The following table of selected financial data should be read in conjunction with our audited consolidated financial statements and the notes thereto and with “
The following is a discussion and analysis of our results of operations for the year ended December 31, 2012 compared to the year ended December 31, 2011 and for the year ended December 31, 2011 compared to the year ended December 31, 2010, and also a discussion of our financial condition as of December 31, 2012. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report on Form 10-K.
The financial measures that we believe are most meaningful in analyzing our performance and assessing whether we are achieving our objectives are growth in book value per share, net operating income, combined ratio, return on average shareholders’ equity and net operating return on average shareholders’ equity. The table below shows the key performance indicators as of December 31, 2012 and 2011 and for the years ended December 31, 2012, 2011 and 2010.
Combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned for property and casualty business.
We target a long-term net operating return on average shareholders' equity, or net operating ROE, of the risk free rate plus 10% over the cycle. We believe that in the current stage of the cycle, our net operating ROE is consistent with this long-term target. For the year ended December 31, 2012, our net operating ROE and return on average shareholders’ equity fell short of our target primarily due to the significant property catastrophe event losses and historically low fixed income investment yields.
Our net operating income, combined ratio, net operating ROE and return on average shareholders’ equity for the year ended December 31, 2011 were adversely impacted, compared to the year ended December 31, 2010, by the significant increase in property catastrophe losses in 2011.
We continued to actively manage our capital during the year by taking advantage of select opportunities to purchase our common shares. We spent $158.6 million to repurchase an aggregate of 6.9 million shares during the year at an average price of $23.04 per share, a 14.4% discount to our December 31, 2011 diluted book value per share. As of December 31, 2012, our remaining share repurchase authorization was $301.7 million.
The markets in which we operate historically have been cyclical. During periods of excess underwriting capacity, competition can result in lower pricing and less favorable policy terms for insurers and reinsurers. During periods of reduced underwriting capacity, pricing and policy terms are generally more favorable for insurers and reinsurers. We believe that the industry has been in a period of excess underwriting capacity, and while 2011 and 2012’s property catastrophe events likely eroded some of that capacity, there was not sufficient pressure on the industry to improve pricing significantly in 2012. In addition, a significant amount of capital has entered the industry in recent years from investors who have not traditionally invested in the insurance industry, but have been attracted by the potential for returns that can be uncorrelated with the rest of the financial services industry. The industry is also operating in a low interest rate environment, which makes it more difficult to generate significant investment income growth. Both of these factors generally result in lower net operating income, return on average shareholders’ equity and net operating return on average shareholders’ equity.
Although there remains uncertainty regarding the timing, location and scale of a favorable turn in the market, we believe that the industry has shown signs of improvement for 2013. However, we intend to maintain our underwriting discipline while actively managing our expenses.
We derive operating revenues from premiums from our insurance and reinsurance businesses. Additionally, we recognize returns from our investment portfolios.
Insurance and reinsurance premiums are a function of the amount and type of contracts written as well as prevailing market prices and conditions. Property and casualty premiums are earned over the terms of the underlying coverage. Life and annuity reinsurance premiums are generally earned when the premium is due from policyholders. Each of our insurance and reinsurance contracts contain different pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying
Our principal expenses are losses and benefits, acquisition costs, interest expense and general and administrative expenses. Losses and benefits are based on the amount and type of insurance and reinsurance contracts written by us during the current reporting period and information received during the current reporting period from clients pertaining to contracts written in prior years. We record losses and benefits based on estimates of the expected losses and benefits to be incurred on each contract written, utilizing a variety of actuarial methods. The ultimate losses and benefits depend on the actual costs to settle these liabilities. We increase or decrease losses and benefits estimates as actual claim reports are received. Our ability to make reasonable estimates of losses and benefits at the time of pricing our contracts is a critical factor in determining profitability.
General and administrative expenses are principally employee salaries, incentive compensation and related personnel costs, office rent, amortization of leasehold improvements, information technology expenditures and other operating costs. These costs generally do not vary with the amount of premiums written.
Our consolidated financial statements are prepared in accordance with GAAP, which require management to make estimates and assumptions. We believe that the following accounting policies affect the significant judgments and estimates used in the preparation of our consolidated financial statements.
The liability for property and casualty losses is the largest and most complex estimate in our consolidated balance sheet. The liability for losses, including loss adjustment expenses, represents estimates of the ultimate cost of all losses incurred but not paid as of the balance sheet date. The reserves are estimated on an undiscounted basis. We utilize a variety of standard actuarial methods to estimate our reserves. Although these actuarial methods have been developed over time, assumptions about anticipated size of loss and loss emergence patterns are subject to fluctuations. We review our estimate of reserves on a quarterly basis and consider all significant facts and circumstances then known. Newly reported loss information from clients or insureds is the principal contributor to adjustments to our loss reserve estimates. These adjustments are recognized in the period in which they are determined, and therefore can impact that period’s results either favorably (when reserve estimates established in prior periods are reduced) or adversely (when reserve estimates established in prior periods are increased).
casualty, medical malpractice, professional liability, surety, whole account and workers compensation lines of business.
(2) Property includes agriculture, aviation, marine & energy, property and other lines of business.
The overall proportion of case reserves and IBNR to total reserves has remained consistent for the year ended December 31, 2012 compared to the year ended December 31, 2011. An increase in the proportion of case reserves in our Global insurance and U.S. insurance segments has been offset by a decrease in the proportion of case reserves in our Alterra at Lloyd's segment. The shift in our Global insurance segment was principally due to significant increases in case reserves estimates on three contracts during the year and the reduction of IBNR due to favorable development of prior year reserves. In our U.S. insurance segment, the increase in case reserves were principally due to claims related to Hurricane Sandy in 2012. The decline in the proportion of case reserves in our Alterra at Lloyd's segment was principally due to growth in newer lines of business, the reserves for which are predominantly IBNR.
Our favorable (unfavorable) development of prior period loss reserves, net of reinsurance has been as follows for the years ended December 31, 2012, 2011 and 2010:
We reinsure or retrocede portions of certain risks for which we have accepted liability. In these transactions, we cede to a counterparty reinsurer or retrocessionaire all or part of the risk we have assumed. This purchase of reinsurance does not legally discharge our liability with respect to the obligations that we have insured or reinsured.
In connection with our ongoing analysis of our loss reserves, we review loss notifications and reports received from our clients to confirm that submitted claims are covered under the contract terms. Disputes with clients arise in the ordinary course of business due to coverage issues such as classes of business covered and interpretation of contract wording. We typically resolve any disputes through negotiations that could vary from a simple exchange of email correspondence to arbitration with a panel of experts. Our contracts generally provide for dispute resolution through arbitration. We are not currently involved in any coverage disputes that we believe would, individually or in the aggregate, have a material adverse effect upon our business or results of operations.
Gross and net reserve for property and casualty losses includes, for the first time, Alterra Capital UK, which we acquired in November 2008.
Gross and net reserve for property and casualty losses includes, for the first time, Harbor Point, which we acquired in May 2010.
Net unfavorable development for our U.S. insurance segment of $8.0 million, including $7.5 million and $3.2 million of net unfavorable development on the general casualty and property lines of business, respectively, relating to our contract binding business, the renewal rights for which we sold during 2011;
Net unfavorable development of $7.9 million arising from increases in reinsurance premium estimates. Changes in premium estimates occur on prior year contracts each year as we receive additional information on the underlying exposures insured and the associated loss is recorded, at the original loss ratio, concurrently with the premium adjustment. The unfavorable development was offset by an increase in earned premium net of acquisition costs of $8.5 million; and
Net unfavorable development of $1.6 million arising from increases in premium estimates in our global insurance segment.
For additional information on our reserves, including a reconciliation of losses and loss adjustment expense reserves for the years ended December 31, 2012, 2011 and 2010, refer to Note 7 of our audited consolidated financial statements included herein.
Level 2-Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.
Our hedge fund portfolio comprises a portfolio of limited partnership and stock investments in trading entities, or funds, which invest in a wide range of financial products. Investments in the funds are carried at fair value. The change in fair value is included in net realized and unrealized gains on investments and recognized in net income. The units of account that we fair value are our interests in the funds and not the underlying holdings of such funds. Thus, the inputs we use to value our investments in each of the funds may differ from the inputs used to value the underlying holdings of such funds. These funds are stated at fair value, which ordinarily will be the most recently reported net asset value as advised by the fund manager or administrator, where the fund’s underlying holdings can be in various quoted and unquoted investments. We believe the reported net asset value represents the fair value market participants would apply to an interest in the fund. The fund managers value their underlying investments at fair value in accordance with policies established by each fund, as described in each of their financial statements and offering memoranda. Based upon information provided by the fund managers, as of December 31, 2012, we estimate that over 83% of the underlying assets in the funds are publicly traded securities or have broker quotes available.
We have ongoing due diligence processes with respect to funds and their managers. These processes are designed to assist us in assessing the quality of information provided by, or on behalf of, each fund and in determining whether such information continues to be reliable or whether further review is necessary. Certain funds do not provide full transparency of their underlying holdings; however, we obtain the audited financial statements for every fund annually, and regularly review and discuss the fund performance with the fund managers to corroborate the reasonableness of the reported net asset values. While reported net asset value is the primary input to the review, when the net asset value is deemed not to be indicative of fair value, we may incorporate adjustments to the reported net asset value. Such adjustments may involve significant management judgment.
During the years ended December 31, 2012, 2011 and 2010, we wrote the following amounts of property and casualty reinsurance premiums on a quota share or proportional basis and excess of loss basis:
U.S. insurance - We offer property and casualty insurance coverage from our offices in the United States primarily to Fortune 3000 companies. Principal lines of business include general/excess liability, marine, professional liability and property.
Alterra at Lloyd’s - We offer property and casualty quota share and excess of loss insurance and reinsurance from our offices in London, Dublin and Zurich, primarily to medium- to large- sized international clients. Principal lines of business include accident & health, agriculture, aviation, financial institutions, international casualty, marine, professional liability and property.
Life and annuity reinsurance - We previously offered reinsurance products focusing on blocks of life and annuity business, which took the form of co-insurance transactions whereby the risks are reinsured on the same basis as the original policies. In 2010 we determined not to write any new life and annuity contracts in the foreseeable future.
We monitor the performance of all of our segments other than life and annuity reinsurance on the basis of underwriting income, loss ratio, acquisition cost ratio, general and administrative expense ratio and combined ratio along with other metrics. We monitor the performance of our life and annuity reinsurance business on the basis of income before taxes for the segment, which includes revenue from net premiums earned and allocated net investment income, and expenses from claims and policy benefits, acquisition costs and general and administrative expenses.
Consolidated Results of Operations-For the years ended December 31, 2012, 2011 and 2010
The loss ratio is calculated by dividing net losses and loss expenses by net premiums earned for the property and casualty business.
Premiums. Gross premiums written for the year ended December 31, 2012 increased by 3.5% compared to the prior year period. The principal reason for the increase was strategic growth in our Alterra at Lloyd’s and U.S. insurance segments partially offset by a decline in business written by our reinsurance segment. Certain lines within our reinsurance segment did experience growth in gross premiums written for the year ended December 31, 2012, including our property and credit/surety lines of business which generated growth through our Latin America operations.
Gross premiums written for the year ended December 31, 2011 increased by 35.0% compared to the year ended December 31, 2010. The principal reason for the increase was the additional reinsurance premiums written as a result of the Amalgamation, which were not included in the comparative period prior to May 12, 2010. In addition, favorable market conditions in the property and auto lines of business in the reinsurance segment resulted in increased premiums written in these lines. We also continued to expand our product offerings in Alterra at Lloyd’s and our operations in Latin America generated increased levels of premiums written in the year ended December 31, 2011. Our global insurance and U.S insurance segments also had modest growth in premiums written during the year primarily due to pricing increases and new business in certain lines of business as well as increased product offerings.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2012 was 33.1% compared to 24.8% in the prior year. The increase in the ratio was principally due to additional property reinsurance purchased in our reinsurance segment and additional ceded reinstatement premiums in our U.S insurance segment resulting from losses associated with Hurricane Sandy. This was in addition to the impact of the 100% retrocession of the business written through our contracted general agent distribution channel, which we refer to as our contract binding business, in our U.S. insurance segment starting from August 1, 2011. We ceased writing and ceding the contract binding business in the second quarter of 2012.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 24.8% compared to 26.3% for the year ended December 31, 2010. The decrease in the percentage of reinsurance premiums ceded compared to the prior year was principally due to the Amalgamation and the reduction in the amount of business ceded by our reinsurance segment. This was partially offset by the 100% retrocession of the business written through our contract binding business in our U.S. insurance segment starting from August 1, 2011, along with the impact of additional ceded reinstatement premiums in our Alterra at Lloyd’s segment.
During the past several years, we have shifted the mix of business written in our reinsurance segment from predominantly long-tail business to predominantly short-tail business, principally in response to market conditions. This greater emphasis on short-tail lines of business, with property being the largest component, and including our investment in the New Point sidecars, has increased our probable maximum loss from property catastrophe events. The industry’s adoption of new external vendor catastrophe models has also contributed to the increase in our aggregate exposure estimates for property catastrophe events. To manage this increased exposure and operate within our risk tolerances, we have increased our purchase of reinsurance, with an emphasis on property reinsurance. As a result of these factors, our net premiums written decreased for the year ended December 31, 2012 compared to the prior year despite an increase in gross premiums written. We regularly monitor our need for reinsurance based on aggregate risk exposures.
Net investment income. Net investment income for the year ended December 31, 2012 decreased by 6.8% compared to the prior year. As investments in our fixed maturity portfolio mature, lower reinvestment yields on new purchases have reduced the weighted average book yield of our portfolio. Our average investment yield was 2.89% for the year ended December 31, 2012 compared to 3.09% and 3.39% for the years ended December 31, 2011 and 2010, respectively.
Net realized and unrealized gains (losses) on investments. Net realized and unrealized gains and losses on investments may vary significantly from period to period. The year ended December 31, 2012 included net realized gains on available for sale fixed maturities of $26.1 million compared to $11.5 million of realized gains in the prior year period. Most of the realized gains in the current period related to sales of longer duration securities, taking advantage of gains caused by declining long term interest rates and at the same time reducing our exposure to longer duration securities. The year ended December 31, 2012 also included income from equity method investments of $20.9 million, principally related to our investment in New Point IV, compared to $1.4 million in the prior year period, and a $13.9 million increase in fair value of the hedge fund portfolio compared to a decrease in fair value of $11.8 million in the prior year period.
For the year ended December 31, 2011, the principal component of the net loss was a $25.0 million loss on a catastrophe bond with exposure to the Japan earthquake and tsunami, compared to an increase in fair value of catastrophe bonds of $0.4 million in the prior year period. Our results for the year ended December 31, 2011 also included a decrease in fair value of our hedge funds of $11.8 million compared to an increase of $14.3 million in the prior year period, and a decrease in fair value of derivatives of $13.6 million compared to a decrease of $12.0 million in the prior year period.
Other income. Other income for the year ended December 31, 2012 principally comprised underwriting fees and profit commission earned from New Point Re IV.
