The following discussion contains "forward-looking statements." Statements that are not historical in nature are forward-looking statements. OneBeacon cannot promise that its expectations in such forward-looking statements will turn out to be correct. OneBeacon's actual results could be materially different from and worse than its expectations. See "Forward-Looking Statements" on page 68 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements.
Net income attributable to OneBeacon's common shareholders was $33.5 million for 2014, which was significantly impacted by an increase in loss and loss adjustment expense (LAE) reserves recorded in the fourth quarter of 2014 of $109.2 million, as noted below in "Fourth Quarter Loss and LAE Reserve Increase."
Pre-tax underwriting loss was $20.5 million for 2014, reflecting a combined ratio of 101.7%, which was adversely impacted by the 2014 fourth quarter reserve increase, compared to pre-tax underwriting income of $84.6 million for 2013, reflecting a combined ratio of 92.4%. Pre-tax net investment results were $82.1 million for 2014, representing a 3.4% total return on average invested assets, compared to $90.5 million for 2013, representing a 3.8% total return on average invested assets.
Our book value was also adversely impacted by $20.6 million associated with discontinued operations, driven primarily by valuation adjustments related to the surplus notes provided in conjunction with the financing of the Runoff Transaction.
Through the first nine months of 2014, we recorded $14.3 million of unfavorable loss and LAE reserve development, driven by greater-than-expected large losses in several underwriting operating segments, primarily in the professional and management liability lines within Professional Insurance. This large loss activity, which occurred mostly during the second and third quarters of 2014, also impacted the current accident year loss and LAE estimates. Additionally, we incurred higher-than-usual claim coverage determination costs, a component of LAE expenses, during the first nine months of 2014. Other underwriting operating segments also reported increased claim activity, including Entertainment, Government Risks, and Accident.
As a result of these enhanced actuarial and claim reviews conducted during the fourth quarter and in order to fully reflect these recent trends, we recorded a $109.2 million increase in loss and LAE reserves, which included a $75.5 million increase in prior accident year loss and LAE reserves and a $33.7 million increase in the current accident year loss and LAE reserves which were previously recorded at September 30, 2014. The components of the 2014 fourth quarter loss and LAE reserve increase and the net loss and LAE development for the full year are provided below:
We ended 2013 with a book value per share of $11.58, reflecting an increase of 17.3%, including quarterly dividends of $0.21 per share, on an internal rate of return basis for the year ended December 31, 2013.
Additionally, our 2013 net income included a $23.0 million pre-tax gain from the sale of Essentia Insurance Company (Essentia), a $6.8 million tax benefit relating to the restructuring of a surplus note with our Houston General Insurance Exchange (HGIE) reciprocal (Reciprocal Note Restructure), and $4.0 million of pre-tax income from a licensing agreement related to the extension of a transition services agreement with the buyer of our personal lines business (Licensing Arrangement).
The following table provides the impact to our book value from the net change in benefit plan assets and obligations:
The 13.7 point increase in the loss and LAE ratio was substantially a result of the items included in the 2014 fourth quarter reserve increase, which had a 9.3 point impact on the combined ratio, and was comprised of a 5.7 point increase in current accident year non-catastrophe losses, a 7.6 point increase in adverse prior year loss reserve development, and a 0.4 point increase in catastrophe losses. Current accident year non-catastrophe losses for 2014 were $711.5 million, or 60.4 points, reflecting the impact of the 2014 fourth quarter reserve increase, compared to $613.0 million, or 54.7 points, for 2013, which was positively impacted by the lower loss and LAE ratio in the Collector Cars and Boats business. Net unfavorable prior year loss and LAE reserve development was $89.8 million, or 7.6 points, for 2014, of which $75.5 million, or 6.4 points, related to the 2014 fourth quarter reserve increase. Of the net unfavorable loss and LAE reserve development resulting from the 2014 fourth quarter reserve increase, $46.4 million related to Professional Insurance, primarily professional liability (including lawyers professional liability) and management liability, and to a lesser extent Entertainment, Government Risks, Specialty Property, Accident, and our inland marine business within IMU. The remaining net unfavorable prior year loss and LAE reserve development for 2014 primarily related to unfavorable development recognized prior to the 2014 fourth quarter also in our professional liability and management liability businesses included within Professional Insurance, offset in part by favorable development in our healthcare business included within Professional Insurance. This compared to no net favorable loss reserve development for 2013, as unfavorable development on a few large claims in both Specialty Property and Entertainment was offset by favorable development in Professional Insurance, IMU and Technology. Catastrophe losses were $13.8 million, or 1.2 points, for 2014, primarily resulting from wind and thunderstorms in the southern, central and eastern United States, as well as ice and snow storms in the midwestern and northeastern United States, compared to $9.1 million, or 0.8 points, for 2013, primarily resulting from storms in the southern United States and rainstorms in Colorado.
