Share and per share data have been retroactively adjusted, as appropriate, to reflect common stock splits.
Includes amounts payable to affiliates and others as follows: 2008-Affiliates $448,346; Others $273,897; 2007-Affiliates $448,158; Others $298,772; 2006-Affiliates $447,980; Others $298,653; 2005-Affiliates $447,812; Others $298,541.
These factors are further discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Part I, Item 1A. Risk Factors of this Form 10-K. TRH is not under any obligation to (and expressly disclaims any such obligations to) update or alter any forward-looking statement, whether written or oral, that may be made from time to time, whether as a result of new information, future events or otherwise.
The following discussion refers to the consolidated financial statements of TRH as of December 31, 2008 and 2007 and for each of the three years in the period ended December 31, 2008, which are presented elsewhere herein. Financial data discussed below have been affected by certain transactions between TRH and related parties. (See Notes 7, 12, 14 and 16 of Notes to Consolidated Financial Statements.)
TRH’s operating strategy emphasizes product and geographic diversification as key elements in managing its level of risk concentration. TRH seeks to focus on more complex risks within the casualty and property lines and adjusts its mix of business to take advantage of market opportunities. Over time, TRH has most often capitalized on market opportunities when they arise by strategically expanding operations in an existing location or opening a branch or representative office in new locations. TRH’s operations that serve international markets leverage TRH’s product knowledge, worldwide resources and financial strength, typically utilizing indigenous management and staff with a thorough knowledge of local markets and product characteristics.
In 2008, casualty lines comprised 70% of TRH’s net premiums written, while property lines totaled 30%. In addition, treaty reinsurance totaled 97% of net premiums written, with the balance representing facultative accounts. Moreover, business written by international operations represented 50% of net premiums written in 2008.
TRH’s major sources of revenues are net premiums earned for reinsurance risks undertaken and income from investments. The great majority of TRH’s investments are in fixed maturity securities held to maturity and available for sale with an average duration of 6.0 years as of December 31, 2008. In general, premiums are received significantly in advance of related claims payments.
American International Group, Inc. (“AIG”), which through its subsidiaries is a provider of insurance and investment products and services to businesses and individuals around the world,
beneficially owned approximately 59% of the Common Stock of the Company (“TRH shares”) as of December 31, 2008, 2007 and 2006.
In September 2008, AIG experienced a severe strain on its liquidity that resulted in AIG entering into an $85 billion credit agreement, subsequently reduced to $60 billion (“AIG’s Fed Credit Agreement”), with the Federal Reserve Bank of New York (the “NY Fed”). Pursuant to that agreement, AIG agreed to issue 100,000 shares of AIG’s Series C Perpetual, Convertible, Participating Preferred Stock (“AIG’s Series C Preferred Stock”) to a trust for the benefit of the U.S. Treasury. AIG’s Fed Credit Agreement is secured by, among other things, 17.1 million shares of the Company’s common stock held directly by AIG; however, TRH did not guarantee AIG’s obligation under AIG’s Fed Credit Agreement and none of TRH’s assets were pledged to secure AIG’s obligations under AIG’s Fed Credit Agreement.
A special committee of the Company’s independent directors (the “Special Committee”) was subsequently formed to evaluate proposals received from AIG relating to the possible disposition of, or other transactions involving, AIG’s 59% beneficial ownership of the Company as well as any related business combination transactions involving TRH’s outstanding shares. The Special Committee is continuing its process; however, there can be no assurance as to whether or when AIG will dispose of all or any portion of its interest in the Company or whether or when the Company will engage in any transaction.
In October 2008, TRH adopted an employee retention plan covering a significant number of its employees, including its senior-most management. Salary expense associated with this plan totaled approximately $8 million in 2008 and is expected to total approximately $20 million in 2009. (See Note 19 of Notes to Consolidated Financial Statements.)
Revenues increased in 2007 compared to 2006 due primarily to increases in Domestic net premiums earned and, to lesser extents, International-Europe net premiums earned, Domestic realized net capital gains and consolidated net investment income, offset in part by decreases in International-Other net premiums earned and international realized net capital gains (losses). The increase in International-Europe net premiums earned occurred principally in the London and Paris branches. The decrease in International-Other net premiums earned occurred in the Miami and Hong Kong branches. The most significant increases in consolidated net premiums earned occurred in the other liability, property and medical malpractice lines, partially offset by a significant decrease in the auto liability line. Net investment income increased in 2007 due largely to an increase in investment income from fixed maturities. The increase in investment income from such securities was due in part to the investment of significant positive net operating cash flows generated in recent periods.
Following the terrorist attacks in the United States in 2001, the insurance and reinsurance markets experienced a considerable hardening of rates as well as terms and conditions. These improvements peaked in late 2003 / early 2004. From that point, while terms and conditions remained strong, globally rates began moving downward with property rate decreases generally outpacing casualty rate decreases and insurance rate decreases outpacing reinsurance rate decreases.
TRH expects that the U.S. property catastrophe reinsurance marketplace will continue to improve during 2009, especially where there is coastal storm or earthquake exposure and casualty rates will also begin to improve as loss trends emerge and the cost of capital increases. Internationally, most lines and markets continued to be impacted by overcapacity in 2008, but increased reinsurance industry discipline and contracting capacity toward the end of 2008 may potentially lead to stabilization or improvement of market conditions in 2009.
Additionally, in April 2008, the Brazilian reinsurance market was opened to the private sector. As an Admitted Reinsurer in Brazil, TRC expects to see new opportunities arise in Brazil in future periods.
of assumptions about certain matters that are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, TRH’s results of operations and financial condition would be affected, possibly materially. A discussion of these most critical accounting estimates follows:
Estimates of loss reserves take into account TRH’s assumptions with respect to many factors that will affect ultimate loss costs but are not yet known. The ultimate process by which actual carried reserves are determined considers not only actuarial estimates but a myriad of other factors. Such factors, both internal and external, which contribute to the variability and unpredictability of loss costs, include trends relating to jury awards, social inflation, medical inflation, worldwide economic conditions, tort reforms, court interpretations of coverages, the regulatory environment, underlying policy pricing, terms and conditions and claims handling, among others. In addition, information gathered through underwriting and claims audits is also considered. To the extent that these assumptions underlying the loss reserve estimates are significantly incorrect, ultimate losses may be materially different from the estimates included in the financial statements and may materially and adversely affect results of operations and financial condition. The impact of those differences is reflected in the period they become known.
While this process is difficult and subjective for ceding companies, the inherent uncertainties of estimating loss reserves are even greater for reinsurers, due primarily to the longer-term nature of much reinsurance business, the diversity of development patterns among different types of reinsurance treaties or facultative contracts, the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies, which are subject to change without notice. Nevertheless, data received from cedants is subjected to audits periodically by TRH claims and underwriting personnel, to help ensure that reported data is supported by proper documentation and conforms to contract terms, and analyzed, as appropriate, by TRH underwriting and actuarial personnel. Such analysis often includes a detailed review of reported data to assess the underwriting results of reinsurance assumed and to explain any significant departures from expected performance. Over time, reported loss information is ultimately corroborated when such information eventually attains paid status.
During the loss settlement period, which can be many years in duration, additional facts regarding individual claims and trends usually become known. As these facts and trends emerge, it usually becomes necessary to refine and adjust the loss reserves upward or downward and even then the ultimate net liability may be materially different from the revised estimates. There is potential for significant variation in the development of loss reserves when actual costs differ from the costs implied by the use of the assumptions employed in the reserve setting process. This is particularly true for assumed reinsurance of long-tail casualty classes. Among the most critical assumptions are those made for ELRs and loss development factors.
Other Liability: The key components of the other liability line of business are excess casualty, D&O and E&O.
Shorter tailed lines: These would include the property lines of business (such as fire and homeowners multiple peril), A&H and certain marine and energy classes. These lines are written out of several of TRH’s worldwide offices and the reserves are reviewed separately for each operating branch. Where sufficiently credible experience exists, these lines are reviewed after segregating pro rata contracts from excess-of-loss contracts. For a reinsurer, these lines do not develop to ultimate loss as quickly as when written on a primary basis; however, they are significantly shorter tailed than the casualty classes discussed earlier. For these classes, a combination of loss development methods and B-F methods are used. Generally, selections for all but the most recent few years are based on loss development methods with the most recent years based on weightings of loss development and expected loss ratio indications.
