Our executive and administrative office is located at 6 International Drive in Rye Brook, N.Y. Our lease for this space expires in February 2014. Our underwriting operations are in various locations with non-cancelable operating leases including Charlotte, NC, Chicago, IL, Coral Gables, FL, Corona, CA, Houston, TX, Irvine, CA, New York City, NY, San Francisco, CA, Schaumburg, IL, Seattle, WA, London, England, Antwerp, Belgium and Stockholm, Sweden.
The following table sets forth selected consolidated financial data including consolidated financial information of the Company for each of the years in the five-year period ended December 31, 2008 derived from the Company’s audited consolidated financial statements. You should read the table in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and Item 8, “Financial Statements and Supplementary Data”, included herein.
While management takes into consideration a wide range of factors in planning the Company’s business strategy and evaluating results of operations, there are certain factors that management believes are fundamental to understanding how the Company is managed. First, underwriting profit is consistently emphasized as a primary goal, above premium growth. Management’s assessment of our trends and potential growth in underwriting profit is the dominant factor in its decisions with respect to whether or not to expand a business line, enter into a new niche, product or territory or, conversely, to contract capacity in any business line. In addition, management focuses on controlling the costs of our operations. Management believes that careful monitoring of the costs of existing operations and assessment of costs of potential growth opportunities are important to our profitability. Access to capital also has a significant impact on management’s outlook for our operations. The Insurance Companies’ operations and ability to grow their business and take advantage of market opportunities are constrained by regulatory capital requirements and rating agency assessments of capital adequacy.
The discussions that follow include tables that contain both our consolidated and segment operating results for each of the years in the three-year period ended December 31, 2008. In presenting our financial results we have discussed our performance with reference to underwriting profit or loss and the related combined ratio, both of which are non-GAAP measures of underwriting profitability. We consider such measures, which may be defined differently by other companies, to be important in the understanding of our overall results of operations. Underwriting profit or loss is calculated from net earned premium, less the sum of net losses and LAE, commission expense, other operating expenses and commission income and other income (expense). The combined ratio is derived by dividing the sum of net losses and LAE, commission expense, other operating expenses and commission income and other income (expense) by net earned premium. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss.
Although not a financial measure, management’s decisions are also greatly influenced by access to specialized underwriting and claims expertise in our lines of business. We have chosen to operate in specialty niches with certain common characteristics which we believe provide us with the opportunity to use our technical underwriting expertise in order to realize underwriting profit. As a result, we have focused on underserved markets for businesses characterized by higher severity and low frequency of loss where we believe our intellectual capital and financial strength bring meaningful value. In contrast, we have avoided niches that we believe have a high frequency of loss activity and/or are subject to a high level of regulatory requirements, such as workers compensation and personal automobile insurance, because we do not believe our technical expertise is of as much value in these types of businesses. Examples of niches that have the characteristics we look for include bluewater hull which provides coverage for physical damage to, for example, highly valued cruise ships, and directors and officers liability (“D&O”) insurance which covers litigation exposure of a corporation’s directors and officers. These types of exposures require substantial technical expertise. We attempt to mitigate the financial impact of severe claims on our results by conservative and detailed underwriting, prudent use of reinsurance and a balanced portfolio of risks.
Our revenue is primarily comprised of premiums and investment income. The Insurance Companies and Lloyd’s Operations derive their premiums primarily from business written by wholly-owned underwriting management companies which produce, manage and underwrite insurance and reinsurance for the Company. The Company’s products are distributed through multiple channels, utilizing global, national and regional brokers as well as wholesalers.
The premium rate increases or decreases as noted below for marine, specialty and professional liability are calculated primarily by comparing premium amounts on policies that have renewed. The premiums are judgmentally adjusted for exposure factors when deemed significant and sometimes represent an aggregation of several lines of business. The rate change calculations provide an indicated pricing trend and are not meant to be a precise analysis of the numerous factors that affect premium rates or the adequacy of such rates to cover all underwriting costs and generate an underwriting profit. The calculation can also be affected quarter by quarter depending on the particular policies and the number of policies that renew during that period. Due to market conditions, these rate changes may or may not apply to new business which generally would be more competitively priced compared to renewal business.