The expense ratio improved 4.4 points to 32.5% for 2014, which was primarily driven by a 2.4 point decrease in the incentive compensation accrual resulting from the 2014 fourth quarter reserve increase. Additionally, the improvement in the expense ratio reflected the beneficial impact of higher earned premiums in 2014 and decreased non-claims litigation expense, partially offset by the 2013 beneficial impact of the transition services agreement with the buyer of our personal lines business in 2013.
Consolidated Results-Year ended December 31, 2013 versus year ended December 31, 2012
Our total revenues of $1,242.1 million for 2013 were flat compared to $1,240.8 million for 2012, as decreases in earned premiums and net investment results were offset by an increase in other revenues resulting from the sale of Essentia and the Licensing Arrangement. Expenses decreased to $1,060.8 million for 2013, compared to $1,134.9 million for 2012, resulting primarily from decreased policy acquisition expenses and net loss and LAE as discussed below in "Underwriting Results."
Our pre-tax underwriting income was $84.6 million for 2013, reflecting a combined ratio of 92.4%, compared to $27.4 million for 2012, reflecting a combined ratio of 97.5%.
Our combined ratio for 2013 of 92.4% reflected a 55.5% loss and LAE ratio and a 36.9% expense ratio, and represented a significant improvement over the combined ratio reported for 2012 of 97.5%, consisting of a 57.4% loss and LAE ratio and a 40.1% expense ratio.
The expense ratio improved 3.2 points to 36.9% for 2013. Our expense ratio was positively impacted by a $40.5 million, or 3.4 points, decrease in policy acquisition expenses for 2013, compared to 2012, driven by our exit of the Collector Cars and Boats business, which carried a high acquisition expense ratio related to contingent commissions. Our other underwriting expense ratio remained relatively flat, as decreased fringe benefits and information technology expenses were offset by increased non-claims litigation expenses and incentive compensation accruals in 2013.
Net investment income decreased to $41.1 million for 2013, compared to $53.6 million for 2012, primarily due to lower investment yields on new purchases during 2013 and a slight decline in average invested assets, including invested assets reclassified to assets held for sale. The decline in average invested assets since December 31, 2012 was driven by $102.3 million of losses paid related to the Runoff Business, as well as dividends paid to shareholders. Net realized and change in unrealized investment gains decreased to $49.4 million in 2013, compared to $55.7 million in 2012, driven by increasing interest rates partially offset by favorable equity market fluctuations.
Our income tax expense related to pre-tax income from continuing operations for 2013 and 2012 represented net effective tax rates of 18.9% and 7.9%, respectively. The effective tax rate for 2013 was lower than the U.S. statutory rate of 35% due to a reduction in the valuation allowance as a result of the $6.8 million tax benefit associated with the restructuring of a surplus note with HGIE and income generated in jurisdictions other than the United States, principally representing interest income taxed in a jurisdiction with a lower effective tax rate. The effective tax rate for the year ended December 31, 2012 was lower than the U.S. statutory rate of 35% due to income generated in jurisdictions other than the United States, principally representing interest income taxed in a jurisdiction with a lower effective tax rate. The effective tax rate on non-U.S. income for 2013 and 2012 was 0.5% and 0.6%, respectively, and the effective tax rate on U.S. income was 28.1% and 26.1%, respectively.
The Specialty Products segment is comprised of eight operating segments, including our Crop business which we started writing in late 2013, as well as the Collector Cars and Boats underwriting operating segment that was exited in 2013, representing an aggregation based on those that offer distinct products and tailored coverages and services to a broad customer base across the United States. See "Item 1. Business-Insurance Business-Specialty Products" for further discussion of the Specialty Products segment, including descriptions of its underwriting operating segments.
OBIC, one of the transferred entities that was sold as part of the Runoff Transaction and was an indirect wholly-owned subsidiary of Armour as of December 31, 2014. There is no net retention of the legacy Runoff Business to OneBeacon.
experienced in the Collector Cars and Boats business that had a significant runoff of earned premium in 2013. The 2014 results included 10.6 points of net unfavorable prior year loss reserve development, of which 8.9 points related to the 2014 fourth quarter reserve increase, primarily driven by professional liability (including lawyers professional liability) and management liability within Professional Insurance and by Specialty Property. The remaining amount of net unfavorable prior year loss reserve development for 2014 was primarily driven by unfavorable development recorded prior to the 2014 fourth quarter also in our professional liability and management liability businesses included within Professional Insurance, offset in part by favorable development in our healthcare business included within Professional Insurance.
The 6.8 point decrease in the expense ratio for 2014, compared to 2013, was primarily driven by a decrease in the incentive compensation accrual resulting from the 2014 fourth quarter reserve increase, and to a lesser extent reflective of the beneficial impact of higher earned premiums in 2014, and decreased non-claims litigation expense, partially offset by the prior year beneficial impact of the transition services agreement with the buyer of our personal lines business in 2013.
The Specialty Products combined ratio for 2013 decreased to 93.2% from 97.9% for 2012, as the loss and LAE ratio decreased by 0.8 points to 56.4% and the expense ratio decreased by 3.9 points to 36.8%.
The decrease in the expense ratio for 2013, compared to 2012, was primarily due to a 5.7 point decrease in policy acquisition expenses, due primarily to lower expense in Collector Cars and Boats which carried a higher acquisition ratio. This decrease in policy acquisition expense was partially offset by a 1.8 point increase in other underwriting expense, driven by increased non-claims litigation expenses and incentive compensation accruals, offset in part by decreased fringe benefits and information technology expenses.
Specialty Industries-Year ended December 31, 2013 versus year ended December 31, 2012
Net written premiums for Specialty Industries increased to $579.0 million in 2013 from $548.3 million in 2012. The increase in 2013 was due to increases in net written premiums of $21.1 million from our Government Risks underwriting operating segment, $20.9 million from IMU (which includes $6.2 million of energy business net written premiums that were included in Energy in 2012), $10.8 million from Technology, $5.4 million from Entertainment, and $3.9 million from Accident, which were primarily due to rate increases and new business, as well as solid retention levels. These increases were partially offset by a $25.2 million decrease in net written premiums from the Energy underwriting operating segment, which we exited in 2013.
The Specialty Industries combined ratio for 2013 decreased to 91.7% from 97.1% for 2012, as the loss and LAE ratio decreased by 3.0 points to 54.7% and the expense ratio decreased by 2.4 points to 37.0%.
The 2013 results included 1.1 points of favorable prior year loss reserve development primarily related to our ocean marine business included in IMU and to Technology, offset in part by few large claims in Entertainment, compared to 1.1 points of favorable prior year loss reserve development in 2012 primarily related to Technology. Additionally, current accident year losses decreased 3.0 points for 2013, compared to 2012, as catastrophe losses decreased 3.7 points while non-catastrophe losses increased 0.7 points. The 2013 results included 1.0 point of catastrophe losses, primarily related to storms in the midwestern and southern United States impacting our inland marine business included in IMU, as well as impacting Government Risks and Technology, and rainstorms in Colorado impacting our inland marine business included in IMU. This compared to 4.7 points of catastrophe losses in 2012, primarily related to Superstorm Sandy and, to a much lesser extent, thunderstorms in the midwestern, mid-Atlantic, and northeastern United States, which primarily impacted IMU.
The decrease in the expense ratio included a 1.7 point decrease in other underwriting expenses in 2013, compared to 2012, driven by decreased fringe benefits and information technology expenses that were partially offset by increased incentive compensation accruals, as well as a 0.7 point decrease in policy acquisition expenses, driven by lower premium taxes and commissions.
In 2013, we received approval to provide MPCI through the federal crop insurance program administered by the Risk Management Agency (RMA), which is a division of the U.S. Department of Agriculture. We entered into an exclusive agreement with a managing general agency, Climate Crop Insurance Agency LLC (The Climate Corporation), to provide coverages through the federal program and other supplemental coverages, including crop-hail (a separate, non-federally subsidized product that is regulated by each state). In the federal crop insurance program, the RMA sets the policy terms and conditions, rates and forms, and is also responsible for setting compliance standards. As a participating company, we report all details of underwritten policies to the RMA and are party to a Standard Reinsurance Agreement (SRA). The SRA defines the relationship between participating companies and the Federal Crop Insurance Corporation.
Investing, Financing and Corporate-Year ended December 31, 2014 versus year ended December 31, 2013
Investing, Financing and Corporate reported pre-tax income from continuing operations of $97.7 million in 2013, compared to $80.8 million in 2012. The increase was primarily related to a $23.0 million pre-tax ($15.0 million after tax) gain from the sale of Essentia and a $4.0 million pre-tax benefit related to the Licensing Arrangement, mostly offset by a significant decrease in investment returns. As described in greater detail in "Summary of Investment Results" below, net investment income decreased to $41.1 million in 2013, compared to $53.6 million in 2012, and net realized and change in unrealized investment gains decreased to $49.4 million in 2013, compared to $55.7 million in 2012. Interest expense decreased to $13.0 million for 2013, compared to $16.9 million for 2012, reflecting the lower interest rate of 4.6% on our senior notes for 2013 compared to an interest rate of 5.875% on senior notes prior to their refinancing in the fourth quarter of 2012. See "-Financing."
The vast majority of the gross and net run-off unpaid losses and LAE reserves were included in the entities that were transferred to Armour. As of December 31, 2014, $23.8 million of gross loss and LAE reserves related to the Runoff Business were ceded to OBIC, an indirect wholly-owned subsidiary of Armour as of December 31, 2014, by way of a 100% quota share agreement with ASIC.
The following summarizes the results of operations, including related income taxes associated with the business classified as discontinued operations:
During the third quarter of 2014, we updated our estimated loss on sale to reflect the change in the valuation of the $80.9 million par value of surplus notes resulting in an additional loss of $10.3 million, pre-tax, which was a result of widening credit spreads during the quarter, as well as an increase to the estimated discount rate related to the private nature of the notes (and the related lack of liquidity).
As noted above, the final par value amount of seller financing in the form of surplus notes issued by OBIC, transferred to Armour at closing, was $101.0 million. The estimated fair value of the surplus notes was updated at closing to reflect an additional $17.6 million negative valuation adjustment, pre-tax. The negative adjustment reflected the favorable valuation impacts of an increase in par value of $20.1 million as well as the updated independent stochastic modeling of OBIC’s future cash flows which were more than offset by the unfavorable impact of changes in credit spreads, the discount rate used to reflect the private nature of the notes (and the related lack of liquidity), and the estimated timing, amounts, and likelihood of interest
See “Critical Accounting Estimates” for a sensitivity analysis of potential changes in these key variables that can impact the estimated fair value of the surplus notes.
As a result of the comprehensive actuarial analysis conducted by our actuaries during the fourth quarter of 2013, we recorded $71.5 million of unfavorable prior year non-A&E loss and LAE development related to the Runoff Business. The increase in loss reserves was concentrated in the workers compensation, personal auto liability, and excess liability lines of business. In addition, we increased our estimate of adjusting and other expenses, a component of LAE reserves.
For the full year 2013, we recorded $78.9 million loss and LAE provision for the Runoff Business, which includes a $7.4 million increase in loss and LAE reserves recorded in the second quarter of 2013. The $78.9 million loss and LAE adverse development recorded in 2013 was partially offset by other revenue of $7.8 million associated with a settlement award in the second quarter of 2013 in the Safeco v. American International Group, Inc. (AIG) class action related to AIG's alleged underreporting of workers' compensation premiums to the National Workers' Compensation Reinsurance Pool.
The $71.5 million ($46.5 million after tax) increase in Runoff Business loss and LAE reserves was recorded in the fourth quarter of 2013 as a component of discontinued operations and offset by an equal after tax amount which decreased the estimated ultimate loss on sale of the Runoff Business. The terms of the Stock Purchase Agreement prescribed that the buyer assumed the risk that loss and LAE reserves develop unfavorably from September 30, 2012 onward, resulting in the offset.
During the fourth quarter of 2013, we also increased the estimated pre-tax transaction costs associated with the Runoff Transaction which was partially offset by the accretion of interest on the original purchase price and, coupled with the $46.5 million after tax provision for loss and LAE, resulted in a $46.6 million after-tax reduction in the ultimate loss on sale from discontinued operations in the fourth quarter and full year ended December 31, 2013. This reduction in the ultimate loss on sale was essentially offset by a $46.6 million after tax loss included in loss from discontinued operations for the fourth quarter of 2013, driven by the adverse reserve development.
Our total pre-tax investment results were $82.1 million, a return on average invested assets of 3.4% for 2014, compared to $90.5 million, a return of 3.8% for 2013. The decrease was principally driven by lower returns in our common equity securities portfolio relative to the prior year.
Our fixed income portfolio, which includes fixed maturity and short-term investments, returned 2.4% for 2014, compared to 0.4% for 2013. We maintained a high quality fixed maturity portfolio with a relatively short duration of approximately 2.5 years excluding short-term investments and approximately 2.2 years including short-term investments as of December 31, 2014. Our fixed income portfolio underperformed the longer-duration Barclays U.S. Intermediate Aggregate Index benchmark by 170 basis points for 2014.
Investment Returns-Year ended December 31, 2013 versus year ended December 31, 2012
Includes $236.3 million of fixed maturity investments reclassified to assets held for sale in the December 31, 2013 consolidated balance sheet as part of the Runoff Transaction.
Includes $65.1 million of surplus notes as of December 31, 2014, received in conjunction with the financing of the Runoff Transaction, with no corresponding amount as of December 31, 2013.
The breakdown of our fixed maturity portfolio, including convertible fixed maturity investments, as of December 31, 2014 by credit class, based upon issue credit ratings provided by Standard & Poor's, or if unrated by Standard & Poor's, long-term obligation ratings provided by Moody's, is as follows:
We purchase commercial and residential mortgage-backed securities to maximize our risk adjusted returns in the context of a diversified portfolio. Our non-agency commercial mortgage-backed securities (CMBS) are generally short tenor and structurally senior, with approximately 30 points of subordination on average for fixed and floating rate CMBS as of December 31, 2014. In general, subordination represents the percentage of principal loss on the underlying collateral that would have to
occur before the security incurs a loss. These collateral losses, instead, are first absorbed by other securities lower in the capital structure. We believe this structural protection mitigates the risk of loss tied to refinancing challenges facing the commercial real estate market. As of December 31, 2014, on average less than 1% of the underlying loans were reported as non-performing for all CMBS held. We are not an originator of residential mortgage loans and did not hold any residential mortgage-backed securities (RMBS) categorized as sub-prime as of December 31, 2014. Our investments in hedge funds and private equity funds contain negligible amounts of sub-prime mortgage-backed securities as of December 31, 2014. We consider sub-prime mortgage-backed securities to be those that have underlying loan pools that exhibit weak credit characteristics or are issued from dedicated sub-prime shelves or dedicated second-lien shelf registrations (i.e., we consider investments backed primarily by second-liens to be sub-prime risks regardless of credit scores or other metrics).
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, 2014, we held one mortgage-backed security with a market value of $3.1 million that was 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 classification of the underlying collateral quality and the tranche levels of our non-agency RMBS securities are as follows as of December 31, 2014:
The amount of fixed and floating rate securities and their tranche levels are as follows as of December 31, 2014:
Both internal and external forces influence our financial condition, results of operations and cash flows. Claim settlements, premium levels and investment returns may be impacted by changing rates of inflation and other economic conditions. In many cases, significant periods of time, sometimes several years or more, may lapse between the occurrence of an insured loss, the reporting of the loss to us and the settlement of the liability for that loss. The exact timing of the payment of claims and benefits cannot be predicted with certainty. Our operating subsidiaries maintain portfolios of invested assets with varying maturities and a substantial amount of cash and short-term investments to provide adequate liquidity for the payment of claims.
During the years ended December 31, 2014 and 2013, our unregulated insurance operating subsidiaries paid $4.8 million and $17.3 million, respectively, of dividends to their immediate parent. As of December 31, 2014, our unregulated insurance operating subsidiaries had $78.1 million of net unrestricted cash, short-term investments and fixed maturity investments and also held $101.0 million in par value of surplus notes, with a fair value of $65.1 million classified as other investments.