Net loss reserves include amounts for risks relating to environmental impairment and asbestos-related illnesses. The majority of TRH’s environmental and asbestos-related net loss reserves arose from contracts entered into after 1985 that were underwritten specifically as environmental or asbestos-related coverages rather than as standard general liability coverages, where the environmental or asbestos-related liabilities were neither clearly defined nor specifically excluded. The reserves carried for these claims, including loss and loss adjustment expenses incurred but not reported, are based upon known facts and current law. However, significant uncertainty exists in determining the amount of ultimate liability for environmental impairment and asbestos-related losses, particularly for those occurring in 1985 and prior. This uncertainty is due to inconsistent court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other things.
The degree of judgment used in measuring the fair value of financial instruments generally correlates with the level of pricing observability. Financial instruments with quoted prices in active markets generally have more pricing observability and less judgment is used in measuring fair value. Conversely, financial instruments traded in other-than-active markets or that do not have quoted prices, have less observability and are measured at fair value using valuation models or other pricing techniques that require more judgment. An active market is one in which transactions for the asset being valued occurs with sufficient frequency and volume to provide pricing information on an ongoing basis. An other-than-active market is one in which there are few transactions, the prices are not current, price quotations vary substantially either over time or among market makers, or in which little information is released publicly for the asset being valued. Pricing observability is affected by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and general market conditions.
TRH’s management is responsible for the determination of the value of the financial assets carried at fair value and the supporting methodologies and assumptions. With respect to securities, TRH employs independent third-party valuation service providers to gather, analyze and interpret market information and derive fair values based upon relevant methodologies and assumptions for individual instruments. When TRH’s valuation service providers are unable to obtain sufficient market observable information upon which to estimate the fair value for a particular security, fair value is determined either by requesting brokers who are knowledgeable about these securities to provide a quote, which is generally non-binding, or by employing widely accepted internal valuation models.
As of December 31, 2008, the fair value of substantially all of TRH’s fixed maturity and equity securities is based on external sources, of which approximately $198 million is primarily based on broker quotes.
Under Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”), assets recorded at fair value in the consolidated balance sheet are classified in a hierarchy for disclosure purposes consisting of three “levels” based on the observability of inputs available in the market place used to measure the fair value. (See Note 3 of Notes to Consolidated Financial Statements for additional information about fair value measurements.)
TRH values its assets classified as Level 3 using judgment and valuation models or other pricing techniques that require a variety of inputs including contractual terms, market prices and rates, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs, some of which may be unobservable. The following paragraphs describe the methods TRH uses to measure on a recurring basis the fair value of assets classified in Level 3.
Certain Other Asset-Backed Securities-non-mortgage: These assets initially are valued at the transaction price. Subsequently, they may be valued based on external price/spread data. When position-specific external price data are not observable, the valuation is based on prices of comparable securities.
TRH evaluates its investments for other-than-temporary impairments in valuation. TRH evaluates its investments for other-than-temporary impairment such that a security is considered a candidate for other-than-temporary impairment if it meets any of the following criteria:
The occurrence of a discrete credit event resulting in (i) the issuer defaulting on a material outstanding obligation; (ii) the issuer seeking protection from creditors under the bankruptcy laws or any similar laws intended for court supervised reorganization of insolvent enterprises; (iii) the issuer proposing a voluntary reorganization pursuant to which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than the par value of their claims; or
Net premiums written increased in 2007 compared to 2006. The sources of the most significant growth were premiums generated by domestic regional offices which were opened during 2006 but generated minimal premium volume in that year, increased international other liability business and A&H premiums generated by TRZ. In addition, the impact of changes in foreign currency exchange rates contributed significantly to premium growth as shown in the table below. Premium growth in 2007 was mitigated by increased ceding company retentions in certain lines.
In 2008 and 2007, as compared to the respective immediately prior year, the increase in net premiums written was from treaty business. On a worldwide basis, casualty lines business represented 69.8% of net premiums written in 2008 versus 71.0% and 73.3% in 2007 and 2006, respectively. The balance represented property lines. Treaty business represented 96.8% of net premiums written in 2008 versus 96.3% and 95.3% in 2007 and 2006, respectively. The balance represented facultative accounts.
International net premiums written increased in 2008 by $67.6 million, or 3.4%, from the prior year to $2.07 billion. The most significant increases in net premiums written occurred in the Miami ($37.2 million), London ($15.9 million) and Hong Kong ($11.9 million) branches and in TRZ ($18.7 million), partially offset by a significant decrease in the Toronto ($27.5 million) branch. International net premiums written increased significantly in the property ($35.4 million), credit ($25.1 million) and A&H ($17.2 million) lines and were partially offset by significant decreases in the other liability ($22.0 million) and ocean marine ($12.7 million) lines. International business represented 50.4% of 2008 net premiums written compared to 50.7% in 2007.
Domestic net premiums written increased in 2007 by $196.8 million, or 11.2%, from the prior year to $1.95 billion, with the large majority of that increase emanating from domestic regional offices which were opened during 2006. Significant increases in domestic net premiums written were recorded in the property ($142.8 million), medical malpractice ($58.8 million) and auto liability ($48.2 million) lines. These increases were partially offset by a significant decrease in the A&H ($23.0 million) line.
International net premiums written increased in 2007 by $122.6 million, or 6.5%, from the prior year to $2.00 billion due largely to the impact of changes in foreign currency exchange rates compared to the U.S. dollar. Significant increases in the London ($68.7 million), Paris ($30.1 million) and Toronto ($14.1 million) branches and in TRZ ($24.1 million) were partially offset by a significant decrease in the Miami branch ($11.5 million). Of the $122.6 million increase in international net premiums written, $88.5 million is attributable to changes in foreign currency exchange rates between the U.S. dollar and the currencies in which TRH does business. Significant increases in international net premiums written were recorded in the other liability (principally D&O, E&O and the general casualty class) ($43.9 million), A&H ($40.8 million), property ($33.3 million) and boiler and machinery ($22.8 million) lines.
Generally, reasons for changes in gross premiums written between years are similar to those for net premiums written, except for changes resulting from reinstatement premiums and changes in ceded premiums, including premiums assumed from an affiliate that, by prearrangement, were ceded in an equal amount to other affiliates (see Note 10 and Note 16 of Notes to Consolidated Financial Statements (“Note 16”)). The increase in premiums ceded to affiliates in 2008 compared to 2007 is due principally to an increase in premiums assumed from an affiliate that, by prearrangement with TRH, were then ceded in an equal amount to other affiliates. The decrease in premiums ceded to non-affiliates in 2008 compared to 2007 is due in part to the purchase of less retrocession coverage. As further discussed in Notes 14 and 16 of Notes to Consolidated Financial Statements, TRH transacts a significant amount of business assumed and ceded with other subsidiaries of AIG. TRH either accepts or rejects the proposed transactions with such companies based on its assessment of risk selection, pricing, terms and conditions.
For 2008, 2007 and 2006, the pre-tax effective yields on investments were 3.8%, 3.9% and 4.2%, respectively. The pre-tax effective yield on investments represents net investment income divided by the average balance sheet carrying value of investments and interest-bearing cash. Investment returns from securities lending invested collateral served to negatively impact the yields in each of the above years by 0.3%, 0.7% and 0.5%, respectively, as the net return from the invested collateral is very small in relation to the balance sheet carrying amount because investment income earned from invested collateral is reduced by interest payable to the collateral provider. In 2008 compared to 2007, the decline in investment results from other invested assets reduced the yield by 0.5%. (See Investment Results in Item 1. Business.)
Realized net capital (losses) gains totaled ($435.5) million, $9.4 million and $10.9 million in 2008, 2007 and 2006, respectively (see Note 4(c) of Notes to Consolidated Financial Statements for the components of realized net capital (losses) gains). Realized net capital losses in 2008 included $99.9 million of net losses on sales and redemptions of securities and $317.8 million of other-than-temporary impairment write-downs. The significant realized net capital losses from sales and redemptions of securities and other-than-temporary impairment write-downs in 2008 generally resulted from declines in the market values of securities due to the downturn in the U.S. economy, turmoil in the financial markets, financial market illiquidity and issuer-specific credit events in 2008.
Upon the ultimate disposition of securities for which write-downs have been recorded, a portion of the write-downs may be recoverable depending on market conditions at the time of disposition. (See Critical Accounting Estimates for the criteria used in the determination of such write-downs.)
Through 2008, TRH participated in a securities lending program (the “Securities Lending Program”) managed by a subsidiary of AIG, whereby certain securities from its portfolio were loaned to third parties. (See Note 2(c) of Notes to Consolidated Financial Statements (“Note 2(c)”).) Under such program, TRH loaned securities to counterparties and received collateral, generally cash, which was invested to earn a spread.
Prior to the fourth quarter of 2008, the transfers of securities in exchange for collateral under the Securities Lending Program were accounted for as secured borrowings, with a liability recorded in an amount equal to the collateral received, reflecting TRH’s obligation to return the collateral when the loaned securities were returned. As a result of conditions affecting the financial and credit markets, in the fourth quarter of 2008, counterparties were successful in negotiating significantly reduced collateral levels (i.e., collateral received as a percentage of the fair value of the security loaned). Due to the lower collateral levels, during the fourth quarter of 2008, many of such loaned securities were accounted for as sales at the time of transfer and as purchases when the securities were subsequently returned. In the fourth quarter of 2008, TRH terminated its participation in the Securities Lending Program.
The financial impact on the Statement of Operations of the Securities Lending Program was as follows: With respect to securities lending invested collateral: Net investment income from the Securities Lending Program (i.e., income earned on invested collateral, net of interest payable to the collateral provider) totaled $2.6 million, $2.5 million and $2.2 million in 2008, 2007 and 2006, respectively; Net realized losses on sales of securities lending invested collateral totaled $8.0 million, $1.8 million and nil in 2008, 2007 and 2006, respectively; Other-than-temporary impairment write-downs (included in net realized capital losses) totaled $97.7 million in 2008 and nil in 2007 and 2006. With respect to the securities loaned, realized losses in the fourth quarter of 2008 on “deemed” sales of securities loaned totaled $16 million.
In 2008, TRH repurchased $25 million principal amount of its 5.75% senior notes due in 2015 (the “Senior Notes”) from non-affiliates for $15 million, realizing a gain of $10 million.
The property and casualty insurance and reinsurance industries use the combined ratio as a measure of underwriting profitability. The combined ratio reflects only underwriting results and does not include income from investments. Generally, a combined ratio under 100% indicates an underwriting profit and a combined ratio exceeding 100% indicates an underwriting loss. Underwriting profitability is subject to significant fluctuations due to competition, natural and man-made catastrophic events, economic and social conditions, foreign currency exchange rate fluctuations, interest rates and other factors. The loss ratio represents net losses and LAE incurred expressed as a percentage of net premiums earned. The underwriting expense ratio represents the sum of net commissions and other underwriting expenses expressed as a percentage of net premiums written. The combined ratio represents the sum of the loss ratio and the underwriting expense ratio.
2008 includes net catastrophe costs of $169.7 million, principally relating to Hurricane Ike. Net catastrophe costs in the aggregate added 4.2%, 7.2% and 1.1% to the 2008 combined ratios for consolidated, domestic and international, respectively. (See Note 10 for the amounts of net catastrophe costs by segment and the amounts of consolidated gross and ceded catastrophe losses incurred and reinstatement premiums. See discussion in Catastrophe Exposure of the magnitude of TRH’s catastrophe exposures.)
Amount of reestimation represents the amount of net losses and LAE incurred in 2008 relating to losses occurring in 2007 and prior years.
The favorable development in accident years 2004 through 2007 results generally from favorable loss trends. The net adverse development arising from losses occurring in years 1998 through 2001, which represent the great majority of the 2002 and prior development, generally relates to the fact that for many classes within these years, ceding companies continue to experience increased loss costs relative to expectations, coupled with an unexpected lengthening of the loss emergence patterns. Generally, loss activity was greater than expected from losses occurring in the D&O and E&O classes, although to a lesser extent than in previous calendar year periods. Also, classes such as medical malpractice and excess umbrella were impacted by late reported high layer excess claims to a greater extent than expected. Contributing to this increase, is the fact that many policies during this period covered underlying contracts that extended over multiple years, which contributed to recent reported loss activity exceeding previous expectations. This has led to an increase in both the frequency and severity of claims entering the reinsured excess-of-loss coverage layers at later points in time than had previously been experienced.
Based on information presently available, TRH’s current loss reserves represent management’s best estimate of ultimate losses, but there can be no assurance that TRH’s loss reserves will not develop adversely due to, for example, the inherent volatility in loss trend factors and variability of
There were no significant net catastrophe costs for events occurring in 2006. Net catastrophe costs (relating to events principally occurring in 2005) in the aggregate added 0.8%, 1.1% and 0.6% to the 2006 combined ratios for consolidated, domestic and international, respectively.
However, in 2006, TRH determined that its estimates of the ultimate amounts of net losses occurring in 2005 and prior years needed to be increased as a result of greater than expected loss activity in 2006. As a result of that determination, TRH increased net losses and LAE incurred by $181.1 million, representing significant net adverse development in 2006 of losses occurring in all prior years. This net adverse development was comprised of $339.7 million relating to losses occurring in 2002 and prior, partially offset by favorable development of $158.6 million relating primarily to 2005, and to a lesser extent, 2004 and 2003. The detail of the $181.1 million net adverse development by line of business relating to all prior years is presented in the table below:
Amount of reestimation represents the amount of net losses and LAE incurred in 2006 relating to losses occurring in 2005 and prior years.
The underwriting expense ratio for consolidated TRH decreased in 2008 compared to 2007 due to a decrease of 1.0% in the commission expense component, partially offset by an increase of 0.3% in the other underwriting expense component. The decrease in the commission expense component is due in part to a change in the mix of business. The increase in the other underwriting expense component is due in part to expenses incurred related to the Retention Plan.
In 2008, TRH repurchased $25 million principal amount of the Senior Notes from non-affiliates. $725 million and $750 million principal amount of the Senior Notes were outstanding at December 31,
General corporate expenses, certain stock-based compensation costs and expenses relating to Professional Risk Management Services, Inc. (“PRMS”), which was acquired in 2007, are the primary components of “other, net” expenses on the Consolidated Statement of Operations. PRMS is an insurance program manager specializing in professional liability insurance services. The increase in “other, net” expenses in 2007 compared to 2006 is due to PRMS expenses and an increase in general corporate expenses.
Income before income taxes was $3.2 million in 2008, $595.8 million in 2007 and $539.9 million in 2006. The decrease in income before income taxes in 2008 compared to 2007 resulted from significant net realized capital losses, including significant other-than-temporary impairment write-downs, decreased underwriting profit and lower net investment income in 2008. The decreased net underwriting profit in 2008 is due in part to decreased current accident year underwriting profit (loss) excluding catastrophe costs in 2008 compared to 2007 and increased net catastrophe costs partially offset by lower net loss reserve development. Increased net catastrophe costs and lower net loss reserve development had the net impact of decreasing underwriting profit by $47.3 million. The decrease in net investment income is largely due to a decrease in investment results from other invested assets, principally related to hedge funds, partially offset by increased net investment income from fixed maturities. The increase in income before income taxes in 2007 compared to 2006 resulted primarily from increased underwriting profit (loss) and net investment income. The increased underwriting profit (loss) in 2007 reflected increased net premiums earned together with a lower combined ratio benefiting largely from decreased net adverse loss reserve development offset in part by higher catastrophe costs in 2007 compared to 2006 which together had the impact of increasing income before income taxes in 2007 by $47.7 million.
Federal and foreign income tax (benefit) expense of ($99.0) million, $108.6 million and $111.8 million were recorded in 2008, 2007 and 2006, respectively. The 2008 tax benefit, which exceeds the income before income taxes in 2008, resulted from the tax benefit generated by the significant amount of realized net capital losses occurring during the year, including an $83.5 million current tax benefit resulting from a tax capital loss carryback to prior years, in addition to the customary tax benefits associated with tax-exempt interest and the dividends received deduction.
In 2008, TRH reversed $15.0 million of previously recorded deferred tax benefits from minimum tax credit carryforwards. In 2007 and 2006, TRH generated $32.9 million and $6.6 million, respectively, of deferred tax benefits from minimum tax credit carryforwards.
The effective tax rates, which represent the sum of current and deferred income taxes (benefits) divided by income before income taxes, were (3,073.0%) in 2008, 18.2% in 2007 and 20.7% in 2006. The actual tax benefit in 2008 derived from tax-exempt interest was slightly higher than 2007; however, the percentage impact in the effective tax rate calculation from such item increased significantly. The greater impact is caused by the fact that income before taxes (i.e., the denominator in the effective tax rate calculation) is lower in 2008 compared to 2007 and 2006, due to the significant realized net capital losses and net catastrophe costs in 2008 compared to 2007 and 2006. (See Note 5 of Notes to Consolidated Financial Statements.)
Net income and net income per common share on a diluted basis, respectively, were as follows: 2008-$102.3 million, $1.53; 2007-$487.1 million, $7.31; 2006-$428.2 million, $6.46. Reasons for the changes between years are as discussed earlier. (See Note 9 of Notes to Consolidated Financial Statements.)
2007 includes net catastrophe costs of $8.0 million relating to catastrophe events occurring in 2005. 2006 includes net catastrophe costs of $18.2 million relating to catastrophe events occurring in prior years.
2008 compared to 2007-Revenues increased slightly due to increases in net premiums written, net of the change in unearned premiums, and net investment income, largely offset by an increase in realized net capital losses. Changes in foreign currency exchange rates between the U.S. dollar and the currencies in which premiums are written in 2008 as compared to 2007 lessened the increase in
net premiums written by $10.0 million. Revenues increased in the Paris branch and in TRZ, largely offset by a decrease in the London branch. Net premiums earned increased principally in the credit, A&H and boiler & machinery lines offset in part by a significant decrease in the ocean marine and property lines. The increase in realized net capital losses was due in part to other-than-temporary impairment write-downs. Income before income taxes for 2008 decreased due primarily to a decrease in underwriting profit and increased realized net capital losses, partially offset by an increase in net investment income. The decrease in underwriting profit reflects a higher loss ratio, despite a reduction in net catastrophe costs, partially offset by a lower underwriting expense ratio.
(c) International-Other (Miami (serving Latin America and the Caribbean), Toronto, Hong Kong and Tokyo branches):
underwriting profit from the Miami branch, reflecting a significant increase in loss activity, and a decrease in realized net capital gains (losses), partially offset by increased net investment income.
Assets increased $208 million in 2007 due largely to a $189 million increase in investments and cash. The increase in investments and cash was due in part to significant positive net operating cash flows in recent periods.
Sources of funds for the operating subsidiaries consist primarily of premiums, reinsurance recoverables, investment income and proceeds from the sales, redemptions and maturing of investments. Funds are applied by the operating subsidiaries primarily to payments of claims, commissions, ceded reinsurance premiums, insurance operating expenses, income taxes and securities lending payables and the purchase of investments. Premiums are generally received substantially in advance of related claims payments. Cash and cash equivalents are maintained for the payment of claims and expenses as they become due. TRH does not anticipate any material capital expenditures in the foreseeable future.
While the expected payout pattern of liabilities (see contractual obligations table later in this section) is considered in the investment management process, it is not the only factor considered as TRH has historically funded its claims payments from current operating cash flows. As a result of such funding history, TRH has not historically maintained a credit facility. TRH’s primary investment goal is to maximize after-tax income through a high quality diversified taxable fixed maturity and tax-exempt municipal fixed maturity portfolio, while maintaining an adequate level of liquidity. See discussion later in this section of the potential liquidity strain that could arise as a result of a significant acceleration of paid losses beyond TRH’s ability to fund such cash needs.
TRH’s fixed maturities classified as held to maturity and available for sale are predominantly investment grade, liquid securities, approximately 44.5% of which will mature in less than 10 years. The average duration of these fixed maturities was 6.0 years as of December 31, 2008. Activity within the fixed maturities available for sale portfolio for the years under discussion includes strategic portfolio realignments to maximize after-tax income. TRH adjusts its mix of taxable and tax-exempt investments, as appropriate, generally as a result of strategic investment and tax planning considerations. In 2008, TRH repaid certain securities lending payables using cash from sources other than the sale of securities lending invested collateral. In that regard, fixed maturities were transferred from the securities lending invested collateral portfolio to the fixed maturities available for sale portfolio. Such transferred securities include CMBS, RMBS and other asset-backed securities. This transfer reflects management’s judgment that the ultimate value of these securities is greater than the value currently achievable on sale, given current market conditions. With respect to the fixed maturities which are classified as held to maturity and carried at amortized cost, TRH has the positive intent and ability to hold each of these securities to maturity.
Non-asset-backed fixed maturities in the aggregate include insured municipal bonds with ratings as follows:
At December 31, 2008, the amortized cost of asset-backed securities includes in fixed maturities available for sale by year of vintage and credit rating are as follows:
Through 2008, TRH participated in the Securities Lending Program, whereby certain securities (principally fixed maturities available for sale) from its portfolio were loaned to third parties. (See Note 2(c).) Under such program, TRH loaned securities to counterparties and received collateral, generally cash, which was returned to the counterparties when the loaned securities were returned to
TRH at a future date. The fair values of the loaned securities, which are reflected in the aggregate parenthetically as pledged on the balance sheet, were monitored on a daily basis with additional collateral obtained or refunded as the values fluctuated.
The fair values of fixed maturities available for sale, common stocks available for sale and equities trading that were on loan as of December 31, 2007 are reflected parenthetically as pledged on the balance sheet and totaled $1.97 billion, $21.9 million and $2.1 million, respectively. As of December 31, 2007, securities lending invested collateral consisted of $1.82 billion of fixed maturities available for sale and $196.7 million of cash equivalents.
In general, the increase in unrealized losses in 2008 resulted largely from changes in market interest rates caused principally by a widening of credit spreads and general market illiquidity. (See Disruption in Global Credit and Financial Markets and Item 1A. Risk Factors. See Note 4 of Notes to Consolidated Financial Statements (“Note 4”) for additional details about gross unrealized gains and losses on fixed maturities, equities and securities lending invested collateral.)
Net loss reserves include amounts for risks relating to environmental impairment and asbestos-related illnesses totaling $152 million and $124 million at December 31, 2008 and 2007, respectively, including $28 million and $25 million at the aforementioned dates, respectively, relating to such losses occurring in 1985 and prior. As TRC, the major operating subsidiary of the Company, commenced operations in 1978, the majority of TRH’s environmental and asbestos-related net loss reserves arose from contracts entered into after 1985 that were underwritten specifically as environmental or asbestos-related coverages rather than as standard general liability coverages, where the environmental or asbestos-related liabilities were neither clearly defined nor specifically excluded. The reserves carried for these claims, including IBNR reserves, are based upon known facts and current law. However, significant uncertainty exists in determining the amount of ultimate liability for environmental impairment and asbestos-related losses, particularly for those occurring in 1985 and prior. This uncertainty is due to inconsistent court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other things.
interpretation of legal liability and policy coverages, changes in claims handling practices and inflation. TRH considers not only monetary increases in the cost of what it reinsures, but also changes in societal factors that influence jury verdicts and case law, TRH’s approach to claim resolution, and, in turn, claim costs. TRH believes its aggregate loss reserves reduce the potential that an adverse resolution of one or more of these matters, at any point in time, would have a material impact on TRH’s financial condition or results of operations. However, there can be no assurance that adverse resolutions of such matters in any one period or in the aggregate will not result in a material adverse effect on TRH’s results of operations or financial condition.
For 2008, TRH’s net operating cash inflows totaled $1.10 billion, an increase of $69.7 million from 2007. The increase is due in large part to decreased income taxes paid and an increase in investment income received, partially offset by decreased cash flows from underwriting activities, including decreased collection of reinsurance recoverable.
For 2007, TRH’s net operating cash inflows totaled $1.03 billion, an increase of $181.4 million from 2006. The increase is due in large part to increased cash flows from underwriting activities, including increased collections of reinsurance recoverable, and investment income received, partially offset by increased income taxes paid.
As significant losses from catastrophes occurring in 2005, 2007 and 2008 remain unpaid, TRH expects that payments relating to these events will negatively impact operating cash flows in 2009 and perhaps thereafter.
Based on its history of consistently strong operating cash flows, the present composition of its investment portfolio (including present levels of cash, cash equivalents and liquid investment classes) and consideration of its cash needs, TRH considers its liquidity to be adequate through the end of 2009 and thereafter for a period the length of which is difficult to predict, but which TRH believes will be at least one year.
all investments and cash and accrued investment income. Financial instrument liabilities include unpaid losses and LAE and unearned premiums, each net of reinsurance, and the Senior Notes.
