million and $(8) million for the years ended December 31, 2019, 2018 and 2017, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions, after consideration of other relevant factors including the tax status of specific foreign exchange transactions.
Tax cost (benefit) of $nil, $0.3 million and $nil for the years ended December 31, 2019, 2018 and 2017, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions.
Operating income (loss) is a non-GAAP financial measure as defined in Item 10(e) of SEC Regulation S-K. The reconciliations to net income (loss), the most comparable GAAP financial measure is presented in the table above, and a discussion of the rationale for its presentation is provided in 'Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Financial Measures'.
Refer to Item 8, Note 13 to the Consolidated Financial Statements 'Earnings Per Common Share' for further details.
In addition, we present ex-PGAAP operating income (loss), ex-PGAAP operating income (loss) per diluted common share and ex-PGAAP operating ROACE which are derived from the operating income (loss) measure and can be reconciled to the most comparable GAAP financial measures as follows:
Tax (benefit) of $(7) million, $(35) million and $(10) million for the years ended December 31, 2019, 2018, and 2017, respectively. Tax impact is estimated by applying the statutory rates of applicable jurisdictions.
Consolidated underwriting income(1) is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income (loss) as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative expenses as expenses.
Net investment gains in 2019 mainly reflected net unrealized gains on equity securities and net realized gains on the sale of U.S. government and agency RMBS securities.
Net investment losses in 2018 mainly reflected net realized losses on the sale of agency RMBS, U.S. government and corporate debt securities, and net unrealized losses on equity securities.
Other than temporary impairment ("OTTI") charges were $7 million and $10 million in 2019 and 2018, respectively.
Interest expense and financing costs were $68 million in 2019 compared to $67 million in 2018. The increase of $1 million was due to the issuance of 3.900% senior unsecured notes ("3.900% Senior Notes") on June 19, 2019, and the issuance of 4.900% fixed-rate reset junior subordinated notes ("Junior Subordinated Notes") on December 10, 2019, partially offset by the repayment of the 2.65% senior unsecured notes ("2.65% Senior Notes") on April 1, 2019 and the repayment of the Dekania Notes on November 15, 2018.
The financial results for 2019 resulted in a tax expense of $24 million compared to a tax benefit of $29 million in 2018.
The tax expense of $24 million in 2019 was principally due to the generation of pre-tax income in our U.S. and European operations, partially offset by pre-tax losses in our U.K. operations.
The tax benefit of $29 million in 2018 was principally due to the generation of pre-tax losses in our U.K. and European operations, partially offset by income in our U.S. operations.
VOBA is amortized over its economic useful life and this expense is included in amortization of value of business acquired in the consolidated statement of operations.
Our objective is to generate superior returns on capital that appropriately reward common shareholders for the risks we assume and to grow revenue only when we expect the returns will meet or exceed our requirements. We recognize that the nature of underwriting cycles and the frequency or severity of large loss events in any one year may challenge the ability to achieve a profitability target in any specific period.
ROACE reflects the impact of net income (loss) available (attributable) to common shareholders including net investment gains (losses), foreign exchange losses (gains), reorganization expenses, and interest in income (loss) of equity method investments.
ROACE increased in 2019 compared to 2018, primarily attributable to the investment gains in the year, and a decrease in amortization of VOBA associated with the acquisition of Novae, together with an increase in net investment income and a decrease in reorganization expenses, partially offset by a decrease in underwriting income, an increase in income tax expense, an increase in corporate expenses, and a decrease in foreign exchange gains.
Operating ROACE increased in 2019 compared to 2018, primarily attributable to a decrease in amortization of VOBA associated with the acquisition of Novae, together with an increase in net investment income, partially offset by a decrease in underwriting income, an increase in in income tax expense, and an increase in corporate expenses.
Ex-PGAAP operating ROACE excludes the impact of amortization of VOBA and intangible assets, net of tax, and amortization of acquisition costs, net of tax, associated with Novae's balance sheet at October 2, 2017. Ex-PGAAP operating ROACE for the years ending 2019 and 2018 was 5.2% and 4.7%, respectively.
In 2019, book value per diluted common share increased by 12%, primarily driven by net income generated and net unrealized investment gains reported in other comprehensive income, partially offset by common dividends declared. The net unrealized investment gains in 2019 reflected a decrease in interest rates and a tightening of credit spreads which positively impacted the market values of fixed maturities.
In 2018, book value per diluted common share decreased by 7%, primarily driven by an increase in net unrealized investment losses reported in other comprehensive income and common dividends declared. The net unrealized investment losses in 2018 reflected a widening of credit spreads which negatively impacted the market values of fixed maturities.
We believe in returning excess capital to shareholders by way of dividends. Accordingly, dividend policy is an integral part of the value we create for shareholders. Cumulatively, strong earnings have permitted our Board of Directors to approve sixteen successive annual increases in quarterly common share dividends.
In 2019, book value per diluted common share adjusted for dividends increased by $7.47 or 15%, due to net income generated and net unrealized investment gains reported in other comprehensive income.
Underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income (loss) as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative expenses as expenses. Underwriting results were as follows:
Underwriting-related general and administrative expenses is a non-GAAP financial measure as defined in Item 10(e) of SEC Regulation S-K. The reconciliation to general and administrative expenses, the most comparable GAAP financial measure, is provided in 'Management's Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Results of Operations'.
The decrease in the insurance segment's gross premiums written of $122 million or 3% ($75 million, or 2% on a constant currency basis) was primarily attributable to decreases in property, accident and health, and credit and political risk lines, partially offset by increases in liability, professional lines, and marine lines.
The increase in the reinsurance segment ceded premiums written of $164 million or 21% was primarily driven by increases in catastrophe, liability, credit and surety, and accident and health lines, partially offset by decreases in property, and agriculture lines.
(1) Amounts presented on a constant currency basis are non-GAAP financial measures as defined in Item 10(e) of SEC Regulation S-K. The constant currency basis is calculated by applying the average foreign exchange rate from the current year to prior year amounts. The reconciliations to the most comparable GAAP financial measures are provided in 'Management's Discussion and Analysis of Financial Condition - Executive Summary - Results of Operations.
In June 2019, we obtained catastrophe protection for the insurance and reinsurance segments through a reinsurance agreement with Northshore. In connection with the reinsurance agreement, Northshore issued notes to unrelated investors in an amount equal to the full $165 million of coverage provided under the reinsurance agreement covering a four-year period. At the time of the agreement, we concluded that we do not have a variable interest in the entity, as the variability in results is expected to be absorbed entirely by the investors in Northshore. Accordingly, the results of Northshore are not included in the consolidated financial statements. The premium ceded to Northshore for the year ended December 31, 2019 was $13 million.
In July 2018, we obtained catastrophe protection for the insurance and reinsurance segments through a reinsurance agreement with Northshore. In connection with the reinsurance agreement, Northshore issued notes to unrelated investors in an amount equal to the full $200 million of coverage provided under the reinsurance agreement covering a three-year period. At the time of the agreement, we concluded that we do not have a variable interest in the entity, as the variability in results is expected to be absorbed entirely by the investors in Northshore. Accordingly, the results of Northshore are not included in the consolidated financial statements. The premium ceded to Northshore for the year ended December 31, 2019 was $16 million. The premium ceded to Northshore for the year ended December 31, 2018 was $17 million.
Net premiums earned in the reinsurance segment in 2019 decreased by $32 million or 1% ($18 million or 1% on a constant currency basis) compared to 2018 attributable to decreases in credit & surety, motor lines, partially offset by increases in marine and other, accident and health lines.
The general and administration expense ratio included corporate expenses not allocated to underwriting segments of 2.8%, 2.3% and 3.1% for 2019, 2018 and 2017, respectively. Refer to 'Management’s Discussion and Analysis of Financial Condition and Results of Operations - Other Expenses (Revenues), Net' for further details.
2019 versus 2018: The current accident year loss ratio decreased to 68.1% in 2019 from 70.7% in 2018. The decrease in the current accident year loss ratio was impacted by a lower level of catastrophe and weather-related losses. During 2019, we incurred pre-tax catastrophe and weather-related losses, net of reinstatement premiums, of $336 million or 7.5 points primarily attributable to Japanese Typhoons Hagibis, Faxai and Tapah, Hurricane Dorian, Australia Wildfires and other weather-related events. Comparatively, in 2018, we incurred pre-tax catastrophe and weather-related losses, net of reinstatement premiums, of $430 million or 9.0 points primarily attributable to California Wildfires, Hurricanes Michael and Florence, Typhoon Jebi and other weather-related events.
Net favorable prior year reserve development arises from changes to estimates of losses and loss expenses related to loss events that occurred in previous calendar years. Net prior year reserve development by segment was as follows:
Reinsurance professional lines reserve class recorded net favorable prior year reserve development of $21 million in 2018 reflecting generally favorable experience on older accident years as we continued to transition to more experience based actuarial methods.
Insurance credit and political risk reserve class recorded net favorable prior year reserve development of $19 million in 2019 reflecting generally better than expected loss emergence.
Reinsurance credit and surety reserve class recorded net favorable prior year reserve development of $53 million and $33 million in 2019 and 2018, respectively, reflecting generally better than expected loss emergence.
We caution that conditions and trends that impacted the development of reserve for losses and loss expenses in the past may not recur in the future.
$11 million of net favorable prior year reserve development on property and other business primarily due to overall better than expected loss emergence related to the 2017 catastrophe events and SuperStorm Sandy, partially offset by reserve strengthening within the international book of business, mainly related to the 2018 accident year.
In 2018, we recognized $93 million of net favorable prior year reserve development, the principal components of which were:
$65 million of net favorable prior year reserve development on property and other business primarily due to overall better than expected loss emergence related to the 2017 catastrophe events.
$32 million of net favorable prior year reserve development on professional lines business primarily due to better than expected loss experience, particularly related to the 2014 and 2015 accident years.
$22 million of net adverse prior year reserve development on liability business primarily due to reserve strengthening within the U.S. excess casualty book of business mainly driven by the higher frequency of large auto and general liability claims mainly related to the 2015 accident year.
$71 million of net favorable prior year reserve development on motor business primarily due to the impact of the increase in the Ogden Rate and changes in related actuarial assumptions, on several accident years.
$53 million of net favorable prior year reserve development on credit and surety business primarily due to generally better than expected loss emergence, mainly related to accident years 2015 through 2017.
$31 million of net favorable prior year reserve development on liability business due to increased weight given by management to experience based indications on older accident years.
$133 million of net adverse prior year reserve development on property and other business primarily due to an increase in loss estimates attributable to Hurricanes Irma and Michael consistent with industry trends, an increase in loss estimates attributable to Typhoon Jebi consistent with updated industry insured loss estimates, and reserve strengthening within the U.S. regional and commercial proportional property books of business and the European proportional property book of business.
