In presenting the Company's results, management has included certain schedules containing financial measures that are not calculated under standards and rules that comprise U.S. GAAP. Such measures, including segment underwriting income or loss, related underwriting ratios, book value per common share and fully converted book value per common share, are referred to as non-GAAP. These non-GAAP measures may be defined or calculated differently by other companies. Management believes these measures, which are used to monitor the results of operations, allow for a more complete understanding of the underlying business. These measures should not be viewed as a substitute for those determined in accordance with U.S. GAAP. Reconciliations of such measures to the most comparable U.S. GAAP figures are included within this Form 10-K in accordance with Regulation G.
In 2005, an unprecedented level of hurricane losses caused many reinsurers to report significant net losses after which rating agencies imposed higher capital requirements. Both reinsurers and their clients reassessed their catastrophe pricing parameters and procedures. The result was an increase in catastrophe pricing, particularly for wind exposures in the United States, in 2006 and the beginning of 2007. A number of new companies were formed to take advantage of the improved pricing. The combination of additional capacity and a lack of major catastrophe activity in 2006 and 2007 led to a decline in pricing for catastrophe exposed reinsurance in the second half of 2007. After initially stabilizing, non-catastrophe pricing weakened in late 2006 and continued to decline through the first half of 2008. During the second half of 2008, the financial markets experienced significant adverse credit events and a loss of liquidity and the 2008 hurricane season resulted in substantial losses to the insurance and reinsurance industry, which reduced the amount of capital in the insurance industry. Many reinsurance companies reported strong financial results for 2009 reflecting the absence of major catastrophes and the favorable performance of their investment portfolios during the year. In 2010, many reinsurance companies performed well, with significant growth in shareholders’ equity, despite increased catastrophe activity.
We anticipate that 2011 will be characterized by ample capacity for insurance risk and that risk adjusted pricing will come under downward pressure in all lines of business that have not recently experienced significant losses.
For our Casualty segment, we believe that underlying primary insurance rate increases are generally lower than the trend in loss costs would indicate is appropriate and that capacity for casualty insurance and reinsurance will remain abundant during 2011. We expect that select casualty reinsurance treaties will offer adequate returns during 2011, however the amount of business we write in our Casualty segment will likely decrease during 2011 compared with the amount we wrote in 2010.
The preparation of consolidated financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that are inherently subjective in nature that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent liabilities. Actual results may differ materially from these estimates. Our critical accounting estimates used in the preparation of our consolidated financial statements include premiums written and earned, unpaid losses and LAE, valuation of investments and income taxes. In addition, estimates are used to evaluate risk transfer for assumed and ceded reinsurance transactions.
When estimating premiums written and unearned premiums, we segregate the business into classes by reinsurance subsidiary, by type of coverage and by type of contract (resulting in approximately 65 classes). Within each class, business is further segregated by the year in which the contract incepted (the “Underwriting Year”), starting with 2002, our first year of operations. Classes that are similar in both the nature of their business and estimation process may be grouped for purposes of estimating premiums. Estimates are made for each class or group of classes and Underwriting Year. Premiums are estimated based on ceding company estimates and our own judgment after considering factors such as: (1) the ceding company’s historical premium versus projected premium, (2) the ceding company’s history of providing accurate estimates, (3) anticipated changes in the marketplace and the ceding company’s competitive position therein, (4) reported premiums to date and (5) the anticipated impact of proposed underwriting changes. Estimates of ultimate premium are made by our underwriters for each contract and Underwriting Year. Management reviews these estimates with our underwriters and actuaries and selects an ultimate premium estimate. Estimates of premiums written and unearned premiums are based on the selected ultimate premium estimate and the structure of the reinsurance contracts. We evaluate the appropriateness of these estimates in light of the actual premium reported by the ceding companies, information obtained during audits and other information received from ceding companies.
As of December 31, 2010, the selected estimates of premiums receivable and unearned premiums were lower than the initial estimates made by our underwriters by $22.6 million or 12.2% and $10.2 million or 6.2%, respectively. We believe that we reasonably could have made an adjustment of between $0 and $22.6 million for premiums receivable and between $0 and $10.2 million for unearned premiums. Key factors that affect premium estimates of our underwriters include: (1) the increased competition and lower rate level in many classes of business that make it difficult for ceding companies to achieve their premium targets, and (2) the lack of a historical track record for some ceding companies writing new programs.
Certain of our reinsurance contracts include provisions that adjust premiums based upon the loss experience of the contracts. We take these provisions into account when determining our estimate of premiums written and unearned premiums. Reinstatement premiums are the premiums charged for the restoration of the reinsurance limit of a reinsurance contract to its full amount, generally coinciding with the payment by the reinsurer of losses. These premiums relate to and are earned over the future coverage obtained for the remainder of the contract term. Any unearned premiums existing at the time a contract limit is exhausted or reinstated is earned immediately. Additional premiums are premiums that are triggered by losses and are earned immediately. Premiums written and unearned premiums include estimates of reinstatement premiums and additional premiums based on reinsurance contract provisions and loss experience and rely on the estimates of unpaid losses and LAE.