TRH calculated the VaR with respect to net fair values for 2008 and 2007. The VaR number represents the maximum potential loss as of those dates that could be incurred with a 95% confidence (i.e., only 5% of historical scenarios show losses greater than the VaR figure) within a one-month holding period. TRH uses the historical simulation methodology that entails re-pricing all assets and liabilities under explicit changes in market rates within a specific historical time period. TRH uses the most recent three years of historical market information for interest rates, equity index prices and foreign currency exchange rates. For each scenario, each transaction was re-priced. Scenario values are then calculated by netting the values of all the underlying assets and liabilities.
In the fourth quarter 2008, TRH revised its assumptions with respect to its loss and premium payouts. These revisions are done periodically to ensure that assumptions reflect the most current reporting trends and business mix. The revised payouts resulted in a significant increase in the duration of the projected cash flow of TRH’s net liabilities. This change is partly responsible for the decrease in the VaR with respect to interest rates as the duration of assets and liabilities are now more closely matched than in prior years.
TRH’s stockholders’ equity totaled $3.20 billion at December 31, 2008, a decrease of $150.8 million from year-end 2007. The net decrease consisted primarily of a decrease in accumulated other comprehensive income of $223.0 million, cash dividends declared of $48.4 million, partially offset by net income of $102.3 million.
The abovementioned decrease in accumulated other comprehensive income consisted of net unrealized depreciation of investments, net of income taxes, of $230.8 million, partially offset by net unrealized foreign currency translation gain from functional currencies, net of income taxes, of $7.8 million. The net unrealized depreciation of investments, net of income taxes, is composed principally of increases of $225.1 million in net unrealized depreciation of fixed maturities available for sale, principally states, municipalities and political subdivision bonds and asset-backed securities, $30.6 million in unrealized depreciation of equities available for sale, partially offset by a $26.8 million decrease in net unrealized depreciation of securities lending invested collateral, for reasons discussed earlier. (See Note 4 for details of gross unrealized gains and losses by security type.)
Net unrealized appreciation (depreciation) of investments, net of income taxes, is subject to significant volatility resulting from changes in the fair value of fixed maturities available for sale, equities available for sale, securities lending invested collateral and other invested assets. Fair values may fluctuate due to changes in general economic and political conditions, market interest rates, prospects of investee companies and other factors.
As of December 31, 2008, the amounts due and the estimated period between year-end 2008 and the dates of payment, under specified contractual obligations of TRH are as follows:
Represents commitments to invest in limited partnerships and expected salaries payable under the Retention Plan.
While the analytical tools used to estimate catastrophe exposure are useful in both pricing and monitoring catastrophe risk, the estimates derived by use of these techniques are inherently uncertain and do not reflect TRH’s maximum exposures to these events. While the models are frequently updated, these projections are nevertheless inherently imprecise. It is highly likely that TRH’s losses will vary, perhaps materially, from these estimates.
See Note 10 for catastrophe costs incurred in 2008, 2007 and 2006.
In mid-2007, the U.S. residential mortgage market began to experience serious disruption due to credit quality deterioration in a significant portion of loans originated, particularly to non-prime and sub-prime borrowers; evolving changes in the regulatory environment; a residential housing market characterized by a slowing pace of transactions and declining prices; increased cost of borrowings for mortgage participants; a rising unemployment rate; increased delinquencies in non-mortgage consumer credit; and illiquid credit markets. In addition, the financial strength of certain bond insurers has been compromised to varying degrees by losses these entities are presently experiencing due in part to the coverage they provide for domestic RMBS. These conditions continued and worsened throughout 2008 and into 2009, expanding into the broader global credit markets and resulting in greater volatility, a steep decline in equity markets, less liquidity, widening of credit spreads, a lack of price transparency, increased credit losses in certain markets and the collapse of several prominent financial institutions.
(a) Adoption of Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”)
In February 2007, the FASB issued SFAS 159. SFAS 159 was effective for TRH on January 1, 2008.
(c) Adoption of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109” (“FIN 48”)
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS 141R”).
Consolidated Statements of Comprehensive (Loss) Income For the Years Ended December 31, 2008, 2007 and 2006
III-Supplementary Insurance Information As of December 31, 2008, 2007 and 2006 and For the Years Then Ended
Other invested assets primarily include investments in hedge funds in which TRH holds a 5% or greater interest or where TRH has more than a minor influence over operations of the investee and TRH’s 40% interest in Kuwait Reinsurance Company (K.S.C.). Such investments are accounted for on the equity method. In applying the equity method of accounting, TRH consistently uses the most recently available financial information provided by the general partner or management of each of these investments. The financial information is for the period ended one to three months prior to the end of TRH’s reporting period. The financial statements of these investees are generally audited on an annual basis. The carrying value of such investments represents TRH’s share of the net asset value of these entities. The changes in such net asset values for investments carried on the equity method, other than the portion related to TRH’s share of the investee’s changes in accumulated other comprehensive income, are recorded in net investment income.
Prior to the fourth quarter of 2008, the transfers of securities in exchange for collateral under the Securities Lending Program were accounted for as secured borrowings. Securities lending invested collateral was shown on the balance sheet at fair value. A liability was recorded in an amount equal to the collateral received, reflecting TRH’s obligation to return the collateral when the loaned securities were returned. Income earned on invested collateral, net of interest payable to the collateral provider, was included in net investment income. As a result of conditions affecting the financial and credit markets, in the fourth quarter of 2008, counterparties were successful in negotiating significantly reduced collateral levels (i.e., collateral received as a percentage of the fair value of the security loaned). Due to the lower collateral levels, during the fourth quarter of 2008, many of such loaned securities were accounted for as sales at the time of transfer and as purchases when the securities were subsequently returned. In the fourth quarter of 2008, TRH terminated its participation in the Securities Lending Program.
At each balance sheet date, TRH evaluates its securities holdings with unrealized losses. When TRH does not intend to hold such securities until they have recovered their cost basis, TRH records the unrealized loss in income as a realized capital loss. If a loss is recognized from a sale subsequent to a balance sheet date pursuant to changes in circumstances, the loss is recognized in the period in which the intent to hold the securities to recovery no longer exists.
(g) Unearned Premiums and Premium Revenues: In recent years, premiums from treaty contracts have approximated 97% of net premiums written, while facultative contracts have approximated 3%. For pro rata treaty contracts, premiums written and earned are based on reports received from ceding companies. For excess-of-loss treaty contracts, premiums are generally recorded as written based on contract terms. Premiums are earned ratably over the term of the related coverages. Unearned premiums and prepaid reinsurance premiums represent the portion of gross premiums written and ceded premiums written, respectively, relating to the unexpired terms of such coverages. Premiums written and earned, along with related costs, for which data has not been reported by the ceding companies, are estimated based on historical patterns and other relevant information. These estimates are subject to change when actual data for such items estimated
becomes available. In the Consolidated Statements of Operations, premiums written and earned and the change in unearned premiums are presented net of reinsurance ceded.
Dividend income and distributions from common and preferred stock and other investments when receivable
The estimation of loss reserves is inherently difficult and subjective, especially in view of changes in the legal and tort environment which impact the development of loss reserves, and therefore quantitative techniques frequently have to be supplemented by subjective considerations and managerial judgment. In addition, trends that have affected development of liabilities in the past may not necessarily occur or affect liability development to the same degree in the future.
While the reserving process is difficult for ceding companies, the inherent uncertainties of estimating loss reserves are even greater for reinsurers, due primarily to the longer-term nature of much reinsurance business, the diversity of development patterns among different types of reinsurance treaties or facultative contracts, the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies, which are subject to change without notice. TRH writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess liability business for classes such as medical malpractice, D&O, E&O and general casualty. Claims from such classes can exhibit greater volatility over time than most other classes due to their low frequency, high severity nature and loss cost trends that are more difficult to predict.
(k) Currency Translation: Assets and liabilities denominated in foreign currencies are translated into U.S. dollars at year-end exchange rates. Income and expense accounts are translated at average exchange rates for the year. The resulting net unrealized currency translation gain (loss) for functional currencies is recorded as a separate component of accumulated other comprehensive income, net of related taxes, in stockholders’ equity.
Transaction gains and losses on assets and liabilities denominated in foreign currencies are recorded as a component of realized net capital (losses) gains during the period in which they occur.
(1) Adoption of Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”)
In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure requirements regarding fair value measurements but does not change existing guidance about whether an asset or liability is carried at fair value. The fair value measurement and related disclosure guidance in SFAS 157 does not apply to fair value measurements associated with share-based compensation awards accounted for in accordance with SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”).
TRH adopted SFAS 157 on January 1, 2008, its required effective date. With certain specific exceptions which would require a cumulative-effect adjustment to opening retained earnings on January 1, 2008, SFAS 157 must be applied prospectively. At January 1, 2008, in accordance with the standard, TRH made no adjustment to opening retained earnings. In addition, there were no significant changes to valuation methodologies applied as of December 31, 2008 compared to those used as of December 31, 2007.
(2) SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”).
In February 2007, the FASB issued SFAS 159. SFAS 159 permits entities to choose to measure at fair value many financial instruments and certain other items that are not required to be measured at fair value. Subsequent changes in fair value for designated items will be required to be reported in income. SFAS 159 also establishes presentation and disclosure requirements for similar types of assets and liabilities measured at fair value. SFAS 159 was effective for TRH on January 1, 2008. TRH did not employ this standard to measure any assets or liabilities at fair value that were not previously required to be measured on that basis.
(i) In November 2008, the FASB ratified FASB Emerging Issue Task Force Issue No. 08-6, “Equity Method Investment Accounting Considerations” (“EITF 08-6”). EITF 08-6 clarified the accounting for certain transactions and impairment considerations involving equity method investments. For TRH, EITF 08-6 will be effective on January 1, 2009 and must be applied prospectively. TRH does not expect the adoption of EITF 08-6 to have a material effect on TRH’s financial condition, results of operations or cash flows.
(iii) In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts-an interpretation of FASB Statement No. 60” (“SFAS 163”). SFAS 163 requires insurance companies to recognize a claim liability prior to an event of default when there is evidence that credit deterioration has occurred in an insured financial obligation. SFAS 163 also clarifies how SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities, and requires expanded disclosures about financial guarantee insurance contracts. SFAS 163 does not apply to certain insurance contracts that are similar to financial guarantee insurance contracts issued by insurance companies (such as mortgage guaranty insurance or credit insurance on trade receivables), nor does it apply to financial guarantee insurance contracts that are derivative instruments included within the scope of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” For TRH, SFAS 163 is required to be adopted on January 1, 2009, although certain disclosures are required in the consolidated financial statements for 2008. As current and prior years’ in-force financial guarantee business and related loss and loss adjustment expense reserves were not material as of December 31, 2008, such disclosures for 2008 have not been provided. Early adoption of SFAS 163 is prohibited. Based on the fact that TRH’s financial guarantee business and related loss and loss adjustment expense reserves are presently not material, TRH does not expect the adoption of SFAS 163 to have a material effect on the recognition and measurement of premium revenue and claim liabilities in its consolidated financial statements.
(iv) In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R changes the accounting for business combinations in a number of ways, including broadening the transactions or events that are considered business combinations, requiring an acquirer to recognize 100% of the fair values
Effective January 1, 2008, TRH adopted SFAS 157, which specifies measurement and disclosure standards related to assets and liabilities measured at fair value. See Note 2(l) for additional information.
The degree of judgment used in measuring the fair value of financial instruments generally correlates with the level of pricing observability. Financial instruments with quoted prices in active markets generally have more pricing observability and less judgment is used in measuring fair value. Conversely, financial instruments traded in other-than-active markets or that do not have quoted prices have less observability and are measured at fair value using valuation models or other pricing techniques that require more judgment. An active market is one in which transactions for the asset being valued occur with sufficient frequency and volume to provide pricing information on an ongoing basis. An other-than-active market is one in which there are few transactions, the prices are not current, price quotations vary substantially either over time or among market makers, or in which little information is released publicly for the asset being valued. Pricing observability is affected by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and general market conditions.
(1) Fixed Maturities (Including Fixed Maturities Within Securities Lending Invested Collateral) and Equity Securities Available for Sale
TRH maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. Whenever available, TRH obtains quoted prices in active markets for identical assets at the balance sheet date to measure at fair value fixed maturity and marketable equity securities in its available for sale portfolios. Market price data generally is obtained from exchange or dealer markets.
TRH estimates the fair value of fixed maturity securities not traded in active markets by referring to traded securities with similar attributes, using dealer quotations and matrix pricing methodologies, discounted cash flow analyses or internal valuation models. This methodology considers such factors as the issuer’s industry, the security’s rating and tenor, its coupon rate, its position in the capital structure of the issuer, yield curves, credit curves, prepayment rates and other relevant factors. For fixed maturity securities that are not traded in active markets or that are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments generally are
based on available market evidence. In the absence of such evidence, management’s best estimate is used.
Level 1: Fair value measurements that are quoted prices (unadjusted) in active markets that TRH has the ability to access for identical assets. Market price data generally is obtained from exchange or dealer markets. TRH does not adjust the quoted price for such instruments. Assets measured at fair value on a recurring basis and classified as Level 1 principally include certain government and government agency securities and actively traded listed common stocks and mutual funds (which are included on the balance sheet in common stocks available for sale).
Level 2: Fair value measurements based on inputs other than quoted prices included in Level 1 that are observable for the asset, either directly or indirectly. Level 2 inputs include quoted prices for similar assets in active markets and inputs other than quoted prices that are observable for the asset, such as interest rates and yield curves that are observable at commonly quoted intervals. Assets measured at fair value on a recurring basis and classified as Level 2 generally include certain government and government agency securities, state, municipal and political subdivision obligations, most investment-grade and high-yield corporate bonds, most nonredeemable preferred stocks available for sale, most asset-backed securities and certain short-term investments and cash equivalents.
The following table presents information about assets measured at fair value on a recurring basis at December 31, 2008 and indicates the level of the fair value measurement based on the levels of the inputs used:
The following tables present analyses of the changes during 2008 in Level 3 assets measured at fair value on a recurring basis and the realized and unrealized gains (losses) recorded in income during 2008 related to those assets that remained on the consolidated balance sheet at December 31, 2008:
Net unrealized depreciation related to Level 3 investments approximated $22.7 million at December 31, 2008.
(a) Statutory Deposits: Investments with carrying values of $552 million and $442 million at December 31, 2008 and 2007, respectively, were deposited with governmental authorities as required by law. The substantial majority of these deposits are fixed maturities and common stocks available for sale.
(b) Net Investment Income: An analysis of net investment income of TRH follows:
Changes in net unrealized gains (losses) included in net investment income from equities classified as trading securities in 2008, 2007 and 2006 were $0.6 million, ($1.4) million and $2.5 million.
See Note 4(g) for additional information about gross unrealized losses as of December 31, 2008 and 2007.
The amortized cost and fair value of fixed maturities at December 31, 2008 by contractual maturity are as follows. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Investments in fixed maturities exclude short-term investments.
(f) Securities Lending Program: Through 2008, TRH participated in a securities lending program (the “Securities Lending Program”) managed by a subsidiary of AIG, whereby certain securities (principally fixed maturities available for sale) from its portfolio were loaned to third parties. (See Note 2(c).) Under such program, TRH loaned securities to counterparties and received collateral, generally cash, which was returned to the counterparties when the loaned securities were returned to TRH at a future date. The fair values of the loaned securities, which are reflected in the aggregate parenthetically as pledged on the balance sheet, were monitored on a daily basis with additional collateral obtained or refunded as the values fluctuated.
Prior to the fourth quarter of 2008, the transfers of securities in exchange for collateral under the Securities Lending Program were accounted for as secured borrowings. Securities lending invested collateral was shown on the balance sheet at fair value. A liability was recorded in an amount equal to the collateral received, reflecting TRH’s obligation to return the collateral when the loaned securities were returned. As a result of conditions affecting the financial and credit markets, in the fourth quarter of 2008, counterparties were successful in negotiating significantly reduced collateral levels (i.e., collateral received as a percentage of the fair value of the security loaned). Due to the lower collateral levels, during the fourth quarter of 2008, many of such loaned securities were accounted for as sales at the time of transfer and as purchases when the securities were subsequently returned. The sale and return of such securities resulted in realized net capital losses of $16 million in 2008. In the fourth quarter of 2008, TRH terminated its participation in the Securities Lending Program.
