The table shown below presents selected financial data for each of the five years ended December 31, 2009. This financial information was prepared in accordance with GAAP. The GAAP statement of income data for the years ended December 31, 2009, 2008, 2007, 2006, and 2005 and the GAAP balance sheet data at December 31, 2009, 2008, 2007, 2006 and 2005 were derived from Crum & Forster Holdings Corp.’s consolidated financial statements, which have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The consolidated balance sheets at December 31, 2009 and 2008, and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows for each of the three years ended December 31, 2009, and accompanying notes, appear in “Item 8. Financial Statements and Supplementary Data”. The combined statutory data has been derived from annual statutory financial statements, which have been filed with the domiciliary states of the Company’s insurance subsidiaries, and prepared in accordance with SAP, which differs from GAAP.
Workers’ Compensation ¾ medical inflation, willingness of insured to settle claims, case reserve for known claims, long payment period for the medical portion of claims, expected loss ratios for more recent accident years and legal jurisdiction of the claim.
General Liability ¾ 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 and accident and health, 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.
The following table presents the impact of a 2% change in ultimate loss and ALAE ratios for each line of business for the accident years shown. The years were selected to include those years where management considers a 2% change in ultimates to be a reasonably likely outcome. The 2% change was selected to represent a reasonably likely change in one of the factors described above. For example, for workers’ compensation, this could be due to changes in medical inflation or claim settlement rates. For general liability, this could be due to court award inflation.
For asbestos, a range is developed for each policyholder based on variations in the estimates of the future number of claimants and number of years in the available coverage period (if unknown). For environmental exposures, a range is developed based on variations in alleged site costs and variations in the number of years over which such costs may be allocated. The actuarial central estimate is principally the average of the low estimate and the high estimate for each policyholder.
In 2009, the net favorable loss development before corporate aggregate reinsurance includes an insurance recovery of $13.8 million associated with an asbestos lawsuit which the Company settled in 2008. Excluding this recovery, the net favorable development of $11.2 million was primarily attributable to favorable emergence in workers’ compensation, commercial multi-peril and property lines of business, partially offset by adverse emergence in commercial automobile and asbestos liabilities.
In 2008, the net adverse loss development before corporate aggregate reinsurance was primarily attributable to a loss on commutation of a reinsurance treaty of $84.3 million ($75.5 million after amortization of related deferred gain) as well as the settlement of an asbestos-related lawsuit of $25.5 million, partially offset by favorable development, primarily in the workers’ compensation and general liability lines of business, attributable to net favorable loss emergence in almost all accident years. Specifically, favorable development in the workers’ compensation line was principally attributable to favorable results in non-California medical reserves for older accident years and non-California indemnity reserves for more recent accident years.
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. 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 a number of 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.
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 the number of new filings has resulted in the defense bar focusing on individual cases involving higher severity injuries. As such, average severities have increased. California continues to be the most active and challenging venue for defendants, and increased filing activity has been identified in Illinois.
In 2009, 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 2009, 90% of gross payments for loss and ALAE were made on behalf of approximately 2% of policyholders.
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 the early versions of the pollution exclusion to expand the scope of coverage provided. Since 1986, however, most general liability policies exclude coverage for such exposures.
There is great uncertainty involved in estimating liabilities related to these exposures. First, the number of waste sites subject to cleanup is unknown. Currently, approximately 1,270 cleanup sites are included in the EPA’s National Priorities List. State authorities have identified many additional sites. Second, the liabilities of the policyholders themselves are difficult to estimate. At any given site, the allocation of remediation cost among the PRPs varies greatly depending upon a variety of factors. Third, different courts have been presented with liability and coverage issues regarding pollution claims and have reached inconsistent decisions on several issues. These uncertainties are unlikely to be resolved in the near future.
As with asbestos reserves, exposure for environmental pollution cannot be estimated with traditional loss reserving techniques that rely on historical accident year loss development factors. Since each policyholder presents different liability and coverage issues, the methodology used to establish environmental reserves is similar to that used for asbestos liabilities. In the course of performing these individual policyholder assessments, the following factors are considered: the policyholder’s probable liability and available coverage; the number of sites; the total number of PRPs at each site; the nature of environmental harm and the corresponding remedy at each site; the involvement of other insurers and the potential for other available coverage; and the applicable law in each jurisdiction. A provision for IBNR is developed, using methodology similar to that for asbestos liabilities, and an estimate of ceded reinsurance recoveries is calculated. Aggregate emergence against a benchmark is also considered.
New reports for environmental claims are generally trending downward while the cost of the remedy in certain jurisdictions has increased. Claims against Fortune 500 companies are declining, and, while policyholders with single-site exposures are still active, the Company has resolved the majority of disputes with respect to policyholders with a large number of sites. Statutes in a number of states require administrative involvement in business closures where the business used or produced substances that are considered contaminants. Accordingly, the general economic climate could result in an uptick of reported claims associated with such business or facility closures. Due to the high level of uncertainty, revisions to these reserve estimates could have a material impact on the Company’s results of operations in the period recognized and the ultimate actual payments for claims and LAE could turn out to be significantly different from estimates.
Management believes that the asbestos, environmental and other latent reserves reported at December 31, 2009 are reasonable estimates of the ultimate remaining liability for these claims based on facts currently known, the present state of the law and coverage litigation, current assumptions and the reserving methodologies employed. These latent reserves are continually monitored by management and reviewed by independent consulting actuaries. New developments will continue to be evaluated as they arise in order to supplement the ongoing analyses and reviews of the latent exposures. However, to the extent that future social, scientific, economic, legal or legislative developments alter the volume of claims, the liabilities of the policyholders, or the original intent of the policies and scope of coverage, increases in loss reserves may emerge in future periods. Due to the inherent uncertainties in estimating reserves for unpaid losses and LAE described above, and to the potential impact of recent trends, the ultimate liability for the Company’s loss and LAE reserves, and, in particular, its asbestos, environmental and other latent claims reserves, may vary substantially from the amounts currently reserved.
