Our principal and executive offices are located in Houston, Texas, in buildings owned by Houston Casualty Company. We also maintain offices in approximately 50 locations elsewhere in the United States, the United Kingdom, Spain and Ireland. The majority of these additional locations are in leased facilities.
(2) Calculated by dividing net incurred loss and loss adjustment expense by net earned premium.
We underwrite a variety of relatively non-correlated specialty insurance products, including property and casualty, accident and health, surety, credit and aviation product lines. We market our insurance products through a network of independent agents and brokers, managing general agents and directly to consumers. In addition, we assume insurance written by other insurance companies. We manage our businesses through five insurance underwriting segments and our Investing segment. Our insurance underwriting segments are U.S. Property & Casualty, Professional Liability, Accident & Health, U.S. Surety & Credit and International.
Our business philosophy is to maximize underwriting profit while managing risk. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We also rely on our experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce risk. Our business plan is shaped by our underlying business philosophy. As a result, our primary objective is to maximize net earnings and grow book value per share, rather than to grow gross written premium or our market share.
Key facts about our consolidated group as of and for the year ended December 31, 2011 are as follows:
We generated net earnings of $255.2 million, or $2.30 per diluted share.
We recognized gross losses of $175.5 million and net losses, after reinsurance and reinstatement premium, of $117.9 million from catastrophes in Japan, New Zealand, the United States, Denmark and Thailand, mainly in our International segment.
Our net loss ratio, including the catastrophe losses, was 65.8% and our combined ratio was 90.8%. The catastrophe losses increased the net loss ratio by 5.3 percentage points and the combined ratio by 5.4 percentage points.
We recorded net adverse loss development of $10.1 million. We also recognized $37.3 million of losses related to our increase in the ultimate loss ratio for accident year 2011 for the diversified financial products line of business in our Professional Liability segment.
Our debt to capital ratio was 12.7% at December 31, 2011.
We purchased $373.6 million of our common stock at an average cost of $29.55 per share. At year-end, we had $226.4 million remaining under our current $300.0 million share buyback authorization.
The following sections discuss our key operating results. The reason for any significant variations between 2010 and 2009 are the same as those discussed for variations between 2011 and 2010, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees.
fee and commission income received from third party insurers for premium produced for them by our underwriting agencies,
realized investment gains and losses related to our fixed income securities portfolio.
The 2011 and 2010 growth in premium from our insurance underwriting segments occurred primarily in the International segment, directly related to our new property treaty business, and in the Accident & Health segment, related to our medical stop-loss product. See the “Segment Operations” section below for further discussion of the relationship and changes in premium revenue within each segment.
Fee and commission income, which relates to third party agency and broker commissions, has declined since 2009, primarily due to reduced brokerage volume in our International segment following the sale of our U.K. reinsurance broker in late 2009. The financial instruments line, which relates to two derivative contracts denominated in British pound sterling, includes the effect of foreign currency fluctuations compared to the U.S. dollar. In 2010, this line also included an $8.0 million gain related to terminating one of these derivative contracts. The contract using deposit accounting line includes a $25.0 million fee we received in 2009 for terminating all of our liability, loss-free, under a reinsurance contract that had been accounted for using the deposit method of accounting. Our $25.0 million fee was partially offset by $9.9 million of expenses for reinsurance and other direct costs, which were included in other operating expense. The income from terminating the derivative and reinsurance contracts is included in our U.S. Property & Casualty segment.
The tables below detail, by segment, our net loss and loss adjustment expense, the amount of development included in our net loss and loss adjustment expense, and our net loss ratios.
Our net paid loss ratio decreased slightly in 2011, with offsetting changes in the amount of claims paid across our different lines of business. Our paid loss ratio increased in 2010, primarily due to higher claims payments for our D&O and medical stop-loss products. We commuted certain loss reserves included in our Exited Lines for $43.7 million, $15.8 million and $43.9 million, in 2011, 2010, and 2009, respectively. The commutations had no material effect on net earnings but increased our net paid loss ratios. The amount of claims paid fluctuates period to period due to our mix of business and the timing of claims settlement and catastrophic events.
Policy acquisition costs relate to direct costs we incur to issue insurance policies, including commissions, premium taxes and compensation of our underwriters. The percentage of policy acquisition costs to net earned premium was 15.4% in 2011, 15.8% in 2010 and 15.1% in 2009. The lower percentages in 2011 and 2009 primarily related to reinsurance profit commissions, which are recorded as a reduction of policy acquisition costs, of $17.2 million in 2011, $1.6 million in 2010 and $10.6 million in 2009. After excluding profit commissions, the 2011 increase primarily related to higher commission and premium tax expense due to changes in the mix of business.
Interest expense on debt and short-term borrowings increased $1.7 million in 2011 and $5.2 million in 2010. The increase in 2011 related to $180.0 million of net borrowings during the year on our $600.0 million Revolving Loan Facility. In the fourth quarter of 2009, we issued $300.0 million of 6.30% Senior Notes, with an effective interest rate of 6.37%, and redeemed $124.7 million of 1.30% Convertible Notes. Our 2011 and 2010 interest expense includes $19.3 million for the Senior Notes.
Our income taxes are due to U.S. Federal, state, local and foreign jurisdictions. Our effective income tax rate was 28.1% for 2011, compared to 29.5% for 2010 and 31.8% for 2009. The lower effective rate in 2011 and 2010 related to the increased benefit from higher tax-exempt investment income over the three-year period relative to a declining pretax income base over the same period.
A description of the type of products, distribution channels, risk exposure and other key facts about our five underwriting segments is included in the “Segment and Geographic Information” section of Item 1, Business. The following provides operational information about our five underwriting segments and our Investing segment.
Our U.S. Property & Casualty segment pretax earnings declined 40% in 2011, due to: 1) lower net earned premium, 2) a reduced amount of favorable development in 2011 compared to 2010, 3) $6.2 million of catastrophe losses in 2011, 4) higher operating expenses and 5) the effect of a $5.0 million gain in 2010 related to termination of a derivative contract. The segment’s pretax earnings declined 34% in 2010 primarily due to lower net earned premium, directly related to pricing competition and the mix of products in this segment, and the year-over-year impact of the $5.0 million gain in 2010 and a $15.6 million gain in 2009 related to termination of two contracts, discussed below.
Changes in the segment’s loss ratios primarily reflect the amount of favorable development in each year. The segment had net favorable development of $3.1 million in 2011, $15.9 million in 2010 and $25.9 million in 2009. The 2011 net favorable development primarily related to offsetting favorable and adverse development for products grouped in Other. The 2010 favorable development primarily related to an assumed quota share contract that is in runoff, as well as aviation, public risk, and smaller product lines included in Other. The 2009 favorable development primarily related to aviation and the quota share contract. In 2011, aviation experienced higher 2011 accident year losses, and public risk incurred $5.0 million of catastrophe losses. In 2010, E&O experienced higher 2010 accident year losses, as well as adverse development related to the 2006 - 2009 underwriting years.
Historically, surety bonds and credit insurance have lower net loss ratios and higher expense ratios than other types of property and casualty insurance. The lower net loss ratios reflect the underwriting and claims processes in this business, including collateral drawdowns and subrogation recoveries. The higher expense ratios reflect the additional personnel time and costs required to underwrite these policies and administer claims, as well as higher commission rates paid to agents. The segment’s expense ratio was higher in 2010 compared to 2009 due to additional personnel costs to administer and underwrite the business and handle claims. The expense ratio returned to a lower level in 2011, as growth in expenses was more than offset by higher net earned premium.
In addition to the catastrophe losses, we also recognized gross losses of $31.7 million for the Deepwater Horizon rig disaster in 2010. Due to significant facultative reinsurance, in addition to treaty reinsurance, our pretax net loss was minimal.
The increase in gross written, net written and net earned premium in 2011 and 2010 principally related to our property treaty business, which we began to write in late 2009. In addition, in 2011, we wrote more energy business due to industry rate increases and expansion of our wind storm aggregates and retained a higher percentage of this business. Written and earned premium in our surety & credit product lines increased in 2011 due to changes in market rate pricing and our reinsurance programs. Premium reported in Other decreased in 2011, primarily because we wrote less property (direct and facultative) business and incurred $8.0 million of reinstatement premium related to catastrophe losses in 2011. The Other line is higher in 2010 because we wrote more short-tail property business, which was substantially reinsured.
The segment had favorable loss development of $13.8 million in 2011, compared to $22.3 million in 2010 and $30.9 million in 2009. The three years included $7.6 million, $11.6 million and $12.7 million, respectively, of favorable development related to prior years’ catastrophe losses, primarily in our energy line of business. The remaining favorable development in 2011 primarily related to favorable development for our U.K. professional liability (included in Liability) and energy lines of business, partially offset by adverse development for our public liability (included in Liability) and Spanish construction surety (included in Surety & Credit) lines of business. The U.K. professional liability development related to accident years 2004 - 2010, with approximately half of the development in accident year 2009, while the other development in 2011 related to accident years 2007 - 2010. The remaining favorable development in 2010 and 2009 related to energy and U.K. professional liability for the 2004 - 2008 underwriting years.
This table summarizes our investments by type, substantially all of which are reported at fair value, at December 31, 2011 and 2010.
Our total investments increased $362.7 million in 2011, principally from operating cash flow and a $198.8 million increase in the pretax unrealized gain associated with our available for sale fixed income securities at December 31, 2011, compared to December 31, 2010. During 2010 and 2011, we substantially reduced our short-term investments and re-invested the funds in long-term fixed income securities in order to maximize our investment return.
The methodologies used to determine the fair value of our investments are described in Note 2, “Fair Value Measurements” in the Consolidated Financial Statements. The fair value of our fixed income securities fluctuates depending on general economic and market conditions, including changing interest rates. As market interest rates and credit spreads increase, the fair value will generally decrease, and as market interest rates and credit spreads decrease, the fair value will generally increase. At December 31, 2011, the net unrealized gain on our available for sale fixed income securities portfolio was $333.4 million, compared to $134.6 million at December 31, 2010. The change in the net unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income. Our general policy has been to hold our available for sale fixed income securities through periods of fluctuating interest rates.
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. The gross unrealized losses of individual securities within our available for sale fixed income portfolio were $12.9 million at December 31, 2011 and $35.6 million at December 31, 2010. We evaluate the securities in our available for sale portfolio for possible other-than-temporary impairment losses at each quarter end. We realized other-than-temporary impairment credit losses through pretax earnings of $4.7 million in 2011, $0.4 million in 2010 and $5.5 million in 2009. For additional disclosures about these credit losses and a description of the accounting policies and procedures that we use to determine our other-than-temporary impairment losses, see Note 3, “Investments,” to the Consolidated Financial Statements and the “Critical Accounting Policies - Other-than-temporary Impairments in Investments” section below.
At December 31, 2011, we held $161.1 million of fixed income securities that we designated as held to maturity. We maintain these securities, which are denominated in currencies other than the functional currency of the investing subsidiary, to hedge the foreign currency risk associated with insurance claims that we will pay in these same currencies. Effective in 2011, we discontinued designating new investment purchases as held to maturity securities and plan to designate future investment purchases as available for sale securities. Any unrealized foreign currency gains and losses on available for sale securities must be recorded in other comprehensive income within shareholders’ equity, rather than in net earnings. The pretax income statement benefit related to this change in our investment management philosophy approximated $3.6 million in 2011. This change may create greater volatility in our foreign currency benefit or expense in future periods.
At December 31, 2011, we held $1.9 billion of special purpose revenue bonds, as well as $1.1 billion of general obligation bonds, which are issued by states, municipalities and political subdivisions and collectively referred to, in the investment market, as municipal bonds. The overall rating of our municipal bonds was AA at December 31, 2011. Within our municipal bond portfolio, we held $231.5 million of pre-refunded bonds, which are supported by U.S. government debt obligations. Our special purpose revenue bonds are secured by revenue sources specific to each security. At December 31, 2011, the percentages of our special purpose revenue bond portfolio supported by these major revenue sources were as follows: 1) water and sewer - 24%, 2) education - 21%, 3) transportation - 19%, 4) leasing - 8% and 5) electric - 7%.
