The following tables set forth our selected historical consolidated financial information for the last five years. This data should also be read in conjunction with the Consolidated Financial Statements and the accompanying notes presented under Item 8 and with the Management’s Discussion and Analysis of Financial Condition and Results of Operations under
The following is a discussion and analysis of our results of operations for the years ended December 31, 2009, 2008 and 2007 and our financial condition at December 31, 2009 and 2008. This should be read in conjunction with the Consolidated Financial Statements and related notes included in Item 8 of this report. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.
Results by Segment: Years ended December 31, 2009, 2008 and 2007
Net income available to common shareholders of $461 million, or $3.36 per share basic and $3.07 diluted
Operating income of $766 million , or $5.10 per share diluted(1)
Share repurchases of 5.85 million for total cost of $170 million under share repurchase authorization; additional $500 million share repurchase authorization approved by the Board of Directors in December 2009
Strong liquidity with $4.2 billion available within one to three business days
We are a Bermuda-based global provider of specialty lines insurance and treaty reinsurance products, with operations in Bermuda, the United States, Europe, Singapore, Canada and Australia. Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Reinsurance. Our strategy is to leverage our expertise, experience and relationships to expand our business globally. We are focused on organic growth, which we have supplemented with small acquisitions, while managing a portfolio of diversified and attractively priced risks. We executed on this strategy during 2009 by:
continuing to target small and middle-market insurance business through the acquisition of the operations of Australian managing general agent Dexta Corporation Pty Ltd. (which we acquired in early 2009 and will use as a platform for introduction of additional products into Australian and Asian markets);
We expect these actions will lead to long-term growth in our insurance and reinsurance businesses.
Underwriting income in our insurance segment decreased $103 million compared to 2008. This decrease was driven by a net loss of $133 million on an insurance derivative contract which was cancelled and settled in the fourth quarter of 2009. In addition, our insurance segment was impacted by higher current accident year loss activity on its credit and political risk line of business this year. These factors were partially offset by lower catastrophe activity this year, as discussed above.
2009 versus 2008: The $217 million increase in 2009 was primarily due to improved market conditions for our alternative investments, which was partially offset by lower reinvestment yields on our fixed maturities, short-term investments and cash.
2008 versus 2007: The $236 million decrease in 2008 was driven by significant valuation declines in our alternative investments (credit and hedge funds), resulting from the unprecedented disruption to the global financial markets. This decline was partially offset by a 17% increase in net investment income earned on fixed maturities primarily due to higher average fixed maturities balance.
The 121% increase in 2009 from 2008 was primarily due to foreign exchange losses and an increase in income tax expense on profits earned from our U.S. subsidiaries. The $53 million reduction in 2008 from 2007 was primarily due to higher foreign exchange gains as well as lower financing costs due to the termination of a $400 million repurchase agreement in late 2007.
We believe the following financial indicators are important in evaluating our performance and measuring the overall growth in value generated for our common shareholders:
Our 2009 ROACE improved relative to 2008 as a result of minimal catastrophe activity and strong performance from our investments in hedge and credit funds. However, it was adversely impacted by $312 million of net realized investment losses, a $133 million loss on an insurance derivative contract that was terminated during the fourth quarter and lower reinvestment yields on our fixed maturities portfolio during the year. Our 2008 ROACE was negatively impacted by losses incurred related to Hurricanes Ike and Gustav, as well as investment losses relating to the financial market crisis. In contrast, our 2007 ROACE benefited from an absence of major catastrophe losses and stable financial markets, as well as higher yields earned on our fixed maturities.
We consider DBV per common share an appropriate measure of our returns to common shareholders, as we believe growth in our book value on a diluted basis ultimately translates into growth of our stock price. The increase in 2009 was primarily driven by a net increase in the fair value of our investment portfolio resulting from a recovery in global financial markets coupled with net income available to common shareholders of $461 million. The reduction in 2008 as compared to 2007 was primarily due to the significant decline in the fair value of our investment portfolio as a result of the unprecedented turmoil in global credit and equity markets, combined with higher stock repurchases and lower underwriting income.
(1) Refer to Item 8, Note 3 to the Consolidated Financial Statements, for a reconciliation of underwriting income to “Income before income tax” for the periods indicated above.
Premiums Written: Gross and net premiums written, by segment, were as follows:
2009 versus 2008: The 6% growth in consolidated gross premium written in 2009 was driven by our reinsurance segment, reflecting improved market conditions and the select expansion of our business. In our insurance segment, market conditions have generally improved this year and the segment also benefited from certain growth opportunities, particularly within professional lines business. However, gross premiums written in 2009 were reduced by limited underwriting opportunities for credit and political risk business, as well as our decision to reduce peak zone catastrophe exposures, which particularly impacted property related lines in the first half of the year.
The increase in the premiums ceded ratio in our insurance segment this year reflects a combination of business mix changes and rate increases on our property reinsurance program.
2008 versus 2007: The 6% reduction in consolidated gross premiums in 2008 emanated from our insurance segment, reflecting the reduction of business due to deteriorating market conditions across most property and liability insurance lines of business. In addition, the credit and political risk insurance line was negatively impacted by a reduction in available transactions associated with a slow down in the capital flows amidst the ongoing global financial crisis. Gross premiums written in our reinsurance segment in 2008 were largely unchanged from 2007. Although market conditions deteriorated moderately during the year, the impact of this was largely offset by some growth opportunities.
The increase in the premiums ceded ratio in 2008 primarily reflected the purchase of additional proportional coverage within our liability and professional lines business together with the impact of business mix changes.
2009 versus 2008: Changes in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in premium earning patterns. Overall, consolidated net premiums earned in 2009 increased relative to the prior year, driven by growth of our reinsurance business, as discussed above. Net premiums earned in our insurance segment decreased this year in line with exposure reductions on several lines of business. This was partially offset by the accelerated recognition of credit and political risk premium this year due to the actual and anticipated exhaustion of exposure on certain loss impacted policies.
