The following selected consolidated GAAP financial data of the Company as of and for the years ended December 31, 2008, 2007, 2006, 2005 and 2004 were derived from the consolidated financial statements of the Company, which were audited by PricewaterhouseCoopers LLP. The following financial data should be read in conjunction with the Consolidated Financial Statements and accompanying notes.
Catastrophe losses are presented net of reinsurance and reinstatement premiums. A catastrophe is defined, for purposes of the consolidated Selected Financial Data, as an event that caused a pre-tax loss on property exposures before reinsurance of at least $5.0 million before corporate level reinsurance and taxes. Catastrophe insurance provides coverage for one event. When limits are exhausted, some contractual arrangements provide for the availability of additional coverage upon the payment of additional premium. This additional premium is referred to as reinstatement premium.
Worldwide insurance and reinsurance market conditions continued to be very competitive. Generally, there was ample insurance and reinsurance capacity relative to demand. We noted, however, that in many markets and lines, the rates of decline have slowed, pricing in some segments was relatively flat and there was upward movement in some others. Competition and its effect on rates, terms and conditions vary widely by market and coverage yet continues to be most prevalent in the U.S. casualty insurance and reinsurance
January, 2009, renewal rates, particularly for property catastrophes and retrocessional covers and in international markets were generally firmer compared to a year ago.
Net Realized Capital (Losses) Gains. Net realized capital losses were $695.8 million for 2008, while 2007 and 2006 had net realized capital gains of $86.3 million and $35.1 million, respectively.
Net realized gains in 2007 consisted of $76.6 million in changes in fair value of the equity securities and $18.1 million from sales of equity securities and fixed maturity securities, partially offset by $8.4 million of other-than-temporary impairments of the fixed maturity securities. Net realized gains in 2006 were the result of sales from fixed maturities of $12.8 million and equity securities of $22.3 million.
Net Derivative Expense. In 2005 and prior, we sold seven equity index put options, which are outstanding. These contracts meet the definition of a derivative under FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). We recognized net derivative expense of $20.9 million, $2.1 million and $0.4 million for 2008, 2007 and 2006, respectively. The net derivative expense represents changes in the fair value of these contracts. The increased expense in 2008 was driven by declines in the underlying indexes and interest rates, which are the primary determinants of the contracts’ fair values.
We experienced $24.4 million of adverse reserve development on our attritional reserves in 2008 compared to $188.7 million of favorable reserve development in 2007. The adverse development in 2008 was the result of $85.3 million of development on loss reserves for a run-off auto loan credit insurance program and
a $32.6 million adverse arbitration decision. These items more than offset approximately $93.5 million of favorable development on the remainder of our attritional reserves.
Catastrophe losses, at $364.3 million, were $204.3 million higher than in 2007, driven by hurricanes Gustav and Ike and a major snowstorm in China. While 2008 ranks as one of the costliest years on record for insured natural catastrophe losses, our losses were generally in line with our modeled expected annual aggregate catastrophe losses as developed through our enterprise risk and catastrophe exposure management processes.
Incurred losses and LAE increased by $113.7 million, or 4.7%, in 2007 compared to the same period in 2006. This increase was primarily due to a $280.9 million increase in A&E loss reserve strengthening, which was partially offset by lower catastrophe losses of $127.9 million and lower attritional losses of $39.3 million. The increase in A&E reserves was due to an extensive in-house study by our actuarial and claim units. The decrease in catastrophe losses reflects the decrease in prior years’ development.
Commission, Brokerage, Taxes and Fees. Commission, brokerage, taxes and fees decreased by $31.1 million, or 3.2%, in 2008 compared to 2007. This directly variable expense was influenced by the decline in net earned premiums partially offset by higher commission rates on new insurance programs, higher contingent commissions and higher ceding commissions on some reinsurance treaties due to more competitive market conditions as well as business mix.
Commission, brokerage, taxes and fees increased by $78.5 million, or 8.9% in 2007 compared to 2006. The increase in net earned premiums, an increase in ceding commissions due to market conditions and higher commissions on new insurance programs were the principal drivers of the increase.
Other underwriting expenses for 2007 were $152.6 million compared to $138.0 million for 2006. The increase was primarily due to higher compensation and benefits expense resulting from increased staff, primarily in the U.S. Insurance segment. Included in other underwriting expenses were corporate expenses of $13.1 million and $26.5 million for 2007 and 2006, respectively. The decrease was primarily due to the allocation of share-based compensation expense in 2007 to segments.