The increase in the acquisition cost ratio to 22.3% in 2019 from 20.2% in 2018 was principally related to an increase in the insurance segment, largely associated with the acquisition of Novae.
The increase in general and administrative expense ratio to 13.9% in 2019 from 13.1% in 2018 was mainly driven by a decrease in net premiums earned, an increase in information technology costs and professional fees, partially offset by an increase in fees associated with arrangements with strategic capital partners.
2019 versus 2018: Gross premiums written in 2019 decreased by $122 million or 3% ($75 million or 2% on a constant currency basis) compared to 2018 primarily attributable to property, accident and health, and credit and political risk lines, partially offset by increases in liability, professional lines, and marine lines.
The decrease in property lines was due to the non-renewals associated with underwriting actions taken in recent years to reposition the portfolio, partially offset by new business. The decrease in accident and health lines was due to the cancellation of certain program business. The decrease in in credit and political risk lines was attributable to reduced business opportunities. The increases in liability, professional lines and marine lines were driven by new business and favorable rate changes.
2019 versus 2018: The current accident year loss ratio decreased to 60.8% in 2019 from 67.2% in 2018. The decrease in the current accident year loss ratio was impacted by a lower level of catastrophe and weather-related losses. During 2019, we incurred pre-tax catastrophe and weather-related losses of $84 million, or 3.8 points primarily attributable to Hurricane Dorian, and other weather-related events. Comparatively, in 2018 we incurred pre-tax catastrophe and weather-related losses of $204 million, or 8.7 points primarily attributable to Hurricanes Michael and Florence, California Wildfires, and other weather-related events.
After adjusting for the impact of the catastrophe and weather-related losses, the current accident year loss ratio decreased to 57.0% in 2019 from 58.5% in 2018. The decrease in the current accident year loss ratio after adjusting for the impact of the catastrophe and weather-related losses was principally due to impact of improved pricing over loss trends, and a decrease in loss experience in property lines, partially offset by an increase in loss experience in credit and political risk lines.
The increase in the general and administrative expense ratio to 18.3% in 2019 from 16.8% in 2018 was mainly driven by a decrease in net premiums earned, an increase in the allocation of corporate costs to the segment, and an increase in professional fees, partially offset by a decrease in personnel costs.
2019 versus 2018: Gross premiums written in 2019 increased by $110 million or 4% ($163 million or 5% on a constant currency basis) compared to 2018 primarily attributable to catastrophe, liability, accident and health, and marine and other lines, partially offset by decreases in motor, credit and surety, and property lines.
The increases in catastrophe, liability, accident and health, and marine and other lines were driven by new business. In addition, increased line sizes on a number of treaties, the restructuring of several treaties, and higher level of premiums written on a multi-year basis contributed to the increase in catastrophe and liability lines. The increases in liability, and marine and other lines were also due to premium adjustments.
The decrease in motor lines was driven by non-renewals, decreased line sizes on a number of treaties, and the impact of foreign exchange movements as the strengthening of the U.S. dollar drove comparative premium decreases in treaties denominated in foreign currencies, partially offset by premium adjustments. The decrease in credit and surety lines was driven by non-renewals and premium adjustments, partially offset by new business. The decrease in property lines was primarily due to non-renewals and decreased line sizes on a number of treaties, partially offset by favorable rate changes, the restructuring of several treaties, new business, and premium adjustments.
The decrease in property lines was attributable to the non-renewals of fronting arrangements, together with a decrease in premiums ceded to facultative covers with Harrington Re. The decrease in agriculture lines was attributable to the restructuring of a fronting arrangement and a quota share retrocessional treaty.
Other insurance related income in 2019 of $14 million compared to other insurance related income in 2018 of $7 million, an increase of $7 million, primarily due to an increase in fees associated with arrangements with strategic capital partners.
The decrease in the acquisition cost ratio to 23.2% in 2019 from 23.5% in 2018 was principally related to changes in business mix, adjustments related to loss sensitive features, and the impact of retrocessional contracts.
The decrease in the general and administrative expense ratio to 4.3% in 2019 from 5.1% in 2018 was mainly driven by an increase in fees associated with arrangements with strategic capital partners, together with decreases in information technology costs and personnel costs, partially offset by a decrease in net premiums earned, and an increase in the allocation of corporate costs to the segment.
Some of our business is written in currencies other than the U.S. dollar. Foreign exchange gains in 2019 were mainly driven by the impact of the strengthening of the U.S. dollar on the re-measurement of net insurance-related liabilities denominated in euro, partially offset by the impact of the weakening of the U.S. dollar on the remeasurement of net insurance-related liabilities denominated in pound sterling.
Interest expense and financing costs are related to interest due on the 5.875% senior unsecured notes ("5.875% Senior Notes") issued in 2010, the 5.150% senior unsecured notes ("5.150% Senior Notes") issued in 2014, the 4.000% senior unsecured notes ("4.000% Senior Notes") issued in 2017, the 3.900% Senior Notes and the Junior Subordinated Notes issued in 2019.
Income tax expense (benefit) primarily results from income (loss) generated by our foreign operations in the U.S. and Europe. Our effective tax rate, which is calculated as income tax expense (benefit), divided by income (loss) before tax including interest in income (loss) of equity method investments, was 6.8% and (217.9)%, in 2019 and 2018, respectively. This effective rate can vary between years depending on the distribution of net income (loss) among tax jurisdictions, as well as other factors.
The tax expense of $24 million in 2019 was principally due to the geographic distribution of pre-tax income with the expense being driven by pre-tax income generated in our U.S. and European operations, partially offset by pre-tax losses in our U.K. operations.
The tax benefit of $29 million in 2018 was principally due to the geographic distribution of pre-tax losses with the benefit being driven by pre-tax losses in our U.K. and European operations, partially offset by pre-tax income in our U.S. operations.
The pre-tax return on other investments is calculated by dividing total net investment income from other investments by the average month-end fair value balances held for the periods indicated, excluding overseas deposits.
2019 versus 2018: Pre-tax return on other investments in 2019 increased to 8.5% compared to 6.4% in 2018. The increase was primarily attributable to a realized gain of $13 million associated with the sale of a privately held investment, partially offset by lower returns from CLO-Equities.
Fixed maturities classified as available for sale are reported at fair value. Realized gains (losses) on fixed maturities are reported in net investment gains (losses) when these securities are sold or impaired.
Changes in the fair value of investment derivatives, mainly foreign exchange forward contracts and exchange traded interest rate swaps, are recorded in net investment gains (losses).
Our derivative instruments are not designated as hedges under current accounting guidance, therefore, net unrealized gains (losses) on the hedged securities were recorded in accumulated other comprehensive income in the statement of changes in shareholders’ equity.
The average cash and investments balance is calculated by taking the average of the period end fair value balances.
Pre-tax total return on average cash and investments excluding foreign exchange rate movements is a non-GAAP financial measure as defined in Item 10(e) of SEC Regulation S-K. The reconciliation to pre-tax total return on cash and investments, the most comparable GAAP financial measure, included foreign exchange gains (losses) of $25 million, $(48) million and $80 million for the years ended December 31, 2019, 2018 and 2017, respectively.
increase in the market value of fixed maturities due to a decrease in interest rates and the tightening of credit spreads, and the increase in the market value of equity securities due to the improved performance of global equity markets.
Includes U.S. government-sponsored agencies, residential mortgage-backed securities ("RMBS") and commercial mortgage-backed securities ("CMBS").
An analysis of our fixed maturities portfolio by major asset classes is detailed below.
At December 31, 2019, net unrealized gains on non-U.S. government securities was $12 million (2018: net unrealized losses of $15 million) which included gross unrealized foreign exchange losses of $3 million (2018: $13 million), mainly related to U.K. government bonds.
Details of our corporate debt securities portfolio by sector are as follows:
At December 31, 2019, our non-investment grade portfolio had a fair value of $994 million (2018: $985 million), a weighted average credit rating of B+ (2018: B) and duration of 1.5 years (2018: 2.4 years). At December 31, 2019, our corporate debt portfolio, including non-investment grade securities, had a duration of 3.1 years (2018: 3.1 years).
Non-Agency RMBS mainly include investment-grade bonds originated by non-agencies. At December 31, 2019, non-agency RMBS had an average duration of 2.1 years (2018: 0.8 years) and weighted average life of 6.1 years (2018: 4.0 years).
G.O. bonds are backed by the full faith and credit of the authority that issued the debt and are secured by the taxing powers of those authorities. Revenue bonds are backed by the revenue stream generated by the services provided by the issuer (e.g. sewer, water or utility projects). As issuers of revenue bonds do not have the ability to draw from tax revenues or levy taxes to fund obligations, revenue bonds may carry a greater risk of default than G.O. bonds. At December 31, 2019, 96% (2018: 93%) of municipals are taxable with the remainder being tax exempt.
The severity of the unrealized loss position as a percentage of amortized cost for all investment grade fixed maturities in an unrealized loss position including any impact of foreign exchange losses (gains) was as follows:
At December 31, 2019, net unrealized gains on equity securities were $75 million (2018: $16 million). The increase was due to improved performance of global equity markets.
During 2016, we paid $108 million including direct transactions costs to acquire 19% of the common equity of Harrington Reinsurance Holdings Limited ("Harrington"), the parent company of Harrington Re, an independent reinsurance company jointly sponsored by the Company and The Blackstone Group L.P. ("Blackstone"). Harrington is not a variable interest entity that is required to be included in the consolidated financial statements. We account for our ownership interest in Harrington under the equity method of accounting.
Net cash provided by operating activities was $199 million in 2019 compared to $11 million in 2018. Cash inflows from insurance and reinsurance operations typically include premiums, net of acquisition costs, and reinsurance recoverables. Cash outflows principally include payments of claims and loss adjustment expenses together with payments of premiums to reinsurers and operating expenses. Cash provided by operating activities can fluctuate due to timing differences between the collection of premiums and reinsurance recoverables and the payment of claims and loss adjustment expenses, and the payment of premiums to reinsurers. Operating cash inflows increased in 2019 compared to 2018, primarily attributable to an increase in premiums and reinsurance recoverables received, partially offset by an increase in payments of claims and loss adjustment expenses, an increase in costs associated with the purchase of reinsurance and retrocessional covers and an increase in operating expenses.
Investing cash outflows in 2019 principally related to the net purchases of fixed maturities of $693 million, net purchases of equity securities of $22 million, partially offset by net proceeds from the sale of other investments of $31 million.
We continue to expect that cash flows generated from operations, combined with the liquidity provided by our investment portfolio, will be sufficient to cover required cash outflows and other contractual commitments through the foreseeable future (refer to 'Contractual Obligations and Commitments' below for further details).
