Expense ratio: The expense ratio is the ratio, expressed as a percentage, of acquisition and other operating expenses less fee income to net earned premiums. Our reported expense ratio excludes certain holding company expenses such as interest expense as well as other corporate expenses.
Return on American Safety Insurance Holdings, Ltd. average shareholders’ equity: Return on average shareholders’ equity is the ratio, expressed as a percentage, of net earnings, excluding realized gains and losses, to the average of the beginning of period and end of period total shareholders’ equity, excluding accumulated other comprehensive income.
We segregate our business into insurance operations and other, with the insurance operations being further classified into three divisions: excess and surplus lines (E&S), alternative risk transfer (ART) and assumed reinsurance (Assumed Re). E&S consists of seven business lines: property, environmental, construction, products liability, excess, surety and healthcare. ART consists of two business lines: specialty programs and fully funded. Assumed Re consists of specialty property and casualty business assumed from unaffiliated specialty insurers and reinsurers. Other includes lines of business that we no longer write (run-off) as well as real estate and other ancillary product lines. Prior year amounts have been reclassified to conform to the current year presentation.
Within the E&S division we provide property and general liability coverage across specialty classes of business. The classes of business include environmental, construction, products liability, excess casualty, surety and healthcare. Our environmental business provides general, professional and pollution liability to contractors, consultants and property owners. Construction provides commercial general liability insurance coverages for residential and commercial contractors. Products liability offers general liability and product liability coverages for smaller manufacturers and distributors, non-habitational real estate and certain real property owner, landlord and tenant risks. Excess provides excess and umbrella liability coverages over our own and other carriers’ primary casualty policies, with a focus on construction risks. Surety provides payment and performance bonds primarily to the environmental remediation and construction industries. Healthcare provides customized liability insurance solutions primarily for long-term care facilities.
In our ART division, specialty programs facilitate the offering of insurance to homogeneous niche groups through third party program managers. Our fully funded business allows insureds to self-insure their risks through the posting of collateral. We are paid a fee to front this business.
In our Assumed Re division, the Company provides traditional specialty property and casualty reinsurance for unaffiliated specialty insurers and reinsurers with a focus on small specialty insurers, risk retention groups and captives.
The Other segment consists of amounts associated with the Company’s investment in real estate which was essentially completed in 2005, and lines of business that we have placed in run-off, such as workers’ compensation, excess liability insurance for municipalities and certain commercial lines.
The Company measures all segments using net earnings. The reportable insurance operations segments are measured by net premiums earned, incurred losses and loss adjustment expenses and acquisition expenses. Assets are not allocated to the reportable insurance operations segments.
Net earnings for the year of $24.3 million, or $2.30 per diluted share includes net favorable development recognized in 2009 with respect to prior accident years of $4.5 million. Construction general liability business, excluding construction defect, for accident years 2006 and prior, recognized favorable development of $14.1 million, which was offset by adverse development in environmental business and the ART and Reinsurance divisions. The development within the ART segment was primarily attributable to a discontinued program. The development for the Assumed Reinsurance segment was primarily attributable to one D&O contract written in 2007 that we terminated in 2008. Also during 2009, we re-estimated our ceded loss ratios for business written in 2009 and recorded a $4.0 million adjustment increasing our net losses. Additionally, the tax provision includes a $0.9 million benefit representing a partial reversal of the valuation allowance established in 2008 for realized investment losses.
Net earnings for 2008 of $0.3 million, or $0.03 per fully diluted share, were impacted by $14.3 million of net realized losses on investments primarily due to other-than-temporary impairment of investments, $5.4 million of net adverse development from prior year loss reserves and the $1.6 million of reinstatement premium and a $2.5 million charge related to reinsurance recoverables.
The combined ratio for 2009 was 99.4% with improvements in both the loss ratio and expense ratio. The 2009 loss ratio improved to 57.9% compared to 63.1% in 2008 while the 2009 expense ratio was 41.5% compared to 42.9% in 2008. Accident year loss ratios for 2009 and 2008 were 60.5% and 60.0%, respectively and are reflective of business mix changes, combined with pricing levels. The reduction in expense ratio is primarily due to lower acquisition costs in our assumed reinsurance business due to a shift in business to excess of loss from quota share, as well as increased fee income.