A review of fair value hierarchy classifications is conducted on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification for certain financial assets or liabilities. Reclassifications impacting Level 3 of the fair value hierarchy are reported as transfers in or out of the Level 3 category as of the beginning of the quarterly period in which the reclassifications occur. During the first quarter of 2009, the Company transferred $47.6 million of Level 3 investments (comprised of investment grade mortgage-backed securities), to Level 2, after determining that broker-dealer quotes which utilize observable inputs, would be used to determine the fair value of the instruments. During the fourth quarter of 2009, the Company transferred its investment in Odyssey Re Holdings Corp. (“Odyssey”) at a fair value of $321.1 million from Level 1 to Level 3 and its investment in Advent Capital (Holdings) PLC (“Advent”) at a fair value of $26.4 million from Level 2 to Level 3, following the privatization and subsequent delisting from public stock exchanges of Odyssey and Advent. The privatization changed the inputs used to value these investments from observable exchange traded quoted prices to unobservable inputs. The Company now values these investments using internally developed valuation models based on market multiples derived from a set of publicly traded comparable companies. The models, which require a significant amount of judgment, use current and historical market prices and book values of comparable companies to derive a current fair value. Because of the significant judgment involved in selecting inputs and the effect of the inputs on the valuation model they are considered to be Level 3. At December 31, 2009 Odyssey and Advent had fair values of $305.8 million and $26.6 million, respectively, based on these valuation models (approximately 8.3% of total investment portfolio at that date). Also included in Level 3 securities are certain non-investment grade mortgage-backed securities purchased at deep discounts to par, which are valued using an internal discounted cash flow model. The cash flow model incorporates actual cash flows on the mortgage-backed securities through the current period and projects the remaining cash flows from the underlying mortgages, using a number of assumptions and inputs that are based on the security-specific collateral. The Company assesses the reasonableness of the fair values of these securities by comparing to models validated by qualified personnel, by reference to movements in credit spreads and by comparing the fair values to recent transaction prices for similar assets where available. At December 31, 2009, the fair value of the Company’s Level 3 non-investment grade mortgage-backed securities was $14.3 million (less than 1% of total investment portfolio at that date). At December 31, 2008, the fair value of the Company’s Level 3 securities (after the aforementioned reclassification to Level 2), which were comprised of non-investment grade mortgage-backed securities, was $18.8 million. Gains or losses arising from changes in the fair value of Level 3 securities are recorded as realized investment gains or losses in the consolidated statements of income and amounted to net losses of $3.5 million and $4.3 million in 2009 and 2008, respectively.
Derivative securities held by the Company at December 31, 2009 are principally credit default swaps and total return swaps. The credit default swaps are carried at estimated fair values on the consolidated balance sheets with changes in fair value recorded in realized investment gains and losses in the period in which they occur. The Company obtains broker-dealer quotes which are based on observable credit spreads for its credit default swaps. In addition, the Company assesses the reasonableness of the broker dealer quotes 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, 2009 and 2008, the fair value of the credit default swaps was $20.0 million and $138.8 million, respectively. Gains or losses arising from changes in the fair value of the credit default swaps are recorded in realized investment gains and losses in the consolidated statements of income. For the years ended December 31, 2009, 2008 and 2007, realized investment gains and losses resulting from the net change in fair value of the credit default swaps were (losses) gains of $(9.1) million, $283.5 million and $229.7 million, respectively. The Company utilizes total return swaps to protect a portion of its equity and equity related holdings against a decline in equity markets. These total return swaps contain contractual reset provisions requiring counterparties to cash-settle on a monthly basis any market value movements arising since the prior settlement. Any cash paid to settle unfavorable market value changes and, conversely, any cash received in settlement of favorable market value changes are recognized as realized investment gains or losses on the consolidated statements of income in the period in which they occur. To the extent that a contractual reset date of a contract does not correspond to the balance sheet date, the Company records additional realized investment gains or losses on the consolidated statements of income to adjust the carrying value of the derivative asset or liability associated with each total return swap contract to reflect its fair value at the balance sheet date. For the years ended December 31, 2009 and 2008, realized investment gains and losses resulting from total return swaps were (losses) gains of $(22.3) million and $362.1 million, respectively. The Company did not utilize total return swaps in 2007.
The Company holds significant investments in equities and equity related securities. The market values of these investments are volatile and may vary dramatically either up or down in short periods, and their ultimate value will therefore only be known over the long term. At each reporting date, and more frequently when conditions warrant, management evaluates all available-for-sale securities with unrealized losses to determine whether an other than temporary decline in value exists and whether losses should be recognized in earnings rather than in accumulated other comprehensive income (loss). The process for determining whether a security is other than temporarily impaired requires judgment and involves analyzing many factors. These factors include but are not limited to (i) the length of time and extent to which the fair value has been less than its cost or amortized cost; (ii) the severity of the impairment; (iii) the cause of the impairment; (iv) the financial condition and near-term prospects of the issuer as well as specific credit issues related to the issuer such as changes in credit rating, reduction or elimination of dividends or non-payment of scheduled interest payments; and (v) for fixed income securities, the Company’s intent to sell a security or whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost, which in some cases, may extend to maturity, and for equity securities, the Company’s intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery of fair value in the near term. To the extent management determines that a security is deemed to be other than temporarily impaired, an impairment loss is recognized.
