We lease office space in Hamilton, Bermuda where the our principal executive office is located. Additionally, we lease office space in the United States, Ireland, the United Kingdom and other jurisdictions sufficient for the operation of our insurance and reinsurance operations. We renew and enter into new leases in the ordinary course of business. For further discussion of our leasing commitments at December 31, 2010, see Note 19 of our audited consolidated financial statements.
(a) Includes the results of the former Harbor Point companies from May 12, 2010. Additional information about the Amalgamation with Harbor Point can be found in Note 5 to our audited consolidated financial statements included herein.
(3) Combined ratio is the sum of the loss ratio, the acquisition cost ratio and the general and administrative expense ratio for the property and casualty business.
We consider growth in book value per share to be the most important financial performance measure in assessing whether we are meeting our business objectives. During the year ended December 31, 2010, we distributed $2.94 per share in cash to our shareholders, which provided tangible value to shareholders and reduced our excess capital. We believe that a comparison of book value per share and diluted book value per share from December 31, 2009 to December 31, 2010 should be adjusted for these distributions to fully reflect the return generated for shareholders. Adding back $2.94 per share to our December 31, 2010 diluted book value per share of $25.99 would result in $28.93 per share, an increase of 5.7% over December 31, 2009. The increase in diluted book value per share, as adjusted, was principally due to a combination of operating results, unrealized gains on our investment portfolio and the repurchase of our shares at a discount to diluted book value per share.
We continued to actively manage our capital during the year. We spent $207.8 million to repurchase 10.3 million shares during the year at an average price of $20.19 per share, a 22.3% discount to our December 31, 2010 diluted book value per share. As long as the market price of our shares trades below book value per share, we expect to continue to consider share repurchases as an effective tool to manage capital in a soft cycle and to increase book value per share for our shareholders.
During the year ended December 31, 2010, our return on average shareholders’ equity and our net operating return on average shareholders’ equity decreased compared to the prior year primarily due the combination of lower returns on our investments, in particular in our hedge fund portfolio, and the increased shareholders’ equity resulting from the Amalgamation. Following the Amalgamation we had capital in excess of the amount we consider to be necessary to execute our business plan. This excess capital decreased our return on average shareholders’ equity for the period after the Amalgamation. Since closing of the Amalgamation, we have reduced our excess capital through dividends and share repurchases.
To meet these challenges, we intend to maintain our underwriting discipline while actively managing our expenses. As a result, our gross written premiums for the year ending December 31, 2011 will likely decrease
relative to the year ended December 31, 2010, on a pro forma basis. In 2011, we intend to emphasize our short-tail lines of business more than our long-tail casualty lines of business, and we expect that our new business initiatives will be weighted more to insurance instead of reinsurance.
Acquisition costs consist principally of ceding commissions paid to ceding clients and brokerage expenses. These typically represent a negotiated percentage of the premiums on insurance and reinsurance contracts
Reserve for property and casualty losses and life and annuity reinsurance benefit reserves
We believe that the provision for outstanding losses and benefits will be adequate to cover the ultimate net cost of losses incurred to the balance sheet date, but the provision is necessarily an estimate and could potentially be settled for a significantly greater or lesser amount. These estimates are reviewed regularly and any adjustments to the estimates are recorded in the period they are determined.
Initial Expected Loss Ratio Method. To estimate ultimate losses under the expected loss ratio method, we multiply earned premiums by an expected loss ratio. The expected loss ratio is selected utilizing industry data, historical client data, frequency-severity and rate level forecasts and professional judgment.
Paid Loss Development Method. This method estimates ultimate losses by calculating past paid loss development factors and applying them to exposure periods with further expected paid loss development. The paid loss development method assumes that losses are paid at a rate consistent with the historical rate of payment. It provides an objective test of reported loss projections because paid losses contain no reserve estimates. For many coverages, claim payments are made slowly and it may take many years for claims to be fully reported and settled.
The selection of appropriate actuarial methods to establish reserves may change over time as the underlying loss information becomes more seasoned. Additional discussion of the reserving practices by business segment is included below.
For the purposes of this discussion we consider the losses for the following lines of business to be included within property losses; agriculture, aviation, marine & energy, property and other. We consider losses for the accident & health, auto, credit, excess liability, financial institutions, general casualty, international casualty, medical malpractice, professional liability, surety and whole account lines of business to be classified as casualty losses.
Our reserving methodologies use a loss reserving model that calculates a point estimate for our ultimate losses. Although we believe that our assumptions and methodologies are reasonable, we cannot be certain that our ultimate payments will not vary, potentially materially, from the estimates we have made. If we determine that adjustments to an earlier estimate are appropriate then those adjustments are reflected in our net income during the period in which we determine these adjustments. The establishment of new reserves or the adjustment of reserves for reported claims could result in significant upward or downward changes to our financial condition or results of operations in any particular period. We regularly review and update these estimates using the most current information available to us.
Development of our prior period incurred losses for each of the three years ended December 31, 2010 is reported in Note 7- “Property and casualty losses and loss adjustment expenses” to our consolidated financial statements. Our development of prior period loss reserves has been less than 6.0% in each of the three years ending December 31, 2010 and an average of 3.9% over the past nine years. Based on this experience, we currently believe that it is reasonably likely that loss reserves could change 4.0% from currently reported amounts. This change could be higher or lower depending on our client reported data and potential future commutation of reserves. As of December 31, 2010, a 4.0% change in loss reserves would impact our net income and shareholders’ equity by $156.2 million. Depending on whether the reasonably likely adjustments to loss reserves are on contracts ceded to one of our various reinsurance arrangements, there may also be a partially offsetting change in the losses recoverable, net income and shareholders’ equity.
Our casualty insurance loss reserves include case reserves, an amount for IBNR reserves and loss adjustment expenses. The reserves are compiled on a portfolio basis and are estimated on an undiscounted basis.
As part of our analysis of insurance loss reserves we review loss reports received from our clients to confirm that submitted claims are covered under the contract terms and take into account industry loss activity and industry loss trends. We also consider historical data, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. As additional data becomes available and is reviewed, we may revise our insurance reserve estimates to reflect this additional data. This may result in increases or decreases to reserves for insured events of prior years. These adjustments are recorded in the period they are determined.
Our property reinsurance loss reserves are established on a contract-by-contract basis based on expected loss ratios, losses reported by clients and our assessment of potential losses from catastrophe events. After a catastrophe event our initial estimate is based upon a combination of internal and external catastrophe models, and client- and location-specific assessments and reports, when and as available. Loss estimates are subsequently refined based on broker advices and client notifications.
We establish and review our reinsurance loss reserves on a quarterly basis. The process for establishing our reinsurance loss reserves is based upon actuarial analysis of exposure loss data provided by clients. Along with
management judgment, we use a variety of actuarial techniques and methods in estimating our ultimate liability for reinsurance losses and loss expenses. These methods include expected loss ratio, paid loss development, reported loss development, paid and reported Bornhuetter-Ferguson methods and frequency-severity methods. This actuarial data is analyzed by product, type of risk, coverage and accident or policy year, as appropriate. Industry loss experience is also used to supplement our own data in selecting development factors in areas where our own data or the clients’ data is limited.
With respect to our reinsurance products, we rely on loss data reported by our clients when estimating our reserves. The quality of the loss data varies from client to client. The clients’ loss data is analyzed on a periodic basis by our actuarial and claims management teams to ascertain its quality and credibility. This process may involve comparisons with submission data and industry loss data, claim audits and inquiries about the methods of establishing case reserves or reserves associated with large industry events. There is often a time lag between our clients establishing case reserves and re-estimating their reserves, and notifying us of the new or revised case reserves. On casualty reinsurance transactions, the reporting lag will generally be 60 to 90 days after the end of a reporting period, but can be longer in some cases. Appropriate selection of loss development factors is used to mitigate these issues. We utilize the latest information received from our clients and work to ensure that the loss data is current. However, due to the varying quality of data from our reinsureds and the inherent reporting delays, our reinsurance reserves will have more uncertainty than our insurance reserves, where we receive loss information directly from our insureds.
We establish and review our U.S. specialty IBNR loss and loss expense reserves on a quarterly basis. We use a variety of actuarial techniques and methods in estimating our ultimate liability for excess and surplus lines insurance losses and loss expenses, together with management judgment. These methods include paid loss development, reported loss development, and paid and reported Bornhuetter-Ferguson methods. Industry loss experience is also used to supplement our own data in selecting loss reporting and payment patterns and expected loss ratios. The table below shows our U.S. specialty reserves as of December 31, 2010 and 2009 by casualty and property components.
Our Alterra at Lloyd’s property and casualty reinsurance loss reserves include case reserves, amounts for IBNR reserves and loss adjustment expenses. The reserves are compiled on a portfolio basis and are computed on an undiscounted basis. The majority of the reinsurance business written by the Syndicates is property business. These reserves are adjusted for losses reported by our clients and for our estimate of losses resulting from catastrophe events based on a detailed, location-specific analysis of our clients’ properties impacted by the events.
Casualty claims are long tailed, which means that there can be a significant delay between the occurrence of a loss and the time it is settled. Casualty losses are more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. Due to the long claim-tail nature of casualty business, a high degree of judgment is involved in establishing loss reserves.
We establish and review our Alterra at Lloyd’s reserves on a quarterly basis. The process for adjusting the loss reserves is based upon loss reports received from clients, which are input into actuarial models. A variety of actuarial techniques and methods are used in estimating our ultimate liability for property and casualty insurance and reinsurance losses and loss expenses, together with management judgment. As noted above, these methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency-severity methods. This actuarial data is analyzed by sub-line of business and underwriting year. Industry loss experience is also used to supplement our own data in selecting long term trend and development factors and in areas where our own data or the insureds’ data is limited.
In connection with our ongoing analysis of our Alterra at Lloyd’s loss reserves, we review loss reports received from our clients to confirm that submitted claims are covered under the contract terms and take into account industry loss activity and industry loss trends. We also consider historical data, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. As additional data becomes available and is reviewed, we may revise our Alterra at Lloyd’s reserve estimates to reflect this additional data, which may result in increases or decreases to reserves for insured events of prior years. These adjustments are recorded in the period they are determined.
In connection with our ongoing analysis of our insurance, reinsurance, U.S. specialty, and Alterra at Lloyd’s loss reserves, we review loss notifications and reports received from our clients to confirm that submitted claims are covered under the contract terms. Disputes with clients arise in the ordinary course of business due to coverage issues such as classes of business covered and interpretation of contract wording. We typically resolve any disputes through negotiations that could vary from a simple exchange of email correspondence to arbitration with a panel of experts. Our contracts generally provide for dispute resolution through arbitration. We are not currently involved in any coverage disputes that we believe would, individually or in the aggregate, be material to us.
The following table presents the development of balance sheet property and casualty loss reserves calculated in accordance with U.S. GAAP, as of December 31, 2001 through December 31, 2010. This table does not present accident or policy year development data. The top line of the table shows the gross reserves at the balance sheet date for each of the indicated years and is reconciled to the net reserve by adjusting for reinsurance recoverables. This represents the estimated amount of net claims and claim expenses arising in the current year and all prior years that are unpaid at the balance sheet date, including IBNR reserves. The table also shows the re-estimated amount of the previously recorded reserves as adjusted for new information received as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “net cumulative redundancy (deficiency)” represents the aggregate change to date from the original estimate on the third line of the table “reserve for property and casualty losses, originally stated, net of reinsurance.” The “gross cumulative redundancy (deficiency)” represents the aggregate change to date from the original gross estimate on the top line of the table. The table also shows the cumulative net paid amounts as of successive years with respect to the net reserve liability.
(2) The difference between the reinsurance recoverable included above and that reflected in the reconciliation of losses and loss adjustment expenses in Note 7 to the consolidated financial statements of $294 relates to the remaining net deferred charge on retroactive reinsurance.
(3) Gross and net reserve for property and casualty losses includes, for the first time, Alterra E&S, which we acquired in April 2007.
(4) Gross and net reserve for property and casualty losses includes, for the first time, Alterra America, which we acquired in June 2008.
(6) Gross and net reserve for property and casualty losses includes, for the first time, Harbor Point, which we acquired in May 2010.
During 2010, our re-estimated balance sheet reserves for 2001 and each subsequent balance sheet decreased as a result of net favorable development on a large number of contracts from varied underwriting years and lines of business. The more significant development included:
Net favorable development for the insurance segment of $45.2 million; $22.1 million of which was recognized on professional liability and $8.3 million on general casualty lines of business, primarily on the 2006 and prior years, and $14.8 million on the short tail property and aviation lines of business from the 2009 and 2008 years;
Net favorable development for the reinsurance segment of $44.6 million, excluding the development associated with changes in reinsurance premium estimates described below. We recorded net favorable development on long tail lines of business, including $16.8 million from general casualty primarily on 2002-2009 years, $15.9 million on workers compensation primarily on 2005 and prior years, and $10.7 million on whole account primarily on 2005 and 2006 years, offset by unfavorable development of $12.2 million on professional liability primarily on 2007-2009 years. We recorded net favorable development on short tail lines of business primarily on the 2009 and prior years, including $24.9 million on property, offset by unfavorable development of $9.5 million on the marine and energy lines of business;
Net favorable development for our U.S. Specialty segment of $0.9 million, including $3.1 million of net favorable development on the property line of business offset by net unfavorable development of $2.0 million on our marine line of business;
Changes in loss estimates principally arise from changes in underlying reported, incurred and paid claims data on contracts. Other assumptions used in our process, such as inflation, change infrequently in the reserving process and we do not perform a sensitivity analysis of changes in these assumptions. Given the variety of assumptions and judgments involved in establishing reserves for losses and benefits we have not designed and maintained a system to capture and quantify the financial impact of changes in each of our underlying individual assumptions and judgments.
Our life and annuity reinsurance benefit and claim reserves are compiled by our life and annuity actuaries on a contract-by-contract basis and are computed on a discounted basis using standard actuarial techniques and cash flow models. We establish and review our life and annuity reinsurance reserves regularly based upon cash flow projection models utilizing data provided by clients and actuarial models. We establish and maintain our life and annuity reinsurance reserves at a level that we estimate will, when taken together with future premium payments and investment income expected to be earned on associated premiums, be sufficient to support all future cash flow benefit and third party servicing obligations as they become payable.
Since the development of our life and annuity reinsurance reserves is based upon cash flow projection models, we make estimates and assumptions based on cedant experience and industry mortality tables, longevity, expense and investment experience, including a provision for adverse deviation. The assumptions used to determine policy benefit reserves are best estimate assumptions that are determined at the inception of the contracts and are locked-in throughout the life of the contract unless a premium deficiency develops. We establish these estimates based upon transaction specific historical experience, information provided by the ceding company and industry experience studies. Actual results could differ materially from these estimates. As the experience on the contracts emerges, the assumptions are reviewed by management. We determine whether actual and anticipated experience indicates that existing policy reserves, together with the present value of future gross premiums, are sufficient to cover the present value of future benefits, settlement and maintenance costs and to recover unamortized acquisition costs. If such a review produces reserves in excess of those currently held then the lock-in assumptions are revised and an additional life and annuity benefit reserve is recognized at that time.
There have been no material reserve adjustments to our life and annuity reinsurance benefit reserves during the years ended December 31, 2010, 2009 and 2008.
We invest in a trading portfolio of fixed maturities securities, an available for sale portfolio of fixed maturities securities and a held to maturity portfolio of fixed maturities securities. We record the trading and available for sale portfolios at fair value on our balance sheet. For our trading portfolio, the unrealized gain or loss associated with the difference between the fair value and the amortized cost of the investments is recorded in net income. For our available for sale portfolio, the unrealized gain or loss (absent credit losses) is recorded in other comprehensive income in the shareholders’ equity section of our consolidated balance sheet.
Our hedge fund portfolio comprises a portfolio of limited partnership and stock investments in trading entities, or funds, which invest in a wide range of financial products. Investments in the funds are carried at fair value. The change in fair value is included in net realized and unrealized gains on investments and recognized in net income. The units of account that we fair value are our interests in the funds and not the underlying holdings of such funds. Thus, the inputs we use to value our investments in each of the funds may differ from the inputs used to value the underlying holdings of such funds. These funds are stated at fair value, which ordinarily will be the most recently reported net asset value as advised by the fund manager or administrator, where the fund’s underlying holdings can be in various quoted and unquoted investments. We believe the reported net asset value
represents the fair value market participants would apply to an interest in the fund. The fund managers value their underlying investments at fair value in accordance with policies established by each fund, as described in each of their financial statements and offering memoranda. Based upon information provided by the fund managers, at December 31, 2010, we estimate that over 66% of the underlying assets in the funds are publicly traded securities or have broker quotes available.
Fair values of our catastrophe bonds are based on dealer quotes and if available, trade prices. Our structured deposit has a fair value that is based on publicly quoted indexes. Our derivatives holdings comprise convertible bond equity call options, interest rate linked derivative instruments and foreign exchange forward contracts. The fair value of the equity call options is determined using an option adjusted spread model, the significant inputs for which include equity prices, interest rates, and benchmark yields. The other derivative instruments are priced based on quoted market prices for similar securities.
We follow Accounting Standards Codification, ASC, 944-Financial Services-Insurance in determining the accounting for our insurance and reinsurance products. Assessing whether or not the contracts we write meet the conditions for risk transfer requires judgment. The determination of risk transfer is based, in part, on the use of actuarial and pricing models and assumptions.
Additional premiums assumed and ceded, related net losses and the net impact on operating results for the years ended December 31, 2010, 2009 and 2008 are as follows:
Insurance-This segment offers property and casualty excess of loss capacity from our Bermuda and Dublin offices primarily to Fortune 1000 companies. Principal lines of business include professional lines, excess liability, aviation and property.
Reinsurance-This segment offers property and casualty quota share and excess of loss capacity from our Bermuda, Bogota, Buenos Aires, Dublin, London and United States offices to insurance companies worldwide. The underwriting activities of the former Harbor Point companies, specifically Alterra Re, Alterra Re USA and Alterra Re UK, are included within the reinsurance segment for the period from May 12, 2010. Principal lines of business include agriculture, auto, aviation, credit/surety, general casualty, marine & energy, medical malpractice, professional liability, property, whole account and workers’ compensation.
Alterra at Lloyd’s-This segment offers property and casualty quota share and excess of loss insurance and reinsurance from our London and Copenhagen offices, primarily to medium- to large-sized international clients. It also provides reinsurance to clients in Latin America, operating locally in Rio de Janeiro, Brazil, using Lloyd’s admitted status. This segment comprises our proportionate share of the underwriting results of the Syndicates, and the results of our managing agent, Alterra at Lloyd’s. The Syndicates underwrite a diverse portfolio of specialty risks, including accident & health, aviation, financial institutions, international casualty, professional liability, property and surety.
We also have a corporate function that includes our investment and financing activities.
Consolidated Results of Operations-For the years ended December 31, 2010, 2009 and 2008
(a) The loss ratio is calculated by dividing net losses and loss expenses by net premiums earned for the property and casualty business.
expected reductions across several lines of business due to competitive market conditions, resulting in reduced writings because pricing did not meet our risk/return thresholds. The decrease in our life and annuity segment is principally due to no new contracts being written in this segment during the year ended December 31, 2010, compared to one contract written in the year ended December 31, 2009. We have determined not to write any new life and annuity contracts in the foreseeable future.
(1) The above pro forma financial information for the years ended December 31, 2010 and 2009 is provided, for informational purposes only, to present a summary of the combined gross premiums written and net premiums earned of the Company and the former Harbor Point companies assuming the Amalgamation occurred on January 1, 2010 and January 1, 2009, respectively.
On a pro forma basis, the gross premiums written for the year ended December 31, 2010 would have decreased by 7.8%. This decrease would have principally been driven by lower premium volumes in our insurance and reinsurance segments, along with a decrease in our life and annuity reinsurance segment. A discussion of pro forma reinsurance segment results including Harbor Point in the 2009 comparative figures is included in the section entitled Reinsurance Segment on a pro forma basis.
cash into fixed maturity securities. Our average investment yield was 3.39% for the year ended December 31, 2010 and 3.56% for the year ended December 31, 2009. Our ratio of average cash to average invested assets decreased from 15.6% for the year ended December 31, 2009 to 12.3% for the year ended December 31, 2010 as we redeployed cash into fixed maturity investments and paid a special dividend. As the yields available in the current fixed maturity market are generally lower than the average yield on our existing portfolio the yield on our portfolio has decreased. To date, this reduction has been partially offset by our allocation of more cash into fixed maturities, which has moderated the decrease in yield compared to prior periods. However, due to the continuing low-yield market environment, we expect continued downwards pressure on our investment yield.
Net realized and unrealized gains and losses on investments was a gain of $81.8 million for the year ended December 31, 2009 compared to a loss of $235.0 million for the year ended December 31, 2008. This change was principally driven by net losses on the hedge fund portfolio of $233.5 million in 2008 compared to net gains of $75.8 million in 2009.
Net losses and loss expense, and claims and policy benefits. The loss ratio decreased by 6.3 percentage points for the year ended December 31, 2010 compared to the year ended December 31, 2009. Significant items impacting the loss ratio were:
Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, for the year ended December 31, 2009 of $78.3 million compared to $90.8 million for the year ended December 31, 2008;
The increase in the acquisition cost ratio for the year ended December 31, 2009 compared to the year ended December 31, 2008 was principally due to changes in the mix of business written.
Interest expense. Interest expense reflects interest on funds withheld from reinsurers, and interest on our senior notes and bank loans outstanding. Interest expense for the year ended December 31, 2010 increased by $7.0 million compared to the year ended December 31, 2009 principally due to an increase in funds withheld interest for one of our largest reinsurers and an increase in senior notes outstanding as a result of the issuance of senior notes in September 2010. Interest expense for the year ended December 31, 2009 decreased by $14.8 million compared to the year ended December 31, 2008. This decrease was principally attributable to the repayment of $150.0 million in bank loans in April 2009 and the $225.0 million repayment of a swap loan in August 2009.
Merger and acquisition expenses. Merger and acquisition expenses for the year ended December 31, 2010 comprised advisory, legal and other professional fees, the acceleration of stock based compensation expense and other expenses related to the Amalgamation. These expenses were offset by the negative goodwill gain of $95.8 million recognized from the Amalgamation. Merger and acquisition expenses in the year ended December 31, 2009 comprised advisory, legal and other professional fees related to the proposed transaction with IPC Holdings Limited and IPC Limited, which was terminated in June 2009, offset by a $50.0 million termination fee received. Merger and acquisition expenses in the year ended December 31, 2008 comprised advisory, legal and other professional fees related to the acquisition of Alterra Capital UK and the creation of our Alterra at Lloyd’s segment.
General and administrative expenses for the year ended December 31, 2009 increased by $29.5 million compared to the year ended December 31, 2008. This increase was principally due to the improvement in the net income generated in 2009 compared to 2008, resulting in increased performance based compensation in 2009. In addition, there was a higher level of expense related to information technology in 2009. We consider information technology to be a critical component of our business and we expect to make recurring and often significant investments in upgrading and maintaining our technology infrastructure in future years.
(d) The combined ratio is the sum of the loss ratio, the acquisition cost ratio, and the general and administrative expense ratio.
Premiums. Gross premiums written decreased in the year ended December 31, 2010 by 13.5% compared to the year ended December 31, 2009. Significant factors affecting gross premiums written were:
A decrease in gross premiums written in the aviation line for the year ended December 31, 2010. This decrease was partially offset by an increase in aviation business written in our Alterra at Lloyd’s segment as many of the policies previously written in our insurance segment were renewed by Alterra at Lloyd’s; and
Gross premiums written increased in the year ended December 31, 2009 by 9.9% compared to year ended December 31, 2008. Significant factors affecting gross premiums written were:
An increase in gross premiums written in the professional liability, aviation and property lines where we experienced favorable market pricing and reduced market capacity, particularly in professional liability; and
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2010 was 46.1%, as compared to 49.6% and 50.9%, respectively, in the years ended December 31, 2009 and December 31, 2008. The amount of reinsurance that we purchase can vary significantly by line of business. The decrease in the percentage of reinsurance premiums ceded is principally due to changes in the mix of business. A contributing factor in 2010 was the reduction in property reinsurance premiums ceded to Harbor Point which became fully eliminated intercompany transactions after the Amalgamation. We expect to gradually replace those reinsurance premiums ceded with third parties over the course of the normal renewal periods.
Net losses and loss expenses. The loss ratio for the year ended December 31, 2010 decreased by 5.4 percentage points compared to the year ended December 31, 2009. The net favorable and (unfavorable) development of prior year reserves in the years ended December 31, 2010, 2009 and 2008 by line of business was as follows:
Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, in the year ended December 31, 2010 of $45.2 million compared to $41.3 million in the year ended December 31, 2009;
Net favorable loss development in the year ended December 31, 2010 reflected better than expected loss emergence across all lines of business, most significantly in the professional liability line. Favorable loss development principally emerged on the 2009 year for aviation, 2004 year for excess liability, 2004, 2005 and 2006 years for professional liability, and on the 2008 and 2009 years for the property line of business;
Increases in insurance premium estimates for contracts that incepted before 2010 resulted in an increase in prior year loss reserves of $2.8 million in 2010, $2.4 million in 2009 and $0.8 million in 2008.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2010 increased $4.0 million compared to the year ended December 31, 2009. The increase was principally due to increased performance based compensation expense resulting from improved underwriting results compared to the prior year, and a shift to a larger cash component and fewer stock-based awards.
The underwriting results of the former Harbor Point companies have been included within the reinsurance segment for the period from May 12, 2010. As a result, a comparison of 2010 results with 2009 and 2008 results is not meaningful. For this reason, we have included certain financial information for the reinsurance segment on a combined pro forma basis for informational purposes only as if the Amalgamation had occurred on January 1, 2009. See the section entitled Reinsurance Segment on a pro forma basis for a presentation of the combined pro forma information.
Workers’ compensation premiums decreased principally due to the non-renewal of a significant contract written in the prior year, resulting in a decrease of $45.7 million, as well as a downwards net premium adjustment of $9.5 million on a prior year contract triggered by a similar downwards revision to losses on the contract; and
The market for property reinsurance was favorable and our renewals benefited from an increase in rates. However, with the 41.6% growth in our U.S. specialty property business in the United States we kept our reinsurance premium volumes stable year-over-year as part of our strategy to limit aggregate property exposures; and
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2010 was 12.6% compared to 16.4% for the year ended December 31, 2009. The decrease in the percentage was principally due to the inclusion of Harbor Point business from May 12, 2010 at a lower ratio of reinsurance premiums ceded to gross premiums written.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2009 was 16.4% compared to 22.0% for the year ended December 31, 2008. The decrease in the percentage was principally due to a significant quota share contract incepting in the third quarter of 2008 which renewed in 2009 at a significant lower amount. In addition, reinstatement premiums ceded triggered by property catastrophe losses during 2008 were $1.7 million compared to no significant reinstatement premiums ceded in 2009.
The amount of net premiums earned is a function of the earning of gross premiums written and reinsurance premiums ceded over the last several quarters and, therefore, net premiums earned generally lag quarterly increases and decreases in gross premiums written and reinsurance premiums ceded. As a result, net premiums earned tend to be less volatile than gross premiums written and reinsurance premiums ceded. The increase in net
premiums earned for the year ended December 31, 2010 compared to the year ended December 31, 2009 was principally due to the incremental earnings of the Harbor Point portfolio of contracts written before the Amalgamation, which are included in the 2010 year but have no equivalent in the comparable 2009 year.
The loss ratio increased 1.6 percentage points for the year ended December 31, 2009 compared to the year ended December 31, 2008. Significant items impacting the loss ratio were:
The year ended December 31, 2009 included $2.0 million in property catastrophe-related and significant per-risk losses, compared to $47.0 million in the year ended December 31, 2008; and
Acquisition costs. The ratio of acquisition costs to net premiums earned for the year ended December 31, 2010 increased 2.6 percentage points compared to the year ended December 31, 2009. The reinsurance contracts that we write have a wide range of acquisition cost ratios. The increase in the acquisition cost ratio was principally due to changes in the mix of business written, partially influenced by the additional net premiums earned from the former Harbor Point companies. The former Harbor Point business contains a higher proportion of quota share contracts, which generally carry higher acquisition cost ratios than excess of loss contracts.
The ratio of acquisition costs to net premiums earned for the year ended December 31, 2009 increased 3.3 percentage points compared to the year ended December 31, 2008. This increase was principally as a result of changes in the mix of business written, in particular the significant growth in professional liability and workers compensation business, which raised the average ceding commission.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2010 increased $34.2 million compared to the year ended December 31, 2009. The increase was principally due to the inclusion of Harbor Point’s expenses for the period from May 12, 2010. In addition, there was an increase in performance based compensation expense as a result of improved underwriting results compared to the prior year, and a shift to a larger cash component and fewer stock-based awards, compared to 2009.
Premiums. Gross premiums written for the year ended December 31, 2010 would have been 15.8% lower than the year ended December 31, 2009. Significant factors affecting gross premiums written were:
Included in the net favorable development for the year ended December 31, 2010 was an $8.9 million reduction to net loss reserves on a significant prior year workers’ compensation contract for which there was an offsetting reduction to net premiums earned of $9.5 million. As a result, the net favorable loss development on this workers’ compensation contract had a modest negative impact on net income;
The year ended December 31, 2010 would have included $94.8 million in property catastrophe-related and significant per-risk losses, principally as a result of the Deepwater Horizon oil spill, European windstorm Xynthia, the Chilean earthquake, Australian storms, New Zealand earthquake and Australian floods. The year ended December 31, 2009 would have included $8.9 million of property catastrophe-related net losses, principally related to windstorm Klaus.
Acquisition costs. The ratio of acquisition costs to net premiums earned would have increased 0.8 percentage points for the year ended December 31, 2010 compared to the year ended December 31, 2009. The reinsurance contracts that we write have a wide range of acquisition cost ratios. The increase in the acquisition cost ratio would have been principally due to changes in the mix of business written.
Gross premiums written for the year ended December 31, 2009 increased 46.9% compared to the year ended December 31, 2008. The increase in gross premiums written reflected the expansion of our U.S platform (which commenced underwriting activities in April 2007), including the capability to write business in all states during 2009. This expansion was seen across all lines of business.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2010 was 30.4% compared to 54.3% in the year ended December 31, 2009. We intend to gradually retain more risk in the lines of business that we expect will have the greatest long term potential. Consistent with this strategy, during 2010 we cancelled a property quota share treaty and replaced it with a surplus share treaty under which we retain more of the risk. Further contributing to the decrease in reinsurance premiums ceded from the year ended December 31, 2009 was a decrease in the ceding percentage on our marine quota share treaty.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2009 was 54.3% compared to 61.1% in the year ended December 31, 2008.
Excluding the net favorable loss development, the loss ratio was 63.8% and 60.4% for the years ended December 31, 2010 and December 31, 2009, respectively. The increase in the loss ratio was principally due to changes in the mix of business; and
The loss ratio for the year ended December 31, 2009 decreased 7.9 percentage points compared to the year ended December 31, 2008. Significant items impacting the loss ratio were:
Acquisition expenses. The acquisition cost ratio has increased in each of the last two years principally as a result of corresponding decreases in the amount of reinsurance purchased. As we retain more business, we receive less ceding commission income to offset our brokerage and commission costs, which has increased our acquisition cost ratio.
Premiums. Gross premiums written for the year ended December 31, 2010 increased 57.1% compared to the year ended December 31, 2009. The increase in gross premiums written was primarily due to:
The year ended December 31, 2009 was the first full year of operations for the Alterra at Lloyd’s segment. Gross premiums written for the year ended December 31, 2009 increased 7.3% compared to gross premiums written of $120.2 million for the year ended December 31, 2008 ($111.4 million of which were written prior to our acquisition of Alterra at Lloyd’s, and therefore are not included in the consolidated results for the year ended December 31, 2008, and $8.8 million of which were written following the acquisition and are reflected in the table above). This growth was predominantly in the property and accident & health business lines.
Net losses and loss expense. The loss ratio for the year ended December 31, 2010 decreased by 1.9 percentage points compared to the year ended December 31, 2009. The net favorable and (unfavorable) development of prior year reserves in the years ended December 31, 2010, 2009 and 2008 by line of business was as follows:
Net favorable loss development of prior year reserves in the year ended December 31, 2010 was $14.9 million compared to net favorable development of $6.1 million in the year ended December 31, 2009. The net favorable development in the years ended December 31, 2010 and 2009 reflected better than expected loss emergence;
Losses and loss expense for the year ended December 31, 2010 included $8.1 million in catastrophe-related and significant per-risk losses, which included net losses from the Chilean earthquake, windstorm Xynthia, Australian hail storms, New Zealand earthquake and Australian floods. Losses and loss expense for the year ended December 31, 2009 included $1.4 million in catastrophe-related and significant per risk losses.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2010 increased $8.5 million compared to the year ended December 31, 2009. However, the general and administrative expense ratio for the year ended December 31, 2010 remained consistent with the year ended December 31, 2009 as net premiums earned increased at almost the same rate. General and administrative expenses for this segment includes profit commission income earned by Alterra at Lloyd’s from the Lloyd’s Syndicates that are not wholly owned by Alterra, which partially offsets the costs of managing the Syndicates. Profit commission income in the year ended December 31, 2010 benefited from a non-recurring gain of $4.9 million resulting from the closing of a year of account on one of these third-party Syndicates. Partially offsetting this profit commission income was an increase in information technology expenses, performance-based compensation, and expenses related to our new office in Brazil.
There were no new life and annuity contracts written during the year ended December 31, 2010. One new reinsurance contract was written in the year ended December 31, 2009, accounting for most of the premiums written for that year. Three contracts totaling gross premiums written of $239.6 million, each covering closed blocks of pension annuities for existing clients, were written in the year ended December 31, 2008. Our life and annuity business was focused exclusively on acquiring policies with significant reserve balances, which allowed us to earn a profit by investing at a higher yield than the cost of funds of those reserves. We were able to execute this strategy successfully in prior years as our investment in hedge funds constituted a significant portion of our total investments and investment yields in general were more attractive. Our investment strategy is now focused primarily on holding high quality fixed maturity securities, which makes it difficult to grow our life and annuity business profitably. In addition, we have not been able to identify many meaningful opportunities to write new life and annuity reinsurance contracts where we can earn an attractive investment spread. As a result, we have determined not to write any new life and annuity contracts in the foreseeable future. This determination does not affect our existing life and annuity reinsurance contracts and we will continue to service our existing life and annuity customer base.
The decrease in net investment income for the year ended December 31, 2009 was principally attributable to the increase in the ratio of average cash to average invested assets for the year ended December 31, 2009 as compared to the year ended December 31, 2008. This increase in cash was principally attributable to significant cash redemptions received from our hedge fund portfolio, growth in gross premiums written, and a desire to maintain high levels of liquidity, partially offset by the repayment of debt.
Change in fair value of other investments. Our investment in hedge funds comprise the majority of other investments. The increase in fair value of the hedge fund portfolio was $14.3 million, or a 4.27% rate of return, for the year ended December 31, 2010, compared to an increase of $75.8 million, or a 12.27% rate of return, for the year ended December 31, 2009. Over the last 24 months, we have significantly reduced our level of investment in hedge funds. As a result, the returns generated by our hedge fund portfolio represent a decreasing proportion of our total investment income compared to previous periods. The rate of return of 4.27% for the year ended December 31, 2010 compares to the HFRI Fund of Funds Composite Index returning 5.67% over the same period, which we believe is our most relevant benchmark.
Included in the change in fair value of hedge funds for the year ended December 31, 2008 was a $3.8 million realized loss on a futures transaction that was initiated and fully settled in September 2008. This transaction was initiated as an economic hedge on a portion of our holdings of U.S. government securities.
Our available for sale portfolio is recorded at fair value with unrealized gains and losses recorded in other comprehensive income as part of total shareholders’ equity. Our available for sale fixed maturities investment strategy is not intended to generate significant realized gains and losses as more fully discussed below in the Financial Condition section. Our held to maturity portfolio includes securities for which we have the ability and intent to hold to maturity or redemption, and is recorded at amortized cost. There should be no realized gains or losses related to this portfolio unless there is an other than temporary impairment loss. Our trading portfolio is recorded at fair value with realized and unrealized gains and losses recorded in net income, all of which are reported within our Alterra at Lloyd’s segment. Net realized and unrealized gains (losses) on our fixed maturities portfolios for the years ended December 31, 2010, 2009 and 2008 were $11.0 million, $4.5 million, and $(2.0) million respectively.
Cash and invested assets. Aggregate invested assets, comprising cash and cash equivalents, fixed maturities and other investments, were $7,861.4 million as of December 31, 2010 compared to $5,262.4 million as of December 31, 2009, an increase of 49.4%. The increase in cash and invested assets resulted principally from the Amalgamation, which contributed $2,663.0 million in invested assets as of May 12, 2010, and from the issuance of senior notes in September 2010. This increase during the year ended December 31, 2010 was partially offset by the payment of dividends of $349.5 million and the repurchase of ordinary shares of $207.8 million.
Investments in hedge funds comprise a portfolio of limited partnership and stock investments in trading entities, or funds, which invest in a wide range of financial products. The units of account that we value are our interests in the funds and not the underlying holdings of such funds. Thus, the inputs we use to value our investments in each of the funds may differ from the inputs used to value the underlying holdings of such funds. These funds are stated at fair value, which ordinarily will be the most recently reported net asset value as advised by the fund manager or administrator, where the fund’s underlying holdings can be in various quoted and unquoted investments. We believe the reported net asset value represents the fair value market participants would apply to an interest in the fund. The fund managers value their underlying investments at fair value in accordance with policies established by each fund, as described in each of their financial statements and offering memoranda.
We have designed ongoing due diligence processes with respect to funds and their managers. These processes are designed to assist us in assessing the quality of information provided by, or on behalf of, each fund and in determining whether such information continues to be reliable or whether further review is necessary. While reported net asset value is the primary input to the review, when the net asset value is deemed not to be indicative of fair value, we may incorporate adjustments to the reported net asset value. These adjustments may involve significant judgment. We obtain the audited financial statements for every fund annually, and regularly review and discuss the fund performance with the fund managers to corroborate the reasonableness of the reported net asset values.
Certain funds in which we are invested have a lock-up period. A lock-up period refers to the initial amount of time an investor is contractually required to invest before having the ability to redeem. Funds that do provide for periodic redemptions may, depending on the funds’ governing documents, have the ability to deny or delay a redemption request, called a gate. The fund may implement this restriction because the aggregate amount of redemption requests as of a particular date exceeds a specified level, generally ranging from 15% to 25% of the fund’s net assets. The gate is a method for executing an orderly redemption process, which allows for redemption requests to be executed in a timely manner to reduce the possibility of adversely affecting the remaining investors in the fund.
Certain funds may be allowed to invest a portion of their assets in illiquid securities, such as private equity and convertible debt. In such cases, a common mechanism used is a side-pocket, whereby the illiquid security is assigned to a separate memorandum capital account or designated account. Typically, the investor loses its redemption rights to the designated account. Only when the illiquid security is sold, or otherwise deemed liquid by the fund, may investors redeem their interest. As of December 31, 2010, the fair value of our hedge funds held in side-pockets was $61.6 million.
Losses and benefits recoverable from reinsurers. Losses and benefits recoverable from reinsurers totaled $956.1 million as of December 31, 2010 compared to $1,001.4 million as of December 31, 2009, a decrease of 4.5%. This decrease was principally due to the losses recoverable collected as part of the final settlement of a significant contract during the year, which was partially offset by additional losses ceded under our reinsurance and retrocessional agreements resulting from net earned premiums during the year ended December 31, 2010.
Losses recoverable from reinsurers on property and casualty business were $921.0 million and $964.8 million as of December 31, 2010 and 2009, respectively. Benefits recoverable from reinsurers on life and annuity business were $35.1 million and $36.6 million as of December 31, 2010 and 2009, respectively.
As of December 31, 2010, 88.5% of our losses and benefits recoverable were with reinsurers rated “A” or above by A.M. Best Company and 5.0% were rated “A-”. Grand Central Re, a Bermuda domiciled reinsurance company in which Alterra Bermuda has a 7.5% equity investment, is our largest “NR-not rated” retrocessionaire and accounted for 5.1% of our losses and benefits recoverable as of December 31, 2010. As security for outstanding loss obligations, we retain funds from Grand Central Re amounting to 175.7% of its loss recoverable obligations. The remaining 1.4% of losses and benefits recoverable were with reinsurers rated “B+” or lower, including those not rated.
We tailor our fixed maturities portfolios in an effort to match the duration of expected loss and benefit payments. We believe that our property and casualty loss reserves and life and annuity benefit reserves currently have an average duration of approximately 5.0 years, which compares to an average duration of 4.7 years for our fixed maturities investment portfolio. However, increased loss amounts or settlement of losses and benefits earlier than anticipated can result in greater cash needs. We maintain a significant working cash balance and have generated positive cash flow from operations in each of our last eight years of operating history. We also have the ability to borrow an additional $400.0 million using our current credit facilities. Our two largest credit facilities expire in June and August 2012. Our cash and cash equivalents balance was $905.6 million as of December 31, 2010. We believe that we currently maintain sufficient liquidity to cover existing requirements and provide for contingent liquidity. Nonetheless, it is possible that significant deviations in expected loss and benefit payments can occur, potentially requiring us to liquidate a portion of our fixed maturities portfolios. If we need to liquidate our fixed maturities securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated as of December 31, 2010.
As a holding company, Alterra’s principal asset is its investment in the common shares of its principal operating subsidiary, Alterra Bermuda. Alterra’s principal source of funds is from interest income on cash balances and cash dividends from our subsidiaries, including Alterra Bermuda. The payment of dividends by Alterra Bermuda is limited under Bermuda law. In particular, Alterra Bermuda may not declare or pay any dividends if it is in breach of its minimum solvency or liquidity levels under Bermuda law or if the declaration or payment of the dividends would cause it to fail to meet the minimum solvency or liquidity levels under Bermuda law. As of December 31, 2010, Alterra Bermuda met all minimum solvency and liquidity requirements. Alterra Bermuda returned $475.0 million of capital and surplus during the year ended December 31, 2010 through dividends and distributions of capital, excluding distributions related to our internal corporate restructuring. Alterra Re USA may not pay dividends without the consent of the Connecticut Insurance Commissioner until May 12, 2012.
In the ordinary course of business, we are required to provide letters of credit or other regulatory approved security to certain of our clients to meet contractual and regulatory requirements. As of December 31, 2010, we had three U.S dollar denominated letter of credit facilities totaling $1,525.0 million with an additional $350.0 million available subject to certain conditions. On that date, we had $908.0 million in letters of credit outstanding under these facilities. We also had two GBP denominated letter of credit facilities totaling GBP 90.0 million ($140.5 million) supporting our Funds at Lloyd’s commitments and the underwriting activity at Alterra Re UK, of which GBP 70.1 million ($109.5 million) was utilized as of December 31, 2010. Certain of our credit facilities require that we comply with certain financial covenants, which may include a minimum consolidated tangible net worth, a minimum insurer financial strength rating and restrictions on the payment of dividends. We were in compliance with all the financial covenants of each of our credit facilities as of February 18, 2011.
In April 2007, Alterra USA issued $100.0 million aggregate principal amount of 7.20% senior notes due April 14, 2017, of which $90.6 million principal amount was outstanding as of December 31, 2010. The senior notes are guaranteed by Alterra.
We believe that we have sufficient capital to meet our foreseeable financial obligations.
The amounts in the above table represent our gross estimates of known liabilities as of December 31, 2010 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts paid out in the time periods shown will be greater than those indicated in the table. Furthermore, life and annuity benefits and deposit liabilities recorded in the audited consolidated financial statements as of December 31, 2010 are computed on a net present value basis, whereas the expected payments by period in the table above are the estimated payments at a future time and do not reflect a discount of the amount payable
In this Annual Report on Form 10-K, we have presented net operating income and annualized net operating return on average shareholders’ equity, which are “non-GAAP financial measures” as defined in Regulation G. We believe that these non-GAAP financial measures, which may be defined differently by other companies, allow for a more complete understanding of the performance of our business. These measures, however, should not be viewed as a substitute for those determined in accordance with U.S. GAAP. A reconciliation of the non-GAAP financial measures to their respective most directly comparable U.S. GAAP financial measures is as follows:
(b) Average shareholders’ equity is computed as the average of the quarterly average shareholders’ equity balances. The average for the year ended December 31, 2010 has been weighted to include Harbor Point from May 12, 2010, the date of the consummation of the Amalgamation.
ASU 2010-06, Fair Value Measurements and Disclosures (820)-Improving Disclosures about Fair Value Measurements
ASU 2010-06 requires additional disclosure, and clarifies existing disclosure requirements, about fair value measurements. The additional requirements include disclosure regarding the amounts and reasons for significant transfers in and out of Level 1 and 2 of the fair value hierarchy and also separate presentation of purchases, sales, issuances and settlements of items measured using significant unobservable inputs (i.e. Level 3). The guidance clarifies existing disclosure requirements regarding the inputs and valuation techniques used to measure fair value for measurements that fall in either Level 2 or Level 3 of the hierarchy. The requirements are effective for interim and annual reporting periods beginning after December 15, 2009 except for the disclosures about purchases, sales, issuances and settlements which is effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The guidance has not and is not expected to have a material impact on our consolidated financial statements.
ASU 2010-20, Receivables (310)-Disclosures About the Credit Quality of Financing Receivables and the Allowance for Credit Losses
ASU 2010-20 requires additional disclosures about the credit quality of financing receivables and allowances for credit losses. The additional requirements include disclosure of the nature of credit risks inherent in financing receivables, how credit risk is analyzed and assessed when determining the allowance for credit losses, and the reasons for the change in the allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. We have adopted the requirements of this standard in our consolidated financial statements for the year ended December 31, 2010 and it has not had a material impact.
ASU 2010-26, Financial Services-Insurance (944)-Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
ASU 2010-26 specifies how insurance companies should recognize costs that meet the definition of acquisition costs as defined in FASB guidance. ASU 2010-26 modifies the existing guidance to require that only costs that are associated with the successful acquisition of a new or renewal insurance contract should be capitalized as deferred acquisition costs. Costs that fall outside the proposed definition, such as indirect costs or salaries related to unsuccessful efforts, should be expensed as incurred. ASU 2010-26 will be effective for fiscal periods beginning on or after December 15, 2011 with prospective or retrospective application permitted. We do not expect this standard to have a material impact on our consolidated financial statements.