The following discussion contains “forward-looking statements.” Statements that are not historical in nature are forward-looking statements. OB Holdings cannot promise that its expectations in such forward-looking statements will turn out to be correct. OB Holdings’ actual results could be materially different from and worse than its expectations. See “Forward-Looking Statements” on page 80 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements.
Specialty Insurance Operations. Our Specialty Insurance Operations segment is comprised of twelve underwriting units that are aggregated into three major underwriting units: MGA Business, which includes those businesses that are distributed through MGAs, Specialty Industries, which includes those businesses that are targeted to specific industries, and Specialty Products, which includes those businesses that offer targeted products. See “Business-Specialty Insurance Operations”.
Deferred acquisition costs represent commissions, premium taxes, brokerage expenses and other costs that are directly attributable to and vary with the production of business. These costs are deferred and amortized over the applicable premium recognition period. Deferred acquisition costs are limited to the amount expected to be recovered from future earned premiums and anticipated investment income. This limitation is referred to as a premium deficiency. A premium deficiency is recognized if the sum of expected loss and LAE, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. A premium deficiency is recognized by charging any unamortized acquisition costs to expense to the extent required in order to eliminate the deficiency. On January 1, 2012, we adopted Accounting Standards Update (ASU) 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, codified within ASC 944. ASU 2010-26 is effective for interim periods and annual fiscal years beginning after December 15, 2011. We have elected to adopt ASU 2010-26 on a prospective basis. Under the new guidance, deferrable acquisition costs are limited to costs related to successful contract acquisitions. Acquisition costs that are not eligible for deferral are to be charged to expense in the period incurred. See Note 1-“Nature of Operations and Summary of Significant Accounting Policies” of the accompanying consolidated financial statements.
Our executive compensation policies are designed with one goal in mind, namely, the maximization of shareholder value over long periods of time. We believe that this goal is best pursued by utilizing a pay-for-performance program that serves to attract and retain superior executive talent and provide management with performance-based incentives to maximize shareholder value. Through this compensation program, we seek to maximize shareholder value by aligning closely the financial interests of management with those of our shareholder and ultimately OBIG’s shareholders.
Compensation of our senior management team, including our named executive officers, consists primarily of three components: base salary, annual bonus and long-term incentive awards. Base salaries have been capped at $500,000. Annual bonus targets for all senior executives are 50%, with the exception of the Chief Executive Officer at 75%, of base salary. Long-term incentives for senior executives have in the past been comprised of performance shares and/or performance units. Under these instruments, payouts are explicitly tied to White Mountains’, OBIG’s or OneBeacon’s performance over a three-year period and are highly variable (the actual number of shares/units paid out at the end of the cycle will range from 0% to 200% of target depending on performance against established goals). See Note 9-“Employee Share-Based Incentive Compensation Plans” of the accompanying consolidated financial statements. Additionally, in recognition that the 2007-2009 and 2008-2010 performance share cycles, as described below, were projected to payout at or close to zero, creating a significant retention risk over the next years the OneBeacon Compensation Committee of the Board (the Compensation Committee) in February 2009 approved cash retention awards for the executive officers and certain members of senior management. The Compensation Committee also approved a pool of money for senior management to make retention awards to certain other key personnel.
Our share-based compensation plans consist of performance shares which are typically settled in cash. We account for share-based compensation in accordance with ASC 718. Compensation cost is measured and recognized based on the current market price of the underlying OBIG common shares and on the number of shares that are expected to vest.
In February 2007, the Compensation Committee approved the principal performance share goal of the OneBeacon Long-Term Incentive Plan to be growth in its intrinsic business value per share (GIBVPS). GIBVPS was defined by the Compensation Committee with respect to each award cycle. For the 2007-2009 performance cycle, the Compensation Committee defined GIBVPS to be a weighted measure comprised of growth in OBIG’s adjusted book value per share, underwriting return on equity and growth in OBIG’s price per common share. In the 2007-2009 performance cycle, a total of 682,344 performance shares were earned based upon a performance factor of 14.2%.
In February 2008, the Compensation Committee defined GIBVPS for the 2008-2010 performance cycle to be a weighted measure comprised of growth in OBIG’s adjusted book value per share and underwriting return on equity. In the 2008-2010 performance cycle, a total of 929,849 performance shares were earned based upon a performance factor of 68.5%.
In February 2009, 2010 and 2011, the Compensation Committee granted performance shares with a goal of growth in OBIG’s book value per share for the 2009-2011 performance cycle, the 2010-2012 performance cycle and the 2011-2013 performance cycle, respectively. As of December 31, 2011, 256,751 performance shares, 244,248 performance shares and 151,563 performance shares, respectively, were outstanding with respect to the 2009-2011, 2010-2012 and 2011-2013 performance cycles.
