Our insurance group leases approximately 8,750 square feet in Hamilton, Bermuda for our Bermuda insurance operations. The principal U.S. office of our insurance group support operations (excluding underwriting units) is in Jersey City, New Jersey where we lease approximately 106,800 square feet. Such lease expires in 2024. We lease approximately 68,000 square feet in New York City for the headquarters of the U.S. insurance group's underwriting product lines and Northeast regional underwriting operations. Our insurance group also leases a total of approximately 223,300 square feet for its other primary U.S. offices and its office in Canada.
Arch Insurance Europe leases approximately 15,770 square feet in London. Arch Re Denmark, a branch of Arch Insurance Europe and Arch Re Europe, leases approximately 3,650 square feet in Denmark, and Arch Re Europe leases a total of approximately 1,800 square feet in Dublin and Zurich. ACGL leases approximately 4,000 square feet in Bermuda. In addition, Arch Capital Services Inc., a subsidiary of ACGL which provides certain financial, legal and other administrative support services for ACGL and its subsidiaries, leases approximately 16,730 square feet in White Plains, New York.
The following table sets forth summary historical consolidated financial and operating data for the five-year period ended December 31, 2009 and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our financial statements and the related notes.
(1)After-tax operating income available to common shareholders is defined as net income available to common shareholders, excluding net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. The presentation of after-tax operating income available to common shareholders is a "non-GAAP financial measure" as defined in Regulation G. See "Management's Discussion and Analysis-General-Comment on Non-GAAP Financial Measures" for further details.
(3)Reflects the impact of our share repurchase program, which resulted in repurchases of 6.7 million, 7.5 million and 7.8 million common shares, respectively, in the years ended December 31, 2009, 2008 and 2007.
Arch Capital Group Ltd. ("ACGL" and, together with its subsidiaries, "we" or "us") is a Bermuda public limited liability company with over $4.7 billion in capital at December 31, 2009 and, through operations in Bermuda, the United States, Europe and Canada, writes insurance and reinsurance on a worldwide basis. While we are positioned to provide a full range of property and casualty insurance and reinsurance lines, we focus on writing specialty lines of insurance and reinsurance. It is our belief that our underwriting platform, our experienced management team and our strong capital base that is unencumbered by significant pre-2002 risks have enabled us to establish a strong presence in the insurance and reinsurance markets.
We monitor our natural catastrophe risk globally for all perils and regions, in each case, where we believe there is significant exposure. Our models employ both proprietary and vendor-based systems and include cross-line correlations for property, marine, offshore energy, aviation, workers compensation and personal accident. Currently, we seek to limit our 1-in-250 year return period net probable maximum pre-tax loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders' equity. We reserve the right to change this threshold at any time. Based on in-force exposure estimated as of January 1, 2010, our modeled peak zone catastrophe exposure is a hurricane affecting the Florida Tri-County area, with a net probable maximum pre-tax loss of $750 million, compared to $826 million as of October 1, 2009. Our exposures to other perils, such as U.S. earthquake and international events, are less than the exposures arising from U.S. hurricanes. As of January 1, 2010, our modeled peak zone earthquake exposure (Los Angeles area earthquake) represented less than 80% of our peak zone hurricane exposure, and our modeled peak zone international exposure (United Kingdom windstorm) is substantially less than both our peak zone hurricane and earthquake exposures. Net probable maximum pre-tax loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones. The loss estimates shown above do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer a net loss greater than 25% of our total shareholders' equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders' equity exposed to a single catastrophic event. In addition, actual losses may increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See "Risk Factors-Risk Relating to Our Industry" and "Management's Discussion and Analysis of Financial Condition and Results of Operations-Natural and Man-Made Catastrophic Events."
Book value per common share was $73.01 at December 31, 2009, compared to $51.36 at December 31, 2008 and $55.12 at December 31, 2007. The 42.2% growth in 2009 was generated through the underwriting results of our insurance and reinsurance operations and investment returns which reflected recoveries in value across most asset classes. From December 31, 2004 to 2009, book value per common share increased by an average of 18.7%.
return against which we measured our portfolio during the year. Our investment expenses were approximately 0.20% of average invested assets in 2009, compared to 0.14% in 2008 and 0.15% in 2007.
Throughout this filing, we present our operations in the way we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use our financial information in evaluating the performance of our company. This presentation includes the use of after-tax operating income available to common shareholders, which is defined as net income available to common shareholders, excluding net realized gains or losses, net impairment losses included in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. The presentation of after-tax operating income available to common shareholders is a "non-GAAP financial measure" as defined in Regulation G. The reconciliation of such measure to net income available to common shareholders (the most directly comparable GAAP financial measure) in accordance with Regulation G is included under "Results of Operations" below.
2008 versus 2007: Gross premiums written by the insurance segment were 6.4% lower than 2007, as the insurance segment continued to maintain underwriting discipline in response to the market environment with reductions across most specialty lines of business. Net premiums written decreased by 3.5%, reflecting the market environment, reinstatement premiums and the impact of changes in reinsurance structure.
Commencing in 2006, Arch Reinsurance Ltd. ("Arch Re Bermuda") ceded certain lines of property and marine premiums written under a quota share reinsurance treaty (the "Treaty") to Flatiron Re Ltd. ("Flatiron"). Under the Treaty, Flatiron assumed a 45% quota share of certain lines of property and marine business underwritten by Arch Re Bermuda for the 2006 and 2007 underwriting years (the percentage ceded was increased from 45% to 70% of covered business bound from June 28, 2006 until August 15, 2006 provided such business did not incept beyond September 30, 2006). On December 31,
2007, the Treaty expired by its terms. See note 4, "Reinsurance," of the notes accompanying our consolidated financial statements for further details on the Treaty with Flatiron.