In addition to common equity, we have utilized other external sources of financing, including debt, preferred shares and letter of credit facilities to support our business operations. We believe that we hold sufficient capital to allow us to take advantage of market opportunities and to maintain our financial strength ratings, as well as to comply with various local statutory regulations. We monitor capital adequacy on a regular basis and will seek to adjust our capital base (up or down) according to the needs of our business (refer to Item 1 'Risk and Capital Management' for further details).
We finance our operations with a combination of debt and equity capital. Debt to total capital and debt and preferred equity to total capital ratios provide an indication of our capital structure, along with some insight into our financial strength.
Debt represents the 5.875% Senior Notes issued in 2010, which will mature in 2020 and the 5.150% Senior Notes issued in 2014, which will mature in 2045, the 4.000% Senior Notes issued in 2017, which will mature in 2027, the 3.900% Senior Notes issued in 2019, which will mature in 2029 and the 4.900% Junior Subordinated Notes issued in 2019, which will mature in 2040 (refer to Item 8, Note 10(a) to the Consolidated Financial Statements 'Debt and Financing Arrangements' for further details).
On May 20, 2013, we issued $225 million of 5.50% Series D preferred shares with a liquidation preference of $25.00 per share. Dividends on the Series D preferred shares were non-cumulative. To the extent declared, dividends accumulated, with respect to each dividend period, in an amount per share equal to 5.50% of the liquidation preference per annum. On January 17, 2020, we redeemed all outstanding Series D preferred shares, for an aggregate liquidation preference of $225 million (refer to Item 8, Note 14 to the Consolidated Financial Statements 'Shareholder's Equity' and Note 23 of the Consolidated Financial Statements 'Subsequent Events' for further details).
On March 28, 2019 certain of AXIS Capital's operating subsidiaries (the "Participating Subsidiaries") amended an existing $250 million secured letter of credit facility (the "$250 million Facility") with Citibank Europe plc to extend the expiration date to March 31, 2020.
(1) On December 12, 2018, Standard & Poor's revised its outlook from negative to stable, which reflected their expectation that capital redundancy at the 'AAA' level would be restored by year-end 2019.
In the ordinary course of business, we renew and enter into new leases for office space which expire at various dates (refer to Item 8, Note 12 to the Consolidated Financial Statements 'Leases' for further details).
We have $588 million of unfunded investment commitments related to our other investments portfolio, which are callable by our investment managers (refer to Item 8, Note 5(c) to the Consolidated Financial Statements 'Investments' for further details). In addition, we have $32 million of unfunded commitments related to our commercial mortgage loans portfolio.
Refer to Item 8, Note 10(a) to the Consolidated Financial Statements 'Debt and Financing Arrangements' for further details.
other-than-temporary impairments ("OTTI") in the carrying value of available for sale securities.
Significant accounting policies are also important to understanding the consolidated financial statements (refer to Item 8, Note 2 to the Consolidated Financial Statements 'Basis of Presentation and Significant Accounting Policies' for further details).
With respect to reinsurance business, we are generally notified of losses by ceding companies and/or their brokers. For excess of loss contracts, we are typically notified of insured losses on specific contracts and record a case reserve for the estimated ultimate liability arising from the claim. For contracts written on a proportional basis, we typically receive aggregated claims information and record a case reserve for the estimated ultimate liability arising from the claim based on that information. Proportional reinsurance contracts typically require that losses in excess of pre-defined amounts be separately notified so we can adequately evaluate them. Our claims department evaluates each specific loss notification we receive and records additional case reserves when a ceding company’s reserve for a claim is not considered adequate.
Loss Development Method (also referred to as the "Chain Ladder Method" or "Link Ratio Method"): This method assumes that the losses incurred/paid for each accident year or underwriting year at a particular development stage follow a relatively similar pattern. It assumes that on average, every accident year or underwriting year will display the same percentage of ultimate losses incurred/paid at the same point in time after the inception of that year. The percentages incurred/paid are established for each development stage (e.g. 12 months, 24 months, etc.) after examining averages from historical loss development data and/or external industry benchmark information. Ultimate losses are then estimated by multiplying the actual incurred/paid losses by the reciprocal of the established incurred/paid percentage. The strengths of this method are that it reacts to loss emergence/payments and that it makes full use of historical claim emergence/payment experience. However, this method has weaknesses when the underlying assumption of stable loss development/payment patterns is not valid. This could be the consequence of changes in business mix, claim inflation trends or claim reporting practices and/or the presence of large claims, among other things. Furthermore, this method tends to produce volatile estimates of ultimate losses where there is volatility in the underlying incurred/paid patterns. In particular, where the expected percentage of incurred/paid losses is low, small deviations between actual and expected claims can lead to very volatile estimates of ultimate losses. As a result, this method is often unsuitable at early development stages for an accident year or underwriting year.
accident or underwriting years, established in the prior reporting period. For the initial estimate of the current accident or underwriting year, the available claim data is typically insufficient to produce a reliable estimate of ultimate losses. As a result, initial estimates for an accident or underwriting year is generally based on the ELR Method for longer tailed lines and a BF method for shorter tailed lines. The initial ELR for each reserve class is established collaboratively by our actuaries, underwriters and management at the start of the year as part of the planning process, taking into consideration prior accident years’ or underwriting years' experience and industry benchmarks, adjusted after considering factors such as loss and exposure trends, rate differences, changes in contract terms and conditions, business mix changes and other known differences between the current year and prior accident or underwriting years. The initial expected loss ratios for a given accident or underwriting year may be modified over time if the underlying assumptions, such as loss development or premium rate changes, differ from the original assumptions.
Short-tail business generally includes exposures for which losses are usually known and paid within a relatively short period of time after the underlying loss event has occurred. Our short-tail business primarily relates to property coverages and includes terrorism, accident and health, discontinued lines - Novae, marine, and aviation hull and war business in the insurance segment, together with the catastrophe, property, engineering, agriculture, marine and other, accident and health, and discontinued lines - Novae business in the reinsurance segment.
Our transition from the ELR method to experience-based methods began in 2008, when we commenced gradual transition for the 2004 and prior accident years. As our loss history continued to develop, the transition was expanded to include additional accident years. Refer to 'Underwriting Results - Consolidated - Prior Year Development' for further details.
Refer to 'Reserving for Credit and Political Risk Business' below for a more detailed discussion of specific loss reserve issues related to this business. When considering prior year reserve development for this line of business, it is important to note that the multi-year nature of the credit business distorts loss ratios when a single accident year is considered in isolation. In recent years, the average term of these contracts has been four to five years. Premiums for these contracts generally earn evenly over the contract term, therefore, are reflected in multiple accident years. In contrast, losses incurred on these contracts, which can be characterized as low in frequency and high in severity, are reflected in a single accident year.
The estimation of the value of recoveries on credit and political risk business requires significant management judgment. At December 31, 2019, estimated recoveries on credit and political risk business were $35 million (2018: $24 million).
In contrast to short and medium-tail business, the claim tail for long-tail business is expected to be notably longer, as claims are often reported and ultimately paid or settled years, or even decades, after the related loss events occur. Our long-tail business primarily relates to liability business written in the insurance and reinsurance segments, and reinsurance motor business, and discontinued lines - Novae in the insurance and reinsurance segments.
As a general rule, estimates of accident year or underwriting year ultimate losses for long-tail business are notably more uncertain than those for short and medium-tail business. Factors that contribute additional uncertainty to estimates for long-tail business include, but are not limited to:
potential volatility of actuarial estimates, given the number of years of development it takes to produce a meaningful incurred loss as a percentage of ultimate losses;
the possibility of future litigation, legislative or judicial change that may impact future loss experience relative to the prior industry loss experience relied on in reserve estimation.
Due to the length of the development tail for this business, reserve estimates for most accident years and underwriting years are predominantly based on the BF or ELR method and the consideration of qualitative factors. As part of our quarterly loss reserving process, we monitor actual paid and incurred loss emergence relative to expected loss emergence based on selected loss development patterns. The drivers of any unfavorable loss emergence are investigated and, as a result, have led to an immediate recognition of adverse development in some instances.
Prior to the fourth quarter of 2012, we did not recognize any favorable loss emergence. As a result, during some periods, we recognized net adverse prior year reserve development for insurance liability business in light of unfavorable loss emergence for certain reserve class and accident year combinations.
There are additional risks affecting our ability to accurately estimate ultimate losses for catastrophic events. For example, the estimates of loss reserves related to hurricanes and earthquakes can be affected by factors including, but not limited to, the inability to access portions of impacted areas, infrastructure disruptions, the complexity of factors contributing to losses, legal and regulatory uncertainties, complexities involved in estimating business interruption losses and additional living expenses, the impact of demand surge, fraud and the limited nature of information available. For hurricanes, additional complex coverage factors may include determining whether damage was caused by flooding or wind, evaluating general liability and pollution exposures, and mold damage. The timing of a catastrophe, for example, near the end of a reporting period, can also affect the level of information available to us to estimate loss reserves for that reporting period. Results of operations for 2019 and 2018 were impacted by natural catastrophe activity (refer to 'Underwriting Results - Consolidated - Current Accident Year Loss Ratio' for further details).
While we believe that loss reserves at December 31, 2019 are adequate, new information, events or circumstances may result in ultimate losses that are materially greater or less than provided for in our loss reserves. As previously noted, there are many factors that may cause reserves to increase or decrease, particularly those related to catastrophe losses and long-tail lines of business.
At December 31, 2019, reinsurance recoverables as a percentage of loss reserves was 30% (2018: 29%). At December 31, 2019, reinsurance recoverables (excluding the provision for uncollectible amounts) that were collectible from reinsurers rated A- or better by A.M Best were 89.1% (2018: 89.5%). Refer to Item 8, Note 11 to the Consolidated Financial Statements 'Commitments and Contingencies' for an analysis of the credit risk associated with reinsurance recoverable on unpaid and paid losses and loss expenses at December 31, 2019.
The recognition of reinsurance recoverable balances requires two key estimates. The first estimate is the amount of losses reserves to be ceded to our reinsurers. This amount consists of amounts related to case reserves and amounts related to IBNR.
Consequently, we review reinsurance recoverable balances on a quarterly basis to estimate a provision for uncollectible amounts. Any adjustments to the provision for uncollectible amounts are recognized in the period in which they are determined.
We apply case-specific provisions against reinsurance recoverable balances that we deem unlikely to be collected in full. In addition, we use a default analysis to estimate a provision for uncollectible amounts on the remainder of the reinsurance recoverable balance. The principal components of the default analysis are reinsurance recoverable balances by reinsurer and default factors applied to estimate uncollectible amounts based on our reinsurers’ credit ratings. The default factors are based on a model developed by a major rating agency.
At December 31, 2019, the use of different assumptions within our approach could have a material effect on the provision for uncollectible amounts. To the extent the creditworthiness of our reinsurers deteriorates due to an adverse event affecting the reinsurance industry, such as a large number of catastrophes, uncollectible amounts could be significantly greater than the provision for uncollectible amounts. Given the various considerations used to estimate the provision for uncollectible amounts, we cannot precisely quantify the effect a specific industry event may have on the provision for uncollectible amounts.
Insurance premiums written are recorded in accordance with the terms of the underlying policies.
A limited amount of our insurance business is written on a line slip or proportional basis, where we assume an agreed proportion of the premiums and losses of a particular risk or group of risks along with other unrelated insurers. As premiums for this business are not identified in the policy, premiums are recognized at the inception of the policy based on estimates provided by clients through brokers (refer to 'Reinsurance Segment' below for further details). We review these premium estimates on a quarterly basis and any adjustments to premium estimates are recognized in the period in which they are determined. Gross premiums written on a line slip or proportional basis accounted for 13% and 12% of the segment’s gross premiums written for the years ended December 31, 2019 and 2018, respectively, therefore the impact of these premium estimates on pre-tax net income was immaterial.
In credit and political risk line of business, we write certain policies on a multi-year basis. Premiums in respect of these policies are recorded at the inception of the policy based on management’s best estimate of premiums to be received, including assumptions relating to prepayments/refinancing. At December 31, 2019, the average duration of unearned premiums for credit and political risk line of business was 5.9 years (2018: 5.7 years).
Premiums are earned over the period during which we are exposed to the underlying risk. Changes in circumstances subsequent to the inception of contracts can impact the earning periods. For example, when exposure limits for a contract are reached, any associated unearned premiums are fully earned. This can have a significant impact on net premiums earned, particularly for multi-year contracts such as those in credit and political risk line of business.
Fair value is defined as the price to sell an asset or transfer a liability (i.e. the "exit price") in an orderly transaction between market participants. U.S. GAAP prescribes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement. The hierarchy is broken down into three levels as follows:
on trade data, bids or offers, observed spreads and performance on newly issued securities. They may also establish pricing through observing secondary trading of similar securities.
At December 31, 2019 and 2018, we have not adjusted any pricing provided by independent pricing services (refer to 'Management Pricing Validation' below). In addition, total Level 3 fixed maturities and equity securities amounted to $8 million (2018: $87 million), less than 1% of total fixed maturities and equity securities (refer to Item 8, Note 6 to the Consolidated Financial Statements 'Fair Value Measurements' for further information).
The default and loss severity rates are the most judgmental unobservable market inputs to the discounted cash flow model to which the valuation of our indirect investment in CLO-Equities is most sensitive.
Other privately held investments include convertible preferred shares, common shares, convertible notes and notes payable. These securities are initially valued at cost which approximates fair value. In subsequent measurement periods, the fair values of these investments are generally determined using capital statements obtained from each investee. In 2018, the fair values of some of these investments were determined using an internally developed discounted cash flow model.
As the significant inputs used to price these investments are unobservable, the fair values of other privately held investments are classified as Level 3.
Overseas deposits include investments in private funds held by Syndicate 2007 in which the underlying investments are primarily U.S. government, Non-U.S. government and corporate debt securities. The funds do not trade on an exchange, therefore, are not included in available for sale investments. As the significant inputs used to price the underlying investments are observable market inputs, the fair values of overseas deposits are classified as Level 2.
the reason for the decline (e.g. credit spread widening, credit event, foreign exchange rate movements);
The following discussion provides further details regarding our processes for identification of impairments that are other-than-temporary for fixed maturities and the recognition of the related OTTI charges.
Fixed maturities classified as available for sale are reported at fair value at the balance sheet date. Our available for sale ("AFS") investment portfolio is the largest component of consolidated total assets and it is a multiple of shareholders’ equity. As a result, an OTTI charge could be material to our financial condition and operating results particularly during periods of dislocation in financial markets.
If a fixed maturity is impaired and we intend to sell the security or it is more likely than not that we will be required to sell the security before its anticipated recovery, the impairment is considered other-than-temporary. In these instances, the full amount of the impairment (i.e. the difference between the security’s fair value and its amortized cost) is charged to net income and is included in net investment gains (losses) in the consolidated statements of operations.
For impaired investment-grade securities (i.e. rated BBB- or above) that we do not intend to sell and it is more likely than not that we will not be required to sell, we have established some parameters for identifying securities with potential credit losses.
For impaired securities in our high yield portfolios that we do not intend to sell and it is more likely than not that we will not be required to sell, we have established separate parameters for credit loss assessment. Due to the additional volatility inherent in high yield securities relative to investment-grade securities, we focus on the severity of the impairment and work closely with our external high yield investment managers to identify securities with significant potential credit losses.
Refer to Item 8, Note 2(m) to the Consolidated Financial Statements 'Basis of Presentation and Significant Accounting Policies' for a discussion of recently issued accounting pronouncements that we have not yet adopted.
At December 31, 2019, we were not party to any off-balance sheet arrangements, as defined by Item 303(a)(4) of Regulation S-K to which an entity unconsolidated with the Company is a party that management believes is reasonably likely to have a current or future effect on its financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that we believe is material to investors.
We have audited the accompanying consolidated balance sheets of AXIS Capital Holdings Limited and subsidiaries (the "Company") as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive income, changes in shareholders' equity, and cash flows, for each of the three years in the period ended December 31, 2019, and the related notes and the schedules listed in the Index at Item 15 (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America.
We tested the effectiveness of controls over the valuation of the recorded loss and loss expense reserves, including the review and approval process that management has in place for significant actuarial methods and assumptions used and the approval of management’s best estimate of loss and loss expense reserves.
We independently developed an estimate of the reserves for selected classes of business, compared our estimates to those booked by the Company, and evaluated the differences.
We evaluated the Company’s methodologies against recognized actuarial practices for the remaining classes. We also evaluated the assumptions used by the Company using our industry knowledge and experience and other analytical procedures.
We compared the results of the reserve study prepared by third party actuaries to management’s best estimate and evaluated the differences.
In 2018, total consideration paid for an agreement for the Reinsurance to Close ("RITC") of the 2015 and prior years of account of Syndicate 2007 was $819 million of which $600 million was settled by way of a transfer of securities and was treated as a non-cash activity in the consolidated statement of cash flows (refer to Note 8 'Reserve for Losses and Loss Expenses').
AXIS Specialty Limited ("AXIS Specialty Bermuda"), a Bermuda domiciled company is licensed to provide specialty insurance and treaty reinsurance products on a worldwide basis. In addition, AXIS Specialty Bermuda conducts insurance and reinsurance business through its branch in Singapore, AXIS Specialty Limited (Singapore Branch).
AXIS Insurance Company, domiciled in Illinois and AXIS Reinsurance Company, domiciled in New York, together with AXIS Reinsurance Company (Canadian Branch) are licensed to offer a range of specialty insurance and treaty reinsurance products to a variety of niche markets on a worldwide basis. AXIS Surplus Insurance Company, domiciled in the state of Illinois is eligible to write insurance on a surplus lines basis.
The Company operates in the Lloyd's of London ("Lloyd's") market through its corporate members AXIS Corporate Capital UK Limited and AXIS Corporate Capital UK II Limited (formerly Novae Corporate Underwriting Limited), which provide 70% and 30%, respectively of AXIS Syndicate 1686's ("Syndicate 1686") capital support. AXIS Corporate Capital UK Limited was the sole corporate member of Syndicate 1686 until December 31, 2018. AXIS Syndicate 1686 is managed by AXIS Managing Agency Ltd.
AXIS Ventures Limited ("AXIS Ventures"), regulated by the BMA as an insurance manager, generates fee income from services provided to strategic capital partners.
These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") and the rules and regulations of the U.S. Securities and Exchange Commission ("SEC") and include AXIS Capital and its wholly-owned subsidiaries.
At December 31, 2018 the Company represented reinsurance recoverable on unpaid losses separately from reinsurance recoverable on paid losses in the consolidated balance sheets. This presentation was adopted to facilitate comparison to the reconciliation of beginning and ending net reserves for unpaid losses and loss expenses (refer to Note 8 'Reserve for Losses and Loss Expenses').
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. While management believes that the amounts included in the consolidated financial statements reflect its best estimates and assumptions, actual results could differ from those estimates. The Company’s principal estimates include:
Fixed maturities classified as available for sale are reported at fair value (refer to Note 6 'Fair Value Measurements'). The change in fair values of fixed maturities, net of tax is recognized in accumulated other comprehensive income (loss) ("AOCI") in the consolidated statement of changes in shareholders’ equity.
Net investment income includes interest income and the amortization of market premiums and discounts and is presented net of investment expenses. Investment income is recognized when earned. Purchases and sales of fixed maturities are recorded on a trade-date basis and realized investment gains (losses) on sales of fixed maturities are determined based on the specific identification method. Realized investment gains (losses) on fixed maturities are included in net investment gains (losses) in the consolidated statements of operations.
A fixed maturity is impaired if the fair value of the investment is below amortized cost. On a quarterly basis, the Company assesses whether unrealized losses on fixed maturities represent impairments that are other-than-temporary. The Company's impairment review process begins with a quantitative analysis to identify securities to be evaluated for potential OTTI. For identified securities, fundamental analysis is performed that considers the following quantitative and qualitative factors:
the historical and implied future volatility of the fair value; and
Net investment income includes dividend income and is presented net of investment expenses. Investment income is recognized when earned. Purchases and sales of equity securities are recorded on a trade-date basis and realized gains (losses) on sales of equity securities are determined based on the specific identification method. Realized gains (losses) on equity securities are included in net investment gains (losses) in the consolidated statements of operations.
Investments in which the Company has significant influence over the operating and financial policies of the investee are classified as equity method investments and are accounted for using the equity method of accounting. In applying the equity method of accounting, investments are initially recorded at cost and are subsequently adjusted based on the Company’s proportionate share of net income or loss of the investee. Adjustments are based on the most recently available financial information from the investee. Changes in the carrying value of these investments are recorded in net income as interest in income (loss) of equity method investments.
Insurance and reinsurance premiums balances receivable are reviewed for impairment at least quarterly and an allowance is established for amounts considered uncollectible.
Acquisition costs vary with and are directly related to the successful acquisition efforts of acquiring new or renewing existing insurance and reinsurance contracts and consist primarily of fees and commissions paid to brokers and premium taxes. Acquisition costs are shown net of commissions on reinsurance purchased. Net acquisition costs are deferred and charged to net income as the related premium is earned. Insurance and reinsurance premiums balance receivable is presented net of acquisition costs when contract terms provide for the right of offset.
Reserve for losses and loss expenses represents an estimate of the unpaid portion of the ultimate liability for losses and loss expenses for insured and reinsured events that have occurred at or before the balance sheet date. These amounts reflect claims that have been reported ("case reserves") and claims that have been incurred but have not yet been reported ("IBNR") and are reduced for estimated amounts of salvage and subrogation recoveries.
