The Company’s ability to succeed in the risk assumption and management business is dependent on its ability to accurately analyze and quantify risk, to understand volatility and how risks aggregate or correlate, and to establish the appropriate capital requirements and absolute limits for the risks assumed. All risks are managed by the Company within an integrated framework of policies and processes that ensure the intelligent and consistent evaluation and valuation of risk, and ultimately provide an appropriate return to shareholders.
Similarly, for the Company’s capital markets risks, which include both public and private market investments, diversification of risks is critical to achieving the risk and return objectives of the Company. The Company’s investment policy distinguishes between liquid, high quality assets that support the Company’s liabilities, and the more diversified, higher risk asset classes that make up the Company’s capital funds. While there will be years where capital markets risks achieve less than the risk-free rate of return, or potentially even negative results, the Company believes the rewards for assuming these risks in a disciplined and measured way will produce a positive excess return to the Company over time. Additionally, since capital markets risks are not fully correlated with the Company’s reinsurance risks, this increases the overall diversification of the Company’s total risk portfolio.
Throughout the late 1990s, the industry’s operating profitability and cash flows declined as a result of declining prices, a deterioration in terms and conditions and increasing loss costs. These negative trends were, however, offset by high investment returns that led to continued growth in capital. Between 2001 and 2004,
premium rates increased, driven by large loss events and there were steep declines in interest rates and equity values, adding to the pressure for improvements in pricing and underwriting terms. These began to reverse in late 2003 and continued into 2004, when the Company began to see a flattening in the rate of improvement in the terms and conditions of the most profitable lines, and a slower rate of improvement in those lines that had not yet reached their peak in terms of profitability. During 2005, pricing was generally flat to down, except for wind-exposed lines, with 2005 being the worst year in the history of the industry in terms of catastrophe losses, with Hurricane Katrina being the largest insured event ever, two other significant Atlantic hurricanes, Rita and Wilma, as well as a significant windstorm and a flood in Europe. Consequently, the Company observed in 2006 strong pricing increases in the lines and geographies that were affected by the large 2005 catastrophic loss events. Pricing in other lines was generally stable. In 2007, pricing remained strong for U.S. wind-exposed lines, while all other lines saw pricing declines.
Within the Company’s Life segment, the reinsurance market is differentiated between mortality and longevity products, with mortality being the larger market. For the mortality markets in which the Company writes business, the Company observed stable pricing for continental Europe and Latin America. In contrast, there are more competitive conditions in the U.K. and Ireland, and while these two markets remain attractive, appropriate risk selection and pricing is important. The Company does not write life business in the U.S. market.
The Company’s profitability is significantly affected by the level of its losses and loss expenses incurred. The Company recognizes losses and loss expenses on the basis of actual and expected claims on business written and earned. The Company’s Non-life net reserve position at December 31, 2008 was $7.4 billion. Management believes that it follows prudent reserving policies to maintain a strong financial position. A key challenge for the Company is the accurate estimation of loss reserves for each line of business, which is critical in order to accurately determine the profitability of each line and allocate the appropriate amount of capital to each line in a manner that optimizes profitability.
At year end 2008, given the deterioration in global credit markets and worldwide economies, the Company re-evaluated the loss potential for business written in its Global (Non-U.S.) credit/surety, and to a lesser extent, the U.S. surety line of business, and its Global (Non-U.S.) and U.S. specialty casualty lines of business, primarily directors and officers exposures, to ensure that the Company has reserved for an anticipated increase in claims for the 2006, 2007 and 2008 underwriting years. The Company’s reserves for unpaid losses and loss expenses for its credit/surety and specialty casualty lines of business represent Management’s best estimate of the ultimate cost to settle the liabilities based on information available at December 31, 2008.
The Company’s capital markets and investment operations, including public and private market investments, experienced a difficult year in 2008, with significant economic fallout resulting from the deterioration of the credit markets which began in 2007 and the collapse of the credit and equity markets in 2008. The impact of the turmoil in the credit markets and broader economy was partially mitigated by the Company’s high quality asset portfolio. The Company’s total return on its investment portfolio was well below the risk-free rate of return during 2008, but nevertheless was a positive return, excluding the impact of foreign exchange. The Company believes that capital markets risks managed in a disciplined and measured way will generate positive excess return to the Company over time.
The Company generates revenue from its substantial and high quality investment portfolio. The Company follows prudent investment guidelines through a strategy that seeks to maximize returns while managing investment risk in line with the Company’s overall objectives of earnings stability and long-term book value growth. The Company allocates its invested assets into two categories: liability funds and capital funds. See the discussion of liability funds and capital funds in Financial Condition, Liquidity and Capital Resources. A key challenge for the Company is achieving the right balance between current investment income and total returns (that include price appreciation or depreciation) in changing market conditions. The Company regularly reviews the allocation of investments to asset classes within its investment portfolio and allocates investments to those asset classes the Company anticipates will outperform in the near future, subject to limits and guidelines. Similarly, the Company reduces its exposure to risk asset classes where returns are underperforming, as was the case during 2008 when the Company substantially reduced its allocation to equities. The Company may also lengthen or shorten the duration of its fixed income portfolio in anticipation of changes in interest rates, or increase or decrease the amount of credit risk it assumes, depending on credit spreads and anticipated economic conditions.