2008 versus 2007: Gross premiums written by the reinsurance segment in 2008 were 20.8% lower than 2007. For its January 1, 2008 renewals, Arch Re Bermuda adjusted its book of business in light of the expiration of the Treaty with Flatiron discussed above, and 2008 writings in certain property and marine lines were reduced accordingly. Other reductions in the reinsurance segment's book of business resulted from continued competition which led to non-renewals or lower shares written, partially offset by an increase in writings by the reinsurance segment's property facultative operation.
2008 versus 2007: The reinsurance segment's current year loss ratio was 16.2% higher in 2008 than 2007, primarily due to 19.6 points of catastrophic activity in 2008, compared to 4.3 points in 2007.
2009 prior period reserve development: The reinsurance segment's net favorable development of $142.1 million, or 12.3 points, consisted of $81.7 million from short-tailed lines and $80.4 million came from long-tailed lines, partially offset by $20.0 million of adverse development on medium-tailed lines. Favorable development in short-tailed lines included $57.6 million of favorable development from property catastrophe and other property lines. Such amount included reductions in 2005 to 2008 underwriting years of $9.9 million, $2.2 million, $17.8 million and $25.7 million, respectively. In addition, favorable development in short-tailed lines included $21.8 million from other specialty business, including $6.2 million and $7.5 million from the 2004 and 2005 underwriting years. The reduction of loss estimates for the reinsurance segment's short-tailed lines primarily resulted from a lower level of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2009. Net favorable development of $80.4 million in long-tailed lines included reductions in casualty reserves of $27.0 million, $34.6 million and $17.6 million from the 2004 to 2006 underwriting years which primarily resulted from a lower level of reported and paid claims activity than previously anticipated on U.S. and international excess liability, professional liability and D&O lines. Over time, historical loss information for older underwriting years has been given more weight in the reinsurance segment's reserving process based on the continued maturation of its reserves. Adverse development on medium-tailed lines resulted from increases on marine exposures in the 2008 underwriting year of $31.8 million, due in part to increases in Hurricane Ike estimates, partially offset by reductions in the 2004 to 2006 underwriting years.
2007 prior period reserve development: The reinsurance segment's net favorable development of $172.7 million, or 13.9 points, consisted of $110.6 million from short-tailed lines and $62.1 million from medium-tailed and long-tailed business. The reinsurance segment's favorable development in short-tailed lines of $110.6 million included $66.7 million of favorable development from property catastrophe and other property lines. Of such amount, $16.6 million and $44.3 million came from the 2004 and 2006 underwriting years, respectively. In addition, favorable development in short-tailed lines reflected $47.0 million of favorable development in other specialty business, including $7.9 million,
$11.1 million, $12.4 million and $14.4 million from the 2003 to 2006 underwriting years, respectively. The reduction of loss estimates for the reinsurance segment's short-tailed lines primarily resulted from a lower level of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2007. The net favorable development of $62.1 million in medium-tailed and long-tailed lines was primarily in casualty reserves from the 2003 to 2004 underwriting years, which contributed $17.5 million and $28.5 million, respectively. The reductions in casualty reserves primarily resulted from a lower level of reported and paid claims activity than previously anticipated on U.S. and international excess liability, professional liability and D&O lines.
2009 versus 2008: The underwriting expense ratio for the reinsurance segment was 29.1% in 2009, compared to 29.4% in 2008. The acquisition expense ratio for 2009 was 22.1%, compared to 22.7% for 2008. Commission income from the Treaty with Flatiron discussed above (in excess of the reimbursement of direct acquisition expenses) reduced the reinsurance segment's acquisition expense ratio by 0.7 points in 2009, compared to 2.0 points in 2008. In addition, the 2009 acquisition expense ratio reflected 0.3 points related to estimated net favorable development in prior year loss reserves, compared to 1.0 points in 2008. The comparison of the 2009 and 2008 acquisition expense ratios is influenced by, among other things, the mix and type of business written and earned and the level of ceding commission income. The reinsurance segment's other operating expense ratio was 7.0% for 2009, compared to 6.7% for 2008. The higher ratio in 2009 resulted in part from a lower level of net premiums earned and a higher weighted contribution from the reinsurance segment's property facultative operations, which operates at a higher operating expense ratio due to the nature of its business.
2008 versus 2007: The underwriting expense ratio for the reinsurance segment was 29.4% in 2008, compared to 28.9% in 2007. The acquisition expense ratio for 2008 was 22.7%, compared to 22.4% for 2007. Commission income from the Treaty with Flatiron discussed above (in excess of the reimbursement of direct acquisition expenses) reduced the reinsurance segment's acquisition expense ratio by 2.0 points in 2008, compared to 3.1 points in 2007. In addition, the 2008 acquisition expense ratio reflected 1.0 points related to estimated net favorable development in prior year loss reserves, compared to 1.5 points in 2007. The comparison of the 2008 and 2007 acquisition expense ratios is influenced by, among other things, the mix and type of business written and earned and the level of ceding commission income. The reinsurance segment's other operating expense ratio was 6.7% for 2008, compared to 6.5% for 2007. The higher ratio in 2008 primarily resulted from a lower level of net premiums earned.