Interest, Fees and Bond Issue Cost Amortization Expense. Interest and other expense was $79.2 million and $91.6 million for 2008 and 2007, respectively. The decrease was primarily due to the acceleration of amortization of the bond issue costs for the junior subordinated debt securities which were retired in November, 2007, with no such expense in 2008. In addition, the interest reduction on the retired junior subordinated notes was partially offset by the interest on the new long term notes.
Interest and other expense was $91.6 million and $69.9 million for 2007 and 2006, respectively. The increase was due to the new long term notes we issued in April, 2007 and the acceleration of the amortization of the bond issue costs associated with the November 15, 2007 early retirement of the 7.85% junior subordinated debt securities.
Our combined ratio increased by 1.9 points to 91.6% in 2007 compared to 89.7% in 2006. The loss ratio component increased 0.5 points for 2007, principally due to prior year A&E losses. The commission and brokerage ratio component increased by 1.2 points for 2007. The underwriting expense ratio component increased minimally by 0.2 points for 2007.
Shareholders’ equity increased by $577.1 million to $5,684.8 million in 2007 from $5,107.7 million in 2006, principally as a result of the $839.3 million of net income, $65.4 million from foreign currency translation adjustments, unrealized appreciation and pension adjustments, and $35.1 million of share-based compensation transactions, partially offset by the repurchase of 2.5 million common shares at a cost of $241.6 million and the payment of $121.4 million of shareholder dividends.
Net investment income increased 8.4% to $682.4 million in 2007 from $629.4 million in 2006, primarily due to a growth in invested assets to $14.9 billion at December 31, 2007 from $14.0 billion at December 31, 2006. The asset growth emanated largely from continued positive cash flow from operations.
Gross written premiums decreased by 10.7% to $1,193.5 million for 2007 from $1,336.7 million for 2006, primarily due to a $202.6 million (37.9%) decrease in treaty casualty volume and a $70.5 million (32.7%) decrease in facultative volume, partially offset by a $126.8 million (21.6%) increase in treaty property volume. The increase in treaty property writings emanated principally from new quota share treaties. The more competitive environment for the U.S. casualty business resulted in reduced opportunities to write this business profitably. Net written premiums decreased 11.2% to $1,183.1 million for 2007 compared to $1,331.7 million for 2006, primarily due to the decrease in gross written premiums. Net premiums earned increased slightly to $1,282.9 million for 2007 compared to $1,281.1 million for 2006. The change in net premiums earned relative to net written premiums is the result of timing; premiums are earned ratably over the coverage period whereas written premiums are recorded at the initiation of the coverage period.
Incurred losses were $145.8 (11.4 points) lower for 2007 compared to 2006, primarily due to lower catastrophe losses. We experienced $181.7 million of catastrophe loss development in 2006 which did not recur in 2007, which contributed another 14.6 points. In addition, we had a greater amount of favorable reserve development related to prior years, which provided 7.0 points of improvement. These favorable factors were partially mitigated by an 18.6 point increase driven by asbestos reserve strengthening.
Segment Expenses.Commission and brokerage expenses decreased to $273.3 million for 2008 from $327.2 million in 2007 or by 16.5%, generally in line with the 18.1% decrease in net earned premiums. Segment other underwriting expenses for 2008 decreased slightly to $32.2 million from $33.3 million for 2007.
Premiums.Gross written premiums decreased by 12.9% to $771.8 million for 2008 from $885.6 million for 2007. Conditions for workers’ compensation, contractors and public entity business have gotten increasingly competitive, which has reduced the volume of business that meets our underwriting and pricing criteria. A little less than half of the shortfall compared to last year was from the C.V. Starr program, where we have lost public entity accounts because we did not match market pricing and terms. In addition, the $76.3 million of gross written premium we assumed on a new program in 2007 did not recur in 2008. Net written premiums decreased by 17.1% to $617.0 million for 2008 compared to $744.3 million for 2007. The decrease in net written premiums was larger than the decline in gross written premiums primarily due to increased reinsurance cessions. Net premiums earned decreased 4.1% to $705.5 million for 2008 from $735.9 million for 2007. The lesser reduction in net premiums earned relative to net written premiums is the result of timing; premiums are earned ratably over the coverage period whereas written premiums are reflected at the initiation of the coverage period.