Management is focused on ensuring that the structure and culture of the organization promote intelligent, prudent, transparent and ethical decision-making. Management believes that a sound enterprise culture starts with the tone at the top. The Executive Management holds regular company-wide information sessions to present and review Management’s latest decisions, whether operational, financial or structural, as well as the financial results of the Company. Employees are encouraged to address questions related to the Company’s results, strategy or Management decisions, either anonymously or otherwise to Management so that they can be answered during these information sessions. Management believes that these sessions provide a consistent message to all
A key challenge for Management is to maintain an appropriate level of capital, especially in light of the current disruptions in the global credit and capital markets. Management’s first priority is to hold sufficient capital to meet all of the Company’s obligations to cedants, meet regulatory requirements and support its position as one of the stronger reinsurers in the industry. Holding an excessive amount of capital, however, will reduce the Company’s ROE. Consequently, Management closely monitors its capital needs and capital level throughout the cycle, and in times of volatility and turmoil in global capital markets, and actively takes steps to increase or decrease the Company’s capital in order to achieve the proper balance of financial strength and shareholder returns. Capital management is achieved by either deploying capital to fund attractive business opportunities, or in times of excess capital, returning capital to shareholders by way of share repurchases and dividends.
Individual business units manage assumed risks, subject to the appetite and principles approved by the Board, limits approved by the Risk Management and Finance Committee, and policies established by Executive and Business Unit Management. At an operational level, business units manage assumed risk through risk mitigation strategies for assumed risks including strong processes, technical risk assessment and collaboration among different groups of professionals who each contribute a particular area of expertise.
Operational and financial risks are managed by designated functions within the organization. They include failures or weaknesses in financial reporting and controls, regulatory non-compliance, poor cash management, fraud, breach of information technology security and reliance on third party vendors. The Company seeks to minimize these risks through robust processes and controls. Controls and monitoring processes throughout the organization seek to ensure that the Executive Management and the Board have a comprehensive view of the Company’s risks and related mitigation strategies at all times.
Valuation of fixed maturity and equity investments that are measured using significant unobservable inputs and valuation of other invested assets, including certain derivative financial instruments.
The liability for unpaid losses and loss expenses includes amounts determined from loss reports on individual treaties (case reserves), additional case reserves when the Company’s loss estimate is higher than reported by the cedants (ACRs) and amounts for losses incurred but not yet reported to the Company (IBNR). Such reserves are estimated by Management based upon reports received from ceding companies, supplemented by the Company’s own actuarial estimates of reserves for which ceding company reports have not been received, and based on the Company’s own historical experience. To the extent that the Company’s own historical experience is inadequate for estimating reserves, such estimates may be determined based upon industry experience and Management’s judgment. The estimates are continually reviewed and the ultimate liability may be in excess of, or less than, the amounts provided. Any adjustments are reflected in the periods in which they are determined, which may affect the Company’s operating results in future periods.
Under some of these contracts, cedants retain the assets on a funds held basis. In those cases, the Company records those assets as deposit assets and records the related income in other income or loss in the Consolidated Statements of Operations.
Effective January 1, 2008, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 157, “Fair Value Measurements” (SFAS 157). Fair value is the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company measures the fair value of financial instruments according to a fair value hierarchy that prioritizes the information used to measure fair value into three broad levels.
In October 2008, the FASB issued FSP SFAS 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (FSP SFAS 157-3), which clarifies the application of SFAS 157 and provides considerations in determining the fair value of a financial asset when the market for that financial asset is not active.
Effective January 1, 2008, the Company adopted FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115” (SFAS 159). SFAS 159 allows entities to choose, at specified election dates, to measure eligible financial assets and financial liabilities at fair value that are not otherwise required to be measured at fair value. Following the election of the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in earnings.
Following the adoption of SFAS 159, all of the Company’s fixed maturities, short-term investments and equities that were previously classified as available for sale securities, as well as certain other invested assets, are reported as trading securities. Trading securities are carried at fair value with all changes in fair value included in net realized and unrealized investment gains and losses in the Consolidated Statements of Operations. Prior to the adoption of SFAS 159, fixed maturities, short-term investments and equities that were classified as available for sale were carried at fair value with the difference between cost or amortized cost and fair value, net of the effect of taxes, included as a separate component of accumulated other comprehensive income in the Consolidated Balance Sheets. The Company believes that accounting for its investments as trading provides a better presentation of the Company’s total return on its investments and also removes an element of management judgment from the preparation of its financial statements by no longer requiring an assessment of its investments for other-than-temporary impairment. Prior to the adoption of SFAS 159, the Company evaluated the fair value of its investments on a periodic basis to determine whether a decline in fair value below the amortized cost basis (original cost basis for equities) was other-than-temporary. If the decline in fair value was judged to be other-than-temporary, the cost or amortized cost of the individual security was written down to fair value and a new cost basis was established, with the amount of the write-down included as a realized investment loss in the period in which the determination of other-than-temporary impairment was made.
assets are recorded based on valuation techniques depending on the nature of the individual assets. The valuation techniques used by the Company are generally commensurate with standard valuation techniques for each asset class.
Certain subsidiaries and branches of the Company operate in jurisdictions where they are subject to taxation. Current and deferred income taxes are charged or credited to net income, or, in certain cases, to accumulated other comprehensive income, based upon enacted tax laws and rates applicable in the relevant jurisdiction in the period in which the tax becomes accruable or realizable. Deferred income taxes are provided for all temporary differences between the bases of assets and liabilities used in the Consolidated Balance Sheets and those used in the various jurisdictional tax returns. When Management’s assessment indicates that it is more likely than not that deferred income tax assets will not be realized, a valuation allowance is recorded against the deferred tax assets. The Company recognizes a tax benefit relating to uncertain tax positions only where the position is more likely than not to be sustained assuming examination by tax authorities. A liability must be recognized for any tax benefit (along with any interest and penalty, if applicable) claimed in a tax return in excess of the amount allowed under FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (FIN 48).
The Company utilizes derivative financial instruments as part of its overall currency risk management strategy. SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133) requires the recognition of all derivative financial instruments, including embedded derivative instruments, as either assets or liabilities in the Consolidated Balance Sheets and measurement of those instruments at fair value. On the date the Company enters into a derivative contract, Management designates whether the derivative is to be used as a hedge of an identified underlying exposure (a designated hedge). The accounting for gains and losses associated with changes in the fair value of a derivative and the effect on the Consolidated Financial Statements depends on its hedge designation and whether the hedge is highly effective in achieving offsetting changes in the fair value of the asset or liability being hedged.
Prior to the adoption of SFAS 159, the Company used currency derivatives to hedge the fair value of certain available for sale fixed income securities related to the Company’s liability funds (funds representing invested assets supporting net reinsurance liabilities, defined as the Company’s operating and reinsurance liabilities net of reinsurance assets). These derivatives were designated as fair value hedges under SFAS 133, and accordingly, the changes in fair value of the derivative and the hedged item related to foreign currency were recognized in net realized investment gains and losses in the Consolidated Statements of Operations.
As part of its overall strategy to manage its level of currency exposure, the Company uses forward foreign exchange derivatives to partially hedge the net investment in certain non-U.S. dollar functional currency subsidiaries and branches. These derivatives have been designated as net investment hedges under SFAS 133, and accordingly, the changes in fair value of the derivative and the hedged item related to foreign currency are recognized in currency translation adjustment in the Consolidated Balance Sheets.
The Company formally documents all relationships between designated hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. In this documentation, the Company specifically identifies the asset or liability that has been designated as a hedged item and states how the hedging instrument is expected to hedge the risks related to the hedged item. The Company formally measures effectiveness of its designated hedging relationships, both at the hedge inception and on an ongoing basis. The Company assesses the effectiveness of its designated hedges using the period-to-period dollar offset method on an individual currency basis. If the ratio obtained with this method is within the range of 80% to 125%, the Company considers the hedge effective under SFAS 133. The time value component of the designated net investment hedges is included in the assessment of hedge effectiveness.
The Company has entered into weather related transactions that are structured as insurance, reinsurance or derivatives. When those transactions are determined to be derivatives, they are recorded at fair value with the changes in fair value reported in net realized and unrealized investment gains and losses in the Consolidated Statements of Operations. The Company uses internal valuation models to estimate the fair value of these derivatives.
The fair value of the compensation cost is measured at the grant date and is expensed over the period for which the employee is required to provide services in exchange for the award. Forfeiture benefits are estimated at the time of grant and incorporated in the determination of share-based compensation costs. Awards granted to employees who are eligible for retirement and do not have to provide additional services are expensed at the date of grant.
In February 2008, the FASB issued FSP SFAS 157-2, “Effective Date of FASB Statement No. 157” (FSP SFAS 157-2), which permits a one-year deferral of the application of SFAS 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company will adopt FSP SFAS 157-2 for non-financial assets and non-financial liabilities on January 1, 2009 and is currently evaluating the impact of this adoption on its consolidated shareholders’ equity and net income.
In May 2008, the FASB issued Statement No. 163, “Accounting for Financial Guarantee Insurance Contracts-an interpretation of FASB Statement No. 60” (SFAS 163). SFAS 163 clarifies the recognition and measurement of premium revenue and claim liabilities, and requires expanded disclosures about an entity’s financial guarantee insurance contracts. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company has determined that the impact of the adoption of SFAS 163 on its consolidated shareholders’ equity and net income is immaterial and no additional disclosures are required at December 31, 2008.