Net realized gains (losses) were as follows, excluding other-than-temporary impairment provisions:
Currently, our portfolio is actively managed to maximize total return within certain guidelines. In assessing returns under this approach, we include net investment income, net realized gains and losses and the change in unrealized gains and losses generated by our investment portfolio. The effect of financial market movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced. Total return on our portfolio under management for 2009 was 11.28%, compared to (2.84%) for 2008 and 6.52% for 2007. Excluding foreign exchange, total return was 10.56% for 2009, compared to (2.00%) for 2008 and 5.99% for 2007. Total return is calculated on a pre-tax basis and before investment expenses. The lower total return in 2008 compared to 2007 and 2009 was primarily due to the widening credit spreads which occurred during the last half of 2008, along with the impact of foreign exchange rate changes. For all periods presented, net realized gains or losses from the sale of fixed maturities primarily resulted from our decisions to reduce credit exposure, changes in duration targets, relative value determinations and sales related to rebalancing the portfolio. In addition, net realized gains or losses for 2009 and 2008 include changes in the market value of certain hybrid securities pursuant to applicable guidance. We recorded realized gains of $14.8 million on such securities in 2009, compared to realized losses of $5.4 million in 2008.
successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL's shareholders' equity and earnings could be materially adversely affected. ACGL has subsidiaries and branches that operate in various jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The significant jurisdictions in which ACGL's subsidiaries and branches are subject to tax are the United States, United Kingdom, Ireland, Canada, Switzerland and Denmark. See "Risk Factors-Risks Relating to Taxation" and "Business-Tax Matters."
Loss Reserves for our insurance operations are comprised of (1) estimated amounts for claims reported ("case reserves") and (2) incurred but not reported ("IBNR") losses. For our insurance operations, generally, claims personnel determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices, the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. Our insurance operations also contract with a number of outside third party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of such administrators is reviewed and monitored by our claims personnel. Loss Reserves are also established to provide for loss adjustment expenses and represent the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made. IBNR reserves are established to provide for incurred claims which have not yet been reported to an insurer or reinsurer at the balance sheet date as well as to adjust for any projected variance in case reserving. IBNR reserves are derived by subtracting paid losses and loss adjustment expenses and case reserves from estimates of ultimate losses and loss adjustment expenses. Actuaries estimate ultimate losses and loss adjustment expenses using various generally accepted actuarial methods applied to known losses and other relevant information. Like case reserves, IBNR reserves are adjusted as additional information becomes known or payments are made. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain.
estimating ultimate losses and loss adjustment expenses are magnified by the time lag between when a claim actually occurs and when it is reported and settled. This time lag is sometimes referred to as the "claim-tail". The claim-tail for most property coverages is typically short (usually several months up to a few years). The claim-tail for certain professional liability, executive assurance and healthcare coverages, which are generally written on a claims-made basis, is typically longer than property coverages but shorter than casualty lines. The claim-tail for liability/casualty coverages, such as general liability, products liability, multiple peril coverage, and workers' compensation, may be especially long as claims are often reported and ultimately paid or settled years, even decades, after the related loss events occur. During the long claims reporting and settlement period, additional facts regarding coverages written in prior accident years, as well as about actual claims and trends, may become known and, as a result, our insurance operations may adjust their reserves. If management determines that an adjustment is appropriate, the adjustment is recorded in the accounting period in which such determination is made in accordance with GAAP. Accordingly, should Loss Reserves need to be increased or decreased in the future from amounts currently established, future results of operations would be negatively or positively impacted, respectively.
At December 31, 2009 and 2008, Loss Reserves for our insurance operations by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
Although Loss Reserves are initially determined based on underwriting and pricing analysis, our insurance operations apply several generally accepted actuarial methods, as discussed below, on a quarterly basis to evaluate their Loss Reserves, in addition to the expected loss method, in particular for Loss Reserves from more mature accident years (the year in which a loss occurred). As noted below, beginning in 2005, our insurance operations began to give a relatively small amount of weight to their own experience following reviews of open claims on lines of business written on a claims-made basis for which they developed a reasonable level of credible data. Each quarter, as part of the reserving process, actuaries at our insurance operations reaffirm that the assumptions used in the reserving process continue to form a sound basis for the projection of liabilities. If actual loss activity differs substantially from expectations based on historical information, an adjustment to loss reserves may be supported. Estimated Loss Reserves for more mature accident years are now based more on historical loss activity and patterns than on the initial assumptions based on pricing indications. More recent accident years rely more heavily on internal pricing assumptions. Our insurance operations place more or less reliance on a particular actuarial method based on the facts and circumstances at the time the estimates of Loss Reserves are made. These methods generally fall into one of the following categories or are hybrids of one or more of the following categories:
•Expected loss methods - these methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information derived by underwriters and actuaries during the initial pricing of the business, supplemented by industry data available from organizations, such as statistical bureaus and consulting firms, where appropriate. These ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. Expected loss methods are useful for estimating ultimate losses and loss adjustment expenses in the early years of long-tailed lines of business, when little or no paid or incurred loss information is available, and is commonly applied when limited loss experience exists for a company.
•Historical paid loss development methods - these methods, like historical incurred loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant. These methods use historical loss payments over discrete periods of time to
•Bornhuetter-Ferguson ("B-F") paid and incurred loss methods - these methods utilize actual paid and incurred losses and expected patterns of paid and incurred losses, taking the initial expected ultimate losses into account to determine an estimate of expected ultimate losses. The B-F paid and incurred loss methods are useful when there are few reported claims and a relatively less stable pattern of reported losses.
•Additional analyses - other methodologies are often used in the reserving process for specific types of claims or events, such as catastrophic or other specific major events. These include vendor catastrophe models, which are typically used in the estimation of Loss Reserves at the early stage of known catastrophic events before information has been reported to an insurer or reinsurer, and analyses of specific industry events, such as large lawsuits or claims.