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, 2009.
At December 31, 2009, there are no valuation allowances against the Company’s gross deferred tax assets of $251.2 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.
Market conditions for the Company’s largest accident and health segment by gross written premiums, employer stop loss, are currently intensely competitive. Competition in the Company’s other accident and health segments, such as student medical, travel and pet insurance, varies from product to product but generally is currently less intense.
During 2009, the Company’s renewal retention rates and renewal pricing remained level as compared to 2008. Specifically, renewal retention rates for casualty lines increased by approximately 2 percentage points and renewal retention rates for property lines declined by approximately 4 percentage points, with the property renewal retention rates being depressed by underwriting actions intended to improve profitability. Renewal prices for casualty lines remained flat and renewal prices for property lines declined by approximately 1 percentage point. New business declined by approximately 11%, attributable to a reduction in both casualty and property lines. New business growth continues to be affected by the competitive market environment and ongoing economic downturn.
The decrease in net income in 2009 as compared to 2008 was primarily attributable to substantially lower net realized investment earnings, partially offset by improved underwriting results. Lower investment earnings in 2009 were principally due to the non-recurrence of significant gains realized on derivative and short-sale securities in 2008. Offsetting the lower gains on derivatives and short-sale securities were higher realized gains on fixed income and equity securities, mark-to-market accounting gains on investments accounted for at fair value, higher investment income, primarily higher earnings from investments at equity, and lower other than temporary impairment charges in 2009 as compared to 2008. The increase in underwriting income and corresponding improvement in the loss and LAE ratios was principally due to a lack of major catastrophes in 2009. By comparison, the 2008 loss ratio was adversely affected by one-time charges, including: (i) a charge of $75.5 million arising from the commutation of a reinsurance contract (7.6 loss ratio points); (ii) catastrophe losses associated with Hurricanes Gustav and Ike of $71.5 million (7.2 loss ratio points); and (iii) a charge of $25.5 million associated with the aforementioned lawsuit (2.6 loss ratio points). Excluding the effects of the reinsurance commutation, Hurricanes Gustav and Ike and the asbestos lawsuit activity, the loss and LAE ratio was 65.1% in 2008 as compared to 67.3% in 2009, the increase being primarily due to lower favorable prior year loss development and the cumulative effect of the weak economy and challenging market conditions.
The increase in net income in 2008 as compared to 2007 was primarily due to a significant increase in investment earnings and lower costs related to early retirement of debt, partially offset by substantially lower underwriting income due to catastrophes and other charges discussed above. The increase in investment earnings was predominantly due to higher net realized gains on the Company’s derivative and short-sale securities 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, higher mark-to-market accounting losses incurred on investments accounted for at fair value and lower investment income. Underwriting results were substantially lower in 2008 as compared to 2007, primarily attributable to the adverse effects of the reinsurance commutation, losses associated with Hurricane Gustav and an asbestos lawsuit settlement as noted above.
Lower equity in earnings of investees in 2008 as compared to 2007, was principally due to lower earnings from Northbridge Financial Corporation (“Northbridge”), an affiliated company, due to a change in accounting for Northbridge from equity method to fair value effective January 1, 2008.
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”.
For the year ended December 31, 2009 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 $173.0 million, or 21.2%, as compared to the year ended December 31, 2008, primarily due to a decline in new business of approximately 11% whereas renewal retention rates and prices on renewal policies remained flat. The decline in new business is attributable to a reduction in both property and casualty writings. The prolonged soft market conditions and weak economy continue to adversely affect premium growth, making it very challenging to write new business at acceptable rates. In addition to competitive market conditions, the decline in gross premiums written is also attributable 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 a market environment that remains highly competitive, renewing business and writing new business only where it believes rates are acceptable and terms and conditions are appropriate for the exposure.
For the year ended December 31, 2009, gross premiums written in casualty lines, which include workers’ compensation, general liability and commercial automobile lines of business, declined by $102.5 million, or 17.8%, as compared to the year ended December 31, 2008, due to a decline in new business of approximately 10%, reduced audit premiums and reduced renewal exposure due to the economy, concurrent with a lower renewal premium base, although renewal retention rates increased by approximately two percentage points and prices on renewal policies remained level. In addition, the significant reduction in commercial automobile gross premiums written in 2009 as compared to 2008 and 2007 is due to the Company more aggressively reducing its exposure to transportation accounts where loss experience has been unfavorable. The reduction in general liability largely reflects a decrease in the non-admitted casualty business, primarily related to the impact of the recession on the Company’s construction business. Aside from a modest improvement in California workers’ compensation rates, casualty business across the industry is continuing to suffer from inadequate rates. California workers’ compensation gross premiums written totaled $73.3 million, $65.7 million and $77.5 million in 2009, 2008 and 2007, respectively
For the year ended December 31, 2008, gross premiums written in casualty lines, which include workers’ compensation, general liability and commercial automobile lines of business, declined by $137.5 million, or 19.3%, as compared to the year ended December 31, 2007, due to a decline in new business of approximately 30%, price decreases on renewal policies of approximately 6% and a decrease in renewal retention rates of approximately five percentage points. The decline in new business was most significant for wholesale broker produced casualty business, although casualty new business was down for all producer categories. Pricing pressure for casualty accounts intensified countrywide in 2007 and continued throughout 2008, particularly for larger and middle market accounts, with competitors focusing on retaining their renewals. In addition, casualty gross premiums written in the commercial automobile line were also impacted by underwriting actions taken by the Company as respects the commercial automobile business.