The Company reviews its reserve for losses and loss expenses on a quarterly basis. Case reserves are primarily established based on amounts reported by insureds and/or their brokers. Management estimates IBNR after reviewing detailed actuarial analyses and applying informed judgment regarding qualitative factors that may not be fully captured in the actuarial estimates. A variety of actuarial methods are utilized in this process, including the Expected Loss Ratio, Chain Ladder and Bornhuetter Ferguson methods. The estimate is highly dependent on management’s judgment as to which method(s) are most appropriate for a particular accident/underwriting year and line of business. Historical claims data is often supplemented with industry benchmarks when applying these methodologies.
Reinsurance recoverable is presented net of a provision for uncollectible amounts, reflecting the amount the Company believes ultimately will not be recovered from reinsurers due to insolvency, contractual disputes over contract language or coverage and/or some other reason. The Company applies case specific provisions against reinsurance recoverable balances that it deems unlikely to be collected in full. In addition, the Company uses a default analysis to estimate the provision for uncollectible amounts on the remainder of the reinsurance recoverable balance.
The functional currency of the Company and the majority of its subsidiaries is the U.S. dollar. All foreign currency transactions are initially measured and recorded in functional currency using the rates of exchange prevailing at the transaction date.
The Company’s reporting currency is the U.S. dollar. Assets and liabilities of the Company's subsidiaries and branches where the functional currency is not the U.S. dollar, are translated into U.S. dollars using the rates of exchange in effect at the balance sheet date, and revenue and expenses are translated using the weighted average foreign exchange rates for the period. The effect of translation adjustments is reported as a separate component of AOCI in the consolidated statements of change shareholders’ equity.
From time to time the Company may also enter into insurance and reinsurance contracts that meet the Financial Accounting Standards Board's ("FASB") definition of a derivative contract.
The Company tests goodwill and indefinite intangible assets for potential impairment during the fourth quarter each year and between annual tests if an event occurs or changes in circumstances indicate that the asset is impaired. Such events or circumstances may include an economic downturn in a geographic market or a change in the assessment of future operations.
For the purpose of evaluating indefinite lived intangibles for impairment, the Company may first perform a qualitative assessment to determine whether it is necessary to perform the quantitative impairment test. If the Company elects to perform a qualitative assessment, it first assesses qualitative factors to determine whether it is more likely than not that an indefinite lived intangible asset is impaired. If the Company determines that it is not more likely than not that the indefinite lived intangible asset is impaired, the Company performs the quantitative impairment test.
For other definite lived intangible asset the Company tests for recoverability whenever events or changes in circumstances indicate its carrying amount may not be recoverable. The Company recognizes an impairment loss if the carrying amount of the asset is not recoverable and exceeds its fair value. The carrying amount of a definite lived intangible asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset.
Effective January 1, 2019, the Company adopted ASU 2016-02, "Leases (Topic 842)," which provides a new comprehensive model for lease accounting. Topic 842 requires a lessee to recognize a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. The adoption of this standard resulted in the recognition of lease liabilities and right-of-use assets of $150 million in the Company's consolidated balance sheet at January 1, 2019, which are related to office property and equipment leases.
The Company also elected the package of practical expedients permitted under the transition guidance of Topic 842, which were elected as a package and applied consistently to all leases. At the adoption date, the package of practical expedients permitted the Company to not reassess the following:
Further, the Company made an accounting policy election to not record office property and equipment leases with an initial term of 12 months or less (short-term) in the Company's consolidated balance sheets. For the year ended December 31, 2019, the Company recognized expenses for short-term leases of $1.1 million in the Company's consolidated statements of operations. The adoption of this guidance did not impact the Company's retained earnings or liquidity and it did not have a material impact on the Company's results of operations.
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments," which replaces the "incurred loss" impairment methodology with an approach based on "expected losses" to estimate credit losses on certain types of financial instruments and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The Company's mortgage loans, held for investment, insurance and reinsurance premium balances receivable and its reinsurance recoverables on unpaid and paid losses and loss expenses are its more significant financial assets within the scope of ASU 2016-13. The guidance requires financial assets to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the cost of the financial asset to present the net carrying value at the amount expected to be collected on the financial asset. This guidance is effective for interim and annual periods beginning after December 15, 2019. The Company does not anticipate that the adoption of this guidance will have a material impact on its results of operations, financial condition or liquidity.
The following tables present the underwriting results of the Company's reportable segments, as well as the carrying amounts of allocated goodwill and intangible assets:
In connection with the acquisition of Contessa Limited, the Company recognized goodwill of $1 million.
of $4 million was recognized related to the termination of the Managing General Agent ("MGA") contract intangible asset identified in connection with the acquisition of Novae.
(1) On May 1, 2007, the Company acquired the assets and operations of Media/Professional Insurance (Media/Pro) and recognized the definite life intangible assets detailed above.
The estimated remaining useful lives of finite lived intangible assets range from 2 to 13 years.
In the normal course of investing activities, the Company actively manages allocations to non-controlling tranches of structured securities which are variable interests issued by Variable Interest Entities ("VIEs"). These structured securities include RMBS, CMBS and ABS.
At December 31, 2019, 1,190 fixed maturities (2018: 3,599) were in an unrealized loss position of $32 million (2018: $215 million) of which $5 million (2018: $49 million) was related to securities below investment grade or not rated.
At December 31, 2019, 497 fixed maturities (2018: 1,656) had been in a continuous unrealized loss position for twelve months or greater and had a fair value of $998 million (2018: $3,570 million). Following a credit impairment review, it was concluded that these securities as well as the remaining securities in an unrealized loss position were temporarily impaired at December 31, 2019, and were expected to recover in value as the securities approach maturity. At December 31, 2019, the Company did not intend to sell the securities in an unrealized loss position and it is more likely than not that the Company will not be required to sell these securities before the anticipated recovery of their amortized costs.
The following table provides details of the Company's mortgage loans held-for-investment:
Long/short equity funds: Seek to achieve attractive returns primarily by executing an equity trading strategy involving long and short investments in publicly-traded equity securities.
Two common redemption restrictions which may impact the Company's ability to redeem hedge funds are gates and lockups. A gate is a suspension of redemptions which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the fund’s net assets which may otherwise hinder the general partner or investment manager’s ability to liquidate holdings in an orderly fashion in order to generate the cash necessary to fund extraordinarily large redemption payouts. A lockup period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. During 2019 and 2018, neither of these restrictions impacted the Company's redemption requests. At December 31, 2019, $69 million (2018: $27 million), representing 41% (2018: 14%) of total hedge funds, relate to holdings where the Company is still within the lockup period. The expiration of these lockup periods range from October 2020 to March 2022.
At December 31, 2019, the Company had $170 million (2018: $210 million) of unfunded commitments as a limited partner in direct lending funds. Once the full amount of committed capital has been called by the General Partner of each of these funds, the assets will not be fully returned until the completion of the fund's investment term. These funds have investment terms ranging from five to ten years and the General Partners of certain funds have the option to extend the term by up to three years.
At December 31, 2019, the Company had $24 million (2018: $84 million) of unfunded commitments as a limited partner in multi-strategy hedge funds. Once the full amount of committed capital has been called by the General Partner of each of these funds, the assets will not be fully returned until after the completion of the funds' investment term. These funds have investment terms ranging from two years to the dissolution of the underlying fund.
At December 31, 2019, the Company had $261 million (2018: $16 million) of unfunded commitments as a limited partner in private equity funds. The life of the funds is subject to the dissolution of the underlying funds. The Company expects the overall holding period to be over five years.
During 2015, the Company made a $50 million commitment as a limited partner of a bank revolver opportunity fund. The fund has an investment term of seven years and the General Partners have the option to extend the term by up to two years. At December 31, 2019, this commitment remains unfunded. It is not anticipated that the full amount of this fund will be drawn.
During 2016, the Company paid $108 million including direct transaction costs to acquire 19% of the common equity of Harrington Reinsurance Holdings Limited ("Harrington"), the parent company of Harrington Re Ltd. ("Harrington Re"), an independent reinsurance company jointly sponsored by the Company and The Blackstone Group L.P. ("Blackstone"). Through long-term service agreements, the Company will serve as Harrington Re's reinsurance underwriting manager and Blackstone will serve as exclusive investment management service provider. As an investor, the Company expects to benefit from underwriting profit generated by Harrington Re and the income and capital appreciation Blackstone seeks to deliver through its investment management services. In addition, the Company has entered into an arrangement with Blackstone under which underwriting and investment related fees will be shared equally. Harrington is not a VIE that is required to be included in the Company's consolidated financial statements. The Company accounts for its ownership interest in Harrington under the equity method of accounting. The Company's proportionate share of the underlying equity in net assets resulted in a basis difference of $5 million which represents initial transactions costs.
The following table summarizes the OTTI charge recognized in net income by asset class:
Non-U.S. government securities are evaluated for credit losses primarily through qualitative assessments of the likelihood of credit losses using information such as duration, severity of unrealized losses, credit ratings and price volatility. At December 31, 2019, the Company's holdings of non-U.S. government securities, including $37 million (2018: $29 million) relating to the eurozone countries, were substantially all investment-grade securities. At December 31, 2019, the gross unrealized losses of $2 million (2018: $16 million) were mainly due to foreign exchange losses. At December 31, 2019, the Company does not anticipate any credit losses on its non-U.S. government fixed maturities. In 2019, the OTTI charge on non-U.S. government fixed maturities mainly related to unrealized foreign exchange losses on certain securities where the forecasted recovery of the amortized cost of these securities was uncertain.
To estimate credit losses for corporate debt securities, the Company's projected cash flows are primarily driven by assumptions regarding the probability of default and the severity associated with those defaults. The Company's default and loss severity rates are based on credit rating, credit analysis, industry analyst reports and forecasts, Moody’s historical default data and any other data relevant to the recoverability of the security. In 2019, the OTTI charge on corporate debt securities mainly related to loss severity, unrealized foreign exchange losses on certain securities where the forecasted recovery of the amortized cost of these securities was uncertain, and instances where the Company intended to sell securities before the forecasted recovery of the amortized cost of these securities.
To estimate credit losses for non-agency RMBS, the Company's projected cash flows incorporated underlying data from widely accepted third-party data sources along with certain internal assumptions and judgments regarding the future performance of the security. These assumptions included default, delinquency, loss severity and prepayment rates. The assumptions used to calculate credit losses in 2019 have not changed significantly since December 31, 2018.
At December 31, 2019, the fair value of the Company's non-agency RMBS was $85 million (2018: $41 million), consisting primarily of $54 million (2018: $31 million) of Prime and $11 million (2018: $5 million) of Alt-A MBS. At December 31, 2019, the Company does not anticipate any credit losses on its non-agency RMBS.