Net favorable development of prior year loss reserves, excluding the effect of premium adjustments, for the year ended December 31, 2012 of $90.8 million compared to $153.3 million in the year ended December 31, 2011;
The prior year loss reserve development reduced the loss ratio by 6.7 percentage points for the year ended December 31, 2012, compared to 10.8 percentage points for the year ended December 31, 2011. Excluding the impact of net favorable loss development, the loss ratio for the year ended December 31, 2012 was 74.6%, compared to 77.3% for the year ended December 31, 2011. The decrease in the loss ratio for the year ended December 31, 2012 compared to the prior year was principally due to a decrease in property catastrophe losses; and
For the year ended December 31, 2011, our results included incurred losses net of reinsurance of $269.4 million compared to $54.9 million related to significant property catastrophe events and significant per-risk losses. The significant property catastrophe event net losses for the year ended December 31, 2011 included losses resulting from the Australia floods, Cyclone Yasi, the New Zealand earthquake, the Japan earthquake and tsunami, tornadoes and flooding in the United States, Hurricane Irene and the Thailand floods. For the year ended December 31, 2010, our results included net losses of $54.9 million for property catastrophe events, including losses resulting from the Chile earthquake, Europe Windstorm Xynthia and Australia hailstorms.
Interest expense. Interest expense reflects interest on our senior notes, interest on funds withheld from reinsurers, and
accretion on deposit liability contracts. Interest expense for the year ended December 31, 2012 decreased by $8.0 million
Merger and acquisition expenses. Merger and acquisition expenses for the year ended December 31, 2012 comprised advisory, legal and other professional fees related to the proposed Merger. Additionally, merger and acquisition expenses for the year ended December 31, 2010 comprised advisory, legal and other professional fees, the acceleration of stock based compensation expense and other merger related expenses related to the Amalgamation with Harbor Point. These expenses were offset by the negative goodwill gain of $95.8 million recognized from the Amalgamation.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2012 decreased by $25.5 million compared to the prior year. This decrease was principally due to a decrease in compensation expense, including a reduction in awards granted to retirement eligible employees, as well as a reduction in legal and accounting expenses.
General and administrative expenses for the year ended December 31, 2011 increased by $36.4 million compared to the year ended December 31, 2010. The increase was principally due to the increased size of the Company following the Amalgamation. The year ended December 31, 2011 was the first full fiscal year of post-Amalgamation level expenses. Expansion of our underwriting teams, growth in Latin America and regulatory changes in Europe also contributed to the increase in general and administrative expenses in the period. These increases were partially offset by decreases in incentive based compensation. The increase in net earned premiums resulted in a small decrease in our general and administrative expense ratio for the year ended December 31, 2011 compared to the year ended December 31, 2010.
Income tax expense (benefit). Corporate income tax expense or benefit is generated through our operations in taxable jurisdictions, principally in the United States, Europe and Latin America. The effective tax rate was 7.6% for the year ended December 31, 2012 compared with negative 17.0% in the year ended December 31, 2011 and 1.4% in the year ended December 31, 2010. Our effective income tax rate, which we calculate as income tax expense or benefit divided by net income or loss before taxes, may fluctuate significantly from period to period depending on the geographic distribution of pre-tax net income or loss in any given period between different jurisdictions with different tax rates. The geographic distribution of pre-tax net income or loss can vary significantly between periods principally due to the mix of business written and earned during the period, the geographic location of investment income and realized and unrealized investment gains and losses and the geographic location of net losses and loss expenses incurred.
Our effective tax rate was negative for the year ended December 31, 2011 due principally to two factors. Our results for the year ended December 31, 2011 contained a significant amount of property catastrophe losses and the distribution of these losses was heavily weighted towards jurisdictions with higher tax rates, resulting in a greater amount of tax benefits than tax expense. Further contributing to the negative effective tax rate was the release of a valuation allowance related to deferred tax assets in our U.S. subsidiaries, which had the effect of increasing the tax benefit for the year.
Gross premiums written in our aviation line of business have declined in line with our planned strategy to reduce premiums for this line of business in this segment.
Competitive pricing conditions in professional liability, excess liability and aviation resulted in flat or decreased levels of business written. Our objective is to continue to be selective in our renewals and new business writings, focusing on business that we believe meet our rate of return requirements.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2012 was 50.9% compared to 49.6% and 46.1%, respectively, in the years ended December 31, 2011 and December 31, 2010. The amount of reinsurance that we purchase can vary significantly by line of business and product line. The increase in the percentage of reinsurance premiums ceded on our aviation line of business for the year ended December 31, 2012 was due principally to premium adjustments on an excess of loss reinsurance treaty.
The increase in the percentage of reinsurance premiums ceded for the year ended December 31, 2011 was principally due to changes in the mix of business and an increase in the percentage of quota share reinsurance purchased on our property line of business to manage our aggregate exposures. A contributing factor to the lower percentage ceded in 2010 was the reduction in property reinsurance premiums ceded to Harbor Point, which became fully eliminated intercompany transactions after the Amalgamation. We replaced those reinsurance premiums ceded with third parties over the course of the normal renewal periods.
Net favorable development of prior year loss reserves, excluding the effect of premium adjustments, in the year ended December 31, 2012 of $44.3 million compared to $65.4 million in the year ended December 31, 2011;
Long tail includes general/excess liability and professional liability lines of business.
Growth in our marine line of business resulting from the expansion of our underwriting team; and
Organic growth in business written in our marine and professional liability lines; and
Our results for the year ended December 31, 2012 include net losses of $51.0 million for property catastrophe losses related to Hurricane Sandy and Hurricane Isaac, compared to net losses of $19.6 million for property catastrophe losses for the year ended December 31, 2011. A portion of catastrophe losses generally fall within our attritional loss ratio, as we expect a certain level of property losses each period.