Unpaid losses and LAE represent our best estimate of the costs of claims incurred, and it is possible that our ultimate liability may differ materially from such estimate. We review our estimate of unpaid losses and LAE quarterly. Any adjustments of prior years’ estimates of unpaid losses and LAE are accounted for as changes in estimates and are reflected in our results of operations in the period in which they are made.
The liabilities recorded on our consolidated balance sheets as of December 31, 2010 and 2009 for unpaid losses and LAE were $2.2 billion and $2.3 billion, respectively. These amounts exclude any amounts we may recover from our retrocessionaires under coverage we purchased for such losses. We record estimates of amounts we expect to recover from retrocessionaires as assets on the consolidated balance sheet. The following table sets forth our case reserves, additional case reserves and IBNR by segment as of December 31, 2010 and 2009 ($ in thousands):
Since we rely on information regarding paid losses, case reserves and sometimes IBNR provided by ceding companies in estimating our ultimate liability for unpaid losses and LAE, we perform certain procedures in order to help determine the completeness and accuracy of such information. Periodically, management assesses the reporting activities of these ceding companies on the basis of qualitative and quantitative criteria. These procedures include conferring with ceding companies or brokers on claims matters. Our claims personnel, or consultants engaged by us, may also conduct periodic audits of our ceding companies to: (1) review and establish validity of specific claims, (2) determine that case reserves established by the ceding company are reasonable, (3) assure that there is consistency in claim reporting from period to period, and (4) assess the overall claims practices and procedures of the ceding company. We also monitor the claims handling and reserving practices of ceding companies in order to help establish the proper reinsurance premium for reinsurance contracts with such ceding companies.
Generally, estimates of ultimate losses that are not related to a specific event are initially determined based on the loss ratio method applied to each Underwriting Year and to each class of business. The selected ultimate losses are determined by multiplying the initial expected loss ratio by the earned premium. The initial expected loss ratios are key inputs that involve management judgment and are based on a variety of factors, including: (1) contract by contract expected loss ratios developed during our pricing process, (2) our historical loss ratios and combined ratios (loss plus acquisition cost ratios), and (3) when available, updated and appropriately adjusted, loss information from Travelers on business previously underwritten by St. Paul Re, which was a part of The St. Paul Companies, Inc., (“St. Paul Re”), for the reasons described below. These judgments take into account management’s view of past, current and future factors that may influence ultimate losses, including: (1) market conditions, (2) changes in the business underwritten, (3) changes in timing of the emergence of claims and (4) other factors that may influence ultimate loss ratios and losses.
Over time, as a greater number of claims are reported, actuarial estimates of IBNR are based on the Bornhuetter-Ferguson and the chain ladder techniques. The loss development pattern is a key input to these techniques. The Bornhuetter-Ferguson technique utilizes actual reported losses, a loss development pattern and the initial expected loss ratio to determine an estimate of ultimate losses. We believe this technique is most appropriate when there are few reported claims and a relatively less stable loss development pattern. The chain ladder technique utilizes actual reported losses and a loss development pattern to determine an estimate of ultimate losses that is independent of the initial expected ultimate loss ratio and earned premium. We believe this technique is most appropriate when there are a large number of reported losses with significant statistical credibility and a relatively stable pattern of reported losses. The determination of when reported losses are sufficient and credible to warrant selection of an ultimate loss ratio different from initial expected loss ratio also requires judgment. We generally make adjustments for reported loss experience indicating unfavorable variances from initial expected loss ratios sooner than reported loss experience indicating favorable variances. This is because the reporting of losses in excess of expectations tends to have greater credibility than an absence or lower than expected level of reported losses.
We analyze historical loss development patterns and may adjust them for observed anomalies. For example, we observed that loss development patterns were much slower in Underwriting Years that were characterized by especially intense competition, known as the “soft market,” particularly in the North American excess-of-loss claims made class. We believe this is due to multiple year policies written by ceding companies and the deterioration in underwriting standards during these periods. In determining our loss development patterns for certain classes, we may exclude certain historical data from the soft market years because none of our business was written in these soft market periods. However, one of the risks of excluding some of the years is that we could be obscuring trends in loss development patterns. Our actuaries consider this when determining the credibility of indications that use these patterns. For certain reinsurance contracts, appropriate historical loss development patterns may be developed from ceding company data or other sources.
Generally, an event causing more than $1 billion of property losses to the insurance industry or $10 million of property losses to the Company is considered and tracked as a major catastrophe. Unpaid losses and LAE related to major catastrophes were $304.1 million, which represented 14% of our total unpaid losses and LAE as of December 31, 2010.
Our underwriters will typically prepare an initial estimate of our ultimate losses for a catastrophe event on a contract-by-contract basis. This estimate is typically based on estimates of losses for the insurance industry as a whole, estimates of losses prepared by ceding companies, estimates of market share of our ceding companies and, in certain cases, output from catastrophe models. Information is typically updated as it becomes available. Our actuaries and underwriters will also consider a variety of factors, including: (1) the credibility of ceding company estimates, (2) whether the ceding company estimates include IBNR and (3) whether the ceding company information is current. After reviewing loss estimates and other information with our underwriters, our actuaries make an estimate of ultimate loss.
As losses from catastrophes mature, our actuaries generally consider losses reported to us relative to loss development patterns from prior catastrophe events. Our estimate of ultimate liability for losses and LAE related to a catastrophe event will generally be based on these development patterns after approximately twelve months following the event. However, since loss development patterns may be inconsistent between events, for very large catastrophes, such as Hurricane Katrina in 2005, we will generally review information on a contract-by-contract basis for a longer period. Ultimate losses for a catastrophe event are typically reasonably well known within 12 to 24 months following the event, although ultimate losses from an earthquake may take longer to develop. As of December 31, 2010, the paid and reported losses as a percentage of the current estimated ultimate loss were 30% and 76%, respectively, for the February 27, 2010 earthquake in Chile and 1% and 8%, respectively, for the September 3, 2010 earthquake in New Zealand.
The initial expected loss ratios are key inputs to our loss estimation process, are derived from historical data and involve a high degree of judgment. The selection of the initial expected loss ratios also takes into account management’s view of past, current and future factors that may influence expected ultimate losses. Because of the high degree of judgment required in establishing initial expected loss ratios, there is uncertainty in the resulting estimates.
The loss development patterns are also key inputs to our loss estimation process. Loss development patterns reflect the time lag between the occurrence and settlement of a loss. The time lag in reporting can be several years in some cases and may be attributed to a number of reasons, including the time it takes to investigate a claim, delays associated with the litigation process, and the deterioration, in connection with health related claims, in a claimant’s physical condition many years after an accident occurs. As a predominantly broker market reinsurer for both excess-of-loss and proportional contracts, we are subject to potential additional time lags in the receipt of information as the primary insurer reports to the broker who in turn reports to us. As of December 31, 2010, we did not have any significant back-log related to our processing of assumed reinsurance information. All of the foregoing factors can impact the loss development patterns. A key assumption that our estimates are based on is that past loss development patterns are reasonably predictive of future loss development patterns. However, it may be difficult to identify differences in business reinsured from Underwriting Year to Underwriting Year and how such differences can affect loss development patterns. This difficulty adds to uncertainty in estimates that use these patterns.
Initial expected loss ratios and loss development patterns are key inputs to our loss estimation process. We exercise judgment in establishing key inputs at the beginning of an underwriting year and also as we modify the key inputs, as appropriate, throughout the loss development period. During the years ended December 31, 2010, 2009, and 2008, changes in the initial expected loss ratio and the loss development patterns resulted in net favorable loss development of $13.2 million, $5.9 million and $12.8 million, respectively.
We have selected the initial expected loss ratio and the loss development patterns for sensitivity analysis. Ultimate loss estimates for the North American casualty excess-of-loss classes of business, which generally have the longest loss development patterns, have a higher degree of uncertainty than other reserving classes. IBNR for these classes as of December 31, 2010 was $1.0 billion, which was 64% of the total IBNR at that date. The estimates of unpaid losses and LAE related to North American casualty excess-of-loss classes of business have a higher degree of uncertainty and, consequently, reasonable alternatives to our selected initial expected loss ratios and loss development patterns could vary significantly. For example, if we increased the initial expected loss ratio for these classes by 5% from 69% to 74%, we would increase the IBNR for these classes by $48.4 million, which represents approximately 4% of unpaid losses and LAE for these classes as of December 31, 2010, or if we increased the initial expected loss ratio for these classes by 10% from 69% to 79%, we would increase the IBNR for these classes by $99.9 million, which represents approximately 8% of unpaid losses and LAE for these classes as of December 31, 2010.
We obtain prices for all of our fixed maturity securities, preferred stocks and short-term investments from pricing services, which include index providers, pricing vendors and broker-dealers. As of December 31, 2010, we valued approximately 59% of our investment securities using prices obtained from index providers, 38% using prices obtained from pricing vendors, and 3% using prices obtained from broker-dealers. The number of prices we obtain per instrument varies based on the type of asset class and particular reporting period. Prices are generally obtained from multiple sources when a new security is purchased and a pricing source is assigned to the particular security. A hierarchy is maintained that prioritizes pricing sources based on availability and reliability of information, with preference generally given to prices provided by independent pricing vendors and index providers. Pricing providers may be assigned to a particular security based upon the provider’s expertise. Generally, the initial pricing source selected is consistently used for each reporting period. We have not adjusted any prices that we have obtained from pricing services. However, if we determine that a price appears unreasonable, we investigate and assess whether the price should be adjusted.