For the years ended December 31, 2009 and 2008, net premiums written decreased by $154.8 million, or 17.8%, $228.4 million, or 20.8%, respectively, as compared to the prior year periods. The decrease in both years was generally in line with the decrease in gross premiums written. The lower percentage of net to gross premiums written in 2009 in the general liability line was due to increased reinsurance rates and the purchasing of additional reinsurance coverage on the umbrella book of business, whereas the lower percentage for accident and health was due to the purchase of additional reinsurance principally related to the medical stop loss business.
In 2009, the Company recognized net favorable prior year loss development of $25.0 million (3.2 loss ratio points) prior to corporate aggregate reinsurance activity. Included in the favorable loss development is an insurance recovery of $13.8 million (1.8 loss ratio points) associated with the settlement of an asbestos lawsuit. Excluding this recovery, the Company recognized net favorable loss development after corporate aggregate reinsurance activity of $26.1 million (3.3 loss ratio points), including $14.9 million of favorable development related amortization of deferred gains on retroactive reinsurance. The favorable development was primarily attributable to favorable emergence in workers’ compensation, commercial multi-peril and property lines of business, partially offset by adverse emergence in commercial automobile and asbestos liabilities.
In 2008, the Company recognized net adverse prior year loss development of $39.0 million (3.9 loss ratio points) prior to corporate aggregate reinsurance activity. Included in the adverse loss development is $84.3 million (8.4 loss ratio points) attributable to a loss on commutation of a reinsurance contract ($75.5 million after amortization of related deferred gain) and $25.5 million (2.6 loss ratio points) attributable to the settlement of an asbestos lawsuit. Excluding these one time charges, the Company recognized net favorable loss development after corporate aggregate reinsurance activity of $89.7 million (9.0 loss ratio points) including $18.9 million of favorable development related to amortization of deferred gains on retroactive reinsurance. The favorable development was primarily in the workers’ compensation and general liability lines of business, reflecting favorable loss emergence in almost all accident years, partially offset by unfavorable ALAE emergence in general liability for both latent and non-latent exposures. Specifically, favorable development in the workers’ compensation line was principally attributable to favorable results in non-California medical reserves for older accident years and non-California indemnity reserves for more recent accident years.
Includes book value of assets pledged for derivatives and short-sale obligations of $24.0 million, $4.4 million and $1,047.4 million at December 31, 2009, 2008 and 2007, respectively.
The increase in investment income of $91.4 million, or 126.2%, in 2009 as compared to 2008 is primarily due to the combined effects of: (i) higher earnings from the Company’s investments at equity, attributable to the underlying improvement in the equity markets in 2009; (ii) higher dividends from equity securities due to a shift in portfolio composition to equity securities since the fourth quarter of 2008; and (iii) lower investment expenses related principally to the Standard & Poor’s Depositary Receipts (“SPDRs”) short-sales and total return swaps which were closed out in the latter half of 2008. Offsetting these year-over-year increases in investment income was a decline in interest on cash and cash equivalents due to lower cash collateral held in 2009 as compared to 2008, related to the SPDRs short-sales and a decline in year-over-year short-term interest rates.
The decrease in investment income of $71.0 million, or 49.5%, in 2008 as compared to 2007, was primarily driven by substantially lower earnings from investments at equity which include partnership investments, attributable to depressed equity market conditions, and a year-over-year decline in average short-term interest rates. Losses from investments at equity were $(51.3) million in 2008 as compared to earnings of $13.0 million in 2007. In addition, 2008 investment income was also affected by higher investment expenses, attributable to higher expenses on the SPDRs short-sales and total return swaps, as well as higher incentive management fees. The Company executed an additional $320 million SPDRs short-sales in the latter half of 2007 and a further $105 million of SPDRs total return swaps in July 2008 which contributed to the increased SPDRs expense for 2008.
Pre-tax equity in earnings (losses) of investees in 2009 and 2008 were not material. The decrease in pre-tax equity in earnings (losses) of investees to $(0.7) million in 2008 from $35.8 million in 2007 was primarily attributable to a reduction in earnings from Northbridge, which was previously accounted for under the equity method of accounting prior to January 1, 2008, when the Company elected the fair value option for Northbridge under ASC 825, Financial Instruments. The Company sold its investment in Northbridge in December 2008.
The effective income tax rate (including income taxes on equity in earnings of investees) was 24.0%, 21.0% and 34.2% for the years ended December 31, 2009, 2008 and 2007, respectively. For 2009, the difference between the Company’s effective income tax rate and statutory rate of 35% primarily reflects net tax benefits of $19.2 million (7.2%) from tax exempt municipal bonds and $6.4 million (2.4%) from dividend received deductions. For 2008, in addition to dividend received deductions, the difference primarily reflects 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 (12.2%), mainly as a result of the utilization of foreign tax credits. For 2007, the difference is primarily due to dividend received deductions. For further discussion of income taxes, see Note 9 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Net paid losses and LAE paid in 2008 are net of $302.5 million of proceeds from the commutation of a finite reinsurance contract.
The prolonged soft market conditions in which the insurance subsidiaries are currently operating have resulted in double digit percentage declines in premium volume in each of the last two years. In addition, the Company initiated actions in 2008 to eliminate unprofitable classes of business. The Company’s property business is declining most markedly; however, due to the short tail nature of the claims, it is expected that claim payments will also decline in the relative near term as the exposures run off. The Company’s casualty business (approximately 55% of total gross premiums written in 2009) in general has a longer tail, meaning the period of time from the occurrence of a claim through the settlement of a liability may extend several years into the future and as a result cash flow may be adversely affected by claims from prior years. Additionally, the lapse of time between payments to claimants and recoveries from reinsurers, if collections from reinsurers are not received on a timely basis, will directly affect cash flows. Due to this uncertainty regarding the amount and timing of settlement of unpaid claims and ultimate recoveries from reinsurers, the insurance subsidiaries’ cash flow from operations and liquidity needs may vary from period to period. If premium receipts continue to decline and claim payments continue at historical norms, the Company is likely to have negative cash flow from operations in the near future.
Cash used in operations was $402.4 million as compared to cash provided from operations of $100.9 million in 2008, which included $302.5 million of proceeds from the commutation of a finite reinsurance contract. Excluding the commutation proceeds, cash outflow from operations was worse by $200.8 million. The unfavorable variance from prior year is primarily attributable to lower premium collections (related to the decline in premiums written), higher income tax payments which are substantially related to 2008 realized investment gains and lower investment income, affected by the negative cash flow experienced over the last two years. These unfavorable variances were partially offset by lower net paid losses and ALAE of $37.0 million (after adjusting for $302.5 million of commutation proceeds). The Company’s underwriting cash flows continue to be negative, reflecting declining premiums as a result of the continued soft market and recent underwriting actions in the face of steady or only marginally declining paid losses, ceded reinsurance costs and fixed operating expenses.
2008 cash outflow from operations of $201.6 million (excluding the aforementioned commutation proceeds) was $195.7 million worse than 2007. The unfavorable variance from 2007 was primarily attributable to lower premium collections and higher income tax payments related to realized investment gains.
During the fourth quarter of 2008 and the first quarter of 2009, the Company made significant purchases of fixed income and equity securities, when the Company determined that market price levels were attractive. In doing so, it reduced its historically high levels of cash, cash equivalents and short-term investments to lower levels. During the first quarter of 2009, the Company sold several municipal securities with a fair market value of approximately $146.2 million to third-parties and Fairfax affiliates to meet operating needs and restore its cash and short-term investments position to more normal levels. At December 31, 2009, the insurance subsidiaries held $311.8 million in highly liquid, short-term and other marketable securities to meet their operating needs and provide available cash in the event of unanticipated large claim payments. Management believes that the insurance subsidiaries have sufficient cash and short-term investments, that together with cash generated from future investing operations, will meet their operating liquidity needs.
Included in other long-term liabilities are estimated payments under the Company’s long-term incentive plans totaling $30.6 million, expected contributions to postretirement benefit plans sponsored by the Company totaling $8.1 million and payments to former senior officers of the Company totaling $3.3 million.
For discussion of regulatory issues, see “Item 1. Business ¾ Insurance Regulatory Matters”.
Consolidated Statements of Cash Flows for the Years Ended December 31, 2009, 2008 and 2007
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows present fairly, in all material respects, the financial position of Crum & Forster Holdings Corp. and Subsidiaries at December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Crum & Forster Holdings Corp. (the “Company” or “Crum & Forster”) is a Delaware holding company, which is 100% owned by Fairfax Inc., a Wyoming holding company. Fairfax Inc. is ultimately owned by Fairfax Financial Holdings Limited (“Fairfax”), a Canadian financial services holding company, which is publicly traded on the Toronto Stock Exchange. The Company, through its subsidiaries, offers a full range of commercial property and casualty insurance distributed through an independent producer force located across the United States.
Certain amounts in the Company’s prior year consolidated financial statements have been reclassified to conform to the 2009 presentation.
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, are carried under the equity method of accounting in accordance with ASC 323, Investments - Equity Method and Joint Ventures, (“ASC 323”) or at fair value in accordance with ASC 825, Financial Instruments (“ASC 825”). For all other investments, the Company determines if it exercises significant influence based upon its ownership of voting shares without consideration of the ownership interest of other Fairfax affiliates. Investments accounted for under the equity method of accounting are included as investments at equity on the consolidated balance sheets. The Company’s pro-rata share of earnings of equity method investees is recorded in the consolidated statements of income. Earnings of investment companies and similar equity method investees are reported in investment income and earnings of other equity method investees are reported as equity in earnings of investees, net of tax. The carrying value of investments at equity includes limited partnerships, and is based upon the Company’s share of net asset values of each investee, as determined by the general partner. Dividends from equity method investees reduce the carrying value of the investment. Investments that would have been subject to the equity method of accounting, but for which the Company has elected the fair value option under ASC 825, are included in derivatives and other invested assets on the consolidated balance sheets, with changes in fair value recorded as realized investment gains or losses in the period in which they occur.
The Company uses derivatives to mitigate financial risks arising principally from its investment holdings and receivables. Derivatives include credit default swaps, total return swaps and warrants, none of which is specifically designated or meets the requirements for hedge accounting. All derivative securities are recorded as either assets or liabilities on the consolidated balance sheets and are measured at fair value with changes in fair value recorded as realized investment gains or losses in the period in which they occur.
Cash collateral received from or paid to counterparties as security for derivative contract assets or liabilities, respectively, is included in assets or liabilities on the consolidated balance sheets. Securities received from counterparties as collateral are not recorded as assets. Securities delivered are reflected as assets pledged for derivatives on the consolidated balance sheets.
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 earnings in the period in which the impairment occurs. The Company’s impairment tests in 2009 and 2008 resulted in a conclusion that no goodwill impairment had occurred. Goodwill in the amount of $7,311 is included in other assets on the consolidated balance sheets at December 31, 2009 and 2008.
The Company reinsures, in the ordinary course of business, certain risks with other insurance and reinsurance companies (“reinsurers”). These arrangements provide the means for greater diversification of business and serve to limit the net loss potential of unusually severe or frequent losses. The ceding of insurance does not discharge the original insurer from its primary liability to its policyholder; however, the reinsurer that accepts the risk assumes an obligation to the original insurer (“ceding insurer”). The ceding insurer retains a contingent liability with respect to reinsurance ceded to the extent that any reinsuring company might not be able, or willing, to meet its obligations. Reinsurance recoverable includes the reinsurers’ obligations to reimburse the Company for a share of paid and unpaid losses and LAE pursuant to the reinsurance contracts. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired terms of the ceded contracts.
Reserves for uncollectible reinsurance are determined based upon reviews of the financial condition of reinsurers and assessments of other available information.
Insurance and reinsurance premiums are earned ratably over the terms of the related policies. Unearned premium reserves are established for the unexpired portion of policy premiums. Premiums are accrued for retrospectively rated policies and on policies subject to audit based on estimates throughout the contract or policy term. The reserve for uncollectible premiums includes both specific allowances for probable uncollectible amounts and a non-specific reserve determined principally on the basis of past collection experience. At December 31, 2009 and 2008, the reserve for uncollectible premiums was $17,500 and $20,191, respectively.
Financial statements of foreign investees accounted for using the equity method are translated into U.S. dollars in accordance with ASC 830, Foreign Currency Matters (“ASC 830”). Under ASC 830, investments in entities accounted for under the equity method are translated into U.S. dollars at the rate of exchange in effect at the date of the transaction and related equity earnings are translated at the average rate in effect during the period. At each balance sheet date, the carrying amounts are translated into U.S. dollars at the rate in effect at the balance sheet date and any translation gains or losses are recorded in other comprehensive income.
Accumulated other comprehensive income or loss includes unrealized investment gains and losses on the Company’s available-for-sale fixed income and equity securities, foreign currency translation gains and losses arising from the translation of financial statements of equity method investees denominated in foreign currencies and adjustments to recognize any change in defined benefit postretirement plan costs not yet recognized in net income. At December 31, 2009 and 2008, included in accumulated other comprehensive income (loss) were unrealized investment gains (losses) of $252,946 and $(10,836), net of tax, respectively, foreign currency translation gains (losses) of $107 and $(215), net of tax, respectively, and defined benefit postretirement plan gains of $3,806 and $3,596, net of tax, respectively.
ASC 105. In June 2009, the FASB issued guidance under ASC 105, Generally Accepted Accounting Principles, which establishes the FASB Accounting Standards Codification (“Codification”) as the single source of authoritative GAAP to be applied to nongovernmental entities. The only other source of authoritative GAAP is the rules and interpretive releases of the SEC, which apply only to SEC registrants. The Codification was effective for interim and annual financial reporting periods ending after September 15, 2009 and does not change or alter existing GAAP but changes the way in which GAAP is referenced in the Company’s financial statements. The Company adopted the Codification during the third quarter of 2009 and technical references to GAAP in this report are provided under the new Codification structure.
ASC 825. In April 2009, the FASB issued guidance under ASC 825, which amends previous guidance to require disclosures about the fair value of financial instruments for interim reporting periods in addition to annual reporting periods and also requires companies to disclose the methods and significant assumptions used to estimate the fair value of financial instruments in financial statements on an interim basis and to describe any changes during the period. The Company adopted ASC 825 effective April 1, 2009 and the adoption did not have an impact on the Company’s financial position or results of operations, but resulted in additional disclosures which have been made in Note 4 to the consolidated financial statements.
In February 2007, the FASB issued guidance under ASC 825, which provides a fair value 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 irrevocable 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, ASC 825 allows for a one-time election for existing eligible financial instruments upon adoption, with the transition adjustment recorded to beginning retained earnings. The Company adopted the fair value option guidance under ASC 825 effective January 1, 2008 and upon adoption, elected the fair value option for 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. Subsequently, the Company 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, both of which would otherwise have been subject to the equity method of accounting as they are subsidiaries of Fairfax.
In determining the eligible financial instruments for which to elect the fair value option, the Company considered all of its equity method investments. These investments are often carried at values that do not reflect current fair market value. The Company decided that the fair value option would be appropriate for equity method investments for which there is a publicly quoted market price. Since Northbridge, Advent and Odyssey were traded on public stock exchanges at the time of the fair value option election, their traded price was considered to be a better indicator of value than carrying value under the equity method of accounting. During the fourth quarter of 2009, Fairfax and its affiliates purchased additional shares of Advent and Odyssey, bringing Fairfax’s ownership in each company to 100%. As a result, Advent and Odyssey are no longer traded on public stock exchanges and the Company now values these investments using internally developed valuation models. For further details, see Note 4 to the consolidated financial statements.
ASC 740. In June 2006, the FASB issued an interpretation under ASC 740, Income Taxes (“ASC 740”) which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. Specifically, the interpretation 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. Although the adoption of this guidance did not have a direct impact on the Company’s results of operations or financial position, adoption of the guidance by one of the Company’s equity method investees resulted in the Company recording a charge of $681, net of tax, to opening retained earnings in 2007.
ASU 2009-17. In June 2009, the FASB issued Accounting Standards Update 2009-17, Improvements to Financial Reporting by Enterprises with Variable Interest Entities, (“ASU 2009-17”), which amends previous guidance under ASC 810, Consolidation (“ASC 810”). The guidance replaces the quantitative-based risks and rewards calculation for determining which enterprise has a controlling financial interest in a variable interest entity with an approach focused on identifying which enterprise has (i) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (ii) the obligation to absorb losses of the entity or the right to receive benefits from the entity. It also requires an additional reconsideration event when determining whether an entity is a variable interest entity when any changes in fact and circumstances occur and ongoing assessments of whether an enterprise is the primary beneficiary of a variable interest entity. Additional disclosures about an enterprise’s involvement in variable interest entities are also required. ASC 810 is effective for interim and annual reporting periods beginning after November 15, 2009. The Company is currently evaluating the impact of the adoption of ASC 810, but does not expect adoption to have a material impact on its financial position or results of operations.