The loss ratio for the year ended December 31, 2011 increased 5.4 percentage points compared to the year ended December 31, 2010. Significant items impacting the 2011 loss ratio were:
The prior year loss reserve development increased the loss ratio by 4.5 percentage points for the year ended December 31, 2011, and decreased the loss ratio by 0.4 percentage points for the year ended December 31, 2010. Excluding the impact of prior year loss development, the loss ratio was 64.3% for the year ended December 31, 2011 compared to 63.8% for the year ended December 31, 2010. The increase was principally due to changes in the mix of business, particularly an increase in the marine and professional liability lines of business. These lines of business have a higher average loss ratio than property lines, which declined as a percentage of net premiums earned; and
Acquisition expenses. Acquisition costs decreased $13.2 million for the year ended December 31, 2012 compared to the prior year. This result was due partly to a decrease in net premiums earned and also changes in the mix of business with an increase in excess casualty and retail business earned which have more favorable acquisition cost ratios. In addition, a new quota share reinsurance treaty covering our brokerage-sourced property business that was entered into in the first quarter of
The acquisition cost ratio increased in the year ended December 31, 2011 compared to the year ended December 31, 2010 as we reduced the amount of reinsurance purchased. As we retained more business, we received less ceding commission income to offset our brokerage and commission costs, which increased our acquisition cost ratio.
General and administrative expenses for the year ended December 31, 2011 increased $9.2 million compared to the prior year. The increase was principally due to additional costs associated with the sale of our contract binding business, costs associated with the establishment of our new excess casualty platform and an increase in expenses related to stock based compensation. Notwithstanding these factors, the general and administrative expense ratio for the year ended December 31, 2011 was consistent with the prior year, principally due to the gradual increase in net premiums earned compared to the prior year.
The loss ratio is calculated by dividing net losses and loss expenses by net premiums earned.
The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned.
Short tail includes agriculture, auto, aviation, credit/surety, marine & energy, other, property and whole account lines of business.
Effective July 1, 2012, we redefined our reporting segments by combining the reinsurance and Latin America segments into a single reinsurance segment. The comparative periods have been re-presented to reflect these changes. For the year ended December 31, 2012, gross premiums written from our Latin America operations were $116.3 million. Gross premiums written from our Latin America operations for the years ended December 31, 2011 and 2010 were $91.8 million and $44.8 million, respectively.
Gross premiums written in our auto line of business decreased $44.9 million. The year ended December 31, 2012 included negative premium adjustments of $14.5 million compared to positive premiums adjustments of $14.4 million in the prior year. Excluding the impact of these adjustments, the gross premiums written for the year ended December 31, 2012 were $67.9 million compared to $84.0 million in the prior year. This decrease was principally related to reductions in premiums written on two renewal contracts. These reductions related to increased rates charged by our cedants to their clients that resulted in a lower premium volume of better priced business ceded to us;
Gross premiums written in our agriculture line of business decreased $7.6 million. During the year ended December 31, 2012, a portion of the agriculture business previously written within this segment was renewed in our Alterra at Lloyd's segment.
Gross premiums written for the year ended December 31, 2011 increased by 70.6% compared to the year ended December 31, 2010. Significant factors affecting 2011 gross premiums written were:
Gross premiums written in our property line increased due to new business and increases in participations due to improved pricing and market conditions. This growth included an increase in property gross premiums written related to our Latin America operations from $32.5 million for the year ended December 31, 2010 to $68.7 million for the year ended December 31, 2011;
An increase in medical malpractice premiums resulting from the Amalgamation and the impact of positive premium adjustments of $8.4 million in the year ended December 31, 2011 compared to negative premium adjustments of $2.5 million in the year ended December 31, 2010, was offset by the non-renewal of two contracts that accounted for $23.1 million due to competitive pricing; and
Net losses and loss expenses. The loss ratio decreased by 6.2 percentage points for the year ended December 31, 2012 compared to the prior year. The net favorable and (unfavorable) development of prior year reserves in the years ended December 31, 2012, 2011 and 2010 by line of business was as follows:
The prior year loss reserve development reduced the loss ratio by 9.5 percentage points for the year ended December 31, 2011 compared to 7.1 percentage points for the year ended December 31, 2010. Excluding the impact of net loss development, the loss ratio was 73.6% for the year ended December 31, 2011 compared to 62.7% for the prior year
periods. The increase in the loss ratio for the year ended December 31, 2011 compared to December 31, 2010 was due principally to the increase in property catastrophe and significant per-risk losses; and
The year ended December 31, 2011 included $151.3 million in significant property catastrophe-related losses compared to $27.8 million for the year ended December 31, 2010. For the year ended December 31, 2010, property catastrophe losses included losses for the Deepwater Horizon oil spill, Europe Windstorm Xynthia, Australia hailstorms, the New Zealand earthquake and floods in Australia.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2012 decreased by $13.4 million compared to the prior year. The decreases were due principally to a reduction in compensation expense compared to the prior year, resulting from fewer employees and a lower level of stock based compensation granted to retirement eligible employees.
General and administrative expenses for the year ended December 31, 2011 increased by $14.4 million compared to the year ended December 31, 2010. This increase was principally due to 2011 being the first full fiscal year following the Amalgamation. In addition, an increase in the number of retirement eligible employees, whose stock-based compensation awards are fully expensed when granted, and the transfer of some corporate function employees and expenses to the reinsurance segment as part of the Amalgamation integration also contributed to the increase. This impact was partially offset by a decrease in performance based compensation expense. Growth in net premiums earned exceeded the increase in general and administrative expenses, resulting in a decrease of 1.1 percentage points in the general and administrative loss ratio.
Our Alterra at Lloyd’s segment comprises all of our Lloyd’s operating businesses, other than underwriting activity related to Latin America, which is included within our reinsurance segment.
Short tail includes accident & health, agriculture, aviation, marine and property lines of business.
An increase of $14.0 million in our international casualty line of business. The increase reflects the continued expansion of our client base; and
Gross premiums written for the year ended December 31, 2011 increased 40.8% compared to the prior year. The increase in 2011 gross premiums written was primarily due to:
An increase of $33.2 million in our property line of business for the year ended December 31, 2011 due to the addition of our direct and facultative property insurance underwriting team and improved market conditions, as well as $13.1 million of gross reinstatement premiums principally related to property catastrophe events;
An increase of $6.2 million in our accident & health line of business for the year ended December 31, 2011 principally due to the addition of our accident & health insurance team towards the end of 2010; and
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2012 was 24.3% compared to 25.2% for the prior year. The slight decrease was principally due to a decline in reinstatement premiums ceded, partially offset by an increase in aviation reinsurance purchased.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 25.2% compared to 20.8% for the prior year. For the year ended December 31, 2011, the increase was impacted by reinstatement premiums ceded as a result of the catastrophe losses during the year.
Net losses and loss expense. The loss ratio for the year ended December 31, 2012 decreased 20.4 percentage points compared to the prior year. The net favorable and (unfavorable) development of prior year reserves in the years ended December 31, 2012, 2011 and 2010 by line of business was as follows:
Net favorable development of prior year loss reserves in the year ended December 31, 2012 was $1.2 million compared to net favorable development of $17.3 million in the year ended December 31, 2011;
The net favorable development in the year ended December 31, 2012 was principally on our financial institutions and professional liability lines of business, partially offset by unfavorable development on our international casualty and accident & health lines of business. The unfavorable development in international casualty principally relates to 2011 motor liability which has had worse than expected loss experience, however this is driving some improvement in pricing;
The prior year loss reserve development decreased the loss ratio by 0.5 percentage points for the year ended December 31, 2012 compared to a reduction of 10.6 percentage points for the year ended December 31, 2011. Excluding the impact of prior year loss development, the loss ratio was 76.8% for the December 31, 2012 compared to 107.3% for the year ended December 31, 2011. The decrease for the year ended December 31, 2012 was principally related to fewer major property catastrophe events during 2012 compared to 2011, partially offset by an increase due to the change in the mix of business, particularly an increase in casualty and agriculture lines of business. These lines of business have a higher average loss ratio than property lines, which have declined as a percentage of net premiums earned; and
The year ended December 31, 2012 included a net underwriting loss (net of premiums and acquisition costs earned) of $11.5 million on our agriculture line of business. These agriculture losses relate to the severe drought conditions experienced in many parts of the United States in 2012. The year ended December 31, 2012 also included $4.3 million in significant property catastrophe-related losses compared to $83.2 million in the year ended December 31, 2011. Property catastrophe losses for the year ended December 31, 2012 were principally related to Hurricane Sandy. A portion of these losses fell within our attritional loss ratio, as we expect a certain level of property losses in each period.
The acquisition cost ratio increased 5.1 percentage points for the year ended December 31, 2011 compared to the prior year. The year ended December 31, 2011 was impacted by the re-estimation of certain commission expenses based on updated information. The remaining increase was attributable to changes in the mix of business written.
General and administrative expenses for the year ended December 31, 2011 increased $7.3 million compared to the prior year. Costs associated with expanding our underwriting teams and regulatory changes in Europe contributed to the absolute increase in general and administrative expenses.
Our life and annuity benefit reserves are recorded on a discounted present value basis. This discount is amortized through income as a claims and policy benefits expense over the term of the underlying policies. As a result, income is derived primarily from the spread between the actual rate of return on our investments and the expense related to the discount on our reserves. Over the last several years this spread has narrowed due to declining investment yields. Income can also be impacted by changes in estimated and actual claims, premiums, expenses and persistency of the underlying policies.
The increase in net investment income for the year ended December 31, 2011 compared to the year ended December 31, 2010 was attributable principally to the increase in cash and invested assets as a result of the Amalgamation with Harbor Point on May 12, 2010. This was partially offset by the decline in investment yields.
Net realized and unrealized gains (losses) on investment include the following:
The largest contributors by investment strategy to the increase in fair value for the year ended December 31, 2012 were the long/ short equity and global macro strategies. As of December 31, 2012, 60.6% and 20.9% of our hedge fund portfolio was allocated to the long/short equity and global macro strategies, respectively. The largest decrease in fair value offsetting the overall increase for the year was contributed by the emerging markets strategy. As of December 31, 2012, 1.2% of our hedge fund portfolio was allocated to this strategy.
The largest contributors by investment strategy to the increase in fair value for the year ended December 31, 2010 were the global macro and the diversified arbitrage strategies. As of December 31, 2010, 16.9% and 9.5% of our hedge fund portfolio was allocated to the global macro and diversified arbitrage strategies, respectively. The largest decrease in fair value offsetting the overall increase for the year was contributed by the event driven arbitrage strategy. As of December 31, 2010, 10.2% of our hedge fund portfolio was allocated to this strategy.
