Crum & Forster’s significant accounting policies are described in Note 2 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”. The accounting policies and estimates discussed below are those that require management to make assumptions about highly uncertain matters. If management were to make different assumptions about those matters, or if actual results were to differ significantly from estimates, the Company’s reported consolidated results of operations and financial condition could be materially affected.
General Liability ¾ 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.
Workers’ Compensation ¾ an individual investigation of each reported accident 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 unique statutory scheme of the applicable jurisdiction. Claims personnel make assumptions as to the likely cost of necessary medical treatment, including prescription medications, estimated time of disability, degree of permanency, and, depending on the severity of the individual case, the necessity and cost of vocational, rehabilitative, or long term care as well as other amounts provided for under the applicable statutory scheme such as funeral and dependant benefits, transportation costs, and employee attorney fees.
Commercial Automobile ¾ for third party claims, the methodology for establishing case reserves is virtually identical to that of general liability. First party automobile reserves are established based upon the cost of repair or actual cash value as appropriate under the circumstances, generally confirmed by an appraisal, and consistent with applicable state claims handling regulations.
Property ¾ an individual investigation of each loss reported is undertaken by claims personnel, including conducting on site physical inspections of the covered property in determining the scope of damage. Case reserves are established consistent with the coverages provided under the specific policy applicable to the loss. Depending upon the severity of the loss and coverage part or parts implicated in the specific claim reported, claims personnel may retain the services of experts such as certified building consultants, salvors, forensic accountants, or construction engineers to assist in projecting the ultimate loss to be reserved and paid on an individual claim basis. In the event of a catastrophe loss, assumptions are made based upon the number of risks in the affected area and the severity of the catastrophic events.
Accident and health ¾ claims are primarily handled by third party licensed administrators with oversight by the Company. The short tail nature of the business results in claims being reported and paid very quickly; therefore accident and health reserves are not a material part of the Company’s total reserves.
Commercial Automobile ¾ cost to repair damaged property, medical and court award inflation and expected loss ratios for more recent accident years.
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, 2009, the Company’s actuaries concurred with the reasonableness of management’s best estimate.
The Company recorded $(25.0) million, $39.0 million and $(50.2) million of prior period (favorable) adverse loss development before corporate aggregate reinsurance for 2009, 2008 and 2007, respectively. After corporate aggregate reinsurance, the prior period (favorable) adverse loss development was $(39.9) million, 20.1 million and $(63.9) million for 2009, 2008 and 2007, respectively.
In 2007, the net favorable loss development before corporate aggregate reinsurance was primarily attributable to 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 claim 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. Of the $54.5 million adverse development, $24.3 million of the increase was in asbestos reserves, $22.2 million was in environmental reserves and $8.0 million was in other latent reserves. The strengthening of asbestos reserves was principally due to developments related to one asbestos policyholder. The strengthening of environmental reserves was due 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. In addition, the Company also incurred losses for settlements which secured broader releases on certain active exposures.
At the same time, the loss of revenue to the plaintiffs’ bar due to the decrease in filings, combined with increased scrutiny on individual cases, has resulted in an increase in plaintiffs’ settlement demands. The risk of taking a seriously injured asbestos plaintiff to trial continues to be significant.
Reserves for asbestos cannot be estimated with traditional loss reserving techniques that rely on historical accident year loss development factors. Since each policyholder presents different liability and coverage issues, the Company evaluates its asbestos exposure on a policyholder-by-policyholder basis. Crum & Forster utilizes ground-up, exposure-based methodologies, which draw upon Company experience and supplemental databases, to assess asbestos liabilities on reported claims. The methodology was initially critiqued by outside actuarial consultants, and the results are annually reviewed by independent actuaries, all of whom have found the methodology appropriate and the results reasonable.
In 2009, 2008 and 2007, the Company incurred total asbestos losses and ALAE of $2.8 million, $25.2 million and $24.3 million, respectively, (approximately 1%, 8% and 7%, respectively, of the preceding year-end reserves balances). The increase in 2009 is net of an insurance recovery of $13.8 million associated with a lawsuit settlement. Excluding this receipt, the increase was primarily attributable to increasing claim values and rising legal costs associated with one policyholder. In 2008 and 2007, the increase in each year was largely associated with the aforementioned lawsuit.
As a result of the processes, procedures and analyses described above, management believes that the reserves carried for asbestos claims at December 31, 2009 are adequate based upon known facts, current law and management’s judgment. However, there are a number of uncertainties surrounding the ultimate value of these claims, which may result in changes in these estimates as new information emerges. Among these are the following: the unpredictability inherent in litigation; any impact from the bankruptcy protection sought by asbestos producers and defendants; an unanticipated increase in the number of asbestos claimants; the resolution of disputes pertaining to the amount of coverage for “non-product” claims asserted under premises/operations general liability policies; and future developments regarding the ability to recover reinsurance on asbestos claims. It is also not possible to predict, nor has management assumed, any changes in the legal, social or economic environments and their impact on future asbestos claim development. The carried asbestos reserves also do not reflect any effects of future legislation.
Hazardous waste sites present another significant potential exposure. The federal “Superfund” law and comparable state statutes govern the cleanup and restoration of toxic waste sites and formalize the concept of legal liability for cleanup and restoration by Potentially Responsible Parties (“PRPs”). These laws establish the means to pay for cleanup of waste sites if PRPs fail to do so, and to assign liability to PRPs. Most PRPs named to date are parties who have been generators, transporters, past or present landowners or past or present site operators.
The Company is responsible for determining the fair value of its investment portfolio by utilizing fair value measurements obtained from active markets where available, by considering observable and unobservable inputs and by employing valuation techniques that make use of current market data. The Company categorizes its financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). For further details on the fair value hierarchy refer to Note 4 to the consolidated financial statements.
At December 31, 2009, the Company had unrealized losses of $9.2 million in investments in available-for-sale fixed income and equity securities of which $8.4 million was attributable to fixed income securities and $0.8 million was attributed to equity securities. The majority of the gross unrealized losses in the fixed income portfolio are attributable to investment grade municipal securities. Management has determined that the unrealized losses on its fixed income securities at December 31, 2009 are principally attributable to changes in interest rates and that the Company does not have the intent to sell these securities and it is more likely than not that it will not be required to sell these securities before recovery of their cost bases.
In certain circumstances, the Company may engage in commutation discussions with an individual reinsurer, essentially canceling and settling the contract at its net realizable value. The outcome of such discussions may result in a lump sum settlement that is less than the recorded recoverable balance. Losses arising from commutations could have an adverse impact on the Company’s results of operations.
At December 31, 2009 and 2008, reinsurance recoverable was $892.7 million and $968.2 million, net of reserves for uncollectible reinsurance of $54.2 million and $56.0 million, respectively. Bad debt expense for the years ended December 31, 2009, 2008 and 2007 related to uncollectible reinsurance was $2.0 million, $7.7 million and $8.0 million, respectively. While management believes the allowance for uncollectible reinsurance recoverable is adequate based on information currently available, failure of reinsurers to meet their obligations could have a material adverse impact on the Company’s financial position and results of operations. At December 31, 2009, the two largest gross reinsurance recoverable balances aggregated $478.4 million, or 53.6%, of the total reinsurance recoverable balance. The reinsurer with the largest gross recoverable balance (an unaffiliated company rated A+ by A.M. Best) has provided collateral in an amount of $236.3 million, which reduces its unsecured exposure to $112.7 million. The collateral provided is in the form of a funds held balance in the Company’s general account and equals 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.
Realization of the deferred tax asset under ASC 740, Income Taxes, ultimately depends on the existence of sufficient taxable income available under tax law, including future reversals of existing temporary differences, future taxable income exclusive of reversing differences, taxable income in prior carryback years and tax planning strategies. Future profitability, as it relates to taxable income expectations discussed above, can be negatively affected by substantial changes in premium volume, underwriting losses resulting from significant events such as severe natural disasters or large settlements for asbestos or environmental claims, or materially lower investment results.
The Company generally conducts business on a brokerage basis through its home office and a regional branch network, allowing it to control the underwriting process and build close relationships with producers and policyholders. The Company may also conduct business through third parties such as managing general underwriters where it is cost effective to do so and where the Company can control the underwriting process such as in the Company’s niche accident and health business. The Company has over 1,500 producers located throughout the United States including independent regional retail firms, wholesale brokers, national brokers and managing general underwriters.
The Company’s objective is to expand opportunistically into classes of business or market segments that have the potential to generate an underwriting profit. Additional growth in specialty lines is a significant element of the Company’s business strategy. Management believes the Company’s ability to identify profitable market opportunities where its underwriting expertise can be applied provides it with a competitive advantage.
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, financial market conditions, 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, termed a “soft market”. These soft market conditions heightened in 2008 and the Company has continued to see soft market pricing through all lines of business, aside from modest price increases in California workers’ compensation, throughout 2009. Although there is some evidence of deceleration in rate decreases, overall market conditions deteriorated over the second half of 2009 and still remain extremely competitive. In the property market, earlier in the year some property insurers were reducing available limits in peak catastrophe zones as a result of significant catastrophe losses sustained by the industry in 2008, primarily from Hurricane Ike, and increases in reinsurance costs, resulting in property rates stabilizing. However, more recently, the Company has experienced downward pressure on prices especially in non-catastrophe zones, attributable to the restoration of capital throughout the industry and the light catastrophe season in 2009. In the catastrophe zones, rates have been leveling off as capacity has increased.
Although there is some evidence of deceleration in rate decreases, the Company expects the market to remain competitive throughout 2010, attributable to the combined effects of the light catastrophe season in 2009, the restoration of capital throughout the industry, resulting from the improvement in the financial markets, and additional competitors in some lines of business placing downward pressure on price levels. Under such conditions, the Company will continue to reject underpriced new business submissions and to shed accounts and classes of business that are unprofitable. The Company expects continued pressure on its expense ratio despite aggressive cost cutting measures and the loss ratio may deteriorate marginally as renewal price declines and loss-cost trends take their toll on profitable business. In addition, if premium receipts continue to decline and claim payments continue at current rates, the Company is likely to continue to have negative cash flow from operations in the near future.
For the year ended December 31, 2008, 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 $258.3 million, or 24.1%, as compared to the year ended December 31, 2007, due to the combined effects of a decline in new business of approximately 36%, price decreases on renewal policies of approximately 7% and a decline in renewal retention rates of approximately five percentage points. The decline in new business was due to a reduction in both property and casualty writings, attributable to a weak economy, competitive market conditions and underwriting actions taken by the Company to reduce unprofitable classes of business, most notably a reduction in the property and commercial automobile lines of business.
Overall decline in gross premiums written in the core commercial lines in 2009 and 2008 was partially offset by growth from the accident and health business.
For the year ended December 31, 2009, gross premiums written in property lines, which include the property and commercial multi-peril lines of business, decreased by $70.5 million, or 29.4%, as compared to the year ended December 31, 2008, primarily due to a decline in new business of approximately 13%, price decreases on renewal policies of approximately 1% and a decrease in renewal retention rates of approximately four 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 2009 as compared to 2008 and 2007, is also due to a reduction in habitational business, where loss ratios have been 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, 2008, gross premiums written in property lines, which include the property and commercial multi-peril lines of business, decreased by $120.8 million, or 33.5%, 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. The decline in gross premiums was due to the combined effects of soft market conditions and specific underwriting actions taken by the Company.
For the years ended December 31, 2009 and 2008, other gross premiums written, which include the accident and health, surety, fidelity, personal automobile and homeowners lines of business, increased by $17.2 million, or 8.4%, and $32.9 million, or 19.2%, respectively, as compared to the prior year periods. The increase in both years was primarily due to growth in the Company’s accident and health book of business. Previously written in the “B++” rated Fairmont companies, the accident and health business continues to benefit from Crum & Forster’s “A” A.M. Best rating, which has resulted in the Company acquiring several new programs since 2007 that have contributed to business growth. The growth in 2009 has primarily come from the employer stop loss business. Additionally, in general, the accident and health business is not aligned with the traditional property and casualty market cycle which has been experiencing soft market conditions.
Premiums earned reflect the amount of net premiums written applicable to the portion of the policy term that expires in a given period. The Company generally earns premiums on a pro-rata basis over the period in which the coverage is provided. For the year ended December 31, 2009, premiums earned decreased by $216.7 million, or 21.7%, as compared to the year ended December 31, 2008. For the year ended December 31, 2008, premiums earned decreased by $188.1 million, or 15.9%, as compared to the year ended December 31, 2007. For both years, the decrease in premiums earned was generally comparable to the decrease in net premiums written.
The Company’s losses and LAE reflect the effect of amortization of deferred gain on retroactive reinsurance. For further discussion of the accounting for reinsurance coverage and the amortization of deferred income on retroactive reinsurance, see “Item 1. Business-Reinsurance” and Note 7 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Accident year loss and LAE ratios, as estimated at December 31, 2009 by line of business, are summarized as follows:
The accident year loss and LAE ratio decreased to 72.4% in 2009 from 81.5% in 2008, primarily due to lower catastrophe losses. The accident year loss and LAE ratio increased to 81.5% in 2008 as compared to 65.8% in 2007, primarily due to higher catastrophe losses (principally the effects of Hurricanes Gustav and Ike which added 6.6 loss ratio points) as well as the adverse effect of current unfavorable pricing trends and market conditions across all lines of business. Catastrophes added approximately 1.5, 8.5 and 1.3 points to the Company’s loss and LAE ratio in 2009, 2008 and 2007, respectively, and added approximately 13.1, 51.6 and 5.6 points to the property accident year loss and LAE ratios. In addition to catastrophes, the 2008 property accident year loss ratio was also impacted by an increased frequency of large habitational fire losses. The commercial automobile loss ratio declined in 2009 as a result of specific underwriting actions taken by the Company to reduce exposure to unprofitable transportation accounts. The commercial multi-peril loss ratio increased from 2008 to 2009 due to several large property claims in the second half of 2009.
The accident year loss and LAE ratios represent management’s estimate, at December 31, 2009, of the ultimate cost, expressed as a percentage of net premiums earned for each respective year, of covered claims or events, including settlement costs. For casualty lines of business in particular, where the “tail”, or period from the occurrence of the claim to final settlement, may span several years, the estimates are based on a number of assumptions and, accordingly, are subject to significant variability. See “-Critical Accounting Policies and Estimates- Unpaid Losses and Loss Adjustment Expenses”.
Underwriting expenses include policy acquisition costs (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) and other operating expenses associated with the Company’s underwriting activities, such as salaries and benefits, information technology costs and rent. The Company’s underwriting expense ratio was 34.9%, 32.1% and 28.7% for the years ended December 31, 2009, 2008 and 2007, respectively. Despite reduced other operating expenses in 2009, primarily reflecting the combined effects of cost saving initiatives and a write-off of software development costs of $4.2 million in 2008, the increase in the underwriting expense ratio in 2009 as compared to 2008, is primarily attributable to a reduction in net earned premiums of approximately $216.7 million, or 22%, although general expenses were reduced by approximately $9.7 million, or 6%. The Company is aggressively evaluating all general expenses to better align costs to premium volume in the current economy, however, persistent soft market conditions and a weak economy will continue to adversely affect the Company’s underwriting expense ratio.
The increase in the underwriting expense ratio in 2008 as compared to 2007, was primarily attributable to a reduction in net earned premium of approximately 16% and an increase in other operating expenses, largely due to higher compensation costs and higher technology costs (reflecting the aforementioned write-off). Compensation costs in 2008 included severance costs associated with the reduction in workforce to better align compensation costs with lower premium volume.
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 or losses of investees), net 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. 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 2008, the Company significantly reduced its credit default swap portfolio and closed out its equity hedging positions, realizing significant gains and reinvesting the proceeds to a large extent in equity securities. As a result, the investment portfolio is exposed to a larger degree than in previous reporting periods to volatility in the equity markets, however, the Company has protected a portion of its equity and equity related holdings against a decline in equity markets by entering into equity index total return swaps. The significant increase in the annualized total return on investments for the year ended December 31, 2009 as compared to 2008 and 2007, is primarily attributable to the improvement in financial market conditions in the third and fourth quarters of 2009, resulting in unrealized appreciation of the investment portfolio at the end of 2009.
The year over year decline in the average book value of investments is largely attributable to cash used in operations in 2009 of $402.4 million, as well as dividends paid to Fairfax of $115.0 million, both of which were funded from the proceeds of sales of fixed income securities.
Net realized investment gains for the years ended December 31, 2009, 2008 and 2007 are summarized as follows:
The decrease in net realized investment gains of $381.9 million, or 71.8%, in 2009 as compared to 2008, was principally due to net realized losses on the Company’s derivative securities, as compared to significant realized gains in 2008, partially offset by net realized gains on held-for-trading fixed income securities and other invested assets, primarily mark-to-market accounting gains attributable to changes in fair value, as compared to mark-to-market losses in 2008, higher realized gains on sales of equity securities and lower other than temporary impairment charges.
The increase in net realized investment gains of $297.8 million, or 127.2%, in 2008 as compared to 2007 was principally due to higher net realized gains on the Company’s derivative securities and short-sale obligations, attributable to widening credit spreads and declining equity markets and higher net realized gains on sales of fixed income securities, primarily U.S. Treasuries, partially offset by higher mark-to-market accounting losses attributable to the change in fair value of held-for-trading fixed income securities and other invested assets, and higher other than temporary impairment charges.
Net realized losses on the Company’s derivative securities in 2009 include $9.1 million of net losses on credit default swaps and $22.3 million of net losses on total return swaps. By comparison, 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. 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. For further details on realized gains and losses incurred on the Company’s derivatives and short-sale obligations, see Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”. At December 31, 2009, the Company owned $1.6 billion notional amount of credit default swaps with an average term to maturity of 2.3 years, an original cost of $21.6 million and a fair value of $20.0 million.
Gains on other invested assets in 2009 are principally attributable to mark-to-market gains of $51.5 million and $4.9 million on the Company’s investments in Odyssey and Advent, respectively, affiliated companies for which the Company has elected the fair value option. By comparison, losses on other invested assets in 2008 were principally attributable to mark-to-market losses of $40.8 million related to the change in fair value of the Company’s investment in Northbridge, an affiliated company, which the Company sold in December 2008.
Included in realized investment gains in 2009, 2008 and 2007 were $110.8 million, $194.7 million and $25.4 million, respectively, of other than temporary impairment charges, primarily related to write downs of equity securities in all three years. The impairments recognized in 2009 and 2008 were primarily due to the increased volatility in the financial markets resulting from the global credit and liquidity crisis that began in 2007.
Interest and other expense, excluding costs related to early retirement of debt, was $31.1 million, $36.7 million and $39.4 million in 2009, 2008 and 2007, respectively. The lower expense in 2009 as compared to 2008 was due to lower corporate overhead expense, primarily lower charitable contributions and lower severance payments. The lower expense in 2008 as compared to 2007 was attributable to both lower corporate overhead expenses and 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. The lower interest expense was attributable to the refinancing of the Company’s long-term debt in mid-2007 at a lower interest rate.
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, 2009, US Fire reported statutory earned surplus of $615.6 million and North River reported statutory earned surplus of $231.2 million. In 2009, the insurance subsidiaries paid dividends totaling $138.4 million to the Company. In March 2009, both US Fire and North River received approval from the Delaware Department of Insurance and New Jersey Department of Banking and Insurance, respectively, to pay extraordinary dividends. Although the amount of the dividend for both companies was 10% of prior year-end surplus (the amount of an ordinary dividend), the extraordinary dividend approvals allowed acceleration of the dividend payments from October 2009 to March 2009 for US Fire and from May 2009 to March 2009 for North River. On March 27, 2009, North River paid a cash dividend in the amount of $44.1 million to the Company and on March 30, 2009, US Fire paid a cash dividend in the amount of $94.3 million to the Company. The maximum dividends that can be paid by the insurance subsidiaries to the Company in 2010, without prior regulatory approval, are $163.8 million.
Cash used in financing activities was $115.0 million, $339.5 million and $118.5 million in 2009, 2008 and 2007, respectively and was primarily in respect of dividends paid to Fairfax as well as refinancing of the Company’s long-term debt in 2007. On April 16, 2009 and December 22, 2009, the Company paid cash dividends to Fairfax of $100.0 million and $15.0 million, respectively. In 2008, the Company paid cash dividends to Fairfax of $335.2 million and in-kind dividends in the form of fixed income securities, at fair value, of $158.8 million, resulting in total dividends paid to Fairfax of $494.0 million. In 2007, the Company paid cash dividends to Fairfax of $128.8 million and in-kind dividends of $54.9 million in the form of promissory notes.
In May 2007, the Company issued pursuant to a private offering (the “Offering”) $330.0 million aggregate principal amount of 7-3/4% 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 10-3/8% senior notes due June 15, 2013 (the “2013 Notes”), through a tender offer which the Company completed in May 2009. 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 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 the Company invests, 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 small amount of mortgage-backed securities (approximately 3% of the total investment portfolio of $4.0 billion), purchased at deep discounts to par. 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. At December 31, 2009, there was no collateral held in the name of the Company as the fair value of the Company’s credit default swap portfolio had declined significantly through closing transactions and fair value changes. The Company believes that any credit risk exposure, represented by the uncollateralized fair value of the credit default swaps ($20.0 million at December 31, 2009), is low given the diversification among the various counterparties. The Company funds all its obligations relating to the credit default swaps through the initial premium paid at purchase and as a result there are no requirements for the Company to provide collateral.
At December 31, 2009 and 2008, 83.0% and 86.7%, respectively, of the Company’s fixed income securities were rated investment grade. The decline in investment grade securities was due in part to the sale of municipal securities with a fair market value of approximately $146.2 million in the first quarter of 2009 to third-parties and Fairfax affiliates to meet operating cash needs and restore the Company’s cash and short-term investments position to more normal levels as well as the purchase of approximately $19.8 million of non-investment grade mortgage-backed securities. Fixed income securities and cash and cash equivalents of $306.0 million and $431.9 million were on deposit with various state regulatory authorities at December 31, 2009 and 2008, respectively, as required by insurance laws.
Statutory surplus is an important measure utilized by management, regulators and rating agencies to assess the Company’s ability to support its business operations. The increase in the Company’s statutory surplus in 2009 from 2008 is principally attributable to net unrealized capital gains of $199.4 million and statutory net income of $154.0 million, partially offset by dividends paid by the insurance companies to Crum & Forster Holdings Corp. of $138.4 million. The decrease in the Company’s statutory surplus in 2008 from 2007 is attributable to the payment of $511.3 million of dividends from the insurance subsidiaries to Crum & Forster Holdings Corp. and net unrealized capital losses of $224.2 million, partially offset by statutory net income of $484.0 million. The Company’s ratio of statutory net premiums written to surplus, a measure of operating leverage, improved in 2009 and, according to data from A.M. Best, was below the property and casualty commercial lines sector ratios for 2008, 2007 and 2006 of 0.8x, 0.8x and 0.9x, respectively.
The liability for unpaid losses and LAE includes reserves for unpaid reported losses and LAE and for IBNR losses. The amounts shown above represent management’s best estimate of the expected timing of payments for losses and LAE given information currently available. Actual results may differ significantly from these estimates. For additional information on the Company’s unpaid losses and LAE, see “Item 1. Business-Reserves”, “Item 1A. Risk Factors -The Company may incur a reduction in its net income if its reserves are insufficient” and “-Critical Accounting Policies and Estimates-Unpaid Losses and Loss Adjustment Expenses”.
The Company has outstanding $330.0 million aggregate principal amount of 7-3/4% senior notes due 2017. Interest payments on such notes are approximately $25.6 million per year. For additional information on the Company’s senior notes, see Note 8 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” and “- Liquidity and Capital Resources-Holding Company”.
The Company and its subsidiaries lease office space and equipment under long-term leases expiring through the year 2025. The amounts above represent the minimum contractual rentals for such operating leases at December 31, 2009. 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”.
Consolidated Statements of Income for the Years Ended December 31, 2009, 2008 and 2007
Crum & Forster Holdings Corp. (an indirect wholly-owned subsidiary of Fairfax Financial Holdings Limited) and Subsidiaries:
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of the Company and its wholly-owned subsidiaries, including United States Fire Insurance Company (“US Fire”), The North River Insurance Company (“North River”), Crum & Forster Indemnity Company (“CF Indemnity”) and Crum and Forster Insurance Company (“CF Insurance”). US Fire owns 100% of the stock of Crum & Forster Specialty Insurance Company. North River owns 100% of the stock of Seneca Insurance Company, Inc. and its subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Such estimates and assumptions may differ from actual results.
For equity securities, unrealized losses that are deemed other than temporary are charged to earnings. For debt securities in an unrealized loss position, if the Company intends to sell or it is more likely than not that it will be required to sell a security in an unrealized loss position prior to recovery of its cost basis, the security is deemed other than temporarily impaired and the full amount of the impairment is recognized as a loss through earnings. If the Company does not intend to sell a security and it is more likely than not that it will not be required to sell a security that it considers to be other than temporarily impaired before recovery of its cost basis, the other than temporary impairment is separated into its credit and non-credit components with the credit portion of the other than temporary impairment recognized as a loss through earnings and the non-credit portion recognized in other comprehensive income. At each reporting date and more frequently when conditions warrant, management reviews all available-for-sale securities with unrealized losses to determine whether an other than temporary decline in value exists and whether losses should be recognized in earnings rather than in accumulated other comprehensive income (loss). The process for determining whether a security is other than temporarily impaired requires judgment and involves analyzing many factors. These factors include but are not limited to (i) the length of time and extent to which the fair value has been less than its cost or amortized cost; (ii) the severity of the impairment; (iii) the cause of the impairment; (iv) the financial condition and near-term prospects of the issuer as well as specific credit issues related to the issuer such as changes in credit rating, reduction or elimination of dividends or non-payment of scheduled interest payments; and (v) for fixed income securities, the Company’s intent to sell a security or whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost, which in some cases, may extend to maturity, and for equity securities, the Company’s intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery of fair value in the near term.
Short-term investments, which have an original maturity of greater than 90 days and less than twelve months, are carried at fair value.
The Company considers highly liquid investments, which have an original maturity of three months or less, to be cash equivalents. Cash and cash equivalents on the balance sheet do not include cash pledged as security for the Company’s derivative securities and short-sale obligations.
Certain costs that vary with and are primarily related to the acquisition of new and renewal policies, consisting of commissions and premium taxes, are deferred and amortized over the period in which the related premiums are earned. Deferred policy acquisition costs are limited to their estimated realizable value, which considers anticipated losses and loss adjustment expenses on the related policies and estimated remaining costs of servicing the contracts. Realizability is determined without considering investment income.
For retroactive reinsurance contracts, the excess of reinsurance recoverable from reinsurers pursuant to the contracts over premiums paid for such reinsurance coverage is deferred and amortized as a reduction of losses and LAE over the expected period of recovery using the interest method.
The Company participates in tax sharing agreements that provide for the inclusion of the Company in the consolidated federal income tax returns of Fairfax Inc. (the “Fairfax Group”), as well as the consolidated or combined state income or franchise tax returns of Fairfax Inc. Subject to these tax sharing agreements, every member of the Fairfax Group is severally liable for the federal income tax liabilities of the Fairfax Group and may be liable under similar rules for state income or franchise taxes of the entire group. Under the tax sharing agreements, Crum & Forster and its insurance subsidiaries make payments to Fairfax Inc. equal to the amounts of federal income taxes that each company would pay, subject to some adjustments, as if they each had filed their own separate federal income tax returns, as well as their shares of any state income or franchise taxes. Fairfax stands in the place of the Internal Revenue Service for administering federal income tax payments, including the requirement to honor all valid tax elections. Under a separate tax sharing agreement, between Crum & Forster Holdings Corp. and Fairfax Inc., the Company and its subsidiaries are permitted to file federal income tax returns on a consolidated basis for tax sharing purposes. The agreement 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.
Deferred income taxes are provided for temporary differences between the financial statement and tax bases of assets and liabilities. Such differences relate principally to unpaid losses and LAE, deferred income on retroactive reinsurance, unrealized net appreciation of investments and certain realized investment gains and losses, deferred policy acquisition costs and employee benefit plans. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all, or some portion of, the benefits related to deferred tax assets will not be realized. As of December 31, 2009 and 2008, a valuation allowance was not required. The Company has 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 liability for uncertain tax positions, interest or penalties in 2009 or 2008.
ASU 2010-06. In January 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2010-06, Improving Disclosures About Fair Value Measurements, (“ASU 2010-06”) which amends previous guidance provided under ASC 820 to add new requirements for disclosures about investment transfers into and out of Levels 1 and 2 of the fair value hierarchy and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 investments. ASU 2010-06 also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, except for the requirement to provide the Level 3 activity of purchases, sales, issuances, and settlements on a gross basis, which will be effective for interim and annual reporting periods beginning after December 15, 2010. The Company adopted the provisions of ASU 2010-06 effective December 31, 2009 and has provided the additional disclosures in Note 4 to the consolidated financial statements.
ASC 320. In April 2009, the FASB issued guidance under ASC 320, Investments - Debt and Equity Securities (“ASC 320”), which amends previous other than temporary impairment guidance for debt securities to make the guidance more operational and to improve the presentation and disclosure of other than temporary impairments on debt securities in the financial statements. The guidance requires that if the Company intends to sell, or it is more likely than not that it will be required to sell a security in an unrealized loss position prior to recovery of its cost basis, the security is other than temporarily impaired and the full amount of the impairment is recognized as a loss through earnings. If the Company does not intend to sell a security and it is more likely than not that it will not be required to sell a security that it considers to be other than temporarily impaired before recovery of its cost basis, the other than temporary impairment is separated into its credit and non-credit components with the credit portion of the other than temporary impairment recognized as a loss through earnings and the non-credit portion recognized in other comprehensive income. ASC 320 is effective for interim and annual reporting periods ending after June 15, 2009. The Company adopted ASC 320 effective April 1, 2009 and the adoption did not affect the Company’s financial position or results of operations. ASC 320 requires that the Company record, as of the beginning of the interim period of adoption, a cumulative effect adjustment to reclassify the non-credit component of a previously recognized other than temporary impairment on debt securities which are still held as investments at the date of adoption, from retained earnings to accumulated other comprehensive income. The Company reviewed other than temporary impairments it had previously recorded through earnings on fixed income securities held at April 1, 2009, which were $10,855, and determined that all of these other than temporary impairments were related to specific credit losses as the issuers had filed for bankruptcy and were in default of interest payments, resulting in no cumulative effect adjustment to opening retained earnings or accumulated other comprehensive income as of April 1, 2009.
ASC 820. In April 2009, the FASB issued guidance under ASC 820, Fair Value Measurements and Disclosures (“ASC 820”), which provides additional guidance on estimating the fair value of an asset or liability when the volume and level of activity for the asset or liability have significantly decreased and on identifying transactions that are not orderly. The guidance addresses the factors that determine whether there has been a significant decrease in the volume and level of activity for an asset or liability when compared to the normal market activity. Under this guidance, if the Company determines that the volume and level of activity has significantly decreased and transactions are not orderly, further analysis is required and significant adjustments to the quoted prices or transactions may be needed. The Company adopted ASC 820 effective April 1, 2009 and the adoption did not have an impact on the Company’s financial position or results of operations.
In September 2006, the FASB issued guidance under ASC 820, 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. The guidance also establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques. The Company adopted the guidance under ASC 820 effective January 1, 2008 and concurrent with the adoption established a policy for those securities measured on the basis of bid-ask prices to use the bid price for long positions (assets), which reflects the highest price that a buyer is willing to pay for an asset, and the ask price for short positions (liabilities), which represents the lowest price a seller is willing to accept for an asset. Prior to adoption the Company used a market price within the bid-ask spread. The Company recorded a cumulative adjustment of $1,859, net of tax, to opening shareholder’s equity as of January 1, 2008 (comprised of a reduction of $521 to opening accumulated other comprehensive income and a reduction of $1,338 to opening retained earnings). In October 2008, the FASB issued further guidance under ASC 820, which clarified the guidance for the application of fair value measurements for financial assets in inactive or distressed markets. The guidance was effective upon issuance and its adoption did not impact the Company’s financial position or results of operations.
Upon adoption of the fair value option guidance under ASC 825, the Company recorded a cumulative adjustment of $89,328 to derivatives and other invested assets, a deferred tax liability of $31,265 and a $58,063 adjustment (comprised of a reduction of $29,376 to opening accumulated other comprehensive income and an increase of $87,439 to opening retained earnings), net of tax, to shareholder’s equity as of January 1, 2008.
The Company’s investment in Advent became subject to the equity method of accounting during the third quarter of 2008 as a result of Fairfax gaining majority ownership of Advent. Upon election of the fair value option for Advent, the Company recorded a realized loss of $5,945 on the consolidated statement of income and an unrealized gain of the same amount in other comprehensive income, for the year ended December 31, 2008, which represents the reclassification of the cumulative change in fair value previously recorded in accumulated other comprehensive income.
In February 2006, the FASB issued guidance under ASC 815-15, which applies to certain “hybrid financial instruments” which are instruments that contain embedded derivatives. The guidance 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 and permits an election for fair value measurement of any hybrid financial instrument that otherwise would require bifurcation under GAAP accounting for derivative securities. 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 adopted the guidance effective January 1, 2007 and as a result of the adoption, no longer bifurcates embedded derivatives included in certain fixed income or equity securities, and, beginning January 1, 2007, changes in the fair value of such securities are recorded as realized investment gains or losses in the consolidated statements of income. Prior to adoption, changes in fair value of the host instrument were recorded as unrealized investment gains and losses as a component of shareholder’s equity, while changes in the fair value of the embedded derivatives were recorded as realized investment gains and losses. Upon adoption of the guidance under ASC 815-15, the Company recorded a cumulative adjustment of $10,146, net of tax, to reclassify unrealized investment gains to opening retained earnings.
The aggregate carrying value of the Company’s investment portfolio was $3,992,020 and $4,032,034 at December 31, 2009 and 2008, 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.
Included in equity securities at December 31, 2008 is a $156,642 investment in Johnson & Johnson common stock, which represents 13.4% of shareholder’s equity at that date.
Changes in net unrealized investment gains and losses, net of transfers to realized investment gains and losses, and the related tax effects, are summarized as follows:
The amounts are net of transfers to realized investment gains and losses of $72,863, $54,520 and $21,904 in 2009, 2008 and 2007, respectively.
The Company holds significant investments in equities and equity related securities. The market values and liquidity of these investments are volatile and may vary dramatically either up or down in short periods, and their ultimate value will therefore only be known over the long term. Certain individual available-for-sale securities had gross unrealized losses at December 31, 2009 totaling $9,155, which represented 4.8% of the cost or amortized cost of such securities in the aggregate, of which $8,376 was attributed to fixed income securities and $779 was attributed to equity securities.
The number of continuous months in which securities in an unrealized loss position at December 31, 2009 were in such a position is summarized as follows:
The majority of the gross unrealized losses of $9,155 in the investment portfolio at December 31, 2009 are attributable to investment grade municipal bonds, none of which had a loss that exceeded 10% of its cost at that date. Management has determined that the unrealized losses on its fixed income securities at December 31, 2009 are principally attributable to changes in interest rates and that the Company does not have the intent to sell these securities and it is more likely than not that it will not be required to sell these securities before recovery of their cost bases.
The fair value by contractual maturity of the Company’s fixed income securities in an unrealized loss position is summarized as follows:
Fixed income securities classified as held-for-trading include those purchased for short-term investment objectives and those designated as such by management pursuant to the fair value option under ASC 815-15. These securities, which are recorded at fair value on the consolidated balance sheets, include convertible securities with embedded derivatives, mortgage-backed securities purchased at deep discounts to par and certain corporate fixed income securities. Changes in fair value of held-for-trading securities (including gains or losses on disposal), are recognized as realized investment gains and losses in the consolidated statements of income in the period in which they occur and amounted to gains (losses) of $74,976, $(90,891) and $(30,904) for the years ended December 31, 2009, 2008 and 2007, respectively. The fair values of these securities were $321,359 and $233,998 at December 31, 2009 and 2008, respectively.
Investments at equity include investments in entities that are consolidated subsidiaries of Fairfax, but are less than 50% owned by the Company, as well as investments in certain partnerships, accounted for under the equity method of accounting. These investments consist of equity interests of between approximately 1% and 47% at December 31, 2009, with a total carrying value of $167,331 and $117,586 at December 31, 2009 and 2008, respectively. For the years ended December 31, 2009, 2008 and 2007, total earnings (losses) of investments at equity were $53,308, $(51,947) and $48,831, respectively. Earnings (losses) of investment companies and similar equity method investees of $53,187, $(51,238) and $12,985 in 2009, 2008 and 2007, respectively, are included in investment income on the consolidated statements of income. Pre-tax earnings (losses) of other equity method investees of $121, $(709) and $35,846 in 2009, 2008 and 2007, respectively, are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from other equity method investees were $486, $475 and $5,318 in 2009, 2008 and 2007, respectively.
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.
The Company’s aggregate share of its equity investees’ statements of income, which includes its share of income of those investees accounted for under the fair value provisions of ASC 825, had they been accounted for under the equity method, is summarized as follows:
The Company’s derivative securities are principally comprised of credit default swaps and total return swaps, none of which are designated as hedges, and are included in derivatives and other invested assets or accounts payable and other liabilities on the consolidated balance sheets at fair value. Changes in fair value of derivative securities are included in realized investment gains and losses on the consolidated statements of income in the period in which they occur.
At December 31, 2009, other derivatives are comprised of warrants. At December 31, 2008, other derivatives are comprised of warrants and Eurodollar futures contracts.
The credit default swaps are recorded at fair value with changes in fair value recognized as realized investment gains or losses in the period in which they occur. The Company obtains broker-dealer quotes which are based on observable credit spreads for its credit default swaps. The Company assesses the reasonableness of the broker-dealer quotes 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. The fair values of credit default swaps are subject to significant volatility arising from the potential differences in the perceived risk of default of the underlying issuers, movements in credit spreads and the length of time to the contracts’ maturity. The fair value of the credit default swaps may vary materially either up or down in short periods, and their ultimate value may therefore only be known upon their disposition.
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. At December 31, 2009, there was no collateral held in the name of the Company as the fair value of the Company’s credit default swap portfolio had declined significantly through closing transactions and changes in fair value. The Company believes that any credit risk exposure, represented by the uncollateralized fair value of the credit default swaps ($20,027 and $49,114 at December 31, 2009 and 2008, respectively), is low given the diversification among the various counterparties. The Company funds all its obligations relating to the credit default swaps through the initial premium paid at purchase and as a result there are no requirements for the Company to provide collateral.
The Company’s holdings of credit default swaps have declined significantly in 2009 relative to prior years, largely as a result of closing transactions and changes in fair value. In the latter part of 2008, the Company reviewed the financial objectives of its economic hedging program and decided not to replace closed credit default swaps based on: (i) the Company’s judgment that its exposure to elevated levels of credit risk had moderated and that its historical approaches to managing credit risk were satisfactory in mitigating the Company’s exposure to credit risk arising from its financial assets; (ii) the significant increase in the cost of purchasing credit protection; and (iii) the fact that the Company’s capital and liquidity had benefited from approximately $450 million in realized investment gains from credit default swaps since inception of the hedge program. As a result, the effect that credit default swaps as hedging instruments may be expected to have on the Company’s future financial position, liquidity and results of operations has diminished significantly relative to recent years. The Company may initiate new credit default swap contracts as a hedging mechanism in the future, but there can be no assurance that it will do so.
Excludes $87,765 of U.S. government securities with a loss in other comprehensive income of $26,395 and a realized gain of $1,066.
The net cash flow effect from disposals of the above credit risk exposures and related hedging instruments for the year ended December 31, 2009 was $177,366.
The net cash flow effect from disposals of the above credit risk exposures and related hedging instruments for the year ended December 31, 2008 was $342,705.
In the normal course of effecting its economic hedging strategy with respect to credit risk, the Company expects that there may be periods where the notional value of the hedging instruments may exceed or be deficient relative to the exposure items being hedged. This situation may arise when management compensates for imperfect correlations between the hedging item and the hedge or due to the timing of opportunities related to the Company’s ability to exit and enter hedged or hedging items at attractive prices.
The Company is required to post collateral equivalent to 6% of the notional value of the total return swaps at the time the swap is opened. These assets are recorded at fair value in assets pledged for derivatives on the consolidated balance sheets. At December 31, 2009, the fair value of the collateral posted, in the form of municipal bonds, was $29,425.
The following tables summarize the effect of equity risk hedging instruments and related hedged items on the Company’s financial position and results of operations and cash flows as of and for the years ended December 31, 2009 and 2008:
The net cash flow effect from disposals of the above equity exposures and related hedging instruments for the year ended December 31, 2008 was $481,736.
In the normal course of effecting its economic hedging strategy with respect to equity risk, the Company expects that there may be periods where the notional value of the hedging instruments may exceed or be deficient relative to the exposure items being hedged. This situation may arise when management compensates for imperfect correlations between the hedging item and the hedge or due to the timing of opportunities related to the Company’s ability to exit and enter hedged or hedging items at attractive prices.
The Company has investments in warrants, which are contracts that grant the holder the right to purchase an underlying financial instrument at a given price and time. Warrants are recorded in derivatives and other invested assets at fair value with changes in fair value recognized as realized investment gains or losses in the period in which they occur.
Other includes warrants, Eurodollar futures contracts and S&P Index call options.
During the year ended December 31, 2008, the Company sold credit default swaps with a cost of $46,652 and notional amount of $2,154,472 for proceeds of$383,278.
During the year ended December 31, 2007, the Company sold credit default swaps with a cost of $3,104 and notional amount of $121,290 for proceeds of $22,400.
The Company’s related party investment transactions are noted below. All transactions were completed at fair value.
On May 6, 2009, the Company sold municipal securities with a fair market value of $14,725 to nSpire Re Limited (“nSpire”), a Fairfax affiliate, for cash consideration and a pre-tax gain of $875.
On March 5, 2009, the Company sold municipal securities with a fair market value of $97,112 to certain Fairfax affiliates, for cash consideration and a pre-tax gain of $4,236. Also in March 2009, the Company transferred municipal securities with a fair market value of $54,008 to Fairfax Inc., as partial settlement of its tax liability, resulting in a pre-tax gain of $5,907.
On December 30, 2008, the Company purchased an 8.2% interest in Odyssey common shares, from TIG Insurance Group, Inc., a Fairfax affiliate, for $246,066. As consideration for its investment in Odyssey, the Company released its Fairfax Inc. note (discussed below) of equal fair value.
On December 23, 2008, the Company sold its 15.7% interest in Northbridge to nSpire, for $248,066 and received a Fairfax Inc. note held by nSpire of equal value. Since Northbridge was accounted for at fair value, no gain or loss was recorded on the sale.
In accordance with ASC 820 the Company has categorized its financial instruments into the three-level fair value hierarchy, based on priority of inputs to the valuation technique. ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. ASC 820 also 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. The fair value hierarchy is designed to indicate the relative reliability of fair value measurement. The highest priority is given to quoted prices in active markets and the lowest to unobservable data. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the hierarchy within which the fair value measurement falls is determined based on the lowest level significant input. The hierarchy is broken down into three levels based on the reliability of inputs as follows:
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 (i) the market is the principal (or most advantageous) market and (ii) the entity has the ability to access the principal (or most advantageous) market.
The Company is responsible for determining the fair value of its investment portfolio by utilizing fair value measurements obtained from active markets where available, by considering other observable and unobservable inputs and by employing valuation techniques which make use of current market data.
For determining the fair value of its Level 1 investments (approximately 35% of total investment portfolio at fair value), the Company utilizes quoted market prices in active markets for identical securities. The Company’s Level 1 investments are primarily exchange-traded equity securities that trade in active markets.
The Company has elected the fair value option for certain investments that would have otherwise been accounted for under the equity method of accounting. The fair value option allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities. Changes in the fair value of assets and liabilities for which the election is made are recognized in net income as they occur. The fair value option election is permitted on an instrument-by-instrument basis at initial recognition of an asset or liability or upon occurrence of an event that gives rise to a new basis of accounting for that instrument. 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.
A reconciliation of the ceded unpaid losses and LAE in the table above to the reinsurance recoverable reflected on the balance sheets follows:
For the years ended December 31, 2009, 2008 and 2007, the Company’s calendar year loss and LAE ratios were 67.3%, 82.5% and 63.5%, respectively, of which 72.4%, 80.4% and 68.9%, respectively, were attributable to losses occurring in the current accident year and (5.1)%, 2.1% and (5.4)%, respectively, were attributable to (favorable) adverse development of prior years’ losses.
The improvement in the 2009 accident year ratio as compared to 2008 is primarily due to lower catastrophe losses. The deterioration in the 2008 accident year ratio as compared to 2007 is primarily attributable to the impact of $71,500 of losses associated with Hurricanes Gustav and Ike which contributed 7.2 loss ratio points, adverse development in property where there were several large fire losses, adverse development in commercial automobile where the company experienced increased large loss activity and the effects of current unfavorable pricing trends and market conditions. Refer to Note 14 to the consolidated financial statements for a schedule of the accident year loss and LAE ratios by line of business.
The Company discounts workers’ compensation indemnity reserves using an interest rate of 5%. The amount of related discount was $54,555 and $56,577, at December 31, 2009 and 2008, respectively.
Changes in the Company’s liability for asbestos, environmental and other latent exposures are summarized as follows:
During 2009, net asbestos losses and ALAE incurred and paid reflect an insurance recovery of $13,750 associated with a lawsuit that the Company settled in 2008. Excluding this recovery, net asbestos losses and LAE incurred in 2009 are primarily attributable to increasing claim values and rising legal costs associated with one policyholder. In 2008 and 2007, net asbestos losses and ALAE incurred were primarily attributable to the aforementioned lawsuit. Net losses and ALAE paid in 2009 and 2008 include payments of $18,333 and $22,700, respectively, related to this lawsuit settlement.
The Company also maintains reserves for other latent exposures such as those associated with silica, lead, mold, chemical, gas and vapors and welding fumes. Changes in the Company’s liability for other latent exposures are summarized as follows:
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.
The effect of prospective and retroactive corporate aggregate reinsurance on components of the Company’s consolidated statements of income is summarized as follows ((decrease) increase in indicated component):
At December 31, 2009 and 2008, reinsurance recoverable includes $349,000 related to one retroactive corporate aggregate reinsurance contract, of which $98,758 has been recognized as a reduction of incurred losses and LAE on the Company’s consolidated statements of income.
The Company has one prospective contract in effect covering accident year 2002, which has an unused limit available of $96,272 in the event the net loss and LAE ratio for accident year 2002, before the effect of this contract, exceeds 70%. The subject loss and LAE ratio as valued at December 31, 2009 is 63.2%. No additional premium or funds held interest is due under this contract upon usage of the remaining limit. The reinsurer under this contract is nSpire, a Fairfax affiliate.
During 2008 and 2007, the above activity arose from two prospective contracts both of which were commuted in 2008. The first contract was 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. In June 2008, the Company commuted this stop loss contract and the retroactive amendment to that contract. As a result of the commutation the Company received cash proceeds of $302,500, of which $287,375 was recorded in prospective corporate aggregate reinsurance activity and $15,125 was recorded in retroactive corporate aggregate reinsurance activity. The Company also recorded a decrease of $386,748 in the reinsurance recoverable balance, of which $367,500 was attributable to the prospective contract and $19,248 was attributable to the retroactive amendment. The financial statement effect of the commutation in 2008 was a non-cash pre-tax charge of $84,248, offset by the release of the unamortized deferred gain balance of $8,778 (related to the retroactive amendment), resulting in a net charge to incurred losses and LAE of $75,470 on the consolidated statement of income. Of this amount $80,125 was charged to prospective corporate aggregate reinsurance activity and included in losses and LAE above and $4,655 was credited to retroactive corporate aggregate reinsurance activity.
For the year ended December 31, 2008, losses and LAE is comprised of a loss on commutation of $4,123 offset by $8,778 of unamortized deferred income released on commutation as well as $10,172 of recurring deferred income amortization.
The second contract, which was commuted on June 26, 2008, covered all lines of business and provided $100,000 of limit in excess of a retention for accident periods prior to August 13, 1998, the date of acquisition of the Company by Fairfax. The contract contained sublimits relating to asbestos, environmental and latent, construction defect and other losses and is subject to a maximum economic loss provision. The contract was on a funds held basis with interest credited at 7%. The commutation had no impact on the financial statements as the Company had previously reduced the reinsurance recoverable balance by funds held pursuant to the commutation provision contained in the contract.
In December 2008, the Company sold its 15.7% investment in Northbridge to an affiliated foreign company, which resulted in tax benefits of approximately $51,605 attributable to the utilization of foreign tax credits.
The Internal Revenue Service has completed its audit of tax years 2005 and 2006 with no material adjustments and is presently conducting their audit of tax years 2007 and 2008 in respect of the Fairfax Group companies. There have been no material adjustments proposed for tax years 2007 and 2008. 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 did not record any liability for uncertain tax positions, interest or penalties in 2009.
For the years ended December 31, 2009, 2008 and 2007, the Company ceded premiums of $1, $77 and $12,461, respectively, to nSpire and had reinsurance recoverable balances of $12,448 and $25,195 at December 31, 2009 and 2008, 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.
In the normal course of business, Odyssey, an affiliate of Fairfax, may participate on the Company’s reinsurance agreements. Currently, Odyssey participates on the umbrella per risk contract, the workers’ compensation catastrophe treaty and a difference in conditions program. For the years ended December 31, 2009, 2008 and 2007, the Company ceded $3,046, $5,197 and $2,088, respectively, in premiums to Odyssey and had reinsurance recoverable of $6,062 and $9,002 at December 31, 2009 and 2008, respectively, under these reinsurance agreements.
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, 2009 and 2008, the Company had reinsurance recoverable of $945 and $1,384, respectively, from TIG related to this agreement.
Advent Syndicate 780 (“Syndicate 780”), which is managed by Advent, a wholly-owned subsidiary of Fairfax, is a participant on the Company’s property per risk, property catastrophe and workers’ compensation catastrophe treaties. For the years ended December 31, 2009 and 2008, the Company ceded premiums of $41 and $533, respectively, to Syndicate 780 and had reinsurance recoverable balances of $155 and $185, respectively, at December 31, 2009 and 2008, respectively.
Since 2001, the Company has obtained certain information technology services, including technology management, 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. Beginning in April 2009, the Company assumed direct management responsibility for these functions and hired employees or contractors to perform most of the services previously received from FITS. FITS continues to provide data center, network and hosting services to the Company. Charges for the services provided by FITS, including fees recorded for services subcontracted by FITS to other vendors, for the years ended December 31, 2009, 2008 and 2007 were $17,025, $32,062 and $36,500, respectively. Of such fees, $16,430, $30,056 and $30,462 were charged directly to expense for 2009, 2008 and 2007, respectively. The remaining $595, $2,006 and $6,038 were software development projects capitalized in 2009, 2008 and 2007, respectively. The Company amortizes such fees over various periods beginning on the date the software is placed in service. In 2009, 2008 and 2007, amortization of software development costs of $2,557, $8,682 and $2,863, respectively, was charged to operations, and unamortized costs of $13,582 and $15,544 were included in other assets for the years ended December 31, 2009 and 2008, respectively. The increase in the amortization charge in 2008 was attributable to a write-off of previously capitalized software development costs of $6,383.
Under a royalty agreement effective from January 1, 2003 through April 30, 2009, the Company received 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 $62, $186 and $265 for the years ended December 31, 2009, 2008 and 2007, respectively. Under a similar marketing agreement effective from March 1, 2006 through April 30, 2009, the Company received commissions from MFXChange Ireland Limited (“MFX Ireland”) for the introduction of customers to MFX Ireland. Under this agreement, the Company recorded $83, $200 and $291 in the years ended December 31, 2009, 2008 and 2007, respectively.
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 $1,800, $2,398 and $3,855 in 2009, 2008 and 2007, respectively.
The Company receives loss adjustment services from Cunningham Lindsey U.S., Inc., an affiliate of Fairfax. Expenses incurred for these services were $234, $602 and $794 for the years ended December 31, 2009, 2008 and 2007, respectively.
Included in accounts payable and other liabilities at December 31, 2009 and 2008 are amounts payable to Fairfax and affiliates of $1,475 and $70, respectively. Included in other assets at December 31, 2009 and 2008 are amounts receivable from Fairfax and affiliates of $13 and $803, respectively.
In accordance with guidance provided under ASC 715, Compensation - Retirement Benefits, the Company recognizes the over or underfunded status of its postretirement plans in its balance sheet and records the change in funded status, in the year in which the change occurs, through comprehensive income. At December 31, 2009 and 2008, the Company’s postretirement benefit obligation for healthcare and life insurance benefits, which is an unfunded liability, was $4,548 and $5,581, respectively. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 5.5% and 6.25% at December 31, 2009 and 2008, respectively. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 2009, the health care cost trend rates are assumed to decline gradually from 29.8% in 2010 to 6.0% in 2022 and thereafter for all participants. Increasing or decreasing the assumed health care cost trend rates by one percentage point in each year would not materially increase or decrease the accumulated postretirement benefit obligation at December 31, 2009.
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 $67, $506 and $564 for the years ended December 31, 2009, 2008 and 2007, respectively, is included in the consolidated statements of income.
The Company had commitments to fund limited partnership investments totaling $11,859 and $12,450 at December 31, 2009 and 2008, respectively. These capital commitments can be called by the partnerships during the commitment period (generally five years or less) to fund working capital needs or the purchase of new investments.
The Company’s subsidiaries are involved in various lawsuits and arbitration proceedings arising in the ordinary course of business. While the outcome of such matters cannot be predicted with certainty, in the opinion of management, no such matter is likely to have a material adverse effect on the Company’s consolidated net income, financial position or liquidity. However, it should be noted that the frequency of large damage awards in some jurisdictions, including punitive damage awards that bear little or no relation to actual economic damages incurred by plaintiffs, continues to create the potential for an unpredictable judgment in any given matter.
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 domiciled in Delaware and New Jersey, respectively. The maximum dividends that can be paid by the insurance subsidiaries to the Company in 2010, without prior regulatory approval, ares $163,776.
The loss and LAE amounts and loss and LAE ratios of the Company’s lines of business, as estimated at the respective year-end, are summarized as follows: