The table shown below presents selected financial data for each of the five years ended December 31, 2008. This financial information was prepared in accordance with GAAP. The GAAP statement of income data for the years ended December 31, 2008, 2007, 2006, 2005 and 2004 and the GAAP balance sheet data at December 31, 2008, 2007, 2006, 2005 and 2004 were derived from Crum & Forster Holdings Corp.’s consolidated financial statements, which have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The consolidated balance sheets at December 31, 2008 and 2007, and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows for each of the three years ended December 31, 2008, and accompanying notes, appear in “Item 8. Financial Statements and Supplementary Data”. The combined statutory data has been derived from annual statutory financial statements, which have been filed with the domiciliary states of the Company’s insurance subsidiaries, and prepared in accordance with SAP, which differs from GAAP.
The Company’s consolidated financial statements and related notes thereto are prepared in accordance with GAAP. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of material contingent assets and liabilities as of the balance sheet date and the revenues and expenses reported during the relevant period. In general, management’s estimates are based on historical experience, evaluation of current trends, information from third party professionals and various other assumptions that are believed to be reasonable under the known facts and circumstances.
General Liability - an individual investigation of each loss reported is undertaken and the claims personnel, using their experience and judgment, establish a case reserve in an amount estimated to be the most likely ultimate loss amount to be paid considering the assumed jurisdiction where the claim is pending and the applicable law of allowable direct and consequential damages and defenses, the effect, if any, of the particular venue, including settlement and verdict values, and, where applicable, the advice of counsel retained to represent the defendant in the individual case.
For example, for older years where more credibility can be placed upon actual observed loss emergence, paid or incurred loss development methods are generally the basis of the ultimate loss selection. For more recent years where the actual emergence of losses is less credible, methods that place more emphasis on expected loss development (e.g., the Bornhuetter-Ferguson method) may be selected as the loss ultimate. A central estimate unpaid loss and ALAE reserve is determined by subtracting actual paid losses and ALAE from the projected ultimate losses and ALAE for each line of business by accident year. These reserves are aggregated by line of business and the IBNR component is derived therefrom by deducting the recorded case reserves. The ULAE IBNR reserve is calculated directly by the methods described above. The IBNR reserve includes anticipated additional development of case reserves (either positive or negative), provision for claims that have not been reported and estimated settlement expenses.
The Company’s actuaries also conduct an internal ground-up study of asbestos and environmental reserves on an annual basis. Such ground-up studies involve a policyholder-by-policyholder evaluation considering the following factors: available insurance coverage based upon the type of loss being presented (premises/operations or products), including the role of any umbrella or excess insurance purchased by the policyholder and court decisions concerning specific coverage provisions; other policy specific provisions, including whether defense is included in or in addition to loss; limits, deductibles and self-insured retentions; an analysis of each policyholder’s ultimate potential liability; the jurisdictions involved; past and anticipated future asbestos claim filings against the policyholder; past settlement values of similar claims against the policyholder and their associated defense costs; dismissal rates of claims by jurisdiction; distribution of claims by disease type (cancers, including mesothelioma, asbestosis and no impairment) where known; the potential role of other insurance (estimating the Company’s ultimate participation of loss settlements percentage); and applicable coverage defenses. The evaluations are based on current trends without any assumption of potentially favorable or unfavorable legislation in the future.
At each balance sheet date, Company management establishes its “best estimate” based on the actuarial central estimates by line of business from the most recent internal actuarial reserve review, together with the actual loss emergence since such most recent review. Consideration may also be given to the results of actuarial reserve reviews conducted by the Company’s independent actuaries. Management considers a “best estimate” to be one where the total reserves have an equal likelihood of developing a redundancy or deficiency as the loss experience matures. Following the completion of each semi-annual internal actuarial reserve review, management reviews the actuarial reserve valuation with the Company’s actuaries and compares the indicated reserve levels by line of business to the corresponding recorded reserves. In general, management’s best estimate will approximate the internal actuaries’ central estimates. There may, however, be circumstances in which management chooses not to adjust its best estimate for assumptions made by its actuaries regarding emerging trends - positive or negative - until the passage of further time or additional information has confirmed the credibility of the trend. At December 31, 2008, the Company’s actuaries concurred with the reasonableness of management’s best estimate.
Losses and LAE are charged to income as they are incurred. During the loss settlement period, reserves established in prior years are adjusted as loss experience develops and new information becomes available. Adjustments to previously estimated reserves, both positive and negative, are reflected in the Company’s financial results in the periods in which they are made, and are referred to as prior period loss development. Due to the high level of uncertainty, revisions to these estimated reserves could have a material impact on the Company’s results of operations in the period recognized, and actual payments for claims and LAE could ultimately be significantly different from estimates.
The Company recorded $39.0 million, $(50.2) million and $(85.9) million of prior period adverse (favorable) loss development before corporate aggregate reinsurance for 2008, 2007 and 2006, respectively. After corporate aggregate reinsurance, the prior period adverse (favorable) loss development was $20.1 million $(63.9) million and $(96.2) million for 2008, 2007 and 2006, respectively.
In 2006, the net favorable development before corporate aggregate reinsurance was comprised principally of favorable development across all major casualty lines, with the largest redundancy being recognized in workers’ compensation, principally attributable to the favorable results in California in accident years 2005 and 2004, consistent with industry-wide experience. Additionally, favorable development was also experienced in umbrella and other general liability exposures, due in part to favorable settlements of claims in accident years 2000 and prior and in commercial automobile liability for accident years 2005 and prior. The favorable development was partially offset by adverse development of $33.9 million of asbestos, environmental and other latent liabilities.
Generally, policyholders who assert these positions are installers of asbestos products or property owners who allegedly had asbestos on their property. In addition, in an effort to seek additional insurance coverage, some policyholders that have eroded their aggregate limits are submitting new asbestos claims as “non-product” claims or attempting to reclassify previously resolved claims as non-product claims. Unlike product exposures, these non-product exposures are argued not to be subject to aggregate limits, creating potentially
greater exposure. The extent to which policyholders will be successful in obtaining coverage on this basis is uncertain and court decisions have been inconsistent to date. Accordingly, it is difficult to predict the ultimate size of the claims for coverage not subject to aggregate policy limits.
the number of new filings has resulted in the defense bar focusing on individual cases involving higher severity injuries. California continues to be the most active and challenging venue for defendants.
The reported asbestos survival ratios based on asbestos loss and ALAE reserves, net of per risk reinsurance but before the benefit of corporate aggregate reinsurance, are presented below:
Another industry benchmark that management reviews is the relationship of asbestos loss and ALAE reserves to the estimated ultimate asbestos loss, i.e., the sum of cumulative paid losses and the year-end outstanding loss reserves. These comparisons are summarized as follows:
As discussed in more detail in the following paragraphs, the Company increased its reserves for asbestos liabilities in each of 2008, 2007 and 2006. Asbestos liabilities are uniquely difficult to estimate due to both industry-wide issues and Company-specific factors. Industry-wide trends and factors have generally been adverse to insurance companies and include complex coverage issues, expansive judicial interpretation, lack of historical data, long reporting delays, substantial defense costs, increases in claims by unimpaired plaintiffs, venue shopping, bankruptcies of traditional defendants and targeting of peripheral defendants whose exposures may not be subject to aggregate policy limits. In developing its asbestos reserve estimates, the Company gives consideration to the current state of industry trends and factors, particularly those that most directly affect its policyholder universe such as the targeting of smaller, peripheral defendants. However, changes in these trends or the emergence of new trends or factors may not be reasonably foreseeable or their effects may not be reliably quantifiable as of the date of the Company’s estimate. Further, while industry trends have an effect on the Company, increases in the Company’s asbestos reserve estimates are most directly and significantly affected by changes in the state of asbestos claims against Crum & Forster’s specific policyholders. A comparatively small number of policyholders account for a substantial share of the Company’s asbestos claim payout activity in any given period and of the asbestos net unpaid losses and ALAE reserves at each balance sheet date. Changes in the conditions of specific policyholders, such as being targeted by plaintiffs in a state or states from which claims had not been previously filed or expected, adverse court decisions regarding coverage or defense obligations, the discovery (or allegation) of the existence of additional policies issued by the Company or the inability of another of the policyholder’s insurers to discharge its policy obligations, thereby increasing the obligations of the remaining insurers, can have a material impact on the previous estimate of the potential liability associated with that policyholder. These changes may not have been foreseeable or lacked sufficient credibility, even if foreseeable, as of the date of the Company’s previous estimate.
the early versions of the pollution exclusion to expand the scope of coverage provided. Since 1986, however, most general liability policies exclude coverage for such exposures.
