OneBeacon Ltd.’s headquarters are located in Hamilton, Bermuda, while its United States headquarters are located in Canton, Massachusetts and its principal executive office is located in Minnetonka, Minnesota. OneBeacon also maintains branch offices in various cities throughout the United States.
Selected consolidated income statement data and ending balance sheet data for each of the five years ended through December 31, 2009, follows:
At December 31, 2008, White Mountains had $200 outstanding under its credit facility, which was repaid during 2009. During 2007, White Mountains Re issued the $400 WMRe Senior Notes, a portion of the proceeds of which were used to repay the borrowings under White Mountains’ credit facility. At December 31, 2006, White Mountains had $320 outstanding under its credit facility.
In May 2007, WMRe Group, an intermediate holding company of White Mountains Re, issued $250 non-cumulative perpetual preference shares.
During 2008, Berkshire exchanged 1,634,921 of the Company’s common shares for a combination of cash and assets. During 2008 and 2007, the Company repurchased and retired 129,770 and 290,841 common shares, respectively, under its previously announced share repurchase program.
Includes outstanding Options and warrants to acquire common shares, when applicable. In addition, for periods subsequent to December 31, 2006, the number of common shares outstanding used in the calculation of adjusted book value per share is adjusted to exclude unearned shares of restricted stock , the compensation of which, at the date of calculation, has yet to be amortized.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 and 2007
OneBeacon ended 2009 with a book value per share of $15.03, an increase of 31%, including dividends, from December 31, 2008. OneBeacon’s 2009 results include pre-tax proceeds of $23 million, reflected in other revenues, from the Commercial Lines Transaction that was completed during the fourth quarter. As a result of the Commercial Lines Transaction and the Personal Lines Transaction announced in February 2010, OneBeacon has transformed into a specialty lines company. OneBeacon reported a GAAP combined ratio of 94% for 2009 compared to 95% for 2008. The decrease in OneBeacon’s combined ratio was primarily due to lower catastrophe losses and slightly higher favorable loss reserve development, somewhat offset by higher expenses in 2009, including increased incentive compensation costs and severance and other costs associated with the Commercial Lines Transaction. White Mountains Re reported a GAAP combined ratio of 80% in 2009 compared to 106% in 2008. This decrease was principally due to lower catastrophe losses, $30 million (3 points) of favorable loss reserve development in 2009 compared to $80 million (8 points) of unfavorable loss reserve development in 2008 and improved accident year results. Esurance reported a GAAP combined ratio of 104% in 2009 compared to 106% in 2008. This decrease was mostly due to improvements in the loss and LAE ratio, which was 74% in 2009 compared to 77% for 2008. Loss results were affected by lower frequencies in the first half of the year, partially offset by higher frequencies in the second half due to weather-related losses and increased driving. White Mountains’ investment portfolio produced a total return of 9.5% in 2009, driven by an 18% return on its corporate bond portfolio.
Total net written premiums decreased 6% to $3,492 million in 2009 from $3,718 million in 2008, as all three of White Mountains’ segments experienced lower written premiums in 2009. OneBeacon’s net written premiums decreased by 3% to $1,907 million in 2009, as a 13% increase in specialty lines was more than offset by an 18% decrease in personal lines and an 11% decrease in non-specialty commercial lines business, which is subject to the Commercial Lines Transaction. White Mountains Re’s net written premiums decreased by 13% to $807 million in 2009 from $931 million in 2008, due mainly to reductions in U.S. casualty writings, reductions in property catastrophe excess writings, additional reinsurance purchased on the credit line of business, and the effects of foreign currency translation. Esurance’s net written premiums decreased by 5% in 2009 to $779 million, compared to $823 million in 2008, mainly due to the impact of selective rate adjustments. Despite the decreased premiums at Esurance, new policy sales increased 6% in 2009 compared to 2008. Most of the increase in new policy sales occurred in the second half of the year, as Esurance converted more shoppers into customers through website improvements and improved competitive position.
White Mountains ended 2008 with an adjusted book value per common share of $353, a decrease of 20%, including dividends, from December 31, 2007. The global financial crisis had a significant impact on White Mountains’ results in 2008. The reduction in adjusted book value was due mainly to a -9.4% total return on invested assets, $188 million in losses from WM Life Re and a $22 per share reduction from the impact of the Berkshire Exchange, partially offset by a $162 million tax benefit from the release of a valuation allowance against a deferred tax asset of a subsidiary. The strengthening of the U.S. dollar also generated significant foreign currency translation losses during 2008. White Mountains reported an adjusted comprehensive loss of $749 million in 2008, compared to adjusted comprehensive income of $481 million in 2007.
OneBeacon ended 2008 with a book value per share of $12.15, a decrease of 22%, including dividends, from December 31, 2007. The reduction was due mainly to a -13.0% total return on OneBeacon’s invested assets during 2008. OneBeacon reported a GAAP combined ratio of 95% for 2008 compared to 93% for 2007. The increase was primarily due to higher catastrophe losses reported in 2008, somewhat offset by more favorable loss reserve development in 2008. White Mountains Re reported a GAAP combined ratio of 106% in 2008 compared to 94% in 2007. The increase was primarily due to $156 million of catastrophe losses (16 points) and $80 million (8 points) of net adverse loss reserve development recorded by White Mountains Re in 2008, compared to $76 million (7 points) of catastrophe losses and $39 million (3 points) of net adverse loss reserve development in 2007. Esurance reported a GAAP combined ratio of 106% in 2008 compared to 116% in 2007, as selective rate increases and lower claims frequency more than offset rising severity costs.
Total net written premiums decreased 1% to $3,718 million in 2008 from $3,759 million in 2007, as increases at OneBeacon and Esurance were more than offset by a decrease at White Mountains Re. OneBeacon’s net written premiums increased by 5% to $1,963 million in 2008, driven primarily by premiums from its specialty collector cars and boats business. White Mountains Re’s net written premiums decreased by 15% to $931 million in 2008. The decrease occurred in most lines of business, especially in casualty, and was primarily due to pricing, terms and conditions for certain accounts that no longer met White Mountains Re’s underwriting guidelines. Esurance’s net written premiums increased by 3% in 2008 to $823 million. Esurance’s growth rate slowed due to a decline in shopping for personal auto insurance and due to selective rate increases implemented during 2008.
A summary of White Mountains’ consolidated financial results for the years ended December 31, 2009, 2008 and 2007 follows:
White Mountains’ total revenues increased 50% to $4,448 million in 2009 compared to $2,956 million in 2008, primarily due to significant net unrealized and realized investment gains and foreign currency gains in other revenues in 2009 compared to significant losses from these sources in 2008. White Mountains reported net realized and unrealized investment gains of $396 million in 2009 compared to $1,157 million of net realized and unrealized investment losses in 2008. Earned premiums were down 3% in 2009 compared to 2008, as all three of White Mountains’ segments experienced lower earned premiums. Net investment income decreased 34% to $272 million in 2009 compared to $410 million in 2008, due to lower overall portfolio yields, shifts in portfolio mix to lower risk, lower yield investments and a decrease in the overall invested asset base. Other revenues increased by $187 million to $180 million in 2009, due mainly to the net effect of the change in the fair value of WM Life Re’s variable annuity liabilities and the fair value of the related derivative contracts, which reduced other revenues by $81 million in 2009 compared to $194 million in 2008. Other revenues also included $67 million of foreign currency translation gains at White Mountains Re in 2009 compared to $59 million of foreign currency translation losses reported in 2008.
White Mountains’ results for 2008 included $174 million of unrealized foreign currency exchange losses reported as other comprehensive losses, resulting primarily from the strengthening of the U.S. dollar in comparison to the Swedish Krona.
The Company is domiciled in Bermuda and has subsidiaries domiciled in several countries. The majority of the Company’s worldwide operations are taxed in the United States. Income earned or losses incurred by non-U.S. companies will generally be subject to an overall effective tax rate lower than that imposed by the United States.
The income tax expense (benefit) related to pre-tax income (loss) for 2009, 2008 and 2007 represented an effective tax rate of 27.3%, (43.8)% and 30.7%, respectively. White Mountains’ effective tax rates for 2009 and 2007 were lower than the U.S. statutory rate of 35% due primarily to income generated in jurisdictions other than the United States. White Mountains’ effective tax rate for 2008 generated a higher benefit than the U.S. statutory tax rate of 35% due primarily to a $162 million tax benefit from the release of a valuation allowance against a deferred tax asset in a Luxembourg-domiciled, wholly owned subsidiary, White Mountains International S.à r.l. (“WMI”). WMI had built up substantial net operating loss carryforwards (“NOLs”) that had a full valuation allowance in periods prior to the fourth quarter of 2008 because there was no expected future taxable income at WMI to utilize them. The loss carryforwards at WMI primarily relate to tax deductible write-downs in 2007 and 2008 of investments in U.S. subsidiaries held by WMI.
White Mountains Re partially finances its operations with internal debt instruments. During the fourth quarter of 2008, Sweden enacted tax legislation that limits the deductibility of interest paid to a noteholder in a low tax jurisdiction. Due to uncertainty regarding the application of the new legislation, the deductibility of interest expense on a series of internal debt instruments issued by Sirius International Holdings Sweden AB (the “SIHAB Notes”) became at risk. The SIHAB Notes, which were previously held in a company with a low effective tax rate, were transferred to WMI, which, absent the benefit of the deferred tax asset, has an effective tax rate of 28.59%, in order to preserve the economic value of the internal capital structure by maintaining the deductibility of the interest on the SIHAB Notes in Sweden. Because the restructuring created a stream of expected future taxable income to WMI, White Mountains Re was required to release the valuation allowance. WMI is expected to fully utilize the NOLs at WMI by 2028.
As a result of entering into the Commercial Lines Transaction, OneBeacon’s specialty lines includes Technology, Financial Services, OBSP and PIM segmented commercial businesses, which were formerly included in OneBeacon’s commercial lines underwriting unit. Prior periods have been reclassified to conform to the current presentation.
Personal Lines. On February 2, 2010, OneBeacon entered into a definitive agreement to sell its personal lines business to Tower Group, Inc. The transaction includes two insurance companies containing the personal lines business, and two attorneys-in-fact managing the reciprocal exchanges that write the personal lines business in New York and New Jersey. Net written premiums for the affected books total approximately $420 million for the year ended December 31, 2009. As consideration, OneBeacon will receive an amount equal to the statutory surplus in the reciprocal exchanges (approximately $103 million at December 31, 2009, including the par value of the surplus notes issued by the exchanges), the GAAP equity in the insurance companies and attorneys-in-fact (approximately $45 million at December 31, 2009), plus $32.5 million. AutoOne is not being sold as part of this transaction. The sale is subject to certain state regulatory approvals and is expected to close in the second quarter of 2010.
The following table presents OneBeacon’s adjusted book value per common share and reconciles this non-GAAP measure to book value per common share, the most comparable GAAP measure.
Includes the impact of repurchases of common shares made through OneBeacon’s share repurchase program which commenced in 2007.
OneBeacon Ltd. has paid quarterly dividends of $0.21 per common share beginning in March 2007 and paid a special dividend of $2.03 per common share in March 2008.
Runoff includes non-specialty commercial businesses subject to the Commercial Lines Transaction that were formerly reported in commercial lines. Prior periods have been reclassified to conform to the current presentation.
Specialty lines. Net written premiums for specialty lines increased 13% to $946 million in 2009 from $837 million in 2008. The increase was primarily due to a $37 million increase in net written premiums from EBI, which OneBeacon acquired in the third quarter of 2008, and a $35 million increase in net written premiums from OneBeacon’s collector cars and boats business that it began writing in the second quarter of 2008. The increase was also due to a $27 million increase in net written premiums from OBPI, a $19 million increase in net written premiums from A&H and a $15 million increase in net written premiums from OBGR, partially offset by a $22 million decrease in net written premiums from IMU.
Personal lines. Net written premiums for personal lines decreased 18% to $509 million in 2009 from $619 million in 2008. In traditional personal lines, net written premiums decreased 16% to $420 million. This decrease was primarily from $60 million of written premiums ceded during 2009 under a 30% quota share reinsurance agreement that covered OneBeacon’s Northeast homeowners business. OneBeacon entered into this reinsurance agreement to reduce its property catastrophe exposure. Excluding the impact of the homeowners quota share, traditional personal lines net written premiums decreased by 4%. Further, net written premiums at AutoOne decreased by 26% to $89 million primarily due to a decline in New York’s assigned risk pool and lower writings of voluntary private passenger automobile risks in New York. With respect to the New York assigned risk pool, market trends indicate that assigned risk volumes are expected to increase to approximately $150 million in 2010, which is up from $135 million in 2009 and $143 million in 2008, but down from $176 million in 2007. Market trends indicate that the assigned risk pool in New Jersey is expected to increase to approximately $67 million in 2010, which is up from $52 million in 2009 and $46 million in 2008, but down from $72 million in 2007.
The personal lines combined ratio for 2009 increased to 107% from 96% for 2008. The loss and LAE ratio increased 12 points to 76%, while the expense ratio decreased by 1 point to 31%. The increase in the loss and LAE ratio was primarily due to 8 points of adverse loss reserve development in 2009, primarily related to higher than expected New York personal injury protection litigation costs at AutoOne, compared with 1 point of adverse loss reserve development in 2008, mainly on personal automobile liability at AutoOne. Further, 2009 included a 5 point increase in the current accident year loss and LAE ratio, primarily related to higher current accident year loss ratios related to automobile liability. The decrease in the expense ratio was mainly due to lower policy acquisition expenses as a result of the ceding commission related to the homeowners quota share, as described above.
Run-off. Run-off consists of non-specialty commercial lines business included in the Commercial Lines Transaction, as well as national accounts, certain specialty programs and regional agency business transferred to Liberty Mutual effective November 1, 2001. Net written premiums for run-off decreased 11% to $452 million in 2009 compared to $508 million in 2008. The decrease was primarily due to a $42 million decrease in the non-specialty middle market commercial businesses and a $13 million decrease in the small business division.
OneBeacon ended 2008 with a book value per common share of $12.15, decrease of 22%, including dividends, from December 31, 2007. This decrease is due primarily to a total return on invested assets of -13% during 2008. OneBeacon’s GAAP combined ratio increased to 95% for 2008 compared to 93% for 2007. The increase in OneBeacon’s combined ratio was primarily due to a 2 point increase in its loss and LAE ratio, which was driven by higher catastrophe losses. The 2008 results included 3 points of catastrophe losses, most of which related to hurricane Ike, compared to one point of catastrophe losses in 2007. Favorable loss reserve development was 3 points in both 2008 and 2007. The favorable loss reserve development in 2008 was primarily due to lower than expected severity for professional liability in specialty lines and package business in run-off lines, partially offset by adverse loss reserve development at AutoOne and in run-off. The favorable loss reserve development in 2007 was primarily due to lower than expected frequency for professional liability in specialty lines and lower than expected severity for automobile liability in personal lines, partially offset by adverse loss reserve development for multiple peril and workers compensation, primarily for accident years 2001 and prior.
Specialty lines. Net written premiums for specialty lines increased 28% to $837 million in 2008 from $654 million in 2007. The increase was primarily due to $110 million in net written premiums from OneBeacon’s specialty collector cars and boats business that it began writing in the second quarter of 2008. The increase was also due to a $26 million increase in net written premiums from OBPI and $15 million in writings from EBI, which OneBeacon acquired in the third quarter of 2008, as well as growth in OneBeacon’s A&H and OBGR businesses.
The specialty lines combined ratio for 2008 increased to 85% from 81% for 2007. The loss and LAE ratio decreased 1 point to 48% while the expense ratio increased 5 points to 37%. The decrease in the loss and LAE ratio was mainly due to 9 points of favorable loss reserve development in 2008 primarily related to lower than expected severity in professional liability, compared to 4 points in 2007 primarily related to lower than expected frequency in professional liability. Partially offsetting this decrease was a 2 point increase in current accident year losses in 2008, mainly due to large losses at IMU. Additionally, 2008 included 2 points of catastrophe losses, primarily from hurricane Ike, compared to 1 point of catastrophe losses in 2007. The increase in the expense ratio was mainly due to changes in mix of business from 2007 to 2008. In particular, OneBeacon’s specialty collector cars and boats business and some of its other new specialty lines businesses pay higher agent commissions than most other products within specialty lines. Also, at OBPI, increased writings of long-term care business and decreased writings of provider excess insurance business, which carry a higher and lower commission ratio, respectively, caused the expense ratio to increase in 2008. In addition, during 2008, OneBeacon incurred additional transition costs associated with the new management team at OBPI.
Run-off. Net written premiums for run-off decreased 2% to $508 million in 2008 from $520 million in 2007. The decrease was primarily due to a $29 million decrease in non-specialty middle market commercial business, reflecting the more competitive marketplace, partially offset by an increase of $18 million in the small business division, principally driven by small business package products.
The run-off combined ratio for 2008 increased to 108% from 106% for 2007. The loss and LAE ratio increased 5 points to 72%, while the expense ratio decreased 3 points to 36%. The increase in the loss and LAE ratio was primarily due to 6 points of catastrophe losses in 2008, primarily related to hurricane Ike and from tornadoes in the southeastern United States in 2008, compared to 1 point of catastrophe losses in 2007. The decrease in the expense ratio was primarily due to a 4 point decrease in other underwriting expenses, primarily from decreased incentive compensation costs, partially offset by a 2 point increase in policy acquisition expenses. The year ended December 31, 2007 included a 2 point benefit from the partial settlement of qualified pension plan liabilities, which was partially offset by 1 point of office consolidation costs.
Legacy run-off business generated an underwriting loss of $22 million in 2008 compared to an underwriting loss of $156 million ($39 million excluding a $117 million increase to loss and LAE reserves resulting from the reserve reallocation) in 2007. 2008 includes incurred loss and LAE of $21 million ($9 million of which related to the Liberty Mutual settlement described in Part I, Item 3 - “Legal Proceedings”), compared with $33 million (excluding the reserve reallocation) in 2007. 2007 also included a $5 million benefit from the partial settlement of qualified pension plan liabilities.
White Mountains Re’s gross written premiums decreased 7% to $997 million in 2009 from $1,076 million in 2008. Net written premiums decreased by 13% to $807 million in 2009 from $931 million in 2008. These declines were due mainly to reductions in U.S. casualty writings, reductions in property catastrophe excess writings, additional cessions in the credit line of business and the effects of foreign currency translation. The reduction in U.S. casualty business is due to pricing, terms and conditions for certain accounts that do not meet White Mountains Re’s underwriting guidelines, as well as higher ceding company retentions. The decrease in property catastrophe excess business reflects White Mountains Re’s reduction in net peak zone property catastrophe exposures as part of its capital and risk management strategy.
White Mountains Re’s insurance and reinsurance acquisition expenses decreased 20% to $171 million in 2009 from $214 million in 2008. The decrease is due to the overall decline in premium volume discussed above in addition to increases in ceded commissions on the property and credit lines of business.
White Mountains Re’s other underwriting expenses decreased by $2 million, primarily due to lower headcount as well as the effect of foreign currency translation, partially offset by increased incentive compensation costs. General and administrative expenses increased to $68 million in 2009 from $41 million in the prior period, primarily due to $12 million of higher expenses related to the consolidation of Tuckerman Fund II, in addition to $7 million of costs relating to the reorganization of the White Mountains Re legal and operating structure in 2009.
White Mountains Re Results-Year Ended December 31, 2008 versus Year Ended December 31, 2007
White Mountains Re’s GAAP combined ratio was 106% for 2008 compared to 94% for 2007. The increase in the combined ratio primarily due to higher catastrophe losses and adverse loss reserve development in 2008. The 2008 combined ratio included 16 points ($156 million) of catastrophe losses, net of reinsurance and reinstatement premiums, and 8 points ($80 million) of net adverse loss reserve development, compared to 7 points ($76 million) of catastrophe losses, net of reinsurance and reinstatement premiums, and 3 points ($39 million) of net adverse loss reserve development in 2007. The 2008 catastrophe losses were mainly due to hurricane Ike and Slovenian hailstorms in the third quarter of 2008, an earthquake in China, storms in Germany and floods in the Midwest in the second quarter and European windstorm Emma and winter storms in China in the first quarter. In total, White Mountains Re recognized $99 million of losses from hurricane Ike, which consisted of $87 million in the third quarter and $12 million in the fourth quarter of 2008. White Mountains Re non-renewed nearly all of its excess offshore energy and marine business in the Gulf of Mexico in January 2006 following hurricanes Katrina and Rita, and as a result, its total offshore energy losses on hurricane Ike were limited to $7 million. The 2007 catastrophe losses recognized were primarily from the Peru earthquake and hurricanes Dean and Felix in the third quarter of 2007, floods that impacted the United Kingdom during the second and third quarters, and European windstorms Kyrill and Hanno in the first quarter. The adverse loss reserve development recognized in 2008 was primarily a result of a comprehensive loss reserve review, as described below, in addition to $11 million related to A&E exposures, partially offset by favorable loss reserve development from recent accident years. The adverse loss reserve development recognized in 2007 was a result of $63 million related to A&E exposures, $58 million in strengthening of certain of its U.S. casualty reserves and $7 million related to surety business. These losses were largely offset by favorable loss reserve development of $91 million, primarily on property lines.
White Mountains Re’s insurance and reinsurance acquisition expenses decreased 16% to $214 million in 2008 from $255 million in 2007. The decrease is due to the overall decline in premium volume discussed above.
White Mountains Re’s other underwriting expenses decreased by $18 million primarily due to lower compensation expense, mostly from lower headcount and incentive costs.
White Mountains Re’s general and administrative expenses increased 55% to $41 million in 2008 from $26 million in 2007, primarily due to $26 million of expenses related to the consolidation of Tuckerman Fund II. Excluding the expenses from Tuckerman Fund II, White Mountains Re’s general and administrative expenses decreased 43% to $15 million in 2008, due primarily to $5 million in expenses incurred in 2007 in relation to White Mountains Re’s senior note and preference share offerings, as well as a $4 million reduction in expenses at WMRUS in 2008.
Management commenced a comprehensive loss reserve review (the “Reserve Review”) in the second quarter of 2008, primarily as a result of $41 million of adverse loss reserve development recorded in the first quarter of 2008 related principally to WMRe America’s construction defect exposed accounts from underwriting years 2001 and prior. The Reserve Review was conducted by management, including internal underwriting, claims and actuarial personnel, with assistance from external consultants. The Reserve Review included all of WMRe America’s non-A&E casualty loss reserves as well as certain lines of business at WMRe Sirius. The Reserve Review resulted in $140 million of additional adverse loss reserve development at WMRe America, partially offset by $85 million of favorable loss reserve development at WMRe Sirius during the second quarter of 2008. The adverse loss reserve development at WMRe America was predominantly attributable to its casualty reinsurance book written in the 1996-2002 underwriting years, whereas the favorable loss reserve development at WMRe Sirius was mainly attributable to its property reinsurance book.