Includes assets pledged for derivatives at a fair value of $29,425 (amortized cost of $24,025).
Included in equity securities at December 31, 2009 are certain holdings which represent over 10% of shareholder’s equity at that date as follows: (i) a $177,316 investment in Dell Inc. common stock, which represents 11.7% of shareholder’s equity; (ii) a $168,564 investment in Johnson & Johnson common stock, which represents 11.1% of shareholder’s equity; and (iii) a $162,617 investment in Wells Fargo & Company common stock, which represents 10.7% of shareholder’s equity.
The amortized cost and fair value of available-for-sale fixed income securities by contractual maturity are summarized below. Actual maturities may differ from maturities shown below due to the existence of call features.
For the year ended December 31, 2009, other than temporary impairment charges were $110,814, of which $3,507 was in respect of fixed income securities, all of which was credit related, and the remaining $107,307 was due to write downs of equity securities. There were no fixed income losses for which a portion of the other than temporary impairment has been recognized in accumulated other comprehensive income. For the year ended December 31, 2008, the Company recorded other than temporary impairment charges of $194,670, of which $4,365 was in respect of fixed income securities and $190,305 was due to write downs of equity securities.
Included in held-for-trading securities are two convertible securities issued by Level 3 Communications, Inc. with a combined value of $145,714 which together with an investment in Level 3 Communications, Inc. common stock of $36,828 represented 12.0% of shareholder’s equity at December 31, 2009 (12.8% at December 31, 2008).
The following table summarizes the Company’s derivative securities at December 31, 2009 and 2008:
The Company has purchased credit default swaps, referenced to various issuers in the banking, mortgage and insurance sectors of the financial services industry which serve as economic hedges against declines in the fair value of the Company’s financial assets. Under a credit default swap, as the buyer, the Company agrees to pay to a specific counterparty, fixed premium amounts based on an agreed notional principal amount in exchange for protection against default by the issuers of specified referenced debt securities. The credit events, as defined by the respective credit default swap contracts establishing the rights to recover amounts from the counterparties, include events such as bankruptcy, obligation acceleration, obligation default, failure to pay, repudiation/moratorium and restructuring. As of December 31, 2009, all credit default swap contracts held by the Company have been purchased from and entered into with either Citibank, N.A., Deutsche Bank AG or Barclays Bank PLC as the counterparty, with positions on certain covered risks with more than one of these counterparties.
At December 31, 2009, the credit default swap portfolio had an average term to expiry of 2.3 years. A maturity analysis of the credit default swaps at December 31, 2009 follows:
The following tables summarize the effect of the credit default swaps and related hedged items on the Company’s financial position and results of operations and cash flows as of and for the years ended December 31, 2009 and 2008:
During much of 2008 and immediately preceding years, the Company had been concerned about the valuation of worldwide equity markets, uncertainty resulting from credit issues in the U.S. and global economic conditions. As protection against a decline in equity markets, the Company held short positions in Standard & Poor’s Depositary Receipts (“SPDRs”) and U.S. listed common stocks and equity index and equity total return swaps, referred to in the aggregate as equity hedges. The Company also in the past purchased S&P Index call options to limit the potential loss on its equity index total return swaps and SPDRs short positions and to provide general protection against the short position in common stocks. In the latter half of 2008, following significant declines in global equity markets, the Company reviewed the financial objectives of its hedging program and determined that elevated risks in the global equity markets had moderated and subsequently closed all of its equity hedge positions, realizing substantial gains. During the fourth quarter of 2008, the Company increased its investments in equities as a result of the opportunities presented by significant declines in the global equity markets.
During the third quarter of 2009, as a result of the rapid increase in the valuation level of worldwide equity markets, the Company once again decided to protect a portion of its equity and equity related holdings against a decline in equity markets and entered into equity index total return swaps with a notional value of $452,319. These total return swaps contain contractual reset provisions requiring counterparties to cash-settle on a monthly basis any market value movements arising since the prior settlement. Any cash paid to settle unfavorable market value changes and, conversely, any cash received in settlement of favorable market value changes are recognized as realized investment gains and losses on the consolidated statements of income in the period in which they occur. To the extent that a contractual reset date of a contract does not correspond to the balance sheet date, the Company records additional net realized investment gains or losses on the consolidated statements of income to adjust the carrying value of the derivative asset or liability associated with each total return swap contract to reflect its fair value at the balance sheet date. The total return swaps were in a loss position at December 31, 2009 and are recorded in accounts payable and other liabilities on the consolidated balance sheet.
The net cash flow effect from disposals of the above equity exposures and related hedging instruments for the year ended December 31, 2009 was $1,203.
The following table summarizes the changes in fair value of the Company’s derivative securities and short positions included in net realized investment gains in the consolidated statements of income for the years ended December 31, 2009, 2008 and 2007:
Further analysis of the 2009, 2008 and 2007 net realized investment gains is set forth in the tables below. The net realized investment gains or losses on disposal represent inception to date gains or losses:
On September 15, 2009, the Company purchased additional shares of Advent, a Fairfax affiliate, for cash consideration of $10,050. The Company’s ownership of Advent increased to 17.5% with the purchase of the additional shares (11.7% at December 31, 2008).
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 inception to date losses of approximately $20,000 on its investment in TPF. In September 2009, 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 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% at December 31, 2008.