The Company's investments in ABS consist mainly of CLO debt tranched securities ("CLO Debt") purchased primarily as new issues during 2017 and 2018. Substantially all of these new issues had credit ratings of AA or better. The Company utilizes a scenario-based approach to review its CLO Debt portfolio based on the current asset market price. The Company also reviews subordination levels of these securities to determine their ability to absorb credit losses of underlying collateral. If losses are forecast to be below the subordination level for a tranche held by the Company, the security is determined not to be impaired. At December 31, 2019, the Company does not anticipate any credit losses on its CLO Debt.
At December 31, 2019 collateral held in trust for third-party agreements of $1,856 million included $365 million (2018: $403 million) of fixed maturities and equity securities, and cash of $16 million (2018: $39 million) held on deposit to support the underwriting activities of Syndicate 2007, and also included $169 million (2018: $nil) of fixed maturities and equity securities, and cash of $181 million (2018: $154 million) held on deposit to support the underwriting activities of Syndicate 1686.
The table below provides the fair values of the Company's restricted investments and cash:
At December 31, 2019, the Company held no (2018: $189 million) reverse repurchase agreements. These loans are fully collateralized, are generally outstanding for a short period of time and are presented on a gross basis as part of cash and cash equivalents in the Company's consolidated balance sheets. The required collateral for these loans is either cash or U.S. Treasuries at a minimum rate of 102% of the loan principal. At maturity, the Company receives principal and interest income. The Company monitors the estimated fair value of the securities loaned and borrowed on a daily basis with additional collateral obtained as necessary throughout the duration of the transaction.
Accordingly, the degree of judgment exercised by management in determining fair value is greatest for financial instruments categorized as Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many financial instruments. This may lead the Company to change the selection of valuation technique (from market to cash flow approach) or may cause the Company to use multiple valuation techniques to estimate the fair value of a financial instrument. This circumstance could cause an instrument to be reclassified between levels within the fair value hierarchy.
CMBS mainly include investment-grade bonds originated by non-agencies. The fair values of these securities are determined using a pricing model which uses dealer quotes and other available trade information along with security level characteristics to determine deal specific spreads. As the significant inputs used to price these securities are observable market inputs, the fair values of CMBS are generally classified as Level 2. Where pricing is unavailable from pricing services, the Company obtains non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, the fair values of these securities are classified as Level 3.
The fair value of an indirect investment in CLO-Equities is estimated using an income approach valuation technique, specifically an externally developed discounted cash flow model due to the lack of observable and relevant trades in secondary markets. As the significant inputs used to price this security are unobservable, the fair value of the indirect investment in CLO-Equities is classified as Level 3.
Other underwriting-related derivatives include insurance and reinsurance contracts that are accounted for as derivatives. These derivative contracts are initially valued at cost which approximates fair value. In subsequent measurement periods, the fair values of these derivatives are determined using internally developed discounted cash flow models. As the significant inputs used to price these derivatives are unobservable, the fair values of these contracts are classified as Level 3.
Cash settled awards comprise restricted stock units that form part of the Company's compensation program. Although the fair values of these awards are determined using observable quoted market prices in active markets, the restricted stock units are not actively traded. As the significant inputs used to price these securities are observable market inputs, the fair values of these liabilities are classified as Level 2.
On a quarterly basis, the Company's valuation process for its indirect investment in CLO-Equities includes a review of the underlying cash flows and key assumptions used in the discounted cash flow model. The above significant unobservable inputs are reviewed and updated based on information obtained from secondary markets, including information received from the managers of the Company's CLO-Equities investment. In order to assess the reasonableness of the inputs the Company uses in the discounted cash flow model, the Company maintains an understanding of current market conditions, historical results, and emerging trends that may impact future cash flows. In addition, the assumptions the Company uses in its models are updated through regular communication with industry participants and ongoing monitoring of the deals in which the Company participates.
If there is a reporting lag between the current period end and reporting date of the latest available fund valuation for any hedge fund, the Company estimates fair values by starting with the most recent fund valuation and adjusting for return estimates as well as any subscriptions, redemptions and distributions that took place during the current period. Return estimates are obtained from the relevant fund managers therefore the Company does not typically have a reporting lag in fair value measurements of these funds. Historically, the Company's valuation estimates incorporating these return estimates have not significantly diverged from the subsequently received NAVs.
At December 31, 2019, the carrying values of cash and cash equivalents including restricted amounts, accrued investment income, receivable for investments sold, certain other assets, payable for investments purchased and certain other liabilities approximated their fair values due to their short maturities. As these financial instruments are not actively traded, their fair values are classified as Level 2.
None of the Company's derivative instruments are designated as hedges under current accounting guidance.
The Company's insurance and reinsurance subsidiaries and branches operate in various countries. Some of its business is written in currencies other than the U.S. dollar, therefore the underwriting portfolio is exposed to significant foreign currency risk. The Company manages foreign currency risk by seeking to match its foreign-denominated net liabilities under insurance and reinsurance contracts with cash and investments that are denominated in the same currencies. The Company uses derivative instruments, specifically, forward contracts to economically hedge foreign currency exposures.
During 2013, the Company began to write derivative-based risk management products designed to address weather risks with the objective of generating profits on a portfolio basis. The majority of this business consisted of receiving a payment at contract inception in exchange for bearing the risk of variations in a quantifiable weather-related phenomenon, such as temperature. Where a client wished to minimize the upfront payment, these transactions were structured as swaps or collars. In general, the Company's portfolio of such derivative contracts was of short duration, with contracts being predominantly seasonal in nature. In order to economically hedge a portion of this portfolio, the Company also purchased weather derivatives. Effective July 1, 2017, the Company ceased writing derivative-based risk management products which address weather risks.
The Company's loss reserving process begins with the collection and analysis of paid and incurred claim data for each of the Company's segments. The segmental data is disaggregated by reserve class and further disaggregated by underwriting year and accident year. Underwriting year or accident year information is used to analyze the Company's business and to estimate reserves for losses and loss expenses. Reserve classes are selected to ensure that the underlying contracts have homogeneous loss development characteristics, while remaining large enough to make the estimation of trends credible. The Company's reserve classes are reviewed on a regular basis and adjusted over time as the Company's business evolves. The paid and incurred claim data, in addition to industry benchmarks, serves as a key input to many of the methods employed by the Company's actuaries. The relative weights assigned to the Company's historical loss data versus industry data vary based on a number of factors including the Company's historical track record and the development profile for the reserve class being evaluated (refer to 'Claim Tail Analysis' and 'Net Incurred and Paid Claims Development Tables By Accident Year' below for further details).
In earlier years, significant reliance was placed on industry benchmarks in establishing expected loss ratios and selecting loss development patterns. Over time, more reliance has been placed on historical loss experience in establishing these ratios and selecting these patterns where the Company believes the weight of its experience has become sufficiently credible for consideration. The weight given to the Company's experience differs for each of the three claim tail classes (refer to 'Claim Tail Analysis' below for further details). In establishing expected loss ratios for the insurance segment, consideration is given to a number of other factors, including exposure trends, rate adequacy on new and renewal business, ceded reinsurance costs, changes in claims emergence and underwriters’ view of terms and conditions in the market environment. For the reinsurance segment, expected loss ratios are based on a contract-by-contract review, which considers information provided by clients together with estimates provided by underwriters and actuaries about the impact of changes in pricing, terms and conditions and coverage. Market experience of some classes of business as compiled and analyzed by an independent actuarial firm has also been considered, as appropriate.
a review of the Company's portfolio of contracts performed to identify those contracts which may be exposed to the catastrophic event;
The Company's loss reserving process involves the collaboration of its underwriting, claims, actuarial, legal, ceded reinsurance and finance departments, includes various segmental committee meetings and culminates with the approval of a single point best estimate by the Company's Group Reserving Committee, which comprises senior management. In selecting this best estimate, management considers actuarial estimates and applies informed judgment regarding qualitative factors that may not be fully captured in these actuarial estimates. Such factors include, but are not limited to, the timing of the emergence of claims, volume and complexity of claims, social and judicial trends, potential severity of individual claims and the extent of Company historical loss data versus industry information. While these qualitative factors are considered in arriving at the point estimate, no specific provisions for qualitative factors are established.
On April 1, 2017, the Company acquired 100% ownership interest in Aviabel. At December 31, 2017, foreign exchange and other included reserves for losses and loss expenses of $79 million and reinsurance recoverable on unpaid and paid losses of $5 million related to this acquisition.
Medium-tail business consists primarily of insurance and reinsurance professional lines reserve classes, insurance credit and political risk reserve class and reinsurance credit and surety reserve class.
For the year ended December 31, 2018, the reinsurance professional lines reserve class recorded net favorable prior year reserve development of $21 million (2017: $44 million), reflecting generally favorable experience on older accident years as the Company continued to transition to more experienced based actuarial methods.
Long-tail business consists primarily of insurance and reinsurance liability reserve classes and reinsurance motor reserve class.
For the year ended December 31, 2019, the insurance liability reserve class recognized net adverse prior year reserve development of $25 million (2018: $22 million, 2017: $8 million). The net adverse prior year reserve development in 2019 was primarily related to reserve strengthening within the Company's U.S. excess casualty and U.S. primary casualty books of business. The net adverse prior year reserve development in 2018 was primarily related to reserve strengthening within the Company's U.S. excess casualty book of business. The net adverse prior year reserve development in 2017 was primarily attributable to reserve strengthening within the Company's run-off Bermuda excess casualty book of business.
For the year ended December 31, 2019, the reinsurance liability reserve classes recognized net favorable prior year reserve development of $31 million (2018: $23 million, 2017: $43 million). The net favorable prior year reserve development in 2019, 2018 and 2017 was due to progressively increased weight given by management to experience based indications on older accident years.
The following tables present net incurred and paid claims development by accident year, total incurred-but-not-reported liabilities plus expected development on reported claims, cumulative reported claims frequency and claims duration for each reserve class. The loss development tables are presented on an accident year basis for the insurance and reinsurance segments. The Company does not discount reserves for losses and loss expenses.
The reporting of cumulative claims frequency for the reserve classes within the insurance segment has been measured by counting the number of unique claim references including claim references assigned to nil and nominal case reserves. Claim references are grouped by claimant by loss event for each reserve class. For certain insurance facilities and business produced by managing general agents where underlying data is reported to the Company in an aggregated format, the information necessary to provide cumulative claims frequency is not available therefore reporting of claims frequency is deemed to be impracticable.
This reserve class includes property, terrorism, accident and health, and discontinued lines - Novae.
This reserve class includes the marine line of business which provides cover for traditional marine classes, including offshore energy, cargo, liability, recreational marine, fine art, specie, and hull and war. Offshore energy coverage includes physical damage, business interruption, operators extra expense and liability coverage for all aspects of offshore upstream energy, from exploration and construction through the operation and distribution phases. The complex nature of claims arising under marine policies tends to result in reporting and payment patterns that are longer than those of the property and other reserve class. Exposure to natural perils such as windstorm and earthquake can result in volatility.