Esurance’s financial results and GAAP combined ratios for the years ended December 31, 2009, 2008 and 2007 follows:
Esurance’s GAAP combined ratio decreased to 104% for 2009 from 106% for 2008. The decrease was primarily due to a 3 point improvement in the loss and LAE ratio. Loss results were affected by lower frequencies in the first half of the year partially offset by higher frequencies in the second half due to weather-related losses and increased driving. The expense ratio increased to 30% in 2009 compared to 29% in 2008, primarily due to increased advertising expenses and technology development costs.
Esurance’s net written premiums decreased 5% in 2009 to $779 million compared to $823 million in 2008. Net earned premiums were $782 million for the year, down from $830 million in 2008. These decreases were attributable mainly to the impact of selective rate adjustments. Despite the decreased premiums, new policy sales increased 6% in 2009 compared to 2008. Most of the increase in new policy sales occurred in the second half of the year, as Esurance converted more shoppers into customers through website improvements and improved competitive position. Customer retention improved in 2009 compared to the previous year due to a shift toward more preferred customers, which more than offset the increase in non-pay cancellations resulting from the economic downturn. Esurance’s marketing spend declined slightly to $78 million in 2009 from $80 million in 2008.
Esurance’s GAAP combined ratio decreased to 106% for 2008 from 116% for 2007, due in equal parts to lower loss and LAE and expense ratios. The loss and LAE ratio declined to 77% for 2008 from 82% for 2007. Selective rate increases more than offset rising bodily injury claim severity costs in late 2007 and during 2008. Additionally, claim frequency in 2008 declined due to a reduction in miles driven by policyholders during the year. The expense ratio decreased to 29% for 2008 from 34% for 2007 due to lower acquisition expenses compared to 2007.
A summary of White Mountains’ consolidated pre-tax investment results for the years ended December 31, 2009, 2008 and 2007 follows:
Gross investment returns versus typical benchmarks for the years ended December 31, 2009, 2008 and 2007 are as follows. For purposes of discussing rates of return, all percentages are presented gross of management fees and trading expenses in order to produce a more relevant comparison to benchmark returns, while all dollar amounts are presented net of any management fees and trading expenses.
Net investment income was $272 million in 2009, down from $410 million in 2008, primarily due to lower overall portfolio yields, shifts in portfolio mix to lower risk, lower yield investments and a decrease in the overall invested asset base.
Investment Returns-Year Ended December 31, 2008 versus Year Ended December 31,
During the latter half of 2008, there were significant declines and high volatility in equity markets, a lack of liquidity in the credit markets and a widening of credit spreads on debt securities. These factors had a significant adverse effect on the performance of White Mountains’ investment portfolio.
(1) Includes mortgage-backed securities which carry the full faith and credit guaranty of the United States government (i.e., GNMA) or are guaranteed by a government sponsored entity (i.e., FNMA, FHLMC).
The weighted average duration of White Mountains’ fixed maturity portfolio, excluding short-term investments, at December 31, 2009 was 2.5 years. The cost or amortized cost and carrying value of White Mountains’ fixed maturity and convertible fixed maturity investments at December 31, 2009 is presented below by contractual maturity. Actual maturities could differ from contractual maturities because borrowers may have the right to call or prepay certain obligations with or without call or prepayment penalties.
White Mountains purchases commercial and residential mortgage backed securities to maximize its fixed income portfolio’s risk adjusted returns and diversify the portfolio risk from primarily corporate credit risk to a mix of credit and cash flow risk. White Mountains non-agency commercial mortgage-backed portfolio is generally short tenor and structurally senior, with more than 30 points of credit enhancement on average. White Mountains is not an originator of residential mortgage loans and held $0.1 million of residential mortgage-backed securities categorized as sub-prime as of December 31, 2009. In addition, White Mountains’ investments in hedge funds, limited partnerships, limited liability corporations and private equities contain negligible amounts of sub-prime mortgage backed securities at December 31, 2009. White Mountains considers sub-prime mortgage backed securities to be those that are issued from dedicated sub-prime shelves, dedicated second-lien shelf registrations (i.e., White Mountains considers investments backed primarily by second-liens to be a sub-prime risk regardless of credit score or other metrics) or otherwise have underlying loan pools that exhibit weak credit characteristics.
(1) Represents publicly traded mortgage-backed securities which carry the full faith and credit guaranty of the United States government (i.e., GNMA) or are guaranteed by a government sponsored entity (i.e., FNMA, FHLMC).
(2) Of White Mountains’ total mortgage-backed and asset-backed securities, approximately 94% and 99% as of December 31, 2009 and December 31, 2008, respectively, have the highest rating ascribed by Moody’s (“Aaa”) or S&P (“AAA”).
Holding company level. The primary sources of cash for the Company and certain of its intermediate holding companies are dividends and tax sharing payments received from its insurance and reinsurance operating subsidiaries, capital raising activities, net investment income and proceeds from sales and maturities of holding company investments. The primary uses of cash are repurchases of the Company’s and OneBeacon Ltd.’s common shares, payments on and repurchases/retirements of its debt obligations, dividend payments to holders of the Company’s common shares, to noncontrolling interest holders of OneBeacon Ltd.’s common shares and to holders of the WMRe Preference Shares, purchases of investments, payments made to tax authorities, contributions to operating subsidiaries and operating expenses.
Operating subsidiary level. The primary sources of cash for White Mountains’ insurance and reinsurance operating subsidiaries are premium collections, net investment income, proceeds from sales and maturities of investments, contributions from holding companies and capital raising activities. The primary uses of cash are claim payments, policy acquisition costs, purchases of investments, payments on and repurchases/retirements of its debt obligations, dividend and tax sharing payments made to holding companies and operating expenses.
Management believes that White Mountains’ cash balances, cash flows from operations, routine sales and maturities of investments and the liquidity provided by the WTM Bank Facility and WTM Barclays Facility are adequate to meet expected cash requirements for the foreseeable future on both a holding company and insurance and reinsurance operating subsidiary level.
Generally, OneBeacon’s regulated insurance operating subsidiaries have the ability to pay dividends during any 12-month period without the prior approval of regulatory authorities in an amount equal to the greater of prior year statutory net income or 10% of prior year end statutory surplus, subject to the availability of unassigned funds. Based upon December 31, 2009 statutory surplus of $1.6 billion, OneBeacon’s top tier regulated insurance operating subsidiaries have the ability to pay approximately $157 million of dividends during 2010 without prior approval of regulatory authorities, subject to the availability of unassigned funds. As of December 31, 2009, OneBeacon’s top tier regulated insurance operating subsidiaries had approximately $1.1 billion of unassigned funds. During 2009, OneBeacon’s regulated insurance operating subsidiaries paid $80 million of dividends to their immediate parent, which was comprised of $70 million of cash and $10 million of other assets.
During 2009, OneBeacon’s unregulated insurance operating subsidiaries paid $12 million of dividends to their immediate parent. At December 31, 2009, OneBeacon’s unregulated insurance operating subsidiaries had approximately $19 million of net unrestricted cash and fixed maturity investments.
Subject to certain limitations under Swedish law, WMRe Sirius can voluntarily transfer all or a portion of its pre-tax income to its Swedish parent companies to minimize taxes (referred to as a group contribution). In 2009, WMRe Sirius transferred approximately $62 million of its 2008 pre-tax income to its Swedish parent companies as a group contribution. In 2010, WMRe Sirius intends to transfer approximately $68 million (based on December 31, 2009 SEK to USD exchange rate) of its 2009 pre-tax income to its Swedish parent companies as a group contribution.
WMRe Sirius has the ability to pay dividends subject to the availability of unrestricted statutory surplus. Historically, WMRe Sirius has allocated the majority of its pre-tax income, after group contributions to its Swedish parent companies, to the Safety Reserve (see “Safety Reserve” below). As of December 31, 2009, WMRe Sirius had $260 million (based on December 31, 2009 SEK to USD exchange rate) of unrestricted statutory surplus, which is available for distribution in 2010. During 2009, WMRe Sirius paid $36 million of dividends to its immediate parent. During 2010, WMRe Sirius intends to pay $20 million (based on the December 31, 2009 SEK to USD exchange rate) of dividends to its immediate parent.