The Company must determine the appropriate level in the hierarchy for each financial instrument that it measures at fair value. In determining fair value, the Company uses various valuation approaches, including market, income and cost approaches. The hierarchy is broken down into three levels based on the reliability of inputs as follows:
The Company’s financial instruments that it measures at fair value using Level 3 inputs generally include: unlisted equities including preference shares; unit trusts; private ABS; credit linked notes; loans receivable; total return swaps and weather derivatives.
The following table is a reconciliation of the beginning and ending balances for all financial instruments measured at fair value using Level 3 inputs for the year ended December 31, 2008 (in thousands of U.S. dollars):
Changes in the fair value of the Company’s financial instruments measured at fair value, for which the fair value option was elected, during the year ended December 31, 2008 were as follows (in thousands of U.S. dollars):
The Company’s foreign exchange forward contracts, foreign currency option contracts, equity put and call options, interest rate swaps and credit default swaps are categorized as Level 2 within the SFAS 157 hierarchy. Included within the Company’s Level 3 categorization are unlisted equities including preference shares, unit trusts, credit linked notes, loans receivable, total return swaps and weather derivatives. The Company will generally either (i) receive a price based on a manager’s or trustee’s valuation for the asset; or (ii) develop an internal discounted cash flow model to measure fair value. Where the Company receives prices from the manager or trustee, these prices are based on the manager’s or trustee’s estimate of fair value for the assets and are generally audited on an annual basis. Where the Company develops its own discounted cash flow models, the inputs will be specific to the asset in question, based on appropriate historical information, adjusted as necessary, and using appropriate discount rates. As part of the Company’s modeling to determine the fair value of an investment, the Company considers counterparty credit risk as an input to the model, however, the majority of the Company’s counterparties are highly rated institutions and the failure of any counterparty would not have a significant impact on the Company’s financial statements.
(b) Fair Value of Financial Instruments Prior to the Adoption of SFAS 157 and Fair Value of Financial Instrument Liabilities
Policy benefits for life and annuity contracts have a fair value equal to the cash value available to the policyholder should the policyholder surrender the policy. The fair value of the current and long-term debt have been calculated as the present value of estimated future cash flows using a discount rate reflective of the current market cost of borrowing under similar terms and conditions. The fair value of the Senior Notes and CENts has been calculated using quoted market prices based on the initial issuance of $250.0 million from PartnerRe Finance A and $250.0 million from PartnerRe Finance II, respectively.
The carrying values and fair values of the financial instrument liabilities recorded in the Consolidated Balance Sheets as of December 31, 2008 and 2007 were as follows (in thousands of U.S. dollars):
(1) Policy benefits for life and annuity contracts included short-duration and long-duration contracts.
(2) PartnerRe Finance A LLC, the issuer of the Senior Notes, does not meet the consolidation requirements of FIN 46(R). Accordingly, the Company shows the related intercompany debt of $250.0 million in its Consolidated Balance Sheets.
The cost, gross unrealized gains, gross unrealized losses and fair value of investments at December 31, 2008 and 2007 were as follows (in thousands of U.S. dollars):
At December 31, 2007, in addition to the securities shown in the above table that were classified as available for sale, the Company held fixed maturities that were classified as trading with a fair value of $16.4 million (amortized cost: $15.0 million; unrealized gain: $1.4 million) and equities that were classified as trading with a fair value of $382.9 million (cost: $392.5 million; unrealized loss: $9.6 million).
The distribution of fixed maturities and short-term investments at December 31, 2008, by contractual maturity date, is shown below (in thousands of U.S. dollars). Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
The analysis of the change in net unrealized gains (losses) on investments, net of applicable taxes, reflected in accumulated other comprehensive income for the years ended December 31, 2008, 2007 and 2006 is as follows (in thousands of U.S. dollars):
The Company adopted SFAS 159 effective January 1, 2008. For all periods prior to the adoption of SFAS 159, unrealized gains and losses, net of tax, on available for sale securities were recorded as a component of accumulated other comprehensive income in the Consolidated Balance Sheets. Following the adoption of SFAS 159, the Company’s available for sale securities have been reclassified as trading securities and all changes in pre-tax unrealized investment gains and losses are recorded in net realized and unrealized investment (losses) gains in the Consolidated Statement of Operations. Net investment income and net realized and unrealized investment gains and losses on securities previously classified as trading have been recorded within the related investments classification (fixed maturities or equities) beginning in 2008, and the change in net unrealized investment gains and losses on such securities are included in change in net unrealized investment gains and losses on securities subject to the fair value option under SFAS 159.
Proceeds from the sale of investments classified as available for sale for the years ended December 31, 2007 and 2006 were $5,989.3 million and $13,550.3 million, respectively. Realized investment (losses) gains on securities classified as available for sale for the years ended December 31, 2007 and 2006 were as follows (in thousands of U.S. dollars):
The Company generally earns investment income on funds held by reinsured companies based upon a predetermined interest rate, either fixed contractually at the inception of the contract or based upon a recognized index (e.g., LIBOR). Interest rates ranged from 1.0% to 5.0% at December 31, 2008 and from 1.0% to 6.0% at December 31, 2007.