The allocation of invested assets to our hedge fund portfolio as of December 31, 2012 was 3.7%, which is consistent with our expected ongoing allocation. The objective of our hedge fund portfolio is to achieve a market neutral/absolute return strategy, with diversification by strategy and underlying fund. A market neutral strategy strives to generate consistent returns in both up and down markets by selecting long and short positions with a total net exposure of zero. Returns are derived from the long/short spread, or the amount by which long positions outperform short positions. The objective of an absolute return strategy is to provide stable performance regardless of market conditions, with minimal correlation to market benchmarks.
The fair value of derivatives increased by $6.2 million for the year ended December 31, 2012, compared to decreases in fair value of $13.6 million and $11.9 million for the years ended December 31, 2011 and 2010, respectively. We hold various derivative instruments, including convertible bond equity call options, interest rate linked derivative instruments and foreign exchange forward contracts. The majority of the increase in fair value for the current year resulted from interest rate swap positions, taken as part of a total return strategy followed by a portion of our investment portfolio.
The decrease in fair value of the catastrophe bonds during the year ended December 31, 2011, principally was due to a $25.0 million loss on one catastrophe bond with exposure to the earthquake and tsunami in Japan. During the second quarter of 2011, we disposed of all catastrophe bond holdings.
Our available for sale portfolio is recorded at fair value with unrealized gains and losses recorded in other comprehensive income as part of total shareholders’ equity. Our available for sale fixed maturities investment strategy is not generally intended to generate significant realized gains and losses as more fully discussed below in the "Financial Condition" section. Our held to maturity portfolio includes securities for which we have the ability and intent to hold to maturity or redemption, and is recorded at amortized cost. There should be no realized gains or losses related to this portfolio unless there is an other than temporary impairment loss. Our trading portfolio is recorded at fair value with unrealized gains and losses recorded in net income.
securities, taking advantage of gains caused by declining long term interest rates and at the same time reducing our exposure to longer duration securities, and the sale of the majority of our convertible bond portfolio in April 2012.
Cash and invested assets. Aggregate invested assets, comprising cash and cash equivalents, fixed maturities, equity method investments and other investments, were $8,032.6 million as of December 31, 2012 compared to $7,814.7 million as of December 31, 2011, an increase of 2.8%. The increase in cash and invested assets resulted principally from the combination of the timing of the settlement of premiums and losses, and the increase in fair value of our available for sale portfolio offset by payments for share repurchases and dividends.
Fixed maturities are subject to fluctuations in fair value due to changes in interest rates, changes in issuer specific circumstances, such as credit rating changes, and changes in industry specific circumstances, such as movements in credit spreads based on the market’s perception of industry risks. As a result of these fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolios is to tailor the maturities of the portfolios to the timing of expected loss and benefit payments. At maturity, absent any credit loss, a fixed maturity’s amortized cost will equal its fair value and no realized gain or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell available for sale fixed maturity securities before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period.
Our fixed maturity portfolio comprises high quality, liquid securities. As of December 31, 2012, our fixed maturities investments had a dollar-weighted average credit rating of Aa2/AA. Under our fixed maturities investment guidelines, a minimum weighted average credit rating of Aa3/AA-, or its equivalent, must be maintained for our fixed maturities investment portfolio as a whole. Our fixed maturities investment guidelines also provide that we cannot leverage our fixed maturities investments. Further details of the credit ratings on our fixed maturities investments is included in Note 3 of our consolidated financial statements included herein.
The distribution by credit rating (using the lower of S&P and Moody's ratings) was as follows:
A discussion of our process for estimating other-than-temporary impairments is included in Note 3 of our consolidated financial statements included herein.
As described in Note 4 of our consolidated financial statements, our available for sale and trading fixed maturities investments and the majority of our other investments are carried at fair value.
Fair value prices for all securities in our fixed maturities portfolio are independently provided by our investment custodians, our investment accounting service provider and our investment managers, with each utilizing internationally recognized independent pricing services. We record the unadjusted price provided by the investment custodian, investment accounting service provider or investment manager after validating the prices. Our validation process includes: (i) comparison of prices between two independent sources, with significant differences requiring additional price sources; (ii) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (iii) evaluation of methodologies used by external parties to calculate fair value including a review of the inputs used for pricing; and (iv) comparing the price to our knowledge of the current investment market.
The independent pricing services used by our investment custodians, investment accounting service provider and investment managers obtain actual transaction prices for securities that have quoted prices in active markets. Each pricing service 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 service uses observable market inputs including, but not limited to, reported trades, benchmark yields, broker/dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from market sources to determine a reasonable fair value. In addition, pricing services use valuation
models, 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. The ability to obtain quoted market prices is reduced in periods of decreasing liquidity, which generally increases the use of matrix pricing methods and the uncertainty surrounding the fair value estimates.
Additional information about the hedge fund portfolio can be found in Notes 3 and 4 to our consolidated financial statements included herein.
principally from additional losses ceded under our reinsurance and retrocessional agreements resulting from net earned premiums during the year ended December 31, 2012.
Losses recoverable from reinsurers on property and casualty business were $1,257.6 million and $1,035.0 million as of December 31, 2012 and December 31, 2011, respectively. Benefits recoverable from reinsurers on life and annuity business were $32.0 million and $33.1 million as of December 31, 2012 and December 31, 2011, respectively.