Gross written premiums increased by 2.2% to $885.6 million for 2007 from $866.3 million for 2006. The increase is primarily the result of a new program we assumed late in 2007 with approximately $76 million of gross written premium. Absent this new program, gross written premiums would have decreased due to the further decline in our workers’ compensation and contractors liability writings in response to increased competition. Net written premiums decreased by 1.2% to $744.3 million for 2007 compared to $753.3 million for 2006 as our retention level fell slightly. Net premiums earned decreased 3.4% to $735.9 million for 2007 from $761.7 million for 2006, in line with the decrease in net written premiums.
Incurred losses and LAE decreased by 1.2% to $549.9 million for 2008 from $556.4 million for 2007 driven by the 4.1% decrease in net earned premium and a 2.3 point reduction in the current year loss ratio. In 2008, we strengthened reserves for an auto loan credit insurance program by $85.3 million as the deterioration in general economic conditions adversely impacted loan performance resulting in unforeseen increases in loan default rates and claim amounts. We had strengthened the reserves for this program by $64.7 million in 2007. We commuted our remaining liability on this program with the largest policyholder representing approximately one third of the remaining loss exposure. Given the magnitude of our current reserves, the maturity of the remaining insured portfolio and the reduced principal exposure, we believe future loss development, if any, related to this program will not be material. Other than as related to this run-off program, the segment experienced favorable reserve development in both 2008 and 2007.
Incurred losses and LAE increased by 7.0% to $556.4 million for 2007 from $519.9 million for 2006 as the segment loss ratio increased by 7.3 points to 75.6%. From a ratio perspective, the swing in prior years’ development from favorable in 2006 to adverse in 2007 resulted in 14.0 points of increase. The adverse development in 2007 was the result of $64.7 million of adverse reserve run-off on a canceled auto loan credit insurance program, partially offset by favorable development on the remainder of the reserves. The 2007 accident year loss ratio was 70.5% which was 6.7 points lower than 2006. The 2006 accident year loss ratio was negatively impacted by the auto loan credit insurance program discussed above.
Segment Expenses.Commission and brokerage increased by 7.7% to $146.7 million for 2008 from $136.2 million in 2007, principally due to higher commissions on two new programs. Segment other underwriting expenses for 2008 increased to $64.3 million as compared to $58.2 million for 2007, primarily due to increased compensation costs associated with increased staff.
Incurred losses and LAE increased 5.7% to $173.3 million for 2007 compared to $163.9 million for 2006, generally proportional to the increase in net earned premiums. The loss ratio for the current accident year was slightly lower in 2007 compared to 2006. We experienced 10.2 points of adverse development in 2007 compared to 9.3 points in 2006. Catastrophe loss development, principally within the marine business related to Hurricane Katrina, was the principal driver of the overall development in both 2007 and 2006.
Commission and brokerage increased 1.0% to $68.5 million in 2007 from $67.8 million in 2006 due primarily to premium growth. Segment other underwriting expenses increased 29.0% to $8.5 million for 2007 from $6.6 million for 2006, primarily due to the allocation of certain corporate charges to segments, which had been previously retained in corporate expenses.
Gross written premiums increased by 10.1% to $805.9 million for 2007 from $731.7 million for 2006. Approximately half of this increase was attributable to the impact of other currencies strengthening against the U.S. dollar. We wrote reinsurance contracts in multiple currencies and as these currencies strengthened and were converted to U.S. dollars for financial reporting, they converted to higher dollar values. Business written through the Miami and New Jersey offices increased by $35.0 million (8.0%), business written through the Asian branch increased by $22.3 million (15.6%) and business written through the Canadian branch increased by $17.9 million (11.8%). We have experienced strong fundamental growth in geographic areas where economic growth and demand for reinsurance is strong. Net written premiums increased by 10.3% to $806.0 million for 2007 compared to $730.7 million for 2006, principally as a result of the increase in gross written premiums. Net premiums earned increased 11.7% to $803.8 million for 2007 compared to $719.5 million for 2006, consistent with the increase in net written premiums.
Incurred losses and LAE increased by 31.1% to $501.9 million for 2007 compared to $382.8 million for 2006. The segment loss ratio increased by 9.2 points, principally due to an increase in the catastrophe loss ratio by 6.1 points. In 2007, catastrophe losses included Tabasco, Mexico floods, New South Wales storm, Peruvian earthquake, Hurricane Dean, and Jakarta flood. In addition, the reduction in favorable reserve development, year over year, accounted for the increase in the segment loss ratio in 2007 compared to 2006.
Segment Expenses.Commission and brokerage increased 15.8% to $230.9 million for 2008 from $199.5 million in 2007. The increase was principally due to the growth in premiums earned. In addition, the commission and brokerage ratio increased largely due to increased contingent commissions emanating from the profitable results. Segment other underwriting expenses for 2008 increased to $19.8 million compared to $18.6 million for 2007.
Incurred losses and LAE decreased 31.2% to $420.3 million for 2008 compared to $611.2 million for 2007. The principal driver of the decrease was the absence of development on A&E loss reserves in 2008, which reduced the segment loss ratio by 13.3 points.
Incurred losses and LAE increased 18.3% to $611.2 million for 2007 compared to $516.6 million for 2006. The segment loss ratio for Bermuda increased 6.0 points, reflecting a 5.8 point increase in catastrophe losses and a 3.9 point increase for A&E losses, partially offset by a 3.8 point decrease for attritional losses. The current year catastrophe losses include winter storm Kyrill and the June and July, 2007 London floods. The increase in A&E losses was due to the strengthening of asbestos reserves, principally for the direct business.
Segment Expenses.Commission and brokerage decreased 9.3% to $208.9 million for 2008 from $230.4 million for 2007, principally the result of a decline in premiums earned and the change in the mix of business. Segment other underwriting expenses for 2008 increased to $24.2 million compared to $20.9 million for 2007, primarily due to a general increase in operations to support the business.
Commission and brokerage increased 7.8% to $230.4 million for 2007 from $213.7 million for 2006, principally due to the increase in premiums earned. Segment other underwriting expenses for 2007 increased to $20.9 million compared to $17.2 million for 2006, primarily due to the allocation of certain corporate charges to segments, which had been previously retained in corporate expenses.
Our carried reserves at each reporting date are our best estimate of ultimate unpaid losses and LAE at that date. We complete detailed reserve studies for each exposure group annually for our reinsurance operations and quarterly for our insurance operations. The completed annual reinsurance reserve studies are “rolled forward” for each accounting period until the subsequent reserve study is completed. The roll-forward process involves comparing actual reported losses to expected losses based on the most recent reserve study. We analyze significant variances between actual and expected losses and post adjustments to our reserves as warranted.
We have direct relationships with Mt. McKinley policyholders and we attempt to uphold our contractual rights and assert valid defenses to coverage where appropriate. The uncertainties inherent in asbestos coverage and bankruptcy litigations have provided us the opportunity to engage in settlement negotiations with a number of policyholders who have potentially significant asbestos liabilities. Those discussions are aimed at achieving reasonable negotiated settlements that limit Mt. McKinley’s liability to a given policyholder to a sum certain. Because of the risks and uncertainties inherent in litigation, we cannot be certain that this approach will lead to a negotiated settlement in the range expected by us in each or every instance. Between 2004 and 2008, we concluded settlements or reached agreement in principle with 19 of our high profile policyholders. We continue the approach of attempting to negotiate with such policyholders that may have significant asbestos liabilities, in part because their exposures have developed to the point where we and the policyholder have sufficient information to be motivated to settle. We believe that this active approach will ultimately result in a more cost-effective liquidation of Mt. McKinley’s liabilities than a passive approach, although it may also introduce additional variability in Mt. McKinley’s losses and cash flows as reserves are adjusted to reflect the developments in litigation, negotiations and, ultimately, potential settlements.
Reinsurance Receivables. We have purchased reinsurance to reduce our exposure to adverse claim experience, large claims and catastrophic loss occurrences. Our ceded reinsurance provides for recovery from reinsurers of a portion of losses and loss expenses under certain circumstances. Such reinsurance does not relieve us of our obligation to our policyholders. In the event our reinsurers are unable to meet their obligations under these agreements or are able to successfully challenge losses ceded by us under the contracts, we will not be able to realize the full value of the reinsurance receivable balance. To minimize exposure from uncollectible reinsurance receivables, we have a reinsurance security committee that evaluates the financial strength of each reinsurer prior to our entering into a reinsurance arrangement. In some cases, we may hold full or partial collateral for the receivable, including letters of credit, trust assets and cash. Additionally, creditworthy foreign reinsurers of business written in the U.S. are generally required to secure their obligations. We have established reserves for uncollectible balances based on our assessment of the collectibility of the outstanding balances. As of December 31, 2008 and 2007, the reserve for uncollectible balances was $247.9 million and $173.0 million, respectively. Actual uncollectible amounts may vary, perhaps substantially, from such reserves, impacting income in the period in which the change in reserves is made. See also ITEM 8, “Financial Statements and Supplementary Data” - Note 13 of Notes to the Consolidated Financial Statements and “Financial Condition - Reinsurance Receivables” below.
