Our principal office facilities, with more than 25,000 square feet, are as follows:
The selected consolidated financial data set forth below has been derived from the Consolidated Financial Statements. All information contained herein should be read in conjunction with the Consolidated Financial Statements and the related Notes and with Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Report.
Our business philosophy is to maximize underwriting profit while managing risk in order to preserve shareholders’ equity, grow book value and maximize earnings. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We also rely on our experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce risk. Our business plan is shaped by our underlying business philosophy. As a result, our primary objective is to increase net earnings and grow book value, rather than to grow our market share or our gross written premium.
We had consolidated shareholders’ equity of $3.3 billion, with a book value per share of $28.67.
We produced total revenue of $2.3 billion, of which 89% related to net earned premium and 9% related to net investment income.
Our new property treaty business, which is susceptible to catastrophic events and large losses, generated $47.6 million of net earned premium and had a net loss ratio of 58.2%, including catastrophic losses.
We recognized gross losses of $44.0 million and net losses, after reinsurance, of $22.5 million from various large losses, mainly in our property treaty business, which are viewed as catastrophic events in the specialty insurance market. The catastrophic net losses increased our net loss ratio and our combined ratio by 1.1 percentage points. In addition, we recognized $31.7 million of gross losses for the Deepwater Horizon rig disaster, for which we had a minimal net loss due to significant facultative and treaty reinsurance.
Our net loss ratio, including the catastrophic losses, was 59.4% and our combined ratio was 84.6%.
We increased our dividend for the 14th consecutive year and paid $63.2 million of dividends.
We held a total investment portfolio of $5.7 billion, of which $5.2 billion were fixed income securities with an average rating of AA+.
The following sections discuss our key operating results. The reason for any significant variations between 2009 and 2008 are the same as those discussed for variations between 2010 and 2009, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees.
We also now present an expense ratio for each reportable segment. All of our expense ratios are calculated using amounts included in our GAAP consolidated financial statements. The formulas are as follows:
Consolidated expense ratio - sum of other expense for each of our insurance segments, divided by the sum of segment revenue for each of our insurance segments.
Segment expense ratio - segment other expense divided by segment revenue.
Our results and key metrics for the past three years were as follows:
In 2010, we recognized gross losses of $44.0 million from various catastrophic events, the most significant of which was the Chilean earthquake. After reinsurance, our pretax losses were $22.5 million. In 2008, we incurred gross losses of $98.2 million from Hurricanes Gustav and Ike (referred to herein as the 2008 hurricanes). Our 2008 pretax losses after reinsurance were $22.3 million, which included $19.4 million of losses reported in loss and loss adjustment expense and $2.9 million of premiums to reinstate our excess of loss reinsurance protection, which reduced net earned premium.
realized investment gains and losses and other-than-temporary impairment (OTTI) credit losses related to our fixed income securities portfolio.
The 2010 growth in premium from our insurance segments occurred primarily in the International segment, directly related to our new property treaty business that we began to write in late 2009. There were offsetting increases and decreases in premium in our other segments, which partially offset the reduction of premium in our Exited Lines. The 2009 growth in premium primarily occurred in the Professional Liability and Accident & Health segments, partially offset by a decrease in premium in our U.S. Property & Casualty and International segments. See the “Segment Operations” section below for further discussion of the relationship and changes in premium revenue within each segment.
The tables below detail our net loss and loss adjustment expense by segment, the amount of development by segment included in our net loss and loss adjustment expense, and the net loss ratio by segment.
The year-over-year change in our total loss and loss adjustment expense was minimal for the three-year period, although the amount of favorable development declined each year. Our loss and loss adjustment expense included favorable development of $22.7 million in 2010, $53.5 million in 2009 and $82.4 million in 2008. The International segment’s loss and loss adjustment expense increased in 2010 due to estimated losses on premium written for our new property treaty business, combined with the 2010 catastrophe losses. The International segment’s 2009 loss and loss adjustment expense decreased compared to 2008 due to the 2008 hurricanes occurring in that year. See the “Segment Operations” section below for additional discussion of the changes in our loss and loss adjustment expense, development and net loss ratios for each segment.
Our net paid loss ratio was higher in 2010, primarily due to a higher amount of claims payments for our directors’ and officers’ liability and medical stop-loss products. In 2009, we commuted certain loss reserves related to the assumed accident and health business included in our Exited Lines for $43.9 million. This commutation had no material effect on net earnings but increased our 2009 net paid loss ratio by 2.1 percentage points.
Other operating expense included $13.6 million, $16.0 million and $13.7 million in 2010, 2009 and 2008, respectively, of stock-based compensation expense, after the effect of the deferral and amortization of policy acquisition costs related to stock-based compensation for our underwriters. Stock-based compensation expense was lower in 2010 due to the forfeiture of restricted stock grants by former employees and full vesting of certain stock options. In 2010, we granted $25.0 million of restricted stock awards and units, with a weighted-average life of 5.7 years. At December 31, 2010, there was approximately $26.8 million of total unrecognized
compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 3.8 years.
Interest expense on debt and short-term borrowings increased $5.2 million in 2010 and decreased $4.2 million in 2009. During 2008 and 2009, we had $124.7 million of 1.30% Convertible Notes outstanding and we borrowed and repaid our Revolving Loan Facility (the Facility) as needed. In the fourth quarter of 2009, we issued $300.0 million of 6.30% Senior Notes, with an effective interest rate of 6.37%, and redeemed the Convertible Notes and repaid the Facility. Our 2010 interest expense includes $19.3 million for the Senior Notes. The higher interest expense in 2008 primarily related to more borrowings on the Facility at a higher interest rate. Interest on the Facility was based on 30-day LIBOR plus 25 basis points.
In 2009 and again in 2010, we wrote less premium in most of these product lines due to continued pricing competition in the segment’s markets. In particular, aviation experienced price decreases in its U.S. markets. Our E&O volume also declined as we continued to re-underwrite that product in mid-2009, employing more stringent underwriting criteria in reaction to higher losses. Our public risk premium increased in 2009 due to the acquisition of several small agencies that specialize in public risk insurance in late 2008. Premium grouped in Other, which includes numerous types of specialty insurance products, declined in 2010 and 2009, primarily because we wrote less occupational accident and residual value insurance in 2010 and an assumed quota share contract expired in mid-2008.
The segment’s loss ratios reflect higher 2010 accident year losses, as well as the year-over-year change in loss development. The segment had favorable development of $15.9 million in 2010, compared $25.9 million in 2009 and $23.5 million in 2008. The 2010 favorable development primarily related to an assumed quota share contract that is in runoff, as well as to aviation, public risk and smaller product lines (included in Other). The 2009 and 2008 favorable development primarily related to aviation and the quota share contract. In 2010, E&O experienced higher 2010 accident year losses, as well as adverse development related to the 2006 - 2009 underwriting years. Higher 2009 accident year losses increased aviation’s loss ratio in 2009, compared to 2010. The 2008 hurricanes increased the 2008 loss ratios for aviation, public risk and the quota share contract.
We dissolved our interest in a derivative contract in 2010 and in the MGIC contract in 2009, which generated $5.0 million and $15.6 million, respectively, of pretax earnings in these years. Related to these transactions, we received cash of $8.3 million in 2010 and $25.0 million in 2009, which was included in other revenue, and incurred reinsurance and other direct costs of $3.0 million in 2010 and $9.9 million in 2009, which were included in other expense. These transactions increased the segment’s expense ratio by 0.8 percentage points in 2010 and 2.3 percentage points in 2009. The higher expense ratio in 2010 primarily related to the lower level of earned premium in that year. The segment’s remaining other revenue relates to fee and commission income earned by our agencies from third party insurance companies.
The Professional Liability segment pretax earnings declined 20% in 2010 compared to 2009 due to 1) lower net earned premium, 2) reduced profit commissions from reinsurers, 3) higher operating expenses and 4) the year-over-year effect of loss development. The compound effect of the first three factors caused the 2010 expense ratio to be higher than the 2009 expense ratio. Segment earnings increased 13% in 2009 compared to 2008 due to higher net earned premium, which more than offset the effect of $18.7 million of favorable loss development in 2008, compared to minimal development in 2009.
Gross written premium decreased 7% in 2010 because we wrote less D&O business in the United States due to pricing competition. Gross written premium increased 15% in 2009, primarily due to increased demand for our policies, as the D&O market reacted to financial issues impacting other insurance companies. We obtained more reinsurance in 2010 for our International business and in 2009 for our U.S. business, in order to continue to offer large limits to insureds.
The segment had $9.6 million of adverse loss development in 2010, minimal development in 2009 and $18.7 million of favorable development in 2008. The 2010 development related to our diversified financial products business, which is included in Other, for the 2005 and 2008 underwriting years. In 2009, for our D&O products, we re-estimated our exposure on the 2004 - 2007 underwriting years. As a result, the International D&O reserves had favorable development, which was substantially offset by adverse development in the U.S. D&O reserves. The 2008 favorable development primarily related to the 2004 - 2006 underwriting years for International D&O, but was substantially offset by an increase in the 2007 underwriting year, primarily for our U.S. D&O business. The loss ratio for the products included in Other was higher in 2008 due to both 2008 accident year losses and adverse development from our diversified financial products business.
The segment generated minimal profit commissions in 2010, compared to $10.5 million in 2009 and $11.9 million in 2008. These profit commissions are reported as a reduction of other expense for segment and consolidated reporting purposes. The effect of these profit commissions decreased the segment’s 2009 and 2008 expense ratios by 2.4 percentage points and 3.3 percentage points, respectively. The higher expense ratio in 2010 related to higher operating costs relative to the lower net earned premium level.
Our Accident & Health segment includes medical stop-loss, short-term domestic and international medical, HMO reinsurance and medical excess coverages. The products are written in the United States through our underwriting agencies, third party agents and brokers, and an Internet portal. Medical stop-loss, which represents the majority of the segment’s business, provides catastrophic coverage to groups of employees who have primary coverage through employer sponsored self-funded plans. Due to the nature of this business, claims are reported and settled quickly, with minimal catastrophic exposure to us.
The Accident & Health segment pretax earnings were relatively flat during the three-year period. Segment earnings in 2010 reflected higher net earned premium related to rate increases on our medical stop-loss product to cover the cost of inflation. In addition, our medical stop-loss premium increased in 2010 and 2009 due to the 2008 acquisition of an agency that writes medical stop-loss insurance. We also acquired an agency in 2008 that writes short-term medical insurance, which is reported in Other above. Our short-term medical premium increased in 2010, offset by a reduction related to products in this same category.
The segment had adverse loss development of $9.8 million and $3.1 million in 2010 and 2009, respectively, compared to $12.3 million of favorable development in 2008. The 2010 adverse development primarily related to the 2008 and 2009 underwriting years for our medical excess, short-term medical and HMO reinsurance products. The higher segment loss ratio in 2010 compared to 2009 reflected increased losses in our medical stop-loss product. The 2008 favorable reserve development primarily related to medical stop-loss. The segment’s accident year losses have declined over the past three years.
The following tables summarize the operations of the U.S. Surety & Credit segment.
In early 2009, we purchased a surety insurance company, which increased our written and earned surety premium in 2009. In 2010, increased pricing for commercial surety bonds written by the acquired company contributed to the growth in the 2010 gross written premium. In addition, our large commercial surety team, hired in 2009, wrote more premium in 2010. Our credit premium grew in 2009 and 2010 due to improved market pricing following the 2008 world-wide credit market crisis.
Historically, surety bonds and credit insurance have lower net loss ratios and higher expense ratios than other types of property and casualty insurance. The lower net loss ratios reflect the underwriting and claims processes in this business, including collateral drawdowns and subrogation recoveries. The higher expense ratios reflect the additional personnel time and costs required to underwrite these policies and administer claims, as well as higher commission rates paid to agents. The segment’s expense ratio was higher in 2010 compared to 2009 due to additional personnel costs to administer and underwrite the business and handle claims.
Our International segment includes energy, property treaty, liability, surety, credit, property (direct and facultative), ocean marine, accident and health and other smaller product lines written outside the United States. Products in this segment are susceptible to catastrophic events and large losses, for which we maintain excess of loss, quota share and facultative reinsurance protection to limit our exposure to such losses. We write this business through our insurance companies in the United Kingdom, Spain and the United States, as well as through our Lloyd’s syndicate. In late 2009, we began writing property treaty business, for which we assume catastrophic risks that are written by other insurance companies. Claims for most products in this segment are reported and settled on a medium-term basis, although certain products are longer-tailed business.
The increase in gross written, net written and net earned premium in 2010, compared to 2009, principally related to our new property treaty business, which we began to write in late 2009. In addition, in 2010, we wrote more short-tail property business (included in Other), which was substantially reinsured.
Other revenue in 2009 and 2008 included third party agency and broker commissions earned by Rattner Mackenzie Limited (RML), our U.K. reinsurance broker, which we sold in late 2009. The segment’s expense ratio was lower in 2010 compared to 2009 primarily due to the higher volume of net written premium with minimal incremental operating expense. The lower expense ratio in 2009 compared to 2008 related to a partial year of operating expenses for RML in 2009 and the effect of a $3.8 million premium deficiency reserve, recorded at year-end 2008, which also reduced the amount of policy acquisition costs recognized in 2009.
The following tables summarize the investment results and key metrics related to our Investing segment.
The ratings of our fixed income securities at December 31, 2010 were as follows:
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. The gross unrealized losses of individual securities within our available for sale fixed income securities was $35.6 million at December 31, 2010 and $18.9 million at December 31, 2009. We evaluate the securities in our fixed income securities portfolio for possible other-than-temporary impairment losses at each quarter end. See the “Critical Accounting Policies - Other-than-temporary Impairments in Investments” section below for a description of the accounting policies and procedures that we use to determine our other-than-temporary impairment losses. Over the three-year period, we realized $17.0 million of
At December 31, 2010, we held $1.6 billion of special purpose revenue bonds, as well as $1.1 billion of general obligation bonds, which are issued by states, municipalities and political subdivisions and collectively referred to, in the investment market, as municipal bonds. The overall rating of our municipal bonds was AA+ at December 31, 2010. Within our municipal bond portfolio, we held $266.6 million of pre-refunded bonds, which are supported by U.S. government debt obligations. Our special purpose revenue bonds are secured by revenue sources specific to each security. At December 31, 2010, the percentages of our special purpose revenue bond portfolio supported by these major revenue sources were as follows: 1) water and sewer - 24%, 2) education - 17%, 3) transportation - 16%, 4) special tax - 10% and 5) pre-refunded bonds - 8%.
Many of our special purpose revenue bonds are insured by mono-line insurance companies or supported by credit enhancement programs of various states and municipalities. We view bond insurance as credit enhancement and not credit substitution. We base our investment decision on the strength of the issuer. A credit review is performed on each issuer and on the sustainability of the revenue source before we acquire a special purpose revenue bond and periodically, on an ongoing basis, thereafter. The underlying average credit rating of our special purpose revenue bond issuers, excluding any bond insurance, was AA at December 31, 2010. Although recent economic conditions in the United States may reduce the source of revenue to support certain of these securities, the majority are supported by revenue from essential sources, as indicated above, which we believe generate a stable source of revenue.
At December 31, 2010, we held a commercial MBS securities portfolio with a fair value of $145.2 million, an average rating of AA+ and an average loan-to-value ratio of 75%. We owned no collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), and we are not counterparty to any credit default swap transactions.
We held $585.9 million of cash and liquid short-term investments at December 31, 2010, compared to $940.1 million at December 31, 2009. We reinvested a substantial portion of our short-term investments in higher yielding fixed income securities during 2010 to maximize our net investment income. In addition, in early 2010, we used cash held at year-end 2009 to pay the final $64.5 million due for conversion of our 1.3% Convertible Notes.
Our available for sale bond portfolio had a fair value of $5.0 billion at December 31, 2010, compared to $4.5 billion at December 31, 2009, and an average rating of AA+. We intend to hold these securities until their maturity, but we would be able to sell securities to generate cash if the need arises.
Our insurance companies have sufficient resources to pay potential claims. We project that our insurance companies will pay approximately $1.3 billion of claims in 2011, based on historical payment patterns and claims history. We also project that they will collect approximately $0.3 million of reinsurance recoveries in 2011. These companies have $5.1 billion of short-term investments and available for sale fixed income securities that are available to fund claims payments, if needed, after consideration of expected cash flow from the insurance companies’ 2011 operations.
HCC has a short-duration fixed income securities portfolio of $134.3 million and $105.1 million of short-term investments. Cash flow available to HCC in 2011 is expected to be ample to cover the holding company’s required cash disbursements.
We receive substantial cash from net premiums, ceding commissions on business reinsured, reinsurance recoverables, outward commutations, proceeds from sales and redemptions of investments and investment income. Our principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, inward commutations, purchases of investments, debt service, policy acquisition costs, operating expenses, taxes, dividends and common stock purchases. Cash provided by operating activities can fluctuate due to timing differences in the collection of premiums and reinsurance recoverables and the payment of losses and premium and reinsurance balances payable and the completion of commutations.
The estimated loss and loss adjustment expense payments for future periods assume that the percentage of ultimate losses paid from one period to the next by line of business will be relatively consistent over time. Actual payments will be influenced by many factors and could vary from the estimated amounts.
The average duration of claims in many of our lines of business is relatively short and, accordingly, our investment portfolio has a relatively short duration. The weighted-average duration of all claims was approximately 2.5 years in 2010, 2.7 years in 2009 and 2.5 years in 2008. The weighted-average duration of our fixed income securities was 5.5 years, 4.9 years and 4.8 years 2010, 2009 and 2008, respectively. The longer duration of our fixed income securities reflects the effects of the investment of our capital. In recent years, we have expanded our writings of D&O and E&O insurance, both of which have a longer claims
In 2009, we issued $300.0 million of 6.30% Senior Notes due 2019. The Senior Notes were priced at a discount of $1.5 million, for an effective interest rate of 6.37%. Interest is due semi-annually in arrears on May 15 and November 15 of each year. The Senior Notes are unsecured and subordinated general obligations of the holding company. The Senior Notes rank junior to any secured indebtedness and to all existing and future liabilities of our subsidiaries, including amounts owed to policyholders. We can redeem the notes in whole at any time or in part from time to time, at our option, at the redemption price determined in the manner described in the indenture governing the notes. The indenture contains covenants that impose conditions on our ability to create liens on any capital stock of our restricted subsidiaries (as defined in the indenture) or to engage in sales of the capital stock of our restricted subsidiaries. We were in compliance with the requirements of the indenture at December 31, 2010.
Our $575.0 million Revolving Loan Facility (Facility) allows us to borrow up to the maximum allowed by the Facility on a revolving basis until the Facility expires on December 19, 2011. In the fourth quarter of 2009, we repaid the $335.0 million outstanding balance with proceeds from our Senior Notes and other sources of cash. During 2010, we borrowed $50.0 million to fund a capital contribution to a foreign subsidiary, which we repaid upon receipt of dividends from our other subsidiaries. There were no outstanding borrowings at December 31, 2010. However, the Subsidiary Letters of Credit discussed below reduced our available Facility balance to $556.8 million at year-end 2010. The interest rate on any borrowings is 30-day LIBOR (0.26%, 0.23% and 0.44% at December 31, 2010, 2009 and 2008, respectively) plus 25 basis points. We pay an annual commitment fee of 10 basis points. The Facility is collateralized by guarantees entered into by our domestic underwriting agencies and contains two restrictive financial covenants, with which we were in compliance at December 31, 2010. We expect to replace the Facility in 2011.
At December 31, 2010, certain of our subsidiaries had outstanding letters of credit with banks totaling $18.6 million. Of this amount, $18.2 million of outstanding letters of credit reduced our borrowing capacity under the Revolving Loan Facility at year-end 2010.
In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. Under other indemnifications, we agree to reimburse the purchasers for taxes or ERISA-related amounts, if any, assessed after the sale date but related to pre-sale activities. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires in 2025. We accrue a loss when a valid claim is made by a purchaser and we believe we have potential exposure. We currently have claims under an indemnification that covers certain net insurance losses that were incurred and reinsured prior to our sale of a subsidiary. We paid $4.7 million related to such claims in 2010. At December 31, 2010, we have recorded a liability of $10.3 million and have provided a $3.0 million escrow account and $9.7 million of letters of credit to cover our obligations or anticipated payments under this indemnification.
In 2008, our Board of Directors approved the purchase of up to $100.0 million of our common stock, as part of our philosophy of building long-term shareholder value. In May 2010, our Board of Directors approved a new authorization for $300.0 million and cancelled the $0.7 million remaining under the original authorization. The share purchase plan authorized purchases to be made in the open market or in privately negotiated transactions from time-to-time. In 2010, we repurchased 1.3 million shares of our common stock in the open market for a total cost of $35.1 million and a weighted-average cost of $26.99 per share. In 2009, we repurchased 1.7 million shares for a total cost of $35.5 million and a weighted-average cost of $21.36 per share. Our total purchases of $133.9 million for 6.0 million shares have had a weighted-average cost of $22.42 per share.
Our gross reserves for insurance claims, shown as loss and loss adjustment expense payable on our consolidated balance sheets, consist of reserves for reported claims (referred to herein as case reserves) and reserves for incurred but not reported losses (referred to as IBNR). Our IBNR reserves cover potential movement in reported losses, as well as claims that have occurred but have not yet been reported to us. Our net reserves reflect the offset of reinsurance recoverables due to us from third party reinsurers, based upon the contractual terms of our reinsurance agreements. In the normal course of our business, we cede a portion of our premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although reinsurance does not discharge us from liability to our policyholders, we participate in reinsurance agreements to limit our loss exposure and to protect us against catastrophic losses. Reserves are recorded by product line and are undiscounted, except for an immaterial amount related to an acquisition.
The process of estimating our loss and loss adjustment expense is inherently uncertain and involves a considerable degree of judgment. Our recorded reserves represent management’s best estimate of unpaid losses and loss adjustment expenses as of each quarter end. Because we provide insurance coverage in specialized lines of business that often lack statistical stability, management considers many factors in determining ultimate losses and reserves required for each product line. These factors include: 1) actuarial point estimates and the estimated ranges around these estimates, 2) information used to price the applicable policies, 3) historical loss information, where available, 4) public industry data for the product or similar products, 5) an assessment of current market conditions, 6) information on individual claims and 7) information from underwriting and claims personnel. The estimate of our loss and loss adjustment expense is increased or decreased as more information becomes known to us about the frequency and severity of losses for individual years. We believe our review process is effective, such that any required changes in loss and loss adjustment expense and reserves are recognized in the period of change as soon as the need for the change is evident.
We utilize the actuarial point and range estimates prepared by our internal actuaries to monitor the adequacy and reasonableness of our recorded reserves. Each quarter-end, management compares recorded reserves to the most recent actuarial point estimate and range for each product line. If the recorded reserves vary significantly from the actuarial point estimate, management determines the reasons for the variances and may adjust the reserves up or down to an amount that, in management’s judgment, is adequate based on all of the facts and circumstances considered, including the actuarial point estimates. Historically, our consolidated net reserves have been above the total actuarial point estimate but within the actuarial range.
The excess of the total recorded net reserves over the actuarial point estimate was 4.1% of recorded net reserves at December 31, 2010, compared to 3.6% at December 31, 2009. The percentage will vary each year, in total and by segment, depending upon current economic events, the nature of the underlying products and their potential volatility, severity of claims reported in the current year, historical development patterns and management’s judgment about these factors.
The following table details the characteristics and key assumptions used in the determination of the actuarial point estimates and ranges for our major products in each segment. We considered all lines of business written by the insurance industry when determining the relative characteristics of claims duration, speed of claim reporting and reserve volatility. Other companies may classify their own insurance products in different segments or utilize different actuarial assumptions. Major actuarial assumptions used include historical loss payment and reporting patterns, estimates for rate changes by product line, trends impacting losses, and the effects of large losses.
Direct insurance is coverage that is originated by our insurance companies and brokers in return for premium. Assumed reinsurance is coverage written by another insurance company, for which we assume all or a portion of the risk in exchange for all or a portion of the premium. Assumed reinsurance represented 12% of our gross written premium in 2010 and 10% in 2009, and 17% and 18% of our gross reserves at December 31, 2010 and 2009, respectively. The 2010 increase in assumed written premium relates to property treaty reinsurance business that we began to write in late 2009. Subscription business is direct insurance or assumed reinsurance where we only take a percentage of the total risk and premium and other insurers take their proportionate percentage of the remaining risk and premium.
The property treaty reinsurance business written in our International segment covers catastrophic risks worldwide. Our internal staff underwrite the business, which is placed by major brokers. Given the nature and size of these large losses, the brokers report these claims to us quickly, since the primary insurance and any lower layers of reinsurance generally are exhausted with the catastrophic event. We establish loss reserves for this assumed reinsurance using a combination of our internal models, external sources that independently model catastrophic losses, and estimates provided by our insureds.
We have reserves for assumed quota share surplus lines business, which we discontinued writing in 2008, in our U.S. Property & Casualty segment. Case reserves are reported directly to us by the cedant. We establish IBNR reserves based on our estimates, using the same methods and assumptions we would use to set reserves for comparable direct business. We have not had any disputes with the cedant.
Our Exited Lines, which represented 43% of gross reserves related to assumed business at December 31, 2010, include run-off assumed accident and health reinsurance business, which is primarily reinsurance that provides excess coverage for large losses related to workers’ compensation policies. This business is slow to develop and may take more than twenty years to pay out. Losses in lower layers must develop first before our excess coverage attaches. This business is subject to late reporting of claims by cedants and state guaranty associations. To mitigate our exposure to unexpected losses reported by cedants, our claims personnel review reported losses to ensure they are reasonable and consistent with our expectations. In addition, our claims personnel periodically audit the cedants’ operations to assess whether cedants are submitting timely and accurate claims reports to us. Disputes with cedants related to claims or coverage issues are negotiated to resolution or settled through arbitration. In recent years, we have been commuting a portion of these reserves to reduce our exposure to adverse development. Based on the higher risk of the underlying insurance product and the potential for late reported claims, management believes there may be greater volatility in loss development for this product than for our other product lines.
The case reserves for reported losses related to our direct business and certain assumed reinsurance are initially set by our claims personnel or independent claims adjusters we retain. The case reserves are subject to our review, with a goal of setting them at the ultimate expected loss amount as soon as possible when the information becomes available. Case reserves for reported losses related to other assumed reinsurance are recorded based on information supplied to us by the ceding company. Our claims personnel monitor these assumed reinsurance reserves on a current basis and audit ceding companies’ claims to ascertain that claims are being recorded currently and that net reserves are being set at levels that properly reflect the liability related to the claims.
The following tables show the composition of our gross, ceded and net reserves by segment at December 31, 2010 and 2009.
We purchase reinsurance on a proportional basis to cover loss frequency, individual risk severity and catastrophe exposure. Some of the proportional reinsurance agreements may have maximum loss limits, most of which are at or greater than a 200% loss ratio. We also purchase reinsurance on an excess of loss basis to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type and amount of reinsurance we purchase varies year to year based on our risk assessment, our desired retention levels based on profitability and other considerations, and on the market availability of quality reinsurance at prices we consider acceptable. Our reinsurance programs renew throughout the year, and the price changes in recent years have not been material to our net underwriting results. Our reinsurance generally does not cover war or terrorism risks, which are excluded from most of our policies.
We carefully monitor the credit quality of the reinsurers with which we do business on all new and renewal reinsurance placements and on an ongoing, current basis. Our recoverables are due principally from highly-rated reinsurers. See Note 5, “Reinsurance” to the Consolidated Financial Statements for additional information about the credit quality of our recoverables.
We continuously monitor our financial exposure to the reinsurance market and take necessary actions in an attempt to mitigate our exposure to possible loss. We limit our liquidity exposure for uncollected recoverables by holding funds, letters of credit or other security, such that net balances due from reinsurers are significantly less than the gross balances shown in our consolidated balance sheets. We constantly monitor the collectability of our reinsurance recoverables and record a reserve for uncollectible reinsurance when we determine an amount is potentially uncollectible. Our evaluation is based on our periodic reviews of our disputed and aged recoverables, as well as our assessment of recoverables due from reinsurers known to be in financial difficulty.
In some cases, we make estimates as to what portion of a recoverable may be uncollectible. Our estimates and judgment about the collectability of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required.
We maintain a reserve for potential collectability issues, including disputed amounts and associated expenses. We review the level and adequacy of our reserve at each quarter-end based on recoverable balances that are past due or in dispute. The reserve was $2.5 million at December 31, 2010, compared to $2.9 million at December 31, 2009. While we believe the year-end reserve is adequate based on information currently available, market conditions may change or additional information might be obtained that may require us to change the reserve in the future.
As of April 1, 2009, we adopted a new accounting standard, which specifies new criteria for identification and recognition of OTTI losses. This standard requires us to determine, for each impaired fixed income security, that: 1) we do not intend to sell the security and 2) it is more likely than not that we will not be required to sell the security before recovery of its amortized cost basis. If we cannot assert these conditions, we record the impairment as an other-than-temporary loss through earnings in the current period. For all other impaired
Since April 1, 2009, we have reviewed our impaired securities at each quarter end and assessed whether we have any OTTI losses, based on all relevant facts and circumstances for each impaired security. To assist us in our evaluation, our outside investment advisor also performs detailed credit evaluations of all of our fixed income securities on an ongoing basis. Our quarterly reviews have covered all impaired securities where the loss exceeded $0.5 million and the loss either exceeded 10% of cost or the security had been in a loss position for longer than twelve consecutive months. Our reviews considered various factors including:
We recognize an OTTI loss in earnings in the period we determine: 1) we intend to sell the security, 2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, or 3) the security has a credit loss. Any non-credit portion of the OTTI loss is recognized in shareholders’ equity. In 2010, for those securities judged to have an OTTI loss, we recognized $0.4 million of pretax credit losses, as well as a minimal unrealized gain recorded in shareholders’ equity. In 2009, we recognized $5.4 million of pretax credit losses and $1.0 million of corresponding non-credit losses recorded in shareholders’ equity. In 2008, under the prior accounting standard, we recognized $11.1 million of OTTI losses through earnings. At December 31, 2010, we had $2.5 million of after-tax OTTI losses, primarily related to mortgage-backed and asset-backed securities, included in shareholders’ equity. This amount includes the after-tax unrealized gains and losses on these impaired securities resulting from changes in their fair value subsequent to their initial OTTI measurement dates.
If a mortgage-backed security is not paying the full amount of its expected principal payments, we recognize the unpaid amount as a realized loss in the period due and permanently reduce the security’s cost basis. We recognized $0.8 million of such realized losses in 2010. We assess all such securities with an impairment loss at quarter-end for other-than-temporary impairment, using the methods described above.
See Note 1 to the Consolidated Financial Statements for information about a new accounting standard related to accounting for acquisition costs of new or renewed insurance contracts, which we must adopt by January 1, 2012.