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) was recently moved from New York City to Jersey City, New Jersey where we lease approximately 106,800 square feet. Such lease expires in 2024. We continue to lease approximately 50,000 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 197,000 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 less than 1,000 square feet in Dublin. ACGL leases approximately 1,500 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.
For 2008, 2007 and 2006, our rental expense, net of income from subleases, was approximately $17.5 million, $14.8 million and $12.9 million, respectively. Our future minimum rental charges for the remaining terms of our existing leases, exclusive of escalation clauses and maintenance costs and net of rental income, will be approximately $119.8 million. We believe that the above described office space is adequate for our needs. However, as we continue to develop our business, we may open additional office locations during 2009.
(1)In our securities lending transactions, we receive collateral in excess of the market value of the fixed maturities and short-term investments pledged under securities lending agreements. For purposes of this table, we have excluded $730.2 million, $1.5 billion, $891.4 million and $893.4 million, respectively, of collateral received which is reflected as "investment of funds received under securities lending agreements, at market value" and included $728.1 million, $1.46 billion, $860.8 million and $863.9 million, respectively, of "fixed maturities and short-term investments pledged under securities lending agreements, at market value" at December 31, 2008, 2007, 2006 and 2005.
(2)Book value per share excludes the effects of stock options and restricted stock units and, at December 31, 2004, class B warrants.
(3)Book value per common share at December 31, 2004 was determined by dividing (i) the difference between total shareholders' equity and the aggregate liquidation preference of the series A convertible preference shares of $784.3 million by (ii) the number of common shares outstanding. All outstanding series A convertible preference shares were converted to common shares in 2005.
In general, market conditions improved during 2002 and 2003 in the insurance and reinsurance marketplace. This reflected improvement in pricing, terms and conditions following significant industry losses arising from the events of September 11, 2001, as well as the recognition that intense competition in the late 1990s led to inadequate pricing and overly broad terms, conditions and coverages. Such industry developments resulted in poor financial results and erosion of the industry's capital base. Consequently, many established insurers and reinsurers reduced their participation in, or exited from, certain markets and, as a result, premium rates escalated in many lines of business. These developments provided relatively new insurers and reinsurers, like us, with an opportunity to provide needed underwriting capacity. Beginning in late 2003 and continuing through 2005, additional capacity emerged in many classes of business and, consequently, premium rate increases decelerated significantly and, in many classes of business, premium rates decreased. The weather-related catastrophic events that occurred in the second half of 2005 caused significant industry losses and led to a strengthening of
rating agency capital requirements for catastrophe-exposed business. The 2005 events also resulted in substantial improvements in market conditions in property and certain marine lines of business and slowed declines in premium rates in other lines. During 2006 and 2007, excellent industry results led to a significant increase in capacity and, accordingly, competition intensified in 2007 and prices, in general, declined in all lines of business, including property. We increased our writings in property and certain marine lines of business in 2006, 2007 and 2008 in order to take advantage of improved market conditions and these lines represented a larger proportion of our overall book of business in 2006, 2007 and 2008 than in prior periods.
During the second half of 2008, the financial markets have experienced significant adverse credit events and a loss of liquidity, which have reduced the amount and availability of capital in the insurance industry. In addition, certain of our competitors have experienced significant financial difficulties. We believe that the impacts of such events, along with the recent catastrophic activity, have begun to affect market conditions positively and may lead to rate strengthening in a number of specialty lines. However, the current economic conditions also could have a material impact on the frequency and severity of claims and therefore could negatively impact our underwriting returns. In addition, volatility in the financial markets could continue to significantly affect our investment returns, reported results and shareholders equity. We consider the potential impact of economic trends in the estimation process for establishing unpaid losses and loss adjustment expenses ("LAE") and in determining our investment strategies.
In addition, in the 2009 first quarter, we received approval in principle from the Lloyd's Franchise Board and the Financial Services Authority in the United Kingdom to establish a managing agent and syndicate at Lloyd's. The newly formed Syndicate 2012 is expected to commence underwriting in the 2009 second quarter.
We commenced operations in September 1995 following the completion of the initial public offering of our predecessor, Arch Capital Group (U.S.) Inc. ("Arch-U.S."). Arch-U.S. is a Delaware company formed in March 1995 under the original name of "Risk Capital Holdings, Inc." From that
During the period from May 2000 through the announcement of our underwriting initiative in October 2001, we built and acquired insurance businesses that were intended to enable us to generate both fee-based revenue (e.g., commissions and advisory and management fees) and risk-based revenue (i.e., insurance premium). As part of this strategy, we built an underwriting platform that was intended to enable us to maximize risk-based revenue during periods in the underwriting cycle when we believed it was more favorable to assume underwriting risk. In October 2001, we concluded that underwriting conditions favored dedicating our attention exclusively to building our insurance and reinsurance businesses.
We derive our revenues primarily from the issuance of insurance policies and reinsurance contracts. Insurance and reinsurance premiums are driven by the volume and classes of business of the policies and contracts that we write which, in turn, are related to prevailing market conditions. The premium we charge for the risks assumed is also based on many assumptions. We price these risks well before our ultimate costs are known, which may extend many years into the future. In addition, our revenues include fee income and income we generate from our investment portfolio. Our investment portfolio is comprised primarily of fixed income investments that are classified as "available for sale." Under accounting principles generally accepted in the United States of America ("GAAP"), these investments are carried at market value and unrealized gains and losses on the investments are not included in our statement of income. These unrealized gains and losses are included in accumulated other comprehensive income or loss as a separate component of shareholders' equity in our balance sheet.
We are required by applicable insurance laws and regulations and GAAP to establish reserves for losses and LAE ("Loss Reserves") that arise from the business we underwrite. Loss Reserves for our insurance and reinsurance operations are balance sheet liabilities representing estimates of future amounts required to pay losses and LAE for insured or reinsured events which have occurred at or before the balance sheet date. Loss Reserves do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial.
Loss Reserves for our insurance operations are comprised of (1) case reserves for claims reported and (2) reserves for losses that have occurred but for which claims have not yet been reported, referred to as IBNR reserves. 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 LAE 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 LAE and case reserves from estimates of ultimate losses and LAE. Actuaries estimate ultimate losses and LAE 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.
Ultimate losses and LAE are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can reasonably be expected to persist into the future. In forecasting ultimate losses and LAE with respect to any line of business, past experience with respect to that line of business is the primary resource, developed through both industry and company experience, but cannot be relied upon in isolation. Uncertainties in estimating ultimate losses and LAE
At December 31, 2008 and 2007, Loss Reserves for our insurance operations by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
The reserving method for our insurance 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 insurance operations through December 31, 2008 in some lines of business. See below for a discussion of the key assumptions in our insurance operations' reserving process.
•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 estimate future losses and necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use incurred losses to estimate ultimate losses, they may be more reliable than the other methods that use incurred losses in situations where there are significant changes in how incurred losses are established by a company's claims adjusters. However, historical paid loss development methods are more leveraged (meaning that small changes in payments have a larger impact on estimates of ultimate losses) than actuarial
methods that use incurred losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative incurred amounts. In addition, and for similar reasons, historical paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past.
The estimation of Loss Reserves for our reinsurance operations is subject to the same risk factors as the estimation of Loss Reserves for our insurance operations. In addition, the inherent uncertainties of estimating such reserves are even greater for reinsurers, due primarily to the following factors: (1) the claim-tail for reinsurers is generally longer because claims are first reported to the ceding company and then to the reinsurer through one or more intermediaries, (2) the reliance on premium estimates, where reports have not been received from the ceding company, in the reserving process, (3) the potential for writing a number of reinsurance contracts with different ceding companies with the same exposure to a single loss event, (4) the diversity of loss development patterns among different types of reinsurance treaties or facultative contracts, (5) the necessary reliance on the ceding companies for information regarding reported claims and (6) the differing reserving practices among ceding companies.
Backlogs in the recording of assumed reinsurance can also complicate the accuracy of loss reserve estimation. As of December 31, 2008, there were no significant backlogs related to the processing of assumed reinsurance information at our reinsurance operations.
Although Loss Reserves are initially determined based on underwriting and pricing analysis, our reinsurance operations apply several generally accepted actuarial methods, as discussed above, on a quarterly basis to evaluate their Loss Reserves in addition to the expected loss method, in particular for Loss Reserves from more mature underwriting years (the year in which business is underwritten). Each quarter, as part of the reserving process, actuaries at our reinsurance operations reaffirm that the assumptions used in the reserving process continue to form a sound basis for 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 underwriting years are now based more on actual loss activity and historical patterns than on the initial assumptions based on pricing indications. The more recent underwriting years continue to be mainly based on internal pricing assumptions. Our reinsurance 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.
In response to such factors, and their impact on the credibility of the initial loss estimates for casualty reinsurance exposures, a provision was included in establishing our reinsurance operations' net Loss Reserves in 2002 and 2003 on casualty losses occurring prior to each balance sheet date. As of December 31, 2003, the provision, included in IBNR, was $49.0 million (or 5.0% of our reinsurance operations' net Loss Reserves). Due to the additional data our reinsurance operations had gained on its existing book of business by the end of 2003, it was determined that it was no longer necessary to continue to include a provision in the reserving process beginning in 2004. Based on the recommendation of an independent actuarial firm, our reinsurance operations adopted a methodology to evaluate the existing provision by comparing actual claims experience to a schedule of expected claims experience prepared by the independent actuarial firm. If the actual claims experience is in line with the expected claims experience, a reduction of the provision is made based on the schedule established in the review. For 2008, 2007 and 2006, following reviews of actual and expected claims experience, our reinsurance operations reduced the provision by $2.7 million, $10.6 million and $7.7 million, respectively. At December 31, 2008, the remaining provision included in our reinsurance operations' Loss Reserves was $8.6 million (or 0.3% of our reinsurance operations' net Loss Reserves), compared to $11.3 million (or 0.4% of our reinsurance operations' net Loss Reserves) at December 31, 2007.
reported loss experience emerges quickly and ultimate losses are known in a reasonably short period of time.
For the years ended December 31, 2006 to 2008, on average, our reinsurance segment reported approximately $157 million of estimated net favorable development in prior year Loss Reserves, or 6.5% of average beginning Loss Reserves. Of such amount, approximately $91 million came from short-tail lines, or 13.2% of average beginning short-tail Loss Reserves, $58 million came from long-tail lines, or 3.7% of average beginning long-tail Loss Reserves and $8 million came from medium-tail lines, or 4.4% of average beginning medium-tail Loss Reserves. For the year ended December 31, 2008, estimated net favorable development in prior year Loss Reserves was $231 million, or 9.0% of beginning Loss Reserves. Of such amount, approximately $126 million came from short-tail lines, or 19.4% of beginning short-tail Loss Reserves, $99 million came from long-tail lines, or 5.7% of beginning long-tail Loss Reserves and $6 million came from medium-tail lines, or 3.6% of average beginning medium-tail Loss Reserves. For informational purposes, based on our reinsurance segment's historical results, applying the 6.5% average estimated net favorable development in average beginning Loss Reserves for the years ended December 31, 2006 to 2008 to our reinsurance segment's net Loss Reserves of $2.64 billion at December 31, 2008 would result in an increase in income before income taxes of approximately $171 million, or $2.64 per diluted share, while using the 9.0% of estimated net favorable development in beginning Loss Reserves for the year ended December 31, 2008 to such Loss Reserves would result in an increase in income before income taxes of approximately $237 million, or $3.66 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 reinsurance 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 reinsurance 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 reinsurance segment's Loss Reserves, see "-Simulation Results." Refer to "-Results of Operations" for additional discussion on net favorable or adverse development of our reinsurance operations' prior year Loss Reserves.
We do not have significant exposure to pre-2002 liabilities, such as asbestos-related illnesses and other long-tail liabilities and, to date, we have experienced a relatively low level of reported claims activity in many lines of business, particularly in longer-tailed lines such as primary and excess casualty and executive assurance, which have longer time periods during which claims are reported and paid. Our limited history does not provide meaningful trend information for such lines of business.
In the normal course of business, our insurance operations cede a substantial portion of their premium through pro rata, excess of loss and facultative reinsurance agreements. Our reinsurance operations also obtain reinsurance whereby another reinsurer contractually agrees to indemnify it for all or a portion of the reinsurance risks underwritten by our reinsurance operations. Such arrangements, where one reinsurer provides reinsurance to another reinsurer, are usually referred to as "retrocessional reinsurance" arrangements. In addition, our reinsurance subsidiaries participate in "common account" retrocessional arrangements for certain pro rata treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurers, such as our reinsurance operations, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the reinsurers' ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, our insurance or reinsurance operations would be liable for such defaulted amounts.
Our insurance operations had in effect during 2008 a reinsurance program 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. During 2007, a reinsurance program was in effect which provided coverage equal to a maximum of 88% of the first $325 million in excess of a $75 million retention per occurrence for certain property catastrophe-related losses occurring during each period, compared to a maximum of 92% of the first $325 million in excess of a $75 million retention per occurrence during 2006. In the 2009 first quarter, our insurance operations renewed its reinsurance program which provides coverage for certain property-catastrophe related losses occurring during 2009 equal to a maximum of 80% 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 most of our insurance operations' lines of business. The amount of such insurance premium estimates included in premiums receivable and other assets at December 31, 2008 and 2007 was $52.0 million and $50.1 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 or in cases where the amounts reported by brokers and ceding companies are adjusted to reflect management's
Reinsurance premiums assumed, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Contracts and policies written on a "losses occurring" basis cover claims that may occur during the term of the contract or policy, which is typically 12 months. Accordingly, the premium is earned evenly over the term.
We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. If the financial condition of our reinsurers or retrocessionaires deteriorates, resulting in an impairment of their ability to make payments, we will provide for probable losses resulting from our inability to collect amounts due from such parties, as appropriate. We evaluate the credit worthiness of all the reinsurers to which we cede business. If our analysis indicates that there is significant uncertainty regarding the collectability of amounts due from reinsurers, managing general agents, brokers and other clients, we will record a provision for doubtful accounts. See "Financial Condition, Liquidity and Capital Resources-Financial Condition-Premiums Receivable and Reinsurance Recoverables" for further details.
We recognize a tax benefit where we conclude that it is more likely than not that the tax benefit will be sustained on audit by the taxing authority based solely on the technical merits of the associated tax position. If the recognition threshold is met, we recognize a tax benefit measured at the largest amount of the tax benefit that, in our judgment, is greater than 50% likely to be realized. We record interest and penalties related to unrecognized tax benefits in the provision for income taxes.
In accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," FASB Staff Position Nos. FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" and Securities and Exchange Commission Staff Accounting Bulletin No. 59, "Other-Than-Temporary Impairment of Certain Investments in Debt and Equity Securities," we review our investments each quarter to determine whether a decline in market value below the amortized cost basis is other-than-temporary. Our process for identifying declines in the market value of investments that are other-than-temporary involves consideration of several factors. These factors include (i) the time period in which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline and (iv) our intent and ability to hold the investment for a sufficient period of time for the value to recover. Where our analysis of the above factors results in the conclusion that declines in market values are other-than-temporary, the cost of the securities is written down to market value and is reflected as a realized loss. In periods subsequent to the recognition of an other-than-temporary impairment on fixed maturities, we account for such securities as if they had been purchased on the measurement date of the other-than-temporary impairment and the provision for other-than-temporary impairment (reflected as a discount or reduced premium based on the new cost basis) is amortized into net investment income over the remaining life of the fixed maturities, or until such securities are sold. See note 7, "Investment Information," of the notes accompanying our consolidated financial statements.