Fee income earned increased 107.0% to $5.4 million for the year ended December 31, 2009 compared to $2.6 million for 2008. The increase is primarily attributable to growth in our fully funded business. Our platform allows us to offer multiple solutions to the customer and in this soft market we have been able to leverage our financial strength ratings and generate additional fee income.
Payroll, corporate and other underwriting expenses increased 21.8% to $41.4 million for the year ended December 31, 2009, compared to $34.0 million for the same 2008 period. Payroll expense increased primarily due to the 2009 cash incentive compensation accrual of $2.5 million. In 2008 management did not pay any cash incentive compensation. Other underwriting expenses increased to $15.4 million due to a $1.6 million bad debt write-off related to a legacy program. The increase in corporate and other expenses to $3.4 million was due to an adjustment made in 2008 for $2.8 million, reducing a warranty liability established in 2004 associated with our former real estate project in Florida.
Income tax expense totaled $0.5 million or 2.2% and $0.03 million, or 9.0% of pre-tax earnings for the years ended December 31, 2009 and 2008, respectively. The lower tax rate is primarily a result of the reduction of the valuation allowance established in 2008 for capital losses on investments by $0.9 million.
Net Earnings. Net earnings from Bermuda operations increased to $20.3 million for the year ended December 31, 2009, compared to $7.2 million for 2008, due to 2008 realized losses on investments of $7.3 million, as well as lower underwriting profit in 2008. The U.S. operations had net earnings of $4.0 million for the year ended December 31, 2009, compared to a net loss of $6.9 million for 2008, primarily due to realized gains on investments in 2009 of $2.7 million, compared to 2008 realized losses of $7.0 million.
Equity. Equity in the Bermuda operations was $181.1 million at the end of 2009 compared to $136.6 million at the end of 2008 due to unrealized gains of $14.9 million. Equity of U.S. operations increased to $94.4 million at the end of 2009 from $83.5 million at December 31, 2008 due to unrealized gains of $10.5 million.
The 2008 combined ratio was 106.0%, composed of a loss ratio of 63.1% and an expense ratio of 42.9% compared to the 2007 combined ratio of 97.4% composed of a 61.3% loss ratio and 36.1% expense ratio. The 2008 adjustments discussed above increased the combined ratio by 4.7 percentage points. Also during 2008 the market continued to decline in terms of pricing and competition for premium volume increased and accordingly, pressure on the expense ratio increases. The 2007 combined ratio was impacted by approximately 2.6 percentage points due to adjustments noted above.
During 2008, 33.4% of gross premiums written, compared to 16.7% for 2007, were generated by new products as part of our product diversification strategy, primarily assumed reinsurance and healthcare. As a result, the expense component of the combined ratio has increased due to our investment in these products and will remain higher than historical levels until we achieve critical mass for these products.
In the environmental product net premiums earned decreased by $2.4 million as part of an underwriting review in this product resulting in us ceasing to write contractor business in New York. Additionally net premiums earned for 2008 and 2007 were negatively affected by $1.6 million and $2.3 million, respectively, of additional premiums ceded to reinsurers as a result of large losses, primarily related to New York business. For the construction product, net premiums earned decreased 43.8% to $37.4 million for the year ended December 31, 2008 primarily due to our underwriting discipline in a soft insurance market, coupled with the decline in the housing market.
Net investment income decreased 2.2% to $29.6 million for the year ended December 31, 2008, from $30.3 million for 2007 due to lower investment yields, despite increases in the Company’s invested assets. Average invested assets increased to $645.5 million as of December 31, 2008 from $584.2 million as of December 31, 2007. The increase in invested assets was due primarily to $101.0 million of cash flow from operations. The average pre-tax investment yield decreased from 5.2% for 2007 to 4.6% for 2008.
The $14.3 million net realized losses in 2008 includes other-than-temporary-impairment charges of $13.7 million and realized losses of $1.4 million from the sale of investments due to credit concerns about the financial services sector partially offset by net realized gains of $0.8 million. All but $0.4 million of the impairment relates to securities issued by companies in the financial services sector. Net realized losses in 2007 totaled $0.3 million.
Policy acquisition expenses increased to $43.5 million for the year ended December 31, 2008 from $28.9 million for 2007. Policy acquisition expenses as a function of net premiums earned increased to 24.9% for the year ended December 31, 2008 from 19.4% for 2007. The increase is due to the change in the mix of business and increased acquisition expense in the ART division. The proportion of premiums generated by our assumed reinsurance division, which is currently comprised primarily of quota share reinsurance treaties that carry higher acquisition expenses, resulted in an increase in acquisition expenses of $9.4 million. The increase related to the ART division was due to a change in our reinsurance structure for specialty programs from quota share, where we received a ceding commission to excess of loss, where no ceding commission is received. Specialty programs acquisition expenses increased by $7.8 million. Partially offsetting this increase was a decrease in acquisition expense in the E&S division relative to our construction line of business of $5.5 million due to a 43.8% reduction in net premiums earned.
Payroll and other underwriting expenses increased 25.6% to $33.9 million for 2008, compared to $27.0 million for 2007. The increase is due to normal salary increases, increased headcount primarily from the addition of new product lines and acquisitions added with the Company’s product diversification strategy, the increase in the allowance established for reinsurance recoverables and higher depreciation, amortization and software maintenance expenses. Corporate and other expenses were $0.2 million and $3.0 million for the periods ended December 31, 2008 and 2007, respectively. The decrease was due to the $2.8 million reversal of an accrued warranty liability established in 2004 in connection with our former real estate project in Florida.
Net Earnings. Net earnings from Bermuda operations decreased to $7.2 million for the year ended December 31, 2008, compared to $26.2 million for 2007, due to an increase of $6.8 million related to net realized losses on investments, as well as lower gross underwriting profit of $17.6 million due to higher loss and loss adjustment expenses along with higher acquisition expense. The U.S. operations incurred a net loss of $6.9 million for the year ended December 31, 2008, compared to net earnings of $2.0 million for 2007, primarily due to an increase of $7.3 million related to net realized losses on investments and an increase of $2.2 million from prior year adverse reserve development.
Equity. Equity of the Bermuda operations decreased to $136.6 million at the end of 2008 compared to $157.5 million at the end of 2007 due to higher net unrealized losses on the investment portfolio together with capital of $14.6 million transferred to the U.S operations as discussed below. Equity of U.S. operations increased to $83.5 million at the end of 2008 from $74.9 million at December 31, 2007 due to capital contributions of $14.6 million from the parent, $8.6 million of which was used to acquire the LTC Group, partially offset by current year losses.
After a review of the individual securities in the investment portfolio, the Company recorded $0.05 million of net realized losses due to other-than-temporary-impairment on one fixed maturity. The analysis to determine other-than-temporary-impairment was completed on all securities with additional focus on securities with unrealized losses greater than 30% of book value and securities whose unrealized loss was greater than 20% of book value for more than three months.
Net cash provided by operations was $53.3 million for the year ended December 31, 2009 and $101.0 million for the year ended December 31, 2008. The cash flow from operations decreased in 2009 compared to 2008 primarily due to two components: (1) net paid losses in 2009 were higher than 2008 due to increased retentions and the assumed reinsurance division transitioning from start-up mode to a more mature operation, and, (2) funds on deposit posted to support the assumed reinsurance segment. Funds held shown in Other Assets on the balance sheet increased $18.9 million due to increased funds on deposit for collateral in our reinsurance operations.
Net cash used in investing activities was $31.5 million for the year ended December 31, 2009, compared to net cash used in investing activities of $93.8 million for the same period of 2008. The decrease in net cash used in investing activities was primarily due to less cash generated from operations to be invested.
Our ability to pay future dividends to shareholders will depend, to a significant degree, on the ability of our subsidiaries to generate earnings from which to pay dividends. The jurisdiction in which we and our insurance and reinsurance subsidiaries are domiciled places limitations on the amount of dividends or other distributions payable by insurance companies in order to protect the solvency of insurers. Given the capital requirements associated with our business plan, we do not anticipate paying dividends on the common shares in the near future.
Our contractual obligations (in thousands of dollars) as of December 31, 2009 were:
(1) The above table includes all interest payments through the expiration of debt instruments. All amounts are reflected based on final maturity dates. Variable rate interest obligations are estimated based on current interest rates. As a result of applying interest rates based on the current LIBOR rate plus the contractual spread for each capital trust, the interest rates were 4.5%, 4.2% and 8.3% for American Safety Capital Trust, American Safety Capital Trust II and American Safety Capital Trust III, respectively as of December 31, 2009. These rates are used to calculate the variable interest rate obligations through maturity
(2) The above table includes the expected settlement of our gross loss reserves. The Company relies on reinsurance to reduce current risk exposures. The expected payoff of gross loss reserves net of reinsurance recoverables is as follows: total $420.4 million; $107.8 million less than a year; $229.9 million; 1-3 years, $37.5 million; 3-5 years and $45.0 million; more than 5 years. More information about our unpaid loss and loss adjustment expenses appears in Note 12 to our consolidated financial statements.
The Company routinely monitors and evaluates the difference between the cost and fair value of its investments. Additionally, credit analysis and/or credit rating issues related to specific investments may trigger more intensive monitoring to determine if a decline in market value is other than temporary ("OTTI"). For investments with a market value below cost, the process includes evaluating the length of time and the extent to which cost exceeds market value, the prospects and financial condition of the issuer, and evaluation for a potential recovery in market value, among other factors. This process is not exact and further requires consideration of risks such as credit risk and interest rate risk. Therefore, if an investment’s cost exceeds its market value solely due to changes in interest rates, impairment may not be appropriate.
The Company’s portfolio managers routinely monitor and evaluate the difference between the cost and fair value of our investments. Additionally, credit analysis and/or credit rating issues related to specific investments may trigger more intensive monitoring to determine if a decline in market value is other than temporary. For investments with a market value below cost, the process includes evaluating the length of time and the extent to which cost exceeds market value, the prospects and financial condition of the issuer, and evaluation for a potential recovery in market value, among other factors. As a result, management concluded that the recoverability of the principal and interest on these investments is reasonably assured and no additional impairments needed to be recognized.
Reserves. Claims made policies provide coverage for claims that are incurred and reported during the policy period. Occurrence form policies provide coverage for claims that occur during the policy period regardless of when they are reported. Certain of our insurance policies and reinsurance assumed are occurrence policies and therefore may be subject to claims brought years after an incident has occurred or the policy period has ended. We are required to maintain reserves to cover the unpaid portion of our ultimate liability for losses and loss adjustment expenses with respect to (i) reported claims and (ii) incurred but not reported (IBNR) claims. A full actuarial analysis is performed annually to estimate all of our unpaid losses and loss adjustment expenses under the terms of our contracts and agreements. In evaluating whether the reserves are adequate for unpaid losses and loss adjustment expenses, it is necessary to project future losses and loss adjustment expenses payments. It is probable that the actual future losses and loss adjustment expenses will not develop exactly as projected and may, in fact, vary materially from the projections.
As part of our year-end process, the Company has an external actuarial firm review the analysis prepared by our internal actuary and it issues an actuarial opinion on the insurance operating companies’ reserve adequacy.
A number of assumptions were made in the determination of the best reserve estimates for each line of business at December 31, 2009. The key assumptions among them were the expected loss ratios and loss development patterns. If the actual future losses and loss adjustment expenses develop materially differently from those key assumptions, there could be a potential for significant variation in the development of loss reserves. The effect of any specific assumptions can vary by accident year and line of business. We performed sensitivity analyses that tested the effects on the loss reserve position of using alternative loss ratios and loss development patterns rather than those actually used in determining the net carried reserve at December 31, 2009. The tests addressed each major line of business for which a material deviation to the overall reserve position is believed reasonably possible and used what we believed was reasonably likely range of potential deviation for each line of business. If our net carried reserves were to decrease from our best estimate, this would increase our net earnings, while an increase in our net carried reserves would decrease our earnings.
(1) Represents 33 different programs with diverse risks. Some programs are discontinued. Each individual program is not material to our total net carried reserves therefore no variability has been shown.