For the years ended December 31, 2007 to 2009, on average, our insurance segment reported approximately $46 million of estimated net favorable development in prior year Loss Reserves, or approximately 1.6% of average beginning Loss Reserves. Of such amount, approximately $38 million came from medium-tail lines, or 3.1% of beginning medium-tail Loss Reserves and $11 million from long-tail lines, or 1.0% of average beginning long-tail Loss Reserves, offset partially by adverse development of $3 million from short-tail lines, or 0.5% of average beginning short-tail Loss Reserves. For the year ended December 31, 2009, estimated net favorable development in prior year Loss Reserves was approximately $47 million, or 1.4% of beginning Loss Reserves. Such amount consisted of approximately $40 million from medium-tail lines, or 2.9% of beginning medium-tail Loss Reserves, and $22 million from short-tail lines, or 3.3% of beginning short-tail Loss Reserves, partially offset by adverse development of $15 million from long-tail lines, or 1.2% of beginning long-tail Loss Reserves. For informational purposes, based on historical results, applying the 1.6% average estimated net favorable development in average beginning Loss Reserves for the years ended December 31, 2007 to 2009 to our insurance segment's net Loss Reserves of $3.6 billion at December 31, 2009 would result in an increase in income before income taxes of approximately $58 million, or $0.93 per diluted share, and applying the 1.4% of estimated net favorable development in beginning Loss Reserves for the year ended December 31, 2009 to such Loss Reserves would result in an increase in income before income taxes of approximately $51 million, or $0.83 per diluted share. The amounts noted above are informational only and should not be considered projections of future events. Future favorable or adverse development in our insurance segment's Loss Reserves is subject to numerous factors, and no assurances can be given that we will experience favorable development in our Loss Reserves or that our ultimate losses will not be significantly different than the amounts shown above, and such differences could directly and significantly impact earnings favorably or unfavorably in the period they are determined. Because of our insurance segment's limited operating history, the sensitivity analysis above is one way to gauge the impact of changes in the assumptions in our reserving process. For another estimate of potential variability in our insurance segment's Loss Reserves, see "-Simulation Results." Refer to "-Results of Operations" for a discussion on net favorable or adverse development of our insurance operations' prior year Loss Reserves.
Loss Reserves for our reinsurance operations are comprised of (1) case reserves for claims reported, (2) additional case reserves ("ACRs") and (3) IBNR reserves. Our reinsurance operations
As mentioned above, there can be a considerable time lag from the time a claim is reported to a ceding company to the time it is reported to the reinsurer. The lag can be several years in some cases and may be attributed to a number of reasons, including the time it takes to investigate a claim, delays associated with the litigation process, the deterioration in a claimant's physical condition many years after an accident occurs, the case reserving approach of the ceding company, etc. In the reserving process, our reinsurance operations assume that such lags are predictable, on average, over time and therefore the lags are contemplated in the loss reporting patterns used in their actuarial methods. This means that our reinsurance operations must rely on estimates for a longer period of time than does an insurance company.
Our reinsurance operations rely heavily on information reported by ceding companies, as discussed above. In order to determine the accuracy and completeness of such information, underwriters, actuaries, and claims personnel at our reinsurance operations often perform audits of ceding companies
The reserving method for our reinsurance operations to date has been, to a large extent, the expected loss method, which is commonly applied when limited loss experience exists. Over time, other common reserving methodologies have begun to be employed. Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that relatively limited historical information has been reported to our reinsurance operations through December 31, 2009 in some lines of business. See below for a discussion of the key assumptions in our reinsurance operations' reserving process.
Generally, due to the insufficient amount of historical loss data for our insurance and reinsurance operations in many lines of business, we do not produce a range of estimates in calculating reserves. As described above, we primarily use the expected loss method to calculate our initial Loss Reserves, and such amounts represent management's best estimate of our ultimate liabilities. As the loss data has developed, other actuarial methods have been given more weight in our reserving process for certain lines of business. In order to illustrate the potential volatility in our Loss Reserves, we used a Monte Carlo simulation approach to simulate a range of results based on various probabilities. Both the probabilities and related modeling are subject to inherent uncertainties. The simulation relies on a significant number of assumptions, such as the potential for multiple entities to react similarly to external events, and includes other statistical assumptions.
At December 31, 2009, our recorded Loss Reserves by operating segment, net of unpaid losses and loss adjustment expenses recoverable and the results of the simulation were as follows:
Our insurance operations had in effect during 2009 a reinsurance program which provided coverage equal to a maximum of 80% of the first $275 million in excess of a $75 million retention per occurrence for certain property catastrophe-related losses occurring during 2009. During 2008, a reinsurance program was in effect which provided coverage equal to a maximum of 70% of the first $275 million in excess of a $75 million retention per occurrence for certain property catastrophe-related losses occurring during 2008, compared to a maximum of 88% of the first $325 million in excess of a $75 million retention per occurrence during 2007. In the 2010 first quarter, our insurance operations renewed its reinsurance program which provides coverage for certain property-catastrophe related losses occurring during 2010 equal to a maximum of 77% of the first $275 million in excess of a $75 million retention per occurrence.
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Premiums written include estimates in our insurance operations' programs, specialty lines, collateral protection business and for participation in involuntary pools. The amount of such insurance premium estimates included in premiums receivable and other assets at December 31, 2009 and 2008 was $49.2 million and $52.0 million, respectively. Such premium estimates are derived from multiple sources which include the historical experience of the underlying business, similar business and available industry information. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of in-force insurance policies.