2009 versus 2008: The 11.5 point reduction in our consolidated current accident year loss ratio was driven by lower catastrophe related losses relative to the prior year. In particular, the North Atlantic hurricane season was benign in 2009 compared to 2008, which included net losses incurred of $408 million, or 15.2 points, on Hurricanes Ike and Gustav. These factors were partially offset by additional loss activity on credit and political risk insurance business and trade credit and bond reinsurance business, emanating from the turbulent economic environment. For further discussion on current accident year loss ratios, refer to the insurance and reinsurance segment discussions below.
Overall, net favorable prior period reserve development in each of the last three years has primarily been generated from the property, marine, terrorism and aviation lines of our insurance segment and the property, catastrophe and crop lines of our reinsurance segment. These lines of business, the majority of which have short tail exposures, contributed 63%, 86% and 95% to the total net favorable reserve development in 2009, 2008 and 2007, respectively. The favorable development on these lines of business primarily reflects the recognition of better than expected loss emergence rather than explicit changes to our actuarial assumptions. Refer to the ‘Critical Accounting Estimate on Loss Reserves’ for further discussion.
The continued economic downturn and credit crisis also had some impact on our prior year loss reserves during 2009. Specifically, we strengthened our loss reserves for accident year 2008 trade credit and bond reinsurance business by $40 million and accident year 2008 professional lines insurance business by $44 million to reflect claims emergence that was worse than we had anticipated.
$65 million of net favorable prior period reserve development on property business, the majority of which related to accident year 2008. The favorable development was driven by the continued migration to our actual loss experience, which was broadly better than we expected. As described in our ‘Critical Accounting Estimate on Loss Reserves’, the Bornhuetter-Ferguson actuarial method, which we primarily use for this business, provides for a transition between initial expected loss ratios to actual loss experience, as an accident year matures. The favorable development included a $9 million decrease in our estimate for Hurricanes Ike and Gustav due to a reduction in reported losses.
$40 million of net favorable prior period reserve development on marine business, driven by better than expected loss emergence. This included favorable development on energy offshore business of $21 million, the largest component of which related to a $7 million reduction in a specific case reserve from accident year 2006.
$13 million of net favorable prior period reserve development on aviation business which was spread across several accident years and was the result of better than expected loss emergence.
$73 million of net favorable prior period reserve development on professional lines business. This was driven by net favorable development on accident year 2005, and to a lesser extent accident years 2004 and 2006, as discussed in the overview above. This was partially offset by net adverse development on accident year 2008 business ($44 million), primarily reflecting higher than expected loss activity associated with the financial crisis on financial institutions business.
In 2008, we experienced $202 million of net favorable prior period reserve development, the principal components of which were as follows:
Net favorable prior period reserve development of $65 million from our credit and political risk line of business. The favorable development was driven by the continued migration to our actual loss experience, which was better than we expected.
$7 million of adverse development on our accident year 2004 and 2005 liability reserves, due to a higher than expected emergence of claims on a specific program.
In 2009, we experienced $212 million of net favorable reserve development, the principal components of which were as follows:
$65 million of net favorable prior period reserve development on property business, generated from accident years 2008 ($34 million), 2007 ($22 million) and prior ($9 million), and emanating from property per risk business ($42 million) and property pro rata business ($23 million). The favorable development was driven by the continued migration to our actual loss experience, which was broadly better than we expected. In addition, we updated the loss development profile of property per risk business to reflect a more accelerated profile, based on our review of historic data. For accident year 2008, the favorable development included a $6 million decrease in our estimate for Hurricanes Ike and Gustav due to a reduction in reported losses.
$19 million of net favorable development on crop reserves (included in “Other”), predominately from accident year 2008, reflecting limited reported losses relative to our expectation.
$18 million of net adverse development on trade credit and bond reinsurance lines of business. This was driven by adverse development of $40 million on accident year 2008, reflecting updated loss information received from our cedants this year. This was partially offset by favorable development on earlier accident years reflecting the recognition of better than expected loss emergence.
$69 million of net favorable prior period reserve development on professional lines reinsurance business. This was primarily driven by net favorable development on accident years 2005 and 2004, as discussed in the overview above. This was partially offset by net adverse development of $7 million on accident year 2008 reflecting claims activity associated with the financial market crisis.
$4 million of net favorable development on motor non-proportional business, primarily relating to better than expected loss experience on our accident year 2007 U.K. business.
$78 million of net favorable prior period reserve development on catastrophe business, generated from accident years 2007 ($36 million), 2006 ($25 million) and prior ($17 million), and emanating from property related catastrophe business ($59 million) and workers compensation catastrophe business ($19 million). The favorable development was driven by the continued migration to our actual loss experience, which was better than we expected.
Net favorable development of $11 million from our professional lines business. This was driven by favorable development of $25 million on accident years 2003 and 2004, offset by adverse development of $14 million from accident years 2007 and 2006.
$77 million of net favorable prior period reserve development on catastrophe business, generated from accident years 2006 ($64 million), 2005 ($10 million) and prior ($3 million), and emanating from property related catastrophe business ($66 million) and workers compensation catastrophe business ($11 million). The favorable development was driven by the continued migration to our actual loss experience, which was better than we expected.
$26 million of net favorable prior period reserve development on property business, emanating from property per risk business ($13 million) and property pro rata business ($13 million) and primarily from accident year 2006. The favorable development was driven by the continued migration to our actual loss experience, which was better than we expected.
Partially offsetting these decreases, we experienced growth in professional lines business in 2008. This was partially related to renewal rights we acquired in conjunction with our purchase of the Media Pro business in the second quarter of 2007. In addition, in the later part of the year, the growth was driven by new business arising from disruptions in the financial institutions sector together with some rate increases on renewal business.
2009 versus 2008: Premiums ceded in 2009 were $751 million, or 42% of gross premiums written, compared to $708 million, or 38%, in the same period of 2008. The increase in ceded premium ratios this year primarily reflects a combination of business mix changes and rate increases on our property reinsurance program. Business mix changes primarily relate to growth of professional lines business in 2009 together with a reduction in credit and political risk premiums, a line for which we do not purchase reinsurance cover.
Net Premiums Earned: The following table provides net premiums earned by line of business:
2009 versus 2008: The decrease in net premiums earned in 2009 primarily reflects a 10% reduction in net premiums written this year, although the rate of reduction was less accelerated. This is partially due to the earning of credit and political risk business written in prior years, which typically provides multi-year coverage, and therefore earns over a greater number of periods. The average duration of the unearned premium on credit and political risk line of business at December 31, 2009 was 4.7 years. Net premiums earned on credit and political risk business for 2009 also includes the accelerated recognition of $50 million of premium due to the actual and anticipated exhaustion of exposure on certain loss impacted policies.
2008 versus 2007: The 2% decrease in net premiums earned in 2008 primarily reflects a decrease in net premiums written this year, although the rate of reduction was less accelerated. This was partially due to growth of credit and political risk line of business in prior years, which typically provides multi-year coverage, and therefore earns over a greater number of periods. Net premiums earned in 2008 also benefited from growth in property premiums in prior years as well as lower ceded premium amortized costs on this business in 2008.
Lower catastrophe activity in 2009 relative to 2008, which included net losses incurred of $127 million, or 10.7 points, on Hurricanes Ike and Gustav.
A decrease in the expected loss ratio of our overall professional lines business from 77% in 2008 to 72% for the current accident year. The prior year included additional loss activity emanating from the subprime and related credit crisis.
The 11.0 ratio point increase in our current accident year loss ratio was the net result of several factors. The most significant drivers for the increase were as follows:
A reduction in our credit and political risk loss ratio from 46% in 2007 to 38% for accident year 2008. This was primarily due to accelerating the loss development profile of our credit related classes based on our historical loss experience. Although we experienced an increase in loss activity from these classes during the second half of 2008, stemming from the economic downturn, these losses remained within our initial loss ratios.
Other Insurance Related Income / Loss: During the fourth quarter of 2009, we negotiated the cancellation of our indemnity contract exposed to longevity risk following an analysis of likely ultimate loss as well as a review of our legal rights and obligations under the contract. Under this cancellation agreement, we agreed to pay total cash consideration of $200 million in exchange for a full release and discharge from any and all obligations under the contract, both past and future. This resulted in the recognition of $28 million in income for the quarter. During the third quarter of 2009, we made a significant upward adjustment to our original life expectancy assumptions for the lives backing the note insured under this contract which resulted in a significant increase in the fair value liability. For the full year 2009, we incurred a loss of $133 million for the above contract, net of premiums. This is in addition to the $41 million loss recorded in 2008 due to change in the estimated fair value of the contract. This was the only contract of this kind in our portfolio. Refer to the ‘Critical Accounting Estimate - Fair Value Measurements’ section for further details on the estimation process of the fair value for this contract prior to its cancellation.
In the insurance marketplace, the positive rate changes we observed during the first half of 2009 have generally decelerated, however terms and conditions as well as breadth of coverage remain stable. We continue to observe competition for market share with the most aggressive behavior emanating from admitted markets in the U.S. and new markets.
While rates for catastrophe-exposed property business have recently deteriorated, rates for energy lines of business have remained more stable, particularly in the offshore area. We expect to see a continuation of this trend as we head into the key March 1st and April 1st renewals. On our credit and political risk line of business, as has been the case throughout this year, global lending and trading activity remains weak and, therefore, opportunities in this line are expected to remain limited.
For professional lines insurance, we continue to observe favorable market conditions, particularly for financial institutions business, where pricing is up approximately 20%. Commercial directors’ and officers’ pricing has flattened out after gradual declines in recent years, while errors and omissions pricing has been flat to modestly down. For liability business, we are observing fewer new business opportunities and less available renewal premium as a result of exposure reduction by insureds amidst the current economic environment. This affect is compounded by the competitive pressures around this lower premium base. As a result, we continue to maintain a defensive posture in these lines.
Gross premiums written on our engineering and crop business (included in “Other”) decreased during 2009 primarily reflecting exposure reductions amidst less favorable market conditions. Gross premiums written in 2009 were also negatively impacted from a stronger U.S. dollar relative to 2008. In particular, the U.S. dollar was stronger against the Euro and Sterling at our major renewal of January 1. Gross premiums written excluding the effect of exchange rate movements increased 19% in 2009.
The increase in net premiums earned in 2009 reflects gross premium written growth across several lines of business this year, in particular professional lines, credit and bond and liability business. Net premiums earned in 2008 were largely unchanged with 2007, reflecting a period in which our gross premiums written were also relatively stable.
Loss Ratio: The table below shows the components of our loss ratio:
The 19.0 ratio point decrease in our current accident year loss ratio was the net result of several factors. The most significant drivers for the decrease were as follows:
A benign North Atlantic hurricane season in 2009 compared to 2008, which included net losses incurred of $281 million, or 18.7 points, on Hurricanes Ike and Gustav.
Other catastrophe losses in 2009 were also lower relative to the prior year, which included flood, hail and tornado activity in the U.S., an earthquake in China and storms in Australia. The most significant catastrophe losses this year related to European windstorm activity in the first and third quarter, with total incurred net losses estimated at $27 million.
Increased loss activity on trade credit and bond business this year emanating from continued turbulence in the economic environment. The current accident year loss ratio on credit and bond business in 2009 was 89% compared to 72% for 2008.
The 18.7 ratio point increase in our current accident year loss ratio was the net result of several factors. The most significant drivers for the increase were as follows:
Increased loss activity on trade credit and bond business in 2008 emanating from the deteriorating economic environment. The current accident year loss ratio on credit and bond business in 2008 was 72% compared to 55% for 2007.
Just over 80% of our 2009 expiring premium from our Europe-based reinsurance business renews on January 1st and it was this portfolio that drove our growth. Across the board, the market was more competitive, but not irrational, and we continued to decline business that was not attractively priced. The select areas where we chose to grow, combined with a modest shift in our portfolio towards more proportional business, resulted in growth overall in the European reinsurance account. The most significant areas of growth were our trade credit and bond reinsurance and motor reinsurance lines of business. Our new Latin America surety reinsurance team contributed to growth in the trade credit and bond reinsurance line with new business written at the January 1st renewal. In our motor reinsurance line, we reduced our participation in the excess-of-loss market in France due to the failure of the market to secure rate to compensate for escalating loss costs. However, this reduction was more than offset by new proportional motor treaties in the U.K., where cedants are experiencing rate increases on the underlying account.
Overall, our catastrophe reinsurance premium was down approximately 10% at the January 1st renewal as we reduced our exposure to European windstorm. Increased competition has led to expected margins reducing gradually over the last few years. This business is still attractively priced at current levels, but the expectation of continued pressure in Europe prompted us to re-balance our worldwide cat portfolio. In North America, any price reductions at the January 1st renewal did not alter expected margins materially. Property catastrophe reinsurance remains one of our most attractively priced lines of business. Pricing for regional property per risk and excess of loss accounts was, for the most part, driven by experience. The exception to this was Continental Europe where the market did not react similarly.
Foreign Exchange Losses (Gains): Some of our business is written in currencies other than U.S. dollars. The foreign exchange loss in 2009 was primarily due to the remeasurement of net liabilities denominated in Euro and Sterling, following their appreciation against the U.S. dollar this year. In comparison, the Euro depreciated against the U.S dollar during 2008 driving the foreign exchange gain for that year. The foreign exchange gain in 2007 was driven by the revaluation of net asset balances denominated in several foreign currencies, following their appreciation against the U.S. dollar over this period.
Income Tax Expense: Income tax is generated primarily through our foreign operations in the United States and Europe. The effective tax rate, which is calculated as income tax expense divided by income before tax, was 7.8% for 2009 compared with 4.9% in 2008 and 3.7% in 2007. The effective tax rate varies between periods depending on the distribution of net income or losses among our various taxable jurisdictions.
(1) Pre-tax yield is calculated as net investment income divided by the average amortized cost balance for the period.
2009 versus 2008: The reduction in investment income from fixed maturities reflects lower reinvestment yields during 2009 as a result of the global economic stimuli provided by various government bodies in late 2008 which contributed to the significant tightening of credit spreads. This reduction was partially offset by growth of 12% in our average fixed maturity balances during the year.
2009 versus 2008: The decrease in investment income from cash and cash equivalents in 2009 reflects the decline in global short-term interest rates that the global governments have initiated to stabilize financial markets and the broader economy. Average cash and cash equivalents balances in 2009 were similar to those in 2008.
As noted in our ‘Critical Accounting Estimates-Fair Value Measurements’, we record the change in fair value on our other investments in net investment income. Accordingly, the pre-tax return on other investments may vary materially year over year, in particular during volatile credit and equity markets. The following table provides a breakdown of net investment income (loss) from other investments:
The 15.8% pre-tax return on other investments in 2009 was primarily driven by strong performance by hedge funds and credit funds. Our hedge fund investments have exposures primarily to net long equity positions, and these funds tracked the strong performance of global equity indices during the year. Credit funds also advanced on the recovery of market pricing for the underlying bank loans that form the collateral of these funds. In 2008, credit funds were negatively impacted by illiquidity proliferating throughout the credit markets rather than a fundamental deterioration of the underlying collateral. Loan valuations within our credit funds began falling at the end of 2007 after default expectations increased as a result of the collapse of the sub-prime mortgage industry that effectively shut down credit markets worldwide. This led to a significant widening in credit spreads. Although there was a brief recovery in prices in mid-2008, prices continued to fall dramatically in the months following the failure of Lehman Brothers and other global financial firms that forced de-leveraging by investors within the financial markets. Loan valuations at the end of 2008 were near historical lows. Consequently, this contributed significantly to the negative pre-tax return in 2008.
The net realized investment gains on the sale of fixed maturities and short-term investments in 2009 primarily include gains on sales of U.S. agency pass-throughs (residential mortgage-backed securities (“MBS”)) as the strong rally since late 2008 provided an opportunity to reduce potential extension of our duration risk (refer to ‘Cash and Investments’ section).
Net realized losses on the sale of equities in 2008 include losses of $60 million in connection with the sale of our Fannie Mae and Freddie Mac non-redeemable preferred equities, recognizing their deteriorating financial condition. These publicly traded government sponsored enterprises, which were leading participants in the U.S. secondary mortgage market, were negatively impacted by the housing market downturn and credit crunch. In September 2008, both Fannie Mae and Freddie Mac were placed into conservatorship by the U.S. Treasury.
We review our available-for-sale investment portfolio each quarter to determine if the unrealized loss position of a security is other-than-temporary. Refer to the ‘Critical Accounting Estimates - OTTI’ section for further details on our impairment review process.
In accordance with the new accounting guidance effective April 1, 2009, the OTTI charge to earnings reflects only credit impairments, where projected cash flows are less than the amortized cost of a security, or the full unrealized loss position if we intend to sell a fixed maturity security or it is more likely than not that we will need to sell it to meet our liabilities. The new guidance does not allow for retrospective application, therefore the OTTI charge recorded in the first quarter of 2009 as well as for prior year periods are based on previous OTTI accounting guidance (i.e. the difference between the fair value and amortized cost of a debt security in an unrealized loss position).
The following table summarizes our OTTI recognized in earnings by asset class:
The impairment charges on the residential MBS during 2009 were primarily related to expected credit losses while the OTTI charge on the commercial MBS was related to our intent to sell in order to take advantage of the favorable market conditions and to reduce our exposure on this asset class.
The OTTI losses in 2007 were spread across our portfolio, with no concentration to any particular type of investment or sector.
The OTTI losses on equities in 2009 and 2008 are due to the severity and duration of the unrealized loss positions, for which we concluded the forecasted recovery period was too uncertain. The recognition of such losses does not necessarily indicate that sales will occur or that sales are imminent or planned.
Due to the significant volatility in the Euro vs. U.S. dollar currencies in 2008, we implemented a fair value hedging program to hedge un-matched foreign currency exposures in the third quarter of 2008. During 2009 and 2008, our hedging program was effective, resulting in a net gain of $3 million and net loss of $1 million, respectively. Refer to Item 8, Note 9 of our Consolidated Financial Statements and
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of AXIS Capital Holdings Limited and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 22, 2010 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
While the amounts included in the consolidated financial statements reflect management’s best estimates and assumptions, these amounts could ultimately differ from those estimates. Any such adjustments are reflected in income in the period in which they become known.
We recognize investment income from fixed maturities based on the constant effective yield method which includes an adjustment for estimated principal repayments, if any. The effective yield used to determine the amortization for fixed maturities subject to prepayment risk (e.g., asset-backed, loan-backed and other structured securities) is recalculated and adjusted periodically based upon actual historical and/or projected future cash flows. The adjustments to the yield for highly rated (i.e. AA or above by Standard & Poor’s (“S&P”)) prepayable fixed maturities are accounted for using the retrospective method. The adjustments to the yield for non-highly rated prepayable fixed maturities are accounted for using the prospective method.
For equity securities we continue to consider our ability and intent to hold an equity security in an unrealized loss position for a reasonable period of time to allow for a full recovery. When it is determined that the decline in value of an equity security is other-than-temporary, we adjust the carrying value of the equity security to its fair value, with a corresponding charge to earnings.
We record other investments at fair value (see Note 6 - Fair Value Measurements), with the change in fair value and realized gains and losses reported in net investment income.
Cash equivalents include money-market funds and fixed interest deposits placed with a maturity of under 90 days when purchased. Cash and cash equivalents are recorded at amortized cost, which approximates fair value due to the short-term, liquid nature of these securities.
Insurance premiums written are recorded in accordance with the terms of the underlying policies. For multi-year policies for which premiums are payable in annual installments, premiums are recorded at the inception of the policy based on management’s best estimate of total premiums to be received. However, this excludes premiums for the period during which the insured/reinsured has the ability to unilaterally commute or cancel coverage. Reinsurance premiums are recorded at the inception of the policy and are estimated based upon information received from ceding companies. Any subsequent differences arising on insurance and reinsurance premium estimates are recorded in the period they are determined.
Insurance and reinsurance premiums are earned ratably over the period during which we are exposed to the insured or reinsured risk. Unearned premiums represent the portion of premiums written that is applicable to the unexpired portion of the policies in force.
We determine the fair value of stock-based awards at the date of grant and recognize the share-based compensation expense over the period the award is earned by the employee, net of our best estimate of forfeiture benefits.
New guidance amending the previous recognition and presentation of OTTI for debt securities, as disclosed above. This guidance requires new interim and annual disclosure of both fixed maturities and equities, including more disaggregated information (refer to Note 5 - Investments). As of April 1, 2009, the adoption of this standard resulted in $38 million net after-tax increase to retained earnings with a corresponding decrease to accumulated other comprehensive income (loss), resulting in no change to our total shareholders’ equity. This adjustment reflects the non-credit portion of the total OTTI of $86 million previously recognized in retained earnings for fixed maturity securities still outstanding at March 31, 2009. As part of the cumulative effect adjustment, we also recorded a corresponding adjustment to the amortized cost of our fixed maturities.
New guidance requiring disclosure about fair value of financial instruments for interim reporting periods as well as in annual financial statements. Refer to Note 6 - Fair Value Measurements.
Our insurance segment provides insurance coverage on a worldwide basis. The product lines in this segment are property, marine, terrorism, aviation, credit and political risk, professional lines, liability and other.
The contractual maturities of fixed maturities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
At December 31, 2009, 832 fixed maturities (2008: 1,202) were in an unrealized loss position of $134 million (2008: $812 million) of which $20 million (2008: $16 million) of this balance was related to securities below investment grade or not rated. During 2009, the gross unrealized losses have declined by $678 million primarily due to $317 million of impairments and $361 million of improved valuations as a result of the significant credit spread tightening and losses realized during the year. The reduction of gross unrealized losses on our fixed maturity portfolio at December 31, 2009, are primarily attributable to a partial recovery of the historic wide credit spreads experienced during the credit crisis of 2008.
At December 31, 2008, 266 securities have been in continuous unrealized loss position for 12 months or greater and have a fair value of $702 million. These securities were primarily corporate debt and non-agency commercial MBS with a weighted average S&P credit rating of A and AAA, respectively. Within our corporate debts, $248 million of the $329 million gross unrealized losses was attributable to our holdings in medium-term notes (MTNs). The MTNs are a highly diversified pool of corporate and sovereign debt securities and were significantly impacted by the unprecedented widening of credit spreads experienced during the credit crisis, rather than credit losses. We had the ability and intent to hold these securities to recovery.
At December 31, 2009, 95 securities (2008: 149) were in an unrealized loss position and 56 of these securities (2008: nil) have been in a continuous unrealized loss position for 12 months or greater. In 2009, the gross unrealized losses have declined by $50 million from December 31, 2008, of which $20 million was due to impairments and the remaining $30 million was due to price appreciation driven by the recovery in the equity markets and realized losses during the year.
Based on our OTTI quarterly review process and our ability and intent to hold these securities for a reasonable period of time sufficient for a recovery of fair value, we concluded that the above equities in an unrealized loss position were temporarily impaired at December 31, 2009 and 2008.
Seek to achieve attractive risk-adjusted returns by investing in a large pool of hedge funds across a diversified range of hedge fund strategies.
Seek to achieve attractive risk-adjusted returns by executing a credit trading strategy involving selective long and short positions in primarily below investment-grade credit.
In 2009, we incurred OTTI charges of $317 million (2008: $71 million) relating to fixed maturities. These charges primarily relate to an impairment charge of $263 million recorded on our portfolio of MTNs within our corporate debt holdings as well as $20 million due to our intent to sell certain securities during the year ($3 million of corporate debt, $6 million of residential MBS and $11 million of commercial MBS). In 2008, our OTTI charges included $40 million of write-downs on a number of financial institutions, including $32 million related to Lehman Brothers, following its bankruptcy and sale in September, 2008. The balance of the OTTI charges on corporate debt was spread across the portfolio on securities that are unlikely to recover. The OTTI charges on our ABS and MBS portfolio in 2008 were primarily the result of the credit crisis and the higher risk of defaults on certain identified securities.
The credit losses remaining in retained earnings upon adoption of the new accounting standard were $45 million, comprising $33 million of corporate debt securities, $7 million of ABS, $4 million of residential MBS and $1 million of commercial MBS. Corporate debts included $20 million of credit losses related to the bankruptcy of Lehman Brothers.
Credit losses are calculated based on the difference between the amortized cost of the security and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security prior to the impairment. The significant inputs and the methodology used to estimate the credit losses for which a portion of the OTTI was recognized in AOCI were as follows:
During 2009, based on expected cash flows to be collected, we have recorded credit losses of $14 million on residential MBS.
We are required to maintain assets on deposit with various regulatory authorities to support our insurance and reinsurance operations. The assets on deposit are available to settle insurance and reinsurance liabilities. We also utilize trust accounts in certain large transactions to provide collateral to ceding companies, rather than providing letters of credit. The assets in trust consist primarily of highly rated fixed maturity securities and a foreign bond mutual fund. The fair value of our restricted assets components are as follows:
We used the following methods and assumptions in estimating the fair value of our financial instruments as well as the general classification of such financial instruments pursuant to the above fair value hierarchy.
The valuations for fixed maturity securities are generally obtained from third party pricing services for identical or comparable securities or through the use of “pricing matrix models” using observable market inputs such as yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. Pricing from third party pricing services are sourced from multiple vendors, and we maintain a vendor hierarchy by asset type based on historical pricing experience and vendor expertise.
Where pricing is unavailable from pricing services, we obtain unbinding quotes from broker-dealers or use an internal model to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. These securities are classified within Level 3 and consisted primarily of CLO debt tranched securities, private corporate debt securities and certain residential MBS at December 31, 2009.
The hedge and credit funds are classified within Level 3 as we estimate their respective fair values using net asset values as advised by external fund managers or third party administrators. Refer to Note 5 (b) for further details on this asset class.
The CLO - equity tranched securities (“CLO - Equities”) are classified within Level 3 as we estimate the fair value for these securities based on an internal valuation model due to the lack of observable, relevant trade in the secondary markets. The model includes the following significant unobservable inputs: default and recovery rates and collateral spreads. During the year ended December 31, 2009, the change in fair value for the CLO equities was primarily due to lower recoveries on actual defaults and change to our recovery rate assumption. We have revised our projected default and recovery rates in 2009 based on our assessment of actual experience on the underlying collateral for our CLO - Equities as well as a review of recent credit rating agencies’ forecasted default and recovery rates for U.S. corporate speculative-grade securities. The following table presents the weighted average of each significant input used in our valuation model.
The timing of the receipt of death benefits as well as the amount of premiums to be paid to maintain the policies in force, both of which are directly correlated to life expectancy assumptions for a portfolio of 188 lives;
The tables below present the financial instruments measured at fair value on a recurring basis.
During 2009 and 2008, we had no transfers between Levels 1 and 2.
(1) Realized gains and (losses) on other investments are included in net investment income. Losses on other liabilities are included in other insurance related income (loss).
As the financial markets recovered mostly during the second half of 2009, the volume of market transactions also increased for our Level 3 securities such that significant observable market inputs were used for the valuation of these securities at December 31, 2009. As a result, certain fixed maturities with a fair value of $113 million were transferred out of Level 3 to Level 2.
Transfers into the Level 3 balance reflect the fair value of the securities at the beginning of the period and the transfers out of Level 3 reflect the fair value at the end of the period.
The carrying amount of financial assets and liabilities presented on the Consolidated Balance Sheets as at December 31, 2009, and December 31, 2008, are equal to fair value with the exception of senior notes. Senior notes are recorded at amortized cost with a carrying value of $499 million (2008: $499 million) and a fair value of $510 million (2008: $415 million) at December 31, 2009.
The following table represents a reconciliation of our beginning and ending net unpaid losses and loss expense reserves:
Overall, net favorable prior period reserve development in each of the last three years has primarily been generated from the property, marine, terrorism and aviation lines of our insurance segment and the property, catastrophe and crop lines of our reinsurance segment. These lines of business, the majority of which have short tail exposures, contributed 63%, 86% and 95% to the total net favorable reserve development in 2009, 2008 and 2007, respectively. The favorable development on these lines of business primarily reflects the recognition of better than expected loss emergence rather than explicit changes to our actuarial assumptions.
Credit and political risk business contributed 8% and 17% of the total net favorable reserve development in 2009 and 2008, respectively. In 2009, the favorable development was generated from credit related classes, largely from accident year 2007, and to a lesser extent, accident years 2006 and 2005, and was driven by the recognition of lower than expected loss activity. In 2008, the favorable development was primarily generated from credit related classes, partially in recognition of lower than expected loss activity and also due to adopting a more accelerated loss development profile on these lines. We also recognized favorable prior period reserve development from our traditional political risk book from accident years 2004 and prior.
We purchase treaty and facultative reinsurance to reduce exposure to a large loss or a series of large losses. Facultative reinsurance provides for all or a portion of the insurance provided by a single policy and each policy reinsured is individually negotiated. Treaty reinsurance provides for a specified type or category of risks. The reinsurance agreements are written on either an excess of loss or proportional basis. Excess of loss covers provide a contractually set amount of cover after an excess point has been reached. This excess point can be based on the size of an industry loss or a fixed monetary amount. These covers can be purchased on a package policy basis, which provide cover for a number of lines of business within one contract. Proportional covers provide a proportional amount of coverage from the first dollar of loss. All of these reinsurance covers provide for recovery of a portion of losses and loss expenses from reinsurers. Under our reinsurance security policy, we predominantly cede our business to reinsurers rated A- or better by S&P and/or A.M. Best. We remain liable to the extent that reinsurers do not meet their obligations under these agreements either due to solvency issues, contractual disputes or some other reason.
At December 31, 2009, 6.4% (2008: 6.2%) of the total reinsurance recoverable balance was collateralized.
The following table provides the total unrealized and realized gains (losses) recorded in earnings for the years ended December 31, 2009, 2008 and 2007.
The hedging relationship foreign currency contracts were entered into to mitigate the foreign currency exposure of two available for sale (“AFS”) fixed maturity portfolios denominated in Euros. The hedges were designated and qualified as a fair value hedge. The net impact of the hedges is recognized in net realized investment losses.
Mortgage derivatives are commonly referred as to-be-announced mortgage-backed securities and are accounted for as derivatives. As part of our investment strategy, we may from time to time invest in mortgage derivatives.
In September 2007, we issued a policy which indemnifies a third party in the event of a non-payment of a $400 million asset-backed note (“Note”). This security had a 10 year term with the full principal amount due at maturity and was collateralized by a portfolio of life settlement contracts and cash held by a special purpose entity. We concluded that the indemnity contract was a derivative instrument and accordingly recorded it at its fair value. This contract was cancelled and settled during the fourth quarter of 2009, resulting in a loss of $133 million for the full year (2008: $41 million).
We were in compliance with all covenants at December 31, 2009 and 2008. At December 31, 2009, we had letters of credit outstanding of $453 million (2008: $567 million). There was no debt outstanding under the credit facility at December 31, 2009 and 2008.
Financial instruments that potentially subject us to concentrations of credit risk consist principally of investments and reinsurance recoverable balances.
Our investment portfolio is managed by external investment managers in accordance with our investment guidelines. Specific provisions limit the allowable holdings of a single issue and issuers. Specifically, we manage our credit exposure by limiting the purchase of fixed maturities to investment grade securities. In addition, excluding U.S. government and agency securities, we limit our concentration of credit risk to any single corporate issuer to 2% or less of our fixed maturities portfolio for securities rated A- or above and 1% or less of our fixed maturities portfolio for securities rated between BBB and BBB+. At December 31, 2009, we were in compliance with these limits.
Concentration of credit risk with respect to reinsurance recoverable balances is limited due to the number of reinsurers used on our reinsurance programs. At December 31, 2009, our top ten reinsurers accounted for 73% (2008: 71%) of our reinsurance recoverable on unpaid and paid losses balance net of collateral. Of the balance related to the top ten reinsurers, 43% (2008: 57%) related to reinsurers rated A+ or better, with the remainder rated A, by A.M. Best. Our top three (2008: three) reinsurers accounted for 40% (2008: 38%) of our reinsurance recoverable on unpaid and paid losses balance net of collateral.
We lease office space in the countries in which we operate under operating leases which expire at various dates. We renew and enter into new leases in the ordinary course of business as required. During 2009, total rent expense with respect to these operating leases was $17 million (2008: $15 million: 2007: $12 million).
Except as noted below, we are not a party to any material legal proceedings. From time to time, we are subject to routine legal proceedings, including arbitrations, arising in the ordinary course of business. These legal proceedings generally relate to claims asserted by or against us in the ordinary course of insurance or reinsurance operations. In our opinion, the eventual outcome of these legal proceedings is not expected to have a material adverse effect on our financial condition or results of operations.
On October 5, 2005, we issued $250 million of 7.25% series A Preferred shares, par value $0.0125 per share, with a liquidation preference of $25.00 per share. We may redeem the shares on and after October 15, 2010 at a redemption price of $25.00 per share. Dividends on the series A Preferred shares are non-cumulative. Consequently, if the board of directors does not authorize and declare a dividend for any dividend period, holders of the series A Preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accumulate and be payable. Holders of series A Preferred shares will be entitled to receive, only when, as and if declared by the board of directors, non-cumulative cash dividends from the original issue date, quarterly in arrears on the fifteenth day of January, April, July and October of each year, commencing on January 15, 2006, without accumulation of any undeclared dividends. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 7.25% of the liquidation preference per annum. For 2009 and 2008, the total dividends declared on series A Preferred share was $1.8125 per share.
Commencing on March 1, 2016, the dividend rate on the series B Preferred shares will be payable at a floating rate. During a floating rate period, the floating rate per annum will be reset quarterly at a rate equal to 3.4525% plus the 3-month LIBOR Rate. Dividends on the series B Preferred shares are non-cumulative. Consequently, if the board of directors does not declare a dividend for any dividend period, holders of the series B Preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accumulate and will not be payable. For 2009 and 2008, the total dividends declared on series B Preferred share was $7.50 per share.
During 2009 and 2008, we made the following share repurchases, which were held in treasury.
(1) To satisfy withholding tax liabilities upon the vesting of restricted stock awards and the exercise of stock options. Share repurchases from employees are excluded from the authorized share repurchase plans noted above.
During 2007, under the 2006 repurchase plan, we repurchased 2,786,611 common shares for cancellation for a total cost of $103 million. The total share repurchases made in 2007, including those held in treasury, include 5,263,445 shares repurchased from Trident II, L.P and affiliated entities, for a total purchase price of $201 million.
We have several defined contribution plans that are self directed. Generally, mutual funds are made available pursuant to which employees and we contribute a percentage of the employee’s gross salary into the plan each month. During 2009, our total contribution expenses were $13 million (2008: $10 million and 2007: $10 million).
We have SERPs for our two senior executives: Chairman, Mr. Butt, and President and Chief Executive Officer (CEO), Mr. Charman. The SERP for Mr. Butt requires us to make annual payments to him upon retirement, or beginning January 1, 2010, even if he has not retired, for a period of ten years. The SERP for Mr. Charman requires us to make annual payments to him starting January 1, 2009, even if he has not retired, for a period of 20 years.
At December 31, 2009, the fair value of the SERPs assets was $18 million (2008: $16 million). SERP assets increased in 2009 primarily due to $3 million in improved fund valuations due to the strong recovery in the financial markets, partially offset by $1 million of benefits paid. Our investment strategy is to maintain a conservative and diversified asset allocation strategy to yield a 5.75% annualized return over the life of the SERPs. At December 31, 2009, the plan was over-funded by $1 million.
We have issued stock options, restricted stocks, restricted stock units, and phantom stock units to our employees and non-management directors but none of these awards were subject to performance and market conditions. At December 31, 2009, 5,067,500 equity-based awards remain available for grant under the 2007 Plan. Subsequent to December 31, 2009, we granted 23,328 unrestricted common shares to our non-management directors on January 15, 2010, at a fair value of $28.42 per share. We also granted 1,364,450 restricted shares and units to our employees on February 8, 2010, at a fair value of $28.69 per share. These awards carry a vesting period of four years with 25% of the award to be vested annually.
The total intrinsic value of stock options exercised during 2009 was $3 million (2008: $35 million) and we received proceeds of $3 million (2008: $24 million). At December 31, 2008 and 2007, there was no remaining unrecognized compensation cost related to stock options and accordingly we incurred no related compensation costs during 2009 and 2008.
During 2009, we granted 1,281,500 restricted shares (2008: 2,747,630; 2007: 1,596,400) to our employees and non-management directors with a weighted average grant-date fair value per share of $26.39 (2008: $37.23; 2007: $33.02). The total 2008 granted restricted shares included 1,000,000 shares with a grant date fair value of $35.17 per share to our CEO in connection with an amendment to his employment agreement. The grant made to our CEO has the following vesting schedule: 500,000 shares on January 31, 2009; 166,666 shares on January 1, 2010; 166,667 shares on January 1, 2012; and 166,667 shares on January 1, 2013. We have elected the straight-line recognition method for awards subject to graded vesting based on a service condition.
During 2009, realized additional tax benefits for certain vested restricted stocks and exercised stock options was negligible (2008: $1 million; 2007: $1 million). These excess tax benefits are included in our cash flows from financing activities in the Consolidated Statements of Cash Flows.
Our non-management directors may also elect to receive their meeting and other fees in common shares or phantom stock units rather than cash, based on the fair value of our common shares at the time of the grant. At December 31, 2009, we had 67,461 (2008: 62,091) phantom stock units outstanding and we have issued a cumulative total of 97,900 (2008: 72,189) common shares in lieu of fees.
Although realization is not assured, management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized. Other than the $37 million of deferred tax assets relating to capital items noted in the above table (i.e. capital loss carryforwards, net unrealized losses and impairments), the remaining $114 million of gross deferred tax assets relate to ordinary income items. Substantially all of these deferred tax assets relate to our U.S. operations. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including historical results, operating loss carryback potential and scheduled reversals of deferred tax liabilities. Our U.S. operations have produced significant taxable income in prior periods and have deferred tax liabilities that will reverse in future periods such that we believe sufficient ordinary taxable income is available to utilize all remaining deferred tax assets. There were no unrecognized tax benefits at December 31, 2009 and 2008.
Our insurance and reinsurance operations are subject to insurance and/or reinsurance laws and regulations in the jurisdictions in which they operate, including Bermuda, Ireland and the United States. These regulations include certain restrictions on the amount of dividends or other distributions, such as loans or cash advances, available to shareholders without prior approval of the insurance regulatory authorities.
Our U.S. operations required statutory capital and surplus is determined using risk based capital tests, which is the threshold that constitutes the authorized control level. If a company falls below the control level, the commissioner is authorized to take whatever regulatory actions considered necessary to protect policyholders and creditors. The maximum dividend that may be paid by our U.S. insurance subsidiaries is restricted by the regulatory requirements of the domiciliary states. Generally, the maximum dividend that may be paid by each of our U.S. insurance subsidiaries is limited to unassigned surplus (statutory equivalent of retained earnings) and cannot exceed 10% of total statutory capital and surplus. At December 31, 2009, the maximum dividend that our U.S. insurance operations could pay without regulatory approval was approximately $78 million.
Our Irish subsidiaries, AXIS Specialty Europe and AXIS Re Ltd., are required to maintain minimum levels of statutory and capital surplus. At December 31, 2009 our subsidiaries were in compliance with these requirements. Our Irish subsidiaries may declare dividends out of retained earnings subject to meeting their solvency and capital requirements. At December 31, 2009 the maximum dividend our Irish subsidiaries could pay out of retained earnings, subject to regulatory approval, was $77 million.