Because we no longer write business in Exited Lines, net earned premium and losses have decreased substantially since 2009. The Exited Lines had favorable loss development of $2.6 million in 2011 and adverse development of $3.2 million and $11.4 million in 2010 and 2009, respectively. The 2009 losses included adverse development for accident and health business and larger than expected accident year losses on film completion bonds. The Exited Lines incur operating costs primarily for claims personnel and facilities.
Our Corporate expenses not allocable to the segments increased $3.7 million in 2011, compared to 2010, due to higher information technology costs related to implementation of a new company-wide financial reporting system and higher salary and employee benefit costs. Corporate expenses not allocable to the segments decreased $6.2 million in 2010, compared to 2009, principally due to lower expense for corporate bonuses, stock-based compensation and the fair value adjustment on two expired interest rate swap agreements. Our interest expense increased in 2011 due to a higher amount of outstanding borrowings on our $600 million Revolving Loan Facility. Interest expense increased in 2010 due to long-term debt issued in late 2009.
We held $238.5 million of cash and liquid short-term investments at December 31, 2011.
In 2011, we generated $421.3 million of cash from operating activities.
Our available for sale bond portfolio had a fair value of $5.7 billion at December 31, 2011, compared to $5.0 billion at December 31, 2010. We intend to hold these securities until their maturity, but we would be able to sell securities to generate cash if needed.
We have a $90.0 million Standby Letter of Credit Facility that expires on December 31, 2015, which is used to guarantee our performance in two Lloyd’s of London syndicates.
We have a “Universal Shelf” registration statement that provides for the issuance of an aggregate of $1.0 billion of securities, of which we have $700.0 million of remaining capacity. These securities may be debt securities, equity securities, or a combination thereof. The shelf registration statement provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial market. Our current shelf registration expires in March 2012; however, we plan to replace it with a similar shelf registration.
We receive substantial cash from premiums, reinsurance recoverables, surety collateral, outward commutations, proceeds from sales and redemptions of investments and investment income. Our principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, return of surety collateral, inward commutations, purchases of investments, debt service, policy acquisition costs, operating expenses, taxes, dividends and common stock purchases. Cash provided by operating activities can fluctuate due to timing differences in the collection of premium receivables, reinsurance recoverables and surety collateral; the payment of losses, premium payables and return of surety collateral; and the completion of commutations.
We generated approximately $115.0 million more operating cash flow in 2011, compared to 2010, after consideration of inward commutations, payment of 2011 catastrophe-related claims, and receipt or refund of surety collateral funds. We paid $43.7 million in 2011, $15.8 million in 2010 and $43.9 million in 2009 to commute certain loss reserves in our Exited lines, which reduced our operating cash flow in these years. We also paid $40.0 million in 2011 for claims related to the 2011 catastrophic events. We refunded a net $8.3 million of surety collateral funds in 2011, compared to receiving a net $32.7 million in 2010 and $47.0 million in 2009. Our remaining operating cash flow, excluding the previously discussed items, was $513.3 million in 2011, $398.3 million in 2010 and $579.7 million in 2009, with the 2011 increase driven by additional premium receipts. We completed another inwards commutation after year-end 2011, which will reduce our operating cash flow by $27.5 million in the first quarter of 2012.
We maintain sufficient liquidity from our current cash, short-term investments and investment maturities, in combination with future operating cash flow, to pay anticipated policyholder claims on their expected payment dates. We manage the liquidity of our insurance companies such that each subsidiary’s anticipated claims payments will be met by its own current operating cash flows, cash, short-term investments or investment maturities.
The average duration of claims in many of our lines of business is relatively short and, accordingly, our investment portfolio has a relatively short duration. The weighted-average duration of all claims was approximately 2.5 years in 2011 and 2010, and 2.7 years in 2009. The weighted-average duration of our fixed income securities was 5.0 years, 5.5 years and 4.9 years in 2011, 2010 and 2009, respectively. The longer duration of our fixed income securities reflects the effects of the investment of our capital. In recent years, we have expanded our writings of D&O and E&O insurance, both of which have a longer claims duration than our other products. We consider these different claims payment patterns in determining the duration of our investment portfolio.