This reserve class includes the aviation line of business which provides cover for hull and liability, and specific war cover primarily for passenger airlines but also for cargo operations, general aviation operations, airports, aviation authorities, security firms and product manufacturers. The claims reporting pattern varies by insurance coverage provided. Losses arising from war or terrorism and damage to hulls of aircraft are generally reported quickly compared with liability claims which involve passengers and third parties and generally exhibit longer reporting and payment patterns. To date, the claims reported to the Company have predominantly related to damage to hulls, therefore, reporting and payment patterns have typically exhibited a relatively short tail.
This reserve class includes the professional lines line of business which provides directors’ and officers’ liability, errors and omissions liability, employment practices liability, fiduciary liability, crime, professional indemnity, cyber and privacy insurance, medical malpractice and other financial insurance related covers for public and private commercial enterprises, financial institutions, not-for-profit organizations and other professional service providers. This reserve class also includes discontinued lines - Novae specifically the financial institutions and professional indemnity lines of business that Novae exited or placed into run-off in the first quarter of 2017. This business is predominantly written on a claims-made basis. Typically, this reserve class is anticipated to exhibit medium to long tail claim reporting and payment patterns.
With respect to key actuarial assumptions, the Company relies on its loss experience when establishing expected loss ratios and selected loss development patterns. Loss reporting patterns for professional lines business tend to be volatile, causing instability in actuarial indications based on incurred loss data until an accident year or underwriting year matures. Consequently, initial loss reserves for an accident year or underwriting year are generally based on an ELR Method and the consideration of relevant qualitative factors. As accident years and underwriting years mature, the Company increasingly gives more weight to methods that reflect its experience until its selections are based almost exclusively on experience-based methods. The Company evaluates the appropriateness of the transition to experience-based methods at the reserve class level, commencing this transition when it believes that its incurred loss development is sufficient to produce meaningful actuarial indications. The rate at which the Company transitions fully to sole reliance on experience-based methods can vary by reserve class and by year, depending on its assessment of the stability and relevance of such indications. For some professional lines in the insurance segment, the
Company also relies on the evaluation of the open claim inventory in addition to the commonly employed actuarial methods when establishing reserves.
This reserve class includes the liability line of business which primarily targets primary and low to mid-level excess and umbrella commercial liability risks in the U.S. wholesale markets in addition to primary and excess of loss employers, public and products liability business predominately in the U.K. This reserve class also includes discontinued lines - Novae specifically the international liability line of business that Novae exited or placed into run-off in the fourth quarter of 2016. Target industry sectors include construction, manufacturing, transportation and trucking and other services. The delay between the writing of a contract, notification and subsequent settlement of a claim in respect of that contract results in claim reporting and payment patterns that are typically long-tail in nature. A consequence of the claim development tail is that this line of business is particularly exposed, among a number of uncertainties, to the potential for unanticipated levels of claim inflation relative to that assumed when the contracts were written. Factors influencing claim inflation on this class can include, but are not limited to, underlying economic and medical inflation, judicial inflation, mass tort and changing social trends.
The reporting of cumulative claims frequency for the reserve classes within the reinsurance segment is deemed to be impracticable as the information necessary to provide cumulative claims frequency for these reserve classes is not available to the Company.
The catastrophe line of business provides protection for most catastrophic losses that are covered in the underlying insurance policies written by the Company's cedants. The underlying policies principally cover property-related exposures but other exposures including workers compensation and personal accident are also covered. The principal perils covered by policies in this portfolio include hurricane and windstorm, earthquake, flood, tornado, hail and fire. In some instances, terrorism may be a covered peril or the only peril. This business is written on a proportional and an excess of loss basis.
The property line of business provides protection for property damage and related losses resulting from natural and man-made perils contained in underlying personal and commercial lines insurance policies written by the Company's cedants. The predominant exposure is to property damage, but other risks, including business interruption and other non-property losses, may also be covered when arising from a covered peril. The most significant perils covered by policies in this portfolio include windstorm, tornado and earthquake, but other perils such as freezes, riots, floods, industrial explosions, fires, hail and a number of other loss events are also included. This business is written on a proportional and excess of loss basis.
The engineering line of business provides protection for all types of construction risks and risks associated with erection, testing and commissioning of machinery and plants during the construction stage. This line of business also includes coverage for losses arising from operational failures of machinery, plant and equipment, and electronic equipment as well as business interruption.
In general, reporting and payment patterns are relatively short-tailed and can be volatile due to the incidence of catastrophe events.
Initial and most recent underwriting year loss projections are generally based on the ELR Method, with consideration given to qualitative factors. Given that there is a quicker and more stable reporting pattern for trade credit and mortgage business, the Company generally commences the transition to experience-based methods sooner for these lines of business than for surety business.
The business written on a proportional basis has expanded significantly since 2010 and now represents the majority of the premium in this line of business. Most of the premium relates to a relatively small number of large United Kingdom ("U.K.") quota share reinsurance treaty contracts. The motor proportional class generally has a significantly shorter reported and payment pattern, relative to the motor non-proportional class.
The motor non-proportional business consists of standard excess of loss contracts written for cedants in several European countries with most of the premium related to two major markets, U.K. and France. Since 2009/2010, an increasing number of large bodily injury settlements in the U.K. market were settled using indexed annuities (Periodical Payment Orders "PPOs"). This led to a materially longer development tail on the older accident years for the U.K. non-proportional motor book. This also resulted in the inclusion of capitalization clauses on a number of U.K. motor treaties to help mitigate the lengthening of the development tail on more recent accident years.
The following table reconciles the reserve for losses and loss expenses at December 31, 2019 included in the loss development tables to the reserve for losses and loss expenses reported in the consolidated balance sheet:
Non-U.S. dollar denominated loss data is converted to U.S dollar at the rates of exchange in effect at the balance sheet date for material underlying currencies. Fluctuations in currency exchange rates may cause material shifts in loss development. Reserves for losses and loss expenses disclosed in the consolidated balance sheets are also remeasured using rates of exchange in effect at the balance sheet date.
All of these reinsurance contracts provide the Company with the right to recover a specified amount of losses and loss expenses from reinsurers. To the extent that reinsurers do not meet their obligations under these agreements due to solvency issues, contractual disputes over contract language or coverage and/or other reasons, the Company remains liable. The Company predominantly cedes its business to reinsurers rated A- or better by A.M. Best.
For the year ended December 31, 2019, the Company recognized ceded losses and loss expenses of $1,602 million (2018: $1,565 million; 2017: $1,010 million).
On April 1, 2019, AXIS Specialty Finance PLC, a 100% owned finance subsidiary, repaid $250 million aggregate principal amount of 2.650% Senior Notes at their stated maturity.
The Junior Notes accrue interest from the date of issuance to, but excluding, January 15, 2030 (the "Par Call Date") at the fixed rate of 4.900% and from, and including, the Par Call Date, at a rate equal to the Five-Year Treasury Rate as of the Reset Interest Determination Date, plus 3.186%. Interest of the Junior Notes is payable semi-annually on January 15 and July 15 of each year, beginning on July 15, 2020.
The Company has the option to redeem the Senior Notes at any time and from time to time, in whole or in part, at a ''make-whole'' redemption price, which is equal to the greater of the aggregate principal amount or the sum of the present values of the remaining scheduled payments of principal and interest. The related indentures contain various covenants, including limitations on liens on the stock of restricted subsidiaries, restrictions as to the disposition of the stock of restricted subsidiaries and limitations on mergers and consolidations. The Company was in compliance with all the covenants contained in the indentures at December 31, 2019.
The 4.900% Fixed-Rate Reset Junior Notes are ranked as unsecured junior subordinated obligations of AXIS Specialty Finance LLC, a 100% owned finance subsidiary. AXIS Capital has fully and unconditionally guaranteed all obligations of AXIS Specialty Finance LLC under the Junior Notes. AXIS Capital's obligation under this guarantee is an unsecured junior subordinated obligation and ranks equally with all future unsecured and junior subordinated obligations of AXIS Capital, and junior in right of payment to all outstanding and future senior obligations of AXIS Capital.
Interest expense recognized in relation to the Junior Notes includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period of time during which the Junior Notes are outstanding. For the year ended December 31, 2019, the Company incurred interest expense of $1 million.
On November 20, 2013, certain of AXIS Capital’s operating subsidiaries (the "Participating Subsidiaries") entered into an amendment to extend the term of the Company's secured $750 million letter of credit facility (the "$750 million Facility") with Citibank Europe plc ("Citibank") pursuant to a Master Reimbursement Agreement and other ancillary documents (together, the "LOC Facility Documents"). Under the terms of the $750 million Facility, letters of credit to a maximum aggregate amount of $750 million are available for issuance on behalf of the Participating Subsidiaries. These letters of credit are principally used to support the reinsurance obligations of the Participating Subsidiaries. The $750 million Facility is subject to certain covenants, including the requirement to maintain sufficient collateral, as defined in the LOC Facility Documents to cover all of the obligations under the $750 million Facility. Such obligations include contingent reimbursement obligations for outstanding letters of credit and fees payable to Citibank. In the event of default, Citibank may exercise certain remedies, including the exercise of control over pledged collateral and the termination of the availability of the $750 million Facility to any or all of the Participating Subsidiaries.
On March 28, 2019, the expiration date of the $250 million Facility was extended to March 31, 2020.
The Company monitors and manages the aggregation of credit risk on a group-wide basis allowing it to consider exposure management strategies for individual companies, countries, regions, sectors and any other relevant inter-dependencies. The Company's credit exposures are aggregated based on the origin of risk. As part of its credit aggregation framework, the Company also assigns aggregate credit limits by single counterparty (a group of companies or country). These limits are based on and adjusted for a variety of factors including the prevailing economic environment and the nature of the underlying credit exposures. The Company's credit aggregation measurement and reporting process is facilitated by its credit risk exposure database, which contains relevant information on counterparty details and credit risk exposures. The Company also licenses third-party tools to provide credit risk assessments.
In order to mitigate concentration and operational risks related to cash and cash equivalents, the Company limits the maximum amount of cash that can be deposited with a single counterparty and limits acceptable counterparties based on current rating, outlook and other relevant factors.
At December 31, 2019, the Company was in compliance with these limits.
At December 31, 2019, the three largest balances by reinsurer accounted for 12%, 10% and 9% (2018: 13%, 10% and 10%) of reinsurance recoverable on unpaid and paid losses and loss expenses.
At December 31, 2019, the Company recorded an allowance for estimated uncollectible premium balances receivable of $7 million (2018: $4 million).
For the year ended December 31, 2019, bad debt expense was $nil (2018: $nil; 2017: $nil).
The Company produces its business through brokers and direct relationships with insurance companies. For the year ended December 31, 2019, three brokers accounted for 47% (2018: 43%; 2017: 49%) of gross premiums written.