In the professional liability market, the enactment of the Sarbanes-Oxley Act of 2002, together with financial and accounting scandals at publicly traded corporations and the increased frequency of securities-related class action litigation, has led to heightened interest in professional liability insurance generally. Following substantial average professional liability renewal rate increases in 2002 and 2003, particularly for D&O insurance, average renewal rates decreased approximately 3.2% in 2004 and then remained relatively level in 2005 and 2006 followed by an approximate 6.6% decrease in 2007. Average 2008 professional liability renewal premium rates increased approximately 0.2% for the fourth quarter and decreased approximately 4.5% for the twelve months. The 2008 D&O insurance renewal premium rates increased approximately 0.5% for the fourth quarter and decreased approximately 2.7% for the twelve months. The 2007 D&O insurance renewal premium rates decreased approximately 7.9% following decreases of approximately 1.7% for 2006 and 2.3% for 2005 and 9.5% for 2004. We anticipate a stabilization in 2009 pricing given the industry dislocation.
Our Insurance Companies and Lloyd’s Operations have exposure to losses caused by hurricanes and other natural and man-made catastrophic events. The frequency and severity of catastrophes are unpredictable.
The occurrence of large loss events could reduce the reinsurance coverage that is available to us and could weaken the financial condition of our reinsurers, which could have a material adverse effect on our results of operations. Although the reinsurance agreements make the reinsurers liable to us to the extent the risk is transferred or ceded to the reinsurer, ceded reinsurance arrangements do not eliminate our obligation to pay claims to our policyholders. We are required to pay the losses even if a reinsurer fails to meet its obligations under the reinsurance agreement. Accordingly, we bear credit risk with respect to our reinsurers. Specifically, our reinsurers may not pay claims made by us on a timely basis, or they may not pay some or all of these claims. Either of these events would increase our costs and could have a material adverse effect on our business.
The Company monitors the development of paid and reported claims activities in relation to the estimate of ultimate losses established for the 2008 Hurricanes and the 2005 Hurricanes.
Reserves for Losses and LAE. Reserves for losses and LAE represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known. Actuarial methodologies are employed to assist in establishing such estimates and include judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate, judicial theories of liability and other third party factors which are often beyond our control. Due to the inherent uncertainty associated with the reserving process, the ultimate liability may be different from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. Additional information regarding our loss reserves can be found in “-Results of Operations-Operating Expenses-Net Losses and Loss Adjustment Expenses Incurred,” “Business-Reserves,” and Note 5, Reserves for Losses and Loss Adjustment Expenses, to our consolidated audited financial statements, all of which are included herein.
Reinsurance Recoverables. Reinsurance recoverables are established for the portion of the loss reserves that are ceded to reinsurers. Reinsurance recoverables are determined based upon the terms and conditions of reinsurance contracts which could be subject to interpretations that differ from our own based on judicial theories of liability. In addition, we bear credit risk with respect to our reinsurers which can be significant considering that certain of the reserves remain outstanding for an extended period of time. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. Additional information regarding our reinsurance recoverables can be found in the “Business-Reinsurance Ceded” section and Note 6, Reinsurance, to our consolidated audited financial statements, both included herein.
Accounting for Lloyd’s Results. We record Syndicate 1221’s assets, liabilities, revenues and expenses under U.S. GAAP. At the end of the Lloyd’s three-year period for determining underwriting results for an account year, the syndicate will close the account year by reinsuring outstanding claims on that account year with the participants for the account’s next underwriting year. The amount to close an underwriting year into the next year is referred to as the reinsurance to close (“RITC”). The RITC transaction, recorded in the fourth quarter, does not result in any gain or loss. Additional information regarding our accounting for Lloyd’s results can be found in Note 1, Organization and Summary of Significant Accounting Policies, to our consolidated audited financial statements, included herein.
Translation of Foreign Currencies. Financial statements of subsidiaries expressed in foreign currencies are translated into U.S. dollars in accordance with SFAS 52, Foreign Currency Translation, issued by the Financial Accounting Standards Board (“FASB”). Under SFAS 52, functional currency assets and liabilities are translated into U.S. dollars using period end rates of exchange and the related translation adjustments are recorded as a separate component of accumulated other comprehensive income on the Company’s balance sheet. Statement of income amounts expressed in functional currencies are translated using average exchange rates.
Net investment income increased 8.3% due to the cash flow from operations. The pre-tax investment yield was 4.1% in 2008 compared to 4.4% in 2007.