On March 8, 2011, we entered into a new agreement for a four-year $600.0 million Revolving Loan Facility (Facility). The Facility replaced our $575.0 million Revolving Loan Facility, which was due to expire on December 19, 2011. The Facility allows us to borrow up to the maximum allowed on a revolving basis until the Facility expires on March 8, 2015. As of December 31, 2011, we had borrowed $180.0 million under the Facility, primarily to fund purchases of our common stock. The borrowing rate is LIBOR plus 137.5 basis points, subject to increase or decrease based on changes in our debt rating. The weighted-average interest rate on borrowings under the Facility at December 31, 2011 was 1.65%. In addition, we pay an annual commitment fee of 20 basis points. The borrowings and letters of credit issued under the Facility reduced our available borrowing capacity on the Facility to $407.4 million at December 31, 2011. The Facility contains restrictive financial covenants that require HCC to maintain a minimum consolidated net worth (excluding accumulated other comprehensive income) and a leverage ratio of less than or equal to 35%. We were in compliance with these covenants at December 31, 2011.
In 2009, we issued $300.0 million of 6.30% Senior Notes due 2019. The Senior Notes were priced at a discount of $1.5 million, for an effective interest rate of 6.37%. We pay interest semi-annually in arrears on May 15 and November 15 of each year. The Senior Notes are unsecured and subordinated general obligations of the holding company. The Senior Notes may be redeemed in whole at any time or in part from time to time, at our option, at the redemption price determined in the manner described in the indenture governing the Senior Notes. The indenture contains covenants that impose conditions on our ability to create liens on any capital stock of our restricted subsidiaries (as defined in the indenture) or to engage in sales of the capital stock of our restricted subsidiaries. We were in compliance with these covenants at December 31, 2011.
Our debt to total capital ratio was 12.7% at December 31, 2011 and 8.3% at December 31, 2010, with the increase related to our borrowings under the Revolving Loan Facility. Our fixed charge coverage ratio was 13.30 for 2011, 19.39 for 2010 and 25.13 for 2009. The reduced ratio was due to increased interest expense and lower pre-tax earnings over the three-year period.
We have a $90.0 million Standby Letter of Credit Facility (Standby Facility) that is used to guarantee our performance in two Lloyd’s of London syndicates. The Standby Facility expires on December 31, 2015. We pay an annual fee of 90 basis points. The Standby Facility contains the same restrictive financial covenants as the Facility, with which we were in compliance at December 31, 2011.
At December 31, 2011, certain of our subsidiaries had outstanding letters of credit with banks totaling $13.1 million. Of this amount, $12.6 million of outstanding letters of credit reduced our borrowing capacity under the Revolving Loan Facility at year-end 2011.
During 2011, we purchased $373.6 million, or 12.6 million shares, at an average cost of $29.55 per share. Through December 31, 2011, we have purchased $507.5 million, or 18.6 million shares at a weighted-average cost of $27.26 since our repurchase program began in 2008. At February 17, 2012, $222.2 million of repurchase authority remains under the Plan.
In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. For additional information, see Note 13, “Commitments and Contingencies” to the Consolidated Financial Statements. We currently have claims under one indemnification that covers certain net insurance losses that were incurred and reinsured prior to our sale of a subsidiary. We paid $2.0 million related to such claims in 2011. At December 31, 2011, we have recorded a liability of $12.4 million, and have $6.7 million in escrow and $5.2 million of letters of credit to cover our obligations or anticipated payments under this indemnification.
(2) The 6.30% Senior Notes are due in 2019. We pay interest semi-annually on May 15 and November 15, which is included in the above table.
(3) The $600.0 million Revolving Loan Facility expires on March 8, 2015. In the above table, the outstanding borrowings of $180.0 million at December 31, 2011 are shown in 2015 with the annual commitment fee of 20 basis points shown in each applicable year.
Although we consider the potential effects of inflation when setting premium rates, our premiums, for competitive reasons, may not fully offset the effects of inflation. However, because the majority of our products have a relatively short period of time between the occurrence of an insured event, reporting of the claim to us and the final settlement of the claim, or have claims that are not significantly impacted by inflation, the effects of inflation are minimized.