The following table displays the estimated components of earned but not reported premiums by segment for the periods indicated:
As of December 31, 2008 and 2007, we had net unrealized losses, net of tax, of $163.4 million and net unrealized gains, net of tax, of $73.2 million, respectively. Gains and losses from market fluctuations for investments held at market value are reflected as comprehensive income in the consolidated balance sheets. Gains and losses from market fluctuations for investments held at fair value are reflected as net realized capital gains and losses in the consolidated statements of operations and comprehensive income (loss) in accordance with the provisions of FAS 159. Market value declines for the fixed income portfolio, which are considered other-than-temporary impairments are reflected in our consolidated statements of operations and comprehensive income (loss), as realized capital losses. We consider many factors when determining whether a market value decline is other-than-temporary, including: (1) our ability and intent to hold the security, (2) the length of time the market value has been below book value, (3) the credit strength of the issuer, (4) the issuer’s market sector, (5) the length of time to maturity and (6) for asset-backed securities, increases in prepayments, credit enhancements and underlying default rates. If management’s assessments change in the future, we may ultimately record a realized loss after management originally concluded that the decline in value was temporary. See also ITEM 8, “Financial Statements and Supplementary Data” - Note 1 of Notes to the Consolidated Financial Statements.
Cash and Invested Assets. Aggregate invested assets, including cash and short-term investments, were $13,714.3 million at December 31, 2008, a decrease of $1,221.9 million, compared to $14,936.2 million at December 31, 2007. This decrease was primarily the result of $657.6 million in foreign exchange losses on our portfolio securities and cash, $310.4 million of unrealized depreciation, a $276.0 million decline due to fair value adjustments, $243.3 million of net realized capital losses on sales, $176.5 million of other-than-temporary impairments, repurchases of 1.6 million of our common shares for $150.7 million and $118.6 million paid out in dividends to shareholders, partially offset by $663.0 million of cash flows from operations.
The pre-tax equivalent total return for the bond portfolio was approximately 2.1%, 5.7% and 5.3%, respectively, for 2008, 2007 and 2006. The pre-tax equivalent return adjusts the yield on tax-exempt bonds to the fully taxable equivalent.
Reinsurance Receivables. Reinsurance receivables for both paid and unpaid losses totaled $657.2 million at December 31, 2008 and $666.2 million at December 31, 2007. At December 31, 2008, $185.4 million, or 28.2%, was receivable from Transatlantic; $100.0 million, or 15.2%, was receivable from Continental; $57.0 million, or 8.7%, was receivable from Munich Re; $39.6 million, or 6.0%, was receivable from Ace; $36.9 million, or 5.6%, was receivable from Berkley and $33.8 million or 5.1% was receivable from C.V. Starr. The receivable from Continental is collateralized by a funds held arrangement under which we have retained the premiums earned by the retrocessionaire to secure obligations of the retrocessionaire, recorded them as a liability, credited interest on the balances at a stated contractual rate and reduced the liability account as payments become due. In addition, $227.3 million was receivable from Founders, for which the Company has recorded a full provision for uncollectibility. No other retrocessionaire accounted for more than 5% of our receivables.
Loss and LAE Reserves. Gross loss and LAE reserves totaled $8,840.7 million at December 31, 2008 and $9,040.6 million at December 31, 2007.
There can be no assurance that reserves for, and losses from, claim obligations will not increase in the future, possibly by a material amount. However, we believe that our existing reserves and reserving methodologies lessen the probability that any such increase would have a material adverse effect on our financial condition, results of operations or cash flows. In this context, we note that over the past 10 years, our calendar year operations have been affected by effects from prior period reserve re-estimates, ranging from a favorable $26.4 million in 2005, representing 0.5% of the net prior period reserves for the year in which the adjustment was made, to an unfavorable $249.4 million in 2004, representing 3.7% of the net prior period reserves for the year in which the adjustment was made.
Although totals are displayed for both the low and high range amounts, because of the statistical methods employed, the range of the total is not equal to the sum of the ranges of the segments.
Depending on the specific segment, the range derived for the loss reserves, excluding reserves for A&E exposures, ranges from minus 8.0% to minus 20.9% for the low range and from plus 8.0% to plus 20.9% for the high range. Both the higher and lower ranges are associated with the U.S. Insurance segment. The size of the range is dependent upon the level of confidence associated with the outcome. Within each range, our best estimate of loss reserves is based upon the point estimatederived by our actuaries in detailed reserve studies. Such ranges are necessarily subjective due to the lack of generally accepted actuarial standards with respect to their development. For the above presentation, we have assumed what we believe is a reasonable confidence level but note that there can be no assurance that our claim obligations will not vary outside of these ranges.
Additional losses, including those relating to latent injuries, and other exposures, which are as yet unrecognized, the type or magnitude of which cannot be foreseen by us or the reinsurance and insurance industry generally, may emerge in the future. Such future emergence, to the extent not covered by existing
retrocessional contracts, could have material adverse effects on our future financial condition, results of operations and cash flows.
Asbestos and Environmental Exposures. A&E exposures represent a separate exposure group for monitoring and evaluating reserve adequacy. The following table summarizes incurred losses and outstanding loss reserves with respect to A&E reserves on both a gross and net of retrocessions basis for the periods indicated:
Industry analysts use the “survival ratio” to compare the A&E reserves among companies with such liabilities. The survival ratio is typically calculated by dividing a company’s current net reserves by the three year average of annual paid losses. Hence, the survival ratio equals the number of years that it would take to exhaust the current reserves if future loss payments were to continue at historical levels. Using this measurement, our net three year asbestos survival ratio was 2.8 years for direct business and 11.6 years for reinsurance business at December 31, 2008. From a comparison perspective, A.M. Best published survival ratios as of December 31, 2007, the latest available information, of 8.2 years for the overall insurance industry and 13.6 years for the reinsurance sector.
Shareholders’ Equity. Our shareholders’ equity decreased to $4,960.4 million as of December 31, 2008 from $5,684.8 million as of December 31, 2007. This decrease was the result of unrealized depreciation on investments, net of tax, of $236.6 million, $193.3 million of foreign currency translation adjustments, the repurchase of 1.6 million common shares for $150.7 million, $118.6 million of shareholder dividends and a net loss of $18.8 million, partially offset by $18.7 million of additional paid in capital on share-based compensation transactions.
The Company’s shareholders’ equity increased to $5,684.8 million as of December 31, 2007 from $5,107.7 million as of December 31, 2006, principally due to $839.3 million of net income for the twelve months ended December 31, 2007, partially offset by the repurchase of 2.5 million common shares for $241.6 million and $121.4 million of shareholder dividends.
From time to time, we have used open market share repurchases to adjust our capital position and enhance long term expected returns to our shareholders. On July 21, 2008, our existing authorization to purchase up to 5 million of our shares was amended to authorize the purchase of up to 10 million shares. As of December 31, 2008, we had repurchased 4.2 million shares under this authorization.
On December 17, 2008, we renewed our shelf registration statement on Form S-3ASR with the SEC, as a Well Known Seasoned Issuer. This shelf registration statement can be used by Group to register common shares, preferred shares, debt securities, warrants, share purchase contracts and share purchase units; by Holdings to register debt securities and by Everest Re Capital Trust III (“Capital Trust III”) to register trust preferred securities.
The Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth. Minimum net worth is an amount equal to the sum of $3,575.4 million plus 25% of consolidated net income for each of Group’s fiscal quarters, for which statements are available ending on or after January 1, 2007 and for which consolidated net income is positive, plus 25% of any increase in consolidated net worth during such period attributable to the issuance of ordinary and preferred shares, which at December 31, 2008, was $3,856.5 million. As of December 31, 2008, the Company was in compliance with all Group Credit Facility covenants.
announced by Citibank as its prime rate or (b) 0.5% per annum above the Federal Funds Rate, in each case plus the applicable margin. The amount of margin and the fees payable for the Holdings Credit Facility depends upon Holdings’ senior unsecured debt rating.
The Holdings Credit Facility requires Holdings to maintain a debt to capital ratio of not greater than 0.35 to 1 and Everest Re to maintain its statutory surplus at $1.5 billion plus 25% of future aggregate net income and 25% of future aggregate capital contributions after December 31, 2005, which at December 31, 2008, was $1,821.1 million. As of December 31, 2008, Holdings was in compliance with all Holdings Credit Facility covenants.
At December 31, 2008 and 2007, there were outstanding letters of credit of $28.0 million and $17.2 million, respectively, under the Holdings Credit Facility.
Costs incurred in connection with the Group Credit Facility and the Holdings Credit Facility were $1.3 million and $1.4 million for December 31, 2008 and 2007, respectively.