On January 1, 2006, we adopted the fair value method of accounting for share-based awards using the modified prospective method of transition as described in Financial Accounting Standards Board ("FASB") Statement No. 123 (revised 2004), "Share-Based Payment" ("SFAS No. 123(R)"). Under the fair value method of accounting, compensation expense is estimated based on the fair value of the award at the grant date and is recognized in net income over the requisite service period. Such compensation cost is reduced by assumed forfeitures and adjusted based on actual forfeitures until vesting. Under the fair value method of accounting pursuant to SFAS No. 123(R), the fair value of restricted share and unit awards is measured by the grant date price of our shares. No value is attributed to awards that employees forfeit because they fail to satisfy vesting conditions. As such, the number of shares granted is reduced by assumed forfeitures and adjusted based on actual forfeitures until vesting. Such expense is amortized over the requisite service period of the related awards. For awards granted to retirement-eligible employees where no service is required for the employee to retain the award, the grant date fair value is immediately recognized as compensation cost at the grant date
because the employee is able to retain the award without continuing to provide service. For employees near retirement eligibility, attribution of compensation cost is over the period from the grant date to the retirement eligibility date. The share-based compensation expense associated with awards that have graded vesting features and vest based on service conditions only (i) granted after the effective date of adoption is calculated on a straight-line basis over the requisite service periods of the related awards and (ii) granted prior to the effective date of adoption and that remain unvested as of the date of adoption is calculated on a graded-vesting basis as prescribed under FASB Interpretation No. 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans-an interpretation of APB Opinions No. 15 and 25," over the remaining requisite service periods of the related awards.
The following table sets forth net income available to common shareholders and earnings per common share data:
During 2008, we recorded estimated after-tax net losses of $287.4 million, or $4.44 per share, related to Hurricanes Gustav and Ike, after reinsurance recoveries and net of reinstatement premiums. Such estimates were based on currently available information derived from modeling techniques, industry assessments of exposure, preliminary claims information obtained from our clients and brokers and a review of our in-force contracts. Actual losses from these events may vary materially from our estimates due to the inherent uncertainties in making such determinations resulting from several factors, including the preliminary nature of the available information, the potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques, the contingent nature of business interruption exposures, the effects of any resultant demand surge on claims activity and attendant coverage issues. In particular, the models used for offshore energy risks are relatively new and may be subject to even greater variability. 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.
Net Premiums Earned. Net premiums earned for the insurance segment were $1.68 billion for 2008, compared to $1.7 billion for 2007, and generally reflect changes in net premiums written over the previous five quarters, including the mix and type of business written.
Underwriting Expenses. The underwriting expense ratio for the insurance segment was 30.4% in 2008, compared to 27.9% for 2007. The acquisition expense ratio was 13.2% for 2008, compared to 11.7% for 2007. The acquisition expense ratio is influenced by, among other things, (1) the amount of ceding commissions received from unaffiliated reinsurers, (2) the amount of business written on a surplus lines (non-admitted) basis and (3) mix of business. The acquisition expense ratio in 2008 reflects changes in the form of reinsurance ceded and the mix of business and also included 0.9 points related to favorable prior year loss development, compared to 0.5 points for 2007. The insurance segment's other operating expense ratio was 17.2% for 2008, compared to 16.2% for 2007, with the increase due in part to a lower level of net premiums earned in 2008. In addition, operating expenses in 2008 included approximately $12.3 million, or 0.7 points, related to workforce reductions and the relocation of certain of the insurance segment's U.S. operations. These actions were undertaken as part of an expense management plan, which includes office relocation and personnel and other expense saving initiatives.
The reinsurance segment's underwriting income was $173.0 million for 2008, compared to $318.5 million for 2007. The combined ratio for the reinsurance segment was 85.3% for 2008, compared to 74.5% for 2007. During 2008, the reinsurance segment incurred estimated pre-tax net losses, after reinsurance and net of reinstatement premiums, related to Hurricanes Gustav and Ike of $197.4 million. Before reinsurance, such estimated losses were $221.5 million. The components of the reinsurance segment's underwriting results are discussed below.
August 15, 2006 provided such business did not incept beyond September 30, 2006). On December 31, 2007, the Treaty expired by its terms. For its January 1, 2008 renewals, Arch Re Bermuda adjusted its book of business in light of the expiration of the Treaty 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.
Ceded premiums written by the reinsurance segment were 4.5% of gross premiums written for 2008, compared to 22.0% for 2007. In 2008, Arch Re Bermuda ceded $24.7 million of premiums written, or 2.1%, under the Treaty to Flatiron ($151.4 million on an earned basis), compared to $311.4 million, or 20.5%, in 2007 ($282.2 million on an earned basis), with the lower level due to the expiration of the Treaty. At December 31, 2008, $18.3 million of premiums ceded to Flatiron were unearned.
Net Premiums Earned. Net premiums earned for our reinsurance segment were $1.17 billion for 2008, compared to $1.24 billion for 2007, and generally reflect changes in net premiums written over the previous five quarters, including the mix and type of business written.
Losses and Loss Adjustment Expenses. Reinsurance segment losses and loss adjustment expenses incurred for 2008 were $654.2 million, or 55.9% of net premiums earned, compared to $566.4 million, or 45.6% of net premiums earned, for 2007. The 2008 loss ratio reflected approximately 19.6 points of catastrophic activity, primarily related to Hurricanes Gustav and Ike, while the 2007 loss ratio reflected approximately 4.3 points of catastrophic activity. The 2008 loss ratio also reflected a 19.8 point reduction related to estimated net favorable development in prior year loss reserves, compared to a 13.9 point reduction in the 2007 period. The estimated net favorable development in 2008 was in short-tail and long-tail lines and resulted from better than anticipated claims emergence. The reinsurance segment's loss ratio in 2008 also reflected changes in the mix of business and an increase in expected loss ratios across a number of lines of business primarily due to rate changes.
Underwriting Expenses. The underwriting expense ratio for the reinsurance segment was 29.4% for 2008, compared to 28.9% for 2007. The acquisition expense ratio for 2008 was 22.7%, compared to 22.4% for 2007. The acquisition expense ratio is influenced by, among other things, the mix and type of business written and earned and the level of ceding commission income. The acquisition expense ratio for 2008 included 0.9 points related to favorable prior year loss development, compared to 1.5 points in 2007. In addition, the reinsurance segment's results included commission income (in excess of the reimbursement of direct acquisition expenses) on the quota-share reinsurance treaty with Flatiron, which reduced the acquisition expense ratio by 2.0 points in 2008, compared to 3.1 points in 2007. 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.
Equity in net loss of investment funds accounted for using the equity method was $178.6 million for 2008, compared to $0.2 million for 2007. We record such investments on a one month or three month lag. The 2008 amount primarily related to our investments in U.S. and Euro-denominated bank loan funds and resulted from the extreme volatility in the capital and credit markets during September to November 2008 as the market values of the secured loans underlying the holdings in such funds declined significantly.
(1)Includes net realized gains or losses from derivatives, futures contracts and other items.
Total return on our portfolio under management for 2008 was a negative 2.84%, compared to a positive 6.52% for 2007. Total return is calculated on a pre-tax basis and before investment expenses. The lower total return in 2008 compared to 2007 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 2008, net realized losses on our fixed maturities of $173.2 million included a provision of $155.4 million for declines in the market value of investments held in our available for sale portfolio which were considered to be other-than-temporary, based on reviews performed during 2008. Such amount included $22.8 million of write downs on our holdings in fixed income securities issued by
The income tax provision on income before income taxes resulted in an effective tax rate of 4.4% for 2008, compared to 1.8% for 2007. Our effective tax rate fluctuates from year to year consistent with the relative mix of income reported by jurisdiction due primarily to the varying tax rates in each jurisdiction. We currently estimate that our comparable income tax provision in 2009 will result in an effective tax rate of approximately 2.5% to 4.5%, although no assurances can be given to that effect. See note 9, "Income Taxes," of the notes accompanying our consolidated financial statements for a reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average statutory tax rate for 2008, 2007 and 2006.
Net income available to common shareholders was $832.1 million for 2007, compared to $692.6 million for 2006. The improvement in our results of operations was primarily due to growth in investment income and a low level of catastrophic activity, as discussed in "-Segment Information" below. Our net income available to common shareholders for 2007 represented a 23.9% annualized return on average common equity, compared to 24.1% for 2006.
Premiums Written. Gross premiums written by the insurance segment were $2.66 billion for 2007, compared to $2.62 billion for 2006, and ceded premiums written were 35.4% of gross premiums written for 2007, compared to 37.1% for 2006. Net premiums written by the insurance segment were $1.72 billion for 2007, compared to $1.65 billion for 2006. Contributing to the higher level of net premiums written in 2007 were increases in professional liability business, as a result of growth in policies written, a higher level of travel and accident business and a decrease in the usage of reinsurance, national accounts casualty business and excess workers' compensation and employers' liability business (included in 'other'). This growth was partially offset by a continued reduction in U.S. primary casualty business and surety business in response to increasing competition and market conditions. For information regarding net premiums written by major line of business and geographic location, refer to note 3, "Segment Information," of the notes accompanying our consolidated financial statements.
Losses and Loss Adjustment Expenses. Insurance segment losses and loss adjustment expenses incurred for 2007 were $1.08 billion, or 63.3% of net premiums earned, compared to $1.02 billion, or 63.5% of net premiums earned, for 2006. The 2007 loss ratio reflected a 0.7 point reduction related to estimated net favorable development in prior year loss reserves, compared to a 0.5 point reduction in 2006. Prior to 2005, the insurance segment's reserving method relied heavily on industry data. In 2005,
Premiums Written. Gross premiums written by the reinsurance segment were $1.52 billion in 2007, compared to $1.7 billion for 2006. Gross premiums written for 2007 reflects a lower level of casualty, other specialty and non-catastrophe exposed property business which was in response to continued competition and resulted in either non-renewals or lower shares written by the reinsurance segment. Such reductions were partially offset by continued growth in international property and marine lines, due to higher rates and an increase in exposure.
Net premiums written by the reinsurance segment were $1.18 billion for 2007, compared to $1.37 billion for 2006. Net premiums written for 2007 reflects the lower level of international casualty business noted above, which more than offset growth in international property and marine lines, net of the amounts ceded to Flatiron For information regarding net premiums written by major line and type of business and geographic location, refer to note 3, "Segment Information," of the notes accompanying our consolidated financial statements.
Losses and Loss Adjustment Expenses. Reinsurance segment losses and loss adjustment expenses incurred for 2007 were $566.4 million, or 45.6% of net premiums earned, compared to $773.3 million, or 52.2% of net premiums earned, for 2006. The 2007 loss ratio reflected a 13.9 point reduction related to estimated net favorable development in prior year loss reserves, compared to a 4.6 point reduction in 2006. Of the 2007 net favorable development in the reinsurance segment, a significant portion came from short-tail lines and resulted from better than anticipated loss emergence. In addition, the reinsurance segment's 2007 results included approximately 4.3 points related to 2007 catastrophe losses, while the 2006 results included 3.1 points related to 2006 catastrophe losses. The reinsurance segment's 2007 loss ratio also reflects an increase in expected loss ratios across a number of lines of business, primarily due to premium rate decreases and loss cost trends, and changes in the mix of business.
In its reserving process in 2002 and 2003, the reinsurance segment recognized that there is a possibility that the assumptions made could prove to be inaccurate due to several factors primarily related to the start up nature of its operations. Due to the availability of additional data, and based on reserve analyses, it was determined that it was no longer necessary to continue to include such factors in the reserving process in 2004. Following reserve reviews, and based on the level of claims activity reported to date, the reinsurance segment has reduced the amount it had recorded in 2002 and 2003 by $10.6 million in 2007 and $7.7 million in 2006. Such amounts are reflected in the prior year development indicated above.
For a discussion of the reserves for losses and loss adjustment expenses, please refer to the section above entitled "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Reserves for Losses and Loss Adjustment Expenses."
Underwriting Expenses. The underwriting expense ratio for the reinsurance segment was 28.9% for 2007, compared to 28.5% for 2006. The acquisition expense ratio for 2007 was 22.4%, compared to 24.9% for 2006. The acquisition expense ratio is influenced by, among other things, the mix and type of business written and earned and the level of ceding commission income. The acquisition expense ratio for 2007 included 1.5 points related to favorable prior year loss development, compared to 0.5 points in 2006. In addition, the reinsurance segment's results included commission income (in excess of the reimbursement of direct acquisition expenses) on the quota-share reinsurance treaty with Flatiron, which reduced the acquisition expense ratio by 3.1 points in 2007, compared to 1.6 points in 2006. The reinsurance segment's other operating expense ratio was 6.5% for 2007, compared to 3.6% for 2006. The higher ratio in 2007 primarily resulted from expenses related to the reinsurance segment's property facultative reinsurance operation, which commenced operations during the 2007 second quarter, and a lower level of net premiums earned.
Net investment income was $463.1 million for 2007, compared to $377.5 million for 2006. The increase in net investment income in 2007 resulted from a higher level of average invested assets primarily generated by cash flows from operations. In addition, an increase in the pre-tax investment income yield to 4.97% for 2007 from 4.69% for 2006 contributed to the growth in net investment income. These yields were calculated based on amortized cost. The increase in the pre-tax investment yield primarily resulted from higher interest rates embedded in the investment portfolio.
Net foreign exchange losses for 2007 of $44.0 million consisted of net unrealized losses of $48.8 million and net realized gains of $4.8 million, compared to net foreign exchange losses of $23.9 million for 2006, which consisted of net unrealized losses of $27.3 million and net realized gains of $3.4 million. For the 2007 and 2006 periods, the net unrealized foreign exchange gains or losses recorded were largely offset by changes in the value of our investments held in foreign currencies. The net foreign exchange losses in 2007 and 2006 primarily resulted from a weakening of the U.S. Dollar. For the 2007 and 2006 periods, the net unrealized foreign exchange gains or losses recorded by us were largely offset by changes in the value of our investments held in foreign currencies.
The income tax provision on income before income taxes resulted in an effective tax rate of 1.8% for 2007, compared to 3.6% for 2006. Our effective tax rate fluctuates from year to year consistent with the relative mix of income reported by jurisdiction due primarily to the varying tax rates in each jurisdiction.
On a consolidated basis, our aggregate investable assets totaled $9.97 billion at December 31, 2008, compared to $10.12 billion at December 31, 2007, as detailed in the table below:
At December 31, 2008 and 2007, the weighted average contractual maturities of our total fixed maturity and short-term investments, based on market value, were 12.0 years and 12.0 years, respectively, while the weighted average expected maturities of our total fixed maturity and short-term investments, based on market value, were 4.2 years and 4.6 years, respectively. There were no investments in any entity in excess of 10% of our shareholders' equity at December 31, 2008 or 2007 other than investments issued or guaranteed by the United States government or its agencies.
The distribution of our fixed maturities and fixed maturities pledged under securities lending agreements by type is shown below:
At December 31, 2008, we had the ability and intent to hold fixed maturities which were in an unrealized loss position until recovery. During 2008, pre-tax net realized losses on our investment portfolio were $185.1 million, which reflected $181.2 million of other-than-temporary impairment charges, including $22.8 million of write downs on our holdings in fixed income securities issued by Lehman Brothers Holdings Inc. During the second half of 2008, credit spreads significantly widened, which led to significant unrealized losses on our investment portfolio. See "Risk Factors-Risks Relating to Our Company-Our investment performance may affect our financial results and ability to conduct business."
The following table summarizes our top ten exposures to fixed income corporate issuers at December 31, 2008, including amounts guaranteed by the U.S. government:
(1)Securities issued which are guaranteed by the Federal Deposit Insurance Corporation ("FDIC"), a U.S. government agency, under the Temporary Liquidity Guarantee Program. At December 31, 2008, we held insurance enhanced municipal bonds, net of prerefunded bonds that are escrowed in U.S. government obligations, in the amount of approximately $362.5 million, which represented approximately 4% of our total invested assets. These securities had an average rating of "Aa3" by Moody's and "AA" by Standard & Poor's. Giving no effect to the insurance enhancement, the overall credit quality of our insured municipal bond portfolio had an average underlying rating of "Aa3" by Moody's and "AA" by Standard & Poor's. Guarantors of our insurance enhanced municipal bonds, net of prerefunded bonds that are escrowed in U.S. government obligations, included MBIA Insurance Corporation ($147.8 million), Financial Security Assurance Inc. ($75.9 million), Ambac Financial Group, Inc. ($77.6 million), Financial Guaranty Insurance Company ($32.7 million) and the Texas Permanent School Fund ($28.5 million). We do not have a significant exposure to insurance enhanced asset-backed or mortgage-backed securities. We do not have any significant investments in companies which guarantee securities at December 31, 2008.
Our portfolio includes investments, such as mortgage-backed securities, which are subject to prepayment risk. At December 31, 2008, our investments in mortgage-backed securities ("MBS"), excluding commercial mortgage-backed securities, amounted to approximately $1.58 billion, or 15.9% of total investable assets, compared to $1.23 billion, or 12.2%, at December 31, 2007. Such amounts are classified as "available for sale" and are not held for trading purposes. 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 commercial mortgage backed securities ("CMBS") at December 31, 2008, 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, 2008. 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. The following table provides information on our asset backed securities ("ABS") at December 31, 2008:
(3)The weighted average credit support % on rate reduction bonds is 1.4%.
Effective January 1, 2008, we adopted and implemented SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157"), which 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. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date.
SFAS No. 157 establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).
We use quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its 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 its 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 its knowledge of the current market; and (v) back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. 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.
Where we believe that quoted market prices are not available or that the market is not active, fair values are estimated by using quoted prices of securities with similar characteristics, pricing models or matrix pricing and are generally classified as Level 2 securities. We determined that Level 2 securities included corporate bonds, mortgage backed securities, municipal bonds, asset backed securities, certain U.S. government and government agencies, non-U.S. government securities, certain short-term securities and certain other investments.
The following table details our reinsurance recoverables at December 31, 2008:
(1)The financial strength ratings are as of February 9, 2009 and were assigned by A.M. Best based on its opinion of the insurer's financial strength as of such date. An explanation of the ratings listed in the table follows: the ratings of "A++" and "A+" are designated "Superior"; and the "A" and "A-" ratings are designated "Excellent." Additionally, A.M. Best has five classifications within the "Not Rated" or "NR" category. Reasons for an "NR" rating being assigned by A.M. Best include insufficient data, size or operating experience, companies which are in run-off with no active business writings or are dormant, companies which disagree with their rating and request that a rating not be published or insurers that request not to be formally evaluated for the purposes of assigning a rating opinion.
(5)In connection with our acquisition of Arch Specialty in February 2002, the seller, Sentry, agreed to reinsure and guarantee all liabilities arising out of Arch Specialty's business prior to the closing of the acquisition. In addition to the guarantee provided by Sentry, substantially all of the recoverable from Sentry is still subject to the original reinsurance agreements inuring to Arch Specialty and, to the extent Sentry fails to comply with its payment obligations to us, we may seek reimbursement from the third party reinsurers under such agreements.
(7)A substantial portion of such amount is collateralized through reinsurance trusts or letters of credit. See "-Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Collection of Insurance-Related Balances and Provision for Doubtful Accounts" for further details.
The following table provides a reconciliation of the net Loss Reserves for the years ended December 31, 2008, 2007 and 2006:
The ability of our regulated insurance and reinsurance subsidiaries to pay dividends or make distributions or other payments to us is dependent on their ability to meet applicable regulatory standards. Under Bermuda law, Arch Re Bermuda is required to maintain an enhanced capital requirement which must equal or exceed its minimum solvency margin (i.e., the amount by which the value of its general business assets must exceed its general business liabilities) equal to the greatest of (1) $100.0 million, (2) 50% of net premiums written (being gross premiums written by us less any premiums ceded by us, but we may not deduct more than 25% of gross premiums when computing net premiums written) and (3) 15% of loss and other insurance reserves. Arch Re Bermuda is prohibited from declaring or paying any dividends during any financial year if it is not in compliance with its enhanced capital requirement, minimum solvency margin or minimum liquidity ratio. In addition, Arch Re Bermuda is prohibited from declaring or paying in any financial year dividends of more than 25%
Our insurance and reinsurance subsidiaries are required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support their operations. The assets on deposit are available to settle insurance and reinsurance liabilities to third parties. Our insurance and reinsurance subsidiaries also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. At December 31, 2008 and 2007, such amounts approximated $1.28 billion and $1.17 billion, respectively. In addition, certain of our operating subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies. At December 31, 2008 and 2007, such amounts approximated $4.03 billion and $3.8 billion, respectively.
As part of our investment strategy, we seek to establish a level of cash and highly liquid short-term and intermediate-term securities which, combined with expected cash flow, is believed by us to be adequate to meet our foreseeable payment obligations. However, due to the nature of our operations, cash flows are affected by claim payments that may comprise large payments on a limited number of claims and which can fluctuate from year to year. We believe that our liquid investments and cash flow will provide us with sufficient liquidity in order to meet our claim payment obligations. However, the timing and amounts of actual claim payments related to recorded Loss Reserves vary based on many factors, including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claim payments could differ materially from our estimated amounts. Certain lines of business written by us, such as excess casualty, have loss experience characterized as low frequency and high severity. The foregoing may result in significant variability in
Consolidated net cash provided by operating activities was $1.14 billion for 2008, compared to $1.44 billion for 2007. The lower level of operating cash flows in 2008 primarily resulted from an increase in paid losses, as our insurance and reinsurance loss reserves have continued to mature, along with a lower level of premiums written and collected. 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 $9.97 billion at December 31, 2008, compared to $10.12 billion at December 31, 2007. 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. 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 without having to sell securities at distressed prices in an illiquid market or access credit facilities.
We expect that our operational needs, including our anticipated insurance obligations and operating and capital expenditure needs, for the next twelve months, at a minimum, will be met by our balance of cash, short-term investments and our credit facilities, as well as by funds generated from underwriting activities and investment income and proceeds on the sale or maturity of our investments.
authorization in February 2007 and a $500.0 million authorization in May 2008. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions through February 2010. Since the inception of the share repurchase program through December 31, 2008, ACGL has repurchased approximately 15.3 million common shares for an aggregate purchase price of $1.05 billion. During 2008, ACGL repurchased approximately 7.5 million common shares under the share repurchase program for an aggregate purchase price of $513.1 million.
In August 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. The $300.0 million unsecured loan and letter of credit facility is also available for the issuance of unsecured letters of credit up to $100.0 million for our U.S.-based reinsurance operation. 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 2008 and 2007, we paid $25.8 million to holders of the preferred shares and, at December 31, 2008, had declared an aggregate of $3.3 million of dividends to be paid to holders of the preferred shares.
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, depending on business opportunities and the mix of business that may comprise our insurance and reinsurance portfolio, we may seek to adjust our self-imposed limitations on probable maximum pre-tax loss for catastrophe exposed business. See "-Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Ceded Reinsurance" for a discussion of our catastrophe reinsurance programs.
In May 2008, Arch Re Bermuda provided $100.0 million of funding to Gulf Reinsurance Limited ("Gulf Re"), a newly formed reinsurer based in the Dubai International Financial Centre, pursuant to the joint venture agreement with GIC. Under the agreement, each of Arch Re Bermuda and GIC owns 50% of Gulf Re. The initial total capital of the joint venture consists of $200.0 million, plus an additional $200.0 million to be funded equally by us and GIC depending on the joint venture's business needs.
(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 70% of our net reserves were incurred but not reported at December 31, 2008.
On December 29, 2005, Arch Re Bermuda entered into a quota share reinsurance treaty with Flatiron pursuant to which Flatiron assumed a 45% quota share (the "Flatiron Treaty") of certain lines of property and marine business underwritten by Arch Re Bermuda for unaffiliated third parties for the 2006 and 2007 underwriting years (January 1, 2006 to December 31, 2007). Effective June 28, 2006, the parties amended the Flatiron Treaty to increase the percentage ceded to Flatiron from 45% to 70% of all covered business bound by Arch Re Bermuda from (and including) June 28, 2006 until (and including) August 15, 2006 provided such business did not incept beyond September 30, 2006. The ceding percentage for all business bound outside of this period continued to be 45%. On December 31, 2007, the Flatiron Treaty expired by its terms. As a result of the terms of the Flatiron Treaty, we determined that Flatiron is a variable interest entity. However, Arch Re Bermuda is not the primary beneficiary of Flatiron and, as such, we are not required to consolidate the assets, liabilities and results of operations of Flatiron per FIN 46R.
Fixed Income Securities. We invest in interest rate sensitive securities, primarily debt securities. We consider the effect of interest rate 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 which invest in fixed income securities and the corresponding change in unrealized appreciation. As interest rates rise, the market value of our interest rate sensitive securities falls, and the converse is also true. 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, 2008 and 2007. 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, in recent months interest rate movements in many credit sectors 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 further discussion on investment activity, please refer to "-Financial Condition, Liquidity and Capital Resources-Financial Condition-Investable Assets"
Another method that attempts to measure portfolio risk is Value-at-Risk ("VaR"). VaR attempts to take into account a broad cross-section of risks facing a portfolio by utilizing relevant securities volatility data skewed towards the most recent months and quarters. VaR measures the amount of a portfolio at risk for outcomes 1.65 standard deviations from the mean based on normal market conditions over a one year time horizon and is expressed as a percentage of the portfolio's initial value. In other words, 95% of the time, should the risks taken into account in the VaR model perform per their historical tendencies, the portfolio's loss in any one year period is expected to be less than or equal to the calculated VaR, stated as a percentage of the measured portfolio's initial value. As of December 31, 2008, our portfolio's VaR was estimated to be 8.49%, compared to an estimated 3.73% at December 31, 2007, and reflected the significant increase in volatility in 2008.
Privately Held Securities and Equity Securities. Our investment portfolio includes an allocation to privately held securities and equity securities. At December 31, 2008 and 2007, the market value of our investments privately held securities and equity securities (excluding our investment in Aeolus LP which is accounted for using the equity method) totaled $8.8 million and $105.3 million, respectively. These securities are exposed to price risk, which is the potential loss arising from decreases in market value. An immediate hypothetical 10% depreciation in the value of each position would reduce the market value of such investments by approximately $0.9 million and $10.5 million at December 31 2008 and 2007, respectively, and would have decreased book value per common share by approximately $0.01 and $0.16, respectively.
Investment-Related Derivatives. We began to invest in certain derivative instruments in 2006 to replicate investment positions and to manage market exposures and duration risk. At December 31, 2008 and 2007, the notional value of the net long position for equity futures was nil and $91.2 million, respectively. At December 31, 2008, the notional value of the net long position for Treasury note futures was $556.3 million, compared to $61.7 million at December 31, 2007. At December 31, 2008, the notional value of the net long position for U.K. and German government futures was approximately $363.3 million (at December 31, 2008 foreign currency rates). A 10% depreciation of the underlying exposure to these derivative instruments at December 31, 2008 and 2007 would have resulted in a reduction in net income of approximately $92.0 million and $15.3 million, respectively, and would have decreased book value per common share by $1.52 and $0.23, respectively.