The marine gross written premium for 2008 increased 9.4% compared to 2007 due to new business partially offset by flattening or declining premium in several classes of business due to increased competitive market conditions. The average marine renewal premium rates during 2008 decreased approximately 2.1%. The marine gross written premium for 2007 increased 4.5% compared to 2006 reflecting new business partially offset by flattening or declining premium in several classes of business due to increased competitive market conditions. The average marine renewal premium rates during 2007 decreased approximately 0.1%. The marine gross written premium for 2006 increased 14.1% compared to 2005 due to growth across several lines of business including offshore energy which benefited from rate increases following losses from the 2005 Hurricanes and protection and indemnity where growth was driven by new business. The average overall marine renewal premium rates during 2006 increased approximately 11%, including the approximate 54% increase in offshore energy rates which was primarily the result of the 2005 Hurricane losses.
The 2008 gross written premium decreased 12.3% when compared to 2007 reflecting declines across most lines of business due to negative renewal rate changes and the housing market slowdown, which is most pronounced in the construction liability line. The 2007 gross written premium increased 23.2% when compared to 2006 reflecting growth across all lines of business including primary casualty which started in the third quarter of 2006. The 2006 gross written premium increased 53.5% when compared to 2005 also reflecting growth across all lines of business along with including premiums generated from our primary casualty business which started in the third quarter of 2006. The average renewal premium rate changes in the contractors’ liability business decreased approximately 11.9%, 10.7% and 5.6% in 2008, 2007 and 2006, respectively, following a relatively flat market in 2005 and increases of 13% and 49% in 2004 and 2003, respectively.
Middle Market Premium. The gross written premium for each of the years in the three-year period ended December 31, 2008 consisted of the following:
The 2008 increase in gross written premium of 8.2% resulted from new business, particularly in the marine liability class. The 2007 decrease in gross written premium of 8.1% resulted from generally deteriorating market conditions that have led us to decline risks that we believe are not adequately priced, particularly in the offshore energy line of business. In addition, some premium estimates recorded during 2006 have been lowered during 2007, which has reduced the 2007 calendar year gross written premium. The 2006 increase of 18.3% resulted from growth across several lines of business but primarily offshore energy which benefited from rate increases following losses from the 2005 Hurricanes.
Syndicate 1221 commenced writing professional liability business during the second quarter of 2005. The 2008 and 2007 gross written premium increased 13.4% to $38.9 million and 57.5% to $34.3 million, respectively, compared to the prior year, due to continued expansion and geographic diversification of the book of business.
Property/Other Premium. Property/Other premium consists of gross written premium for engineering and construction business, onshore energy business and European property business. The engineering and construction business provides coverage for construction projects including machinery, equipment and loss of use due to delays. The onshore energy business principally focuses on the oil and gas, chemical and petrochemical industries with coverages primarily for property damage and business interruption. The European property business was discontinued in the 2008 second quarter. Such action did not have a material impact on the Lloyd’s Operations.
The percentage of total ceded written premium to total gross written premium in 2008 was 39.0% compared to 39.7% in 2007 and 46.4% in 2006. The Insurance Companies’ and Lloyd’s Operations 2008 ceded marine written premium includes $7.2 million and $5.0 million, respectively, of reinstatement premium related to the losses from Hurricanes Gustav and Ike.
Excluding the effect of ceded reinstatement premiums for the 2008 Hurricanes losses, the ratio of ceded written premium to gross written premium was 38.4%. The declines in the ratio of ceded written premium to gross written premium in 2008 compared to 2007 and in 2007 compared to 2006 were due to a combination of the following factors:
Reinstatement premium of $12.2 million related to Hurricanes Gustav and Ike recorded in 2008, as discussed above.
A reduction of $1.4 million of ceded written premium in the 2008 second quarter as a result of the rescission of a reinsurer’s participation on an excess of loss treaty for middle markets business.
The elimination of a 5% reinsurer participation in our Syndicate 1221 2008 stamp capacity.
Net Written Premium. The 2008 net written premium increased 2.4% compared to 2007. The increase was 4.3% when excluding the $12.2 million of ceded reinstatement premiums resulting from the 2008 Hurricanes. The 2007 net written premium increased 24.0% compared to 2006. The increases in net written premium are reflective of the changes in gross written and ceded written premium discussed above.