Included in net receivable for securities sold at December 31, 2008 and 2007 were gross payable and receivable balances. The components of net receivable for securities sold at December 31, 2008 and 2007 were as follows (in thousands of U.S. dollars):
5. Unpaid Losses and Loss Expenses and Policy Benefits for Life and Annuity Contracts
following table shows unpaid losses and loss expenses reported by cedants (case reserves) and those estimated by the Company (ACRs and IBNR reserves) at December 31, 2008 and 2007 (in thousands of U.S. dollars):
The table below is a reconciliation of losses and loss expenses including life policy benefits for the years ended December 31, 2008, 2007 and 2006 (in thousands of U.S. dollars):
Within the Company’s U.S. sub-segment, the Company reported net favorable loss development for prior accident years in 2008, 2007 and 2006. The net favorable development in 2008 included net favorable development for prior accident years in all lines of business, with the exception of the motor and multiline lines of business, which experienced net adverse loss development for prior accident years of $10 million. The net favorable development in 2007 included net favorable loss development for prior accident years in all lines of business, with the exception of multiline, which included net adverse loss development of $5 million. The net favorable loss development in 2006 included net favorable development for prior accident years in the agriculture, casualty and multiline lines of $27 million, partially offset by net adverse development in the property, motor, surety and structured risk lines of $25 million (including a net adverse development of $13 million related to the 2005 Hurricanes Katrina, Rita and Wilma). Other than for losses related to the 2005 hurricanes, loss information provided by cedants during each of these years for prior accident years included no individually significant losses or reductions but a series of attritional losses or reductions. Attritional losses are losses that may not be significant on an individual basis, but are monitored on an aggregated basis by the Company to identify trends that may be meaningful from a reserving standpoint.
For the Catastrophe sub-segment, the Company reported net favorable development for prior accident years in 2008 and 2007 and net adverse loss development in 2006. During 2008 and 2007, the net favorable development was primarily due to favorable loss emergence, as losses reported by cedants for prior accident years were lower than the Company expected. During 2006, the net adverse loss development on prior accident years of $24 million included net adverse loss development of $36 million related to the large 2005 catastrophic losses. Other than for losses related to the 2005 hurricanes, loss information provided by cedants for prior accident years included no significant losses or reductions but a series of attritional losses or reductions.
Based on information currently available and the range of potential estimated ultimate liabilities, the Company believes that the unpaid loss and loss expense reserves for U.S. and Global (Non-U.S.) specialty casualty, Global (Non-U.S.) credit/surety, U.S. surety and other potentially exposed classes of business contemplate a reasonable provision for exposures related to the effect of increased financial stress in the world economies. The Company is unaware of any specific issues that would materially affect its unpaid loss and loss expense reserves related to this exposure.
The Life segment reported net adverse development for prior accident years of $24 million and $2 million during the years ended December 31, 2008 and 2007 and net favorable development for prior accident years of $12 million for the year ended December 31, 2006.
The net adverse development and the net favorable development reported in 2008, 2007 and 2006 was primarily related to certain proportional guaranteed minimum death benefit treaties, where the payout is linked to the performance of underlying capital market assets and where increases in credit spreads have impacted certain indexed-linked products that are interest-rate sensitive, as well as the receipt of additional reported loss information from cedants.
The Company used interest rate assumptions to estimate its liabilities for policy benefits for life and annuity contracts which ranged from 1.0% to 5.0% and 1.0% to 4.9% at December 31, 2008 and 2007, respectively.
Net premiums written, net premiums earned and losses and loss expenses and life policy benefits are reported net of reinsurance in the Company’s Consolidated Statements of Operations. Assumed, ceded and net amounts for the years ended December 31, 2008, 2007 and 2006 were as follows (in thousands of U.S. dollars):
Income tax expense for the years ended December 31, 2008, 2007 and 2006 was as follows (in thousands of U.S. dollars):
Deferred tax assets and liabilities reflect the tax impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the net deferred tax assets and liabilities as of December 31, 2008 and 2007 were as follows (in thousands of U.S. dollars):
The net tax assets and liabilities and their components at December 31, 2008 and 2007 were as follows (in thousands of U.S. dollars):
The total amount of unrecognized tax benefits for the years ended December 31, 2008 and 2007 was as follows (in thousands of U.S. dollars):
For the year ended December 31, 2008, there were no unrecognized tax benefits that, if recognized, would create a temporary difference between the reported amount of an item in the Company’s Consolidated Balance Sheet and its tax basis.
The total amount of unrecognized tax benefits for which it is reasonably possible to change within twelve months was $15.0 million at December 31, 2008, which primarily relates to the expected expiration of the statute of limitations related to foreign exchange tax positions and various intra-group transactions in Europe.