In connection with purchase accounting for the OneBeacon Acquisition, we were required to adjust to fair value our loss and LAE reserves and the related reinsurance recoverables by $646.9 million and $346.9 million, respectively, on our balance sheet as of June 1, 2001. This net change to loss and LAE reserves of $300.0 million is being accreted through an income statement charge ratably with and over the period the claims are settled. Accordingly, we recognized $5.4 million of such charges, recorded as loss and LAE, in the year ended December 31, 2009. As of December 31, 2011 and 2010, the outstanding pre-tax unaccreted adjustment was $0.
The income tax expense related to pre-tax income from continuing operations for the years ended December 31, 2011, 2010 and 2009 represented effective tax rates of 34.5%, 28.4% and 33.6%, respectively. Our effective tax rate for the year ended December 31, 2011 was lower than the U.S. statutory rate of 35% due to tax exempt interest and dividend received deduction, partially offset by state income taxes and an increase in the valuation allowance for the insurance reciprocal. Our effective tax rate for the year ended December 31, 2010 was lower than the U.S. statutory rate of 35% due to recognition of a deferred tax asset for a higher tax basis and deconsolidation of the companies sold as part of the Personal Lines Transaction, partially offset by an increase in the valuation allowance for insurance reciprocals. Our effective tax rate for the year ended December 31, 2009 was lower than the U.S. statutory rate of 35% due to the receipt of nontaxable interest and dividend income, tax reserve adjustments and a decrease in the valuation allowance.
A summary of our consolidated financial results for the years ended December 31, 2011, 2010 and 2009 is as follows:
The following table provides ratios of our consolidated underwriting results for the years ended December 31, 2011, 2010 and 2009:
Our comprehensive income attributable to OB Holdings’ common shareholder was $17.0 million in the year ended December 31, 2011, compared to $104.0 million in the year ended December 31, 2010. Change in other comprehensive income and loss items in the year ended December 31, 2011 included the impact of an $11.2 million after tax decrease in our pension plans primarily related to a decrease in the over-funded status of our qualified pension plan driven by a decline in the value of the investment results, as compared to a $5.8 million after tax increase in our pension plans in the prior year also driven by investment assets in the plan. Net income attributable to OB Holdings’ common shareholder was $28.2 million in the year ended December 31, 2011, compared to $97.5 million in the year ended December 31, 2010.
Our total expenses decreased 30.6% in the year ended December 31, 2011 to $997.9 million, compared to $1,438.9 million in the year ended December 31, 2010. Loss and LAE decreased 32.3% to $580.9 million in the year ended December 31, 2011, reflective of the decrease in our book of business resulting from the Commercial Lines Transaction and the Personal Lines Transaction, partially offset by a strengthening of our run-off reserves, principally for unallocated loss adjustment expenses, the impact of which was mitigated by favorable loss reserve development in our specialty businesses. Policy acquisition expenses decreased 29.7% to $219.0 million and other underwriting expenses decreased 25.7% to $173.3 million in the year ended December 31, 2011, reflective of the shrink in our book of business resulting from the Commercial Lines Transaction and the Personal Lines Transaction. Interest expense decreased 30.1% to $20.7 million in the year ended December 31, 2011, reflective of actions taken to reduce outstanding debt.
Our income tax expense related to pre-tax income from continuing operations for the years ended December 31, 2011 and 2010 represented net effective tax rates of 34.5% and 28.4%, respectively. The effective tax rate for the year ended December 31, 2011 was lower than the U.S. statutory rate of 35% due to tax exempt interest and dividend received deduction, partially offset by state income taxes and an increase in the valuation allowance for the insurance reciprocal. The effective tax rate for the year ended December 31, 2010 was lower than the U.S. statutory rate of 35% due to recognition of a deferred tax asset for a higher tax basis and deconsolidation of the companies sold as part of the Personal Lines Transaction, partially offset by an increase in the valuation allowance for insurance reciprocals. See Note 7 - “Income Taxes” of the accompanying consolidated financial statements.
Consolidated Results-Year ended December 31, 2010 versus year ended December 31, 2009
Our comprehensive income attributable to OB Holdings’ common shareholder was $104.0 million in the year ended December 31, 2010, compared to $326.2 million in the year ended December 31, 2009. Change in other comprehensive income and loss items in the year ended December 31, 2010 included the impact of a $5.8 million after tax increase in our pension plans primarily related to an increase in the over-funded status of our qualified pension plan driven by investment results, as compared to a $12.1 million after tax increase in our pension plans in the prior year also driven by investment results. Change in other comprehensive income and loss items in the year ended December 31, 2009 also included a $7.4 million pre-tax ($4.8 million after tax) increase resulting from the settlement of our interest rate swap relating to the mortgage note. The impact was offset by a $7.4 million realized loss related to the settlement of the interest rate swap reflected in net other revenues. Net income attributable to OB Holdings’ common shareholder was $97.5 million in the year ended December 31, 2010, compared to $307.4 million in the year ended December 31, 2009.