Commission Income. Commission income from unaffiliated business decreased 42.1% to $1.0 million in 2008 compared to 2007 and decreased 43.5% to $1.7 million in 2007 compared to $3.1 million in 2006. Beginning with the 2006 underwriting year, there are no longer any marine pool unaffiliated insurance companies with the elimination of the marine pool and no longer any unaffiliated participants at Syndicate 1221 with the purchase of the minority interest. Any profit commission therefore results from the run-off of underwriting years prior to 2006.
Net Investment Income. Net investment income increased 8.3% and 24.2% in 2008 and 2007, respectively, due primarily to the increase in invested assets resulting from positive cash flow from operations and the net proceeds from the debt offering of $123.5 million received in April 2006. See the “Business-Investments” section included herein for additional information regarding our net investment income.
Net Realized Capital Gains (Losses). Pre-tax net income included $38.3 million of net realized capital losses for 2008 compared to $2.0 million of net realized capital gains for 2007 and net realized capital losses of $1.0 million for 2006. On an after-tax basis, the net realized capital losses were $24.9 million or $1.46 per share compared to the net realized capital gains of $1.3 million or $0.08 per share for 2007 and the net realized capital losses of $0.7 million or $0.04 per share for 2006.
During 2008 and 2007, reserve reductions resulting from periodic reviews of the 2005 Hurricanes’ exposures reduced gross losses incurred by $12.3 million and $29.3 million, respectively. The reductions to the 2005 Hurricanes gross reserve estimates resulted in reductions of $1.0 million and $1.9 million to our 2008 and 2007 net loss incurred estimates, respectively, and reductions of $0.8 million and $0.7 million to our 2008 and 2007 reinstatement cost estimates, respectively. As a result of these reviews in 2007, we also reallocated our net retention for these events between our Insurance Companies and Lloyd’s operations and the result was to increase the Insurance Companies loss incurred by $1.5 million and decrease the Lloyd’s loss incurred by $3.4 million.
The following tables sets forth our net reported loss and LAE reserves and net IBNR reserves (a non-GAAP measure reconciled above) by segment and line of business for the periods indicated:
At December 31, 2008, the IBNR loss reserve was $633.6 million or 63.4% of our total loss reserves compared to $558.5 million or 65.9% in 2007.
The increase in gross loss reserves on the Company’s 2008 and 2007 balance sheets primarily relates to incurred losses for events occurring in those years less loss payments. Gross loss reserves and related reinsurance recoverable amounts related to losses from the 2008 Hurricanes were $107.4 million and $94.5 million at December 31, 2008. Gross loss reserves and related reinsurance recoverable amounts related to losses from the 2005 Hurricanes were $97.7 million and $94.1 million at December 31, 2008, respectively, compared to $141.8 million and $137.3 million at December 31, 2007, respectively.
As discussed below and under the caption “Business-Loss Reserves,” there are a number of factors that could cause actual losses and loss adjustment expenses to differ materially from the amount that we have reserved for losses and loss adjustment expenses.
Loss ratio method: This method is based on the assumption that ultimate losses vary proportionately with premiums. Pursuant to the loss ratio method, IBNR loss reserves are calculated by multiplying the earned premium by an expected ultimate loss ratio to estimate the ultimate losses for each underwriting year, then subtracting the reported losses, consisting of paid losses and case loss reserves, to determine the IBNR loss reserve amount. The ultimate loss ratios applied are the Company’s best estimates for each underwriting year and are generally determined after evaluating a number of factors which include: information derived by underwriters and actuaries in the initial pricing of the business, the ultimate loss ratios established in the prior accounting period and the related judgments applied, the ultimate loss ratios of previous underwriting years, premium rate changes, underwriting and coverage changes, changes in terms and conditions, legislative changes, exposure trends, loss development trends, claim frequency and severity trends, paid claims activity, remaining open case reserves and industry data where deemed appropriate. Such factors are also evaluated when selecting ultimate loss ratios and/or loss development factors in the methods described below.
The substantial majority of the specialty loss reserves are for the contractors liability business, which insures mostly general and artisan contractors. Contractor liability claims are categorized into two claim types: construction defect and other general liability. Other general liability claims typically derive from workplace accidents or from negligence alleged by third parties, and take a long time to report and settle. Construction defect claims involve the discovery of damage to buildings that was caused by latent construction defects. These claims take a very long time to report and to settle compared to other general liability claims. Since construction defect claims report much later than other contractor liability claims, they are analyzed separately in the annual loss reserve study.
The commercial middle markets business consists of general liability, auto liability and property exposures for a variety of commercial middle market businesses, principally hospitality, manufacturing and garages. Commencing in 2007, our actuaries are segmenting and analyzing the components of the loss development for this business among the property, liability and auto exposures which had been previously combined.
Primary casualty insurance provides primary general liability coverage principally to corporations in the construction and manufacturing sector. Excess casualty insurance is purchased by corporations which seek higher limits of liability than are provided in their primary casualty policies. Neither product line has a significant amount of loss activity reported to date. Because the Company has limited historical experience in these products, the IBNR loss reserves for both of these products currently are established using the loss ratio method primarily based on our underwriters’ input and industry loss experience.
The losses for D&O business are generally very large and infrequent, and typically involve securities class actions. D&O claims report reasonably quickly, but may take several years to settle. While the Company has been writing D&O business since 2001, the limited claim history is generally insufficient to establish IBNR loss reserves using Company data. As a result, the Company principally employs assumptions based on industry experience coupled with input from its underwriters and its claims staff’s assessment of potential exposure to establish IBNR loss reserves. Another key assumption with respect to establishing IBNR loss reserves for D&O business is that such industry experience is representative of our future potential loss development with respect to trends in class action activity, such as the impact of stock option backdating, laddering and, most recently, the sub-prime mortgage crisis. As time passes, for a given underwriting year, additional weight is given to assumptions relating to our actual experience and claims outstanding.
Other: Loss reserves for other include inland marine business and European property business written by the U.K. Branch. Both businesses were started in 2006. The Company has limited loss history and relies primarily on assumptions based on underwriters’ input and industry experience. Also included are loss reserves for aviation, property and assumed reinsurance business in runoff since 1999, which are periodically monitored and evaluated by claims and actuarial personnel.
The Lloyd’s Operations products also include property coverages for engineering and construction projects and onshore energy business, which are substantially reinsured. Losses from engineering and construction projects tend to result from loss of use due to construction delays while losses from onshore energy business are usually caused by fires or explosions. Large losses tend to be catastrophic in nature and are heavily reinsured. IBNR loss reserves for attritional losses are established based on the Syndicate’s extensive loss experience.
The segment and line of business breakdowns of prior period net reserve deficiencies (redundancies) were as follows:
The Insurance Companies recorded $1.6 million of net adverse development in the middle markets business as a result of an actuarial analysis that indicated that strengthening is required for the automobile coverage due to frequency and severity in excess of our expectations.
The Insurance Companies recorded $3.7 million of net prior year savings in the property and aviation run-off business as a result of an actuarial analysis that indicated that the losses are substantially reported and the IBNR loss reserves can be reduced.
The Insurance Companies recorded $10.7 million of net prior years’ savings in the marine business primarily comprised of $6.5 million of savings in the transport business, $3.7 million of savings in the marine liability business, $1.6 million of savings in the cargo business, $1.0 million of savings in each of the hull and offshore energy businesses; partially offset by $1.9 million of 2005 Hurricanes Katrina and Rita loss development and $1.6 million for uncollectible reinsurance recoverables for asbestos losses. The favorable development for the liability, cargo, hull and offshore energy coverages was primarily due to reduced claim activity for the 2005 and 2006 underwriting years. Prior to 2007, because the Company did not have sufficient experience in the transport product line, it instead used its hull and liability products loss development experience as a key assumption in setting the IBNR loss reserves for its transport product. Commencing in 2007, our actuaries determined that the Company’s loss development experience for its transport product had become sufficiently credible to begin establishing transport reserves using such experience, which resulted in the prior year savings referred to above recorded for this business.
The Lloyd’s Operations recorded $13.2 million of net prior year savings, comprised of $3.4 million due to a review of the 2005 Hurricanes Katrina and Rita loss estimates, a release of approximately $2.0 million following a review of open claim files for the years 1998 to 2001, a $4.6 million reduction in our 2004 underwriting year estimates for the marine liability book due to favorable loss trends, and the remaining $3.2 million was mostly for offshore energy and marine liability business on business underwritten during 2002.
Following is a discussion of relevant factors impacting our 2006 loss reserves:
As discussed above, the Company establishes reserves for the professional liability business using ultimate loss ratios based on industry experience. During 2006 the Insurance Companies further reduced the net reserves for such claims-made policies compared to year-end 2005, by $1.2 million mostly related to the 2004 year. The reductions were to recognize the low level of open claim counts and continued favorable development compared to expectations at the time the reserves were initially established.
Commission Expense. Commission expense paid to unaffiliated brokers and agents is generally based on a percentage of the gross written premium and is reduced by ceding commissions the Company may receive on the ceded written premium. Commissions are generally deferred and recorded as deferred policy acquisition costs to the extent that they relate to unearned premium. The percentages of commission expense to net earned premium were 13.9% in 2008, 12.9% in 2007 and 12.4% in 2006. The 2008 commission expense ratio excluding the effects of the 2008 Hurricanes was 13.7%.
Other Operating Expenses. The 11.5% and 28.8% increases in other operating expenses when comparing 2008 to 2007 and comparing 2007 to 2006, respectively, were attributable primarily to employee related expenses resulting from expansion of the business.
Income Taxes. The income tax expense was $17.0 million, $43.6 million and $34.1 million for 2008, 2007 and 2006, respectively. The effective tax rates for 2008, 2007 and 2006 were 24.8%, 31.3% and 31.9%, respectively. The Company’s effective tax rate is less than 35% due to permanent differences between book and tax return income, with the most significant item being tax exempt interest. As of December 31, 2008 and 2007, the net deferred Federal, foreign, state and local tax assets were $54.7 million and $29.2 million, respectively.
We are subject to the tax regulations of the United States and foreign countries in which we operate. The Company files a consolidated federal tax return, which includes all domestic subsidiaries and the U.K. Branch. The income from the foreign operations is designated as either U.S connected income or non-U.S. connected income. Lloyd’s is required to pay U.S. income tax on U.S. connected income written by Lloyd’s syndicates. Lloyd’s and the IRS have entered into an agreement whereby the amount of tax due on U.S. connected income is calculated by Lloyd’s and remitted directly to the IRS. These amounts are then charged to the corporate members in proportion to their participation in the relevant syndicates. The Company’s corporate members are subject to this agreement and will receive U.K. tax credits for any U.S. income tax incurred up to the U.K. income tax charged on the U.S. income. The non-U.S. connected insurance income would generally constitute taxable income under the Subpart F income section of the Internal Revenue Code since less than 50% of the Company’s premium is derived within the U.K. and would therefore be subject to U.S. taxation when the Lloyd’s year of account closes. Taxes are accrued at a 35% rate on our foreign source insurance income and foreign tax credits, where available, are utilized to offset U.S. tax as permitted. The Company’s effective tax rate for Syndicate 1221 taxable income could substantially exceed 35% to the extent the Company is unable to offset U.S. taxes paid under Subpart F tax regulations with U.K. tax credits on future underwriting year distributions. U.S. taxes are not accrued on the earnings of the Company’s foreign agencies as these earnings are not subject to the Subpart F tax regulations. These earnings are subject to taxes under U.K. tax regulations. A finance bill was enacted in the U.K. on July 19, 2007 that reduces the U.K. corporate tax rate from 30% to 28% effective April 1, 2008. The effect of such tax rate change was not material to the Company’s financial statements.
We have not provided for U.S. deferred income taxes on the undistributed earnings of approximately $48.4 million of our non-U.S. subsidiaries since these earnings are intended to be permanently reinvested in the foreign subsidiary. However, in the future, if such earnings were distributed to the Company, taxes of approximately $3.4 million would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested in the foreign subsidiary assuming all foreign tax credits are realized.
The Company had net state and local deferred tax assets amounting to potential future tax benefits of $6.2 million at both December 31, 2008 and 2007. Included in the deferred tax assets are net operating loss carryforwards of $0.5 million and $2.5 million at December 31, 2008 and 2007, respectively. A valuation allowance was established for the full amount of these potential future tax benefits due to the uncertainty associated with their realization. The Company’s state and local tax carryforwards at December 31, 2008 expire from 2021 to 2025.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), an interpretation of SFAS 109, Accounting for Income Taxes. FIN 48, which became effective in 2007, established the threshold for recognizing the benefits of tax-return positions in the financial statements as more-likely-than-not to be sustained by the taxing authorities, and prescribes a measurement methodology for those positions meeting the recognition threshold. The Company’s adoption of FIN 48 at January 1, 2007 did not have a material effect on its financial condition or results of operations.
The Company classifies its business into two underwriting segments consisting of the Insurance Companies and the Lloyd’s Operations, which are separately managed, and a corporate segment. Segment data for each of the two underwriting segments include allocations of revenues and expenses of the wholly-owned underwriting agencies and the Parent Company’s expenses and related income tax amounts.
We provide letters of credit to Lloyd’s to support our participation in Syndicate 1221’s stamp capacity as discussed below under the caption Liquidity and Capital Resources.
Whenever a member of Lloyd’s is unable to pay its debts to policyholders, such debts may be payable by the Lloyd’s Central Fund. If Lloyd’s determines that the Central Fund needs to be increased, it has the power to assess premium levies on current Lloyd’s members up to 3% of a member’s underwriting capacity in any one year. The Company does not believe that any assessment is likely in the foreseeable future and has not provided any allowance for such an assessment. However, based on the Company’s 2008 capacity at Lloyd’s of £123 million, the December 31, 2008 exchange rate of £1 equaled $1.46 and in the event of a maximum 3% assessment, the Company would be assessed approximately $5.4 million. In addition, beginning with the 2005 underwriting year, Lloyd’s added a second tier of assets to the existing Central Fund. This second tier was built up through a compulsory interest bearing loan to the Society of Lloyd’s from the Lloyd’s members based on the stamp capacity of each syndicate for the respective underwriting year. The funds were invested in assets eligible for Society of Lloyd’s solvency. The loans, of which the Company had $5.9 million at June 30, 2007, were repaid during the 2007 third quarter from a bond offering completed by Lloyd’s in September 2007.
The following table sets forth the results of operations of the Lloyd’s Operations for each of the years in the three-year period ended December 31, 2008:
Marine and energy premium rate increases occurred in 2005 and continued into 2006 following Hurricanes Katrina and Rita, particularly in the offshore energy business. Market conditions then began to soften and the average renewal premium rates in 2007 decreased approximately 1.2% for the marine and energy business and decreased approximately 3.4% in the professional liability business. The average renewal premium rates for 2008 decreased approximately 8.2% for the marine and energy business and decreased approximately 1.3% for the professional liability business.
See “Results of Operations and Overview - Income Taxes” for a discussion of the Lloyd’s Operations income taxes, included herein.
For 2009, Syndicate 1221’s stamp capacity is £115 million ($168 million) and our consolidated net participation is 100%. We have applied to increase our 2009 stamp capacity to £125 million to enable us to increase our writings resulting from new business opportunities.
Investments and cash increased to $1.92 billion at December 31, 2008 from $1.77 billion at December 31, 2007. The increase was primarily due to the positive cash flow from operations. Net investment income was $76.6 million for 2008, $70.7 million for 2007 and $56.9 million for 2006.
At December 31, 2008, the weighted average rating of our fixed maturity investments was “AA” by Standard & Poor’s and “Aa” by Moody’s. We believe that we have limited exposure to credit risk since the fixed maturity investment portfolio, except for $28.3 million consists of investment-grade bonds. At December 31, 2008, our investment portfolio had an average maturity of 5.7 years and a duration of 4.3 years. Management periodically projects cash flow of the investment portfolio and other sources in order to maintain the appropriate levels of liquidity to ensure our ability to satisfy claims. Impairment losses of $37.0 million and $0.7 million were recorded in 2008 and 2007, respectively. No impairment losses were incurred in 2006. As of December 31, 2008 and 2007, all fixed maturity securities and equity securities held by us were classified as available-for-sale.
As part of our capital management program, we may seek to raise additional capital or may seek to return capital to our shareholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our board of directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements, credit facility limitations and such other factors as our board of directors deems relevant.
In July 2006, the Company filed a universal shelf registration statement with the Securities and Exchange Commission. This registration statement, which expires in July 2009, allows for the future possible offer and sale by the Company of up to $300 million, in the aggregate, of various types of securities, including common stock, preferred stock or debt securities. The shelf registration statement enables us to efficiently access the public equity or debt markets in order to meet future capital needs, if necessary. This report is not an offer to sell or the solicitation of an offer to buy nor shall there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of such state.