The following is a discussion and analysis of our results of operations for the year ended December 31, 2010 compared to the year ended December 31, 2009 and for the year ended December 31, 2009 compared to the year ended December 31, 2008, and also a discussion of our financial condition as of December 31, 2010. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report on Form 10-K.
The financial measures that we believe are most meaningful in analyzing our performance and assessing whether we are achieving our objectives are growth in book value per share, net operating income, combined ratio, return on average shareholders’ equity and net operating return on average shareholders’ equity. The table below shows the key performance indicators as of December 31, 2010 and 2009 and for the years ended December 31, 2010, 2009 and 2008.
(4) Return on average shareholders’ equity and net operating return on average shareholders’ equity are calculated by dividing net income and net operating income, respectively, by average shareholders’ equity (determined using the average of the quarterly average shareholders’ equity balances for the year).
The year ended December 31, 2010 is the first year in which the results of operations of the former Harbor Point companies are included in our financial results. This contributed to an increase in net operating income for
the year ended December 31, 2010 as the results of operations of the former Harbor Point companies are included in our financial results for the period from May 12, 2010 to December 31, 2010 and are not reflected in our financial results for the prior year. This also had a favorable impact on our combined ratio for the year as there were few significant property catastrophe losses affecting the Harbor Point portfolio of contracts during the period from May 12, 2010 to December 31, 2010.
Our combined ratio decreased in the year ended December 31, 2010 primarily as a result of the addition of the Harbor Point portfolio of contracts to our business mix. Losses incurred from the New Zealand earthquake, Deepwater Horizon oil spill, Chilean earthquake, European windstorm Xynthia, Australian hailstorms and Australian floods during the year were within our risk tolerances. The property catastrophe and significant per-risk losses experienced during the year ended December 31, 2010 represented less than 1.9% of our shareholders’ equity as of December 31, 2010. Given the multi-billion dollar estimated industry losses from these combined events, we believe these results demonstrate the effectiveness of our conservative underwriting strategy and our product line and geographic diversification.
In prior years, we targeted a long-term net operating return on average shareholders’ equity of the 15% over the cycle. Commencing in 2011, we will target a long-term net operating return on average shareholders’ equity of the risk free rate plus 10% over the cycle, which we believe more accurately reflects current investment yields.
The markets in which we operate historically have been cyclical. During periods of excess underwriting capacity, competition can result in lower pricing and less favorable policy terms. During periods of reduced underwriting capacity, pricing and policy terms are generally more favorable for insurers and reinsurers. We are currently in a period of excess underwriting capacity with soft pricing and deteriorating policy terms. As a result, our premium volumes in most of our lines of business (after adjusting for the Harbor Point premiums that are included in 2010’s results of operations but are not included in 2009’s results of operations) have decreased. In addition, we are operating in a low interest rate environment, which has decreased our investment income. Both of these factors generally result in lower net operating income, return on average shareholders’ equity and net operating return on average shareholders’ equity. There are no indications that the pricing or investment environment in 2011 will be substantially different than 2010.
Our principal expenses are losses and benefits, acquisition costs, interest expense and general and administrative expenses. Losses and benefits are based on the amount and type of insurance and reinsurance contracts written by us during the current reporting period and information received during the current reporting period from clients pertaining to contracts written in prior years. We record losses and benefits based on actuarial estimates of the expected losses and benefits to be incurred on each contract written. The ultimate losses and benefits depend on the actual costs to settle these liabilities. We increase or decrease losses and benefits estimates as actual claim reports are received. Our ability to make reasonable estimates of losses and benefits at the time of pricing our contracts is a critical factor in determining profitability.
written. Acquisition costs are stated net of ceding commissions associated with premiums ceded to our quota share partners on our insurance and reinsurance business. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers. We defer and amortize these costs over the period in which the related premiums are earned.
The liability for property and casualty losses is the largest and most complex estimate in our consolidated balance sheet. The liability for losses, including loss adjustment expenses, represents estimates of the ultimate cost of all losses incurred but not paid as of the balance sheet date. In estimating reserves we utilize a variety of standard actuarial methods. Although these actuarial methods have been developed over time, assumptions about anticipated size of loss and loss emergence patterns are subject to fluctuations. Newly reported loss information from clients or insured is the principal contributor to changes in our loss reserve estimates. These estimates, which generally involve actuarial projections, are based upon an assessment of known facts and circumstances, as well as estimates of future trends in claims severity and frequency and judicial theories of liability factors, including the actions of third parties, which are beyond our control.
We rely on data reported by clients when calculating reserves. The quality of the data varies from client to client. On a periodic basis the clients’ loss data is analyzed by our actuarial and claims management teams to ascertain its quality and credibility. This process may involve comparisons with submission data and industry loss data, claims audits and inquiries about the methods of establishing case reserves associated with large industry events.
When determining reserves we also consider historical data, industry loss trends, legal developments, changes in social attitudes and economic conditions, including the effects of inflation.
Consistent with industry practice, in estimating reserves we utilize a variety of standard actuarial methods together with management judgment. The loss reserve selection from these methods is based on the loss development characteristics of the specific line of business and contracts, which take into consideration coverage terms, type of business, maturity of loss data, reported claims and paid claims. We do not necessarily utilize the same actuarial method or group of actuarial methods for all contracts within a line of business or segment as
variations between contracts result in a number of different methods or groups of methods being appropriate. These actuarial methods have been designed to address the lag in loss reporting in the insurance industry as well as the delay in obtaining information that would allow us to more accurately estimate future payments. There is often a time lag between reinsurance clients establishing case reserves and re-estimating their reserves, and notifying us of the new or revised case reserves. Reporting lag is more pronounced in our reinsurance contracts than in our insurance contracts due to the reliance on insurers to report their claims to us. Casualty business generally has a longer reporting lag and payment pattern than property business. On casualty reinsurance transactions the reporting lag will generally be 60 to 90 days after the end of a reporting period, but can be longer than this in some cases. Based on the experience of our actuaries and management we select loss development factors and trending techniques to mitigate the problems caused by reporting lags. We regularly evaluate and update our loss development and trending factor selections using client specific and industry data. The principal actuarial methods we use to perform our quarterly loss reserve analysis may include one or more of the following methods:
Property and casualty losses, net of related reinsurance recoverables, are charged to income as incurred. Unpaid losses (including loss adjustment expenses) represent the accumulation of:
The table below shows our reserves as of December 31, 2010 by these components and by segment.
The majority of our insurance reserves are related to casualty business. Casualty losses are long-tailed, which means that there can be a significant delay between the occurrence of a loss and the time it is settled by the insurer. Casualty losses are also more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. Due to the long claim-tail nature of casualty business, a high degree of judgment is involved in establishing loss reserves.
Our property insurance loss reserves are compiled on a portfolio basis and are computed on an undiscounted basis. These reserves are adjusted for losses reported by our clients and for our estimate of losses resulting from catastrophe events. The reserves for catastrophe events are based on a detailed, location-specific analysis of our clients’ properties impacted by the events.
We establish and review our insurance loss reserves on a quarterly basis. The process for adjusting our insurance loss reserves is based upon loss reports received from clients, which are input into actuarial models. Along with management judgment, we use a variety of actuarial techniques and methods in estimating our ultimate liability for property and casualty insurance losses and loss expenses. As noted above, these methods include paid loss development, reported loss development, paid and reported Bornhuetter-Ferguson methods, and frequency-severity methods. This actuarial data is analyzed by product, type of risk, coverage and accident or policy year. Industry loss experience is also used to supplement our own data in selecting long term trend and development factors and in areas where our own data or the insureds’ data is limited. The table below shows our insurance reserves as of December 31, 2010 and 2009 by casualty and property components.
Our reinsurance loss reserves include case reserves, amounts for IBNR reserves and loss adjustment expenses. The reserves are compiled on a contract-by-contract basis and are estimated on an undiscounted basis. The majority of our reinsurance reserves are related to casualty business. Casualty claims are long tailed, which means that there can be a significant delay between the occurrence of a loss and the time it is settled by the insurer we reinsure. Casualty losses are also more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. Due to the long claim-tail nature of casualty business, a high degree of judgment is involved in establishing loss reserves.
When determining reserves, we also consider additional historical data, industry loss trends, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. Rapidly changing economic conditions will increase the inherent uncertainty of the reserve estimates. As additional data becomes available and is reviewed, we revise our reinsurance reserve estimates to reflect this additional data, which may result in increases or decreases to reserves for insured events of prior years. These adjustments are recorded in the period they are determined. The table below shows our reinsurance reserves as of December 31, 2010 and 2009 by casualty and property components.
Our U.S. specialty property and casualty loss reserves, which include case reserves, amounts for IBNR reserves and loss adjustment expenses, are compiled on a portfolio basis and are computed on an undiscounted basis.
We determine our IBNR reserves by first projecting the ultimate expected losses by product within each line of business. We then subtract paid losses and case reserves from the ultimate loss reserves. The remainder is our incurred but not reported reserves. The level of IBNR reserves in relation to total reserves depends upon the characteristics of the line of business, particularly with respect to the speed that losses are reported and outstanding loss reserves are adjusted. Lines for which losses are reported quickly will have a lower percentage of IBNR reserves than lines for which losses are reported more slowly and lines for which reserve volatility is low will have a lower percentage of IBNR reserves than higher volatility lines.
The case reserves related to our U.S. specialty business 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.
The table below shows our Alterra at Lloyd’s loss reserves as of December 31, 2010 and 2009 by casualty and property components.
Net favorable development for our Alterra at Lloyd’s segment of $14.9 million, principally recognized on the property and financial institutions line of business;
Favorable development of $7.8 million arising from reductions in reinsurance premium estimates. Changes in premium estimates occur on prior year contracts each year as we receive additional information on the underlying exposures insured and the associated loss is recorded, at the original loss ratio, concurrently with the premium adjustment. The favorable development was offset by a decrease in earned premium net of acquisition costs of $8.5 million; and
Unfavorable development of $2.8 million arising from increases in premium estimates in our insurance segment.
For additional information on our reserves, including a reconciliation of losses and loss adjustment expense reserves for the years ended December 31, 2010, 2009 and 2008 refer to Note 7 of our audited consolidated financial statements included herein.
In an effort to match the expected cash flow requirements of our long term liabilities, we invest a portion of our fixed maturity investments in long duration securities. Because we intend to hold a number of these long duration securities to maturity, we classify those securities as held to maturity in our consolidated balance sheet. This held to maturity portfolio is recorded at amortized cost. As a result, we do not record changes in the fair value of this portfolio, which should reduce the impact on shareholders’ equity of fluctuations in fair value of those investments.
We measure fair value in accordance with ASC 820, Fair Value Measurements. The guidance dictates a framework for measuring fair value and a fair value hierarchy based on the quality of inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:
We perform regular reviews of our available for sale and held to maturity fixed maturities portfolios and utilize a process that considers numerous indicators in order to identify investments that are showing signs of potential other than temporary impairments. These indicators include the length of time and extent of the unrealized loss, any specific adverse conditions, historic and implied volatility of the security, failure of the issuer of the security to make scheduled interest payments, expected cash flow analysis, significant rating changes and recoveries or additional declines in fair value subsequent to the balance sheet date. The consideration of these indicators and the estimation of credit losses involve significant management judgment.
We recognized other than temporary impairment charges through earnings of $2.6 million, $3.1 million and $16.9 during the years ended December 31, 2010, 2009 and 2008, respectively.
The independent pricing services used by our investment custodian, investment accounting service provider and investment managers obtain actual transaction prices for securities that have quoted prices in active markets. Each pricing service has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing service uses observable market inputs, including reported trades, benchmark yields, broker/dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from market sources to determine a reasonable fair value. In addition, pricing services use valuation models, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage-backed and asset-backed securities. The ability to obtain quoted market prices is reduced in periods of decreasing liquidity, which generally increases the use of matrix pricing methods and generally increases the uncertainty surrounding the fair value estimates. This could result in the reclassification of a security between levels of the hierarchy.
As of December 31, 2010, certain of our funds had either imposed a gate on redemptions or segregated a portion of the underlying assets into a side-pocket (whereby the funds are assigned to a separate memorandum capital account or designated account). A gate refers to funds which provide for periodic redemptions, however, in accordance with the funds’ governing documents, have the ability to deny or delay a redemption request. Based on the review process applied by management on such funds, a reduction of $3.2 million was made to the net asset values reported by the fund managers as of December 31, 2010 (2009-$0.7 million) to adjust the carrying value of the funds to our best estimate of fair value.
Our insurance premiums are recorded at the inception of each contract based upon contract terms. The amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is made to the minimum and/or deposit premium if there are changes in underlying exposures insured based on information received from our clients. Premiums are earned on a pro rata basis over the coverage period.
For each of the years ended December 31, 2010, 2009 and 2008, additional premiums relate to contracts where the coverage period had expired. Therefore, these additional premiums, representing revisions to our initial estimate of ultimate premiums as a result of changes in the estimate of loss reserves, were fully earned since the exposure period had ended.
Certain contracts we write, particularly property reinsurance contracts, provide for reinstatements of coverage. Reinstatement premiums are the premiums for the restoration of the insurance or reinsurance limit of a contract to its full amount after a loss occurrence by the insured or reinsured and principally relate to our property catastrophe reinsurance contracts. The purpose of optional and required reinstatements is to permit the insured / reinsured to reinstate the insurance coverage at a pre-determined price level once a loss event has penetrated the insured layer. In addition, required reinstatement premiums permit the insurer / reinsurer to obtain additional premiums to cover the additional loss limits provided.
We accrue for reinstatement premiums resulting from losses recorded. Such accruals are based upon contractual terms and the only element of management judgment involved is with respect to the amount of losses recorded. Changes in estimates of losses recorded on contracts with reinstatement premium features will result in changes in reinstatement premiums based on contractual terms. Reinstatement premiums are recognized at the time we record losses and are earned on a pro-rata basis over the coverage period. Reinstatement premiums assumed and ceded for each of the three years to December 31, 2010, were not material to our financial results.
Our life and annuity reinsurance premiums are recorded at the inception of the contract based on actual premiums received and are fully earned at that time. We may periodically receive additional premiums, which are recorded and earned when received. Additional premium receipts are generally infrequent and not material.
U.S. specialty-This segment offers property and casualty insurance coverage from offices in the United States primarily to small- to medium-sized companies. Principal lines of business include general liability, inland marine, ocean marine, professional liability and property.
Life and annuity reinsurance-This segment operates from our Bermuda office and offers reinsurance products focusing on existing blocks of life and annuity business, which take the form of co-insurance transactions whereby the risks are reinsured on the same basis as the original policies. We have determined not to write any new life and annuity contracts in the foreseeable future.
The U.S. specialty segment, Alterra at Lloyd’s segment and the U.S. companies within the reinsurance segment have their own portfolio of fixed maturities investments. As a result, the investment income earned by each of these portfolios is reported in its respective segment. These portfolios, however, are managed on a consolidated basis together with the invested assets of the insurance, reinsurance and life and annuity segments.
Net investment income and net realized and unrealized gains on investments are discussed within the investing activities section of this report and not within the segment sections of this report. See “Investing Activities.”
The following is a discussion and analysis of our consolidated results of operations for the years ended December 31, 2010, 2009 and 2008, which are summarized below:
(b) The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned for the property and casualty business.
Premiums. Gross premiums written for the year ended December 31, 2010 increased by 2.6% compared to the prior year. Our reinsurance segment was impacted in 2010 by the addition of premiums written by the former Harbor Point companies. Gross premiums written also increased in our U.S. specialty and Alterra at Lloyd’s segments as a result of our new product offerings, the addition of new underwriting teams, and our expansion into Latin America. These increases, and those resulting from the Amalgamation, were principally offset by decreases in the level of premiums written in our insurance, reinsurance (excluding Harbor Point) and life and annuity reinsurance segments. The lower premium volume in our insurance and reinsurance segments reflect
The inclusion of premiums written by the former Harbor Point companies does not necessarily represent new business growth, since our 2009 results of operations did not include the results of operations of the former Harbor Point companies. On a pro forma basis, gross premiums written and net premiums earned for the year ended December 31, 2010 and 2009 would have been as follows:
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2010 was 26.3% compared to 34.9% and 33.0% for the years ended December 31, 2009 and December 31, 2008, respectively. The decrease was principally due to the inclusion of the former Harbor Point business from May 12, 2010 at a lower ratio of ceded to written premiums, and the cancellation of a significant property quota share treaty in our U.S. specialty segment. The cancellation of the property quota share treaty in our U.S. specialty segment reduced reinsurance premiums ceded by $20.6 million. We intend to gradually retain more risk in this segment, particularly in the lines of business we expect to have the greatest long term potential.
Net investment income. Net investment income for the year ended December 31, 2010 increased by 31.1%, compared to the year ended December 31, 2009. The increase was principally attributable to the increase in cash and invested assets as a result of the Amalgamation, and additional investment income generated by reinvesting
Net investment income for the year ended December 31, 2009 decreased by 6.6% compared to the year ended December 31, 2008. The decrease was principally due to an increase in the ratio of average cash to average invested assets during the year ended December 31, 2009 compared to the year ended December 31, 2008. This increase in cash was principally due to significant cash redemptions received from our hedge fund portfolio, increased gross premiums written, and a desire to maintain high levels of liquidity, partially offset by the repayment of debt.
Net realized and unrealized gains (losses) on investments. Net realized and unrealized gains and losses on investments decreased for the year ended December 31, 2010 compared to the year ended December 31, 2009. The principal components of the decrease were hedge fund and derivative returns. Investment gains from hedge funds decreased by $61.5 million for the year ended December 31, 2010 compared to the 2009 year. Also, contributing to this decrease was a $10.4 million loss on an interest rate forward transaction entered into in the second quarter of 2010 in contemplation of a possible long term debt issuance.
Net favorable loss development for the year ended December 31, 2010 was principally the result of net favorable development in our workers compensation, property, general casualty, professional liability and whole account lines of business, partially offset by net unfavorable development on marine & energy lines, compared to net favorable development on professional liability, property and general casualty lines offset by net unfavorable development on marine & energy lines in the year ended December 31, 2009;
Excluding the net favorable loss development, the loss ratio was 65.1% for the year ended December 31, 2010 compared to 72.3% for the year ended December 31, 2009. The decrease in the loss ratio for the year ended December 31, 2010 compared to the prior year was principally due to the inclusion of net premiums earned from Harbor Point since May 12, 2010 at a significantly lower loss ratio, which reduced the average loss ratio despite the increase in property catastrophe losses discussed below. The loss ratio for the year ended December 31, 2010 on the net premiums earned related to the Harbor Point portfolio of contracts does not include any significant property catastrophe losses other than from the New Zealand earthquake as most of the significant property catastrophe loss events occurred prior to the Amalgamation;
Also contributing to the decrease in the loss ratio, the year ended December 31, 2010 benefitted from the $14.4 million amortization of the fair value adjustment made to acquired Harbor Point net loss reserves at the date of the Amalgamation. This fair value adjustment is being amortized over a weighted average period of 4.0 years; and
The loss ratio decreased by 6.5 percentage points for the year ended December 31, 2009 compared to the year ended December 31, 2008. Significant items impacting the loss ratio were:
The net favorable loss development for the year ended December 31, 2009 was principally the result of net favorable development in our workers compensation, property and general casualty lines of business, partially offset by net unfavorable development on professional liability and marine & energy lines, compared to net favorable development on professional liability, property and general casualty lines offset by net unfavorable development on marine & energy lines in the year ended December 31, 2008; and
Excluding the net favorable loss development, the loss ratio was 72.3% for the year ended December 31, 2009 compared to 84.8% for the year ended December 31, 2008. The decrease in the loss ratio for the year ended December 31, 2009 compared to the prior year period was principally due to lower property catastrophe events and significant per-risk losses. For the year ended December 31, 2009, our results included net losses of $8.9 million related to property catastrophe events and significant per-risk losses. For the year ended December 31, 2008, our results included net losses of $57.4 million for such events.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2010 increased by $66.6 million compared to the year ended December 31, 2009. The increase was principally related to the additional general and administration expenses of the former Harbor Point companies. In addition, there was an increase in performance based compensation expense as a result of a larger cash component of the 2010 performance based compensation than in 2009. However, the corresponding increase in net earned premiums as a result of the Amalgamation resulted in no change in our general and administrative expense ratio for the year ended December 31, 2010 compared to the year ended December 31, 2009.
Income tax expense. Corporate income tax expense is generated through our foreign operations in the United States and Europe. The effective tax rate was 1.4% for the year ended December 31, 2010 compared with 3.9% in the year ended December 31, 2009. The decrease in the effective tax rate in 2010 compared to 2009 was principally due to an increase in deferred tax benefits in our U.S. operations in 2010. For the year ended December 31, 2008, we had a consolidated loss before tax but recorded income tax expense on our operations in the United States and Ireland. The effective tax rate varies between periods depending on the distribution of net income or losses among our various taxable jurisdictions.
A decrease in gross premiums written in our excess liability line for the year ended December 31, 2010 due to fewer attractive opportunities. We continue to experience a competitive pricing environment across the segment. Our objective is to continue to be selective in our renewals and business writings, focusing on business that meets our rate of return requirements.
A decrease in gross premiums written in our excess liability line where, similar to the 2010 year, we experienced a more competitive pricing environment, and additional capacity entering the market place.
The amount of net premiums earned is a function of the earning of gross premiums written and reinsurance premiums ceded over the last several quarters and, therefore, net premiums earned generally lag quarterly increases and decreases in gross premiums written and reinsurance premiums ceded. As a result, net premiums earned tend to be less volatile than gross premiums written and reinsurance premiums ceded.
Excluding the net favorable loss development, the loss ratio was 79.6% for the year ended December 31, 2010 compared to 84.3% for the year ended December 31, 2009. The decrease was principally due to better current year loss experience in our aviation line of business during the year ended December 31, 2010 ; and
For the year ended December 31, 2010 our results included net losses of $12.1 million, related to property catastrophe events and significant per-risk losses. Large events during the year ended December 31, 2010 included the Chilean earthquake and flooding in Australia. These losses were contained within our annual loss expectations for the property line of business. There were no significant such losses occurring in the year ended December 31, 2009.
The loss ratio for the year ended December 31, 2009 decreased by 13.8 percentage points compared to the year ended December 31, 2008. Significant items impacting the loss ratio were:
Net favorable loss development of prior year reserves in the year ended December 31, 2009 of $41.3 million compared to $22.6 million in the year ended December 31, 2008;
Net favorable loss development in the year ended December 31, 2009 reflected better than expected loss emergence, principally on the 2005 and prior years for excess liability and professional liability, and the 2008-2007 years for aviation and property lines of business. Net favorable loss development in the year ended December 31, 2008 reflected better than expected loss emergence principally in our property line of business;
Excluding the net favorable loss development, the loss ratio was 84.3% for the year ended December 31, 2009 compared to 90.6% for the year ended December 31, 2008; and
For the year ended December 31, 2009 there were no significant losses related to property catastrophe events and significant per-risk losses, compared to $5.4 million of hurricane losses in the year ended December 31, 2008.
Acquisition costs. Acquisition costs are presented net of ceding commission income associated with reinsurance premiums ceded. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers. Acquisition costs fluctuate moderately based on shifts in business mix.
General and administrative expenses for the year ended December 31, 2009 increased $3.5 million compared to the year ended December 31, 2008. The increase was principally due to an increase in performance based compensation and an increase in expenses related to information technology.
Premiums. Gross premiums written for the year ended December 31, 2010 increased by 4.1% compared to the year ended December 31, 2009. Significant factors affecting gross premiums written were:
Across our lines of business, we continued to experience a competitive price environment. We have been selective in our renewals and business writings, focusing on business that meets our rate of return requirements.
Gross premiums written increased in the workers compensation line of business principally due to a significant quota share treaty written in 2009;
Gross premiums written increased in the professional liability line of business where we took advantage of favorable market pricing and reduced market capacity;
Gross premiums written increased in the general casualty line of business; however, the general casualty premium volume was generally flat compared to the year ended December 31, 2008 as there were negative premium adjustments in 2008 that did not recur in 2009;
The year ended December 31, 2009 included reductions in premium estimates on prior year contracts of $10.9 million compared to reductions of $46.0 million in 2008.
Net losses and loss expenses. The loss ratio decreased by 10.2 percentage points for the year ended December 31, 2010 compared to the year ended December 31, 2009. The net favorable and (unfavorable) development of prior year reserves in the years ended December 31, 2010, 2009 and 2008 by line of business was as follows:
Excluding the net favorable loss development (and after adding back the $9.5 million reduction to net premiums earned for the workers’ compensation contract discussed above), the loss ratio was 61.6% for the year ended December 31, 2010 compared to 73.9% for the year ended December 31, 2009. The decrease in the loss ratio for the year compared to the prior year was principally due to the inclusion of net premiums earned from the former Harbor Point companies since May 12, 2010 at a significantly lower loss ratio, which reduced the average loss ratio. Despite the increase in property catastrophe losses discussed below, the current year loss ratio on the net premiums earned related to the former Harbor Point portfolio of contracts does not include any significant property catastrophe losses other than from the New Zealand earthquake as most of the current year’s property catastrophe loss events occurred prior to the Amalgamation;
Also contributing to the decrease in the loss ratio, the year ended December 31, 2010 benefitted from the $14.4 million amortization of the fair value adjustment made to the acquired Harbor Point net loss reserves at the date of the Amalgamation. This fair value adjustment is being amortized over a weighted average period of 4.0 years; and
Partially offsetting the decrease described above was the increased property catastrophe-related and significant per-risk losses. The year ended December 31, 2010 included $27.8 million in property catastrophe-related and significant per-risk losses, principally as a result of the Deepwater Horizon oil spill, European windstorm Xynthia, Australian storms, New Zealand earthquake and the Australian floods. The year ended December 31, 2009 included $2.0 million in property catastrophe-related and significant per-risk losses.
Net favorable loss development of prior year reserves in the year ended December 31, 2009 was $32.0 million compared to $68.1 million in the year ended December 31, 2008. The net favorable development in the year ended December 31, 2009 reflected better than expected loss emergence. Favorable loss development emerged on the 2008 and prior years for property, 2005 and prior years for general casualty, 2006 and prior years for professional liability, and 2007 and prior years for medical malpractice. The net favorable development in the year ended December 31, 2008 emerged primarily on the 2005 and 2006 years for the professional liability and whole account lines of business;
Excluding the net favorable loss development the loss ratio was 73.9% for the year ended December 31, 2009 compared to 83.9% for the year ended December 31, 2008;
Decreases in reinsurance premium estimates, net of acquisition costs, of $8.5 million, $11.7 million and $24.2 million, in 2010, 2009 and 2008, respectively, resulted in a decrease in prior year loss reserves of $7.8 million in 2010, $11.4 million in 2009 and $17.0 million in 2008.
General and administrative expenses for the year ended December 31, 2009 increased $3.3 million compared to the year ended December 31, 2008. The improvement in the segment’s overall result in 2009 compared to 2008 resulted in increased performance based compensation for 2009. The year ended December 31, 2009 also included increased expenses related to information technology compared to 2008.
The following table presents certain financial information for the reinsurance segment on a combined pro forma basis (after the elimination of intercompany transactions and the amortization of certain acquisition accounting adjustments) for the years ended December 31, 2010 and 2009, for informational purposes only, as if the Amalgamation had occurred on January 1, 2010 and January 1, 2009, respectively. The pro forma data does not necessarily represent results that would have occurred if the Amalgamation had taken place at the beginning of each period presented, nor is it indicative of future results.
The favorable development in the year ended December 31, 2010 would have been principally on our property, general casualty and workers compensation lines of business, partially offset by adverse development on our professional liability and marine & energy lines of business. The favorable development in the year ended December 31, 2009 would have been principally on our property and general casualty lines of business, partially offset by adverse development recognized on our marine & energy line of business;
General and administrative expenses. General and administrative expenses for the year ended December 31, 2010 would have decreased compared with the year ended December 31, 2009, principally due to the decrease in
the amortization expense of renewal rights held by Harbor Point. The renewal rights were included in the assets of Chubb Re acquired by Harbor Point in 2005 and were fully amortized by the end of 2009. The general and administrative expense ratio would not have changed significantly from 2009 to 2010 as the 6.8% decrease in general and administrative expense was offset by an 8.5% decrease in net premiums earned.
Premiums. Gross premiums written for the year ended December 31, 2010 increased 13.5% compared to the year ended December 31, 2009. The increase in gross premiums written was principally due to:
Market conditions remain competitive across all lines of business. Owing to the smaller average policy size of our U.S. specialty client base, we expect premium volumes to be less sensitive to market rate changes than for similar product lines written by our insurance segment.
Net losses and loss expenses. The loss ratio for the year ended December 31, 2010 increased 1.9 percentage points compared to the year ended December 31, 2009. The net favorable and (unfavorable) development of prior year reserves in the years ended December 31, 2010, 2009 and 2008 by line of business was as follows:
The expansion of the U.S. Specialty segment, increase in gross premium volume and broader client base resulted in an improvement in the loss ratio;
Net unfavorable loss development of prior year reserves in the year ended December 31, 2009 was $1.1 million compared to no development of prior year reserves in the year ended December 31, 2008; and
The year ended December 31, 2008 included net losses of $5.0 million for property catastrophe losses and significant per-risk losses. During the year ended December 31, 2009, we did not incur any significant property catastrophe losses or significant per-risk losses.
General and administrative expenses. General and administrative expenses principally comprise personnel and infrastructure costs, both of which increased in 2010 compared to 2009, and in 2009 compared to 2008. However, our general and administrative expense ratio has decreased each year from 2008 to 2010. The decreases in the ratio was principally due to the increases in net premiums earned each year.
Our Alterra at Lloyd’s segment comprises all of our Lloyd’s operating businesses. This includes the underwriting operations of the Syndicates for which we record our proportionate share. Our Lloyd’s operating businesses were acquired on November 6, 2008. As a result, a comparison of 2010 and 2009 results with 2008 results is not meaningful.
The addition of aviation business to our Alterra at Lloyd’s segment in the fourth quarter of 2009, which largely represents a transfer of business previously written within our insurance segment;
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2010 was 18.5%, compared to 25.5% for the year ended December 31, 2009. The volume of reinsurance premiums ceded did not increase at the same rate as the increase in gross premiums written because a significant proportion of our reinsurance program are excess of loss (non-proportional) contracts rather than quota share (proportional) contracts.
Excluding the net favorable loss development, the loss ratio was 55.4% for the year ended December 31, 2010 compared to 52.7% for the year ended December 31, 2009. The increase in the loss ratio was principally due to changes in the mix of business, which now includes aviation and international casualty lines of business, and an increase in catastrophe-related and significant per risk losses.
Acquisition expenses. The acquisition cost ratio decreased 1.2 percentage points for the year ended December 31, 2010 compared to the year ended December 31, 2009. The decrease in acquisition costs was principally attributable to the addition of international casualty business in the first quarter of 2010, which has a lower average acquisition cost ratio.
The nature of life and annuity reinsurance transactions that we consider results in a limited number of transactions actually bound with potentially large variations in quarterly and annual premium volume. Consequently, components of our underwriting results, such as premiums written, premiums earned and benefits can be volatile and, accordingly, period-to-period comparisons are not necessarily representative of future trends. Our life and annuity benefit reserves are recorded on a discounted present value basis. This discount is amortized through income as a claims and policy benefits expense over the term of the underlying policies. As a result, income is driven by the spread between the actual rate of return on our investments and the interest discount on our reserves, together with differences between estimated and actual claims, premiums, expenses and persistency of the underlying policies.
The results of investing activities discussed below include the net investment income, net realized and unrealized gains (losses) on investments and net impairment losses recognized in earnings for all of our segments, including amounts that are allocated to the segments. These investment results are presented below on a consolidated basis.
Net investment income. The increase in net investment income for the year ended December 31, 2010 was principally attributable to the increase in cash and invested assets as a result of the Amalgamation and the issuance of senior notes together with additional investment income generated by shifting cash into higher yielding fixed maturity securities. Our ratio of average cash to average invested assets decreased from 15.6% for the year ended December 31, 2009 to 12.3% for the year ended December 31, 2010 as we redeployed cash into fixed maturity investments and paid a special dividend. The yields available in the current fixed maturity market are generally lower than the average yield on our existing portfolio. As we have invested cash generated by operations and cash generated from maturing investments into our fixed maturity portfolio, the yield on our portfolio has decreased. To date, this reduction has been partially offset by our redeployment of a larger portion of cash into fixed maturities, helping to slow the decline in yield compared to the prior periods. However, due to the continuing low-yield market environment, we expect continued downwards pressure on our investment yield.
(a) An increase in fair value of derivatives of $8.1 million and $22.2 million from a wholly-owned hedge fund are included in the increase (decrease) in fair value of hedge funds for the years ended December 31, 2009 and December 31, 2008, respectively.
Eight of the ten hedge fund strategies we employed experienced positive returns during the year ended December 31, 2010. The largest contributors by investment strategy to the increase in fair value for the year ended December 31, 2010 were the global macro and the diversified arbitrage strategies. As of December 31, 2010, 16.9% and 9.5% of our hedge fund portfolio was allocated to the global macro and diversified arbitrage strategies, respectively. The largest decrease in fair value offsetting the overall increase for the year was contributed by the event driven arbitrage strategy. As of December 31, 2010, 10.2% of our hedge fund portfolio was allocated to this strategy.
The allocation of invested assets to our hedge fund portfolio as of December 31, 2010 was 3.7%. The objective of our hedge fund portfolio is to achieve a market neutral/absolute return strategy, with diversification by strategy and underlying fund. A market neutral strategy strives to generate consistent returns in both up and down markets by selecting long and short positions with a total net exposure of zero. Returns are derived from the long/short spread, or the amount by which long positions outperform short positions. The objective of an absolute return strategy is to provide stable performance regardless of market conditions, with minimal correlation to market benchmarks.
The fair value of derivatives decreased by $12.0 million for the year ended December 31, 2010, and increased $0.8 million for the year ended December 31, 2009. We did not hold any derivative instruments outside of the hedge fund portfolio as of December 31, 2008. We hold various derivative instruments, including convertible bond equity call options, interest rate linked derivative instruments and foreign exchange forward contracts. During the second quarter of 2010, we considered replacing our revolving bank loan with longer term debt. In contemplation of this plan, we entered into two interest rate forward contracts indexed to the U.S. treasury rate. Due to market volatility at that time, we elected not to replace our revolving bank loan and the forward contracts were settled for a loss of $10.4 million in the second quarter.
At December 31, 2010, we had $47.2 million invested in catastrophe bonds, with a par value of $45.3 million, which are scheduled to mature at various dates between May 24, 2011 and June 6, 2013. The increase in fair value of the catastrophe bonds was $0.4 million during the year ended December 31, 2010, which is included in the change in fair value of other investments.
We also hold an index-linked structured deposit. The deposit has a guaranteed minimum redemption amount of $24.3 million and a scheduled redemption date of December 18, 2013. The increase in fair value of the structured deposit was $2.6 million during the year ended December 31, 2010, which is included in the change in fair value of other investments.
Net realized and unrealized gains and losses on available for sale and trading securities. Our total fixed maturities portfolio is split into three portfolios:
Net impairment losses recognized in earnings. As a result of our quarterly review of securities in an unrealized loss position, we recorded other-than-temporary impairment losses through earnings for the years ended December 31, 2010, 2009 and 2008 of $2.6 million, $3.1 million and $16.9 million, respectively. These impairment losses are presented separately from all other net realized and unrealized gains and losses on investments. A discussion of our process for estimating other-than-temporary impairments is included in Note 3 of our audited consolidated financial statements included herein.
Our fixed maturities are recorded at fair value and are subject to fluctuations in fair value due to changes in interest rates, changes in issuer specific circumstances, such as credit rating changes, and changes in industry specific circumstances, such as movements in credit spreads based on the market’s perception of industry risks. As a result of these fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolios is to tailor the maturities of the portfolios to the timing of expected loss and benefit payments. At maturity, absent any credit loss, a fixed maturity’s amortized cost will equal its fair value and no realized gain or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell available for sale fixed maturity securities before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period.
Our fixed maturity portfolio comprises high quality, liquid securities. As of December 31, 2010, our fixed maturities investments had a dollar-weighted average credit rating of Aa2/AA. Under our fixed maturities investment guidelines, a minimum weighted average credit rating of Aa2/AA, or its equivalent, must be maintained for our fixed maturities investment portfolio as a whole. Our fixed maturities investment guidelines also provide that we cannot leverage our fixed maturities investments. Further details of the credit ratings on our fixed maturities investments is included in Note 3 of our audited consolidated financial statements.
Our portfolio of investment grade fixed maturities includes mortgage-backed and asset-backed securities and collateralized mortgage obligations. These types of securities have cash flows that are backed by the principal and interest payments of a group of underlying mortgages or other receivables. As a result of the increasing default rates of borrowers, there is a greater risk of defaults on mortgage-backed and asset-backed securities and collateralized mortgage obligations, especially those that are non-investment grade. These factors make the estimate of fair value more uncertain. We obtain fair value estimates from multiple independent pricing sources in an effort to mitigate some of the uncertainty surrounding the fair value estimates. If we need to liquidate these securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated at December 31, 2010.
A discussion of our process for estimating the fair value of our available for sale and trading fixed maturities investments is included in Note 4 of our audited consolidated financial statements.
We performed a review of securities in an unrealized loss position as of December 31, 2010 for other-than-temporary impairments, which included the consideration of relevant factors, including prepayment rates, subordination levels, default rates, credit ratings, weighted average life and cash flow testing. Together with our investment managers, we continue to monitor our potential exposure to mortgage-backed and asset-backed securities, and we will make adjustments to the investment portfolio, if and when we deem necessary. As a result of this process, we recognized an other than temporary impairment charge through net income of $2.6 million during the year ended December 31, 2010.
The other investments we held at December 31, 2010 principally comprise our investments in hedge funds, catastrophe bonds and structured deposits which are recorded at fair value.
The majority of our hedge fund portfolio is redeemable within one year, and the imposition of gates by certain funds is not expected to significantly impact our cash flow needs. Based upon information provided by the fund managers, as of December 31, 2010, we estimate that over 66% of the underlying assets held by our hedge fund portfolio are traded securities or have broker quotes available. Typically, the imposition of a gate delays a portion of the requested redemption, with the non-gated portion settled in cash shortly after the redemption date. Of our December 31, 2010 outstanding redemptions receivable of $38.1 million, none of which are gated, $37.0 million were received in cash prior to February 18, 2011. The fair value of our holdings in funds with gates imposed as of December 31, 2010 was $30.2 million.
Due to the uncertainty surrounding the timing of the redemption of the underlying assets within funds with gates and side-pockets, we have included these funds in the greater than 365 days category in the table below. If we requested full redemptions for all of our holdings in the funds, the tables below indicate our best estimate of the earliest date from December 31, 2010 on which such redemptions might be received. This estimate is based on available information from the funds and is subject to significant change.
Although we believe that our significant cash balances, fixed maturities investments and credit facilities provide sufficient liquidity to satisfy the claims of insureds and ceding clients, in the event that we were required to access assets invested in the hedge fund investment portfolio, our ability to do so may be limited by these liquidity constraints.
Additional information about the hedge fund portfolio can be found in Notes 3 and 4 to our audited consolidated financial statements included herein.
As of December 31, 2010, we had $47.2 million invested in catastrophe bonds, with a par value of $45.3 million. We receive quarterly interest payments on the catastrophe bonds based on variable interest rates ranging from 3.7% to 14.6% and are scheduled to mature at various dates between May 24, 2011 and June 6, 2013. The redemption value of the bonds will adjust based on the occurrence of covered events such as windstorms and earthquakes across a number of geographic regions, including Japan, Europe, Mexico and the United States. The maximum possible loss to us is limited to the value of our investment.
Liabilities for life and annuity benefits. Life and annuity benefits totaled $1,275.6 million at December 31, 2010 compared to $1,372.5 million as of December 31, 2009. The decrease was principally attributable to movements in foreign exchange rates. We endeavor to match these liabilities with assets of similar currency and duration in order to limit the net impact to shareholders’ equity of movements in foreign exchange rates. In addition, we paid $100.8 million of benefit payments during the year ended December 31, 2010.
Senior notes. On September 27, 2010, Alterra Finance, a wholly-owned indirect subsidiary of Alterra, issued $350.0 million principal amount of 6.25% senior notes due September 30, 2020 with interest payable on March 30 and September 30 of each year. The 6.25% senior notes are Alterra Finance’s senior unsecured obligations and rank equally in right of payment with all of Alterra Finance’s future unsecured and unsubordinated indebtedness and rank senior to all of Alterra Finance’s future subordinated indebtedness. The
On April 16, 2007, Alterra USA privately issued $100.0 million principal amount of 7.20% senior notes due April 14, 2017 with interest payable on April 16 and October 16 of each year. The senior notes are Alterra USA’s senior unsecured obligations and rank equally in right of payment with all existing and future senior unsecured indebtedness of Alterra USA. The senior notes are fully and unconditionally guaranteed by Alterra. Following repurchases of $8.5 million and $0.9 million principal amount in December 2008 and December 2009, respectively, the principal amount of the senior notes outstanding as of December 31, 2010 was $90.6 million.
Shareholders’ equity. Our shareholders’ equity increased to $2,918.3 million as of December 31, 2010 from $1,564.6 million as of December 31, 2009, an increase of 86.5%, principally due to the Amalgamation, which increased shareholders’ equity by $1,481.8 million. In addition, we generated net income of $302.3 million and a $73.5 million increase in accumulated other comprehensive income for the year ended December 31, 2010. These increases were offset by the declaration of dividends of $351.0 million and repurchases of common shares of $207.8 million during the year ended December 31, 2010.
Liquidity. We generated $308.3 million of cash from operations during the year ended December 31, 2010 compared to $193.2 million for the year ended December 31, 2009. The two principal factors that impact our operating cash flow are premium collections and timing of loss and benefit payments. In addition, during the year ended December 31, 2010, we settled $147.1 million of reinsurance balances payable as part of the final settlement of a significant contract.
Our casualty business generally has a long claim-tail. As a result, we expect that we will generate significant operating cash flow as we accumulate property and casualty loss reserves on our balance sheet. Our property business generally has a short claim-tail. Consequently, we expect volatility in our operating cash flow levels as losses are incurred. We expect increases in the amount of expected loss payments in future periods with a resulting decrease in operating cash flow; however, we do not expect loss payments to exceed the premiums generated. Actual premiums written and collected and losses and loss expenses paid in any period could vary materially from our expectations and could have a significant and adverse effect on our operating cash flows.
The amount which Alterra provides as Funds at Lloyd’s is not available for distribution for the payment of dividends. Our corporate members may also be required to maintain funds under the control of Lloyd’s in excess of their capital requirements and such funds also may not be available for distribution or the payment of dividends.
We repurchase our shares from time to time through the market, privately negotiated transactions or Rule 10b5-1 stock trading plans. During the year ended December 31, 2010, we repurchased 10,288,434 common shares for $207.8 million.