Generally, pricing services determine prices by maximizing the use of observable inputs to determine the fair value measurement. The inputs used in index pricing may include, but are not limited to, benchmark yields, transactional data, broker-dealer quotes, security cash flows and structures, credit ratings, prepayment speeds, loss severities, credit risks and default rates. The inputs used by pricing vendors may include, but are not limited to, benchmark yields, reported trades, broker-dealer quotes, issuer spreads, bids, offers and industry and economic events. Broker-dealers value securities through trading desks primarily based on observable inputs. For further discussion on fair values of investments see “Financial Condition - Liquidity - Sources of Liquidity”.
In accordance with ASC 320, we also consider our intent to sell a security and the likelihood that we will be required to sell a security before an unrealized loss is recovered. Our intent to sell a security is based, in part, on adverse changes in the credit worthiness of a debt issuer, pricing and other market conditions and our anticipated net cash flows. If we determine that we intend to sell a security that is in an unrealized loss position, then the unrealized loss related to such a security, representing the difference between the security’s amortized cost and its fair value, is recognized as a net impairment loss in our consolidated statements of operations at the time we determine our intent is to sell.
Year Ended December 31, 2010 as Compared with the Year Ended December 31, 2009
Net underwriting income was $108.9 million and $218.2 million for the years ended December 31, 2010 and 2009, respectively. The decrease was primarily due to an increase in net underwriting losses arising from major catastrophes, partially offset by an increase in net favorable development and a reduction in our ULAE reserves.
Net losses arising from major catastrophes were $214.8 million and $35.5 million for the years ended December 31 2010 and 2009, respectively. Net favorable development was $151.9 million and $101.0 million for the years ended December 31, 2010 and 2009, respectively. Net favorable or unfavorable development is the development of prior years’ unpaid losses and LAE and the related impact on premiums and commissions. The net favorable development for the year ended December 31, 2010 relating to prior years was in both the Property and Marine and Casualty segments. Additionally, we conducted a review of ULAE reserve factors across all lines of business during the third quarter of 2010. The review involved a detailed analysis of our administrative costs of managing claims since our inception and, in our judgment, we concluded that the amounts paid had reached sufficient credibility for us to change our previously selected ULAE reserve factors. The change in our estimate of the administrative costs of managing claims resulted in a $13.2 million reduction of ULAE reserves.
We conduct our worldwide reinsurance business through three operating segments: Property and Marine, Casualty and Finite Risk. In managing our operating segments, we use measures such as net underwriting income and underwriting ratios to evaluate segment performance. We do not allocate assets or certain income and expenses such as investment income, net realized gains on investments, net impairment losses on investments, net changes in fair value of derivatives, net foreign currency exchange gains and losses, interest expense and certain corporate expenses by segment. Segment net underwriting income is reconciled to the U.S. GAAP measure of income before income taxes in Note 14 to the “Consolidated Financial Statements” contained elsewhere in this Form 10-K. The measures we used in evaluating our operating segments should not be used as a substitute for measures determined under U.S. GAAP. Our operating segment results are discussed in detail below.
Net favorable development in the property per-risk excess-of-loss class related primarily to the 2006 through 2008 underwriting years. Net favorable development in the catastrophe excess-of-loss (non-major events) class related primarily to the 2008 underwriting year. Net unfavorable development in major catastrophes related primarily to marine losses related to Hurricane Rita in the 2005 underwriting year. Net unfavorable development in the crop class related primarily to the North American business in the 2008 underwriting year. Net unfavorable development in the marine, aviation and satellite class related primarily to the marine business in the 2007 underwriting year. Net favorable development in the property proportional class related primarily to the 2005 through 2007 underwriting years.
Net acquisition expenses and related net acquisition expense ratios were $60.2 million and 14.4% for the year ended December 31, 2010 and $67.0 million and 12.7% for the year ended December 31, 2009. The decrease in net acquisition expenses in 2010 as compared with 2009 was primarily due to a decrease in net premiums earned. The increase in the acquisition expense ratio was due to an increase in commissions related to the increase in net favorable loss development and was also impacted by changes in the mix of business.
The following table sets forth the net favorable (unfavorable) development in the year ended December 31, 2009 by class of business ($ in thousands):
Net acquisition expenses and related net acquisition expense ratios were $71.5 million and 20.8% for the year ended December 31, 2010 and $88.8 million and 22.8% for the year ended December 31, 2009. The decrease in net acquisition expenses in 2010 as compared with 2009 was primarily due to the decrease in net premiums earned. The decrease in the acquisition expense ratio was primarily due to changes in the mix of business. In addition, the decrease was partially due to a decrease in commissions related to prior years’ losses of $4.8 million, which, with related premium adjustments, represented 1.6% of net earned premiums in 2010 as compared with a decrease of $4.4 million in commissions which, with related premium adjustments, represented 1.2% of net premiums earned in 2009.