Liabilities for property and casualty losses. Property and casualty losses totaled $4,690.3 million as of December 31, 2012 compared to $4,216.5 million as of December 31, 2011, an increase of 11.2%. During the year ended December 31, 2012, we incurred gross losses of $1,308.1 million and we paid $848.1 million in property and casualty losses. Included in gross losses was gross favorable development on prior year reserves of $173.8 million. Net of reinsurance, we paid $683.9 million in property and casualty losses during the year ended December 31, 2012.
Shareholders’ equity. Our shareholders’ equity increased to $2,839.7 million as of December 31, 2012 from $2,809.2 million as of December 31, 2011, an increase of 1.1%, principally due to net income of $143.8 million and an increase in accumulated other comprehensive income of $77.2 million. Offsetting these increases were the repurchase of $158.7 million of common shares and warrants and the declaration of dividends of $58.7 million.
Liquidity. We generated $313.1 million of cash from operations during the year ended December 31, 2012 compared to $235.6 million for the year ended December 31, 2011. The principal factors that impact our operating cash flow are premium collections and payments, the timing of loss and benefit payments and recoveries, and the receipt of interest on our fixed maturity investments.
Our casualty business generally has a long claim-tail. As a result, we expect that we will generate significant operating cash flow as we accumulate property and casualty loss reserves on our balance sheet. Our property business generally has a short claim-tail. Consequently, we expect volatility in our operating cash flow levels as losses are incurred. We believe that our property and casualty loss reserves and life and annuity benefit reserves currently have an average duration of approximately 4.7 years. We expect increases in the amount of expected loss payments in future periods with a resulting decrease in operating cash flow; however, we do not expect loss payments to exceed the premiums generated. Actual premiums written and collected and losses and loss expenses paid in any period could vary materially from our expectations and could have a significant and adverse effect on operating cash flow.
operating history. We also have the ability to borrow an additional $250.0 million using our current credit facilities, subject to certain conditions. Our largest credit facility, a $1,100.0 million four-year secured facility, expires in December 2015. Our unrestricted cash and cash equivalents balance was $440.3 million as of December 31, 2012. We believe that we currently maintain sufficient liquidity to cover existing requirements and provide for contingent liquidity. Nonetheless, significant deviations in expected loss and benefit payments can occur, potentially requiring us to liquidate a portion of our fixed maturities portfolios. If we need to liquidate our fixed maturities securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated as of December 31, 2012. We believe that our portfolio has sufficient liquidity to mitigate this risk, and we believe that we can continue to hold any potentially illiquid position until we can initiate an appropriately priced transaction.
A closing condition of the Merger Agreement requires us to have $500.0 million of cash available for distribution to shareholders on closing of the Merger. We believe we have sufficient liquid investments together with cash generated from operations to meet this requirement.
minimum consolidated tangible net worth, minimum insurer financial strength rating and restrictions on the payment of dividends. We were in compliance with all of the financial covenants of each of our credit facilities as of December 31, 2012.
As of December 31, 2012, we provided $280.3 million in required capital for the Syndicates, or Funds at Lloyd's. These amounts are not available for distribution for the payment of dividends. Our Funds at Lloyd’s commitments are met using cash and fixed maturity securities. Our corporate members may also be required to maintain funds under the control of Lloyd’s in excess of their capital requirements and such funds also may not be available for distribution or the payment of dividends.
In September 2010, Alterra Finance issued $350.0 million principal amount of 6.25% senior notes due September 30, 2020 with interest payable on March 30 and September 30 of each year pursuant to the shelf registration statement. The senior notes are guaranteed by Alterra.
In April 2007, Alterra USA sold $100.0 million aggregate principal amount of 7.20% senior notes due April 14, 2017, of which $90.6 million principal amount was outstanding as of December 31, 2012. The senior notes are guaranteed by Alterra.
Net realized and unrealized (gains) losses on investments not included in operating income includes realized and unrealized (gains) losses on trading securities, realized (gains) losses on available for sale securities, net impairment losses recognized in earnings, earnings from equity method investments in run-off, and changes in fair value of investment derivatives, catastrophe bonds and structured deposits.
ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
Accounting Standards Update, or ASU, 2010-26 specifies how insurance companies should recognize costs that meet the definition of acquisition costs as defined in guidance from the Financial Accounting Standards Board, or FASB. ASU 2010-26
indirect costs or salaries related to unsuccessful efforts, should be expensed as incurred. ASU 2010-26 was effective for fiscal
ASU 2011-04 principally clarifies existing guidance relating to fair value measurement and disclosures. ASU 2011-04
also includes changes to certain fair value principles that affect both measurement and disclosure requirements. These changes
to changes in unobservable inputs, and categorization by level of the fair value hierarchy for items that are not measured at fair
also requires that all nonowner changes in shareholders’ equity be presented either in a single continuous statement of
requirements effective for the current period in our consolidated financial statements and they did not have a material
ASU 2011-08 permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting
ASU 2013-02 requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under GAAP that provide additional detail about those amounts. ASU 2013-02 will be effective prospectively for fiscal periods beginning after December 15, 2012 with early adoption permitted. We do not expect this standard to have a material impact on our consolidated financial statements.