New reports for environmental claims are generally trending downward while the cost of the remedy in certain jurisdictions has increased. Claims against Fortune 500 companies are declining, and, while policyholders with single-site exposures are still active, the Company has resolved the majority of disputes with respect to policyholders with a large number of sites. Statutes in a number of states require administrative involvement in business closures where the business used or produced substances that are considered contaminants. Accordingly, the general economic climate could result in an uptick of reported claims associated with such business or facility closures. In many cases, claims are being settled more expeditiously due to improved site remediation technology and effective policy buybacks. However, due to the high level of uncertainty, revisions to these reserve estimates could have a material impact on the Company’s results of operations in the period recognized and the ultimate actual payments for claims and LAE could turn out to be significantly different from estimates.
In addition to asbestos and environmental pollution, the Company faces exposure to other types of latent mass tort claims. These other latent claims include those associated with silica, gas and vapors, lead, mold, chemicals, welding fumes and pesticides. Similar to asbestos and pollution, traditional actuarial techniques cannot be used to estimate ultimate liability for these exposures. Management sets reserves for other latent exposures at a selected gross survival ratio (approximately 6 years) and selects a gross to net ratio based on the gross to net ratio of historical payments. An analysis of gross and net reserves from other latent exposures is presented in Note 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Management believes that the asbestos, environmental and other latent reserves reported at December 31, 2008 are reasonable estimates of the ultimate remaining liability for these claims based on facts currently known, the present state of the law and coverage litigation, current assumptions and the reserving methodologies employed. These latent reserves are continually monitored by management and reviewed by independent consulting actuaries. New developments will continue to be evaluated as they arise in order to supplement the ongoing analyses and reviews of the latent exposures. However, to the extent that future social, scientific, economic, legal or legislative developments alter the volume of claims, the liabilities of the policyholders, or the original intent of the policies and scope of coverage, increases in loss reserves may emerge in future periods. Due to the inherent uncertainties in estimating reserves for unpaid losses and LAE described above, and to the potential impact of recent trends, the ultimate liability for the Company’s loss and LAE reserves, and, in particular, its asbestos, environmental and other latent claims reserves, may vary substantially from the amounts currently reserved.
For additional discussion on the Company’s reserves, see “Item 1. Business - Reserves” and Notes 5 and 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
At December 31, 2008, the Company had unrealized losses of $137.9 million in investments in available-for-sale fixed income and equity securities of which $22.5 million was attributed to fixed income securities and $115.4 million was attributed to equity securities. The majority of the gross unrealized losses in the fixed income portfolio are attributable to municipal securities, substantially all of which are fully insured by Berkshire Hathaway Assurance Corp. for the payment of interest and principal in the event of issuer default. Gross unrealized losses of $115.4 million in the equity portfolio are attributable to 14 securities in an unrealized loss position, 13 of which have been in a loss position for less than six consecutive months. The decline in the fair value of the fixed income and equity securities is primarily due to an increase in credit spreads and a decline in equity markets resulting from the continuing financial market disruption. With respect to securities that were not impaired, the Company has the ability and intent to hold these securities in an unrealized loss position for a period of time sufficient to allow a market recovery, or to maturity if necessary.
An estimated allowance for uncollectible reinsurance recoverable is recorded on the basis of periodic evaluation of balances due from reinsurers, judgments regarding reinsurer solvency, known disputes, reporting characteristics of the underlying reinsured business, historical experience, current economic conditions and the state of insurer/reinsurer relations in general, and at the Crum & Forster companies in particular.
Although realization is not assured, management believes the recorded deferred tax assets are fully recoverable based on estimates of the future profitability of Crum & Forster’s taxable subsidiaries and current forecasts for the periods through which losses may be carried back and/or forward. The Company has several material deferred tax assets arising from investments (a significant portion of which relate to impairments), loss reserve discounting, deferred income on retroactive reinsurance and unearned premium adjustments. The realizability of these reversing deferred tax assets is considered in conjunction with similar originating deferred tax assets and other taxable income.
The Company participates in a tax sharing agreement with Fairfax, entered into in 2007, that permits the Company and its subsidiaries to elect to file federal income tax returns on a consolidated basis for tax sharing purposes. The Company made that election effective January 1, 2007, which resulted in the utilization of its cumulative holding company net operating losses (“NOLs”) in that year, and the avoidance of the generation of holding company NOLs going forward, provided the subsidiaries earn sufficient taxable income to offset holding company losses arising principally from interest on the Company’s senior notes. For further details see Note 2 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” and “- Results of Operations - Income Taxes” below.
The Company’s objective is to expand opportunistically into classes of business or market segments that are consistent with its underwriting expertise and have the potential to generate an underwriting profit. Management believes the Company’s ability to identify and react to changing market conditions provides it with a competitive advantage. Based on the experience and underwriting expertise of management, the Company seeks to write new lines of business and expand existing classes of business based on market conditions and expected profitability. The Company offers insurance products designed to meet specific insurance needs of targeted policyholder groups and underwrites specific types of coverage for markets that are generally underserved by the industry.
The property and casualty insurance business is cyclical and influenced by many factors, including price competition, economic conditions, natural and man-made disasters (for example hurricanes, earthquakes and terrorism), availability and cost of reinsurance, interest rates, state regulations, court decisions and changes in the law. For the last several years, the property and casualty market has experienced challenging market conditions characterized by intense competition and downward pricing trends. For a brief period in 2006, the property market experienced significant rate increases and improved terms and conditions in the wake of the 2005 hurricane activity, but the market began to soften again in the fourth quarter of 2006, fueled by the mild hurricane season. The property market continued to soften throughout 2007, with several major competitors offering more capacity in the coastal wind areas and greater capacity and more competitive pricing on non-catastrophe exposed business and became significantly softer in 2008. Habitational business has been most dramatically affected, experiencing a significant drop in market prices and an expansion of limits. Pricing pressure in casualty lines intensified countrywide throughout 2007 and 2008, particularly for larger and middle market accounts, with competitors focusing on retaining their renewals. Some competitors are writing accounts at levels management believes are below average developed losses with multi-year rate lock deals and frequently terms and conditions are expanded without much price consideration.
The increase in net income in 2008 as compared to 2007 was primarily due to a significant increase in investment earnings and lower costs related to early retirement of debt, partially offset by substantially lower underwriting income and lower equity in earnings of investees.
Underwriting results were substantially lower in 2008 as compared to 2007, primarily attributable to the adverse effects of (i) a $75.5 million loss on commutation of a reinsurance contract (7.6 loss ratio points); (ii) catastrophe losses associated with Hurricanes Gustav and Ike of $71.5 million (7.2 loss ratio points); and (iii) a $25.5 million charge (2.6 loss ratio points) associated with the settlement of an asbestos lawsuit. Excluding these specific charges, the combined ratio in 2008 was 97.0%, reflecting a higher expense ratio as premiums declined and the effects of deteriorating market conditions on the loss ratio.
Lower equity in earnings of investees was principally due to lower earnings from Northbridge Financial Corporation (“Northbridge”), an affiliated company, due to a change in accounting for Northbridge from equity method to fair value effective January 1, 2008.
For the year ended December 31, 2007, gross premiums written associated with the Company’s core commercial lines of business (excluding accident and health and “other” lines of business in the table above) declined by approximately $167.8 million, or 13.4%, as compared to the year ended December 31, 2006, primarily due to a decline in new business of 28% and price decreases on renewal policies of approximately 8%, partially offset by a modest increase in the renewal retention rate of approximately two percentage points. The decline in new business was largely due to a decrease in property and general liability writings.
Overall decline in gross premiums written in the core commercial lines in 2008 and 2007 was partially offset by growth from the accident and health business.
For the year ended December 31, 2008, gross premiums written in casualty lines, which include workers’ compensation, general liability and commercial automobile lines of business, declined by $137.5 million, or 19.3%, as compared to the year ended December 31, 2007, due to a decline in new business of approximately 30%, price decreases on renewal policies of approximately 6% and a decrease in renewal retention rates of approximately five percentage points. The decline in new business was most significant for wholesale broker produced casualty business, although casualty new business was down for all producer categories. Pricing pressure for casualty accounts intensified countrywide in 2007 and continued throughout 2008, particularly for larger and middle market accounts, with competitors focusing on retaining their renewals. In addition, the decline in commercial automobile gross premiums written is due to the Company more aggressively reducing its exposure to transportation accounts, where loss experience was greater than the overall book of business.
For the year ended December 31, 2008, gross premiums written in property lines, which include the property and commercial multi-peril lines of business, decreased by $116.2 million, or 31.1%, as compared to the year ended December 31, 2007, primarily due to a decline in new business of approximately 47%, price decreases on renewal policies of approximately 9% and a decrease in renewal retention rates of approximately five percentage points. In addition to soft market conditions which have significantly affected the Company’s property business, the decrease in property gross premiums written in 2008 is also due to a reduction in habitational business, where loss ratios are higher than the remainder of the book of business, as well as a reduction in accounts with larger total insured values.
For the year ended December 31, 2007, gross premiums written in property lines, which include the property and commercial multi-peril lines of business, decreased by $86.0 million, or 18.7%, as compared to the year ended December 31, 2006, primarily due to a decline in new business of approximately 33% and price decreases on renewal policies of approximately 9%, partially offset by an increase in renewal retention rates of approximately two percentage points. The property market began to soften in the fourth quarter of 2006 after a brief turnaround in the first three quarters, in the wake of the 2005 hurricanes, fueled by the mild 2006 hurricane season. This market softening continued throughout 2007, with several major competitors offering more capacity in the coastal wind areas and greater capacity and more competitive pricing in non-catastrophe exposed business. The property market became significantly softer mid-2007, even in catastrophe-exposed areas.
For the year ended December 31, 2008, net premiums written decreased by $228.4 million, or 20.8%, as compared to the year ended December 31, 2007. The decrease was generally in line with the decrease in gross premiums written.
For the year ended December 31, 2007, net premiums written decreased by $66.9 million, or 5.7%, as compared to the year ended December 31, 2006. The lower decline in net premiums written as compared to gross premiums written is due to increased retentions on the property and accident and health lines of business. The increased retention on the property line is due to lower reinsurance costs, attributable to higher retained limits, on the Company’s property per risk and catastrophe treaties in 2007. The increased retention on the accident and health line is due in part to this business being written directly by the Company in 2007, at higher retained limits, whereas in 2006 the majority of this business was assumed from Fairmont with existing reinsurance commitments.
Further, accident and health premiums, which grew in both 2008 and 2007, but more significantly in 2007, are earned as written.
In 2007, the Company recognized net favorable prior year loss development of $(50.2) million (4.2 loss ratio points) prior to corporate aggregate reinsurance activity. The net favorable development was comprised of favorable development across all major casualty lines as well as commercial multi-peril, with the largest redundancy being recognized in workers’ compensation. Specifically, favorable development in the workers’ compensation line was principally attributable to favorable results in non-California for older accident years due to favorable claims settlements and continued recognition of favorable development for California in accident years 2004 and 2005 due to the impact of industry reforms. Favorable development for general liability and commercial multi-peril exposures in accident years 2003 through 2006 was due to the selection of faster loss development factors, recognizing decreased loss activity in those years. The favorable development in these lines was partially offset by $54.5 million of adverse development of asbestos, environmental and other latent liabilities.
In 2006, the Company recognized net favorable prior year loss development of $(85.9) million (7.9 loss ratio points) prior to corporate aggregate reinsurance activity. The net favorable development was comprised principally of favorable development across all major casualty lines, with the largest redundancy being recognized in workers’ compensation, principally attributable to the favorable results in California in accident years 2004 and 2005, consistent with industry-wide experience. Additionally, favorable development was also experienced in umbrella and other general liability exposures, due in part to favorable settlements of claims in accident years 2000 and prior and in commercial automobile liability for accident years 2005 and prior. The favorable development was offset by adverse development of asbestos, environmental and other latent liabilities of $33.9 million.
The accident year loss ratio increased from 65.8% in 2006 to 67.4% in 2007. The increase from 2006 is primarily due to favorable prior year loss development recognized in workers’ compensation for accident year 2006, partially offset by lower catastrophe losses in 2007 as compared to 2006.
The workers’ compensation loss ratio increase from accident year 2006 to 2008 reflects the effects of price softening beginning prior to 2006 and continuing throughout 2007 and 2008, particularly as respects the California business. Management monitors the price adequacy of each line of business and believes that this business remains profitable. More recently, prices appear to be stabilizing for California workers’ compensation accounts.
The increase in the commercial multi-peril loss ratio in 2007 from 2006 is primarily attributable to the effects of price softening and the severe rainstorms which struck in April 2007. Such rainstorms were reflected in the catastrophe impact cited above for 2007 (1.3 points) but had a comparatively larger impact on the commercial multi-peril line.
Underwriting expenses are comprised of policy acquisition costs and other underwriting expenses. Policy acquisition costs are those costs that vary with and are primarily related to the acquisition of new and renewal policies and are comprised of commissions paid to producers and premium taxes. Other underwriting expenses consist of all other operating expenses associated with the Company’s underwriting activities, including salaries and benefits, information technology and rent. The Company’s underwriting expense ratio was 32.1%, 28.7% and 29.0% for the years ended December 31, 2008, 2007 and 2006, respectively. The policy acquisition ratio and the other underwriting expense ratio components of the underwriting expense ratio follow:
The other underwriting expense ratio increased to 16.8% for the year ended December 31, 2008 from 13.7% for the year ended December 31, 2007. The change from 2007 is primarily attributable to a reduction in net earned premium of approximately 16% and an increase in general expenses, largely due to higher compensation costs and higher technology costs reflecting a write-off of previously capitalized software development costs of $4.2 million. Compensation costs in 2008 include severance costs associated with a reduction in workforce to better align compensation costs with lower premium volume. The other underwriting expense ratio improved to 13.7% for the year ended December 31, 2007, from 14.7% for the year ended December 31, 2006, primarily due to the growth in earned premiums. The Company is currently operating in a soft market, characterized by declining premiums, and, should such conditions persist, the other underwriting expense ratio may continue to be adversely affected in 2009.
The Company manages its investment portfolio with an emphasis on total return on assets under management. Total return for the period is the sum of investment income (including pre-tax equity in earnings of investees), realized investment gains and losses and changes in the market value of the portfolio expressed as a percentage of the average book value of the portfolio during the period. Total rate of return on investments was 13.0%, 13.3% and 7.2% for the years ended December 31, 2008, 2007 and 2006, respectively. General economic conditions, stock market conditions, fluctuations in interest rates and many other factors can affect the returns on investments and the Company’s ability to control the timing of the realization of investment income. In addition, the Company also owns a number of investments in derivative securities, including credit default swaps, and equity method investments, which are subject to greater volatility than fixed income investments. Although these derivative securities and equity method investments may provide higher expected returns, they present greater risk, and in the case of equity method investments, are less liquid than fixed income and equity investments. As a result of these factors, the Company’s return on its investments may fluctuate substantially in a given period.
In addition, in 2008, investment income was also affected by higher investment expenses, attributable to higher expenses on the Standard and Poor’s Depositary Receipts (“SPDRs”) short-sales and total return swaps, as well as higher incentive management fees. The Company executed an additional $320 million SPDRs short-sales in the latter half of 2007 and a further $105 million of SPDRs total return swaps in July 2008 which contributed to the increased SPDRs expense for 2008. Both the SPDRs short-sales and total return swaps were closed out as of December 31, 2008.
Net realized gains on derivatives and short-sales in 2008 include $362.1 million of net gains on total return swaps, $283.5 million of net gains related to credit default swaps and $70.3 million of net gains on SPDRs and common stock short-sale obligations. By comparison, net realized gains on derivatives and short-sale obligations in 2007 include $229.7 million of net gains related to credit default swaps and $15.4 million of net gains on SPDRs and common stock short-sales. As of December 31, 2008, the Company had closed out its total return swaps and short positions. For further details on realized gains and losses incurred on the Company’s derivatives and short-sale obligations, refer to Note 3 to the consolidated financial statements.
The decrease in pre-tax equity in earnings of investees to $(0.7) million in 2008 from $35.8 million in 2007 was primarily attributable to a reduction in earnings from Northbridge, which was previously accounted for under the equity method of accounting prior to January 1, 2008, when the Company elected the fair value option for Northbridge under SFAS 159. The Company sold its investment in Northbridge in December 2008. The increase in pre-tax equity in earnings of investees of $15.6 million, or 77.2%, in 2007 as compared to 2006 was primarily attributable to higher earnings from Northbridge. In 2007, Northbridge reported significant realized investment gains, attributable to the gain on the sale of its investment in Hub International Limited. Northbridge contributed $0 million, $35.1 million and $17.9 million, to the Company’s pre-tax equity in earnings of investees in 2008, 2007 and 2006, respectively.
Interest and other expense, excluding costs related to early retirement of debt, was $36.7 million, $39.4 million and $41.0 million in 2008, 2007 and 2006, respectively. The lower expense in 2008 was attributable to lower corporate overhead expenses as well as lower interest expense on long-term debt. The lower corporate overhead expense was due in part to a retirement expense incurred in 2007 in respect of the Company’s then President and Chief Executive Officer, partially offset by higher charitable contributions in 2008 as compared to 2007. The lower interest expense in 2008 was attributable to the refinancing of the Company’s long-term debt in mid-2007 at a lower interest rate. The lower expense in 2007 as compare to 2006 was attributable to lower interest expense as a result of the restructuring of the Company’s long-term debt, and lower compensation costs, partially offset by the aforementioned retirement expense.