Reinsurance premiums written include amounts reported by brokers and ceding companies, supplemented by our own estimates of premiums where reports have not been received. The determination of premium estimates requires a review of our experience with the ceding companies, familiarity with each market, the timing of the reported information, an analysis and understanding of the characteristics of each line of business, and management's judgment of the impact of various factors, including premium or loss trends, on the volume of business written and ceded to us. On an ongoing basis, our underwriters review the amounts reported by these third parties for reasonableness based on their experience and knowledge of the subject class of business, taking into account our historical experience with the brokers or ceding companies. In addition, reinsurance contracts under which we assume business generally contain specific provisions which allow us to perform audits of the ceding company to ensure compliance with the terms and conditions of the contract, including accurate and timely reporting of information. Based on a review of all available information, management establishes premium estimates where reports have not been received. Premium estimates are updated when new information is received and differences between such estimates and actual amounts are recorded in the period in which estimates are changed or the actual amounts are determined. Premiums written are recorded based on the type of contracts we write. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, the minimum premium, as defined in the contract, is generally recorded as an estimate of premiums written as of the inception date of the treaty. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.
Acquisition expenses and other expenses that vary with, and are directly related to, the acquisition of business in our underwriting operations are deferred and amortized over the period in which the related premiums are earned. Acquisition expenses, net of ceding commissions received from unaffiliated reinsurers, consist primarily of commissions, brokerage and taxes paid to obtain our business. Other operating expenses also include expenses that vary with, and are directly related to, the acquisition of business. Deferred acquisition costs, which are based on the related unearned premiums, are carried at their estimated realizable value and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income.
We determine the existence of an active market based on our judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. We use quoted values and other data provided by nationally recognized independent pricing sources as inputs into our process for determining fair values of our fixed maturity investments. To validate the techniques or models used by pricing sources, our review process includes, but is not limited to: (i) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to their target benchmark, with significant differences identified and investigated); (ii) a review of the average number of prices obtained in the pricing process and the range of resulting market values; (iii) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value including a review of deep dive reports on selected securities which indicated the use of observable inputs in the pricing process; (iv) comparing the fair value estimates to our knowledge of the current market; (v) a comparison of the pricing services' fair values to other pricing services' fair values for the same investments; and (vi) back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. At December 31, 2009 and 2008, we obtained an average of 2.6 quotes per investment. Where multiple quotes or prices were obtained, a price source hierarchy was maintained in order to determine which price source provided the fair value (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used from a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, we will challenge any prices for a security or portfolio which are considered not to be representative of fair value.
The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for
determining the fair value of securities that are not actively traded. In general, these methods involve the use of "matrix pricing" in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair market value. In addition, pricing vendors use model processes, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage backed and asset backed securities. In certain circumstances, when fair market values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above. Of the $10.74 billion of financial assets and liabilities measured at fair value, approximately $1.17 billion, or 10.8%, were priced using non-binding broker-dealer quotes.
This guidance required that we record, as of the beginning of the interim period of adoption, a cumulative effect adjustment to reclassify the noncredit component of a previously recognized OTTI from retained earnings to other comprehensive income (loss). For purposes of calculating the cumulative effect adjustment, we reviewed OTTI that we had recorded through realized losses on securities held at December 31, 2008, which were $171.1 million, and estimated the portion related to credit losses (i.e., where the present value of cash flows expected to be collected are lower than the amortized cost basis of the security) and the portion related to all other factors. We determined that $109.1 million of the OTTI previously recorded related to specific credit losses and $62.0 million related to all other factors. We increased the amortized cost basis of these debt securities by $62.0 million and recorded a cumulative effect adjustment, net of tax, in our shareholders' equity section. The cumulative effect adjustment had no effect on total shareholders' equity as it increased retained earnings and reduced accumulated other comprehensive income.
We performed quarterly reviews of our investments in 2009, 2008 and 2007 in order to determine whether declines in market value below the amortized cost basis were considered other-than-temporary in accordance with applicable guidance. During 2009, we recorded $66.1 million of net impairment losses recognized in earnings, compared to $181.2 million in 2008 and $30.2 million in 2007. See note 7, "Investment Information-Other-Than-Temporary Impairments," of the notes accompanying our consolidated financial statements for additional information.
The finance and investment committee of our board of directors establishes our investment policies and sets the parameters for creating guidelines for our investment managers. The finance and investment committee reviews the implementation of the investment strategy on a regular basis. Our current approach stresses preservation of capital, market liquidity and diversification of risk. While maintaining our emphasis on preservation of capital and liquidity, we expect our portfolio to become more diversified and, as a result, we may expand into areas which are not currently part of our investment strategy. Our Chief Investment Officer administers the investment portfolio, oversees our investment managers, formulates investment strategy in conjunction with our finance and investment committee and directly manages certain portions of our fixed income portfolio.
On a consolidated basis, our aggregate investable assets totaled $11.38 billion at December 31, 2009, compared to $9.97 billion at December 31, 2008, as detailed in the table below:
(2)We participate in the Federal Reserve Bank of New York's ("FRBNY") Term Asset-Backed Securities Loan Facility ("TALF"), which provides secured financing for asset-backed securities backed by certain types of consumer and small-business loans and for legacy commercial mortgage-backed securities. See "-Contractual Obligations and Commercial Commitments-TALF Program" for further details on the TALF program.
(3)Our investment portfolio includes certain funds that invest in fixed maturity securities which, due to the ownership structure of the funds, are accounted for by us using the equity method. In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which include changes in the market value of the underlying securities in the funds). Changes in the carrying value of such investments are recorded as "Equity in net income (loss) of investment funds accounted for using the equity method" rather than as an unrealized gain or loss component of accumulated other comprehensive income in shareholders' equity as are changes in the carrying value of our other fixed income investments.