Marsh & McLennan Companies Inc. accounted for 18% (2018: 17%; 2017: 20%), Aon plc accounted for 19% (2018: 17%; 2017: 17%), and Willis Tower Watson PLC accounted for 10% (2018: 9%; 2017: 12%).
At December 31, 2019, investments and cash of $1.3 billion (2018: $1.3 billion) were restricted to satisfy the Company's FAL requirements (refer to Note 5 'Investments' and Note 21 'Statutory Financial Information').
In the ordinary course of business, the Company renews and enters into new leases for office property and equipment, which expire at various dates.
At the lease inception date, the Company assesses whether a contract is or contains a lease. At the commencement date, the Company determines the classification of each separate lease component as either a finance lease or an operating lease. The Company's leases are all currently classified as operating leases. For operating leases that have a lease term of more than 12 months, the Company recognizes a lease liability and a right-of-use asset in the Company's consolidated balance sheets at the present value of the lease payments at the lease commencement date.
At the commencement date, the Company determines lease terms by assuming the exercise of those renewal options that are deemed to be reasonably certain. The exercise of lease renewal options is at the sole discretion of the Company.
(1) Short-term lease expense is recognized on a straight-line basis over the lease term.
(3) Weighted-average remaining lease term was calculated on the basis of the remaining lease term and the lease liability balance for each lease at the reporting date.
The Company's lease for its office property in Alpharetta, Georgia, which expired on December 31, 2019 was extended to January 31, 2020. The Company executed a 15 year lease for a new office property in Alpharetta, Georgia. The Company was not involved in the construction or design of this office property and the commencement date of the lease is February 1, 2020. Given that the commencement date is after the balance sheet date, the Company has not reflected this lease in the maturity table above or in the Company's consolidated balance sheets at December 31, 2019. The total contractual lease costs over the 15 year lease is $40 million.
The following table presents the Company's future minimum lease payments at December 31, 2018:
Due to the net loss recognized for the year ended December 31, 2017, the share equivalents were anti-dilutive.
On January 17, 2020, the Company redeemed all 9,000,000 Series D preferred shares, for an aggregate liquidation preference of $225 million (refer to Note 23 'Subsequent Events').
The Company maintains defined contribution plans to provide retirement benefits to eligible employees. Contributions to the plans, which are managed externally, are based on eligible compensation.
For eligible U.S. employees, the Company provides a non-qualified deferred compensation plan that enables employees to make contributions to the plan that are in excess of those permitted under the Company's 401(k) Plan. In addition, employees are permitted to make additional contributions from any bonus received and to benefit from discretionary employer contribution to the Plan.
During 2019, total pension expenses were $28 million (2018: $27 million and 2017: $24 million) for the above retirement benefits.
In May 2017, shareholders approved the establishment of the AXIS Capital Holdings Limited 2017 Long-Term Equity Compensation Plan (the "2017 Plan"). The 2017 Plan provides for, among other things, the issuance of restricted shares, restricted stock units (share-settled awards and cash-settled awards), performance units (share-settled awards and cash-settled awards), stock options, stock appreciation rights and other equity-based awards to the Company's employees and directors. The 2017 Plan authorizes the issuance of a total of 3,400,000 common shares. The Company's 2017 Plan replaced its 2007 Long-Term Equity Compensation Plan ("2007 Plan") on expiration of the 2007 Plan in May 2017. All remaining shares available pursuant to the 2007 Plan have been canceled although awards made pursuant to the 2007 Plan prior to its expiration remain in effect in accordance with the terms of the 2007 Plan. At December 31, 2019, 2,565,143 equity-based awards remained available for grant pursuant to the 2017 Plan. The grant date fair value of each award is established at the fair market value of the Company's common shares at the date of grant.
Restricted shares granted pursuant to the 2007 Plan generally vest in accordance with a four year graded vesting schedule in four annual installments beginning on the grant date.
Share-settled restricted stock units granted pursuant to the 2017 Plan or the 2007 Plan either cliff vest at the end of a three year period, vest in accordance with a three year graded vesting schedule, or vest in accordance with a four year graded vesting schedule in four annual installments beginning on the grant date.
Cash-settled restricted stock units granted pursuant to the 2017 Plan or the 2007 Plan are liability awards and generally cliff vest at the end of a three year period, or vest in accordance with a four year graded vesting schedule in four annual installments beginning on the grant date.
Performance restricted stock units granted pursuant to the 2017 Plan or the 2007 Plan, represent the right to receive a specified number of common shares in the future, based on the achievement of established performance criteria and continued service during the applicable performance period. Awards granted pursuant to these plans generally cliff vest at the end of a three year period. Compensation expense is recognized on a straight-line basis over the applicable requisite service period and is subject to periodic adjustment based on the achievement of established performance criteria during the applicable performance period. Performance restricted stock units granted are either share-settled awards or cash-settled liability awards.
The following table provides an activity summary of the Company's share-settled restricted stock units:
The following table provides an activity summary of the Company's cash-settled restricted stock units:
(1) Related to restricted shares, share-settled stock units, and cash settled restricted stock units.
The Company's investment portfolio includes certain investments where it is considered to have the ability to exercise significant influence over the operating and financial policies of the investee. Significant influence is generally deemed to exist where the Company has an investment of 20% or more in the common stock of a corporation or an investment greater than 3% to 5% in closed end funds, limited partnerships, LLCs or similar investment vehicles. At December 31, 2019, the Company has $410 million (2018: $450 million) of investments where it is deemed to have the ability to exercise such significant influence. The Company generally pays management and performance fees to the investment managers of these investments. The Company considers all fees paid to the investment managers to be at market rates consistent with negotiated arms-length contracts.
Harrington and Harrington Re commenced operations in 2016 (refer to Note 5 'Investments'). The Company has the ability to exercise significant influence over the operating and financial policies of Harrington and Harrington Re. In the normal course of business, the Company entered into certain reinsurance transactions with Harrington Re. For the year ended December 31, 2019, the Company ceded reinsurance premiums of $247 million (2018: $194 million; 2017: $213 million) and ceded losses of $157 million (2018: $142 million; 2017: $119 million) to Harrington Re. In addition, Harrington Re paid certain acquisition costs and administrative fees to the Company. At December 31, 2019, the amount of reinsurance recoverable on unpaid and paid losses was $518 million (2018: $363 million) and the amount of ceded reinsurance payable included in insurance and reinsurance balances payable was $159 million (2018: $115 million) in the consolidated balance sheets. All transactions were conducted at market rates consistent with negotiated arms-length contracts.
AXIS Capital's 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 regulations. Should the U.S. subsidiaries pay a dividend outside the U.S. group, withholding taxes will apply. The Company's U.S. subsidiaries are not under examination but remain subject to examination for tax years 2016 through 2019.
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 following table provides details of the significant components of deferred tax assets and liabilities:
At December 31, 2019, all remaining operating and capital loss carryforwards and tax credits can be carried forward indefinitely.
At December 31, 2019 and 2018, the U.K. operating loss carryforward includes Lloyd's deferred year of account losses of $293 million and $403 million, respectively.
will produce significant taxable income in future periods and have deferred tax liabilities that will reverse in future periods, such that the Company believes sufficient ordinary taxable income is available to utilize all remaining ordinary deferred tax assets.
At December 31, 2019 and 2018, there were no unrecognized tax benefits.
Effective January 1, 2018, the Company adopted ASU No. 2016-01. The adoption of this guidance resulted in a cumulative adjustment to reclassify unrealized investment gains on equity securities from accumulated other comprehensive income to retained earnings. Refer to Item 8, Note 2 'Basis of Presentation and Significant Accounting Policies' to the consolidated financial statements for additional information.
The following table presents details of amounts reclassified from accumulated other comprehensive income ("AOCI") to net income (loss):
On March 27, 2017, as part of the wind down of the Company's Australia operation, the Australia Prudential Regulation Authority revoked the authorization of AXIS Specialty Australia to carry on insurance business in Australia. As this resulted in the substantial liquidation of AXIS Specialty Australia, the Company released the cumulative translation adjustment related to AXIS Specialty Australia of $24 million from AOCI in the consolidation balance sheet to foreign exchange losses (gains) in the consolidated statement of operations.
Under the Act, AXIS Specialty Bermuda is restricted as to the payment of dividends for amounts greater than 25% of the prior year’s statutory capital and surplus, whereby an affidavit signed by at least two members of the Board of Directors is required, attesting that any dividend in excess of this amount would not cause the Company to fail to meet its relevant margins. At December 31, 2019, the maximum dividend AXIS Specialty Bermuda could pay, without a signed affidavit, having met minimum levels of statutory capital and surplus requirements, was approximately $844 million (2018: $864 million).
Effective January 1, 2016, the Company's Irish subsidiaries, AXIS Specialty Europe and AXIS Re SE, are required to maintain the Minimum Capital Requirement ("MCR") and the Solvency Capital Requirement ("SCR") at all times. The capital requirements are calculated by reference to Solvency II definitions. If an entity falls below the MCR or SCR, the Central Bank of Ireland is authorized to take action to restore the financial position of the Company's Irish subsidiaries. During 2019 and 2018, the Company's Irish subsidiaries were in compliance with these requirements.
AXIS Capital UK II Limited is the sole corporate member of Syndicate 2007. Novae Syndicates Limited ("NSL") managed Syndicate 2007 and SPA 6129, until it was deregistered on January 1, 2018. On January 1, 2018, the Company received authorization from Lloyd’s for AXIS Managing Agency to commence management and oversight of Syndicate 2007 and SPA 6129.
Each year, corporate members can apply to Lloyd's to release accumulated funds, whether syndicate profits or interest on FAL, which are in excess of the agreed FAL requirements. At December 31, 2019 and 2018, actual capital and assets exceeded the FAL requirements for Syndicates 1686 and 2007.
During 2019, AXIS Corporate Capital UK II Limited released $47 million of funds in relation to the projected December 31, 2019 FAL requirement. AXIS Corporate Capital UK Limited did not release any funds during 2019. During 2018, Syndicates 1686 and 2007 did not apply to release funds for the year ended December 31, 2018.
Consolidated underwriting income is a pre-tax measure of underwriting profitability that takes into account net premiums earned and other insurance related income (loss) as revenues and net losses and loss expenses, acquisition costs and underwriting-related general and administrative expenses as expenses. Consolidated underwriting income (loss) is a non-GAAP financial measure as defined in Item 10(e) of SEC Regulation S-K. The reconciliation to income (loss) before income taxes and interest in income (loss) of equity method investments, the most comparable GAAP financial measure, is provided in Note 3 'Segment Information'.
On January 17, 2020, the Company redeemed all 9,000,000 Series D preferred shares, for an aggregate liquidation preference of $225 million (refer to Note 14 'Shareholder's Equity').