We focus on potential losses that could result from any single event, or series of events as part of our evaluation and monitoring of our aggregate exposures to catastrophic events. Accordingly, we employ various techniques to estimate the amount of loss we could sustain from any single catastrophic event in various geographic areas. These techniques range from non-modeled deterministic approaches, such as tracking aggregate limits exposed in catastrophe prone zones and applying historic damage factors, to modeled approaches that scientifically measure catastrophe risks using sophisticated Monte Carlo simulation techniques that forecast frequency and severity of expected losses on a probabilistic basis.
No single universal model is currently capable of projecting the amount and probability of loss in all global geographic regions in which we conduct business. In addition, the form, quality and granularity of underwriting exposure data furnished by ceding companies is not uniformly compatible with the data requirements for our licensed models, which adds to the inherent imprecision in the potential loss projections. Further, the results from multiple models and analytical methods must be combined and interpolated to estimate potential losses by and across business units. The combination of techniques potentially adds to the imprecision of our estimates. Also, while most models have been updated to better incorporate factors that contributed to unprecedented industry storm losses in 2004 and 2005, such as flood, storm surge and demand surge, catastrophe model projections are inherently imprecise. In addition, uncertainties with respect to future climatic patterns and cycles add to the already significant uncertainty of loss projections from models using historic long term frequency and severity data.
be no assurance that any actual event will align with the modeled event or that actual losses from events similar to the modeled events will not vary materially from the modeled event PML.
We believe that our greatest worldwide 1 in 100 year exposure to a single catastrophic event is to a hurricane affecting the U.S. southeast coast, where we estimate we have a gross PML exposure of $845 million. See also table under ITEM 1, “Business - Risk Management of Underwriting and Retrocession Arrangements”.
If such a single catastrophe loss were to occur, management estimates that the economic loss to us would be approximately $534 million. The estimate involves multiple variables, including which Everest entity would experience the loss, and as a result there can be no assurance that this amount would not be exceeded.
Contractual Obligations. The following table shows our contractual obligations for the period indicated:
The contractual obligations for senior notes, long term notes and junior subordinated debt are the responsibility of Holdings. We have sufficient cash flow, liquidity, investments and access to capital markets to satisfy these obligations. Holdings generally depends upon dividends from Everest Re, its operating insurance subsidiary for its funding, capital contributions from Group or access to the capital markets. Our various operating insurance and reinsurance subsidiaries have sufficient cash flow, liquidity and investments to settle outstanding reserves for losses and LAE. Management believes that we, and each of our entities, have sufficient financial resources or ready access thereto, to meet all obligations.
implementation of FIN 48, we recorded no adjustment in the liability for unrecognized income tax benefits and no adjustment to beginning retained earnings.
In September 2006, the FASB issued FAS No. 157 “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value consistently in GAAP and expands disclosures about fair value measurements. We adopted FAS 157 as of January 1, 2007.
In September 2006, the FASB issued FAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“FAS 158”). FAS 158 requires an employer to (a) recognize in its financial statements an asset for a plan’s over funded status or a liability for a plan’s under funded status, (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year and (c) recognize changes in the funded status of a defined benefit post-retirement plan in the year in which the changes occur as other comprehensive income. We adopted FAS 158 for the reporting period ended December 31, 2006.
In February 2007, the FASB issued FAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment to FASB Statement No. 115” (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. We adopted FAS 159 as of January 1, 2007.
In March 2008, the FASB issued FAS No. 161 “Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133” (“FAS 161”). FAS 161 requires entities to provide additional disclosures on derivative and hedging activities regarding their effect on financial position, financial performance and cash flows. This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We will adopt FAS 161 on January 1, 2009.
In October 2008, the FASB issued FASB Staff Position FAS 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active” (“FAS 157-3”). FAS 157-3 clarifies the application of FAS No. 157 “Fair Value Measurements” (“FAS 157”), in a market that is not active. This FASB Staff Position was effective upon issuance.
Our current investment strategy seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. Our mix of taxable and tax-preferenced investments is adjusted periodically, consistent with our current and projected operating results, market conditions and our tax position. The fixed maturities in the investment portfolio are comprised of non-trading available for sale securities. Additionally, we have invested in equity securities. We have also written a small number of equity index put options.
Interest Rate Risk. Our $13.7 billion investment portfolio at December 31, 2008 is principally comprised of fixed maturity securities, which are generally subject to interest rate risk and some foreign currency exchange rate risk, and some equity securities, which are subject to price fluctuations and some foreign exchange rate risk. The impact of the foreign exchange risks on the investment portfolio is partially mitigated by changes in the dollar value of foreign currency denominated liabilities and their associated income statement impact.
We had $8,840.7 million and $9,040.6 million of gross reserves for losses and LAE as of December 31, 2008 and 2007, respectively. These amounts are recorded at their nominal value, as opposed to present value, which would reflect a discount adjustment to reflect the time value of money. Since losses are paid out over a period of time, the present value of the reserves is less than the nominal value. As interest rates rise, the present value of the reserves decreases and, conversely, as interest rates decline, the present value
increases. These movements are the opposite of the interest rate impacts on the fair value of investments. While the difference between present value and nominal value is not reflected in our financial statements, our financial results will include investment income over time from the investment portfolio until the claims are paid. Our loss and loss reserve obligations have an expected duration of approximately 4.2 years, which is reasonably consistent with our fixed income portfolio. If we were to discount our loss and LAE reserves, net of $0.7 billion of reinsurance receivables on unpaid losses, the discount would be approximately $1.5 billion resulting in a discounted reserve balance of approximately $6.7 billion, representing approximately 53% of the market value of the fixed maturity investment portfolio funds.
Foreign Currency Risk. Foreign currency risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Each of our non-U.S./Bermuda (“foreign”) operations maintains capital in the currency of the country of its geographic location consistent with local regulatory guidelines. Generally, we prefer to maintain the capital of our operations in U.S. dollar assets, although this varies by regulatory jurisdiction in accordance with market needs. Each foreign operation may conduct business in its local currency, as well as the currency of other countries in which it operates. The primary foreign currency exposures for these foreign operations are the Canadian Dollar, the British Pound Sterling and the Euro. We mitigate foreign exchange exposure by generally matching the currency and duration of our assets to our corresponding operating liabilities. In accordance with FAS No. 52, “Foreign Currency Translation”, we translate the assets, liabilities and income of non-U.S. dollar functional currency legal entities to the U.S. dollar. This translation amount is reported as a component of other comprehensive income. As of December 31, 2008 there has been no material change in exposure to foreign exchange rates as compared to December 31, 2007.
We sold six equity index put options based on the S&P 500 index for total consideration, net of commissions, of $22.5 million. These contracts each have a single exercise date, with maturities ranging from 12 to 30 years and strike prices ranging from $1,141.21 to $1,540.63. No amounts will be payable under these contracts if the S&P 500 index is at or above the strike prices on the exercise dates, which fall between June 2017 and March 2031. If the S&P 500 index is lower than the strike price on the applicable exercise date, the amount due will vary proportionately with the percentage by which the index is below the strike price. Based on historical index volatilities and trends and the December 31, 2008 index value, we estimate the probability for each contract of the S&P 500 index falling below the strike price on the exercise date to be less than 55%. The theoretical maximum payouts under the contracts would occur if on each of the exercise dates the S&P 500 index value were zero. At December 31, 2008, the present value of these theoretical maximum payouts using a 6% discount factor was $239.6 million.
We sold one equity index put option based on the FTSE 100 index for total consideration, net of commissions, of $6.7 million. This contract has an exercise date of July 2020 and a strike price of £5,989.75. No amount will be payable under this contract if the FTSE 100 index is at or above the strike price on the exercise date. If the FTSE 100 index is lower than the strike price on the exercise date, the amount due will vary proportionately with the percentage by which the index is below the strike price. Based on historical index volatilities and trends and the December 31, 2008 index value, we estimate the probability that the FTSE 100 index contract will fall below the strike price on the exercise date to be less than 57%. The theoretical maximum payout under the contract would occur if on the exercise date the FTSE 100 index value was zero. At December 31, 2008, the present value of the theoretical maximum payout using a 6% discount factor was $24.2 million.
Because the equity index put options meet the definition of a derivative under FAS 133, we report the fair value of these instruments in our consolidated balance sheets as a liability and record any changes to fair value in our consolidated statements of operations and comprehensive income as net derivative expense or income. Our financial statements reflect fair values for our obligations on these equity put options at December 31, 2008 and 2007 of $60.6 million and $39.7 million, respectively; however, we do not believe that the ultimate settlement of these transactions is likely to require a payment that would exceed the initial consideration received or any payment at all.
The tables below display the impact of potential movements in interest rates and the equity indices, which are the principal factors affecting fair value of these instruments, looking forward from the fair value for the period indicated. As these are estimates, there can be no assurance regarding future market performance. The asymmetrical results of the interest rate and S&P 500 and FTSE 100 indices shift reflect that the liability cannot fall below zero whereas it can increase to its theoretical maximum.