We underwrite risks that are denominated in a number of foreign currencies. As a result, we have receivables and payables in foreign currencies and we establish and maintain loss reserves with respect to our insurance policies in their respective currencies. There could be a negative impact on our net earnings from the effect of exchange rate fluctuations on these assets and liabilities. Our principal area of exposure is related to fluctuations in the exchange rates between the British pound sterling, the Euro and the U.S. dollar. We constantly monitor the balance between our receivables and payables and loss reserves to mitigate the potential exposure should an imbalance be expected to exist for other than a short period of time. Imbalances are generally net liabilities, and we economically hedge such imbalances with cash and short-term investments denominated in the same foreign currency as the net imbalance. We recognized a $1.1 million gain from foreign currency in 2011, compared to a loss of $1.6 million in 2010 and a gain of $0.6 million in 2009.
The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires us to make estimates and assumptions when applying our accounting policies. The following sections provide information about our estimation processes related to certain of our critical accounting policies.
The excess of the total recorded net reserves over the actuarial point estimate was 4.2% of recorded net reserves at December 31, 2011, compared to 4.1% at December 31, 2010. The percentage will vary each year, in total and by segment, depending upon current economic events, the nature of the underlying products and their potential volatility, severity of claims reported in the current year, historical development patterns and management’s judgment about these factors.
The low end of the actuarial range and the high end of the actuarial range for our total net reserves will not equal the sum of the low and high ends of the actuarial ranges for our insurance segments due to the estimated effect of diversification across the products in each segment. Some of the products in our segments may be more effectively modeled by a statistical distribution that is skewed or non-symmetric, which causes the midpoint of the range to be above the actuarial point estimate or mean value of the range. Our actuarial assumptions, estimates and judgments can change based on new information and changes in conditions, and, if they change, it will affect the determination of the range amounts.
Direct insurance is coverage that is originated by our insurance companies and brokers in return for premium. Assumed reinsurance is coverage written by another insurance company, for which we assume all or a portion of the risk in exchange for all or a portion of the premium. Assumed reinsurance represented 13% of our gross written premium in 2011 and 12% in 2010, and 16% and 17% of our gross reserves at December 31, 2011 and 2010, respectively. The 2011 increase in assumed written premium relates to property treaty reinsurance business that we began to write in late 2009. Subscription business is direct insurance or assumed reinsurance where we only take a percentage of the total risk and premium and other insurers take their proportionate percentage of the remaining risk and premium.
The property treaty reinsurance business written in our International segment covers catastrophic risks worldwide. Our internal staff underwrites the business, which is placed by major brokers. Given the nature and size of these large losses, the brokers report these claims to us quickly, since the primary insurance and any lower layers of reinsurance generally are exhausted with the catastrophic event. We establish loss reserves for this assumed reinsurance using a combination of our internal models, external sources that independently model catastrophic losses, and estimates provided by our insureds.
We assume facultative reinsurance business in our U.S. Property & Casualty, Professional Liability and International segments. This business includes reinsurance of a company’s captive insurance program or business that must be written through another insurance company licensed to write insurance in a particular country or locality. We establish loss reserves for this assumed reinsurance using the same methods and assumptions we use to set reserves for comparable direct business. Disputes, if any, generally relate to claims or coverage issues with insureds and are administered in the normal course of business.
We have reserves for assumed quota share surplus lines business, which we discontinued writing in 2008, in our U.S. Property & Casualty segment. Case reserves are reported directly to us by the cedant. We establish incurred but not reported (IBNR) reserves based on our estimates using the same methods and assumptions we would use to set reserves for comparable direct business. We have not had any disputes with the cedant.
We underwrite and administer the claims for medical excess products in our Accident & Health segment. This business, although very similar to our direct medical stop-loss business, is written as excess reinsurance of HMOs, hospitals and other insurance companies. We establish loss reserves using the same methods and assumptions we would use to set reserves for comparable direct business. Disputes, if any, are administered in the normal course of business.
Our Exited Lines, which represented 34% of assumed reserves at December 31, 2011, include run-off assumed accident and health reinsurance business, which is primarily reinsurance that provides excess coverage for large losses related to workers’ compensation policies. This business is slow to develop and may take more than twenty years to pay out. Losses in lower layers must develop first before our excess coverage attaches. This business is subject to late reporting of claims by cedants and state guaranty associations. To mitigate our exposure to unexpected losses reported by cedants, our claims personnel review reported losses to ensure they are reasonable and consistent with our expectations. In addition, our claims personnel periodically audit the cedants’ operations to assess whether cedants are submitting timely and accurate claims reports to us. Disputes with cedants related to claims or coverage issues are negotiated to resolution or settled through arbitration. In recent years, we have been commuting a portion of these reserves to reduce our exposure to adverse development. Based on the higher risk of the underlying insurance product and the potential for late reported claims, management believes there may be greater volatility in loss development for this product than for our other product lines.
The following tables show the composition of our gross, ceded and net reserves by segment at December 31, 2011 and 2010.
In order to reduce our exposure to reinsurance credit risk, we evaluate the financial condition of our reinsurers and place our reinsurance with a diverse group of companies and syndicates, which we believe to be financially sound. Our Reinsurance Security Policy Committee carefully monitors the credit quality of our reinsurers when we place new and renewal reinsurance, as well as on an ongoing, current basis. The Committee uses objective criteria to select and retain our reinsurers, including requiring: 1) minimum surplus of $250 million, 2) minimum capacity of £100 million for Lloyd’s syndicates, 3) a financial strength rating of “A-” or better from A.M. Best Company, Inc. or Standard & Poor’s Corporation, 4) an unqualified opinion on the reinsurer’s financial statements from an independent audit, 5) approval from the reinsurance broker, if a party to the transaction, and 6) a minimum of five years in business for non-U.S. reinsurers. The Committee approves exceptions to these criteria when warranted.
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability, taking in consideration our history of earnings, expectations for future earnings, taxable income in carryback years and the expected timing of the reversals of existing temporary differences. When we believe it is more likely than not that a deferred tax asset will be not be realized, we establish a valuation allowance for that deferred tax asset. Although realization is not assured, we believe that, as of December 31, 2011, it is more likely than not that we will be able to realize the benefit of recorded deferred tax assets, with the exception of certain tax loss carryforwards for which valuation allowances have been provided. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions, which could result in a change in the valuation allowance required.
An indicator of impairment of goodwill exists when the fair value of a reporting unit is less than its carrying amount. We assess our goodwill for impairment annually, or sooner if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.
For our annual June 2011 impairment test, we considered three valuation approaches (market, income and cost) to determine the fair value of each reporting unit. We utilized the income and market valuation approaches and based our assumptions and inputs on market participant data, as well as our own data. For the income approach, we estimated the present value of each reporting unit’s expected cash flows to determine its fair value. We utilized estimated future cash flows of the portfolio of products included in each reporting unit, as well as a risk-appropriate rate of return specific to each reporting unit. We utilized our budgets and projection of future operations based on historical and expected industry trends to estimate our future cash flows and their probability of occurring as projected. We also determined fair value of each reporting unit based on market participant data, and used those results to test the reasonableness and validity of the income approach results.
We recognize an OTTI loss in earnings in the period we determine: 1) we intend to sell the security, 2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, or 3) the security has a credit loss. Any non-credit portion of the OTTI loss is recognized in shareholders’ equity. In the past three years, for those securities judged to have an OTTI loss, we recognized OTTI losses as follows:
If a mortgage-backed security is not paying the full amount of its expected principal payments, we recognize the unpaid amount as a realized loss in the period due and permanently reduce the security’s cost basis. We recognized no such realized losses in 2011 or 2009 and $0.8 million in 2010. We assess all such securities with an impairment loss at quarter end for other-than-temporary impairment, using the methods described above.
See Note 1, “General Information and Significant Accounting and Reporting Policies - Recent Accounting Guidance” to the Consolidated Financial Statements for a description of recently issued accounting guidance that will impact our consolidated financial statements in future periods.