For employee retirement benefits, the Company maintains defined contribution plans, an active defined benefit plan and a frozen non-contributory defined benefit plan.
Contributions are made by the Company, and in some locations, these contributions are supplemented by the local plan participants. Contributions are based on a percentage of the participant’s base salary depending upon competitive local market practice. Vesting provisions meet legal compliance standards and market trends; the accumulated benefits for the majority of these plans vest immediately or over a four-year period. As required by law, certain retirement plans also provide for death and disability benefits and lump sum indemnities to employees upon retirement.
The Company incurred expenses for these defined contribution arrangements of $13.1 million, $10.3 million and $10.0 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Since 1999, the Company has maintained an active pension plan for its Zurich office employees (the Zurich Plan), which was classified and accounted for as a defined contribution plan. Amendments to the Zurich Plan during 2006, in conjunction with changes to Swiss pension law, led the Company to conclude that the features of the plan made it a hybrid plan (which is accounted for as a defined benefit plan) for the year ended December 31, 2006 and onwards.
At December 31, 2008 and 2007, the funded status of the Zurich Plan was as follows (in thousands of U.S. dollars):
The assumptions used to determine the pension obligation and net periodic benefit cost for the years ended December 31, 2008, 2007 and 2006 were as follows:
At December 31, 2008, estimated employer contributions to be paid in 2009 were $5.1 million and future benefit payments were estimated to be paid as follows (in thousands of U.S. dollars):
In May 2008, the Company approved an allocation of an additional 0.6 million shares to the EEP. Currently, the plan permits the grant of up to 2.9 million shares, of which a total of 1.3 million shares can be issued as either RS or RSU and 1.6 million shares can be issued as stock options or SARs. If an award under the EEP is cancelled or forfeited without the delivery of the full number of shares underlying such award, only the net number of shares actually delivered to the participant will be counted against the EEP’s authorized shares. Under the EEP, the exercise price of the award will not be less than the fair value of the award at the time of grant. The fair value is defined in the EEP as the closing price reported on the grant date. Awards issued under the EEP generally vest over 3 years of continuous service, either ratably or with a cliff-vest provision, are expensed ratably over the vesting period and have a ten year contractual term. Participants in the EEP are eligible to receive dividends, which the Company records as an expense, on awards that are unvested. Shares available for grant under the EIP at the time of replacement were transferred and became available for grant under the EEP, including an additional 1.0 million common shares approved by shareholders for issuance under the EEP.
options at the time of grant, as defined in the Directors’ Stock Plan. Option awards issued under the Directors’ Stock Plan generally vest at the time of grant and are expensed immediately and have a ten year contractual term. RSU awards issued under the Directors’ Stock Plan generally vest at the time of grant with a minimum delivery date restriction of five years and are expensed immediately. At December 31, 2008, 0.1 million shares remained available for issuance under this plan.
The Employee Share Purchase Plan (the ESPP), which is shareholder-approved, has one offering period per year with two purchase periods of six months. All employees are eligible to participate in the ESPP and can contribute between 1% and 10% of their base salary toward the purchase of the Company’s shares up to the limit set by the IRC. Employees who enroll in the ESPP may purchase the Company’s shares at a 15% discount of the fair value. Participants in the ESPP are eligible to receive dividends on their shares as of the purchase date. A total of 0.4 million common shares may be issued under the ESPP.
Under each of the Company’s equity plans, the Company issues new shares upon the exercise of stock options or the conversion of RSU and SAR into shares.
For the years ended December 31, 2008, 2007 and 2006, the Company’s share-based compensation expense was $28.1 million, $24.9 million and $23.0 million, respectively with a tax benefit of $2.0 million, $1.0 million and $2.2 million, respectively. The adoption of SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)) resulted in additional compensation expense in 2006 of $2.0 million, or approximately $0.03 per basic and diluted share.
During 2008, 2007 and 2006, the Company issued 119,052 stock options, 76,434 stock options and 83,435 stock options with a weighted average grant date fair value of $11.07, $13.76 and $14.87, respectively.
In 2008, 2007 and 2006 153,146 stock options, 707,444 stock options and 285,382 stock options with a total grant date value of $2.3 million, $10.0 million and $4.1 million were exercised, respectively. The aggregate intrinsic value of stock options exercised for the years ended December 31, 2008, 2007 and 2006 was $3.4 million, $18.9 million and $5.6 million, respectively. The Company received $8.1 million, $35.1 million and $14.1 million from stock option exercises for the years ended December 31, 2008, 2007 and 2006, respectively.
The activity related to the Company’s stock options for the years ended December 31, 2008, 2007 and 2006 was as follows:
During 2008, 2007 and 2006, the Company issued 241,458 RSU, 316,427 RSU and 118,193 RSU with a weighted average grant date fair value of $77.19, $71.63 and $61.77, respectively. The Company values RSU issued under all plans at the fair value of its common shares at the time of grant, as defined by the plan document.
The activity related to the Company’s RSU for the years ended December 31, 2008, 2007 and 2006 was as follows:
The activity related to the Company’s SAR for the years ended December 31, 2008, 2007 and 2006 was as follows:
The Company values SAR issued with a Black-Scholes valuation model and used the following assumptions for the years ended December 31, 2008, 2007 and 2006:
The statutory net income (loss) of the Company’s reinsurance subsidiaries for the years ended December 31, 2008, 2007 and 2006 was as follows (in thousands of U.S. dollars):
In October 2005, the Company entered into a loan agreement with Citibank, N.A. under which the Company borrowed $400.0 million. The loan, which had an original maturity of April 2009, bears interest quarterly at a floating rate of 3-month LIBOR plus 0.50%. The Company was not permitted to prepay the loan prior to its maturity, and the loan was not callable or puttable by the lender other than upon an event of default. Citibank, N.A. has pledged its rights under the loan agreement, including the proceeds of any repayment or syndication of the loan, to the Company to secure its obligations to the Company under a forward sale agreement (see Note 15), subject to Citibank, N.A.’s right to substitute cash collateral.
In May 2008, PartnerRe Finance A LLC (PartnerRe Finance A), an indirect wholly-owned subsidiary of the Company, issued $250.0 million aggregate principal amount of 6.875% Senior Notes (Senior Notes). The Senior Notes will mature on June 1, 2018 and may be redeemed at the option of the issuer, in whole or in part, at any time. Interest on the Senior Notes is payable semi-annually commencing on December 1, 2008 at an annual fixed rate of 6.875%, and cannot be deferred.
Contemporaneously, PartnerRe U.S. Holdings issued a 6.440% Fixed-to-Floating Rate promissory note, with a principal amount of $257.6 million to PartnerRe Finance II. Under the term of the promissory note, PartnerRe U.S. Holdings promises to pay to PartnerRe Finance II the principal amount on December 1, 2066, unless previously paid. Interest on the promissory note is payable semi-annually commencing on June 1, 2007 to December 1, 2016 at an annual fixed rate of 6.440% and will be payable quarterly thereafter until maturity at an annual rate of 3-month LIBOR plus a margin equal to 2.325%. For the years ended December 31, 2008 and 2007, the Company incurred interest expense of $16.6 million and $16.5 million, respectively, and paid interest of $16.6 million and $17.7 million, respectively.
In September 2008, the Company’s Board of Directors increased the shares authorized for repurchase by the Company to 5 million shares. At December 31, 2008, the Company had 5 million common shares remaining under its current share repurchase authorization.
Under the terms of the extended forward sale agreement, contract fees of approximately $8.1 million were recorded against additional paid-in capital in 2008 and will be paid over the contract period. Prior to the issuance of shares under the forward sale agreement, this transaction has no other impact on the Company’s common shareholders’ equity, and the Company calculates the dilutive impact related to the forward sale agreement, if any, using the treasury stock method prescribed under SFAS 128, “Earnings per Share”.
The Company’s investment strategy allows for the use of derivative instruments, subject to strict limitations. Derivative instruments may be used to replicate investment positions, manage currency, market exposure and duration risk, or to enhance investment performance that would be allowed under the Company’s investment policy if implemented in other ways. The Company is exposed to credit risk in the event of non-performance by the counterparties to the Company’s foreign exchange forward contracts and other derivative contracts. However, the Company diversifies the counterparties to its derivative contracts to reduce credit risk, and because the counterparties to these contracts are high-credit-quality international banks, the Company does not anticipate
non-performance. These contracts are generally of short duration and settle on a net basis. The difference between the contract amounts and the related market value represents the Company’s maximum credit exposure.
The Company has exposure to credit risk related to reinsurance balances receivable and reinsurance recoverable on paid and unpaid losses (see Note 6). The credit risk exposure related to these balances is mitigated by several factors, including but not limited to, credit checks performed as part of the underwriting process, monitoring of aged receivable balances and the contractual right to offset premiums receivable or funds held balances against unpaid losses and loss expenses. As of December 31, 2008 and 2007, the Company has recorded a provision for uncollectible premiums receivable of $6.5 million and $10.8 million, respectively.
The Company has also entered into non-cancelable operating subleases expiring in various years through 2010. The minimum rental income to be received by the Company in the future is $2.3 million. The leases are renewable at the option of the lessee under certain circumstances.
The Company has entered into service agreements and lease contracts that provide for business and information technology support and computer equipment. Future payments under these contracts amount to $27.4 million through 2014.
The Company has entered into strategic investments with unfunded capital commitments totaling $89.1 million through 2012. The Company expects to fund capital commitments of $51.1 million, $18.0 million, $16.5 million and $3.5 million during 2009, 2010, 2011 and 2012, respectively.
The Company utilizes foreign exchange forward contracts as part of its overall currency risk management and investment strategies. In accordance with SFAS 133, these derivative instruments are recorded in the Consolidated Balance Sheets at fair value, with changes in fair value recognized in net foreign exchange gains and losses in the Consolidated Statements of Operations.
The Company also utilizes foreign currency option contracts to mitigate foreign currency risk. For the year ended December 31, 2007, the balances related to contracts maturing on December 31 were a receivable of $0.8 million. At December 31, 2007, there were no outstanding contracts.
credit default swaps in the event of a default on the underlying issuer, no issuer was in default at December 31, 2008. The counterparties on the Company’s assumed credit default swaps are all highly rated financial institutions. The fair value of the Company’s assumed credit default swaps was an unrealized loss of $2.1 million and the notional value was $34 million at December 31, 2007.
The Company has entered into various weather derivatives. The fair value of weather derivatives (the Company’s net liabilities) was a net unrealized loss of $1.8 million at December 31, 2007. The notional value of the Company’s weather derivatives was $39 million at December 31, 2007.
The fair value of all derivatives at December 31, 2008 is recorded in other invested assets in the Company’s Consolidated Balance Sheet. The effect of net investment hedging derivatives for the year ended December 31, 2008 was a $37.5 million loss recognized in accumulated other comprehensive income and $nil included in the Consolidated Statement of Operations.
The effect of derivatives not designated as hedges included in the Consolidated Statement of Operations for the year ended December 31, 2008 was as follows (in thousands of U.S. dollars):
This facility is predominantly used for the issuance of letters of credit, although the Company and its subsidiaries have access to a revolving line of credit of up to $350 million as part of the Company’s syndicated unsecured credit facility. At December 31, 2008 and 2007, there were no borrowings under this revolving line of credit.
Some of the credit facilities contain customary default, cross payment and acceleration provisions and require that the Company maintain certain covenants, including the following:
iii. a minimum consolidated tangible net worth of $2,100 million plus 50% of cumulative net income (if positive) since July 1, 2005 through the most recent June 30 or December 31, for periods subsequent to June 30, 2006. For the purposes of this covenant, consolidated tangible net worth includes the CENts and excludes goodwill. Minimum tangible net worth required at December 31, 2008 was $2,695.7 million.
Because the Company does not manage its assets by segment, net investment income is not allocated to the Non-life segment. However, because of the interest-sensitive nature of some of the Company’s Life products, net investment income is considered in Management’s assessment of the profitability of the Life segment. The following items are not considered in evaluating the results of the Non-life and Life segments: net realized and unrealized investment gains and losses, interest expense, net foreign exchange gains and losses and income tax expense or benefit. Segment results are shown net of intercompany transactions.
The following tables provide a summary of the segment revenues and results for the years ended December 31, 2008, 2007 and 2006 (in millions of U.S. dollars, except ratios):
The following table provides the distribution of net premiums written by line of business for the years ended December 31, 2008, 2007 and 2006:
The following table provides the geographic distribution of gross premiums written based on the location of the underlying risk for the years ended December 31, 2008, 2007 and 2006:
The Company had two brokers that individually accounted for 10% or more of its gross premiums written during the years ended December 31, 2008, 2007 and 2006. The brokers accounted for 23%, 17% and 18% and 19%, 19% and 20% of gross premiums written for the years ended December 31, 2008, 2007 and 2006, respectively.
ChannelRe Holdings is a non-publicly traded financial guaranty reinsurer based in Bermuda, which assumed a portfolio of in-force business from MBIA, and which participates in MBIA reinsurance treaties and provides facultative reinsurance support to MBIA. The Company’s investment represents 20% of the common shares of Channel Reinsurance Ltd. (“Channel Reinsurance”), which is a subsidiary and the primary asset of ChannelRe Holdings. The investment in ChannelRe Holdings is accounted for using the equity method. The Company’s share of ChannelRe Holdings’ net income and accumulated other comprehensive income is reported in the Company’s net income and accumulated other comprehensive income, respectively, on a one-quarter lag. The Company calculates its share of ChannelRe Holdings’ net income and accumulated other comprehensive income on the basis of the Company’s ownership percentage of ChannelRe Holdings’ common shares currently outstanding.
In addition to ChannelRe Holdings’ results for the twelve month period ended September 30, 2007 below, the Company recorded an additional charge of $87 million in its Consolidated Statements of Operations for the year ended December 31, 2007. This additional charge represented the write-down to $nil of its investment in ChannelRe Holdings due to unrealized mark-to-market losses on Channel Reinsurance’s credit derivative portfolio, which Channel Reinsurance expected to incur during the three months ended December 31, 2007, and which were expected to result in ChannelRe Holdings having negative U.S. GAAP shareholders’ equity at that date. ChannelRe Holdings’ financial statements as of December 31, 2007 and September 30, 2008 did present negative U.S. GAAP shareholders’ equity, and accordingly at December 31, 2008, the carrying value of the Company’s investment in ChannelRe Holdings remains $nil.
We have audited the accompanying consolidated balance sheets of PartnerRe Ltd. and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of operations and comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.