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 can be considered as the cost of insurance float. One manner in which we calculate our insurance float is by taking our insurance liabilities and subtracting insurance assets. In prior periods, OneBeacon had calculated its insurance float by taking invested assets and subtracting total capital. The current presentation simplified the insurance float calculation by including only insurance assets and liabilities, which is also more consistent with traditional insurance float presentations. As a result of the change in calculation, the float as of December 31, 2013 decreased from the previously reported $1,382.0 million down to $1,135.1 million under the new method, with the decrease resulting primarily from the net assets transferred at the closing of the Runoff Transaction. 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.
Insurance float can increase in a number of ways, including through acquisitions of insurance operations, organic growth in existing insurance operations and recognition of losses that do not immediately cause a corresponding reduction in investment assets. Conversely, insurance float can decrease in a number of other ways, including sales of insurance operations, shrinking or run-off of existing insurance operations, the acquisition of operations that do not have substantial investment assets (e.g., an agency) and the recognition of gains that do not cause a corresponding increase in investment assets. We intend to generate low-cost float over time through a combination of organic growth and acquisitions. However, we seek to increase overall profits sometimes by reducing float, such as in the Runoff Transaction.
During 2014, insurance float increased by $320.2 million, primarily driven by growth in our newer business, as well as the 2014 fourth quarter reserve increase of $109.2 million, which increased loss and LAE reserves.
We also have future binding commitments to fund certain limited partnership investments. These commitments, which total $10.6 million as of December 31, 2014, do not have fixed funding dates and are therefore excluded from the table above.
During 2014 and 2013, we repurchased 106,366 and 3,300 common shares to satisfy employee income tax withholding, pursuant to employee benefit plans. No shares were repurchased during 2012. Shares repurchased pursuant to employee benefit plans do not fall under the board authorizations referred to above.
For 2014, net cash flows provided from operations was $97.5 million, consisting of $152.0 million provided from continuing operations and $54.5 million used for discontinued operations. For 2013, net cash flows used for operations was $128.7 million, consisting of $205.4 million provided from continuing operations and $76.7 million used for discontinued operations. For 2012, net cash flows used for operations was $53.7 million, consisting of $142.7 million provided from continuing operations and $196.4 million used for discontinued operations. Net cash flows for operations in 2014, 2013 and 2012 were reduced by the run-off of reserves related to the Runoff Business, which are included in discontinued operations. Net cash flows relating to continuing operations in 2014 decreased $53.4 million relative to 2013, primarily due to outflows from loss and LAE payments exceeding inflows from premiums driven by larger claims in 2014, premium advances to the Federal Crop Insurance Corporation related to our Crop business in 2014, and a $39.6 million decrease in net collateral receipts related to our Surety business.
During 2013, we made payments with respect to our long-term incentive compensation plans totaling $3.9 million, in cash or by deferral into certain of our non-qualified compensation plans. These payments were made primarily with respect to 158,890 performance units for the 2010-2012 performance cycle.
During 2014, we declared and paid $80.0 million of regular quarterly cash dividends to holders of OneBeacon's common shares.
During 2012, we completed the sale of a shell company, Pennsylvania General Insurance Company, and received $15.0 million as consideration.
During 2012, we sold one of our subsidiaries, OB Lux, to a subsidiary of White Mountains and recognized a gain of $14.0 million as additional paid in capital. Net of transaction costs expensed through the statement of operations, the gain was $13.6 million.
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).
Under the contractual terms of both the seller priority and pari passu notes, scheduled interest payments accrue at 6% until the scheduled maturity date of March 15, 2020 and at a floating interest rate thereafter, should any principal remain outstanding. All interest and principal due on the seller priority note must first be paid before any interest or principal payments can be paid on the pari passu note. As required by the Pennsylvania Insurance Department (PID), interest on the notes is not compounding. The notes restrict the Issuer's ability to make distributions to the holders of its equity interest. All such distributions are prohibited while the seller priority note is outstanding, and while the pari passu note is outstanding, distributions are permitted only if the Issuer concurrently repays a pro rata amount of any outstanding principal on the pari passu note.