During the years ended December 31, 2010 and 2009, the Finite Risk portfolio consisted of one in force contract and we expect little or no new activity in this segment in the foreseeable future due to the relatively low level of demand for finite risk products. Due to the decline in the premium volume in recent years, current year ratios may be significantly impacted by minor adjustments of prior years’ reserves. The decreases in net premiums written and net premiums earned in 2010 as compared with 2009 were attributable to a decrease in our share of the one contract.
Sales of investments for the year ended December 31, 2010 resulted in net realized gains of $106.4 million primarily from U.S. Government securities, U.S. Government agency residential mortgage-backed securities (“RMBS”) and non-U.S. Government securities. The net gains from mark-to-market adjustments on trading securities for the year ended December 31, 2010 included net gains of $1.4 million primarily related to non-U.S. Government securities. Sales of investments for the year ended December 31, 2009 resulted in net realized gains of $80.9 million primarily from U.S. Treasury Inflation-Protected Securities (“TIPS”), U.S. Government agency securities, corporate bonds and non-agency RMBS. The net losses from mark-to-market adjustments on trading securities in 2009 were comprised of $2.1 million related to non-U.S. dollar denominated securities and $1.2 million related to TIPS, which were partially offset by net gains of $1.0 million related to insurance-linked securities.
The following table sets forth net impairment losses on investments for the years ended December 31, 2010 and 2009 ($ in thousands):
We routinely review our available-for-sale investments to determine whether unrealized losses represent temporary changes in fair value or are the result of an OTTI. During 2010 and 2009 we analyzed the projected cash flows of our non-agency structured securities at an individual security level. If the projected cash flows are less than the amortized cost, a credit loss has generally occurred. The amount of the credit loss of an impaired debt security is the difference between the amortized cost and the greater of (i) the present value of expected future cash flows and (ii) the fair value of the security. The credit loss is recognized in net income and the portion of OTTI related to all other factors is recognized in accumulated other comprehensive income or loss. We evaluate the unrealized losses of our preferred stocks by individual issuer and determine if we can forecast a reasonable period of time by which the fair value of the securities would increase and we would recover our cost. If we were unable to forecast a reasonable period of time in which to recover the cost of our preferred stocks, we recorded a net impairment loss in our consolidated statement of operations equivalent to the entire unrealized loss.
The net changes in the fair value of derivatives were $9.6 million and $9.7 million for the years ended December 31, 2010 and 2009, respectively. The net changes in the fair value of derivatives were attributed to a three year derivative contract with Topiary Capital Limited (“Topiary”) that commenced in August 2008 and provides us with annual second event catastrophe protection. See “Financial Condition - Liquidity” for additional discussion of Topiary.
Income tax expense was $43.2 million and $4.3 million for the years ended December 31, 2010 and 2009, respectively. The effective tax rates were 16.7% and 1.1% for the years ended December 31, 2010 and 2009, respectively. The effective tax rate in any given period is primarily driven by the composition of income before income tax expense from our subsidiaries. The increase in income tax expense and effective tax rate for the year ended December 31, 2010 as compared with the same period in 2009 was primarily due to the increase in the proportion of income before income taxes generated by our U.S.-based subsidiaries. The percentage of income before income taxes derived from our U.S.-based subsidiaries was 50% for the year ended December 31, 2010 as compared with 4% for the year ended December 31, 2009.
Net income and diluted earnings per common share for the years ended December 31, 2009 and 2008 were as follows ($ and amounts in thousands, except earnings per share):
The increase in net income for the year ended December 31, 2009 as compared with 2008 was primarily due to an increase in net underwriting income as a result of a decrease in net losses arising from major catastrophes in 2009 as compared with 2008. The increase in diluted earnings per common share for the year ended December 31, 2009 as compared with 2008 was primarily due to the increase in net income. Diluted earnings per common share was also favorably impacted by a decrease in weighted average shares outstanding used to calculate diluted earning per common share, primarily due to the repurchase of 7,852,498 of our common shares in 2009.
Net underwriting income was $218.2 million and $90.1 million for the years ended December 31, 2009 and 2008, respectively. The increase was primarily due to a decrease in net underwriting losses arising from major catastrophes, partially offset by a decrease in net favorable development.
Property and Marine segment underwriting income increased by $100.9 million for the year ended December 31, 2009 as compared with the year ended December 31, 2008, primarily due to a decrease in net losses arising from major catastrophes, partially offset by a decrease in net favorable development and net premiums earned. Net losses arising from major catastrophes, net of reinstatement premiums and commissions, were $35.5 million and $198.0 million for the years ended December 31, 2009 and 2008, respectively. Net losses arising from major catastrophes for the year ended December 31, 2009 were primarily attributable to the Irish Floods, Hailstorm Wolfgang and Winterstorm Klaus. Net losses arising from major catastrophes for the year ended December 31, 2008 were primarily attributable to Hurricanes Gustav and Ike and Winterstorm Emma. Net favorable development was $25.1 million and $77.6 million for the years ended December 31, 2009 and 2008, respectively.
Net losses and LAE decreased by $146.6 million in the year ended December 31, 2009 as compared with the year ended December 31, 2008, primarily due to the decrease in losses arising from major catastrophes in 2009. Net losses and LAE arising from major catastrophes were $42.6 million and $224.9 million for the years ended December 31, 2009 and 2008, respectively. The decrease in losses from major catastrophes was partially offset by the decrease in net favorable loss development. Net favorable loss development was $14.3 million and $71.2 million in 2009 and 2008, respectively. Net losses arising from major catastrophes, with related premium adjustments, increased the net loss and LAE ratio by 7.5 points and 36.1 points for the years ended December 31, 2009 and 2008, respectively. Net favorable loss development and related premium adjustments decreased the net loss and LAE ratio by 3.2 and 13.4 points in 2009 and 2008, respectively. Net favorable loss development in both 2009 and 2008 was primarily attributable to a level of cumulative losses reported by our ceding companies that was lower than we expected and that, in our judgment, resulted in sufficient credibility in the loss experience to change our previously selected loss ratios. The net loss and LAE ratios were also affected by changes in the mix of business.
The Casualty operating segment generated 39.7% and 41.5% of our net premiums written for the years ended December 31, 2009 and 2008, respectively. The following table summarizes underwriting activity and ratios for the Casualty segment for the years ended December 31, 2009 and 2008 ($ in thousands):
Net premiums written decreased by $73.6 million in the year ended December 31, 2009 as compared with the year ended December 31, 2008. The decrease was primarily due to decreases in business underwritten in 2008 and 2009 across most casualty classes and was the result of fewer opportunities that met our underwriting standards. The decrease in net premiums earned was the result of the decrease in net premiums written in current and prior years. Net premiums written and earned were also affected by changes in the mix of business and the structure of the underlying reinsurance contracts.
Net favorable development was $78.1 million for the year ended December 31, 2009. See “Results of Operations - Year Ended December 31, 2010 as Compared with the Year Ended December 31, 2009 - Underwriting Results - Casualty” above for discussion of net favorable development by class of business for the year ended December 31, 2009.
Net favorable development in the North American claims made excess-of-loss class related primarily to the 2003 through 2006 underwriting years. During the year an analysis of our medical malpractice business resulted in changes to the loss development pattern and initial expected loss ratios for the 2004 and later underwriting years which resulted in $9.2 million of the net favorable development. The 2007 underwriting year experienced net unfavorable development due to exposure to claims relating to the financial crisis. Net favorable development in the North American umbrella class related primarily to the 2004 and 2005 underwriting years. Net favorable development in the financial lines class related primarily to the 2004 through 2007 underwriting years’ credit and surety excess-of-loss classes. Net favorable development in the international casualty class related primarily to the 2002 through 2004 underwriting years’ motor excess-of-loss and claims made classes, partially offset by net unfavorable development in the 2006 underwriting year.
Net acquisition expenses and related net acquisition expense ratios were $88.8 million and 22.8% for the year ended December 31, 2009 and $125.9 million and 25.0%, for the year ended December 31, 2008. The decrease in net acquisition expenses in 2009 as compared with 2008 was primarily due to the decrease in net premiums earned. The decrease in the acquisition expense ratio was due to a decrease in commissions related to prior years’ losses of $4.4 million, which, with related premium adjustments, represented 1.2% of net earned premiums in 2009 as compared with an increase of $4.8 million in commissions which, with related premium adjustments, represented 0.3% of net premiums earned in 2008. Net acquisition expense ratios were also impacted by changes in the mix of business.
Other underwriting expenses were $25.6 million and $24.0 million for the years ended December 31, 2009 and 2008, respectively. The increase in other underwriting expenses in 2009 as compared with 2008 was primarily due to an increase in performance-based compensation in 2009.
The Finite Risk segment generated 2.7% and 1.4% of our net premiums written for the years ended December 31, 2009 and 2008, respectively. The following table summarizes underwriting activity and ratios for the Finite Risk segment for the years ended December 31, 2009 and 2008 ($ in thousands):
During the years ended December 31, 2009 and 2008, the Finite Risk portfolio consisted of one in force contract. Due to the decline in the premium volume in recent years, current year ratios may be significantly impacted by minor adjustments of prior years’ reserves. The increases in net premiums written and net premiums earned in 2009 as compared with 2008 were attributable to an increase in our share of one contract.
Sales of investments for the year ended December 31, 2009 resulted in net realized gains of $80.9 million primarily from TIPS, U.S. Government agency securities, corporate bonds and U.S. Government agency RMBS. The U.S. Government agency securities that we sold consisted of securities issued by financial institutions under the Temporary Liquidity Guarantee Program and that are guaranteed by the Federal Deposit Insurance Corporation. The net losses from mark-to-market adjustments on trading securities in 2009 were comprised of net losses of $2.1 million related to non-U.S. dollar denominated securities and $1.2 million related to TIPS, which were partially offset by net gains of $1.0 million related to insurance-linked securities. Sales of investments for the year ended December 31, 2008 resulted in net realized gains of $51.8 million primarily from TIPS, U.S. Government securities, U.S. Government agencies, and U.S. Government agency RMBS and net realized losses of $4.2 million from corporate bonds. The net gains from mark-to-market adjustments on trading securities in 2008 were comprised of $8.4 million related to non-U.S. dollar denominated securities and $1.3 million of changes in the fair value of TIPS.
The net impairment losses on investments recorded for the year ended December 31, 2008 reflect the entire difference between the amortized cost basis and the fair value of the impaired securities at the balance sheet date.
The net changes in the fair value of derivatives were $9.7 million and $14.1 million for the years ended December 31, 2009 and 2008, respectively. The decrease in expense in the year ended December 31, 2009 as compared with 2008 was due to the expiration of three derivative contracts that were in effect in the year ended December 31, 2008. In 2008, in addition to the derivative contract with Topiary, we had an additional contract that provided second event catastrophe protection along with two derivative contracts that were options to purchase industry loss warranty retrocessional protection.
Net foreign currency exchange gains for the year ended December 31, 2009 were $0.4 million compared with net foreign currency exchange losses of $6.8 million for the year ended December 31, 2008. We routinely transact business in currencies other than the U.S. dollar. The net foreign currency exchange losses in 2008 were the result of holding more non-U.S. dollar denominated assets than non-U.S. dollar denominated liabilities, primarily the Euro and the British pound sterling, as the U.S. dollar strengthened against those currencies. In 2009 we held non-U.S. dollar denominated assets and liabilities in approximately equivalent amounts.
Interest expense was $19.0 million for each of the years ended December 31, 2009 and 2008 and was related to our $250.0 million of the Series B Notes.
Income tax expense was $4.3 million and $13.0 million for the years ended December 31, 2009 and 2008, respectively. The effective tax rates were 1.1% and 5.4% for the years ended December 31, 2009 and 2008, respectively. The decrease in income tax expense and effective tax rate for the year ended December 31, 2009 was primarily due to the decrease in the proportion of income before income taxes generated by our U.S.-based subsidiaries. The decrease in taxable income was partially attributable to an increase in the proportion of assets in Platinum US that was invested in tax-advantaged municipal bonds. The effective tax rate in any given period is primarily driven by the composition of income before income tax expense from our subsidiaries. The decrease in the effective tax rate in 2009 as compared with 2008 was the result of a greater portion of income before income tax expense being generated by Platinum Holdings and Platinum Bermuda, which are not subject to corporate income tax. In 2009, the percentage of income before income tax expense derived from Platinum Holdings and Platinum Bermuda was 94.3% as compared with 84.4% in 2008.
Platinum Holdings is a holding company, the assets of which consist primarily of shares of its subsidiaries. Platinum Holdings depends primarily on its available cash resources and liquid investments, and dividends, interest and other distributions from its subsidiaries, to meet its obligations. Such obligations may include operating expenses, debt service obligations, dividends on its common shares and repurchases of common shares or other securities. Applicable laws and statutory requirements of the jurisdictions in which our regulated reinsurance subsidiaries operate, Bermuda and the United States, limit the payment of dividends and other distributions from these subsidiaries. The ability of the reinsurance subsidiaries to pay dividends is also constrained by our dependence on the financial strength ratings by A.M. Best and S&P of our reinsurance subsidiaries, which depend to a large extent on the capitalization levels of the reinsurance subsidiaries. We believe that Platinum Holdings has sufficient cash resources and its subsidiaries have available dividend capacity to service our current outstanding obligations. Platinum Holdings received dividends from its subsidiaries of $396.5 million during the year ended December 31, 2010. Based on the regulatory restrictions, the maximum amount available for payment of dividends or other distributions by the reinsurance subsidiaries of Platinum Holdings without prior regulatory approval in 2011 is estimated to be $406.1 million. Subsequent to December 31, 2010, Platinum Bermuda made dividend payments of $180.0 million to Platinum Holdings.
Platinum Bermuda is not licensed, approved or accredited as a reinsurer in the United States and, therefore, under the terms of most of its contracts with U.S. ceding companies, it is required to provide collateral to its ceding companies for unpaid ceded liabilities in a form acceptable to state insurance commissioners. Typically, this type of collateral takes the form of letters of credit issued by a bank, the establishment of a trust, or funds withheld.
Platinum Bermuda and Platinum US have reinsurance and other contracts that also require them to provide collateral to ceding companies should certain events occur, such as a decline in our financial strength rating by A.M. Best or S&P below specified levels or a decline in statutory equity below specified amounts, or when certain levels of assumed liabilities are attained. Some reinsurance contracts also have special termination provisions that permit early termination should certain events occur. As of December 31, 2010 and 2009, we held investments with a carrying value of $69.8 million and $275.5 million, respectively, and cash and cash equivalents of $9.9 million and $26.8 million, respectively, in trust to collateralize obligations under various reinsurance contracts. As of December 31, 2010 and 2009, we held investments with a carrying value of $48.6 million and $206.5 million, respectively, and cash and cash equivalents of $100.3 million and $17.0 million, respectively, to collateralize letters of credit issued under our credit facility. The letters of credit were issued to collateralize obligations under various reinsurance contracts. See “Financial Condition - Liquidity - Sources of Liquidity” below for additional discussion on our credit facility.
On a consolidated basis, our aggregate cash and invested assets totaled $4.2 billion and $4.4 billion at December 31, 2010 and 2009, respectively. Additionally, there were net balances due from brokers related to the sale of securities of $0.1 million and $123.3 million at December 31, 2010 and December 31, 2009, respectively. Balances due from and to brokers are included in other assets and other liabilities, respectively. Our investment portfolio consists primarily of diversified, high quality, predominantly investment grade fixed maturity securities. Our aggregate cash and invested assets, including accrued investment income and net balances due to and from brokers, had a duration of 4.1 years and 3.5 years as of December 31, 2010 and 2009, respectively.
As of December 31, 2010, the fair value of our available-for-sale securities was $2.9 billion, with a net unrealized loss of $23.7 million, and the fair value of our trading securities was $182.1 million. The following table sets forth the fair values, with net unrealized gains and losses and average credit quality of our fixed maturity securities as of December 31, 2010 ($ in thousands):
The net unrealized loss position of our RMBS portfolio was $25.9 million, of which $25.6 million related to non-agency RMBS, as of December 31, 2010 as compared with $52.6 million, of which $45.0 million related to non-agency RMBS, as of December 31, 2009. This improvement in the net unrealized loss position was attributable to a decrease in yields and the recognition of credit impairments during 2010. Approximately 49% of the RMBS in our investment portfolio are issued or guaranteed by the Government National Mortgage Association, the Federal National Mortgage Association, Federal Home Loan Mortgage Corporation or the Federal Deposit Insurance Corporation and are referred to as U.S. Government agency RMBS. The remaining 51% of our RMBS were issued by non-agency institutions and included securities with underlying Alt-A mortgages. The net unrealized loss position of our portfolio of sub-prime asset-backed securities (“ABS”) was $4.4 million as of December 31, 2010 as compared with $25.7 million as of December 31, 2009. This improvement in the net unrealized loss position was primarily attributable to the recognition of credit impairments during 2010. We analyze our non-agency RMBS and sub-prime ABS on a periodic basis using default loss models based on the performance of the underlying loans. Performance metrics include, but are not limited to, delinquencies, defaults, foreclosures, prepayment speeds and cumulative losses incurred. The expected losses for a mortgage pool are compared to the current level of credit support, which generally represents the point at which our security would experience losses. We evaluate projected cash flows as well as other factors in order to determine if a credit impairment has occurred.
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2010 ($ in thousands):
At December 31, 2010, our capital resources of $2.1 billion consisted of common shareholders’ equity of $1.9 billion and $250.0 million of the Series B Notes. At December 31, 2009, our capital resources of $2.3 billion consisted of common shareholders’ equity of $2.1 billion, and $250.0 million of the Series B Notes. The decrease in capital during year ended December 31, 2010 was primarily attributable to share repurchase activity and the purchase of options, offset by net income and an improvement in accumulated other comprehensive loss.
To the extent that our existing capital is insufficient to fund our future operating requirements or maintain our financial strength or debt ratings, we may need to raise additional capital through financings, which may be in the form of debt securities, preferred shares, common equity, bank credit facilities providing loans and/or letters of credit, or any combination of these sources. Any equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result, and such securities may have rights, preferences and privileges that are senior to those of our outstanding securities. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by rating agencies to our reinsurance subsidiaries, which could place those reinsurance subsidiaries at a competitive disadvantage compared with higher-rated competitors, (2) reductions in the amount of business that our reinsurance subsidiaries are able to write in order to meet capital adequacy-based tests enforced by regulatory authorities, and (3) increases in the cost of bank credit and letters of credit. We can provide no assurance that, if needed, we would be able to obtain additional funds through financing on satisfactory terms or at all.
We do not have any material commitments for capital expenditures as of December 31, 2010.
We do not have any off-balance sheet arrangements, as defined for purposes of SEC rules, which are not accounted for or disclosed in the consolidated financial statements as of December 31, 2010.
Our contractual obligations as of December 31, 2010 by estimated maturity are presented below ($ in thousands):
See Note 7 to the Consolidated Financial Statements contained elsewhere in this Form 10-K.
See Note 15 to the Consolidated Financial Statements contained elsewhere in this Form 10-K.