As a holding company with no direct operations, Crum & Forster Holdings Corp.’s (referred to in this section as the Company) assets consist primarily of its investments in the capital stock of its insurance subsidiaries. The Company requires cash to meet its annual debt service obligations (approximately $26 million per year), to pay corporate expenses, including income taxes, and, ultimately, to repay the $330.0 million aggregate principal amount of senior notes due in 2017.
The Company’s ability to satisfy its corporate obligations is primarily dependent on the dividend paying capacity of its subsidiaries and income tax payments from them under the Company’s tax sharing agreement. State insurance laws restrict the amount of shareholder dividends that insurance companies may pay without prior approval of regulatory authorities. The ability of the Company’s insurance subsidiaries to pay dividends depends, among other things, on such subsidiaries having positive statutory earned surplus. Dividends in excess of certain thresholds are considered “extraordinary” and require prior regulatory approval. The Company’s principal insurance subsidiaries are US Fire and North River. At December 31, 2008, US Fire reported statutory earned surplus of $503.4 million and North River reported statutory earned surplus of $128.8 million. In 2008, the insurance subsidiaries paid dividends totaling $511.3 million to the Company. Specifically, on March 31, 2008, US Fire paid a cash dividend in the amount of $116.0 million to the Company, on May 16, 2008, North River paid a cash dividend in the amount of $45.3 million to the Company and in October 2008, US Fire received approval from the Delaware Department of Insurance to pay a dividend of $350.0 million to the Company, which it subsequently paid on October 23, 2008. US Fire’s dividend payments to the Company in 2009 will require prior approval by the Delaware Department of Insurance to the extent any such payment, together with all other dividends and distributions made in the preceding 12 months, exceeds the greater of 10% of US Fire’s statutory surplus at December 31, 2008, or, net income not including realized capital gains for the calendar year preceding the date of dividends.
In May 2007, the Company issued pursuant to a private offering (the “Offering”) $330.0 million aggregate principal amount of 73/4% senior notes due May 1, 2017 at an issue price of 100%. Net proceeds of the Offering to the Company, after commissions and expenses, of approximately $325.1 million were used to repurchase $295.7 million of the Company’s outstanding $300 million aggregate principal amount of 103/8% senior notes due June 15, 2013 (the “2013 Notes”), through a tender offer which the Company completed in May 2008. The Company paid approximately $325.7 million to purchase the 2013 Notes tendered. For further information on the Company’s long-term debt see Note 8 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The table below provides a summary of cash flow provided by (used in) operations under the direct method:
The insurance subsidiaries are currently operating in a soft market and as a result have experienced a double digit percentage decline in premium volume over the last twelve months. In addition, the Company has also taken actions to eliminate unprofitable classes of business which has contributed to declining premium volume. The Company’s property business is declining most markedly; however, due to the short tail nature of the claims, it is expected that claim payments will also decline in the relative near term as the exposures run off. The Company’s casualty business (approximately 60% of total gross premiums written in 2008) in general has a longer tail, meaning the period of time from the occurrence of a claim through the settlement of a liability may extend several years into the future and as a result cash flow may be adversely affected by claims from prior years. Additionally, the lapse of time between payments to claimants and recoveries from reinsurers, if collections from reinsurers are not received on a timely basis, will directly affect cash flows. Due to this uncertainty regarding the amount and timing of settlement of unpaid claims and ultimate recoveries from reinsurers, the insurance subsidiaries’ cash flow from operations and liquidity needs may vary from period to period. If premium receipts continue to decline and claim payments continue at historical norms or greater, the Company is likely to have negative cash flow from operations in 2009.
The insurance subsidiaries maintain a substantial portion of their assets in highly liquid, short term and other marketable securities in order to provide available cash in the event of unanticipated large claim payments. Management believes that, for the foreseeable future, the insurance subsidiaries have sufficient cash and short-term investments, that together with cash generated from future investing operations, will meet their operating liquidity needs.
The Company’s investment portfolio has exposure to credit risk primarily related to fixed income securities. Management attempts to control this exposure by emphasizing investment grade credit quality in the fixed income securities purchased, although at times the Company may invest to a limited extent in non-investment grade fixed income securities if market opportunities avail. Management believes that this concentration in investment grade securities reduces the Company’s exposure to credit risk to an acceptable level. The Company holds a minimal amount of mortgage backed securities (less than 2% of the total investment portfolio of $4.0 billion), that were purchased at deep discounts to par in the fourth quarter of 2008, which it does not believe to be material to the overall investment portfolio and has generally avoided taking long positions in equity securities where there may be indirect exposure to mortgages. In addition, the Company has purchased credit default swaps, referenced to various issuers in the banking, mortgage and insurance sectors of the financial services industry, which serve as economic hedges against declines in the fair value of the Company’s financial assets. Counterparties to the credit default swaps expose the Company to credit risk in the event of non-performance, which the Company endeavors to limit through the terms of agreements negotiated with the counterparties. Pursuant to the swap agreements, the counterparties are required to pledge cash or U.S. Treasury securities as collateral, in the event that appreciation in the fair value of the credit default swaps meets certain thresholds. The fair value of this collateral, which is not reflected on the Company’s balance sheet, is held by an independent custodian in the name of Fairfax on behalf of the Company, or directly in the name of the Company, and amounted to $89.7 million at December 31, 2008. The Company has the right to sell or repledge $54.5 million of this collateral, which it has not exercised. The Company believes that any remaining credit risk exposure, represented by the uncollateralized fair value of the credit default swaps ($49.1 million at December 31, 2008), is low given the diversification among the various counterparties.
In 2008, the Company realized significant gains as a result of substantial defensive positions that it previously held in the mortgage, financial guarantee and other financial services industries through short-sales of individual securities and SPDRs, as well as total return swaps. As of December 31, 2008, the Company had closed out all of its short positions, SPDRs and total return swaps.
Estimates of future payments pursuant to the Company’s contractual obligations at December 31, 2008 are summarized as follows:
The Company and its subsidiaries lease office space and equipment under long-term leases expiring through the year 2022. The amounts above represent the minimum contractual rentals for such operating leases at December 31, 2008. For more information on the Company’s operating leases, see Note 12 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The Company’s long-term incentive plans, which include the Crum & Forster Holdings Corp. Long Term Incentive Plan (“2004 LTIP”), the Crum & Forster Holdings Corp. 2007 Long Term Incentive Plan (“2007 LTIP”) and the Crum & Forster Holdings Corp. 2008 Long Term Incentive Plan (“2008 LTIP”) are compensation arrangements for certain of the Company’s employees who hold senior management or officer positions. Included in the contractual obligations table above are 2004 LTIP payments of $14.4 million in 2009, 2007 LTIP payments of $10.8 million in 2012 and 2008 LTIP payments of $8.0 million in 2017. These amounts are based upon the December 31, 2008 valuations of the plans and are management’s best estimates. The actual payments could be materially different from these estimates.
Consolidated Statements of Income for the Years Ended December 31, 2008, 2007 and 2006
Consolidated Statements of Shareholder’s Equity for the Years Ended December 31, 2008, 2007 and 2006
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows present fairly, in all material respects, the financial position of Crum & Forster Holdings Corp., an indirect wholly-owned subsidiary of Fairfax Financial Holdings Limited, and its subsidiaries at December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform our audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Certain amounts in the Company’s prior year consolidated financial statements have been reclassified to conform to the 2008 presentation.
Unrealized losses that are deemed other than temporary are charged to operations. The Company considers an impairment as “other than temporary” if evidence indicating that an investment’s carrying amount is recoverable within a reasonable period of time which, in the case of fixed income securities, may mean until maturity, is outweighed by evidence to the contrary. The Company also considers its ability and intent to hold an investment until such recovery of the security’s fair value. Notwithstanding the foregoing, with respect to fixed income securities, an impairment may be considered other than temporary if it is probable that the Company will be unable to collect all amounts due under the terms of the securities. Recognition of impairment losses for declines in the value of fixed income
Realized investment gains or losses are determined on the basis of average cost. Investment income is recorded as earned.
The majority of the Company’s derivative securities are credit default swaps for which the Company obtains fair values from third-party providers, principally broker-dealers. In addition, the Company assesses the reasonableness of the fair values obtained from these providers by comparing the fair values to values produced using individual issuer credit default swap yield curves, by referencing them to movements in credit spreads and by comparing them to recent market transaction prices for similar credit default swaps where available. Gains or losses arising from changes in the fair value of derivatives are recorded in realized investment gains and losses on the consolidated statements of income.
The reserve for unpaid losses and loss adjustment expenses (“LAE”) includes estimates of the ultimate settlement value of reported claims, incurred but not reported claims, future expenses to be incurred in the settlement of claims and claim recoveries. These estimates are determined based on the Company’s loss experience, as well as consideration of industry experience and current trends and conditions. The reserve for unpaid losses and LAE is an estimate and future loss payments could differ significantly from initial estimates. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. Changes in the reserve for unpaid losses and LAE are reflected in income in the period in which such changes are required.
The Company maintains a reserve for uncollectible loss deductibles. This reserve includes both specific allowances for probable uncollectible amounts and a non-specific reserve determined principally on the basis of past collection experience. At December 31, 2008 and 2007, the amount of the reserve was $8,588 and $12,780, respectively.
The Company reinsures, in the ordinary course of business, certain risks with other insurance and reinsurance companies (“reinsurers”). These arrangements provide the means for greater diversification of business and serve to limit the net loss potential of unusually severe or frequent losses. The ceding of insurance does not discharge the original insurer from its primary liability to its policyholder; however, the reinsurer that accepts the risk assumes an obligation to the original insurer (“ceding insurer”). The ceding insurer retains a contingent liability with respect to reinsurance ceded to the extent that any reinsuring company might not be able, or willing, to meet its obligations. Reinsurance recoverable includes the reinsurers’ obligations to reimburse the Company for a share of paid and unpaid losses and LAE pursuant to the reinsurance contracts.
Reserves for uncollectible reinsurance are determined based upon reviews of the financial condition of reinsurers and assessments of other available information. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired terms of the ceded contracts.
Prior to 2007, the Company did not offset its losses (including amounts arising from interest expense on its senior notes) or losses of one of its subsidiaries against income of another in computing the federal income tax payments to Fairfax Inc. In the third quarter of 2007, the Company entered into a new tax sharing agreement with Fairfax Inc. The new agreement, between Crum & Forster Holdings Corp. and Fairfax Inc., permits the Company and its subsidiaries to elect to file federal income tax returns on a consolidated basis for tax sharing purposes. The agreement also provides that all tax sharing payments otherwise payable directly to Fairfax from the Company’s subsidiaries be paid instead to Crum & Forster Holdings Corp., where they are netted against holding company losses before being remitted as net tax sharing to Fairfax. The Company made this election effective January 1, 2007. The election resulted in the utilization of the holding company net operating losses (“NOLs”) in the amount of $82,369 in 2007 and will avoid the generation of holding company NOLs going forward, provided the subsidiaries earn sufficient taxable income to offset holding company losses.
The Company elected to recognize accrued interest and penalties, if any, associated with uncertain tax positions as part of the income tax provision. The Company did not record any uncertain tax positions, interest or penalties in 2008 or 2007.
Accumulated other comprehensive loss or income includes unrealized investment gains and losses on the Company’s available-for-sale fixed income and equity securities, foreign currency translation gains and losses arising from the translation of financial statements of equity method investees denominated in foreign currencies and adjustments to recognize the overfunded or underfunded status of the
In determining the eligible financial instruments for which to elect the fair value option, the Company considered all of its equity method investments. These investments are often carried at values that do not reflect current fair market value. The Company decided that the fair value option would be appropriate for equity method investments for which there is a publicly quoted market price. The Company concluded that the election would be inappropriate for those equity method investments that do not have quoted market prices due to the degree of judgment that would be needed to measure their fair values and the additional accounting risk associated with those valuations. Since Northbridge, Advent and Odyssey are publicly traded on equity exchanges, the Company believes that their traded price is a better indicator of value than carrying value under the equity method of accounting. Although the Company accounts for other investments under the equity method there are no other equity method investments which are publicly traded on an equity exchange for which the SFAS 159 election has not been made.
on the consolidated statement of income and an unrealized gain of the same amount in other comprehensive income, which represents the reclassification of the cumulative change in fair value previously recorded in accumulated other comprehensive income. For the year ended December 31, 2008, the total change in fair value of Advent was a loss of $8,485 (inclusive of the $5,945 noted above), which was recorded through earnings, in realized investment gains and losses, in the consolidated statements of income. Dividends of $907 were received from Advent for the year ended December 31, 2008 and have been recorded as investment income in the consolidated statement of income. No dividends were received for the year ended December 31, 2007.
The Company’s investments in Odyssey’s common and preferred stock are included in derivatives and other invested assets on the consolidated balance sheet at December 31, 2008, at fair values of $256,570 and $5,740, respectively. The Company’s investment in Odyssey preferred stock is included in equity securities at fair value of $7,347 at December 31, 2007. Upon election of SFAS 159 for Odyssey preferred stock (concurrent with the acquisition and SFAS 159 election for the investment in Odyssey common stock in December 2008), the Company recorded a realized loss of $2,350 on the consolidated statement of income and an unrealized gain of the same amount in other comprehensive income, which represents the reclassification of the cumulative change in fair value previously recorded in accumulated other comprehensive income. For the year ended December 31, 2008, the total change in fair value of Odyssey common and preferred stock was a net gain of $8,155 (inclusive of the loss of $2,350 noted above), which was recorded through earnings, in realized investment gains and losses, in the consolidated statement of income. Preferred dividends of $799 and $499 were received from Odyssey for the years ended December 31, 2008 and 2007, respectively, and have been recorded as investment income in the consolidated statements of income.
SFAS No. 155. On January 1, 2007, the Company adopted SFAS No. 155, Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements Nos. 133 and 140 (“SFAS 155”). SFAS 155 applies to certain “hybrid financial instruments” which are instruments that contain embedded derivatives. The standard established a requirement to evaluate beneficial interests in securitized financial assets to determine if the interests represent freestanding derivatives or are hybrid financial instruments requiring bifurcation. SFAS 155 also permits an election for fair value measurement of any hybrid financial instrument that otherwise would require bifurcation under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”). Changes in fair value are recorded as
realized investment gains or losses in the consolidated statements of income. The fair value election can be applied to existing instruments on an instrument-by-instrument basis at the date of adoption and to new instruments on a prospective basis. The Company elected fair value measurement of its convertible securities, effective with its adoption of SFAS 155. Prior to the adoption of SFAS 155, the Company bifurcated all derivatives embedded in its convertible securities. The original host instruments were recorded at fair value in fixed income investments and the embedded derivatives were recorded at fair value in derivatives and other invested assets. Upon adoption of SFAS 155, the Company recorded a cumulative adjustment of $10,146, net of an adjustment of $301 in respect of adoption of SFAS 155 by one of the Company’s equity method investees, net of tax, to reclassify unrealized investment gains associated with the host instruments to opening retained earnings.
FIN 48. On January 1, 2007, the Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). The interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS 109, Accounting for Income Taxes. Specifically, the pronouncement prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. Although the adoption of FIN 48 did not have a direct impact on the Company’s results of operations or financial position, adoption of FIN 48 by one of the Company’s equity method investees resulted in the Company recording a charge of $681, net of tax, to opening retained earnings in 2007.
The aggregate carrying value of the Company’s investment portfolio was $4,032,034 and $4,547,529 at December 31, 2008 and 2007, respectively, and is comprised of available-for-sale securities, held-for-trading securities, investments at equity, derivatives and other invested assets, short-term investments, cash and cash equivalents and assets pledged for derivatives and short-sale obligations.
Investments in available-for-sale fixed income and equity securities are summarized below:
The amounts are net of transfers to realized investment gains and losses of $54,520, $21,904 and $108,045 in 2008, 2007 and 2006, respectively.
The number of continuous months in which securities in an unrealized loss position at December 31, 2008 were in such a position is summarized as follows:
Of the 14 equity securities in an unrealized loss position at December 31, 2008, 13 had been in a loss position for less than six consecutive months and eight had a loss that exceeded 10% of their cost. Three of these eight securities account for $92,618, or 80.3%, of total equity security losses of $115,366 and have losses exceeding their cost of between 32% and 42%.
The unprecedented events in the credit markets during 2008 have resulted in extreme volatility and disruption to the financial markets, particularly in the latter half of the year, which has contributed to the increase in unrealized losses in the Company’s fixed income and equity portfolios at December 31, 2008 as compared to December 31, 2007. Management reviewed currently available information regarding all securities where the estimated fair value was less than cost or amortized cost at December 31, 2008 and based thereon, recorded other than temporary impairment charges of $118,894 in the fourth quarter of 2008. The remaining 45 securities were not considered to be other than temporarily impaired. Other than temporary impairment charges incurred for the full year in 2008 were $194,670.
The Company’s aggregate share of its equity investees’ balance sheets, which includes its share of those investees accounted for under SFAS 159 (fair value option), had they been accounted for under the equity method, is summarized as follows:
The difference between the Company’s aggregate share of shareholders’ equity or partners’ capital and the carrying value on the consolidated balance sheets is primarily due to mark-to-market adjustments for changes in fair value of equity investments for which the Company has elected the fair value option under SFAS 159.
The Company’s aggregate share of its equity investees’ statements of income, which includes its share of income of those investees accounted for under SFAS 159 (fair value option), had they been accounted for under the equity method is summarized as follows:
The fair values of the Standard & Poor’s Depositary Receipts (“SPDRs”) and common stock short-sales in the table above have been restated as of December 31, 2007, to reflect the adoption of SFAS 157. The Company uses the bid price for long positions (assets) and the ask price for short positions (liabilities). Previously, the Company used a price within the bid-ask spread.
Eurodollar futures contracts are settled daily and therefore have no fair value at December 31, 2008.
The cost, notional amount and fair value of the Company’s credit default swaps are shown in the preceding table. During the year ended December 31, 2008, the Company purchased $4,600 of credit default swaps with a notional amount of $182,500, and sold credit default swaps with a cost of $46,652 and notional amount of $2,154,472 for proceeds of $383,278. The credit default swap portfolio had an average term to expiry of 3.1 years at December 31, 2008 (3.7 years at December 31, 2007).
The Company was required to post collateral in connection with its total return swaps and short positions. At December 31, 2008, the Company did not hold any total return swap or short positions and therefore did not hold any collateral related to these positions. At December 31, 2007, the fair value of assets pledged as collateral for the obligations to purchase securities sold short totaled $1,043,436 of which $734,956 was held in cash and $308,480 was held in U.S. Treasury securities.
The following table summarizes the changes in fair value of the Company’s derivative securities and short positions included in net realized investment gains in the consolidated statements of income for the years ended December 31, 2008, 2007 and 2006:
For 2006, gains and losses noted above are primarily attributable to mark-to-market gains or losses in each year.
On May 1, 2008, the Company invested $1,000 in the Ivy Realty Fund II, L.P, which represented the first capital call of a $10,000 capital commitment made to this fund.
On August 3, 2007, the Company sold its 5.1% ownership interest in Chou Associates Management Fund for proceeds of $28,145 and a realized investment gain of $2,839.
On March 15, 2007, the Company sold its 1.1% ownership interest in Odyssey common stock to TIG for proceeds of $30,160 and a realized investment gain of $8,300.
Fixed income securities and cash and cash equivalents of $403,892 and 431,934 were on deposit with various state regulatory authorities at December 31, 2008 and 2007, respectively, as required by insurance laws.
In 2008, losses from investments at equity and other invested assets were principally attributable to substantially lower earnings from partnership investments, driven by depressed equity market conditions. The amount for 2006 includes $60,555 of realized investment gains reported in the earnings of HWIC.
The components of realized investment gains for the years ended December 31, 2008, 2007 and 2006 are summarized below:
On January 1, 2008, the Company adopted SFAS 157, which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 clarifies that fair value is the exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities. A quoted price for an identical asset or liability in an active market provides the most reliable fair value measure and, whenever available, should be used to measure fair value, provided that (1) the market is the principal (or most advantageous) market and (2) the entity has the ability to access the principal (or most advantageous) market.
Level 2 - Valuations based on information (other than quoted prices included within Level 1) that is observable for the asset and liability, either directly or indirectly. This includes quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active and observable inputs other than quoted prices, such as interest rates and yield curves.
The Company values its Level 3 investments, which are comprised of mortgage-backed securities purchased at deep discounts to par during 2008 (approximately 2% of total investment portfolio at fair value), using an internal discounted cash flow model. The cash flow model incorporates actual cash flows on the mortgage-backed securities through the current period and projects the remaining cash flows from the underlying mortgages, using a number of assumptions and inputs that are based on the security-specific collateral. The Company assesses the reasonableness of the fair values of these securities by comparing to models validated by qualified personnel, by reference to movements in credit spreads and by comparing the fair values to recent transaction prices for similar assets where available.
The following table presents the Company’s assets (excluding cash and cash equivalents) measured at fair value on a recurring basis, within the fair value hierarchy, at December 31, 2008:
In 2008, the Company recognized $20,075 of adverse prior year loss development (2.1 loss ratio points). Included in the adverse loss development is $75,470 (7.6 loss ratio points) attributable to a loss on commutation of a reinsurance contract and $25,500 (2.6 loss ratio points) attributable to the settlement of an asbestos lawsuit. Excluding these one-time charges, the Company recognized net favorable loss development of $80,895 (8.1 loss ratio points), including $10,172 related to amortization of deferred gains on retroactive reinsurance. The favorable development was primarily in the workers’ compensation and general liability lines of business, attributable to favorable loss emergence in almost all accident years, partially offset by unfavorable ALAE emergence in general liability for both latent and non-latent exposures.
In 2006, the Company recognized net favorable prior year loss development of $96,162 (8.8 loss ratio points) including $12,889 of amortization of deferred gains on retroactive reinsurance. The net favorable development was comprised of favorable development across all major casualty lines with the largest redundancy being recognized in workers’ compensation, principally attributable to favorable results in California in accident years 2004 and 2005, consistent with industry-wide experience. Additionally, favorable development was also experienced in umbrella and other general liability exposures, due in part to favorable settlements of claims in accident years 2000 and prior and in commercial automobile liability for accident years 2005 and prior. The favorable development was partially offset by $33,897 of adverse development of asbestos, environmental and other latent liabilities.
The increase in environmental losses incurred in 2007 was attributable to a newly reported large claim, identification of additional policies associated with existing policyholders and a slight increase in the number of sites for policyholders with previously reported claims. 2007 incurred losses also include settlements which secured broader releases on certain active exposures.
The increase in other latent losses incurred in 2007 is due in part to a policyholder with both asbestos and silica claims. In 2007, the exposures for silica were identified as the predominant exposure for this policyholder and the reserves were established in other latent.
For the year ended December 31, 2008, claims incurred ceded to reinsurers include $75,866 of losses on commutations.
The Company actively monitors and evaluates the financial condition of its reinsurers and develops estimates of the uncollectible amounts due from reinsurers. Such estimates are made based on periodic evaluation of balances due from reinsurers, judgments regarding reinsurers’ solvency, known disputes, reporting characteristics of the underlying reinsured business, historical experience, current economic conditions and the state of reinsurer relations in general and with the Crum & Forster companies in particular. Management attempts to mitigate collection risk from reinsurers by obtaining collateral and by entering into reinsurance arrangements only with reinsurers that have strong credit ratings and statutory surplus above certain levels. Reinsurance recoverable on the consolidated balance sheets is stated net of reserves for uncollectible reinsurance of $55,999 and $50,021 at December 31, 2008 and 2007, respectively.
At December 31, 2008, the Company had reinsurance recoverable of $968,217, due from approximately 290 reinsurers. At such date, the five largest gross reinsurance recoverable balances aggregated $586,866, or approximately 60.6% of the total reinsurance recoverable balance. The reinsurer with the largest gross recoverable balance (an unaffiliated company rated A+ by A.M. Best Company) has provided collateral in an amount of $220,843, which reduces its unsecured exposure to $128,158. The collateral provided is in the form of a funds held balance in the Company’s general account and equal premiums plus interest thereon credited at the rate stipulated in the related reinsurance contract. There is no limitation on the ability of the Company to access these funds in accordance with the related reinsurance agreement. After giving effect to this collateral, the unsecured exposure of the top five reinsurers reduces to $366,023.
The amount for 2007 includes the $389,010 discussed below, $28,719 on the 2000 accident year prospective aggregate stop loss contract and $76,248 of amortization of deferred gains on the retroactive reinsurance contracts.
Includes $389,010 which has been recognized as a reduction of losses and LAE less $21,510 for additional premiums due on retrospectively rated insurance policies that inure to the benefit of the reinsurer.
The above activity arises from three prospective contracts of which only one contract covering accident year 2002 remains in effect at December 31, 2008.
The first contract is a stop loss agreement, which the Company entered into in 1998, in connection with the acquisition of the Company by Fairfax. The contract was with an unaffiliated reinsurer and provided coverage of $367,500 in excess of a retention. The contract provided coverage for loss reserve development for accident periods prior to August 13, 1998, the date of acquisition of the Company by Fairfax. The initial premium of $75,000 was paid by the former parent of the Company. There were no premium cessions to the contract in 2008, 2007 and 2006 and reinsurance recoverable on the contract was $367,500 at December 31, 2007. The Company amended the contract in 2001 to provide an additional $19,248 of coverage for a premium of $7,925, which was recorded in 2001. This contract amendment was treated as retroactive reinsurance and was fully utilized. See discussion under retroactive corporate aggregate reinsurance. On June 26, 2008, the Company commuted this stop loss contract and the retroactive amendment to that contract. As
On May 7, 2007, the Company issued pursuant to a private offering (the “Offering”) $330,000 aggregate principal amount of 73/4% senior notes due May 1, 2017 (the “2017 Notes”) at an issue price of 100%. The 2017 Notes are redeemable at the option of the Company beginning May 1, 2012, at prices set forth in the indenture governing the 2017 Notes. Net proceeds of the Offering to the Company, after commissions and expenses, were approximately $325,100. In connection with the sale of the 2017 Notes, the Company entered into a registration rights agreement under which the Company agreed to use its reasonable best efforts to register with the SEC notes having substantially the same terms as the 2017 Notes, as part of an offer to exchange freely tradeable exchange notes for the 2017 Notes. Pursuant to an exchange offer which was completed on August 16, 2007, the Company issued $330,000 aggregate principal amount of registered notes with substantially the same terms as the 2017 Notes, in exchange for all of the outstanding 2017 Notes.
On May 21, 2007, the Company completed a cash tender offer (the “Tender Offer”) to purchase any and all of its outstanding $300,000 aggregate principal amount of 103/8% senior notes due June 15, 2013 (the “2013 Notes”). In conjunction with the Tender Offer, the Company entered into a supplemental indenture eliminating substantially all restrictive covenants and certain event of default provisions contained in the indenture under which the 2013 Notes were issued. Pursuant to the Tender Offer, all but $4,270 aggregate principal amount of the 2013 Notes were purchased and cancelled. The Company paid total consideration of approximately $325,700 to purchase the 2013 Notes tendered and, in addition, paid accrued and unpaid interest of approximately $12,100. The purchase of the 2013 Notes was funded with proceeds from the sale of the aforementioned 2017 Notes and available cash on hand. On June 16, 2008, the Company redeemed its entire outstanding $4,270 aggregate principal amount of the 2013 Notes.
For the years ended December 31, 2008, 2007 and 2006, total interest expense on the notes was $27,885, $29,850 and $32,986, respectively, including amortization of related deferred financing costs, and, in respect of the 2013 Notes, accretion of the discount. In 2007, the Company also recognized additional costs related to the early retirement of its 2013 Notes of $21,187, which were comprised of premium payments, related fees and expenses and write-off of unamortized deferred financing costs. At December 31, 2008 and 2007, deferred financing costs in conjunction with the issuance of the notes totaled $5,258 and $5,983, respectively, and are included in other assets on the consolidated balance sheet. These deferred financing costs are being amortized to interest expense on a straight-line basis over the duration of the notes.
The fair value of the long-term debt, determined from quoted market prices, was $244,200 and $329,616, respectively, at December 31, 2008 and 2007.
The increase in the Company’s net deferred tax assets at December 31, 2008 as compared to December 31, 2007 is primarily attributable to deferred taxes associated with realized mark to market losses on investments for which the Company has elected the fair value option, other than temporary impairment charges recognized on certain investments and an increase in unrealized capital losses in the investment portfolio during 2008. Management believes it is more likely than not that the Company will realize the benefits of its net deferred tax assets and, accordingly, no valuation allowance has been recorded as of December 31, 2008 and 2007.
In 2008, the Internal Revenue Service completed its audit of tax years 2003 and 2004, with no major adjustments for the Company. They are presently conducting their audit of tax years 2005 and 2006 in respect of the Fairfax Group companies. There have been no material adjustments proposed under the current audit cycle. Income tax returns filed with various state and foreign jurisdictions remain open to examination in accordance with the statutes of the respective jurisdictions. The Company elects to recognize accrued interest and penalties associated with uncertain tax positions as part of the income tax provision. The Company did not record any uncertain tax positions, interest or penalties in 2008.
The decrease in premiums written and earned and losses and LAE assumed in the year ended December 31, 2008, as compared to 2007, was principally due to the Fairmont business, which the Company assumed at the start of 2006. Prior to 2008, the majority of policies underwritten by Fairmont were issued initially by Fairmont and assumed by the Company through a 100% quota share reinsurance agreement. By the end of 2007, substantially all Fairmont business was being written directly by Crum & Forster. For further details on Fairmont, see Note 1 to the consolidated financial statements. For the years ended December 31, 2008 and 2007, the Company assumed premiums of $86 and $18,769, respectively, from Fairmont and had unpaid losses and LAE balances of $22,753 and $48,383 in respect of assumed losses from Fairmont at December 31, 2008 and 2007, respectively.
In the normal course of business, a Fairfax offshore reinsurance affiliate, Wentworth Insurance Company Ltd. (“Wentworth”), participates in reinsurance agreements covering several reinsured lines of business. In 2006 and prior, nSpire, also a Fairfax affiliate, participated in these agreements. For the years ended December 31, 2008 and 2007, the Company ceded premiums of $19,342 and
For the years ended December 31, 2008, 2007 and 2006, the Company ceded premiums of $77, $12,461 and $35,515, respectively, to nSpire and had reinsurance recoverable balances of $25,195 and $42,772 at December 31, 2008 and 2007, respectively. Pursuant to the terms of the reinsurance agreements between Wentworth and nSpire and the Company, both Wentworth and nSpire, as foreign reinsurers, are required to collateralize in full reinsurance balances due to the Company. This collateral is comprised of irrevocable trusts in compliance with NAIC regulations. There are no regulatory or other restrictions on payments to the Company from either Wentworth or nSpire.
Effective February 1, 2002, the Company entered into an arrangement with TIG whereby the Company issued policies on behalf of TIG totaling $22,923 in gross premiums written. The Company entered into reinsurance agreements under which approximately 30% of the total risk under these policies was ceded to TIG with the remaining 70% ceded to third party reinsurers. This arrangement with TIG was terminated as of June 30, 2002. At December 31, 2008 and 2007, the Company had reinsurance recoverable of $1,384 and $2,011, respectively, from TIG related to this agreement.
Effective January 1, 2001, the Company entered into a reinsurance agreement with Lombard General Insurance Company of Canada (“Lombard”), an affiliate of Fairfax, under which the Company has agreed to reinsure 100% of the surety business of Lombard underwritten by the Company. For the years ended December 31, 2008, 2007 and 2006, the Company assumed $8, $(7) and $98,
respectively, in premiums from Lombard. At December 31, 2008 and 2007, the Company had $56 and $1,002 in reserves for this assumed business.
Effective January 1, 2006, the Company, in connection with its assumption of the Fairmont business, entered into a reinsurance agreement with Markel Insurance Company of Canada (“Markel”), an affiliate of Fairfax, under which the Company has agreed to provide commercial auto coverage to U.S. or Canadian domiciled companies, for which Markel has written the Canadian auto coverage business, and to cede 100% of the coverage provided by the Company to Markel. During the years ended December 31, 2008, 2007 and 2006, the Company ceded premiums of $2,128, $1,966 and $1,175, respectively, to Markel and had a reinsurance recoverable balance of $1,959 and $1,587, respectively, at December 31, 2008 and December 31, 2007.
Advent Syndicate 780 (“Syndicate 780”), which is managed by Advent, a Fairfax affiliate, is a participant on the Company’s property per risk, property catastrophe and workers’ compensation catastrophe treaties. For the years ended December 31, 2008 and 2007, the Company ceded premiums of $533 and $1,190, respectively, to Syndicate 780 and had reinsurance recoverable balances of $185 and $430, respectively, at December 31, 2008 and 2007, respectively.
The Company and its subsidiaries have entered into agreements with Hamblin Watsa Investment Counsel Ltd. (“Hamblin Watsa”), a wholly-owned subsidiary of Fairfax, for investment management services, and with Fairfax for investment administration services. Pursuant to the agreements, fees, based upon assets under management, totaled $11,150, $7,134 and $17,528 for the years ended December 31, 2008, 2007 and 2006, respectively, and were included as investment expenses in the consolidated statements of income.
Since 2001, the Company has obtained certain information technology services, including production and operations support and systems development, on a non-exclusive basis from Fairfax Information Technology Services, Inc. (“FITS”), a wholly-owned subsidiary of Fairfax. Charges for these services, including fees recorded for services subcontracted by FITS to other vendors, for the years ended December 31, 2008, 2007 and 2006 were $32,062, $36,500 and $33,125, respectively. Of such fees, $30,056, $30,462 and $29,158 were charged directly to expense for 2008, 2007 and 2006, respectively. The remaining $2,006, $6,038 and $3,967 were software license fees capitalized in 2008, 2007 and 2006, respectively. The Company amortizes such fees over a seven-year or ten-year period beginning on the date the software is placed in service. In 2008, 2007 and 2006, software license amortization of $8,682, $2,863 and $3,287, respectively, was charged to operations, and $15,544 and $22,155 were included in other assets for the years ended December 31, 2008 and 2007, respectively. The increase in the amortization charge for the year in 2008 was attributable to a write-off of previously capitalized software development costs of $6,383.
Under an agreement effective January 1, 2001, FITS is provided certain management and general services by the Company, for which the Company recorded $0, $172 and $139 for the years ended December 31, 2008, 2007 and 2006, respectively.
Under an agreement effective January 1, 2003, the Company receives royalty payments from FITS for the use of software by other clients of FITS that was developed for and funded by the Company. Under this agreement, the Company recorded $186 and $265 for the years ended December 31, 2008 and 2007, respectively. No royalty payments were recorded in 2006.
Under an agreement effective January 1, 2006, the Company provides underwriting, administration, financial and claims services for the business of Fairmont Premier Insurance Company, Fairmont Specialty Insurance Company and Fairmont Insurance Company, affiliates of Fairfax. The fees recorded for such services were $2,398, $3,855 and $13,043 in 2008, 2007 and 2006, respectively. The decrease in fees since 2006 reflects the transition of the Fairmont business to the Company.
Under a marketing agreement effective March 1, 2006, the Company receives commissions from MFXChange Ireland Limited (“MFX Ireland”) for the introduction of customers to MFX Ireland. Under this agreement the Company recorded $200 and $291 in the years ended December 31, 2008 and 2007, respectively. No commissions were recorded in 2006.
The Company receives loss adjustment services from Cunningham Lindsey U.S., Inc., an affiliate of Fairfax. Expenses incurred for these services were $602, $794 and $213 for the years ended December 31, 2008, 2007 and 2006, respectively.
Included in other expense for the years ended December 31, 2008, 2007 and 2006 are incurred charitable contributions of $6,600, $3,986 and $4,571, respectively, related to the Six Four Foundation, a not-for-profit entity affiliated with Fairfax.
The Company sponsors a qualified defined contribution plan pursuant to sections 401(k) and 401(a) of the Internal Revenue Code for which all employees are eligible. The Company makes an annual contribution equal to 3% of base salary and a matching contribution equal to one-half of each employee’s contribution up to the first 6% of base salary. Certain employees also have the opportunity to participate in a non-qualified plan that permits contributions that would otherwise be limited by IRS regulations. Total defined contribution plan expense was $5,582, $6,091 and $4,495 for the years ended December 31, 2008, 2007 and 2006, respectively.
The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 6.25% and 5.75% at December 31, 2008 and 2007, respectively. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 2008, the health care cost trend rates are assumed to decline gradually from 10.0% in 2009 to 6.0% in 2021 and thereafter for all participants.
At December 31, 2008, the future benefit payments through 2018, net of estimated participant contributions, are expected to be as follows:
The Company has established long term incentive plans for certain employees who hold senior management or officer positions. In 2004 the Company established the Crum & Forster Holdings Corp. Long Term Incentive Plan (“2004 LTIP”). The 2004 LTIP provides for the award of phantom stock, the value of which is based on the book value of the Company, which fully vested on January 1, 2009. 2004 LTIP expense of $1,626, $4,760 and $4,112 for the years ended December 31, 2008, 2007 and 2006, respectively, is included in the consolidated statements of income. In 2007 the Company established the Crum & Forster Holdings Corp. 2007 Long Term Incentive Plan (“2007 LTIP”). The 2007 LTIP provides for cash awards that will fully vest on January 1, 2012. 2007 LTIP expense of $2,550 and $2,500, for the years ended December 31, 2008 and 2007, respectively, is included in the consolidated statements of income. In 2008 the Company established the Crum & Forster Holdings Corp. 2008 Long Term Incentive Plan (“2008 LTIP”). The 2008 LTIP provides for the award of phantom stock, the value of which is based on the book value of the Company, which will fully vest on December 31, 2017. 2008 LTIP expense of $768 is included in the consolidated statement of income for the year ended December 31, 2008.
Certain employees of the Company have been granted shares of restricted common stock of Fairfax under the Fairfax Financial 1999 Restricted Share Plan. The restricted stock vests over periods ranging from five to ten years. Restricted stock expense of $506, $564 and $633 for the years ended December 31, 2008, 2007 and 2006, respectively, is included in the consolidated statements of income.
All employees of the Company are eligible to participate in the Fairfax Financial Holdings Limited Employee Share Ownership Plan (the “Plan”). The Plan provides an opportunity to purchase Fairfax subordinate voting shares through a combination of employee and company contributions. Employees may elect to contribute from 1% to 10% of base salary through regular payroll deductions, and the Company is required to make matching contributions equal to 30% of the employee contributions. In addition, the Company is required to make an annual contribution equal to 20% of employee contributions upon Fairfax and the Company achieving certain financial objectives. The Plan expense of $370 (including $128 for achieving the aforementioned financial objectives), $213 and $165 for the years ended December 31, 2008, 2007 and 2006, respectively, is included in the consolidated statements of income.
The amounts above are reduced by space subleased to other companies in the aggregate amount of $11.
On September 7, 2005, Fairfax announced that it had received a subpoena from the SEC requesting documents regarding any non-traditional insurance or reinsurance transactions entered into or offered by Fairfax and the entities in its consolidated group, which includes the Company. The U.S. Attorney’s Office for the Southern District of New York is reviewing documents provided to the SEC in response to the subpoena and is participating in the investigation of these matters. Fairfax and entities in its consolidated group are cooperating fully with these requests. Fairfax and certain of the entities in its consolidated group, including the Company, have prepared presentations and provided documents to the SEC and the U.S. Attorney’s Office, and employees of Fairfax and certain of the entities in its consolidated group, including senior officers, have attended interviews conducted by the SEC and the U.S. Attorney’s Office. This inquiry is ongoing and the Company is cooperating fully in addressing its obligations under this subpoena. At the present time, the Company cannot predict the outcome of these matters, or the ultimate effect on the Company’s consolidated financial statements, which effect could be material and adverse. No assurance can be made that the Company will not be subject to further requests or other regulatory proceedings of a similar kind.
The Company’s insurance subsidiaries are domiciled in the states of Delaware, New Jersey, New York and Arizona. The principal insurance subsidiaries are US Fire and North River. In October 2008, US Fire received approval from the Delaware Department of Insurance (DOI) to pay a dividend of $350,000 to the Company and after the payment of this dividend, US Fire’s dividend payments to the Company in 2009 will require prior approval by the DOI to the extent any such payment, together with all other dividends and distributions made in the preceding 12 months, exceeds the greater of 10% of US Fire’s statutory surplus at December 31, 2008 and net income not including realized capital gains for the calendar year preceding the date of dividends.
The maximum dividend that could be paid by the insurance subsidiaries to the Company before October 23, 2009, without prior regulatory approval, is $46,733. This capacity increases to $141,061 after October 23, 2009, when US Fire’s capacity increases to $94,328, provided it has not paid any extraordinary dividends prior to that date.
The losses and LAE and losses and LAE ratios of the Company’s lines of business, as estimated at the respective year-end, are summarized as follows:
The cumulative charge to net income in the year ended December 31, 2006 was $3,089 pre-tax ($2,008 after-tax) for these adjustments. Of the $3,089 pre-tax charge, $4,255 was recorded as a charge to realized investment gains, $3,534 was recorded as a charge to equity in earnings of investees (including $456 of previously waived immaterial adjustments) and $4,700 was recorded as an increase to investment income on the consolidated statements of income. Additionally, the Company recorded a $7,369 increase to accumulated other comprehensive income, net of tax, which together with the aforementioned $2,008 charge to net income, resulted in a $5,361 increase in shareholder’s equity.
The Company’s quarterly financial data is summarized in the table below. This quarterly financial data is unaudited. In the opinion of management, all adjustments (consisting of normal recurring accruals) necessary to present fairly the results of operations for such periods have been made.
The decrease in investment income in the fourth quarter of 2008 as compared to the fourth quarter of 2007 was primarily attributable to substantially lower earnings from investments at equity.
The increase in realized investment gains in the fourth quarter of 2008 as compared to the fourth quarter of 2007 and the third quarter of 2008 was primarily attributable to higher realized gains on total return swaps and credit default swaps.
The decrease in losses and LAE in the fourth quarter of 2008 as compared to the third quarter of 2008 is primarily attributable to catastrophe losses of $71.5 million associated with Hurricanes Gustav and Ike incurred in the third quarter.