During 2009, White Mountains Re substantially completed a reorganization of its reinsurance operations whereby the in-force business and infrastructure of WMRe Bermuda was transferred to WMRe Sirius, which established a branch office in Bermuda to maintain the group’s presence in the Bermuda market. WMRe Bermuda will be run off as a subsidiary of WMRe Sirius. As part of the reorganization, White Mountains Re distributed $350 million to its immediate parent and contributed $200 million to WMRe Sirius as additional unrestricted statutory surplus. Prior to the reorganization, WMRe Bermuda distributed $50 million to its immediate parent. In February 2010, WMRe Bermuda distributed an additional $36 million to its immediate parent, prior to its contribution to WMRe Sirius.
During 2009, WMRUS paid $6 million of dividends to its immediate parent.
Esurance Insurance Company has the ability to pay dividends during any 12-month period without the prior approval of regulatory authorities in an amount equal to the lesser of prior year statutory net income or 10% of prior year end statutory surplus, subject to the availability of unassigned funds. Based on 2009 statutory net income, Esurance Insurance Company has the ability to pay $3 million in dividends during 2010. As of December 31, 2009, Esurance Insurance Company had $46 million of unassigned funds.
WM Advisors paid $15 million in dividends to its immediate parent during 2009. As of December 31, 2009, WM Advisors had approximately $22 million of net unrestricted cash and fixed maturity investments.
As of December 31, 2009, the Company and its intermediate holding companies had approximately $258 million of net unrestricted cash and fixed maturity investments included in its Other Operations segment.
(2) Excludes preferred stock subject to mandatory redemption having an aggregate accreted liquidation preference at December 31, 2007 and 2006 of $278 and $269, respectively (and $306 and $339 of investments held in irrevocable grantor trusts for the purpose of economically defeasing the preferred stock as of these dates).
The following table summarizes White Mountains’ capital structure as of December 31, 2009 and 2008:
Management believes that White Mountains generally has the flexibility and capacity to obtain funds externally as needed through debt or equity financing on both a short-term and long-term basis.
White Mountains has a $418 million revolving credit facility with a syndicate of banks administered by Bank of America that matures in June 2012 (the “WTM Bank Facility”) and a $33 million revolving credit facility with Barclays Bank PLC that matures in June 2010 (the “WTM Barclays Facility”). In September 2009, White Mountains repaid the entire $200 million that had been drawn on the WTM Bank Facility with funds distributed from White Mountains Re. At December 31, 2009, White Mountains had no outstanding borrowings under either facility.
On October 31, 2008, White Mountains sold its remaining interest in the Sierra Group (CCIC) as part of the Berkshire Exchange transaction. White Mountains is still obligated to repay the Sierra Note, but Berkshire has provided White Mountains an indemnity, whereby Berkshire will reimburse White Mountains all amounts due under the Sierra Note at its maturity, as adjusted for future reserve development, except for the portion of the interest on the Sierra Note that accrued from its issue date through December 31, 2009. Accordingly, White Mountains recorded a $36 million receivable from Berkshire in connection with the closing of the Berkshire Exchange. As a result of the adverse development since the closing of the transaction, both the Sierra Note and the receivable from Berkshire were adjusted to a carrying value of $31 million at December 31, 2009.
See “RATINGS” in Item 1 - Business for the current ratings of the OBH Senior Notes, the WMRe Senior Notes and the WMRe Preference Shares. It is possible that, in the future, one or more of the rating agencies may lower White Mountains’ existing ratings. If one or more of its ratings were downgraded, White Mountains could incur higher borrowing costs on future borrowings and its ability to access the capital markets could be impacted. In addition, White Mountains’ insurance and reinsurance operating subsidiaries could be adversely impacted by a downgrade in their financial strength ratings, including a possible reduction in demand for their products in certain markets.
Below is a schedule of White Mountains’ material contractual obligations and commitments as of December 31, 2009:
(1) Represents expected future cash outflows resulting from loss and LAE payments. The amounts presented are gross of reinsurance recoverables on unpaid losses of $2,791 and include the discount on OneBeacon’s workers compensation loss and LAE reserves of $127 as of December 31, 2009. These balances add back the remaining purchase accounting fair value adjustment of $191 related to the acquisition of OneBeacon as it is a non-cash item.
(2) Does not reflect the $31 receivable recorded by White Mountains in relation to the indemnity of the Sierra Note provided by Berkshire as part of the Berkshire Exchange.
The WMRe Preference Shares are not included in the table above as these perpetual preferred shares have no stated maturity date and are redeemable only at the option of WMRe Group. See Item 1 - Business-WHITE MOUNTAINS RE for more details.
White Mountains purchases derivative instruments, including futures and over-the counter option contracts on interest rates, major equity indices, and foreign currencies, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. At December 31, 2009, the fair value of these derivative instruments was $194 million. In addition, WM Life Re held approximately $234 million of cash and fixed maturity investments at December 31, 2009.
During the third quarter of 2009, the Company repaid the entire $200 million that had been drawn on the WTM Bank Facility. During 2009, OneBeacon repaid the entire $41 million outstanding under its Mortgage Note and repurchased $69 million face value of its outstanding OBH Senior Notes for $63 million.
During 2009, OneBeacon paid $37 million in interest on the OBH Senior Notes, White Mountains Re paid $26 million in interest on the WMRe Senior Notes and the Company paid $4 million in interest on the WTM Bank Facility.
During 2009, White Mountains contributed $133 million in cash to WM Life Re and $98 million in cash to Esurance.
During 2009, White Mountains made payments totaling $43 million, in cash or by deferral into certain non-qualified compensation plans, to participants in the long-term incentive compensation plans of certain of the Company’s subsidiaries.
During 2009, the Company issued a total of 3,600 common shares to its employees through the exercise of options during the period for cash proceeds of approximately $0.3 million.
During 2008, the Company declared and paid $42 million in cash dividends to its common shareholders. During the third quarter of 2008, the Company’s Board of Directors adopted a new dividend policy whereby the Company expects to declare a $1 per share annual dividend in the first quarter of each year, rather than the then current $2 per share quarterly dividend. As a result, the Company did not pay any dividends on its common shares in the third and fourth quarters of 2008.
During 2008, the Company repurchased and retired 129,770 of its common shares for $56 million through its share repurchase program.
During 2008, OneBeacon Ltd. declared and paid $276 million in cash dividends to its common shareholders, including a $195 million special dividend and $80 million of regular quarterly dividends. White Mountains received a total of $206 million of these dividends.
During 2008, OneBeacon declared and paid $12 million in cash dividends on, and repaid the $300 million redemption value of, the Berkshire Preferred Stock, using funds that had been held in trust.
During 2008, OneBeacon paid $40 million in interest on the OBH Senior Notes and White Mountains Re paid $26 million in interest on the WMRe Senior Notes.
During the first quarter of 2008, White Mountains Re acquired Helicon Re Holdings, Ltd. for approximately $150 million.
During 2008, White Mountains acquired 100% of the outstanding debt and equity of Answer Financial for $75 million.
During 2008, OneBeacon sold one of its inactive licensed subsidiaries, Farmers and Merchants Insurance Company, for $8 million in cash.
During the first quarter of 2008, White Mountains made payments totaling $66 million, in cash or by deferral into certain non-qualified compensation plans of the company and its subsidiaries or by issuing common shares of the Company, to participants in the long-term incentive compensation plans of the Company and its subsidiaries.
During 2007, the Company repurchased and retired 290,841 of its common shares for $145 million through its share repurchase program.
During 2007, OneBeacon declared and paid $28 million and $1 million in cash dividends on the Berkshire Preferred Stock and the Zenith Preferred Stock, and repaid the $20 million redemption value of the Zenith Preferred Stock, using funds that had been held in trust.
In March 2007, White Mountains Re received net proceeds of $392 million through the issuance of the WMRe Senior Notes and subsequently declared and paid a $392 million cash dividend to its immediate parent. White Mountains used a portion of these proceeds to repay the $320 million outstanding balance on its existing bank facility.
During 2007, White Mountains Re declared and paid $20 million in cash dividends to its immediate parent in addition to the $392 million from the WMRe Senior Notes proceeds.
During 2007, White Mountains sold 645,262 shares of OneBeacon Ltd. to OneBeacon’s employee stock ownership plan for proceeds of $17 million.
On May 1, 2007, White Mountains sold all of its remaining interest in Montpelier Re, which consisted of 939,039 common shares and warrants to purchase 7,172,376 common shares, for total proceeds of $65 million.
In April 2007, White Mountains invested $50 million in Pentelia, a fund that invests in insurance-related investment assets.
During 2007, the Company issued a total of 11,550 common shares to its employees through the exercise of Options during the period for proceeds of $2 million. The Company also accepted 4,465 common shares from an employee in satisfaction of a $3 million employee withholding tax liability associated with the vesting of restricted shares.
Adjusted comprehensive income is a non-GAAP financial measure that excludes the change in net unrealized investment gains and losses from Symetra’s fixed maturity portfolio from comprehensive income. In the calculation of comprehensive income under GAAP, fixed maturity investments are marked-to-market while the liabilities to which those assets are matched are not. Symetra attempts to earn a “spread” between what it earns on its investments and what it pays out on its products. In order to try to fix this spread, Symetra invests in a manner that tries to match the duration and cash flows of its investments with the required cash outflows associated with its life insurance and structured settlements products. As a result, Symetra typically earns the same spread on in-force business whether interest rates fall or rise. Further, at any given time, some of Symetra’s structured settlement obligations may extend 40 or 50 years into the future, which is further out than the longest maturing fixed maturity investments regularly available for purchase in the market (typically 30 years). For these long-dated products, Symetra is unable to fully match the obligation with assets until the remaining expected payout schedule comes within the duration of securities available in the market. If at that time, these fixed maturity investments have yields that are lower than the yields expected when the structured settlement product was originally priced, the spread for the product will shrink and Symetra will ultimately harvest lower returns for its shareholders. GAAP comprehensive income increases when rates decline, which would suggest an increase in the value of Symetra-the opposite of what is happening to the intrinsic value of the business. Therefore, White Mountains’ management and Board of Directors use adjusted comprehensive income when assessing Symetra’s quarterly financial performance. In addition, this measure is typically the predominant component of change in adjusted book value per share, which is used in calculation of White Mountains’ performance for both short-term (annual bonus) and long-term incentive plans. The reconciliation of adjusted comprehensive income to comprehensive income is included on page 50.
Adjusted book value per share is a non-GAAP measure which is derived by expanding the GAAP calculation of book value per White Mountains common share to exclude net unrealized gains/(losses) from Symetra’s fixed maturity portfolio. In addition, the number of common shares outstanding used in the calculation of adjusted book value per share are adjusted to exclude unearned shares of restricted stock, the compensation cost of which, at the date of calculation, has yet to be amortized. The reconciliation of adjusted book value per share to book value per share is included on page 49.
Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of White Mountains.
· Historical paid loss development methods: These methods use historical loss payments over discrete periods of time to estimate future losses. Historical paid loss development methods assume that the ratio of losses paid in one period to losses paid in an earlier period will remain constant. These methods necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use case reserves to estimate ultimate losses, they can be more reliable than the other methods discussed below that look to case reserves (such as actuarial methods that use reported losses) in situations where there are significant changes in how case reserves are established by a company’s claims adjusters. However, historical paid loss development methods are more leveraged, meaning that small changes in payments have a larger impact on estimates of ultimate losses, than actuarial methods that use reported losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative reported amounts. In addition, and for similar reasons, historical paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past.
· Adjusted historical paid and reported loss development methods: These methods take traditional historical paid and reported loss development methods and adjust them for the estimated impact of changes from the past in factors such as inflation, the speed of claim payments or the adequacy of case reserves. Adjusted historical paid and reported loss development methods are often more reliable methods of predicting ultimate losses in periods of significant change, provided the actuaries can develop methods to reasonably quantify the impact of changes.
White Mountains performs an actuarial review of its recorded reserves each quarter. White Mountains’ actuaries compare the previous quarter’s estimates of paid loss and LAE, case reserves and IBNR to amounts indicated by actual experience. Differences between previous estimates and actual experience are evaluated to determine whether a given actuarial method for estimating loss and LAE should be relied upon to a greater or lesser extent than it had been in the past. While some variance is expected each quarter due to the inherent uncertainty in loss and LAE, persistent or large variances would indicate that prior assumptions and/or reliance on certain reserving methods may need to be revised going forward.
· Increases in case reserve adequacy over the 2001-2004 calendar periods have resulted in trends in case incurred activity that OneBeacon believes will not continue into the future. Case incurred activity can be the result of underlying changes in expected claim costs or changes in the adequacy of the case reserves relative to the underlying expected claim cost. If the activity is the result of underlying changes in expected costs, it is more likely to repeat in the future, and would likely result in prior year reserve development, as the change in ultimate claim costs would not have been considered when making the previous selection of IBNR reserves. If the activity is the result of changes in case reserve adequacy, it would not indicate any change in the ultimate claim costs and would not be expected to repeat in the future. In these cases, it is unlikely that prior year reserve development would occur, as the change in case reserves would be offset by a corresponding change in IBNR reserves (i.e., deficiency or redundancy in case reserves was implicitly captured when making the previous selection of IBNR reserves).
· In 2004, OneBeacon established a separate claim group to manage run-off claims. Due to the nature of this event, OneBeacon does not believe that the impacts of this group on future losses have been reflected in historical losses. Therefore, OneBeacon has given considerable weight to the most recent loss experience for this segment.
Workers compensation covers an employer’s liability for injuries, disability or death of employees, without regard to fault, as prescribed by state workers compensation law and other statutes. Workers compensation is generally considered a long tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. While certain payments such as initial medical treatment or temporary wage replacement for the injured worker are made quickly, some other payments are made over the course of several years, such as awards for permanent partial injuries. In addition, some payments can run as long as the injured worker’s life, such as permanent disability benefits and ongoing medical care. Despite the possibility of long payment tails, the reporting lags are generally short, settlements are generally not complex, and most of the liability can be considered high frequency with moderate severity. The largest reserve risk generally comes from the low frequency, high severity claims providing lifetime coverage for medical expense arising from a worker’s injury. Examples of common reserving factors that can change and, thus, affect the estimated workers compensation reserves include:
Multiple peril represents a package policy sold to insureds or to members of trade associations or other groups that include general liability and property insurance. General liability covers businesses for any liability resulting from bodily injury and property damage arising from general business operations, accidents on a premises and the products manufactured or sold. Property covers losses to a business’ premises, inventory and equipment as a result of weather, fire, theft and other causes. Because commercial multiple peril provides a combination of property and liability coverage typically for small businesses, it includes both short and long tail coverages. For property coverage, it generally takes a relatively short period of time to close claims, while for the other coverages, generally for the liability coverages, it takes a longer period of time to close claims. The reserving risk for this line is dominated by the liability coverage portion of this product, except occasionally in the event of catastrophic or large single losses.
At December 31, 2008, management had estimated that future payments from personal injury protection (“PIP”) litigation from AutoOne business would be approximately $8 million. During 2009, the legal expenses related to this litigation were higher than expected. As a result, management increased estimates of all accident years for AutoOne. The total increase in estimate was $33 million.
At December 31, 2007, management had estimated that future payments from PIP litigation from OneBeacon’s NYAIP business would be approximately $14 million. During 2008, the legal expenses related to this litigation were higher than expected as the 2002 accident year neared conclusion. As a result, management increased estimates of all accident years for NYAIP and other similar business in New York. The total increase in estimate was $11 million.
At December 31, 2007, based on actuarial techniques described above, management estimated that IBNR related to workers compensation was $41 million, or approximately 96% of case reserves of $43 million for 2005 and subsequent accident years. During 2008, case incurred loss and ALAE was $20 million, which was greater than expected for this line of business. As a result of the higher than expected case incurred loss and ALAE during 2008, the actuarial methods based on case incurred losses produced higher estimated ultimate losses for these accident years. As a result, at December 31, 2008, the IBNR was determined to be $35 million, or approximately 81% of the remaining case reserves. The impact of this revised estimate was an increase to workers compensation reserves of $14 million.
OneBeacon’s range of reserve estimates at December 31, 2009 was evaluated to consider the strengths and weaknesses of the actuarial methods applied against OneBeacon’s historical claims experience data. The following table shows the recorded reserves and the high and low ends of OneBeacon’s range of reasonable loss reserve estimates at December 31, 2009. The high and low ends of OneBeacon’s range of reserve estimates in the table below are based on the results of various actuarial methods described above.
The percentages shown in the following table represent the linear interpolation of where OneBeacon’s recorded loss and LAE reserves are within the range of reserves estimates by line of business at December 31, 2009 and 2008, where the low end of the range equals zero, the middle of the range equals 50% and the high end of the range equals 100%.
Construction defect claims are a non-A&E exposure that has proven to have a greater degree of uncertainty when estimating loss and LAE using generally accepted actuarial methods than many other lines of business. OneBeacon’s general liability and multiple peril lines of business have been significantly impacted by a large number of construction defect claims. Construction defect is a liability allegation relating to defective work performed in the construction of structures such as apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. Such claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. Much of the recent claims activity has been generated by plaintiffs’ lawyers who approach new homeowners, and in many cases homeowner associations with large numbers of homeowners in multi-residential complexes, about defects or other flaws in their homes. Claims for construction defects began with claims relating to exposures in California. Then, as plaintiffs’ lawyers organized suits in other states with high levels of multi-residential construction, construction defect claims were reported in nearby western states, such as Colorado and Nevada, and eventually throughout the country. The reporting of such claims can be quite delayed as the statute of limitations can be up to ten years. Court decisions have expanded insurers’ exposure to construction defect claims as well. For example, in 1995 California courts adopted a “continuous trigger” theory in which all companies that had ever insured a property that was alleged to have been damaged must respond to the claimant, even if evidence of the alleged damage did not appear until after the insurance period had expired. As a result, construction defect claims may be reported more than ten years after a project has been completed as litigation can proceed for several years before an insurance company is identified as a potential contributor. Claims have also emerged from parties claiming additional insured status on policies issued to other parties (e.g., such as contractors seeking coverage on a sub-contractor’s policy). Further, in reserving for these claims, there is additional uncertainty due to the potential for further unfavorable judicial rulings and regulatory actions. The primary actuarial methods that are used to estimate loss and LAE reserves for construction defect claims are frequency and severity methods. These methods separately project the frequency of future reported claims and the average cost, or severity, of individual claims. The reserve is the product of the projected number of reported claims and the severity.
A large number of construction defect claims have been identified relating to coverages that OneBeacon had written in the past through Commercial Union Corporation and General Accident Corporation of America and their subsidiaries in California, Colorado, Nevada, Washington and Oregon, which OneBeacon refers to as their legacy companies. OneBeacon’s management has sought to mitigate future construction defect risks in all states by no longer providing insurance to certain residential general contractors and sub-contractors involved in multi-habitational projects. Mitigating actions also included initiating the withdrawal from problematic sub-segments within OneBeacon’s construction book of business, such as street and road construction, water, sewer and pipeline construction. As a result of these actions, OneBeacon’s management believes that the number of reported construction defect claims relating to coverages written in the past peaked in 2004 and will continue to decline.
OneBeacon also incurred A&E losses via its participation in industry pools and associations. The most significant of these pools was Excess Casualty Reinsurance Association (“ECRA”), which provided excess liability reinsurance to U.S. insurers from 1950 until the early 1980s. ECRA incurred significant liabilities for A&E, of which OneBeacon bears approximately a 4.7% share, or $36 million and $40 million at December 31, 2009 and 2008, respectively, which is fully reflected in OneBeacon’s loss and LAE reserves.
More recently, since the 1990s, OneBeacon has experienced an increase in claims from commercial insureds, including many non-Fortune 500-sized accounts written during the 1970s and 1980s, who are named as defendants in asbestos lawsuits. As a number of large well-known manufacturers of asbestos and asbestos-containing products have gone into bankruptcy, plaintiffs have sought recoveries from peripheral defendants, such as installers, transporters or sellers of such products, or from owners of premises on which the plaintiffs’ exposure to asbestos allegedly occurred. At December 31, 2009, 482 policyholders had asbestos-related claims against OneBeacon. In 2009, 93 new insureds with such peripheral involvement presented asbestos claims under prior OneBeacon policies.
Historically, most asbestos claims have been asserted as product liability claims. Recently, insureds who have exhausted the available products liability limits of their insurance policies have sought from insurers such as OneBeacon payment for asbestos claims under the premises and operations coverage of their liability policies, which may not be subject to similar aggregate limits. OneBeacon expects this trend to continue. However, to date there have been fewer of these premises and operations coverage claims than product liability coverage claims. This may be due to a variety of factors, including that it may be more difficult for underlying plaintiffs to establish losses as stemming from premises and operations exposures, which requires proof of the defendant’s negligence, rather than products liability under which strict legal liability applies. Premises and operations claims may vary significantly and policyholders may seek large amounts, although such claims frequently settle for a fraction of the initial alleged amount. Accordingly, there is a great deal of variation in damages awarded for the actual injuries. As of December 31, 2009, there were approximately 240 active claims by insureds against OneBeacon without product liability coverage asserting operations or premises coverage, which may not be subject to aggregate limits under the policies.
As part of its previously described actuarial review process, OneBeacon reviews A&E activity each quarter and compares that activity to what was assumed in the most recently completed internal study. As of December 31, 2009, OneBeacon noted no change in the range of reasonable outcomes around its best estimate described above.
White Mountains Re’s net loss and LAE reserves by class of business at December 31, 2009 and 2008 were as follows:
Upon notification of a loss from a ceding company, White Mountains Re establishes case reserves, including LAE reserves, based upon White Mountains Re’s share of the amount of reserves established by the ceding company and its independent evaluation of the loss. In cases where available information indicates that reserves established by the ceding company are inadequate, White Mountains Re establishes case reserves or IBNR in excess of its share of the reserves established by the ceding company. In addition, specific claim information reported by ceding companies or obtained through claim audits can alert management to emerging trends such as changing legal interpretations of coverage and liability, claims from unexpected sources or classes of business, and significant changes in the frequency or severity of individual claims. Such information is often used to supplement estimates of IBNR.
White Mountains Re’s expected annual loss reporting assumptions are updated at least once a year. These assumptions are applied to year-end IBNR to generate expected reported losses for the subsequent year. Interpolation methods are applied to estimate quarterly reported losses, which are then compared to actual reported losses each quarter. Significant differences may result in a change in estimates or a revision in the estimated loss reporting pattern. Expected loss ratios underlying the current accident year are updated quarterly, to reflect new business that is underwritten by the company.
As mentioned above, there can be a considerable time lag from the time a claim is reported to a ceding company to the time it is reported to the reinsurer. The lag can be several years in some cases. This lag can be due to a number of reasons, including the time it takes to investigate a claim, delays associated with the litigation process, the deterioration in a claimant’s physical condition many years after an accident occurs, etc. In its loss reserving process, White Mountains Re assumes that such lags are predictable, on average, over time and therefore the lags are contemplated in the loss reporting patterns used in its actuarial projection methods. This means that, as a reinsurer, White Mountains Re must rely on such actuarial estimates for a longer period of time after reserves are first estimated than does a primary insurance company.
Backlogs in the recording of assumed reinsurance can also complicate the accuracy of loss reserve estimation. As of December 31, 2009, there were no significant backlogs related to the processing of assumed reinsurance information at White Mountains Re.
In 2009, White Mountains Re recorded $30 million of net favorable loss reserve development due mainly to a $20 million cession under a retrocessional contract related to the 2001 accident year (discussed further below) and favorable commutation activity on certain old casualty treaties, partially offset by $18 million of additional losses related to A&E exposures. These retroceded losses were substantially offset in the combined ratio and pre-tax income by $10 million of retroceded premiums as well as $7 million of interest charges on funds held under the contract.
In 2008, White Mountains Re recorded $80 million of adverse loss reserve development, which consisted of $181 million of strengthening of certain of its U.S. casualty reserves and $11 million related to A&E exposures. This adverse development was largely offset by favorable loss reserve development of $85 million, primarily on property lines from prior accident years.
The probability that ultimate losses will fall outside of the range of estimates by class of business is higher for each class of business individually than it is for the sum of the estimates for all classes taken together due to the effects of diversification. Management believes that it is reasonably likely that actual ultimate losses will fall within the total range noted above because the ranges were developed by using generally accepted actuarial methods supplemented with input of underwriting and claims staff. However, due to the inherent uncertainty in predicting the future, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above or below the range of actuarial projections.
In the study, White Mountains Re sought to include adequate provision for future reported claims, premises/operations coverage (in addition to products liability coverage), and future adverse court decisions. To estimate this provision, White Mountains Re measured the changes in individual insured estimates from the 2005 study to the 2007 study to estimate future reported losses. The combined effect of all these estimates resulted in an increase of $52 million in IBNR for asbestos losses and LAE in 2007.
In 2009 and 2008, White Mountains Re recorded $18 million and $11 million of asbestos related IBNR losses and LAE. These increases were the result of management’s monitoring of a variety of metrics including: actual paid and reported claims activity; net survival ratios; peer comparisons; and industry benchmarks. In 2009 and 2008, White Mountains Re recorded $(1) million and $1 million of environmental losses.
The following tables show gross and net loss and LAE payments for A&E exposures for the years ending December 31, 2001 through December 31, 2009:
The costs associated with administering the underlying A&E claims by White Mountains Re’s clients tend to be higher than non-A&E claims due to generally higher legal costs incurred by ceding companies in connection with A&E claims ceded to White Mountains Re under the reinsurance contracts.
After reviewing the indications from a variety of commonly accepted actuarial methods, Esurance actuaries select an indicated reserve level for each accident period, which are the primary consideration in determining management’s best estimate of required reserves. However, in making its best estimate, management also considers other qualitative factors that may lead to a difference between held reserves and actuarially recommended levels. Such factors may include, among others, improvements in the claims department, regulatory developments, level of inflation in loss costs, and legislative or legal changes. At both December 31, 2009 and 2008, total carried reserves were 3% above the actuarial point estimate.
The following table illustrates Esurance’s recorded net loss and LAE reserves and high and low estimates at December 31, 2009.
On January 1, 2008, White Mountains adopted FAS 157 (included in ASC 820-10), Fair Value Measurements. FAS 157 provides a revised definition of fair value, establishes a framework for measuring fair value and expands financial statement disclosure requirements for fair value information. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price) at a particular measurement date. The Statement establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). The fair value hierarchy prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumptions that market participants would use, having the lowest priority (“Level 3”).
White Mountains carries certain financial instruments at fair value with changes therein recognized in earnings. Assets and liabilities carried at fair value include substantially all of the investment portfolio; derivative instruments, both exchange traded and over the counter instruments; and reinsurance assumed liabilities associated with variable annuity benefit guarantees. Valuation of assets and liabilities measured at fair value require management to make estimates and apply judgment to matters that may carry a significant degree of uncertainty. In determining its estimates of fair value, White Mountains uses a variety of valuation approaches and inputs. Whenever possible, White Mountains estimates fair value using valuation methods that maximize the use of observable prices and other inputs. Where appropriate, assets and liabilities measured at fair value have been adjusted for the effect of counterparty credit risk.
The following table summarizes White Mountains’ fair value measurements and the percentage of Level 3 investments at December 31, 2009:
“Transfers in” for the year ended December 31, 2009 comprise securities for which observable inputs became unavailable as well as securities for which quoted market prices were deemed to be unreliable. Observable inputs in the form of quoted market prices for similar securities became unavailable for one security with a fair value of $2 million. Quoted market prices for this security had been used at December 31, 2008 to estimate fair value, and as such, this security was categorized as a Level 2 measurement at December 31, 2008. In addition, the estimated fair value for 14 securities of $133 million for which the quoted price provided by a third party source was deemed unreliable and could not be validated against an alternative source is reflected in “Transfers in”. The fair value of these securities was estimated using industry standard pricing models, in which management selected inputs using its best judgment. These inputs principally included benchmark yields, benchmark securities, reported trades, issuer spreads, bids, offers, credit ratings and prepayment speeds. The pricing models used by White Mountains use the same valuation methodology for all Level 3 measurements for fixed maturities. These securities are considered to be Level 3 because the measurements are not directly observable. At December 31, 2009 the estimated fair value for these securities determined using the industry standard pricing models was $2 million more than the estimated fair value based upon quoted prices provided by a third party. “Transfers out” of $198 million comprise 45 securities which had been classified as Level 3 measurements and were recategorized as Level 2 measurements when quoted market prices for similar securities that were considered reliable and could be validated against an alternative source became available during the year ended December 31, 2009.
WM Life Re uses derivative instruments, including put options, total return swaps on bond indices, interest rate swaps, and futures contracts on major equity indices, currencies and government bonds, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. The types of inputs used to estimate the fair value of these derivative instruments, with the exception of actuarial assumptions regarding policyholder behavior and risk margins, are generally the same as those used to estimate the fair value of the variable annuity liabilities.
The following table summarizes the estimated financial impact on WM Life Re’s derivatives and benefit guarantee liabilities of instantaneous changes in individual market variables as of December 31, 2009. The table below assumes that all other market variables are constant and does not reflect the inter-dependencies between individual variables.
The “down market” scenario assumes equity indices decrease 20%, foreign currencies depreciate by 15% against the Japanese Yen, interest rates decrease by 100bps, and implied market volatility increases as described in footnote 2 to the table above. The “up market” scenario assumes opposite movements in the same variables.
The following table summarizes the changes in White Mountains’ variable annuity reinsurance liabilities and derivative contracts for the year ended December 31, 2009:
Comprises interest rate swaps and total return swaps. Fair value measurement based upon bid/ask pricing quotes for similar instruments that are actively traded, where available. Swaps for which an active market does not exist have been priced using observable inputs including the swap curve and the underlying bond index.
The following table summarizes White Mountains Re’s premium estimates and related commissions and expenses:
The collectibility of reinsurance recoverables is subject to the solvency and willingness to pay of the reinsurer. White Mountains is selective in choosing its reinsurers, placing reinsurance principally with those reinsurers with a strong financial condition, industry ratings and underwriting ability. Management monitors the financial condition and ratings of its reinsurers on an ongoing basis. See Note 4-“Third Party Reinsurance” in the accompanying Consolidated Financial Statements for additional information on White Mountains’ reinsurance programs.
These statements are based on certain assumptions and analyses made by White Mountains in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors believed to be appropriate in the circumstances. However, whether actual results and developments will conform with its expectations and predictions is subject to a number of risks and uncertainties that could cause actual results to differ materially from expectations, including: