The most significant accounting estimates relate to the Company’s reserves for unpaid losses and LAE. Unpaid losses and LAE include reserves for both reported claims (case reserves) and IBNR.
Workers’ Compensation - an individual investigation of each reported accident is undertaken and the claims personnel, using their experience and judgment, establish a case reserve in an amount estimated to be the most likely ultimate loss amount to be paid considering the unique statutory scheme of the applicable jurisdiction. Claims personnel make assumptions as to the likely cost of necessary medical treatment, including prescription medications, estimated time of disability, degree of permanency, and, depending on the severity of the individual case, the necessity and cost of vocational, rehabilitative, or long term care as well as other amounts provided for under the applicable statutory scheme such as funeral and dependant benefits, transportation costs, and employee attorney fees.
In all lines of business, throughout the life of the claim, claims personnel evaluate any new information that is received, analyze the impact of new information on the existing reserve, and, if warranted, increase or decrease the case reserve as appropriate.
The Company’s internal actuaries conduct full reserve studies using generally accepted actuarial methods for each line of business except asbestos, environmental and other latent, every six months, and for asbestos, environmental and other latent, annually. For all lines of business other than asbestos, environmental and other latent, ultimate losses and ALAE are projected by line of business by accident year using several standard actuarial methodologies, including paid and incurred loss development, the Bornhuetter-Ferguson incurred and paid loss methods, case reserve adequacy methods and frequency and severity approaches. For ULAE, the Company utilizes paid ULAE to paid loss analysis and the Wendy Johnson method. The Company’s actuaries utilize assumptions in determining their estimates, including loss development factors, expected loss ratios, frequency and severity trends, year-on-year price changes and inflation. These assumptions are affected by items such as past loss experience, changes in legislative conditions, changes in judicial interpretation of legal liability and policy coverage, and changes in claims handling practices. In addition, prevailing economic, social and legal factors, such as inflation in medical services, costs to repair damaged property or changes in statutory benefits, influence these assumptions. After projecting ultimate losses for each of the various actuarial methodologies, the actuaries select a central estimate ultimate for each accident year within a line of business based on many factors, such as the age of the accident year and the risk characteristics of the individual line of business.
General Liability - delay of reporting the claim to the Company, court award inflation and the expected loss ratio for the more recent accident years.
The shorter tailed lines, such as property, in which claims are paid shortly after the loss occurrence, have less variability in IBNR reserve estimates and are less dependent on the above assumptions. The key assumptions for the property line of business are catastrophe reserve estimates (when catastrophes occur) and cost to repair damaged property.
For liabilities other than asbestos, environmental and other latent, a range is developed around the central estimate loss and LAE reserves using statistical techniques to create an aggregate loss distribution. The methodology attempts to quantify the variability in the historical loss development data for each line of business separately. The variability depends on the line of business specific factors described above. From the aggregate loss distribution, an 80% confidence interval is constructed which represents a reasonable range of possible outcomes.
If the Company experienced a change in its ultimate loss and ALAE reserves in the amount depicted in the chart above, its income before income taxes and unpaid loss and loss adjustment reserves would be affected by the same amount.
In 2007, the net favorable loss development before corporate aggregate reinsurance was primarily attributable to favorable development across all major casualty lines as well as commercial multi-peril with the largest redundancy being recognized in workers’ compensation. Specifically, favorable development in the workers’ compensation line was principally attributable to favorable results in non-California for older accident years due to favorable claim settlements and continued recognition of favorable development for California in accident years 2004 and 2005 due to the impact of industry reforms. Favorable development for general liability and commercial multi-peril exposures in accident years 2003 through 2006 was due to the selection of faster loss development factors, recognizing decreased loss activity in those years. The favorable development in these lines was partially offset by $54.5 million of adverse development of asbestos, environmental and other latent liabilities. Of the $54.5 million adverse development, $24.3 million of the increase was in asbestos reserves, $22.2 million was in environmental reserves and $8.0 million was in other latent reserves. The strengthening of asbestos reserves was principally due to developments related to one asbestos policyholder. The strengthening of environmental reserves was due to a newly reported large claim, identification of additional policies associated with existing policyholders and a slight increase in the number of sites for policyholders with previously reported claims. In addition, the Company also incurred losses for settlements which secured broader releases on certain active exposures. For other latent reserves, the increase was due in part to a policyholder with both asbestos and silica claims. In 2008, the exposures for silica were identified as the predominant exposure for this policyholder and the reserves were established in other latent.
The Company’s asbestos exposure is related mostly to policyholders that are peripheral defendants, including a mix of manufacturers, distributors and installers of asbestos-containing products, as well as premises owners. For the most part, these policyholders are defendants on a regional, rather than a nationwide, basis. As the financial assets and insurance recoveries of traditional asbestos defendants have been depleted, plaintiffs are increasingly focusing on these peripheral defendants. Generally, only policies underwritten prior to 1986 have potential asbestos exposure since most policies underwritten after that date contain an absolute asbestos exclusion.
In 1994, Congress enacted a new section of the bankruptcy code aimed at facilitating the reorganization of businesses with large asbestos liabilities. Under this law, an asbestos defendant can receive a discharge from present and future asbestos claims by following the provisions of the bankruptcy code. Insurers of the defendant have typically been excluded from the pre-petition negotiations between the asbestos defendant and the asbestos plaintiffs’ lawyers, although the typical plan presumes the insurers will pay for claims under negotiation. These “pre-packaged bankruptcies” can inflate claim costs and accelerate the timing of claims payments, and it is likely that additional defendants will seek protection under this provision in the future. Although the pace of new filings has slowed considerably, bankruptcy filings by various defendants in the asbestos arena continue to result in larger claim values to be paid by the remaining solvent defendants, including certain Crum & Forster policyholders. To date, this continued flow of claims has forced at least 81 manufacturers and users of asbestos products into bankruptcy. These bankruptcies have, in turn, aggravated both the volume and the value of claims against viable asbestos defendants. Accordingly, there is a high degree of uncertainty with respect to future exposure from asbestos claims, both in identifying which additional policyholders may become targets in the future and in predicting the total number of asbestos claimants.
The Company’s future exposure to the asbestos liabilities resulting from the bankruptcies of those entities, however, is limited. The Company’s exposure and potential future exposure to those entities is summarized as follows:
Tort reform in certain jurisdictions initially resulted in increased filings by plaintiffs seeking to avoid the potential effective date of the reform legislation in 2003. Since 2004, insurers, including Crum & Forster, generally experienced either flat or slightly decreased frequency in numbers of newly reported asbestos-related claims due to, among other things, tort reform in certain jurisdictions previously known for large volume filings. As a result of tort reform the landscape of asbestos litigation is changing in the U.S. Many states (Mississippi, Texas, Ohio, for example) have enacted reforms serving to restrict the volume of filings, increase plaintiffs’ burden of demonstrating injury, and provide seriously injured plaintiffs with preferential treatment on the docket. Also, within the past few years, the doctors and screening companies that diagnosed large numbers of unimpaired plaintiffs have come under scrutiny. The result has been a significant decrease in the number of unimpaired plaintiffs filing claims. The number of mesothelioma, lung cancer and impaired asbestosis cases have remained at consistent levels, and accordingly now make up a larger percentage of the total filings. The reduction in
As part of the overall review of the Company’s asbestos exposure, management compares the level of reserves to various industry benchmarks. The most widely reported benchmark is the survival ratio, which equals the outstanding loss and ALAE reserves (including IBNR) at December 31 divided by the average paid losses and ALAE for the past three years. The resulting ratio is a simple measure of the estimated number of years before the year-end loss and ALAE reserves would be exhausted using recent payment run rates. The higher the ratio, the more years the loss and ALAE reserves would be expected to cover.
In 2008, the trends noted previously have continued, including flat or slightly decreased numbers of claimants filing asbestos claims against the Company’s policyholders, increased value of claims against viable asbestos defendants as co-defendants seek bankruptcy protection, an increased number of policyholders asserting that their asbestos claims are not subject to aggregate limits and that each individual bodily injury claim should be treated as a separate occurrence, and a shift towards a focus on single cases with significant injury, rather than a large volume of cases with little, if any, injury. In general, a small percentage of policyholders account for the majority of paid losses. In 2008, 92% of gross payments for loss and allocated loss adjustment expenses were made on behalf of approximately 2% of policyholders.
As a result of the processes, procedures and analyses described above, management believes that the reserves carried for asbestos claims at December 31, 2008 are adequate based upon known facts, current law and management’s judgment. However, there are a number of uncertainties surrounding the ultimate value of these claims, which may result in changes in these estimates as new information emerges. Among these are the following: the unpredictability inherent in litigation; any impact from the bankruptcy protection sought by asbestos producers and defendants; an unanticipated increase in the number of asbestos claimants; the resolution of disputes pertaining to the amount of coverage for “non-product” claims asserted under premises/operations general liability policies; and future developments regarding the ability to recover reinsurance on asbestos claims. It is also not possible to predict, nor has management assumed, any changes in the legal, social or economic environments and their impact on future asbestos claim development. The carried asbestos reserves also do not reflect any effects of future legislation.
An analysis of gross and net reserves from asbestos exposures is presented in Note 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Most sites have multiple PRPs. Most insurance policies issued to PRPs did not expressly cover the costs of pollution cleanup since pollution was not a recognized hazard at the time many of these policies were issued. Over time, judicial interpretations in many cases have found that the scope of coverage of the policies included pollution exposure, unless excluded, with some courts narrowly applying
Uncertainties also remain as to the Superfund law itself. The excise tax imposed to fund Superfund lapsed at the end of 1995 and has not been renewed. While a number of proposals to reform Superfund have been put forward by various parties, Congress has enacted no reforms since then. It is unclear what legislation, if any, will be enacted in the future and what potential effect it will have on the insurance industry. In the absence of federal movement on Superfund, the enforcement of Superfund liability is shifting to the states, which are reconsidering state-level cleanup statutes and regulations. As individual states move forward, the potential for conflicts among states becomes greater, increasing the uncertainty of the cost to remediate state sites.
The Company’s environmental survival ratio calculation, based on environmental loss and ALAE reserves, net of per risk reinsurance, but before the benefit of corporate aggregate reinsurance, is presented below:
An analysis of gross and net reserves from environmental exposures is presented in Note 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Unrealized gains or losses on the Company’s available-for-sale fixed income and equity securities, net of applicable income taxes, are included in other comprehensive income. Declines in the market value of invested assets below cost or amortized cost are evaluated for other than temporary impairment losses on a quarterly basis. Management considers an impairment as “other than temporary” if evidence indicating that an investment’s carrying amount is recoverable within a reasonable period of time, which in the case of fixed income securities, may mean until maturity, is outweighed by evidence to the contrary. Management also considers its ability and intent to hold an investment until such recovery of the security’s fair value. Notwithstanding the foregoing, with respect to fixed income securities, an impairment may be considered other than temporary if it is probable that the Company will be unable to collect all amounts due under the terms of the securities. Recognition of impairment losses for declines in the value of fixed income and equity securities attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment. Factors considered by management include, but are not limited to, the impact of issuer-specific events, current and expected future market and economic conditions, the nature of the investment, the number of investment positions with losses, the severity and duration of the impairment and the volatility of the security’s market price.
There are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary such as significant subsequent changes in general economic conditions, as well as specific business conditions affecting particular issuers; subjective assessment of issuer-specific factors (seniority of claims, collateral value, etc.); future financial market effects; stability of foreign governments and economies; future rating agency actions; and significant disclosures relating to accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, significant assumptions and management judgment regarding these risks and uncertainties are involved in determining if a decline is other than temporary. The turmoil in the financial markets which has resulted in unprecedented volatility in the debt and equity markets and significant declines in stock and bond prices over a short duration period, has made it particularly difficult for management to evaluate whether declines in the fair value of its investments are other than temporary. For the years ended December 31, 2008, 2007 and 2006, charges for other than temporary impairments amounted to $194.7 million, $25.4 million and $15.9 million, respectively.
Management’s evaluation of other than temporary losses is particularly sensitive to assumptions it makes relative to forecasts of an issuer’s financial performance and near term prospects such as earnings trends, dividends, analysts’ forecasts and cash flows supporting fixed income securities. Although management is unable to quantify the likelihood of changes to these assumptions that may occur in the future, any change in assumptions could result in recognition of impairments in the future in an amount potentially greater than the unrealized losses on the securities at December 31, 2008.
Derivatives held by the Company at December 31, 2008 include credit default swaps, warrants and Eurodollar futures contracts, the most significant of which are credit default swaps. These credit default swaps are carried at estimated fair values on the consolidated balance sheets with changes in fair value recorded in net income in the period in which they occur. The Company obtains market-derived fair values for its credit default swaps from third-party providers, principally broker-dealers. In addition, the Company assesses the reasonableness of the fair values obtained from these providers by comparing the fair values to values produced using individual issuer credit default swap yield curves, by referencing them to movements in credit spreads and by comparing them to recent market transaction prices for similar credit default swaps where available. The fair values of credit default swaps are subject to significant volatility arising from the potential differences in the perceived risk of default of the underlying issuers, movements in credit spreads and the length of time to the contracts’ maturity. Due to the inherent uncertainties of these valuations as well as the volatility in interest rates and stock market conditions, realized values may differ from estimates reflected in the consolidated financial statements.
At December 31, 2008 and 2007, reinsurance recoverable was $968.2 million and $1,539.8 million, net of reserves for uncollectible reinsurance of $56.0 million and $50.0 million, respectively. The decrease in the reinsurance recoverable balance from 2007 is primarily due to a significant commutation which reduced the reinsurance recoverable by $386.7 million. Bad debt expense for the years ended December 31, 2008, 2007 and 2006 related to uncollectible reinsurance was $7.7 million, $8.0 million and $9.5 million, respectively. While management believes the allowance for uncollectible reinsurance recoverable is adequate based on information currently available, failure of reinsurers to meet their obligations could have a material adverse impact on the Company’s financial position and results of operations. At December 31, 2008, the five largest gross reinsurance recoverable balances aggregated $586.9 million, or approximately 60.6% of the total reinsurance recoverable balance. The reinsurer with the largest gross recoverable balance (an unaffiliated company rated A+ by A.M. Best Company) has provided collateral in an amount of $220.8 million, which reduces its unsecured exposure to $128.2 million. The collateral provided is in the form of a funds held balance in the Company’s general account and equals premiums plus interest thereon credited at the rate stipulated in the related reinsurance contract. There is no limitation on the ability of the Company to access these funds in accordance with the related reinsurance agreement. After giving effect to this collateral, the unsecured exposure of the top five reduces to $366.0 million.
At December 31, 2008, there are no valuation allowances against the Company’s gross deferred tax assets of $271.5 million. The Company’s current projections of future taxable income are based on assumptions of level to modestly declining business growth and relatively stable combined ratios, with portfolio yields approximating current levels. Should the assumptions of future profitability change significantly, however, or the taxable income of these entities fall far below expectations, a valuation allowance, which could be significant, may have to be established if management believes any portion of the deferred tax asset will not be realized. A valuation allowance may also be required if there is a material change in the tax laws such that the actual effective tax rate or the time periods within which the underlying temporary differences become taxable or deductible change.
Realization of the deferred tax asset under SFAS 109 ultimately depends on the existence of sufficient taxable income available under tax law, including future reversals of existing temporary differences, future taxable income exclusive of reversing differences, taxable income in prior carryback years and tax planning strategies. Future profitability, as it relates to taxable income expectations discussed above, can be negatively affected by substantial changes in premium volume, underwriting losses resulting from significant events such as severe natural disasters or large settlements for asbestos or environmental claims, or materially lower investment results.
Because of the deteriorating market conditions described above, renewal retention rates, renewal pricing and new business growth all declined in 2008 as compared to 2007. Renewal retention rates declined by approximately 5 percentage points for both casualty and property lines. Renewal pricing for casualty and property lines declined by approximately 6% and 9%, respectively. New business declined by approximately 36%, attributable to a significant reduction in both casualty and property writings.
The Company expects the market to remain competitive in 2009, although perhaps with some stabilization in pricing. Under such conditions, the Company will continue to reject underpriced new business opportunities and to shed accounts and classes of business that appear to be unprofitable. As a consequence, it is likely that the Company’s premium volume will decline further in 2009, the expense ratio will increase as the shrinkage of premium revenues outpaces cost-cutting measures and the loss ratio may deteriorate marginally as renewal price declines and loss-cost trends take their toll on profitable business. In addition, as premium receipts decline and claim payments continue at historical norms or greater, the Company is likely to have negative cash flow from operations in 2009.
The increase in investment earnings is predominantly due to higher net realized gains on the Company’s total return swaps, short positions and credit default swaps as well as an increase in net realized gains on sales of U.S. Treasury securities, partially offset by higher other than temporary impairment charges, primarily related to write-downs of equity securities, higher mark-to-market accounting losses incurred on investments accounted for at fair value and lower partnership income.
For further discussion of loss development in each year, see “- Results of Operations - Losses and Loss Adjustment Expenses”. For further discussion of investment results, see “- Results of Operations - Investment Results”, “- Liquidity and Capital Resources” and Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The decrease in net income in the year ended December 31, 2007 as compared to 2006, was due to the combined effects of lower underwriting profit, lower investment earnings and higher debt retirement costs, partially offset by higher equity in earnings from investees. The decline in underwriting profit was primarily attributable to lower favorable development of prior years’ losses and LAE of $63.9 million in 2007, as compared to $96.2 million in 2006, partially offset by an improved accident year loss ratio. The decline in investment income and realized investment gains was primarily attributable to the significant level of realized investment gains achieved on the sale of certain fixed income and equity securities, as well as higher earnings from HWIC Asia Fund (“HWIC”), an affiliated investment at equity method investee, and higher earnings from other partnerships in 2006. Partially offsetting these effects were the significant mark-to-market gains on the Company’s credit default swaps in 2007.
During 2006, the Company identified and recorded certain adjustments associated with its accounting for investments. The adjustments relate principally to four areas: (i) equity method accounting - the Company did not properly reflect adjustments to realized investment gains and losses reported by equity method investees arising from basis differences associated with initial purchases or changes in ownership percentages. These adjustments relate principally to the Company’s investments in Northbridge Financial Corporation (“Northbridge”), an affiliated company, and HWIC; (ii) partnership accounting - several of the Company’s partnership interests were recorded on the equity method of accounting pursuant to Statement of Position 78-9, Accounting for Investments in Real Estate Ventures, even though the Company did not have the ability to exercise significant influence over the investees. In such circumstances, the Company should have retained the investment company accounting of the investees; (iii) embedded derivatives mark-to-market - the Company did not properly reflect the mark-to-market through earnings of derivative features embedded in convertible securities pursuant to SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. Several of the Company’s equity investees also held the same or similar securities with embedded derivatives. The Company determined that the investees also did not properly bifurcate their investments, which required adjustments to the Company’s financial statements; and (iv) valuation of an affiliated equity method investee - the Company did not correctly reflect the carrying value of its 1.4% ownership interest in TRG Holding Corp. (“TRG”) in 2002, pursuant to guidance in SFAS No. 141, Business Combinations.
Management evaluated the financial impact of these accounting adjustments and concluded that the effect both individually and in the aggregate was not material to any prior period consolidated financial statements and accordingly, prior period consolidated financial statements were not restated. Instead, the Company recorded a cumulative charge to net income in the year ended December 31, 2006 of $3.1 million pre-tax ($2.0 million after- tax) for these adjustments. Of the $3.1 million pre-tax charge, $4.3 million was recorded as a charge to realized investment gains, $3.5 million was recorded as a charge to equity in earnings of investees and $4.7 million was recorded as an increase to investment income on the consolidated statements of income.
For the year ended December 31, 2008, gross premiums written associated with the Company’s core commercial lines of business (excluding accident and health and “other” lines of business in the table above) declined by $253.7 million, or 23.3%, as compared to the year ended December 31, 2007, due to the combined effects of a decline in new business of approximately 36%, price decreases on renewal policies of approximately 7% and a decline in renewal retention rates of approximately five percentage points. The decline in new business is attributable to a reduction in both property and casualty writings. The property and casualty insurance market, like most others, has been affected by disruptions in the financial markets and the slow down in the economy and new business growth continues to remain very challenging. In addition to soft market conditions, the decline in gross premiums written is also due to underwriting actions taken by the Company to reduce unprofitable classes of business, most notably a reduction in the property and commercial automobile lines of business. The Company continues to maintain its disciplined approach to underwriting in this highly competitive market, renewing business and writing new business only where it believes rates are acceptable and terms and conditions appropriate for the exposure.
For the year ended December 31, 2007, gross premiums written in casualty lines decreased by $81.8 million, or 10.3%, as compared to the year ended December 31, 2006, due to a decline in new business of approximately 24% and price decreases on renewal policies of approximately 8%, partially offset by an increase in renewal retention rates of approximately three percentage points. The decline in new business was largely due to a decrease in general liability writings, attributable to the non-admitted business, where the market became significantly softer, leading to fewer new policies and at a reduced average premium per policy.
In recent years, the Company’s casualty business has also been adversely impacted by declining premiums from its California workers’ compensation business which has been affected by declining market prices as a consequence of system reforms and very favorable industry accident year results in recent years. More recently, prices appear to be stabilizing. California workers’ compensation gross premiums written totaled $65.7 million, $77.5 million and $97.4 million in 2008, 2007 and 2006, respectively.
For the year ended December 31, 2008 and 2007, other gross premiums written, which include the accident and health, surety, personal automobile and homeowners lines of business, increased by $28.3 million, or 17.9%, and $61.2 million, or 63.4%, respectively, as compared to the prior year periods. The increase in both years was primarily due to growth in the Company’s accident and health book of business. Previously written in the “B++” rated Fairmont companies, the accident and health business has continued to benefit from Crum & Forster’s “A” category A.M. Best rating, resulting in the Company acquiring several new programs. Additionally, in general, the accident and health business is not aligned with the traditional property and casualty market cycle which is currently experiencing very soft market conditions.
Premiums earned reflect the amount of net premiums written applicable to the portion of the policy term that expires in a given period. The Company generally earns premiums on a pro-rata basis over the period in which the coverage is provided. For the year ended December 31, 2008, premiums earned decreased by $188.1 million, or 15.9%, as compared to the year ended December 31, 2007. The lower decline in premiums earned relative to premiums written is principally attributable to the lag in recognition of the decreased premiums written in the latter half of 2008.
The Company’s losses and LAE reflect the effect of corporate aggregate reinsurance, including the amortization of deferred gain on retroactive reinsurance. For further discussion of the accounting for reinsurance coverage and the amortization of deferred income on retroactive reinsurance, see “Item 1. Business - Reinsurance” and Note 7 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Accident year loss and LAE ratios, as estimated at December 31, 2008 by line of business, are summarized as follows:
The accident year loss and LAE ratio increased from 67.4% in 2007 to 80.4% in 2008. The increase primarily reflects increased catastrophe losses (primarily the effects of Hurricanes Gustav and Ike which added 7.2 loss ratio points) as well as the adverse effect of current unfavorable pricing trends and market conditions across all lines of business. Catastrophes added approximately 9.1, 1.3 and 2.3 points to the Company’s loss and LAE ratio in 2008, 2007 and 2006, respectively, and added approximately 52.6, 5.5 and 9.9 points to the property accident year loss and LAE ratios. In addition to catastrophes, the 2008 property accident year loss ratio was also impacted by an increased frequency of large habitational fire losses.
The accident year loss and LAE ratios represent management’s estimate, at December 31, 2008, of the ultimate cost, expressed as a percentage of net premiums earned for each respective year, of covered claims or events, including settlement costs. For casualty lines of business in particular, where the “tail”, or period from the occurrence of the claim to final settlement, may span several years, the estimates are based on a number of assumptions and, accordingly, are subject to significant variability. See “- Critical Accounting Policies and Estimates - Unpaid Losses and Loss Adjustment Expenses”.
The Company’s policy acquisition ratio increased to 15.3% for the year ended December 31, 2008 from 15.0% for the year ended December 31, 2007, primarily due to a charge of $2.8 million (0.3 expense ratio points) associated with an assessment from the Texas Windstorm Insurance Association related to Hurricane Ike. The Company’s policy acquisition expense ratio increased to 15.0% for the year ended December 31, 2007 from 14.3% for the year ended December 31, 2006, primarily due to higher direct commission rates and lower reinsurance ceding commissions attributable to higher retained limits.
The decrease in investment income of $76.6 million, or 34.8%, in 2007 as compared to 2006, was primarily due to lower earnings from HWIC, which realized significant capital gains in 2006, as well as lower earnings from other partnerships in 2007 as compared to 2006. Earnings from HWIC and other partnerships were $7.7 million and $5.3 million, respectively, in the year ended December 31, 2007 and $60.5 million and $27.3 million, respectively, in the year ended December 31, 2006. Partially offsetting these effects were lower investment fees in 2007 compared to 2006.
Net realized investment gains for the years ended December 31, 2008, 2007 and 2006 are summarized as follows:
The increase in net realized investment gains of $297.8 million, or 127.2%, in 2008 as compared to 2007 was principally due to substantially higher net realized gains on the Company’s total return swaps, credit default swaps and short-sale obligations, attributable to widening credit spreads and declining equity markets and higher net realized gains on sales of fixed income securities, primarily U.S. Treasuries, partially offset by higher mark-to-market losses attributable to the change in fair value of held-for-trading fixed income securities and assets for which the Company has elected the fair value option under SFAS 159, and higher other than temporary impairment charges.
At December 31, 2008, the Company owned $3.0 billion notional amount of credit default swaps with an average term to maturity of 3.1 years, an original cost of $42.5 million and a fair value of $138.8 million. At December 31, 2007, the Company owned $5.2 billion notional amount of credit default swaps, with an original cost of $84.5 million and a fair value of $234.1 million.
During 2008, the Company liquidated substantially all of its U.S. Treasury portfolio, realizing net gains of approximately $143.2 million. Partially offsetting these gains were mark-to-market losses incurred on the change in fair value of held-for-trading fixed income securities of approximately $90.8 million.
Losses on other invested assets in 2008 are principally attributable to mark-to-market losses of $40.8 million related to the change in fair value of the Company’s investment in Northbridge, which the Company elected to account for at fair value under SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115 (“SFAS 159”), effective January 1, 2008. For further details on SFAS 159, refer to Note 2 to the consolidated financial statements.
Included in realized investment gains in 2008, 2007 and 2006 were $194.7 million, $25.4 million and $15.9 million, respectively, of losses related to other than temporary impairments. The impairments recognized in 2008 were primarily due to the increased volatility in the financial markets resulting from the global credit and liquidity crisis. At December 31, 2008, the Company had unrealized losses of $137.9 million in investments in available-for-sale fixed income and equity securities of which $22.5 million was attributed to fixed income securities and $115.4 million was attributed to equity securities. Substantially all of these securities have been in an unrealized
loss position for less than three consecutive months. Unrealized losses in the equity securities portfolio are primarily attributable to three securities which account for $92.6 million, or 80.3%, of the losses. These three securities have losses, exceeding their cost of between 32% and 42% at December 31, 2008. If the current economic downturn and financial market volatility continue through 2009, the Company may determine that some of those declines in value are other than temporary and, accordingly, record further impairment charges in 2009.
The effective income tax rate (including income taxes on equity in earnings of investees) was 21.0%, 34.2% and 34.3% for the years ended December 31, 2008, 2007 and 2006, respectively. The difference between the Company’s effective income tax rate and the statutory rate of 35% was primarily due to the benefit of dividends received deductions in all three years and, in 2008, benefits recognized related to the utilization of foreign tax credits associated with the sale of the Company’s investment in Northbridge. In December 2008, the Company sold its investment in Northbridge to an affiliated foreign company, which resulted in permanent tax benefits of approximately $51.6 million, mainly as a result of the utilization of foreign tax credits. For further discussion of income taxes, see Note 9 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The Company participates in a tax sharing agreement with Fairfax, entered into in 2007, that permits the Company and its subsidiaries to elect to file federal income tax returns on a consolidated basis for tax sharing purposes. The Company made that election effective January 1, 2007 which resulted in the utilization of its cumulative holding company net operating losses (“NOLs”) in that year, and the avoidance of the generation of holding company NOLs going forward, provided the subsidiaries earn sufficient taxable income to offset holding company losses arising principally from interest on the Company’s senior notes.
Cash used in financing activities was $339.5 million, $118.5 million and $90.0 million in 2008, 2007 and 2006, respectively, and was primarily in respect of dividends paid to Fairfax as well as refinancing of the Company’s long-term debt in 2007. During 2008, the Company paid cash dividends to Fairfax of $335.2 million and in-kind dividends in the form of fixed income securities, at fair value, of $158.8 million, resulting in total dividends paid of $494.0 million.
Shareholder’s equity was $1,166.4 million and $1,293.5 million at December 31, 2008 and 2007, respectively. The decrease was primarily the result of dividends paid to Fairfax of $494.0 million, partially offset by current year earnings of $332.8 million.
The aggregate carrying value of the Company’s investment portfolio, including cash and cash equivalents and assets pledged for derivatives and short-sale obligations, was approximately $4.0 billion and $4.5 billion at December 31, 2008 and 2007, respectively, of which $709.8 million and $343.6 million was held in cash, cash equivalents and short-tem investments at December 31, 2008 and 2007, respectively. For detailed information on the Company’s investment portfolio, see Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
At December 31, 2008 and 2007, 86.7% and 94.0%, respectively, of the Company’s fixed income securities were rated investment grade. Fixed income securities and cash and cash equivalents of $403.9 million and $431.9 million were on deposit with various state regulatory authorities at December 31, 2008 and 2007, respectively, as required by insurance laws.
Statutory surplus is an important measure utilized by management, regulators and rating agencies to assess the Company’s ability to support its business operations. The decrease in the Company’s statutory surplus from 2007 to 2008 is attributable to the payment of $511.3 million of dividends from the insurance subsidiaries to Crum & Forster Holdings Corp. and net unrealized capital losses of $224.2 million, partially offset by statutory net income of $484.0 million. The increase in the Company’s combined statutory surplus in 2007 as compared to 2006 was primarily attributable to statutory net income of $191.7 million and net unrealized capital gains of approximately $175 million, partially offset by dividends of $138.2 million paid to the insurance companies’ parent. The Company’s ratio of statutory net premiums written to surplus, a measure of operating leverage, improved in 2008 and, according to data from A.M. Best, was below the property and casualty commercial lines sector ratios for 2007, 2006 and 2005 of 0.8x, 0.9x and 1.0x, respectively.
The Company has outstanding $330.0 million aggregate principal amount of 73/4% senior notes due 2017. Interest payments on such notes are approximately $25.6 million per year. For additional information on the Company’s senior notes, see Note 8 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” and “- Liquidity and Capital Resources - Holding Company”.
Included in other long-term liabilities are estimated payments under the Company’s long-term incentive plans totaling $33.2 million, expected contributions to postretirement benefit plans sponsored by the Company totaling $9.6 million and payments to former senior officers of the Company totaling $14.7 million.
The postretirement obligations are estimated ultimate payments required to provide medical and life insurance benefits. Actual payments may differ significantly from these estimates. Although the Company provides various benefit plans, programs and arrangements to its employees, the Company has reserved the right to amend, modify or terminate these plans, programs or arrangements at any time, subject to the terms and conditions of such plans, programs or arrangements and applicable law. For more information on the Company’s postretirement benefit plans, see Note 11 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The Company did not have any transactions, agreements or other contractual arrangements with an unconsolidated entity that would be considered an off-balance sheet arrangement required to be disclosed pursuant to Item 303(a)(4)of Regulation S-K.
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2008, 2007 and 2006
As described in Note 2 of the consolidated financial statements, the Company changed its method of accounting for certain equity method investments on January 1, 2008.
Effective January 1, 2006, Fairfax announced that certain of the business of the insurance companies of Fairmont Specialty Group, affiliates of Fairfax, would be conducted as Fairmont Specialty, a division of Crum & Forster (“Fairmont”), thereby giving Fairmont access to the then “A-” A.M. Best rating of Crum & Forster. A.M. Best upgraded the financial strength ratings of the Crum & Forster companies to “A” in June 2008. The Fairmont business is comprised of standard commercial and personal lines, bail bonds and accident and health coverages. In return for the opportunity to quote Fairmont Specialty Group’s renewals effective January 1, 2006 and thereafter, the Company hired substantially all Fairmont Specialty Group employees and assumed certain operating obligations. Pending regulatory approval of Crum & Forster company rate and form filings for the Fairmont business, the policies underwritten by Fairmont were issued initially by the insurance companies of Fairmont Specialty Group and assumed by the Company through a 100% quota share reinsurance agreement. Since the second half of 2007, substantially all Fairmont business has been written directly by Crum & Forster.
The Company’s fixed income and equity securities, the majority of which are classified as available-for-sale, are carried at fair value. Fair value is defined as the amount that would be received for an asset in an orderly transaction between market participants at the measurement date. The Company is responsible for determining fair values by utilizing quoted market prices in active markets for identical securities or other inputs, such as quoted market prices for similar securities that are observable, either directly or indirectly and by employing valuation techniques which make use of current market data. U.S. Treasury, corporate and municipal fixed income securities are priced using broker-dealer quotes. Equity securities prices are obtained from market exchanges. Unrealized gains or losses on the Company’s available-for-sale fixed income and equity securities, net of applicable taxes, are included in other comprehensive income.
investments and equity securities attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment. Factors considered by management include, but are not limited to, the impact of issuer-specific events, current and expected future market and economic conditions, the nature of the investment, the number of investment positions with losses, the severity and duration of the impairment and the volatility of the security’s market price.
Fixed income securities classified as held-for-trading include those purchased for short term investment objectives and those designated as such by management pursuant to the fair value option under SFAS 155. These securities include convertible securities with embedded derivatives (which allow the Company to convert the fixed income securities to equity securities) and mortgage-backed securities purchased at deep discounts to par. Held-for-trading securities are recorded at fair value in the consolidated balance sheets with changes in fair value recognized as realized investment gains and losses in the consolidated statements of income in the period in which they occur. See the “Recent Accounting Pronouncements - SFAS 155” section of this note for further details of the accounting treatment of convertible securities, also known as hybrid financial instruments.
The Company utilizes derivatives to mitigate financial risks arising principally from its investment holdings and receivables. Derivatives including credit default swaps, total return swaps, warrants, Eurodollar futures contracts and equity index options, that are not specifically designated or do not meet the requirements for hedge accounting, are carried at fair value on the consolidated balance sheets with changes in fair value recorded in realized investment gains or losses on the consolidated statements of income.
Goodwill is subject to an assessment of impairment on an annual basis or more frequently under certain circumstances. The assessment of impairment involves a two-step process whereby an initial assessment for potential impairment is performed followed by a measurement of the impairment, if any. Impairments are charged to operations in the period in which the impairment occurs. The Company’s annual impairment tests in 2008 and 2007 resulted in a conclusion that no goodwill impairment has occurred. Goodwill in the amount of $7,311 is included in other assets on the consolidated balance sheets at December 31, 2008 and 2007.
Premiums withheld from reinsurers pursuant to reinsurance contracts are included in funds held under reinsurance contracts on the consolidated balance sheets. Interest accrues on these funds in accordance with the contract terms and is included as a reduction of investment income on the consolidated statements of income.
Deferred income taxes are provided for temporary differences between the financial statement and tax bases of assets and liabilities. Such differences relate principally to deferred income on retroactive reinsurance, unpaid losses and LAE, unearned premiums, certain realized gains and losses, deferred policy acquisition costs, unrealized net appreciation of investments and employee benefit plans. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all, or some portion of, the benefits related to deferred tax assets will not be realized. As of December 31, 2008 and 2007, a valuation allowance was not required.
SFAS No. 159. On January 1, 2008, the Company adopted SFAS 159, which provides the option to measure many financial instruments and certain other items at fair value primarily on an instrument-by-instrument basis, that are not otherwise accounted for at fair value under other accounting standards. The election to use the fair value option is available at specified election dates, such as when an entity first recognizes a financial instrument. Subsequent changes in fair value are recorded through earnings. Additionally, SFAS 159 allows for a one-time election for existing eligible financial instruments upon adoption, with the transition adjustment recorded to beginning retained earnings. Upon adoption of SFAS 159, the Company elected to apply the fair value option to its investment in Northbridge Financial Corporation (“Northbridge”), an affiliated company traded on the Toronto Stock Exchange, which was previously accounted for under the equity method of accounting. The Company has also elected the fair value option for its investments in Advent Capital (Holdings) PLC (“Advent”), an affiliated company traded on the Alternative Investment Market of the London Stock Exchange, and Odyssey Re Holdings Corp. (“Odyssey”), an affiliated company traded on the New York Stock Exchange. The Company elected the fair value option for its investment in Advent, rather than the equity method of accounting, which would otherwise have been applied as a result of Fairfax gaining majority ownership of Advent during the third quarter of 2008. Previously, the Company’s investment in Advent was recorded at fair value, pursuant to SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”), with changes in fair value recorded through other comprehensive income. The Company’s investments in Odyssey include investments in Odyssey’s common and preferred stock. The investment in common stock was acquired in December 2008 and would have been subject to the equity method of accounting as Fairfax is a majority owner in Odyssey. The investment in preferred stock was previously recorded at fair value, pursuant to SFAS 115, with changes in fair value recorded through other comprehensive income.
The Company’s investment in Northbridge, which was sold in December 2008, is included in investments at equity on the consolidated balance sheet at December 31, 2007. At December 31, 2007, the carrying value of Northbridge was $200,484 and the fair value was $289,812 ($288,870 after restating for the adoption of SFAS 157, effective January 1, 2008, discussed further below). Upon adoption of SFAS 159, the Company recorded a cumulative adjustment of $89,328 to derivatives and other invested assets to recognize the difference between the fair value and carrying value of Northbridge, a deferred tax liability of $31,265 and a $58,063 adjustment (comprised of a reduction of $29,376 to opening accumulated other comprehensive income and an increase of $87,439 to opening retained earnings), net of tax, to opening shareholder’s equity. For the year ended December 31, 2008, the change in fair value of Northbridge was a loss of $40,804, which was recorded through earnings, in realized investment gains and losses, in the consolidated statements of income. Dividends of $4,798 were received from Northbridge for the year ended December 31, 2008 and have been recorded as investment income in the consolidated statement of income.
The Company’s investment in Advent is included in derivatives and other invested assets on the consolidated balance sheet at December 31, 2008 and in equity securities at December 31, 2007. At December 31, 2008 and 2007, the carrying and fair value of Advent was $11,607 and $15,996, respectively. Since Advent was previously recorded at fair value, the SFAS 159 election had no effect on the carrying value of Advent or shareholder’s equity. Upon election of SFAS 159 for Advent, the Company recorded a realized loss of $5,945
SFAS No. 157, FSP FAS 157-2 and FSP FAS 157-3. On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 also establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques. The fair value hierarchy is designed to indicate the relative reliability of fair value measurement. The highest priority is given to quoted prices in active markets and the lowest to unobservable data. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company determines fair value of its investments using inputs that are published exchange prices, third party broker quotes or quoted prices for similar securities. Concurrent with the adoption of SFAS 157, the Company established a policy for those securities measured on the basis of bid-ask prices to use the bid price for long positions (assets), which reflects the highest price that a buyer is willing to pay for an asset, and the ask price for short positions (liabilities), which represents the lowest price a seller is willing to accept for an asset. Prior to the adoption of SFAS 157, the Company used a market price within the bid-ask spread. Upon adoption of SFAS 157, the Company recorded a cumulative adjustment of $1,859, net of tax, to opening shareholder’s equity (comprised of a reduction of $521 to opening accumulated other comprehensive income and a reduction of $1,338 to opening retained earnings).
In February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”), which permits a one year deferral of the application of SFAS 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This deferral is effective until fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. At that time, the provisions of SFAS 157 will apply to non-financial assets and non-financial liabilities that are measured at fair value on a non-recurring basis. The Company does not expect the adoption of SFAS 157 for non-financial assets and non-financial liabilities to have a material impact on its financial position or results of operations.
On October 10, 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (“FSP FAS 157-3”), which clarifies the application of SFAS 157 in a market that is not active and provides guidance in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 is effective upon issuance, including prior periods for which financial statements have not been issued. Adoption of this FSP did not affect the Company’s financial position or results of operations.
SFAS No. 161. In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities - an Amendment of FASB Statement No. 133 (“SFAS 161”), which is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures about: (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008. Since SFAS 161 requires only additional disclosures concerning derivatives and hedging activities, adoption of SFAS 161 will not affect the Company’s financial position or results of operations.
SOP 07-1. In June 2007, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 07-1, Clarification of the Scope of the Audit and Accounting Guide for Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies (“SOP 07-1”), which provides guidance for determining whether an entity is within the scope of the AICPA Audit and Accounting Guide for Investment Companies. For those entities that are investment companies under the SOP, it also addresses whether investment company accounting should be retained by a parent company in consolidation or by an investor that has the ability to exercise significant influence over the investment company and applies the equity method of accounting to its investment in the entity. In addition, the SOP includes certain disclosure requirements for parent companies and equity method investors in investment companies that retain investment company accounting in the parent company’s consolidated financial statements or the financial statements of an equity method investor. The Company anticipates that the adoption of SOP 07-1 will not have a material effect on its results of operations or financial position. In February 2008, the FASB issued FASB Staff Position SOP 07-1-1, Effective Date of AICPA Statement of Position 07-1, which provides an indefinite deferral of SOP 07-1.
Includes U.S. Treasury securities pledged for short-sale obligations at a fair value of $308,480 (amortized cost of $312,439).
Changes in net unrealized investment gains and losses, net of transfers to realized gains and losses, and the related tax effects, are summarized as follows:
The majority of the gross unrealized losses of $22,492 in the fixed income portfolio at December 31, 2008 are attributable to investment grade municipal bonds, substantially all of which are fully insured by Berkshire Hathaway Assurance Corp. for the payment of interest and principal in the event of issuer default. Without the benefit of insurance, these bonds would still be rated AA or A. The Company has the ability and intent to hold these securities for a period of time sufficient to allow a market recovery, or to maturity if necessary. Of the 31 fixed income securities in a loss position at December 31, 2008, nine had a loss that exceeded 10% of their cost. However, no fixed income security had a loss that exceeded 20% of its cost.
The contractual maturity of the Company’s fixed income securities in an unrealized loss position is summarized as follows:
Fixed income securities classified as held-for-trading include those purchased for short-term investment objectives and those designated as such by management pursuant to the fair value option under SFAS 155. These securities, which are recorded at fair value on the consolidated balance sheets, include convertible securities with embedded derivatives and mortgage-backed securities purchased at deep discounts to par. Changes in fair value of held-for-trading securities are recognized as realized investment gains and losses in the consolidated statements of income in the period in which they occur and amounted to $90,891 and $30,904 for the years ended December 31, 2008 and 2007, respectively. The Company did not hold any held-for-trading securities during 2006. The fair values of these securities were $233,998 and $125,848 at December 31, 2008 and 2007, respectively. At December 31, 2007, held-for-trading securities were comprised entirely of convertible securities with embedded derivatives.
Included in held-for-trading securities are two convertible securities issued by Level 3 Communications, Inc (“Level 3”) with a combined value of $132,784, which together with an investment in Level 3 common stock of $16,829, represented 12.8% of shareholder’s equity at December 31, 2008.
Investments at equity include investments in entities that are consolidated subsidiaries of Fairfax, but are less than 50% owned by the Company, as well as investments in certain partnerships, accounted for under the equity method of accounting. These investments consist of equity interests of between 1.4% and 40.0% at December 31, 2008, with a total carrying value of $103,959 and $384,030 at December 31, 2008 and 2007, respectively.
For the years ended December 31, 2008, 2007 and 2006, total (losses) earnings of investments at equity were $(51,972), $48,831 and $108,011, respectively. (Losses) earnings of investment companies and similar equity method investees of $(51,263), $12,985 and $87,762 in 2008, 2007 and 2006, respectively, are included in investment income on the consolidated statements of income. Pre-tax (losses) earnings of other equity method investees of $(709), $35,846 and $20,249 in 2008, 2007 and 2006, respectively, are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from other equity method investees were $475, $5,318 and $5,113 in 2008, 2007 and 2006, respectively. Due to the timing of receipt of financial information reported by investees, results attributable to investments at equity are generally reported by the Company on a one month or one quarter lag.
Included in investments at equity at December 31, 2007, is the Company’s investment in Northbridge, which had a carrying value of $200,484. This investment, which was sold during December 2008, was accounted for under the equity method prior to the Company electing the fair value option under SFAS 159, effective January 1, 2008. For the years ended December 31, 2007 and 2006, pre-tax equity in earnings of Northbridge were $35,079 and $17,907, respectively, and were included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from Northbridge were $4,795 and $4,545 in 2007 and 2006, respectively. For further details on the accounting for Northbridge see the “Recent Accounting Pronouncements Adopted - SFAS 159” section of Note 2 to the consolidated financial statements. For further details on the sale of Northbridge refer to the “Investments in Related Parties” section below.
The Company utilizes derivatives and short positions to mitigate financial risks arising principally from its investment holdings and receivables. Derivatives including credit default swaps, total return swaps, warrants, Eurodollar futures contracts and equity index options, that are not specifically designated or do not meet the requirements for hedge accounting, are carried at fair value on the consolidated balance sheets with changes in fair value recorded in realized investment gains or losses on the consolidated statements of income.
The following table summarizes the Company’s derivatives and short positions at December 31, 2008 and 2007. The fair value of derivatives are included in derivatives and other invested assets on the consolidated balance sheets and the fair values of the obligations to purchase the securities sold short are included in the balance sheet in short-sale obligations.
therefore only be known upon their disposition. Counterparties to the credit default swaps expose the company to credit risk in the event of non-performance, which Fairfax and the Company endeavor to limit through the terms of agreements negotiated with the counterparties. Pursuant to the swap agreements, the counterparties are required to pledge cash or U.S. Treasury securities as collateral, in the event that appreciation in the fair value of the credit default swaps meets certain thresholds. The fair value of this collateral, which is not reflected on the Company’s balance sheet, is held by an independent custodian in the name of Fairfax on behalf of the Company, or directly in the name of the Company, and amounted to $89,716 at December 31, 2008. The Company has the right to sell or repledge $54,508 of this collateral, which it has not exercised. The Company believes that any remaining credit risk exposure, represented by the uncollateralized fair value of the credit default swaps ($49,114 at December 31, 2008), is low given the diversification among the various counterparties.
A maturity analysis of the credit default swaps at December 31, 2008 is summarized as follows:
At December 31, 2007, as an economic hedge against a decline in the U.S. equity markets and deteriorating conditions in the credit markets, the Company held short positions in SPDRs and common stocks of certain U.S. financial institutions. During the second quarter of 2008, the Company closed out its short positions and substantially replaced these investments with equity index total return swaps and other company specific total return swaps. The replacement of the short positions with total return swaps was primarily to reduce margin maintenance requirements and counterparty credit risk. The Company had also purchased S&P Index call options (the “call options”) to limit the potential loss on the short positions and swaps. Changes in fair value of the total returns swaps, short positions and call options are recorded as realized investment gains or losses in the consolidated statements of income in the period in which they occur. The Company closed out all of its total return swaps in the fourth quarter of 2008 and as of December 31, 2008, did not have any total return swaps or short positions. At December 31, 2007, the short positions were recorded at fair value in short-sale obligations on the consolidated balance sheet.
The Company has investments in warrants ($0 fair value at December 31, 2008), which are contracts that grant the holder the right to purchase an underlying financial instrument at a given price and time. Warrants are recorded at fair value with changes in fair value recognized as realized investment gains or losses in the period in which they occur.
During the third quarter of 2008, the Company entered into Eurodollar futures contracts to manage interest rate risk. The Eurodollar futures contracts are settled on a daily basis with changes in fair value recognized as realized investment gains or losses in the period in which they occur.
Further analysis of the 2008 and 2007 realized gains is set forth in the tables below. The realized gains or losses on disposal represent inception to date gains or losses:
The notional amount and related proceeds of the credit default swaps sold in 2007 was $121,290 and $22,400, respectively.
Other invested assets include investments for which the Company has elected the fair value option under SFAS 159, effective January 1, 2008 and investments in partnerships where the Company has an ownership interest of less than 20% and does not have the ability to exercise significant influence. Other invested assets had a carrying value of $287,544 and $7,462 at December 31, 2008 and 2007, respectively. At December 31, 2008, investments for which the Company has elected the fair value option under SFAS 159 include the Company’s investments in Odyssey common stock, Odyssey preferred stock and Advent at fair values of $256,570, $5,740 and $11,607,
At December 31, 2008 and 2007, cost has been reduced by an other than temporary impairment charge of $7,253.
On December 30, 2008, the Company purchased an 8.2% interest in Odyssey common shares, from TIG Insurance Group, Inc. (“TIG”), a Fairfax affiliate, for $246,066. As consideration for its investment in Odyssey, the Company released its Fairfax Inc. note (discussed below) of equal fair value.
On December 23, 2008, the Company sold its 15.7% interest in Northbridge to nSpire Re Limited (“nSpire”), a Fairfax affiliate, for $248,066 and received a Fairfax Inc. note held by nSpire of equal value. Since Northbridge was accounted for at fair value, no gain or loss was recorded on the sale.
On December 15, 2008, the Company liquidated its interest in TPF, recording a realized investment loss of $171. The Company recorded pre-tax equity losses of $18,618 on TPF for the year ended December 31, 2008 and has incurred inception to date losses of approximately $20,000 on its investment in TPF. In September 2008, the Company transferred a portion of its interest in TPF to TIG at net carrying value at the date of sale, for cash consideration of $6,516.
On November 7, 2008, the Company released its TPF, L.P convertible debenture in exchange for securities in an amount of $331, resulting in a realized loss of $2,169.
On September 23, 2008, October 24, 2008 and December 30, 2008, the Company purchased additional shares in Advent for cash consideration totaling $4,096 and thereby increased its ownership interest in Advent to 11.7% from 8.1%.
On December 11, 2007, the Company sold 116,000 shares of HWIC stock to Fairfax in exchange for a note of $12,993 and recorded a realized investment gain of $2,658.
At December 31, 2008 and 2007, the Company had pledged $4,416 and $1,043,436, respectively, as collateral for its derivative securities and obligations to purchase securities sold short. Of the $1,043,436 held at December 31, 2007, $734,956 was held in cash and $308,480 was held in U.S. Treasury securities, at fair value. These amounts are included in assets pledged for derivatives and short-sale obligations on the consolidated balance sheets. The substantial reduction in the pledged collateral from 2007 was due to the short positions being closed out during 2008.
The components of net investment income for the years ended December 31, 2008, 2007 and 2006 are summarized as follows:
Includes interest of $16,394, $25,609 and $16,893 in 2008, 2007 and 2006, respectively, on cash collateral pledged for derivatives and short-sale obligations.
Included in realized investment losses for the years ended December 31, 2008, 2007 and 2006 are $194,670, $25,443 and $15,857, respectively, of other than temporary impairment charges. The amount for 2008 includes write-downs of $190,305 attributable to equity securities and $4,365 attributable to fixed income securities. The amount for 2007 includes write-downs of $22,461 attributable to equity securities and $2,982 attributable to fixed income securities. The amount for 2006 is attributable to write-downs of equity securities only. The impairments recognized in 2008 were primarily due to the increased volatility in the financial markets resulting from the global credit and liquidity crisis.
For further details of realized gains or losses attributable to the Company’s derivatives transactions and short-sale obligations, refer to the section above “Derivative Securities and Short-Sale Obligations’.
The Company is responsible for determining the fair value of its investment portfolio by utilizing quoted market prices in active markets for identical securities or other inputs, such as quoted market prices for similar securities that are observable, either directly or indirectly and by employing valuation techniques which make use of current market data. For determining the fair value of its Level 1 investments (approximately 33% of total investment portfolio at fair value), the Company utilizes quoted market prices. The Company’s Level 1 investments include exchange-traded securities in active markets.
The Company’s Level 2 investments (approximately 65% of total investment portfolio at fair value), the majority of which are in government, corporate and municipal securities, are priced using publicly traded over-the-counter prices and broker-dealer quotes. Observable inputs such as benchmark yields, reported trades, broker-dealer quotes, issuer spreads and bids are available for these investments. For determining the fair value of credit default swaps, which are classified as Level 2, the Company utilizes broker-dealer quotes which include observable credit spreads. Also included in Level 2 investments are inactively traded convertible corporate debentures which are valued using a pricing model and include observable inputs such as credit spreads and discount rates in the calculation.
The following table provides a summary of changes in fair value of Level 3 financial assets for the year ended December 31, 2008.
For the years ended December 31, 2008, 2007 and 2006, the Company’s calendar loss and LAE ratios were 82.5%, 63.5% and 61.5% , respectively, of which 80.4%, 68.9% and 70.3%, respectively, were attributable to losses occurring in the current accident year and 2.1%, (5.4)% and (8.8)%, respectively, were attributable to adverse (favorable) development of prior years’ losses. The deterioration in the 2008 accident year ratio as compared to 2007 is primarily attributable to the impact of catastrophe losses of $71,500 associated with Hurricanes Gustav and Ike which contributed 7.2 loss ratio points, adverse development in property where there were several large fire losses, adverse development in commercial automobile where the company experienced increased large loss activity and the effects of current unfavorable pricing trends and market conditions. The improvement in the 2007 accident year loss ratio as compared to 2006 was primarily due to lower catastrophe losses, partially offset by the continued adverse effects of price softening in the California workers’ compensation business which the Company has experienced since 2005. In addition, accident year 2006 was also adversely affected by unfavorable loss emergence in property, due to an increased frequency of large fire losses. Refer to Note 14 to the consolidated financial statements for a schedule of the accident year loss and LAE ratios by line of business.
The Company discounts workers’ compensation indemnity reserves using an interest rate of 5%. The amount of related discount was $56,577 and $62,337, at December 31, 2008 and 2007, respectively.
Net losses incurred for asbestos claims in 2008, 2007 and 2006 were primarily attributable to developments related to one policyholder with whom the Company settled a lawsuit in the first quarter of 2008. Net losses and ALAE paid for 2008 include $22,700 related to this claim.
Crum & Forster’s underwriting results are significantly affected by reinsurance. The net impact of ceded reinsurance transactions for each of the fiscal years 2008, 2007 and 2006 is summarized as follows:
The Company currently purchases, or has in the past purchased, reinsurance to limit its exposure to loss from any one claim or occurrence (“per risk or per occurrence reinsurance”), from aggregate loss experience for an accident year that exceeds an amount the Company is willing to accept and from adverse development of prior years’ loss and loss adjustment expenses (“LAE”) reserves (the latter two types of reinsurance are referred to herein as “corporate aggregate reinsurance”, as distinct from the aforementioned “per risk or per occurrence reinsurance”). The Company’s corporate aggregate reinsurance contracts are of the type commonly referred to as “finite” reinsurance and cover or covered, in varying amounts and on varying terms, accident years 2002 and prior. The majority of these contracts have been commuted or had limits paid. The Company has not purchased corporate aggregate reinsurance since 2001 and does not currently have plans to purchase corporate aggregate reinsurance in the future. At December 31, 2008, only one retroactive contract with a remaining limit of $51,000 and one prospective contract with a remaining limit of $96,272 remain in effect.
Corporate aggregate reinsurance contracts provide either current accident year protection or adverse development protection related to prior accident years. In general, contracts covering future insurable events are referred to as “prospective reinsurance” and contracts covering past insurable events, such as adverse loss development covers, are categorized as “retroactive reinsurance”. Coverage under retroactive reinsurance contracts is generally triggered when the loss ratio for the subject period exceeds a specified level, or when reserves related to all periods prior to a certain date exceed a stated amount. The Company will recover ceded losses and LAE from its reinsurers as it settles the related claims, which may occur over many years. These contracts may provide for future payments to be made by Crum & Forster when it cedes losses under such policies and may also provide that interest expense is charged to the Company, for the benefit of the reinsurers, on any premiums withheld.
Amounts ceded under prospective contracts are recognized, as to premiums, as a reduction of premiums written and earned in the period in which premiums are ceded and, as to losses, as a reduction of incurred losses as the losses are ceded to the reinsurer. Under retroactive contracts, the excess of reinsurance recoverable due from reinsurers pursuant to the contract over premiums paid for coverage is deferred and amortized as a reduction of incurred losses over the expected period of recovery, generally many years, using the interest method. Under both prospective and retroactive contracts, funds held interest, if applicable, is recognized as a reduction of investment income in the period in which the interest is credited to the funds held account.
At December 31, 2008, reinsurance recoverable includes $349,000 related to one retroactive corporate aggregate reinsurance contracts, of which $83,875 has been recognized as a reduction of incurred losses and LAE on the Company’s consolidated statements of income. At December 31, 2007, reinsurance recoverable includes $396,219 and $388,248 related to prospective and retroactive corporate aggregate reinsurance contracts, respectively, of which $493,9771
had been recognized as a reduction of incurred losses and LAE on the Company’s consolidated statements of income as of December 31, 2007.
a result of the commutation the Company received cash proceeds of $302,500, of which $287,375 was recorded in prospective corporate aggregate reinsurance activity and $15,125 was recorded in retroactive corporate aggregate reinsurance activity. The Company also recorded a decrease of $386,748 in the reinsurance recoverable balance, of which $367,500 was attributable to the prospective contract and $19,248 was attributable to the retroactive amendment. The financial statement effect of the commutation was a non-cash pre-tax charge of $84,248, offset by the release of the unamortized deferred gain balance of $8,778 (related to the retroactive amendment), resulting in a net charge to incurred losses and LAE of $75,470 on the consolidated statement of income for the year ended December 31, 2008. Of this amount $80,125 has been charged to prospective corporate aggregate reinsurance activity and included in losses and LAE above and $4,655 has been credited to retroactive corporate aggregate reinsurance activity.
The second contract is an aggregate stop loss agreement with unaffiliated reinsurers covering accident year 2000, which provided coverage of $118,493 and was fully utilized by the Company at December 31, 2004. This stop loss agreement covered the casualty lines of business. The contract provided 29 loss ratio points of coverage in excess of a loss and ALAE ratio of 66% for covered losses. The contract was on a funds held basis with interest credited at 7.5%. Premiums and losses ceded pursuant to the contract, all of which were ceded prior to 2006, totaled $76,353 and $118,493, respectively. On March 31, 2008, the Company commuted this contract and in accordance with the terms of the commutation agreement, the Company commuted ceded loss reserves of $32,348 in consideration of release to the Company of the funds held balance of $31,952 resulting in a commutation loss of $396 which was charged to incurred losses and LAE on the consolidated statement of income for the year ended December 31, 2008.
The third contract, which remains in effect, covers accident years 2000 through 2002 and has an unused limit available of $96,272 in the event the net loss and LAE ratio for accident year 2002, before the effect of this contract, exceeds 70%. The subject loss and LAE ratio as valued at December 31, 2008 is 63.2%. No additional premium or funds held interest would be due under this contract upon usage of the remaining limit. Coverage of accident year 2000 has been exhausted and recovered in full and accident year 2001 was commuted. There have been no premium cessions since 2002 and no loss cessions under this contract. The reinsurer under this contract is nSpire, a Fairfax affiliate.
The above activity arises from two retroactive contracts of which only the 2001 retroactive adverse development contract for $400,000 remains in effect at December 31, 2008. This contract covers substantially all lines of business and provides $400,000 of limit in excess of a retention for accident years 2000 and prior, subject to a $200,000 sublimit on 1998 and prior accident years and an asbestos and environmental sublimit of $100,000. Premiums are currently based on 35% of amounts ceded plus a reinsurer margin of $8,000. The contract contains provisions that would increase the premium rate to as high as 62% under conditions that Company management considers unlikely. The contract is on a funds held basis with interest credited at 7%. At December 31, 2008, the Company had ceded cumulative losses of $349,000, which is comprised of $(20,000) in 2008, $(3,577) million in 2007, $(4,443) in 2006 and $377,020 prior to 2006 and paid premiums of $143,848, which is comprised of $(8,186) million in 2008, $(1,273) in 2007, $(796) in 2006 and $154,103 prior to 2006, related to this contract. At December 31, 2008 and 2007, the Company had reinsurance recoverable balances of $349,000 and $369,000, respectively, and funds held balances of $220,843 and $218,889, respectively, related to this agreement.
The second contract, which was commuted on June 26, 2008, covered all lines of business and provided $100,000 of limit in excess of a retention for accident periods prior to August 13, 1998, the date of acquisition of the Company by Fairfax. The contract contained sublimits relating to asbestos, environmental and latent, construction defect and other losses and is subject to a maximum economic loss provision. Premium for this contract was $32,597, all of which was paid prior to 2006. The contract was on a funds held basis with interest credited at 7%. At December 31, 2007, the Company had no cumulative ceded losses under this contract. The commutation had no impact on the financial statements as the Company had previously reduced the reinsurance recoverable balance by funds held pursuant to the commutation provision contained in the contract.
The premiums for both contracts are included in funds held under reinsurance contracts on the consolidated balance sheets and the reinsurance recoverable due from reinsurers in excess of amounts paid for the coverage are reflected on the balance sheets as deferred income on retroactive reinsurance. Such deferred income is amortized based on the expected amount and timing of future recoveries, using the interest method. The Company amortized deferred income of $18,950 in 2008, $13,673 in 2007, $12,889 in 2006 and $49,686 prior to 2006. This amortization of deferred income is included as a reduction of losses and LAE in the consolidated statements of income.
In addition to the two contracts noted above, the Company amended its prospective 1998 aggregate stop loss agreement, discussed above under prospective corporate aggregate reinsurance, to provide an additional $19,248 of coverage for a premium of $7,925, which was recorded in 2001. This contract amendment, which was commuted in 2008, was treated as retroactive reinsurance. Amortization of deferred income on this amendment is included in the amortization amounts previously discussed. The effect of commutation was a loss of $4,123 offset by $8,778 of unamortized deferred income released on commutation which resulted in a net pre-tax credit of $4,655 included in losses and LAE on the consolidated statement of income for the year ended December 31, 2008.
Concurrent with the issuance of the 2013 Notes, the Company entered into a non-interest bearing standby credit agreement, subordinate to the notes, whereby Fairfax agreed, under certain conditions, to lend up to $40,000 to the Company to meet certain corporate obligations. With the refinancing of the 2013 Notes in May 2007, the obligation to maintain the credit facility was terminated. As a result, the credit facility, which was never drawn upon and was cancellable at the option of the Company, was cancelled effective October 1, 2008.
Income tax expense shown on the consolidated statements of income excludes $(248), $12,546 and $7,087 of deferred income tax (benefit) expense on equity in earnings of investees in 2008, 2007 and 2006, respectively. Total income tax expense in 2008, 2007 and 2006, inclusive of these amounts, was $88,355, $152,533 and $163,243, respectively. Income taxes paid in 2008, 2007 and 2006 were $99,514, $35,024 and $178,063, respectively. Included in accounts payable and other liabilities on the consolidated balance sheets at December 31, 2008 and 2007, respectively, is $165,622 and $13,656 in respect of current income taxes payable.
Deferred income taxes reflect the income tax impact of temporary differences between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by income tax laws and regulations. Total deferred income tax (benefit)/expense in 2008, 2007 and 2006 was $(164,313), $143,814 and $(62,007), respectively.
In 2007, the Company entered into a new tax sharing agreement that provided for the utilization of the company’s net operating losses and will avoid the generation of holding company NOLs going forward, provided the Company’s subsidiaries earn sufficient taxable income to offset holding company losses. Based on projections of estimated future operations, management expects the deferred income tax asset to be recovered from taxable income in future years. Accordingly, no valuation allowance was recorded at December 31, 2008 or 2007. For further details on the Company’s tax sharing arrangements, see Note 2 to the consolidated financial statements.
In June 2006, the FASB issued FIN 48, which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS 109, Accounting for Income Taxes. Specifically, the pronouncement prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. The interpretation is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 on January 1, 2007 and its adoption did not have a direct impact on the Company’s results of operations or financial position.
$18,623, respectively, to Wentworth and had reinsurance recoverable balances of $13,850 and $6,036, respectively, at December 31, 2008 and 2007.
The Company entered into an aggregate stop loss agreement covering accident years 2000 through 2002. The reinsurer under this contract is nSpire. The 2000 accident year was exhausted in 2000 and recovered in full in 2004. Accident year 2001 was commuted in 2003. Accident year 2002 is subject to a per-term maximum recovery of $96,272 and the Company retains an ultimate net loss of up to 70% of net premiums earned in 2002. Pursuant to the agreement, the Company ceded premiums of $32,091 and $31,398 for accident years 2002 and 2001, respectively. At December 31, 2008 and 2007, no losses were ceded to nSpire under this contract for accident year 2002.
In the normal course of business, Odyssey, an affiliate of Fairfax, may participate on the Company’s reinsurance agreements. Currently, Odyssey participates on the umbrella per risk contract, the workers’ compensation catastrophe treaty and a difference in conditions program. For the years ended December 31, 2008, 2007 and 2006, the Company ceded $5,197, $2,088 and $2,911, respectively, in premiums to Odyssey and had reinsurance recoverable of $9,002 and $10,990 at December 31, 2008 and 2007, respectively, under these reinsurance agreements.
Reinsurance recoverable from TIG, a subsidiary of Fairfax, totaled $120,758 and $133,093 at December 31, 2008 and 2007, respectively. TIG is domiciled in California and cessions to domestic insurance companies do not require collateral to be recognized for statutory reporting purposes. The Company has considered several factors in assessing the collectability of reinsurance recoverable balances from TIG. TIG is a runoff company with a B+ (stable) financial strength rating from A.M. Best, a financial strength rating of BB (negative) from Standard and Poor’s and BB+ (stable) from Fitch, all nationally recognized rating agencies. TIG is a sizable regulated entity with policyholders’ surplus of $673,979 at December 31, 2008 and is subject to periodic independent examination by the California Insurance Department. TIG also had short-term liquidity represented by cash and short-term investments of $474,195 at December 31, 2008. The Company has fifteen years of experience with TIG, during which the balances due from TIG have declined from approximately $267,000 to $120,758 at December 31, 2008, principally through settlement of underlying claims. There are no regulatory or other restrictions on payments to the Company from TIG. A former parent of the Company required the transfer of a number of policies and related assets and liabilities among insurance companies controlled by the former parent, effective through assumption and indemnity reinsurance agreements. The assuming parties were required to seek novation of certain policies. At December 31, 2008 and 2007, amounts recoverable from TIG included $95,240 and $111,201, respectively, related to these policies, which were not novated.
Effective March 1, 1999, the Company entered into a reinsurance agreement with Fairmont Specialty Insurance Company (“Fairmont”, formerly Ranger Insurance Company), an affiliate of Fairfax, covering 100% of policies that are classified as excess liability for public entities and that incept, renew, have an anniversary date or come into effect on or after March 1, 1999. Effective June 30, 2002, this agreement was terminated and a new agreement was signed with TIG covering the same business, at substantially the same terms. The new agreement covers policies written on or after July 1, 2002. The agreement was terminated effective September 1, 2003. At December 31, 2008 and 2007, the Company had reinsurance recoverable of $38,237 and $34,675, respectively, from Fairmont, and $24,134 and $19,881, respectively, from TIG, related to these agreements.
Fairfax purchases insurance coverage for itself and on behalf of its subsidiaries, including comprehensive crime, insurance companies’ professional liability, directors’ and officers’ liability, employment practices liability, fiduciary liability and special accident insurance. The Company’s share of the expense incurred for this coverage was $842, $1,151 and $1,534 for the years ended December 31, 2008, 2007 and 2006, respectively.
The Company receives income from subleases of office space to Fairfax affiliates. Sublease income recorded from affiliates in 2008, 2007 and 2006 amounted to $3, $3 and $235, respectively.
Included in accounts payable and other liabilities at December 31, 2008 and 2007 are amounts payable to Fairfax and affiliates of $70 and $692, respectively. The 2007 amount is principally related to FITS fees. Included in other assets at December 31, 2008 and 2007 are amounts receivable from Fairfax and affiliates of $803 and $295, respectively.
The estimated net actuarial gain, prior service credit and transition obligation expense that will be amortized from accumulated other comprehensive income into net benefit costs during 2009 is $(348).
Increasing or decreasing the assumed health care cost trend rates by one percentage point in each year would not materially increase or decrease the accumulated postretirement benefit obligation at December 31, 2008 or the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2008. The Company’s expected contribution to the Plan in 2009 is $594.
Rental expense, before sublease income, under these operating leases was $13,023, $13,178 and $14,318 in 2008, 2007 and 2006, respectively. The Company recognized $83, $163 and $601 in 2008, 2007 and 2006, respectively, from subleases.
The Company has purchased structured settlement annuities from various insurance companies in order to settle certain claim liabilities. Should these other companies become unable to make the annuity payments, the Company would be liable. The value of these annuities included in reinsurance recoverable in the consolidated balance sheets at December 31, 2008 and 2007 was approximately $142,213 and $141,056, respectively. Approximately 83.2% of this balance is due from insurance companies rated A- or better by A.M. Best Company.
The Company had commitments to fund limited partnership investments totaling $12,450 and $4,120 at December 31, 2008 and 2007, respectively. These capital commitments can be called by the partnerships during the commitment period (generally five years or less) to fund working capital needs or the purchase of new investments.
Crum & Forster Holdings Corp. and US Fire, among numerous other insurance company and insurance broker defendants, have been named as defendants in a class action suit filed by policyholders alleging, among other things, that the defendants used the contingent commission structure to deprive policyholders of free competition in the market for insurance. The action was filed in the U.S. District Court for the District of New Jersey. Plaintiffs seek certification of a nationwide class consisting of all persons who between August 26, 1994 and the date of the class certification engaged the services of any one of the broker defendants and who entered into or renewed a contract of insurance with one of the insurer defendants. The trial court dismissed the federal antitrust claims and RICO claims with prejudice and declined to accept supplemental jurisdiction over plaintiffs’ state law claims. On October 24, 2007, plaintiffs filed an appeal with the U.S. Court of Appeal for the Third Circuit. The briefing on appeal has been completed. The court set oral argument on appeal for April 20, 2009 in Philadelphia, Pennsylvania. A final ruling is not expected from the Court of Appeals before late 2009. Crum & Forster Holdings Corp. and US Fire continue to be named as defendants and intend to vigorously defend the action
The Company’s insurance subsidiaries are subject to state regulatory restrictions that limit the maximum amount of dividends they can pay to the Company. These regulations vary by state. The restrictions are generally based on the net income, investment income and policyholders’ surplus of each insurance company, and further provide that the payment of dividends must be from the earned policyholders’ surplus of the insurance company. Any payment of dividends above the regulatory limits is considered “extraordinary” and is subject to the approval of the Insurance Commissioner in the state of domicile.
The combined statutory basis net income and policyholders’ surplus of Crum & Forster’s insurance subsidiaries are presented below:
The principal differences between statutory policyholders’ surplus and shareholder’s equity determined in accordance with GAAP relate to accounting for deferred gains on retroactive insurance, unrealized gains and losses on fixed income securities, deferred policy acquisition costs and deferred federal income taxes.
During the second and third quarters of 2006, the Company identified and recorded certain adjustments associated with its accounting for investments. The adjustments related principally to four areas: (i) equity method accounting - the Company did not properly reflect adjustments to realized investment gains and losses reported by equity method investees arising from basis differences associated with initial purchases or changes in ownership percentages. These adjustments related principally to the Company’s investments in Northbridge and HWIC; (ii) partnership accounting - several of the Company’s partnership interests were recorded on the equity method of accounting pursuant to Statement of Position 78-9, Accounting for Investments in Real Estate Ventures, even though the Company did not have the ability to exercise significant influence over the investees. In such circumstances, the Company should have retained the investment company accounting of the investees; (iii) embedded derivatives mark-to-market - the Company did not properly reflect the mark-to-market through earnings of derivative features embedded in convertible securities pursuant to SFAS 133. Several of the Company’s equity investees also held the same or similar securities with embedded derivatives. The Company determined that the investees also did not properly bifurcate their investments, which required adjustments to the Company’s financial statements; and (iv) valuation of an affiliated equity method investee - the Company did not correctly reflect the carrying value of its 1.4% ownership interest in TRG in 2002, pursuant to guidance in SFAS No. 141, Business Combinations.
Management evaluated the financial impact of these accounting adjustments in accordance with SEC Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, which considers the effect of misstatements from both a balance sheet and income statement perspective, and concluded that the effect both individually and in the aggregate was not material to any prior period consolidated financial statements and accordingly, prior period consolidated financial statements were not restated. The Company recorded cumulative adjustments in the second and third quarters. The net effect of the adjustments recorded in the third quarter was a charge to investment income for the three months ended September 30, 2006 of $6,962 pre-tax ($4,525 after-tax). The net effect of the adjustments recorded in the second quarter was a charge to net income for the three months ended June 30, 2006 of $5,678 pre-tax ($3,691 after-tax). Of the $5,678 pre-tax charge, $4,255 was recorded as a charge to realized investment gains, $3,534 ($2,297 after-tax) was recorded as a charge to equity in earnings of investees (including $456 of previously waived immaterial adjustments) and $2,111 was recorded as an increase to investment income on the consolidated statements of income.