Pursuant to the notes, the Issuer shall seek to redeem the notes annually each March 15 at a requested redemption amount such that the Issuer’s total adjusted capital following the proposed redemption payment would equal 200% of the Issuer’s “authorized control level RBC,” as such term is defined by the insurance laws of the Commonwealth of Pennsylvania and as prescribed by the PID. All redemptions or repayments of principal and payments of interest on the notes are subject to approval by the PID. Below is a table illustrating the valuation adjustments taken to arrive at estimated fair value as of December 31, 2014:
Represents the value of the surplus notes, at current market yields on publicly traded debt, and assuming issuer is allowed to make principal and interest payments when its financial capacity is available, as measured by statutory capital in excess of a 250% RBC score.
As a means to provide the degree of variability for each of the key assumptions that affect the fair value of the surplus notes, below is a table of sensitivities which measure hypothetical changes in such variables and the resulting pre-tax increase (or decrease) impact on the valuation of the surplus notes:
As of December 31, 2014 and 2013, other investments reported at fair value represented approximately 7% and 5%, respectively, of the total investment portfolio. Other investments accounted for at fair value as of December 31, 2014 and 2013 were comprised of $65.1 million surplus notes, none of which were held as of December 31, 2013, and $42.3 million and $49.4 million, respectively, in hedge funds, $60.1 million and $56.1 million, respectively, in private equity funds and $14.3 million and $14.4 million, respectively, in an investment in a community reinvestment vehicle. As of December 31, 2014 and 2013, OneBeacon held investments in 7 and 8 hedge funds, respectively. OneBeacon held investments in 17 and 19 private equity funds as of December 31, 2014 and 2013, respectively. The largest investment in a single fund was $15.8 million and $14.9 million as of December 31, 2014 and 2013, respectively. As of December 31, 2014 and 2013, other investments also included $18.0 million and $19.7 million, respectively, of an investment in a tax advantaged federal affordable housing development fund which is accounted for using the equity method. Additionally, other investments accounted for at fair value as of December 31, 2014 included $0.2 million in trust certificates issued upon dissolution of a private equity fund, with no such investments held as of December 31, 2013.
Excludes the carrying value of $18.0 million and $19.7 million as of December 31, 2014 and 2013, respectively, associated with a tax advantaged federal affordable housing development fund accounted for using the equity method.
(2) Includes $236.3 million of fixed maturity investments reclassified to assets held for sale in the December 31, 2013 consolidated balance sheet as part of the Runoff Transaction.
Includes purchases of $64.9 million in surplus notes provided in conjunction with the financing of the Runoff Transaction.
“Transfers in” to Level 3 fixed maturity investments of $61.3 million for the year ended December 31, 2013 was comprised of one agency commercial mortgage-backed security for which the estimated fair value was determined using industry standard pricing models that take into account unobservable inputs such as prepayment rate, default rate and swap spread. See Note 5-"Investment Securities" of the accompanying consolidated financial statements for information regarding significant unobservable inputs.
Loss and LAE reserves associated with the Runoff Business were sold on December 23, 2014 and were included in liabilities held for sale on the December 31, 2013 balance sheet; as such, those reserves are excluded from the disclosures contained herein.
The process of establishing loss reserves is complex and imprecise as it must consider many variables that are subject to the outcome of future events. As a result, informed subjective estimates and judgments as to our ultimate exposure to losses are an integral component of our loss reserving process. We, like other insurance companies, categorize and track our insurance reserves by "line of business", such as general liability, automobile liability and workers compensation. Furthermore, we regularly review the appropriateness of reserve levels at the line of business level, considering the variety of trends that impact the ultimate settlement of claims for the subsets of claims in each particular line of business.
General liability policies are written on a claims made or occurrence or form.
The general liability occurrence and property coverages, described above, are often provided under a multiple peril package policy sold to insureds includes general liability and property insurance. Because commercial multiple peril provides a
Medical professional liability policies cover the defense expenses and damages related to negligence claims brought against the insured health care institution or provider. The coverage focuses on damages resulting from an alleged failure to perform, error or omission in the service provided by the policyholder. See the above discussions with regard to reserving factors for general liability which are similar to the reserving factors for medical malpractice.