In 2008, TRH repaid certain securities lending payables using cash from sources other than the sale of securities lending invested collateral. In that regard, fixed maturities were transferred from the securities lending invested collateral portfolio to the fixed maturities available for sale portfolio. Such
transferred securities included commercial mortgage-backed securities, residential mortgage-backed securities and other asset-backed securities.
See Note 4(g) for additional information about gross unrealized losses as of December 31, 2007.
(g) Additional Information on Gross Unrealized Losses on All Fixed Maturities, on Equities Available for Sale and, in 2007 only, on Securities Lending Invested Collateral: As of December 31, 2008 and 2007, TRH’s aggregate gross unrealized losses on all fixed maturities, on equities available for sale and on securities lending invested collateral totaled $549.5 million and $164.9 million, respectively. As of December 31, 2008 and 2007, no single issuer accounted for more than 5% and 4%, respectively, of the aggregate gross unrealized losses.
As of December 31, 2008 and 2007, the aging of the gross unrealized losses with respect to all fixed maturities, equities and securities lending invested collateral, grouped by percentage of gross unrealized loss (the extent by which the fair value is less than cost or amortized cost) relative to cost or amortized cost, including the number of respective items, was as follows:
The fair value of fixed maturities and securities lending invested collateral, which is comprised principally of fixed maturities, in an unrealized loss position at December 31, 2008 and 2007, by contractual maturity, is shown below:
Asset-backed fixed maturities by their nature do not generally have single maturity dates.
The U.S. federal income tax rate was 35% for 2008, 2007 and 2006. Actual tax (benefit) expense on income before income taxes differs from the “expected” amount computed by applying the U.S. federal income tax rate because of the following:
The domestic current tax benefit for 2008 includes $83.5 million resulting from a tax capital loss carryback to prior years. In addition, the 2008 deferred tax benefit includes the reversal of a previously recorded minimum tax credit carryforward in the amount of $15.0 million. The domestic deferred tax benefit for 2007 and 2006 includes $32.9 million and $6.6 million, respectively, resulting from a minimum tax credit carryforward. By law, minimum tax credits may be carried forward indefinitely.
The components of the net deferred income tax asset at December 31, 2008 and 2007 were as follows:
No valuation allowance has been recorded as TRH has concluded that it is more likely than not that TRH will fully realize the deferred tax assets. The most significant deferred tax assets arise from the discounting of loss reserves and realized and unrealized losses on investments. TRH’s strong history of operating earnings supports its conclusion that it has the ability to realize the full benefits associated with all deferred tax assets, particularly the assets associated with the discounting of loss reserves. In addition to TRH’s strong history of operating earnings, TRH also has a strong history of generating capital gains to offset capital losses. During 2007 and 2006, TRH generated $135 million of capital gains on a tax basis that are available for carryback of losses generated in 2008 and 2009. TRH also notes that while the other-than-temporary impairment write-downs on its fixed maturity securities are reflected as realized losses for GAAP purposes, the securities continue to be held in its available for sale portfolio and, as such, the carryforward period for capital losses on a tax basis has not begun to run. Finally, TRH’s strong history of positive operating cash flow, having generated $2.97 billion over the last three years, supports the conclusion that TRH has the ability to hold until maturity, or until the values recover, those fixed income securities that have been written down, as well as those securities that are in an unrealized loss position.
Interest and penalties relating to unrecognized tax benefits/expenses are recognized in income tax expense, when applicable. As of December 31, 2008 and 2007, there was $9.1 million and $4.3 million, respectively, of net interest receivable on income taxes. There was no interest or penalties accrued as of December 31, 2008. Current income tax expense was reduced by $3.7 million and $4.3 million of interest on net tax refunds in 2008 and 2007, respectively.
There were no unrecognized tax positions in 2008. The table below reconciles the total amounts of unrecognized tax positions, including interest and penalties, if any, from the beginning of 2007 to the end of 2007:
includes net catastrophe losses incurred of $180.4 million, principally relating to Hurricane Ike. In addition, in 2008, TRH decreased its estimates of the ultimate amounts of net losses occurring
in 2007 and prior years by $0.5 million. This net favorable development was comprised of net favorable development of $209.7 million for losses occurring in 2003 to 2007, offset by net adverse development of $209.2 million relating to losses occurring in 2002 and prior.
Significant net favorable development was recorded for losses occurring in the allied lines ($43.6 million) and fire ($11.6 million) lines, each arising principally from losses occurring in 2007, and in the homeowners multiple peril ($17.0 million) and auto liability ($13.2 million) lines, each arising principally from losses occurring in 2005 to 2007. The line of business with the most significant net adverse development recorded in 2008 was the other liability line ($79.6 million), arising principally from losses occurring between 1997 and 2002, partially offset by favorable development from losses occurring in 2004 to 2006. The other liability line includes certain specialty casualty classes, such as D&O and E&O, and general casualty classes. In addition, significant net adverse development was recorded in 2008 for losses occurring in the medical malpractice ($35.4 million) line, arising principally from losses occurring in 1995 to 2001 and in 2006. (See Note 10 for amounts included in net adverse development that relate to catastrophe losses.)
In December 2005, the Company completed a public offering of $750 million principal amount of its 5.75% senior notes due on December 14, 2015 (the “Senior Notes”). Of the $750 million aggregate principal amount of the Senior Notes offered, $450 million principal amount was purchased by certain subsidiaries of AIG. In 2008, TRH repurchased $25 million principal amount of the Senior Notes for $15 million from non-affiliates, realizing a gain of $10 million.
At December 31, 2008 and 2007, $725 million and $750 million, respectively, principal amount of Senior Notes remained outstanding. In addition, the unamortized original issue discount, which totaled $2.8 million and $3.1 million at December 31, 2008 and 2007, respectively, has been deducted from the carrying value of the Senior Notes and is being amortized over the term of the Senior Notes on the effective interest rate method. The fair value of the Senior Notes as of December 31, 2008 and 2007 was $469.4 million and $714.3 million, respectively, based on quoted market price.
Interest expense incurred in connection with the Senior Notes was $43.4 million in each of 2008, 2007 and 2006. Interest payments on the Senior Notes totaled $43.1 million in each of 2008, 2007 and 2006.
While there were no significant net catastrophe costs for events occurring during 2006, income before income taxes in 2006 includes net catastrophe costs of $28.7 million relating to events which occurred in prior years. Such costs consist of net catastrophe losses incurred of $29.7 million (gross $84.5 million; ceded $54.8 million) and net assumed reinstatement premiums of $1.0 million.
Net assumed reinstatement premiums serve to increase net premiums written and earned by such amounts in their respective periods. Reinstatement premiums may arise on assumed and ceded business as a result of contractual provisions found in certain excess-of-loss catastrophe reinsurance contracts that require additional premium to be paid in the event of a loss to reinstate coverage for the remaining portion of the contract period.
The components of accumulated other comprehensive (loss) income and changes in such amounts between years are as follows:
TRH’s employees participate in benefit plans administered by the AIG Group, including noncontributory defined benefit pension plans, other postretirement benefit plans and incentive savings plans (such as a 401(k) plan) which provides for certain matching contributions. A substantial majority of TRH’s employees are eligible to participate in these plans. Certain of the pension plans are multiemployer plans in that they do not separately identify plan benefits and plan assets attributable to
employees of participating companies. For such plans, only contributions paid or accrued are charged to expense.
Net cash (paid) received from exercises of stock-based compensation was ($0.9) million, $6.0 million and $3.3 million during 2008, 2007 and 2006, respectively. The net cash paid from exercises of stock-based compensation is due to the payment of the employee portion of withholding taxes to governmental tax authorities on vested restricted stock units. TRH has not paid out any cash to settle share-based payment awards during the 2008, 2007 or 2006. Cash savings resulting from excess tax benefits, as defined by SFAS 123R, totaled $1.8 million, $1.1 million and $1.9 million in 2008, 2007 and 2006, respectively.
Income tax benefits realized by TRH on stock-based compensation exercises totaled $2.5 million, $2.7 million and $1.5 million in 2008, 2007 and 2006, respectively.
The impact on the financial statements of the Stock Purchase Plan was not material to TRH in 2008, 2007 and 2006. A discussion of the more significant stock-based compensation plans follows.
(a) Stock Option Plans: In 2000, the Company’s Board of Directors (the “Board”) adopted, and the stockholders approved, the 2000 Plan. In 2006, the Board adopted, and the stockholders approved, amendments to the 2000 Plan increasing the maximum number of options which may be granted under the plan to 3,712,500 and increasing the maximum number of options which may be granted to any one person to 600,000. In 2008, the Board adopted and the stockholders approved an amendment to the 2000 Plan increasing the maximum number of options which may be granted to any one person from 600,000 to 800,000 shares. This plan provides that options to purchase the Company’s common stock (“TRH shares”) may be granted to certain key employees and non-employee directors at prices not less than their fair market value at the date of grant.
197,500 and 210,000 options were granted in 2008 and 2007, respectively. No options were granted in 2006. The fair value of each option grant is estimated on the date of grant using a binomial option pricing model. The following table presents the weighted average grant date fair value and the weighted average assumptions which were used in the calculation for options granted in 2008 and 2007:
A summary of the status of the Stock Option Plans as of December 31, 2008 and the changes since January 1, 2008 is presented below:
The aggregate intrinsic value of options exercised (the aggregate amount by which the market price of TRH shares at the time of exercise exceeded the exercise price of options exercised) was $1.0 million, $7.1 million and $4.4 million in 2008, 2007 and 2006, respectively. A total of approximately 190,000, 301,000 and 368,000 options vested in 2008, 2007 and 2006, respectively, with aggregate fair values of $3.8 million, $5.0 million and $5.8 million in 2008, 2007 and 2006, respectively.
(b) Stock Incentive Plan, Partners Plan and Senior Partners Plan: In 2003, the Board adopted, and the stockholders approved, the Stock Incentive Plan. In 2006, the Board adopted, and the stockholders approved, certain amendments which increased the maximum number of shares available for grant under the Stock Incentive Plan to 925,000, increased the maximum number of awards a grantee may receive in any one year to 60,000, allowed for flexibility in determining the vesting terms of grants and allowed for grants of performance-based restricted stock or restricted stock units. In 2008, the Board approved certain amendments to the Stock Incentive Plan, Partners Plan and Senior Partners Plan which provided for treatment upon a change in control. The Stock Incentive Plan provides that equity-based or equity-related awards can be granted to officers, directors, employees
A summary of the status of the Service RSUs and Performance RSUs granted pursuant to the Stock Incentive Plan as of December 31, 2008 and the changes since January 1, 2008 are presented below:
The great majority of Service RSUs will vest on the third anniversary of the date of grant for those grantees with continued employment through such date, reflecting a one-year acceleration during 2008 of the previous vesting date. The impact of such acceleration increased 2008 expenses but was not material. The Company reserves the right to make payment for the Service RSUs in TRH shares or the cash equivalent of the fair value of such shares on the date of vesting.
The fair value of each Performance RSU grant under the Partners Plan and the Senior Partners Plan is estimated on the date of grant based on the closing market price of TRH shares on the date of grant.
As of December 31, 2008, there was $16.5 million of total unrecognized compensation costs relating to Performance RSUs granted but not yet vested under the Senior Partners Plan and the Partners Plan. Compensation expense for Performance RSUs is recognized on a straight-line basis. These costs are expected to be recognized over a weighted average period of 2.7 years. Because the performance period for the second award in 2006 under the Partners Plan did not begin until January 1, 2007, the second award was not included in TRH’s 2006 expenses.
(c) Non-Employee Directors’ Plan: In 2008, the Board adopted, and the stockholders approved, the Non-Employee Directors’ Plan. The Non-Employee Directors’ Plan provides that equity-based or equity-related awards can be granted to non-employee directors as determined by the Compensation
Committee. The maximum number of shares available for grant under the Non-Employee Directors’ Plan is 100,000.
Pursuant to the Non-Employee Directors’ Plan, Service RSUs have been granted. As of December 31, 2008, there were 79,200 shares of common stock available for issuance in connection with future grants of awards under the Non-Employee Directors’ Plan.
A summary of the status of the Service RSUs granted pursuant to the Non-Employee Directors’ Plan as of December 31, 2008 and the changes since January 1, 2008 are presented below:
As of December 31, 2008, there was $0.4 million of total unrecognized compensation costs relating to Service RSUs granted but not yet vested under the Non-Employee Directors’ Plan. These costs are expected to be recognized over a weighted average period of 1.8 years.
(a) Recent Actions by AIG which Impact TRH: As of December 31, 2008, 2007 and 2006, AIG beneficially owned approximately 59% of the Company’s outstanding shares.
On September 29, 2008, AIG filed an amendment to its Schedule 13D relating to the Company, stating, among other things, that “AIG is exploring all strategic alternatives in connection with a potential disposition or other monetization of its...interest in the Company.” In October 2008, AIG announced a restructuring of its operations, and its intent to retain its U.S. property and casualty and foreign general insurance businesses, and to retain a continuing ownership interest in certain of its foreign life insurance operations, while exploring divestiture opportunities for its remaining businesses.
Proceeds from these sales are contractually required to be applied toward the repayment of AIG’s Fed Credit Agreement.
Pursuant to AIG’s Fed Credit Agreement, AIG will be required to issue AIG’s Series C Preferred Stock. It is expected that AIG’s Series C Preferred Stock will not be redeemable and will, to the extent permitted by law, vote with AIG common stock as a single class and represent 77.9% of the voting power of AIG’s common stock.
activities. Under the guidance of TRH’s Finance and Investment Committee of the Board of Directors and senior management, certain subsidiaries of AIG act as financial advisors and managers of TRH’s investment portfolio. In 2008, 2007 and 2006, $13.8 million, $13.8 million and $13.1 million, respectively, of operating and investment expenses relate to services and expenses provided by the AIG Group under these agreements.
Principles as primary guidance on statutory accounting. All material statutory accounting practices of TRC and Putnam are prescribed in the authoritative literature described above.
Premiums written and earned that were ceded to affiliates principally represent amounts which, by prearrangement with TRH, were assumed from an affiliate and then ceded in an equal amount to other affiliates.
TRH conducts its business and assesses performance through segments organized along geographic lines. The Domestic segment principally includes financial data from branches in the United States except Miami, as well as revenues and expenses of the Company (including interest expense on the Senior Notes) and stock-based compensation expense. (See Notes 7 and 13.)
Net premiums earned from affiliates approximate $386.5 million, $427.9 million and $422.7 million in 2008, 2007 and 2006, respectively, and are included mainly in Domestic.
Includes revenues from the London branch of $879.7 million, $884.6 million and $819.5 million in 2008, 2007 and 2006, respectively.
The Miami and Toronto branch segment data are each considered significant for 2008 only. Certain key Miami and Toronto data elements which are included in International-Other are as follows:
As part of these settlements, AIG has agreed to retain, for a period of three years, an independent consultant who will conduct a review that will include, among other things, the adequacy of AIG’s internal controls over financial reporting, the policies, procedures and effectiveness of AIG’s regulatory, compliance and legal functions and the remediation plan that AIG has implemented as a result of its own internal review. TRH, as a subsidiary of AIG, is cooperating with the terms of the settlements that are applicable to TRH.
In addition, from time to time, other regulators have commenced, and may in the future commence, investigations into insurance brokerage practices relating to contingent commissions and other industry-wide practices as well as other broker-related conduct, such as alleged bid-rigging, finite insurance and reinsurance transactions and other reinsurance practices. TRH has cooperated, and will continue to cooperate, in producing documents and other information in response to subpoenas and other requests. While TRH does not believe that any of these inquiries will have a material impact on TRH’s business or financial results, it is not possible to predict with any certainty at this time what impact, if any, these inquiries may have on TRH’s business or financial results.
(b) Commercial Commitments: In the normal course of business, TRH has letters of credit outstanding as of December 31, 2008 totaling $41.5 million. These letters of credit are provided to secure certain loss reserves and other balances due to ceding companies. Where TRH provides a letter of credit, it is generally contractually obligated to continue to provide a letter of credit to the ceding company in the future to secure certain reserves and other balances.
Rent expense approximated $12.0 million, $11.3 million and $9.7 million in 2008, 2007 and 2006, respectively.
In October 2008, TRH adopted a retention program (the “Retention Plan”) covering a significant number of its employees, including its senior-most management. Salary expenses incurred related to the Retention Plan totaled approximately $8 million in 2008 and is expected to total approximately $20 million in 2009. The vast majority of the Retention Plan is payable 60% in 2008 and 40% in 2009, subject to the employee’s continued employment through December 31, 2009. Approximately $15 million was paid in 2008 and $13 million is expected to be paid in 2009, mainly in July.