Combined ratio: The combined ratio is the sum of the losses and loss adjustment expenses ratio and the expense ratio.
Return on average shareholders’ equity: Return on average shareholders’ equity is the ratio, expressed as a percentage, of net earnings, excluding realized gains and losses, net of tax, to the average of the beginning of period and end of period total shareholders’ equity, excluding accumulated other comprehensive income.
We segregate our business into two segments: insurance operations and other. The insurance operations are further classified into three divisions: excess and surplus lines (E&S), alternative risk transfer (ART) and assumed reinsurance (Assumed Re). E&S consists of eight product lines: property, environmental, construction, products liability, excess, surety, healthcare, and professional liability. ART consists of two product lines: specialty programs and fully funded. Assumed Re consists of specialty property and casualty business assumed from unaffiliated specialty insurers and reinsurers. Other includes lines of business that we no longer underwrite (run-off) as well as real estate and other ancillary product lines. Prior year amounts have been reclassified to conform to the current year presentation.
Within the E&S division we provide property and general liability coverage across specialty classes of business. Our environmental business provides general, professional and pollution liability to contractors, consultants and property owners. Construction provides commercial general liability insurance coverages for residential and commercial contractors. Products liability offers general liability and product liability coverages for smaller manufacturers and distributors, non-habitational real estate and certain real property owner, landlord and tenant risks. Excess and umbrella provides liability coverages over our own and other carriers’ primary casualty policies, with a focus on construction risks. Surety provides payment and performance bonds primarily to the environmental remediation and construction industries. Healthcare provides customized liability insurance solutions primarily for long-term care facilities.
The Company measures all segments using net earnings. The reportable insurance operations divisions are measured by net premiums earned, incurred losses and loss adjustment expenses and acquisition expenses. Assets are not allocated to the reportable insurance operations segments.
Other underwriting expenses of $42.2 million include a $2.5 million charge increasing the reinsurance balances receivable allowance for doubtful accounts. Fee income of $4.6 million as compared to $5.4 million for 2009 and investment income increased to $32.1 million from $30.6 million in 2009. Fee income decreased due to market conditions and investment income increased due to cash flow from operations offsetting lower yields as compared to 2009. Additionally 2010 includes $2.3 million in realized gains as compared to $.2 million in 2009.
Net earned premiums totaled $200.7 in 2010 compared to $168.5 million in 2009, an increase of 19.1%. E&S totaled $102.9 million, an 11.8% increase from $92.0 million the same period in 2009; ART added $13.1 million, a 32.4% increase over the 2009 period; Assumed Reinsurance totaled $44.1 million, a 22.4% increase from 2009. The increase in earned premium for the E&S lines division was due to continued growth in newer product lines added since 2006 such as property, surety, excess and products liability, and professional liability. The Alternative Risk Transfer division's increase in net earned premium was due primarily to the addition of a dealer open lot program. The Assumed Reinsurance division's increase in net earned premium was due to continued penetration in targeted classes of business such as medical malpractice, professional liability, and general liability.
Equity. Equity in the Bermuda operations was $219.2 million at the end of 2010 compared to $181.1 million at the end of 2009. The increase is due to net earnings coupled with an increase in net unrealized gains associated with the investment portfolio. Equity of U.S. operations increased to $99.4 million at the end of 2010 from $94.4 million at December 31, 2009 primarily due to net unrealized gains in the investment portfolio and 2010 net earnings.
Year Ended December 31, 2009 compared to Year Ended December 31, 2008
The combined ratio for 2009 was 99.4% with improvements in both the loss ratio and expense ratio. The 2009 loss ratio improved to 57.9% compared to 63.1% in 2008 while the 2009 expense ratio was 41.5% compared to 42.9% in 2008. The loss ratio improved due to favorable development on prior accident loss reserves of $4.5 million compared to unfavorable development of $5.4 million in 2008. See “Loss and Loss Adjustment Expenses” discussion. The reduction in expense ratio is primarily due to lower acquisition costs in our assumed reinsurance business due to a shift in business to excess of loss from quota share, as well as increased fee income.
Net investment income increased 3.3% to $30.6 million for the year ended December 31, 2009 compared to $29.6 million for 2008 due to higher average invested assets. Average invested assets increased to $712.1 million as of December 31, 2009 from $645.5 million as of December 31, 2008. The increase in invested assets was due primarily to $53.4 million of cash flow from operations. This increase to the portfolio was offset in terms of investment income by yield compression in 2009. The average pre-tax investment yield decreased to 4.3% for 2009 from 4.6% for 2008.
Income tax expense totaled $0.5 million or 2.2% and $0.03 million, or 9.0% of pre-tax earnings for the years ended December 31, 2009 and 2008, respectively. The lower tax rate in 2009 is primarily a result of the reduction of the valuation allowance established in 2008 for capital losses on investments by $0.9 million.
Assets. Assets attributable to the Bermuda operations increased to $545.0 million at the end of 2009 compared to $428.6 million at the end of 2008. This increase is primarily due to earnings from operations and increased market value of investment assets. Assets attributable to the U.S. operations at the end of 2009 increased to $602.6 million as compared to $597.7 million at the end of 2008 due to earnings for 2009.
Equity. Equity of the Bermuda operations was $181.1 million at the end of 2009 compared to $136.6 million at the end of 2008 due primarily to unrealized gains in the investment portfolio. Equity of U.S. operations increased to $94.4 million at the end of 2009 from $83.5 million at December 31, 2008 due to unrealized gains in the investment portfolio.
collateral structure and credit support of the security, if applicable, (v) the time during which there has been a decline below cost, and (vi) the extent of the decline below cost. If we conclude a security is other-than-temporarily impaired, we write down the amortized cost of the security to fair value, with a charge to net realized investment losses in the Consolidated Statements of Operations.
After a review of the individual securities in the investment portfolio, the Company did not record net realized losses due to other-than-temporary-impairment on one fixed maturity. The analysis to determine other-than-temporary-impairment was completed on all securities with additional focus on securities with unrealized losses greater than 30% of book value and securities whose unrealized loss was greater than 20% of book value for more than three months.
Net cash used in investing activities was $56.4 million for the year ended December 31, 2010, compared to net cash used in investing activities of $31.5 million for the same period of 2009. The increase in net cash used in investing activities was primarily due to cash generated from operations being invested.
(2) The above table includes the expected settlement of our gross loss reserves. The Company relies on reinsurance to reduce current risk exposures. The expected payout of gross loss reserves net of reinsurance recoverables is as follows: total $453.1 million; $85.6 million less than a year; $122.5 million 1-3 years, $64.6 million; 3-5 years and $180.4 million; more than 5 years. More information about our unpaid loss and loss adjustment expenses appears in Note 13 to our consolidated financial statements.
The OTTI is split between a credit loss portion and a portion due to other factors like liquidity and market interest rate changes. The credit portion of the OTTI is the difference between the amortized cost of the debt security and the present value of the estimated cash flows to be received from the security and is charged to expense. The non-credit portion is recorded in a new category of other comprehensive income ("OCI"), net of applicable deferred taxes, separately from unrealized gains and losses on available-for-sale ("AFS") securities.
Effective January 1, 2008, on a prospective basis, we determined the fair values of certain financial instruments based on the fair value hierarchy established in Statement of Financial Accounting Standard 157, “Fair Value Measurements” (“ASC 820-10-15”). ASC 820-10-15 requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.
Level 1: quoted price (unadjusted) in active markets for identical assets.
Level 3: Significant unobservable inputs that reflect a reporting entity's own assumption about the assumptions that market participants would use in pricing an asset or liability.
Our Level 1 instruments are primarily U.S. Treasuries, money market funds and equity securities listed on stock exchanges. We use quoted prices for identical instruments to measure fair value.
Because the Company’s loss reserves are primarily comprised of long-tail business, current year ultimate losses are developed using mostly the expected loss ratio method. The method is appropriate because there are very few claims reported from the most recent accident year for long-tail lines of business. The expected loss ratio is determined based on the review of the projected ultimate loss ratios for similar risks from the prior years. At December 31, 2010 the carried loss and loss adjustment expense reserves for accident years prior to 2007 were determined largely based on the indications produced by the Bornhuetter-Ferguson method or loss development factor method because of the additional claims experience gained as the business line matures.
Construction defect claims in general have a higher frequency, a lower severity and a longer reporting period than other types of claims. The construction defect exposures in California were analyzed separately from other states because of the state’s relatively longer statute which makes the claim reporting period longer, and the litigious environment, which potentially increases the per claim cost. The Company wrote New York commercial contractor risks in 1999, 2000 and 2001. Due to the short amount of time we wrote this business and the higher severity with respect to these New York claims, the reserves for these exposures are estimated separately. Products liability claims tend to be severe and can be reported over an extended period.
Environmental: Most exposures involved common types of bodily injury and property damage claims. These claims tend to be reported sooner but take longer to settle because often times multiple parties are involved in a claim. The loss development patterns and the expected loss ratios are estimated based on our internal trend analysis.
Ceded Reinsurance. Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not relieve us of our legal liability to our policyholders. We continuously monitor the financial condition of our reinsurers. Our policy is to periodically charge to earnings, in the form of an allowance, an estimate of unrecoverable amounts from troubled or insolvent reinsurers. We believe that current reserve levels for uncollectible reinsurance are sufficient to cover our exposures.
Recognition of Premium Income. Our premiums are primarily estimated based upon the annual revenues of the underlying insureds or other factors specific to the class of business. Additional or return premiums are recognized for differences between provisional premiums billed and ultimate premiums due when a final audit is complete after the policy has expired. Our premiums are earned ratably over the policy period with unearned premium calculated on a pro rata basis over the lives of the underlying coverages. The Company reviews the collectibility of its premium receivables on a quarterly basis.