Our total revenues decreased 29.7% to $1,586.9 million in the year ended December 31, 2010, compared to $2,255.8 million in the year ended December 31, 2009. The decrease was mainly due to a 24.5% decrease in earned premiums primarily due to the sale of our personal lines and our non-specialty commercial lines. Net realized and unrealized investment gains decreased 69.1% to $76.8 million, compared to $248.6 million in the year ended December 31, 2009. Net investment income decreased 23.1% to $96.3 million in the year ended December 31, 2010, primarily due to lower fixed maturity investment yields, a reduction in invested assets as a result of the Personal Lines Transaction, repurchases of our Senior Notes and an increased allocation to lower yielding short-term investments during the first six months of 2010 in preparation for the closing of the Personal Lines Transaction. These were partially offset by a $1.7 million inflation adjustment related to our inflation indexed treasury securities as compared to a $(1.1) million inflation adjustment related to these securities for the year ended December 31, 2009. Net other revenues decreased 57.1% to $9.9 million in the year ended December 31, 2010, compared to $23.1 million in the year ended December 31, 2009. The year ended December 31, 2010 included the $8.5 million net gain on the Personal Lines Transaction and $10.2 million of additional consideration related to the Commercial Lines Transaction, partially offset by a $10.8 million loss related to the purchase of a portion of our Senior Notes. The year ended December 31, 2009 included pre-tax proceeds of $23.2 million from the Commercial Lines Transaction and a $5.4 million gain related to the purchase of a portion of our Senior Notes, partially offset by a $7.4 million realized loss related to the settlement of the interest rate swap.
Our total expenses decreased 17.3% in the year ended December 31, 2010 to $1,438.9 million, compared to $1,740.2 million in the year ended December 31, 2009. Loss and LAE decreased 14.6% to $858.2 million in the year ended December 31, 2010, reflective of the shrink in our book of business resulting from the Commercial Lines Transaction and the Personal Lines Transaction, partially offset by higher current accident year catastrophe losses and a number of large losses experienced earlier in the year, particularly in businesses we have exited. Current accident year catastrophe losses were $55.3 million in the year ended December 31, 2010, compared to $23.8 million in the year ended December 31, 2009. Other underwriting expenses decreased 24.4% to $233.1 million and policy acquisition expenses decreased 17.2% to $311.6 million in the year ended December 31, 2010, reflecting the change in our book of business resulting from the Commercial Lines Transaction and the Personal Lines Transaction. Interest expense decreased 25.4% to $29.6 million in the year ended December 31, 2010, reflective of actions taken to reduce outstanding debt. General and administrative expenses were essentially flat as compared to the prior year.
Our income tax expense related to pre-tax income from continuing operations for the years ended December 31, 2010 and 2009 represented effective tax rates of 28.4% and 33.6%, respectively. The effective tax rate for the year ended December 31, 2010 was lower than the U.S. statutory rate of 35% due to recognition of a deferred tax asset for a higher tax basis and deconsolidation of the companies sold as part of the Personal Lines Transaction, partially offset by an increase in the valuation allowance for insurance reciprocals. The effective tax rate for the year ended December 31, 2009 was lower than the U.S. statutory rate of 35% due to the receipt of nontaxable interest and dividend income, tax reserve adjustments and a decrease in the valuation allowance.
(2) Includes loss and LAE relating to catastrophes. For the years ended December 31, 2011, 2010 and 2009, total calendar year incurred loss and LAE relating to catastrophes increased our Specialty Insurance Operations loss and LAE and total combined ratios by 3.8 points, 1.5 points and 1.0 points, respectively, including development on prior accident year catastrophes which increased (decreased) our Specialty Insurance Operations loss and LAE and total combined ratios by 0.2 points, (0.7) points and (0.6) points, respectively.
(3) Prior accident year development, including development on catastrophes, for the years ended December 31, 2011, 2010 and 2009 decreased our Specialty Insurance Operations loss and LAE and total combined ratios by 2.9 points, 2.8 points and 9.2 points, respectively.
As Other Insurance Operations consists of business in run-off, GAAP ratios are not meaningful for the 2011 period. The following table provides underwriting ratios for Other Insurance Operations for the years ended December 31, 2010 and 2009:
(1) Includes our long-term incentive compensation expense. For the years ended December 31, 2010 and 2009, long-term incentive compensation expense increased our Other Insurance Operations combined ratio by 1.8 points and 1.9 points, respectively.
(2) Includes loss and LAE relating to catastrophes. For the years ended December 31, 2010 and 2009, total calendar year incurred loss and LAE relating to catastrophes increased our Other Insurance Operations loss and LAE and total combined ratios by 7.3 points and 0.6 points, respectively, including development on prior accident year catastrophes which decreased our loss and LAE and total combined ratios by 0.7 points and 0.3 points, respectively.
(3) Prior accident year development, including development on catastrophes, for the years ended December 31, 2010 and 2009 decreased our Other Insurance Operations loss and LAE and total combined ratios by 6.9 points and 3.4 points, respectively.
As described in “Critical Accounting Estimates”, we have a reinsurance contract with NICO for up to $2.5 billion in old A&E claims and certain other exposures. Under the terms of the NICO Cover, NICO receives the economic benefit of reinsurance recoverables from certain of our third party reinsurers in existence at the time the NICO Cover was executed (Third Party Recoverables). As a result, the Third Party Recoverables serve to protect the $2.5 billion limit of NICO coverage for our benefit.
The ratio of reserves net of Third Party Recoverables for A&E losses at December 31, 2011 to trailing three year average paid loss and allocated LAE (known in the industry as the “survival ratio”) is 13.3 years including the remaining available protection under the NICO Cover.
Our reserves for A&E losses at December 31, 2011 represent management’s best estimate of our ultimate liability based on information currently available. However, significant uncertainties, including but not limited to case law developments, medical and clean-up cost increases and industry settlement practices, limit our ability to accurately estimate ultimate liability and we may be subject to A&E losses beyond currently estimated amounts. In addition, we remain liable for risks reinsured in the event that a reinsurer does not honor its obligations under reinsurance contracts. To the extent that actual experience differs from our estimate of incurred A&E losses and Third Party Recoverables, future losses could exceed the $198.3 million of protection remaining under the NICO Cover.
Gross investment returns versus typical benchmarks for the years ended December 31, 2011, 2010 and 2009 are as follows:
(1) Gross investment returns exclude investment expenses of $6.5 million, $8.8 million and $10.8 million, respectively, for the years ended December 31, 2011, 2010 and 2009.
Our total pre-tax investment results were $76.0 million, a return of 3.0% for the year ended December 31, 2011, compared to $173.1 million, a return of 5.1% for the year ended December 31, 2010. Net investment income in the year ended December 31, 2011 was $67.3 million, a decrease of $29.0 million, compared to $96.3 million in the year ended December 31, 2010. The decrease was principally due to lower investment yields, a reduction in invested assets as a result of the Personal Lines Transaction, repurchases of debt and the Commercial Lines Transaction, including the impact of claim payments related to non-specialty commercial lines reserves. Net realized investment gains were $60.4 million in the year ended December 31, 2011, a decrease of $23.1 million compared to $83.5 million in the year ended December 31, 2010. The change in net unrealized investment gains and losses was a decrease of $51.7 million in the year ended December 31, 2011, compared to a decrease of $6.7 million in the year ended December 31, 2010.
Investment Returns-Year ended December 31, 2010 versus year ended December 31, 2009
Our fixed income portfolio, which includes fixed maturity and short-term investments, returned 3.7% for the year ended December 31, 2010, compared to 10.0% for the year ended December 31, 2009. The fixed maturity portfolio, in particular the corporate bond portfolio, performed well during the year ended December 31, 2009, driven by spread tightening. We recorded $57.8 million in net realized gains in the year ended December 31, 2010, mainly due to sales of fixed maturity investments during the first six months of 2010 in preparation of the close of the Personal Lines Transaction. We maintained a high quality fixed maturity portfolio with a relatively short duration of approximately 2.8 years excluding short-term investments, and approximately 2.7 years including short-term investments at December 31, 2010. Our fixed maturity portfolio performed consistently with its characteristics and below the Barclays U.S. Intermediate Aggregate Index benchmark for the year ended December 31, 2010.
The following table presents the composition of our investment portfolio as of December 31, 2011 and 2010:
The weighted average duration of our fixed maturity portfolio, including convertible fixed maturity investments, at December 31, 2011 is approximately 2.5 years. The maturity distribution for fixed maturity investments, including convertible fixed maturity investments, held at December 31, 2011 is as follows:
There are also mortgage-backed securities that we categorize as “non-prime” (also called “Alt A” or “A-”) that are backed by collateral that has overall credit quality between prime and sub-prime, as determined based on our review of the characteristics of their underlying mortgage loan pools, such as credit scores and financial ratios. As of December 31, 2011, we held $2.3 million of mortgage-backed securities that were classified as non-prime. Our non-agency residential mortgage-backed portfolio is generally of moderate average life, fixed rate and structurally senior. We do not own any collateralized debt obligations, including residential mortgage-backed collateralized debt obligations.
The following table summarizes the carrying value of our asset-backed securities as of December 31, 2011 and 2010:
The security issuance years of our investments in non-agency RMBS and non-agency CMBS securities as of December 31, 2011 are as follows:
The amount of fixed and floating rate securities and their tranche levels are as follows as of December 31, 2011:
(3) At issuance, Subordinate were not rated AAA by Standard & Poor’s or Aaa by Moody’s and were senior to other bonds.
Generally, our regulated insurance operating subsidiaries have the ability to pay dividends during any 12-month period without the prior approval of regulatory authorities in an amount set by formula based on the greater of prior year statutory net income or 10% of prior year end statutory surplus, subject to the availability of unassigned funds. Our top tier regulated insurance operating subsidiaries have the ability to pay $103 million of dividends during 2012 without the prior approval of regulatory authorities, subject to the availability of unassigned funds. At December 31, 2011, OB Holdings’ top tier regulated insurance operating subsidiaries had $0.7 billion of unassigned funds and statutory surplus of $1.0 billion. At December 31, 2011, we had approximately $24 million of net unrestricted cash, short-term investments and fixed maturity investments outside of our regulated insurance operating subsidiaries.
Insurance float is an important aspect of our insurance operations. Insurance float represents funds that an insurance company holds for a limited time. In an insurance operation, float arises because premiums are collected before losses are paid. This interval can extend over many years. During that time, the insurer invests the funds. When the premiums that an insurer collects do not cover the losses and expenses it eventually must pay, the result is an underwriting loss, which is considered to be the cost of insurance float. We calculate our insurance float by taking our net invested assets and subtracting our total capital. Although insurance float can be calculated using numbers determined under GAAP, insurance float is not a GAAP concept and, therefore, there is no comparable GAAP measure.
On May 3, 2010, we commenced a cash tender offer for up to $200.0 million in aggregate principal amount of the Senior Notes at a price of $1,027.50 per $1,000 principal amount. The cash tender offer, which was not subject to the tender of any minimum principal amount of Senior Notes, expired on May 28, 2010. Holders of Senior Notes who tendered on or before May 14, 2010 received an early tender payment of $30 for every $1,000 principal amount of Senior Notes validly tendered. Payment for the Senior Notes included accrued and unpaid interest up to the settlement date. OBH accepted and retired $156.4 million aggregate principal amount of the Senior Notes, of which $155.2 million was tendered by the early tender deadline, for purchase for $165.4 million, which resulted in a $9.6 million loss, including transaction fees.
White Mountains provides an irrevocable and unconditional guarantee as to the payment of principal and interest on the Senior Notes. In consideration of this Guarantee, we have agreed to pay a specified fee to White Mountains in the amount of 25 basis points per annum on the outstanding principal amount of the Senior Notes. We have further agreed that if White Mountains’ voting interest in OBIG ceases to represent more than 50% of all its voting securities, we are obligated to seek to redeem, exchange or otherwise modify the Senior Notes in order to fully and permanently eliminate White Mountains’ obligations under the Guarantee (the Guarantee Elimination). White Mountains has agreed to provide written notice to us when its voting interest in OBIG has been reduced below 50%. We will have 180 days from the receipt of such notification to complete the Guarantee Elimination. If the Guarantee Elimination is not completed within the initial 180-day period, the Guarantee fee shall increase by 200 basis points. The Guarantee fee shall further increase by 100 basis points for each subsequent 90-day period thereafter, up to a maximum Guarantee fee of 425 basis points, until the Guarantee Elimination has been completed.
The indenture documents provide that, if OBH or White Mountains as guarantor of the Senior Notes defaults under a credit agreement, mortgage or similar debt agreement with a principal amount greater than $25 million, and such default results in the acceleration of such debt, there is a default under the Senior Notes. Such a default would permit the trustees or holders of 25% or more of the Senior Notes to declare an event of default under the indenture documents resulting in a required repayment of the Senior Notes. See Note 15-“Related Party Disclosures” of the accompanying consolidated financial statements.
(1) Represents expected future cash outflows resulting from loss and LAE payments. The amounts presented are gross of reinsurance recoverables on unpaid losses of $2,330.8 million and include the discount on our workers compensation loss and LAE reserves of $108.3 million as of December 31, 2011. These balances add back the remaining purchase accounting fair value adjustment of $163.3 million related to the OneBeacon Acquisition as it is a non-cash item.
The balances included in the table above regarding our long-term incentive compensation plans include amounts payable for performance shares and units, as well as deferred compensation balances. Exact amounts to be paid cannot be predicted with certainty as the ultimate amounts of these liabilities are based on future performance. The estimated payments reflected in the table are based on current accrual factors (common share price and pay-out percentage) and assume that all outstanding balances were 100% vested as of December 31, 2011.
Detailed information concerning our cash flows during the years ended December 31, 2011, 2010 and 2009 follows:
Cash flows from operations for the years ended December 31, 2011, 2010 and 2009
Net cash flows (used for) provided from operations were $(144.5) million, $(23.2) million and $177.2 million, respectively, for the years ended December 31, 2011, 2010 and 2009. Net cash flows for operations in the years ended December 31, 2011 and 2010 were adversely impacted by the run-off of reserves related to the Commercial Lines Transaction. Net cash flows for operations in the years ended December 31, 2011, 2010 and 2009 were adversely impacted by declining net investment income, primarily due to lower overall portfolio yields, shifts in portfolio mix to lower risk, lower yield investments and a decrease in the overall invested asset base. In addition, the decline in cash flows from operations for the year ended December 31, 2010 reflects the impact of the Personal Lines Transaction.
During 2010, we paid $535.0 million of cash distributions to OBEH, including $526.0 million of dividends and $9.0 million representing a return of capital.
During 2010, we made payments with respect to our long-term incentive compensation plans totaling $21.4 million, in cash or by deferral into certain of our non-qualified compensation plans. These payments were made primarily with respect to 682,344 performance shares for the 2007-2009 performance cycle.
During 2009, we paid $68.1 million of cash dividends to OBEH.
During 2009, we repaid $2.2 million of principal on our debt obligations.
See Note 15-“Related Party Disclosures” of the accompanying consolidated financial statements.
On an ongoing basis, management evaluates its estimates, including those related to fair value measurements of investments, loss and LAE reserves, reinsurance transactions and purchase accounting. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.
We measure certain assets at estimated fair value in our consolidated financial statements, with changes therein recognized in current period earnings. In addition, we disclose estimated fair value for certain assets and liabilities measured at historical or amortized cost. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price). Fair value measurements are categorized into a hierarchy that distinguishes between inputs based on market data from independent sources (observable inputs) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (unobservable inputs). Quoted prices in active markets for identical assets or liabilities have the highest priority (Level 1), followed by observable inputs other than quoted prices, including prices for similar but not identical assets or liabilities (Level 2) and unobservable inputs, including the reporting entity’s estimates of the assumptions that market participants would use, having the lowest priority (Level 3).
As of December 31, 2011 and 2010, approximately 92% and 90%, respectively, of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. Investments valued using Level 1 inputs include fixed maturity investments, primarily investments in U.S. Treasuries, common equities and short-term investments, which include U.S. Treasury Bills. Investments valued using Level 2 inputs comprise fixed maturity investments including corporate debt, state and other governmental debt, convertible fixed maturity investments and mortgage and asset-backed securities. Fair value estimates for investments that trade infrequently and have few or no observable market prices are classified as Level 3 measurements. Level 3 fair value estimates based upon unobservable inputs include our investments in hedge funds and private equity funds, as well as certain investments in debt and equity securities, including asset-backed securities, where quoted market prices are unavailable.
Our process to assess the reasonableness of the market prices obtained from the outside pricing sources covers substantially all of our fixed maturity investments and includes, but is not limited to, evaluation of model pricing methodologies, review of the pricing services’ quality control processes and procedures on at least an annual basis, comparison of market prices to prices obtained from different independent pricing vendors on at least an annual basis, monthly analytical reviews of certain prices and review of assumptions utilized by the pricing service for selected measurements on an ad hoc basis throughout the year. We also perform back-testing of selected purchases and sales activity to determine whether there are any significant differences between the market price used to value the security prior to purchase or sale and the actual purchase or sale price on at least an annual basis. Prices provided by the pricing services that vary by more than 5% and $1.0 million from the expected price based on the procedures are considered outliers. In circumstances where the results of our review process does not appear to support the market price provided by the pricing services, we challenge the price. During the past year, a few securities fell outside of our variance thresholds, thereby triggering the challenge with the pricing services. If we cannot gain satisfactory evidence to support the challenged price, we rely upon our own pricing methodologies to estimate the fair value of the security in question.
Other investments, which are primarily comprised of hedge funds and private equity funds for which the fair value option has been elected, are carried at fair value based upon our proportionate interest in the underlying fund’s net asset value, which is deemed to approximate fair value. The fair value of our investments in hedge funds and private equity funds has been estimated using net asset value because it reflects the fair value of the funds’ underlying investments in accordance with ASC 820. We employ a number of procedures to assess the reasonableness of the fair value measurements, including obtaining and reviewing each fund’s audited financial statements and discussing each fund’s pricing with the fund’s manager. The fair values of our investments in hedge funds and private equity funds have been classified as Level 3 under the fair value hierarchy since the fund managers do not provide sufficient information to independently evaluate the pricing inputs and methods for each underlying investment, and therefore the inputs are considered to be unobservable.
In circumstances where the underlying investments are publicly traded, such as the investments made by hedge funds, the fair value of the underlying investments is determined using current market prices. In circumstances where the underlying investments are not publicly traded, such as the investments made by private equity funds, the private equity fund managers have considered the need for a liquidity discount on each of the underlying investments when determining the fund’s net asset value in accordance with ASC 820. In circumstances where our portion of a fund’s net asset value is deemed to differ from fair value due to illiquidity or other factors associated with our investment in the fund, including counterparty credit risk, the net asset value is adjusted accordingly. At December 31, 2011 and 2010, we did not record a liquidity adjustment to the net asset value related to our investments in hedge funds or private equity funds.
The fair value measurements at December 31, 2011 and 2010 for assets recorded in accordance with ASC 825 and any related Level 3 inputs are as follows:
(1) Includes $111.8 million of fixed maturity investments reclassified to assets held for sale in the December 31, 2011 consolidated balance sheet as part of the AutoOne Transaction.
(2) Excludes the carrying value of $21.8 million and $21.2 million, respectively, associated with a tax advantaged federal affordable housing development fund accounted for using the equity method as of December 31, 2011 and 2010.
The changes in Level 3 fair value measurements for the year ended December 31, 2011 are as follows:
· Historical paid loss development methods: These methods use historical loss payments over discrete periods of time to estimate future losses. Historical paid loss development methods assume that the ratio of losses paid in one period to losses paid in an earlier period will remain constant. These methods necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use case reserves to estimate ultimate losses, they can be more reliable than the other methods discussed below that look to case reserves (such as actuarial methods that use incurred losses) in situations where there are significant changes in how case reserves are established by a company’s claims adjusters. However, historical paid loss development methods are more leveraged, meaning that small changes in payments have a larger impact on estimates of ultimate losses, than actuarial methods that use incurred losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative incurred amounts. In addition, and for similar reasons, historical paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past.
More recently, since the 1990s, we have experienced an influx of claims from commercial insureds, including many non-Fortune 500-sized accounts written during the 1970s and 1980s, who are named as defendants in asbestos lawsuits. As a number of large well-known manufacturers of asbestos and asbestos-containing products have gone into bankruptcy, plaintiffs have sought recoveries from peripheral defendants, such as installers, transporters or sellers of such products, or from owners of premises on which the plaintiffs’ exposure to asbestos allegedly occurred. At December 31, 2011, 449 policyholders had asbestos-related claims against us. In 2011, 94 new insureds with such peripheral involvement presented asbestos claims under prior policies we had written.
Immediately preceding the OneBeacon Acquisition, we purchased a reinsurance contract with NICO under which we are entitled to recover from NICO up to $2.5 billion in the future for asbestos claims arising from business written by us in 1992 and prior, environmental claims arising from business written by us in 1987 and prior, and certain other exposures. Under the terms of the NICO Cover, NICO receives the economic benefit of reinsurance recoverables from certain of our third-party reinsurers in existence at the time the NICO Cover was executed, or Third-Party Recoverables. As a result, the Third-Party Recoverables serve to protect the $2.5 billion limit of NICO coverage for the benefit of us. Any amounts uncollectible from third-party reinsurers due to dispute or the reinsurers’ financial inability to pay are covered by NICO under its agreement with us. Third-Party Recoverables are typically for the amount of loss in excess of a stated level each year. Of claim payments from 2001 through 2011, approximately 47% of A&E losses have been recovered under the historical third-party reinsurance.
Our reserves for A&E losses, net of Third-Party Recoverables but prior to NICO recoveries, were $0.8 billion at December 31, 2011. An industry benchmark of reserve adequacy is the “survival ratio”, computed as a company’s reserves divided by its historical average yearly loss payments. This ratio indicates approximately how many more years of payments the reserves can support, assuming future yearly payments are equal to historical levels. Our survival ratio was 13.3 at December 31, 2011. This was computed as the ratio of A&E reserves, net of Third-Party Recoverables prior to the NICO Cover of $0.8 billion plus the remaining unused portion of the NICO Cover of $198.3 million, to the average A&E loss payments over the three-year period ended December 31, 2011, net of Third-Party Recoverables. Our survival ratio was 10.7 at December 31, 2010. We believe that as a result of the NICO Cover and our historical third-party reinsurance programs, we should not experience material financial loss from A&E exposures under current coverage interpretations and that our survival ratio compares favorably to industry survival ratios. However, the survival ratio is a simplistic measure estimating the number of years it would be before the current ending loss reserves for these claims would be paid using recent annual average payments subject to adjustments for unusual items. Many factors, such as aggressive settlement procedures, mix of business and coverage provided, have a significant effect on the amount of A&E reserves and payments and the resultant survival ratio. Thus, caution should be exercised in attempting to determine reserve adequacy for these claims based simply on this survival ratio.
Our reserves for A&E losses at December 31, 2011 represent management’s best estimate of its ultimate liability based on information currently available. However, significant uncertainties, including but not limited to case law developments, medical and clean-up cost increases and industry settlement practices, limit our ability to accurately estimate ultimate liability and we may be subject to A&E losses beyond currently estimated amounts. In addition, we remain liable for risks reinsured in the event that a reinsurer does not honor its obligations under reinsurance contracts. See Note 3-“Reserves for Unpaid Loss and LAE-Asbestos and environmental loss and LAE reserve activity” of the accompanying consolidated financial statements for more information regarding our A&E reserves.
Our A&E claims activity, which is all in our Other Insurance Operations segment, is illustrated in the table below:
· Use of preferred provider networks and other medical cost containment practices
· Change in average severity of accidents, or proportion of severe accidents
With respect to the favorable loss reserve development in Specialty Insurance Operations, at December 31, 2010, management had revised its expectations downward for future loss emergence in the professional liability business, which had initially been based on market analysis when this business was initiated in 2002 and 2003. However, during the year ended December 31, 2011, losses continued to be lower than these revised expectations. As a result, management lowered its selected reserves on the earliest years which affected more recent years as total loss expectations for those years are based in part on prior years’ results. The impact of this revised estimate was a decrease to professional liability reserves of $11.5 million which affected Specialty Insurance Operations.
With respect to the $26.7 million of adverse loss reserve development in Other Insurance Operations, management completed a detailed review of loss and defense and cost containment expenses (allocated LAE or ALAE) and other adjusting expenses (ULAE) during the fourth quarter of 2011. The analysis considered costs, based on current non-staff expenses and staffing projections for the run-off business, as management continues efforts to segregate its claims operations between ongoing claims and run-off claims. The analysis also factored in the revised definition of run-off operations to include the non-specialty commercial lines business that was exited via the renewal rights sale beginning with January 1, 2010 effective dates.
During the year ended December 31, 2009, OneBeacon experienced $116.7 million of favorable loss and LAE reserve development on prior accident year loss reserves, with $84.6 million in Specialty Insurance Operations and $32.1 million in Other Insurance Operations. The favorable loss reserve development was primarily related to lower than expected severity on non-catastrophe losses. The favorable non-catastrophe loss reserve development was primarily related to professional liability lines, multiple peril liability lines and other general liability lines.
Specifically, at December 31, 2008, management had revised its expectations downward with respect to future loss emergence in the professional liability business, which had initially been based on market analysis when this business was initiated in 2002 and 2003. However, during the year ended December 31, 2009, losses continued to be significantly lower than these revised expectations. As a result, management lowered its selected reserves on the earliest years which affected more recent years as total loss expectations for those years are based in part on prior years’ results. The impact of this revised estimate was a decrease to professional liability reserves of $60.0 million which affected Specialty Insurance Operations.
Our range of reserve estimates at December 31, 2011 was evaluated to consider the strengths and weaknesses of the actuarial methods applied against our historical claims experience data. The following table shows the recorded loss and LAE reserves, net of reinsurance recoverables on unpaid losses, and the high and low ends of our range of reasonable loss and LAE reserve estimates at December 31, 2011. The high and low ends of our range of reserve estimates in the table below are based on the results of various actuarial methods described above.
The following table shows the recorded reserves and the high and low ends of our range of reasonable loss and LAE reserve, net of reinsurance recoverables on unpaid losses, estimates by line of business at December 31, 2011.
· Professional liability: Recorded loss and LAE reserves, net of reinsurance recoverables, for professional liability were $387.8 million at December 31, 2011. A key assumption for professional liability is the implicit loss cost trend, particularly the severity inflation trend component of loss costs. Across the entire reserve base, a 5.0 point change in assumed annual severity would have changed the estimated net reserve by approximately $64 million at December 31, 2011, in either direction.
· Multiple peril liability: Recorded loss and LAE reserves, net of reinsurance recoverables including that provided under the GRC Cover on claims arising from accident years 2000 and prior, for multiple peril were $47.7 million at December 31, 2011. Recorded loss and LAE reserves, net of reinsurance recoverables, for multiple peril for accident years 2002 through 2011 were $232.7 million at December 31, 2011. Reported loss development patterns are a key assumption for these lines of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g. construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. If case reserve adequacy for non-construction defect claims changed by 10.0 points this would have changed the estimated net reserve by approximately $15 million at December 31, 2011, in either direction.
In connection with purchase accounting for the OneBeacon Acquisition, we were required to adjust to fair value our loss and LAE reserves and the related reinsurance recoverables by $646.9 million and $346.9 million, respectively, on OneBeacon’s acquired balance sheet as of June 1, 2001. This net reduction to loss and LAE reserves of $300.0 million is being accreted through an income statement charge ratably with and over the period the claims are settled. As of both December 31, 2011 and 2010, the outstanding pre-tax unaccreted adjustment was $0.
The information contained in this report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report that address activities, events or developments which we expect or anticipate will or may occur in the future are forward-looking statements. The words “will,” “believe,” “intend,” “expect,” “anticipate,” “project,” “estimate,” “predict” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to our:
· the risks discussed beginning on page 20 of this Form 10-K;
· an economic downturn or other economic conditions adversely affecting our financial position including stock market volatility;