In addition to the examples of common reserving factors related to general liability, described above, other examples of common reserving factors that can change and, thus, also affect estimated commercial automobile liability reserves include:
Multiperil crop and crop-hail is generally considered a very short tailed coverage yet the reserve estimate often contains a fair amount of uncertainty. As a new business, lack of historical data means external data is heavily relied upon where available and applicable. Crop reserving factors that can change and, thus, affect estimated crop reserves include changes in crop prices, estimated acreage covered, claim reporting or payment patterns, or claim handling philosophies (e.g., case reserving standards).
Net unfavorable prior year loss and LAE reserve development was $89.8 million for 2014, of which $75.5 million related to the 2014 fourth quarter reserve increase described in "Item 7. Management's Discussion and Analysis-Overview." Of the net unfavorable loss and LAE reserve development resulting from the 2014 fourth quarter reserve increase, $46.4 million related to Professional Insurance, primarily professional liability (including lawyers professional liability) and management liability, and to a lesser extent Entertainment, Government Risks, Specialty Property, Accident, and our inland marine business within IMU. The remaining net unfavorable prior year loss and LAE reserve development for 2014 primarily related to unfavorable development recognized prior to the 2014 fourth quarter also in our professional liability and management liability businesses included within Professional Insurance, offset in part by favorable development in our healthcare business included within Professional Insurance.
During 2013, OneBeacon experienced no net loss and LAE reserve development on prior accident year reserves. The Company experienced unfavorable development primarily related to the property line in Specialty Property, Entertainment (primarily, general liability), and the A&H line within the Accident underwriting operating segment. This amount was offset by favorable development in other liability (claims made) within the managed care E&O business included in the Professional Insurance underwriting operating segment, and in the ocean marine line of business, included in the IMU.
During 2012, OneBeacon experienced $7.4 million of favorable loss and LAE reserve development on prior accident year reserves. During 2010, management began separately reviewing loss reserves for some business which had been previously managed as a part of OneBeacon's former commercial lines underwriting unit. As of December 31, 2011, the reserves for these businesses had been selected based on expected emergence which was based in large part on the historic loss development of the former commercial lines underwriting unit. The favorable reserve development was primarily due to emergence which continued to be lower than expected for these businesses, particularly in the workers' compensation, multiple peril liability and general liability lines. This favorable development was partially offset by adverse development on excess property claims.
During 2014, the Company changed its presentation of line of business reserves. We have reclassified the 2013 case reserves, IBNR and total reserves to report consistent line of business activity for both years presented. As a result, for "General liability - claims made," case reserves increased $0.6 million, IBNR increased $3.3 million, and total reserves increased by $3.9 million, with corresponding decreases to "General liability - occurrence", and for "Other," case reserves increases increased by $3.8 million, IBNR increased $8.6 million, and total reserves increased by $12.4 million, with corresponding decreases to "Property," compared to the previous presentation for 2013.
Various sources of inflation volatility impact all of our reserves in different ways. Using our internal economic capital model we have derived a distribution of future loss payments under the range of inflation scenarios and related claim cost trends in our economic scenario set, holding all other sources of reserve volatility constant. At the 75th percentile of modeled outcomes, the estimated impact of claim cost inflation above our actuarially indicated reserves is $39 million, net of reinsurance.
The volatility associated with the frequency and severity of large losses, defined as net claims greater than or equal to $2.5 million, can have a material impact on our results. The frequency and severity of large claims is driven primarily by the random nature of the insurance process but also by claim cost inflation and parameter risk. These large losses often emerge over a long time period potentially leading to a material impact on our reserves. One way we consider this sensitivity is by examining the volatility of large losses in the current accident year using our economic capital model. At the 75th percentile of modeled outcomes, we estimate that large losses could exceed the mean by $19 million, net of reinsurance.
We also consider variations and sensitivities for certain lines of business such as:
Workers compensation: Recorded workers compensation loss and LAE reserves, net of reinsurance recoverables, were $112.3 million as of December 31, 2014. The two most important assumptions for workers compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately half of the workers compensation net reserves are related to future medical costs. Across the entire reserve base, a 0.5 point change in calendar year medical inflation would have changed the estimated net reserve by approximately $8 million as of December 31, 2014, in either direction.
incurred loss and loss adjustment expenses and the adequacy of our loss and loss adjustment expense reserves and related reinsurance;
Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the anticipated results or developments will be realized or, even if substantially realized, that