At December 31, 2009, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had a "AA+" average credit quality rating, an average effective duration of 2.87 years, and an average yield to maturity (imbedded book yield), before investment expenses, of 3.64%. At December 31, 2008, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had a "AA+" average credit quality rating, an average effective duration of 3.62 years, and an average yield to maturity (imbedded book yield), before investment expenses, of
4.55%. At December 31, 2009, approximately $6.6 billion, or 58%, of total investable assets was internally managed, compared to $5.3 billion, or 52%, at December 31, 2008. Our fixed maturities at December 31, 2009 included exposures to certain corporate sectors, such as the financial sector (8% of total investable assets) and the industrial sector (5% of total investable assets).
The following table summarizes our fixed maturities and fixed maturities pledged under securities lending agreements, excluding TALF investments:
The credit quality distribution of our fixed maturities and fixed maturities pledged under securities lending agreements is shown below. Approximately 95% of the fixed maturities and fixed maturities
under securities lending agreements which were in an unrealized loss position at December 31, 2009 and 2008:
At December 31, 2009 and 2008, below-investment grade securities comprised approximately 4.9% and 2.7%, respectively, of our fixed maturities and fixed maturities pledged under securities lending agreements. In accordance with our investment strategy, we invest in high yield fixed income securities which are included in "Corporate bonds." Upon issuance, these securities are typically rated below investment grade (i.e., rating assigned by the major rating agencies of "BB" or less). At December 31, 2009, corporate bonds represented 27% of the total below investment grade securities at market value, mortgage backed securities represented 69% of the total and 4% were in other classes. At December 31, 2008, corporate bonds represented 94% of the total below investment grade securities at market value while mortgage backed securities represented 6% of the total. The improvement in the percentage of below investment grade corporate bonds in 2009 primarily reflected tightening credit spreads while the higher percentage of mortgage backed securities primarily reflected rating downgrades on certain positions during 2009.
We determine estimated recovery values for our fixed maturities and fixed maturities pledged under securities lending agreements following a review of the business prospects, credit ratings, estimated loss given default factors and information received from asset managers and rating agencies for each security. For structured securities, we utilize underlying data, where available, for each security provided by asset managers and additional information from credit agencies in order to determine an expected recovery value for each security. The analysis provided by the asset managers includes expected cash flow projections under base case and stress case scenarios which modify expected default expectations and loss severities and slow down prepayment assumptions. In the tables above, securities at December 31, 2009 which were in an unrealized loss position of greater than 40% of amortized cost were primarily in asset backed and mortgage backed securities where the estimated market value for the securities was lower than our expected recovery value.
Our portfolio includes investments, such as mortgage-backed securities, which are subject to prepayment risk. At December 31, 2009, our investments in mortgage-backed securities ("MBS"), excluding commercial mortgage-backed securities, amounted to approximately $1.45 billion, or 12.7% of total investable assets, compared to $1.58 billion, or 15.9%, at December 31, 2008. As with other fixed income investments, the market value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to changes in the prepayment rate on these investments. In periods of declining interest rates, mortgage prepayments generally increase and MBS are prepaid more quickly, requiring us to reinvest the proceeds at the then current market rates. Conversely, in periods of rising rates, mortgage prepayments generally fall, preventing us from taking full advantage of the higher level of rates. However, current economic conditions may curtail prepayment activity as refinancing becomes more difficult, thus limiting prepayments on MBS.
The following table provides information on our mortgage backed securities ("MBS") and CMBS at December 31, 2009, excluding amounts guaranteed by the U.S. government:
(2) The weighted average life for MBS is based on the interest rates in effect at December 31, 2009. The weighted average life for CMBS reflects the average life of the collateral underlying our CMBS holdings.
(5) Current credit support % represents the percentage for a collateralized mortgage obligation ("CMO") or CMBS class/tranche from other subordinate classes in the same CMO or CMBS deal.
(6) Represents Re-REMICs issued in 2009 with an average credit quality of "AAA" from Fitch Ratings.
The following table provides information on our asset backed securities ("ABS") at December 31, 2009:
Our investment strategy allows for the use of derivative instruments. We utilize various derivative instruments such as futures contracts to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. See note 9, "Derivative Instruments," of the notes accompanying our consolidated financial statements for additional disclosures concerning derivatives.
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. See note 8, "Fair Value" of the notes accompanying our consolidated financial statements for a summary of our financial assets and liabilities measured at fair value at December 31, 2009 and 2008 by level.
At December 31, 2009, approximately 73% of premiums receivable of $595.0 million represented amounts not yet due, while amounts in excess of 90 days overdue were 4.2% of the total. At December 31, 2008, approximately 62.0% of premiums receivable of $629.0 million represented amounts not yet due, while amounts in excess of 90 days overdue were 4.1% of the total. Approximately 9.1% of the $60.8 million of paid losses and loss adjustment expenses recoverable were in excess of 90 days overdue at December 31, 2009, compared to 2.2% of the $63.3 million of paid losses and loss adjustment expenses recoverable at December 31, 2008. At December 31, 2009 and 2008, our reserves for doubtful accounts were approximately $9.5 million and $5.8 million, respectively.
reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of $1.79 billion were due from carriers which had an A.M. Best rating of "A-" or better, and the largest reinsurance recoverable from any one carrier was less than 7.3% of our total shareholders' equity.
(4)The A.M. Best group rating of "A" (Excellent) has been applied to all Lloyd's syndicates.
(6)A substantial portion of such amount is collateralized through reinsurance trusts or letters of credit.
We establish reserves for losses and loss adjustment expenses ("Loss Reserves") which represent estimates involving actuarial and statistical projections, at a given point in time, of our expectations of the ultimate settlement and administration costs of losses incurred. Estimating Loss Reserves is inherently difficult, which is exacerbated by the fact that we are a relatively new company with relatively limited historical experience upon which to base such estimates. We utilize actuarial models as well as available historical insurance industry loss ratio experience and loss development patterns to assist in the establishment of Loss Reserves. Actual losses and loss adjustment expenses paid will deviate, perhaps substantially, from the reserve estimates reflected in our financial statements.
Our shareholders' equity was $4.32 billion at December 31, 2009, compared to $3.43 billion at December 31, 2008. The increase of $890.4 million in 2009 was attributable to net income and an after-tax increase in the market value of our investment portfolio, partially offset by share repurchase activity in the period.
ACGL is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, ACGL depends on its available cash resources, liquid investments and dividends or other distributions from its subsidiaries to make payments, including the payment of debt service obligations and operating expenses it may incur and any dividends or liquidation amounts with respect to the series A non-cumulative and series B non-cumulative preferred shares and common shares. ACGL's readily available cash, short-term investments and marketable securities, excluding amounts held by our regulated insurance and reinsurance subsidiaries, totaled $25.7 million at December 31, 2009, compared to $16.8 million at December 31, 2008. During 2009, ACGL received dividends of $530.4 million from Arch Re Bermuda which were used to fund the share repurchase program described below along with the payment of preferred dividends, interest expense and other corporate expenses.
Consolidated net cash provided by operating activities was $992.6 million for 2009, compared to $1.14 billion for 2008. The lower level of operating cash flows in 2009 primarily resulted from an increase in paid losses, as our insurance and reinsurance loss reserves have continued to mature, partially offset by an increase in net premium collections. Cash flow from operating activities are provided by premiums collected, fee income, investment income and collected reinsurance recoverables, offset by losses and loss adjustment expense payments, reinsurance premiums paid, operating costs and current taxes paid.
On a consolidated basis, our aggregate cash and invested assets totaled $11.3 billion at December 31, 2009, compared to $10.0 billion at December 31, 2008. The primary goals of our asset liability management process are to satisfy the insurance liabilities, manage the interest rate risk embedded in those insurance liabilities and maintain sufficient liquidity to cover fluctuations in projected liability cash flows, including debt service obligations. Generally, the expected principal and interest payments produced by our fixed income portfolio adequately fund the estimated runoff of our insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the market value of the fixed income portfolio exceeds the expected present value of the net insurance liabilities, as well as the positive cash flow from newly sold policies and the large amount of high quality liquid bonds, provide assurance of our ability to fund the payment of claims and to service our outstanding debt without having to sell securities at distressed prices in an illiquid market or access credit facilities.
In 2006, we entered into a five-year agreement for a $300.0 million unsecured revolving loan and letter of credit facility and a $1.0 billion secured letter of credit facility. Under the terms of the agreement, Arch Reinsurance Company ("Arch Re U.S.") is limited to issuing $100 million of unsecured letters of credit as part of the $300 million unsecured revolving loan. Arch Re Bermuda also has access to other letter of credit facilities, some of which are available on a limited basis for limited purposes. See "-Contractual Obligations and Commercial Commitments-Letters of Credit and Revolving Credit Facilities" for a discussion of our available facilities, applicable covenants on such facilities and available capacity. It is anticipated that the available facilities will be renewed (or replaced) on expiry, but such renewal (or replacement) will be subject to the availability of credit from banks which we utilize. Given the recent disruptions in the capital markets, we can provide no assurance that we will be able to renew the facilities in August 2011 on satisfactory terms and, if renewed, the costs of the facilities may be significantly higher than the costs of our existing facilities.
During 2006, ACGL completed two public offerings of non-cumulative preferred shares. On February 1, 2006, $200.0 million principal amount of 8.0% series A non-cumulative preferred shares ("series A preferred shares") were issued with net proceeds of $193.5 million and, on May 24, 2006, $125.0 million principal amount of 7.875% series B non-cumulative preferred shares ("series B preferred shares" and together with the series A preferred shares, the "preferred shares") were issued with net proceeds of $120.9 million. The net proceeds of the offerings were used to support the underwriting activities of ACGL's insurance and reinsurance subsidiaries. ACGL has the right to redeem all or a portion of each series of preferred shares at a redemption price of $25.00 per share on or after (1) February 1, 2011 for the series A preferred shares and (2) May 15, 2011 for the series B
preferred shares. Dividends on the preferred shares are non-cumulative. Consequently, in the event dividends are not declared on the preferred shares for any dividend period, holders of preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accrue and will not be payable. Holders of preferred shares will be entitled to receive dividend payments only when, as and if declared by ACGL's board of directors or a duly authorized committee of ACGL's board of directors. Any such dividends will be payable from the date of original issue on a non-cumulative basis, quarterly in arrears. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 8.0% of the $25.00 liquidation preference per annum for the series A preferred shares and 7.875% of the $25.00 liquidation preference per annum for the series B preferred shares. During 2009, 2008 and 2007, we paid $25.8 million to holders of the preferred shares and, at December 31, 2009, had declared an aggregate of $3.3 million of dividends to be paid to holders of the preferred shares.
At December 31, 2009, ACGL's capital of $4.72 billion consisted of $300.0 million of senior notes, representing 6.4% of the total, $100.0 million of revolving credit agreement borrowings due in August 2011, representing 2.1% of the total, $325.0 million of preferred shares, representing 6.9% of the total, and common shareholders' equity of $4.0 billion, representing the balance. At December 31, 2008, ACGL's capital of $3.83 billion consisted of $300.0 million of senior notes, representing 7.8% of the total, $100.0 million of revolving credit agreement borrowings due in August 2011, representing 2.6% of the total, $325.0 million of preferred shares, representing 8.5% of the total, and common shareholders' equity of $3.11 billion, representing the balance. TALF borrowings are not included in the calculation of total capital. The increase in capital during 2009 was primarily attributable to net income and an after-tax increase in the market value of our investment portfolio.
As of December 31, 2009, we had a $300 million unsecured revolving loan and letter of credit facility and a $1.0 billion secured letter of credit facility (the "Credit Agreement"). Under the terms of the agreement, Arch Re U.S. is limited to issuing $100 million of unsecured letters of credit as part of the $300 million unsecured revolving loan. Borrowings of revolving loans may be made by ACGL and Arch Re U.S. at a variable rate based on LIBOR or an alternative base rate at our option. Secured letters of credit are available for issuance on behalf of our insurance and reinsurance subsidiaries. The Credit Agreement and related documents are structured such that each party that requests a letter of credit or borrowing does so only for itself and for only its own obligations. Issuance of letters of credit and borrowings under the Credit Agreement are subject to our compliance with certain covenants and conditions, including absence of a material adverse change. These covenants require, among other things, that we maintain a debt to total capital ratio of not greater than 0.35 to 1 and shareholders' equity in excess of $1.95 billion plus 25% of future aggregate net income for each quarterly period (not including any future net losses) beginning after June 30, 2006 and 25% of future aggregate proceeds from the issuance of common or preferred equity and that our principal insurance and reinsurance subsidiaries maintain at least a "B++" rating from A.M. Best. In addition, certain of our subsidiaries which are party to the Credit Agreement are required to maintain minimum shareholders' equity levels. We were in compliance with all covenants contained in the Credit Agreement at December 31, 2009. The Credit Agreement expires on August 30, 2011.
Including the secured letter of credit portion of the Credit Agreement, we had access to letter of credit facilities for up to a total of $1.45 billion. Arch Re Bermuda also has access to other letter of credit facilities, some of which are available on a limited basis and for limited purposes (together with the secured portion of the Credit Agreement and these letter of credit facilities, the "LOC Facilities"). The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from our reinsurance subsidiaries in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd's in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, certain letters of credit are secured by a portion of our investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which we were in compliance with at December 31, 2009. At such date, we had $775.7 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a market
In May 2004, ACGL completed a public offering of $300.0 million principal amount of 7.35% senior notes ("Senior Notes") due May 1, 2034 and received net proceeds of $296.4 million. ACGL used $200.0 million of the net proceeds to repay all amounts outstanding under a revolving credit agreement. The Senior Notes are ACGL's senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. Interest payments on the Senior Notes are due on May 1st and November 1st of each year. ACGL may redeem the Senior Notes at any time and from time to time, in whole or in part, at a "make-whole" redemption price. For 2009, 2008 and 2007, interest expense on the Senior Notes was $22.1 million. The market value of the Senior Notes at December 31 2009 and 2008 was $298.6 million and $246.1 million, respectively.
The following table provides an analysis of our contractual commitments at December 31, 2009:
(1)The estimated expected contractual commitments related to the reserves for losses and loss adjustment expenses are presented on a gross basis. It should be noted that until a claim has been presented to us, determined to be valid, quantified and settled, there is no known obligation on an individual transaction basis, and while estimable in the aggregate, the timing and amount contain significant uncertainty. Approximately 68% of our net reserves were incurred but not reported at December 31, 2009.
or have not been previously, otherwise reflected therein. In addition, we determined that Flatiron is a variable interest entity but we are not required to consolidate the assets, liabilities and results of operations of Flatiron. Under the amended guidance governing accounting for VIEs, which is effective January 1, 2010, we do not expect that Flatiron will be considered a variable interest entity. See note 2 (n), "Recent Accounting Pronouncements," for information on the amended guidance. See note 4, "Reinsurance," of the notes accompanying our consolidated financial statements for information on Flatiron.
In accordance with the SEC's Financial Reporting Release No. 48, we performed a sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, market values or cash flows of our financial instruments as of December 31, 2009. Market risk represents the risk of changes in the market value of a financial instrument and consists of several components, including liquidity, basis and price risks.
The following table summarizes the effect that an immediate, parallel shift in the interest rate yield curve would have had on the portfolio at December 31, 2009 and 2008. Based on historical observations, there is a low probability that all interest rate yield curves would shift in the same direction at the same time. Furthermore, interest rate movements in many credit sectors during 2009 and 2008 have exhibited a much lower correlation to changes in U.S. Treasury yields. Accordingly, the actual effect of interest rate movements may differ materially from the amounts set forth below. For
In addition, we consider the effect of credit spread movements on the market value of our fixed maturities, fixed maturities pledged under securities lending agreements, short-term investments and certain of our other investments and investment funds accounted for using the equity method which invest in fixed income securities and the corresponding change in unrealized appreciation. As credit spreads widen, the market value of our fixed income securities falls, and the converse is also true.
Investment-Related Derivatives. Derivative instruments may be used to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. The market values of those derivatives are based on quoted market prices. See note 9, "Derivative Instruments," of the notes accompanying our consolidated financial Statements for additional disclosures concerning derivatives. At December 31, 2009, the notional value of the net long position of derivative instruments (excluding to-be-announced mortgage backed securities which are included in the fixed income securities analysis above and foreign currency forward contracts which are included in the foreign currency exchange risk analysis below) was $1.13 billion, compared to $919.6 million at December 31, 2008. A 100 basis point depreciation of the underlying exposure to these derivative instruments at December 31, 2009 and 2008 would have resulted in a reduction in net income of approximately $11.3 million and $9.2 million, respectively, and would have decreased book value per common share by $0.21 and $0.15, respectively.
We do not believe that inflation has had a material effect on our consolidated results of operations, except insofar as inflation may affect our reserves for losses and loss adjustment expenses and interest rates. The potential exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The anticipated effects of inflation on us are considered in our catastrophe loss models. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled.