(e) Includes the dilutive effects of outstanding incentive options to acquire common shares (“Options”) and, for years prior to 2004, warrants to acquire common shares.
(g) During 2003, 677,966 common shares were issued in satisfaction of Convertible Preference Shares. During 2004, 1,724,200 common shares were issued in satisfaction of warrants exercised.
The following discussion also includes three non-GAAP financial measures, adjusted comprehensive net income (loss), fully converted tangible book value per common and equivalent share and tangible capital, that have been reconciled to their most comparable GAAP financial measures (see page 56). White Mountains believes these measures to be more relevant than comparable GAAP measures in evaluating White Mountains’ financial performance and condition.
During 2005, White Mountains experienced $288 million in after-tax losses from hurricanes Katrina, Rita and Wilma, a $104 million after-tax losses (net of dividends received) from the Company’s investment in Montpelier and $70 million of after-tax unrealized foreign currency losses that adversely impacted fully converted tangible book value per common share. These losses offset solid underwriting results produced by OneBeacon. Esurance also had a good year in 2005 while growing its premiums 75%.
The following table presents the Company’s tangible book value per share for the years ended December 31, 2005, 2004, and 2003 and reconciles this non-GAAP measure to the most comparable GAAP measure:
White Mountains reported adjusted comprehensive net income of $68 million for 2005, compared to $539 million in 2004 and $360 million in 2003. Net income was $290 million in 2005, compared to $419 million in 2004 and $281 million in 2003. The reduction in 2005 adjusted comprehensive net income resulted primarily from the aforementioned hurricane losses and Montpelier investment decline, as well as the impact of $181 million in transaction gains reported in 2004, primarily from the Sirius Acquisition.
administrative expenses, primarily due to decreased incentive compensation expense resulting from a 14% decline in White Mountains’ share price during the year.
White Mountains’ total revenues increased by 20% in 2004 compared to 2003. Growth in revenues was driven by the 22% increase in earned premiums due to the Sirius Acquisition and Atlantic Specialty transactions. Net investment income grew 24% in 2004 primarily due to the income earned on the additional invested assets acquired in the Sirius Acquisition offset by decreased net invested assets at OneBeacon.
The income tax provision related to pretax earnings for 2005, 2004 and 2003 represents an effective tax rate of 12.5%, 19.0% and 34.3%, respectively. White Mountains’ effective tax rate for 2005 was lower than the U.S. statutory rate of 35% primarily due to income generated in jurisdictions other than the United States. White Mountains’ effective tax rate for 2004 was lower than the U.S. statutory rate of 35% primarily due to income generated in jurisdictions other than the United States and the recognition of foreign tax credits, offset by taxes incurred from an internal restructuring of the company. White Mountains’ effective tax rate for 2003 was lower than the U.S. statutory rate of 35% primarily due to income generated in jurisdictions other than the United States.
OneBeacon’s 2004 results included $31 million of hurricane losses, primarily from four hurricanes in the southeastern United States, and $100 million in adverse development, primarily relating to 2002 and prior accident years, which impacted the loss ratio by a total of 6 points. The 2004 adverse development was partially offset by a release of approximately $20 million of the New York assigned risk liability due to the shrinking of the New York assigned risk pool.
Net realized investment gains for 2005 included a realized loss of $55 million due to an other-than-temporary impairment with respect to OneBeacon’s investment in Montpelier common shares. During 2005, the market value of Montpelier common shares decreased from $38.45 per share to $18.90 per share. OneBeacon’s original cost of this investment in 2001 was $106 million, which was subsequently increased by $65 million in equity in earnings recorded from 2001 to March 2004, the period in which OneBeacon accounted for the investment under the equity method of accounting. The impairment charge represented the difference between OneBeacon’s GAAP cost of $171 million and the investment’s fair value of $116 million at December 31, 2005.
Commercial Lines. The commercial lines combined ratio for 2005 was 93%, compared to 97% for 2004. The decrease in the combined ratio was primarily due to the settlement of the retiree medical plan, which reduced the combined ratio by 3 points. Commercial lines results in both 2005 and 2004 included storm losses of $13 million, which impacted the combined ratio by 2 points in each period.
OneBeacon Results - Year Ended December 31, 2004 versus Year Ended December 31, 2003
OneBeacon’s pre-tax income for 2004 was $391 million, compared to pre-tax income of $405 million for 2003 and its GAAP combined ratio was 99% for 2004, compared to 98% for 2003. The earnings and combined ratios for each period were relatively consistent as each period had solid performance for the current underwriting year, partially offset by some adverse development in prior year’s reserves. In total, adverse development was $100 million in 2004 (relating primarily to 2002 and prior accident years) and $147 million in 2003 (relating primarily to 2000 and prior accident years). The 2004 development related primarily to personal auto liability, general liability and multiple peril reserves due in part to emerging trends in claims experienced in OneBeacon’s run-off operations, as well as national account and program claims administered by third parties. These claim trends principally included higher defense costs and higher damages from liability assessments. The 2003 development was primarily related to construction defect claims. Adverse development in 2004 and 2003, respectively, was partially offset by the release of approximately $20 million and $30 million of the New York assigned risk liability due to the shrinking New York assigned risk pool.
OneBeacon’s total expenses for 2004 increased 13% compared to 2003, primarily as a result of increased incentive compensation accruals driven by the 41% rise in White Mountains’ share price in 2004, partially offset by the release of $20 million of the New York assigned risk liability. The release of this liability resulted from the continued effects of favorable revisions to the structure of credit programs. General and administrative expenses were higher in 2004 primarily due to increased expenses resulting from the aforementioned commencement of two new private equity funds.
Specialty Lines. The specialty lines combined ratio was 90% for 2004, compared to 86% for 2003. The 2004 combined ratio was higher than 2003 primarily due to losses relating to the four storms in the southeastern United States that impacted IMU and better than expected weather losses in 2003. Written premiums for specialty lines were up 16% in 2004, driven by growth in writings at OBPP and AutoOne Insurance, as well as the introduction of OBSP in 2004, a new division offering coverages to the excess and surplus property market.
Personal Lines. The combined ratio for personal lines for 2004 was 94%, compared to 91% for 2003. The 2004 personal lines combined ratio was adversely impacted by 7 points as a result of increased incentive compensation accruals, partially offset by 3 points due to the reduction of the New York assigned risk liability. The 2003 combined ratio benefitted by 4 points due to a reduction of the New York assigned risk liability. Premiums in this line grew 7% due in part to improved production of new business and increased retention levels and also $47 million in premiums assumed from New Jersey Skylands Insurance through a quota-share reinsurance agreement.
Commercial Lines. The combined ratio for commercial lines for 2004 was 97%, compared to 95% for 2003. The 2004 combined ratio was higher as a result of transition and integration costs related to the Atlantic Specialty Transaction and adverse results from its non-Atlantic Mutual New York commercial lines book. The 2004 loss ratio includes 2 points relating to the four storms in the southeastern United States, which primarily related to Atlantic Specialty business in that area. Excluding these losses, the commercial lines loss ratio significantly improved. Premiums in this line grew by 89% primarily due to the Atlantic Specialty Transaction.
Financial results and GAAP combined ratios for White Mountains Re for the years ended December 31, 2005, 2004 and 2003 follows:
White Mountains Re’s pre-tax loss for 2005 was $17 million, compared to pre-tax income of $87 million for 2004, and its GAAP combined ratio was 118% for 2005, compared to 104% for 2004. White Mountains Re’s 2005 results included pre-tax losses, net of reinstatements and reinsurance, of $351 million from hurricanes Katrina, Rita and Wilma and $33 million from European storm Erwin, which added a total of 28 points to the combined ratio. In addition, White Mountains Re recorded $51 million of net unfavorable loss reserve development in 2005 (discussed below), which contributed 4 points to the loss ratio. During 2005, earnings from business segments not impacted by the property catastrophe events and increased net investment income partially offset these losses. Additionally, White Mountains Re’s expense ratio decreased to 28% in 2005, from 31% in 2004, due mainly to a decrease in incentive compensation accruals. White Mountains Re’s 2004 results included $135 million of pre-tax losses, net of reinstatements and reinsurance, from the four hurricanes that affected the southeastern United States and the tsunami that impacted South Asia, which added a total of 11 points to the combined ratio.
White Mountains Re’s gross written premiums increased in 2005 by $48 million, or 2.5%, and net written premiums increased by $58 million, or 4.7%, over the prior year. The increase was due primarily to Sirius, which was acquired in the second quarter of 2004 and contributed nine months of premiums in 2004 versus twelve months in 2005, partially offset by decreased premium volume at both Sirius International and Folksamerica as a result of the general softness in the reinsurance market prior to the Gulf Coast hurricanes.
White Mountains Re receives fee income on reinsurance placements referred to Olympus and is entitled to a profit commission based on net underwriting profits on referred business. During 2005 and 2004, White Mountains Re earned $61 million and $69 million, respectively, of fee income from Olympus. The decrease in fee income from the prior period is primarily due to the significant loss events in 2005, including the Gulf Coast hurricanes, which resulted in White Mountains Re not earning any profit commission in 2005 compared to earning $12 million of profit commission in 2004. The profit commission arrangement with Olympus is subject to a deficit carryforward whereby net underwriting losses from one underwriting year carryover to future underwriting years. As a result of the significant loss events in 2005, Olympus recorded a substantial net underwriting loss for the year. Accordingly, White Mountains Re does not expect to record profit commissions from Olympus for the foreseeable future.
White Mountains Re’s pre-tax income for 2004 was $87 million, compared to $144 million for 2003, and its combined ratio was 104% for 2004, compared to 96% for 2003. The decrease in pre-tax income was due primarily to $135 million of claims incurred related to significant property catastrophe events in the second half of 2004. These catastrophes, which are discussed further below, increased the combined ratio in 2004 by 11 points. In general, White Mountains Re has experienced favorable underwriting conditions for the past three underwriting years. Earnings from business segments not impacted by the property catastrophe events, and earnings from the recently completed Sirius Acquisition, have partially offset the impact of these natural disasters. Net written premiums, total revenues, and total expenses were all up substantially in 2004 due to the Sirius Acquisition.
During 2004, White Mountains Re recorded $11 million of net unfavorable loss reserve development, which contributed 1 point to the loss ratio in 2004, as compared to $46 million, or 5 points in 2003. The majority of the unfavorable development recorded in 2004 resulted from certain discontinued lines at Folksamerica as well as run-off operations acquired as part of the Sirius Acquisition. This unfavorable development was partially offset by favorable development in the Sirius International reserve portfolio, stemming mainly from the three most recent underwriting years, and is indicative of the favorable terms and conditions that have existed in the global reinsurance marketplace during that time. Additionally, White Mountains Re recorded $10 million of unfavorable loss development on its workers compensation reserves acquired as part of the Sierra acquisition in 2004. This adverse development was offset dollar-for-dollar by the adjustable note discussed above.
White Mountains Re recognized net fee income of $69 million from Olympus in 2004 as compared to $98 in 2003. The decline in the fee income earned is due primarily to the negative impact of the four hurricanes on the profit commission arrangement between White Mountains Re and Olympus.
Esurance’s financial results and GAAP combined ratios for the years ended December 31, 2005, 2004 and 2003 follows:
Esurance reported a pre-tax loss of $13 million for the year ended December 31, 2005, compared with pretax income of $4 million for the prior year. Esurance’s GAAP combined ratio was 109% for 2005 compared to 102% in 2004. Esurance’s loss ratio decreased to 67% in 2005, from 69% in the prior year, despite $2 million in losses sustained from hurricane Wilma during 2005. The decrease in the loss ratio resulted primarily from improved claims performance and increased pricing sophistication. The expense ratio increased to 42% in 2005, from 33% in the prior year, mainly due to higher acquisition expenses from Esurance’s marketing programs, driven by increased competition for new customers. The combined ratio was also adversely impacted by approximately 3 points from the adoption of a new long-term incentive compensation plan in 2005.
Esurance Results - Year Ended December 31, 2004 versus Year Ended December 31, 2003
Esurance’s pre-tax income of $4 million for 2004 represented an improvement over the pre-tax loss of $19 million in 2003. Esurance’s 2004 combined ratio improved to 102% from 120% in 2003 due to improvements in both loss and expense ratios. Esurance’s loss ratio improvement resulted from the continued rollout and refinement of Esurance’s proprietary auto insurance program. Loss ratio improvement also resulted from better claims performance, driven by the transition from a third party administrator to an in-house claims operation in 2003, as well as 3 points of favorable development on loss reserves.
The auto program, combined with Esurance’s self-service, web-enabled operating platform, allowed Esurance to increase premium volume and in-force policy count while reducing the expense ratio from 39% to 33%. As of December 31, 2004, Esurance’s in-force count was 118,513 policies, a 60% increase over December 31, 2003. Increased advertising, particularly in radio and TV, drove policy count growth.
Other Operations consists of the operations of the Company and the Company’s intermediate subsidiary holding companies, WM Advisors and the International American Group, as well as White Mountains’ investments in Montpelier and Symetra warrants. A summary of White Mountains’ financial results from its Other Operations segment for the years ended December 31, 2005, 2004 and 2003 follows:
Other Operations Results - Year Ended December 31, 2005 versus Year Ended December 31, 2004
During 2003, Peninsula was the only operating company in the segment, and therefore it accounts for all of the premiums reported in the table above. During January 2004, White Mountains sold Peninsula for $23 million. The operations of American Centennial and British Insurance Company are not significant to White Mountains, as those companies have been in run-off since they were acquired in 1999.
White Mountains’ GAAP pre-tax total return on invested assets was 2% for the year ended December 31, 2005 versus 7% for 2004. White Mountains’ equity portfolio returned 8% in 2005, which was 3 percentage points better than the S&P 500, despite its largest equity position, Montpelier, having a significant decline (as noted below). On the fixed income side, White Mountains maintained a relatively short duration (about 2 years, including short-term investments), high-quality portfolio, which performed consistent with its characteristics, while its exposure to the Swedish krona through Sirius detracted from its fixed income returns due to the strengthening of the U.S. dollar.
White Mountains’ GAAP total return on invested assets was 7% for both 2004 and 2003. White Mountains’ equity portfolio returned 20% in 2004, which was 9 percentage points better than the S&P 500, while the bond portfolio performed in line with its duration and credit characteristics. Net investment income in 2004 was up 24% from 2003, mainly due to the Sirius Acquisition.
Adjusted comprehensive net income is a non-GAAP measure that excludes the change in net unrealized gains from Symetra’s fixed maturity portfolio from comprehensive net income. GAAP requires these assets to be marked-to-market, which results in gains during periods when interest rates fall and losses in periods when interest rates rise. Because the liabilities related to the life insurance and structured settlement products that these assets support are not marked-to-market, it is likely that the economic impact on Symetra would be the opposite of that shown under GAAP (i.e., in general, Symetra’s intrinsic value increases when interest rates rise and decreases when interest rates fall). The reconciliation of adjusted comprehensive net income to comprehensive net income is included on page 44.
Book value per share is derived by dividing the Company’s total GAAP shareholders’ equity as of a given date by the number of common shares outstanding as of that date, including the dilutive effects of outstanding Options and warrants to acquire common shares, as well as the unamortized accretion of preferred stock. Fully converted tangible book value per common and equivalent share is a non-GAAP measure which is derived by expanding the GAAP book value per share calculation to include the effects of assumed conversion of all convertible securities and to exclude any unamortized goodwill and net unrealized gains from Symetra’s fixed maturity portfolio. The reconciliation of fully converted tangible book value per common and equivalent share to book value per share is included on page 43.
Total capital at White Mountains is comprised of common shareholders’ equity, debt and preferred stock subject to mandatory redemption. Tangible capital excludes from total capital the unamortized goodwill and the equity in net unrealized gains from Symetra’s fixed maturity portfolio. The reconciliation of total capital to total tangible capital is included on page 60.
Operating subsidiary level. The primary sources of cash for White Mountains’ insurance and reinsurance operating subsidiaries are premium collections, net investment income and proceeds from sales and maturities of investments. The primary uses of cash are claim payments, policy acquisition costs, operating expenses, the purchase of investments and dividend and tax sharing payments made to parent holding companies.
Under the insurance laws of the states and jurisdictions under which White Mountains’ insurance and reinsurance operating subsidiaries are domiciled, an insurer is restricted with respect to the timing or the amount of dividends it may pay without prior approval by regulatory authorities. Accordingly, there can be no assurance regarding the amount of such dividends that may be paid by such subsidiaries in the future. Following is a description of the ability of White Mountains’ insurance and reinsurance operating subsidiaries to pay dividends to the Company and certain of its intermediate holding companies:
In addition, as of December 31, 2005, OneBeacon had approximately $20 million of cash and investments outside of its regulated insurance operating subsidiaries available for distribution during 2006. During 2005, OneBeacon paid $340 million of dividends to Fund American.
Folksamerica Re has the ability to pay dividends during any 12-month period without the prior approval of regulatory authorities in an amount equal to the lesser of net investment income, as defined by statute, or 10% of statutory surplus, in both cases as most recently reported to regulatory authorities, subject to the availability of earned surplus. Based upon December 31, 2005 statutory surplus of $1.1 billion, Folksamerica Re would have the ability to pay approximately $107 million of dividends during 2006 without prior approval of regulatory authorities, subject to the availability of earned surplus. However, as a result of the hurricane-related losses it sustained during 2005, Folksamerica Re had $59 million of negative earned surplus as of December 31, 2005. Consequently, Folksamerica Re cannot pay any dividends without regulatory approval until it has earned surplus and, therefore, does not expect to pay any dividends without regulatory approval until late 2006 or early 2007. During 2005, Folksamerica Re paid $15 million of dividends to its immediate parent.
In accordance with the provisions of Swedish law, Sirius International can voluntarily transfer its pre-tax income, or a portion thereof, subject to certain limitations, to its parent company to minimize taxes. In early 2006, Sirius International contributed approximately $49 million of its 2005 pre-tax income to its parent company.
As of December 31, 2005, WMU had $6 million of cash and investments available for distribution during 2006. In addition, WMU has the ability to distribute its 2006 earnings without restriction. During 2005, WMU paid $33 million of dividends to its immediate parent.
In addition, as of December 31, 2005, White Mountains Re had approximately $39 million of cash and investments outside of its regulated insurance and reinsurance operating subsidiaries available for distribution during 2006. During 2005, White Mountains Re distributed $98 million of cash and investments from various holding companies to its immediate parent.
availability of unassigned funds. As of December 31, 2005, Esurance’s top tier regulated insurance operating subsidiary had $15 million of unassigned funds available for dividend distribution.
(2) Excludes funds held by White Mountains under reinsurance treaties for which White Mountains does not provide interest credits.
White Mountains has historically obtained its float primarily through acquisitions, as opposed to organic growth. In recent years, White Mountains has had negative cash flows from operations but has grown float from its insurance and reinsurance operations. This is due to the fact that White Mountains’ cash flow from operations does not reflect cash and investments generated by the acquisition of insurance and reinsurance businesses in recent years. Post-acquisition, such companies are often placed into partial or complete run-off, thereby resulting in negative cash flows from operations as the investments acquired are liquidated over time to pay claims.
(1) See Note 6 - "Debt" of the accompanying Consolidated Financial Statements for a discussion of operating subsidiary debt.
Fund American and the Company are both permitted borrowers under the Bank Facility, which matures in August 2009. Under the Bank Facility, the Company guarantees all obligations of Fund American, and Fund American guarantees all borrowings of the Company, subject to certain limitations imposed by the terms of the Berkshire Preferred Stock. As of December 31, 2005, the $400 million available under the Bank Facility was undrawn.
December 31, 2005, White Mountains was in compliance with all of the covenants under the Senior Notes, and anticipates it will continue to remain in compliance with these covenants for the foreseeable future.
White Mountains has recorded a liability of $8 million for its share of the expected future shortfall between LUC Holdings’ head lease payments and sub-lease receipts. White Mountains does not believe that future shortfalls, if any, will have a material impact on its results of operations.
Detailed information concerning White Mountains’ liquidity and capital resource activities during 2005, 2004 and 2003 follows:
During 2005, OneBeacon drew down $18 million on an 18-year mortgage note that it entered into in connection with its purchase of land and a future home office building. As OneBeacon incurs construction costs associated with the renovation of the building, it will draw down additional principal up to the $41 million limit on the mortgage note.
During 2005, White Mountains received a total of $60 million in tax refunds and interest from the Internal Revenue Service related to the completion of an audit of White Mountains’ 1997-2000 tax years, the period during which the Company redomesticated to Bermuda.
On June 29, 2004, Berkshire exercised of all of its warrants to purchase 1,724,200 common shares of White Mountains for $294 million. Berkshire acquired the warrants in connection with the financing of White Mountains’ acquisition of OneBeacon in 2001. The warrants were exercisable at any time until May 2008 and callable by the Company on or after May 31, 2005. In consideration for the early exercise of the warrants, Berkshire and the Company agreed to reduce the exercise price by approximately 2%.
During 2004, White Mountains declared and paid dividends of $9 million, $28 million and $2 million to holders of White Mountains’ common shares, the Berkshire Preferred Stock and the Zenith Preferred Stock, respectively.
On August 27, 2004, White Mountains repaid the $25 million note that was issued as part of the financing of its 2001 acquisition of C-F Insurance Company.
See Note 2 - "Significant Transactions" of the accompanying Consolidated Financial Statements for further discussion of these transactions.
In September 2003, White Mountains established its $300 million revolving Bank Facility. As discussed earlier, this Bank Facility was restructured and re-syndicated in August 2004.
During 2003, White Mountains made scheduled principal amortization payments of $7 million and paid a total of $23 million in interest under its previous bank facility, including $11 million paid under the interest rate swap agreements, prior to its repayment.
During 2003, White Mountains declared and paid dividends of $8 million, $28 million and $2 million to holders of White Mountains’ common shares, the Berkshire Preferred Stock and the Zenith Preferred Stock, respectively.
During 2003, OneBeacon declared and paid a total of $235 million in dividends to Fund American. Also during 2003, WMU paid a total of $35 million in dividends to its immediate parent and WM Advisors paid a total of $10 million in dividends to Fund American.
During 2003, the Company issued a total of 11,116 common shares to its employees through the exercise of Options and, as a result, the Company received cash proceeds of $1.5 million in connection with these Option exercises.
During 2003, OneBeacon sold one of its subsidiaries, National Farmers Union Standard Insurance Company , for $22 million.
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of White Mountains. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
• Expected loss ratio methods: These methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss ratios are typically developed based upon the information used in pricing, and are multiplied by the total amount of premiums written to calculate ultimate losses. Expected loss ratio methods are useful for estimating ultimate losses in the early years of long-tailed lines of business, when little or no paid or incurred loss information is available.
• Adjusted historical paid and incurred loss development methods: These methods take traditional historical paid and incurred loss development methods and adjust them for the estimated impact of changes from the past in factors such as inflation, the speed of claim payments or the adequacy of case reserves. Adjusted historical paid and incurred loss development methods are often more reliable methods of predicting ultimate losses in periods of significant change, provided the actuaries can develop methods to reasonably quantify the impact of changes.
OneBeacon’s general liability and multiple peril lines of business have been significantly impacted by a large number of construction defect claims. Construction defect is a liability allegation relating to defective work performed in the construction of structures such as apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. Such claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. Much of the recent claims activity has been generated by plaintiffs’ lawyers who approach new homeowners, and in many cases homeowner associations with large numbers of homeowners in multi-residential complexes, about defects or other flaws in their homes. Claims for construction defects began with claims relating to exposures in California. Then, as plaintiffs’ lawyers organized suits in other states with high levels of multi-residential construction, construction defect claims were reported in nearby western states, such as Colorado and Nevada, and eventually throughout the country. The reporting of such claims can be quite delayed as the statute of limitations can be up to ten years. Court decisions have expanded insurers’ exposure to construction defect claims as well. For example, in 1995 California courts adopted a “continuous trigger” theory in which all companies that had ever insured a property that was alleged to have been damaged by defective construction must respond to the claimant, even if evidence of the alleged damage did not appear until after the insurance period had expired. As a result, claims may be reported more than ten years after a project has been completed as litigation can proceed for several years before an insurance company is identified as a potential contributor. Claims have also emerged from parties claiming additional insured status on policies issued to other parties (e.g., such as contractors seeking coverage on a sub-contractor’s policy). Further, in reserving for these claims, there is additional uncertainty due to the potential for further unfavorable judicial rulings and regulatory actions.
A large number of construction defect claims have been identified relating to coverages that OneBeacon had written in the past through Commercial Union and General Accident and their subsidiaries in California, Colorado, Nevada, Washington and Oregon. Management has sought to mitigate future construction defect risks in all states by no longer providing insurance to certain residential general contractors and sub-contractors involved in multi-habitational projects. Mitigating actions also included initiating the withdrawal from problematic sub-segments within OneBeacon’s construction book of business, such as street and road construction, water, sewer and pipeline construction. As a result of these actions, management believes that the number of reported construction defect claims relating to coverages written in the past peaked in 2004 and will continue to decline.
OneBeacon’s liabilities for A&E losses from business underwritten in the recent past are substantially limited by the application of exclusionary clauses in the policy language that eliminated coverage for such claims. After 1987 for pollution and 1992 for asbestos, most liability policies contained industry-standard absolute exclusions of such claims. In earlier years, various exclusions were also applied, but the wording of those exclusions was less strict and subsequent court rulings have reduced their effectiveness.
OneBeacon also incurred A&E losses via its participation in industry pools and associations. The most significant of these pools was Excess Casualty Reinsurance Association (“ECRA”), which provided excess liability reinsurance to U.S. insurers from 1950 until the early 1980s. ECRA incurred significant liabilities for A&E, of which OneBeacon bears approximately a 4.7% share, or $65 million at both December 31, 2005 and 2004, which is fully reflected in OneBeacon’s loss and LAE reserves.
More recently, since the 1990s, OneBeacon has experienced an influx of claims from commercial insureds, including many non-Fortune 500-sized accounts written during the 1970s and 1980s, who are named as defendants in asbestos lawsuits. As a number of large well-known manufacturers of asbestos and asbestos-containing products have gone into bankruptcy, plaintiffs have sought recoveries from peripheral defendants, such as installers, transporters or sellers of such products, or from owners of premises on which the plaintiffs’ exposure to asbestos allegedly occurred. At December 31, 2005, 592 policyholders had asbestos-related claims against OneBeacon. In 2005, 128 new insureds with such peripheral involvement presented asbestos claims under prior OneBeacon policies.
Historically, most asbestos claims have been asserted as product liability claims. Recently, insureds who have exhausted the available products liability limits of their insurance policies have sought payment for asbestos claims under the premises and operations coverage of their liability policies. It is more difficult for plaintiffs to establish losses as stemming from premises and operations exposures, which requires proof of the defendant’s negligence, rather than products liability under which strict legal liability applies. Hence, there are fewer of such claims and there is a great deal of variation in damages awarded for the actual injuries. Additionally, several accounts that seek such coverage find that previously paid losses exhausted the aggregate limits under their policies. In these situations there is no coverage for these claims. There are currently 243 active claims against OneBeacon without product liability coverage asserting operations or premises coverage.
Immediately prior to White Mountains’ acquisition of OneBeacon, OneBeacon purchased a reinsurance contract with NICO under which OneBeacon is entitled to recover from NICO up to $2.5 billion in the future for asbestos claims arising from business written by OneBeacon in 1992 and prior, environmental claims arising from business written by OneBeacon in 1987 and prior, and certain other exposures. Under the terms of the NICO Cover, NICO receives the economic benefit of reinsurance recoverables from certain of OneBeacon’s third party reinsurers in existence at the time the NICO Cover was executed (“Third Party Recoverables”). As a result, the Third Party Recoverables serve to protect the $2.5 billion limit of NICO coverage for the benefit of OneBeacon. Any amounts uncollectible from third party reinsurers due to dispute or the reinsurers’ financial inability to pay are covered by
OneBeacon’s reserves for A&E losses, net of Third Party Recoverables but prior to NICO recoveries, are $1.3 billion at December 31, 2005. An industry benchmark of reserve adequacy is the “survival ratio”, computed as a company’s reserves divided by its historical average yearly loss payments. This ratio indicates approximately how many more years of payments the reserves can support, assuming future yearly payments are equal to historical levels. OneBeacon’s survival ratio was approximately 18.6 at December 31, 2005, which was computed as the ratio of A&E reserves, net of Third Party Recoverables, of $1.3 billion plus the remaining unused portion of the NICO Cover of $404 million, to the average loss payments, net of Third Party Recoverables, in the past three years. The average loss payments used to calculate OneBeacon’s survival ratio were net of a large commutation ($64 million) in 2003 with a third party reinsurer. White Mountains believes that as a result of the NICO Cover and its historical third party reinsurance programs, OneBeacon should not experience material financial loss from old A&E exposures under current coverage interpretations and that its survival ratio compares favorably to industry survival ratios.
OneBeacon’s reserves for A&E losses at December 31, 2005 represent management’s best estimate of its ultimate liability based on information currently available. OneBeacon believes the NICO Cover will be adequate to cover all of its A&E obligations. However, as case law expands, medical and clean-up costs increase and industry settlement practices change, OneBeacon may be subject to asbestos and environmental losses beyond currently estimated amounts. Therefore, OneBeacon cannot guarantee that its A&E loss reserves, plus the remaining coverage under the NICO Cover, will be sufficient to cover additional liability arising from any such unfavorable developments. See Note 3 to the financial statements for more information regarding White Mountains’ A&E reserves.
OneBeacon’s A&E claim activity for the last two years is illustrated in the table below.
For OneBeacon, the range of reserve estimates at December 31, 2005 was evaluated to consider the strengths and weaknesses of the actuarial methods applied against OneBeacon’s historical claims experience data. The following table shows the recorded reserves and the high and low ends of OneBeacon’s range of reasonable loss reserve estimates at December 31, 2005. The high and low ends of OneBeacon’s range of reserve estimates in the table below are based on the results of various actuarial methods described above. The recorded reserve for each line is the result of the actuarial method that management believes to be most appropriate based on known facts and trends.
The recorded reserves represent management’s best estimate of unpaid loss and LAE by line of business. In its selection of recorded reserves, management has generally given greater weight to adjusted paid loss development methods, which are not dependent on the consistency of case reserving practices, rather than methods that rely on incurred losses, because of the increased adequacy of case reserving by OneBeacon’s claim staff in the recent past. For multiple peril this resulted in OneBeacon recording reserves nearer the low end of the range. For some types of claims, such as workers compensation and construction defect, management also considered special purpose forecasting models that its claims and actuarial staff have created that consider the unique loss development characteristics of these types of claims. For personal automobile liability, homeowners and “other” (principally shorter tailed lines of business such as ocean and inland marine insurance) recorded reserves remain rather high in the respective ranges, as management’s selections reflect a conservative approach to recognition of recent favorable development experienced in our ongoing businesses.
While variability is reflected in part in the size of the range of reserves developed by OneBeacon, that range may still not be indicative of the potential variance between the ultimate outcome and recorded reserve. This is because ranges are developed based on known events as of the valuation date, whereas the ultimate disposition of losses is subject to the outcome of events and circumstances that may be unknown as of the valuation date. The probability that ultimate losses will fall outside of the ranges of estimates by line of business is higher for each line of business individually than it is for the sum of the estimates for all lines taken together due to the effects of diversification. The diversification effects result from the fact that losses across OneBeacon’s different lines of business are not completely correlated. Although management believes OneBeacon’s reserves are reasonably stated, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above the high end of the range of actuarial projections.
Folksamerica sets up claim files for each reported claim by each cedent for each individual insured. In many instances, a single claim notification from a cedent could involve several years and layers of coverage resulting in a file being set up for each involvement. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to pursue coverage under the reinsurance contract. Such notices do not contain an incurred loss amount to Folksamerica, accordingly, an open claim file is not established. As of December 31, 2005, White Mountains Re had approximately 1,339 open claim files for asbestos and 750 open claim files for environmental exposures.
White Mountains Re establishes loss reserves based on a single point estimate, which is management’s best estimate of ultimate losses and loss expenses. This “best estimate” is derived from a combination of methods as described above. Once a point estimate is established, White Mountains Re’s actuaries estimate loss reserve ranges to measure the sensitivity of the actuarial assumptions used to set the point estimates. These ranges are calculated using similar methods to the point estimate calculation, but with different expected loss ratio and loss reporting pattern assumptions. For the low estimate, more optimistic loss ratios and faster reporting patterns are assumed, while the high estimate uses more conservative loss ratios and slower reporting patterns. These variable assumptions are derived from historical variations in loss ratios and reporting patterns by class and type of business. Due to the inherent difficulties in estimating ultimate A&E exposures, White Mountains Re does not estimate ranges for these reserves.
White Mountains Re closely monitors its estimation process on a quarterly basis and adjusts its estimates as more information and actual amounts become known. There is no assurance that the amounts estimated by White Mountains Re will not deviate from the amounts reported by the ceding company or reinsurance broker. Any such deviations are reflected in the results of operations when they become known.
The collectibility of reinsurance recoverables is subject to the solvency and willingness to pay of the reinsurer. The Company is selective in choosing its reinsurers, placing reinsurance principally with those reinsurers with a strong financial condition, industry ratings and underwriting ability. Management monitors the financial condition and ratings of its reinsurers on an ongoing basis. See Note 4 - "Third Party Reinsurance" in the accompanying Consolidated Financial Statements for additional information on White Mountains’ reinsurance programs.
When White Mountains acquires another company, management must estimate the fair values of the assets and liabilities acquired, as prescribed by SFAS No. 141, “Business Combinations.” Certain assets and liabilities require little judgment to estimate their fair values, particularly those that are quoted on a market exchange, such as publicly-traded investment securities. Other assets and liabilities, however, require a substantial amount of judgment to estimate their fair values. The most significant of these is the estimation required to fair value loss and LAE reserves. White Mountains estimates the fair value of loss and LAE reserves obtained in an acquisition following the principles contained within FASB Statement of Financial Accounting Concepts No. 7: “Using Cash Flow Information and Present Value in Accounting Measurements” (“CON 7”). Under CON 7, the fair value of a particular asset or liability essentially contains five elements: (1) an estimate of the future cash flows, (2) expectations about possible variations in the amount or timing of those cash flows; (3) the time value of money, represented by the risk-free rate of interest; (4) the price for bearing the uncertainty inherent in the asset or liability; and (5) other, sometimes unidentifiable, factors including illiquidity and market imperfections.
• growth in book value per share or return on equity;
• changes in domestic or foreign laws or regulations, or their interpretation, applicable to White Mountains, its competitors or its clients;