On March 31, 2008, the Company sold its entire 9.3% ownership interest in MFX to Fairfax for nominal consideration and recorded a realized loss of $1,550 on this security which was deemed to have no value.
Fixed income securities and cash and cash equivalents of $306,012 and $403,892 were on deposit with various state regulatory authorities at December 31, 2009 and 2008, respectively, as required by insurance laws.
The components of net investment income for the years ended December 31, 2009, 2008 and 2007 are summarized as follows:
Includes interest (expense) income of $(47), $25,609 and $16,893 in 2009, 2008 and 2007, respectively, on cash collateral pledged for derivatives and short-sale obligations.
The components of realized investment gains for the years ended December 31, 2009, 2008 and 2007 are summarized below:
Included in realized investment losses for the years ended December 31, 2009, 2008 and 2007 are $110,814, $194,670 and $25,443, respectively, of other than temporary impairment charges. The amount for 2009 includes write-downs of $107,307 attributable to equity securities and $3,507 attributable to fixed incomes securities, all of which was credit related. 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. For further details of realized investment 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”.
Level 3 - Valuations based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect the Company’s own assumptions about the methodology and valuation techniques that a market participant would use in pricing the asset or liability.
The Company uses valuation models to establish the fair value of its Level 3 securities (approximately 10% of total investment portfolio at fair value). Level 3 securities include the Company’s investments in Odyssey and Advent, which were transferred from Level 1 and Level 2, respectively, during the fourth quarter of 2009, following their privatization and subsequent delisting from public stock exchanges. The Company values these investments using internally developed valuation models based on market multiples derived from a set of publicly traded comparable companies. The models, which require a significant amount of judgment, use current and historical market prices and book values of comparable companies to derive a current fair value. Also included in Level 3 are non investment grade mortgage-backed securities purchased at deep discounts to par which are valued using an internal discounted cash flow model, which includes unobservable inputs that are supported by limited market-based activity. The Company assesses the reasonableness of the fair values of these securities by comparing the fair values to models validated by qualified personnel, by reference to movements in credit spreads and by comparing the fair values to recent transaction prices for similar assets where available.
The following table presents the Company’s assets (excluding cash and cash equivalents) measured at fair value on a recurring basis, within the fair value hierarchy, at December 31, 2009 and 2008:
Transfers into Level 3 for equity securities are in respect of the Company’s investments in Odyssey and Advent, which were transferred from Level 1 and Level 2, respectively, during the fourth quarter of 2009. Transfers from Level 3 and into Level 2 are in respect of mortgage-backed securities for which broker-quotes, which utilize observable inputs, are used to value those securities.
During the third quarter of 2008, the Company elected the fair value option for its investment in Advent. At the time, Advent was publicly traded on a foreign stock exchange and its traded price was determined to be a better indicator of its value than its carrying value under the equity method. During the third and fourth quarters of 2009, Fairfax purchased the remaining outstanding shares of Advent which Fairfax did not already own, resulting in Advent becoming a wholly owned subsidiary of Fairfax. The Company owned approximately 17.5% of Advent at December 31, 2009. At December 31, 2009 and December 31, 2008, the Company’s investment in Advent is recorded in derivatives and other invested assets on the consolidated balance sheets at a fair value of $26,603 and $11,607, respectively. For the years ended December 31, 2009 and December 31, 2008, the change in fair value of the Company’s investment in Advent was a gain (loss) of $4,946, and $(8,485), respectively, which was recorded through net realized investment gains and losses in the consolidated statements of operations. Dividends of $0 and $907 were received from Advent for the twelve months ended December 31, 2009 and December 31, 2008, respectively, and have been recorded as investment income in the consolidated statements of operations.
In 2009, the Company recognized $39,864 of favorable prior year loss development (5.1 loss ratio points) including an insurance recovery of $13,750 associated with the settlement of an asbestos lawsuit and $14,883 of amortization of deferred gains on retroactive reinsurance. The other net favorable development of $11,231 was primarily attributable to favorable emergence in workers’ compensation, commercial multi-peril and property lines, partially offset by adverse emergence in commercial auto and asbestos liabilities.
In 2007, the Company recognized net favorable prior year loss development of $63,854 (5.4 loss ratio points) including $13,673 of amortization of deferred gains on retroactive reinsurance. The net favorable development was comprised of 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 claims 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 $54,547 of adverse development of asbestos, environmental and other latent liabilities.
The Company has exposure to asbestos, environmental and other latent claims arising from the sale of general liability, commercial multi-peril and umbrella insurance policies, the majority of which were written for accident years 1985 and prior. Estimation of ultimate liabilities for these exposures is unusually difficult due to such issues as whether or not coverage exists, definition of an occurrence, determination of ultimate damages and allocation of such damages to financially responsible parties. At December 31, 2009 and 2008, total net unpaid asbestos, environmental and other latent losses were $356,262 and $401,125, respectively, representing 17.5% and 17.4% of total net unpaid losses at December 31, 2009 and 2008, respectively.
In 2007, environmental losses incurred were significantly higher than both 2008 and 2009, 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. The 2007 incurred losses also include settlements which secured broader releases on certain active exposures.
The net impact of ceded reinsurance transactions for each of the fiscal years 2009, 2008 and 2007 is summarized as follows:
For the years ended December 31, 2009, 2008 and 2007, accident and health earned premiums ceded to reinsurers were $60,672, $42,070 and $18,602, respectively.
The reinsurance recoverable balances above are net of reserves for uncollectible reinsurance of $54,228 and $55,999 at December 31, 2009 and December 31, 2008, respectively. Included in reinsurance recoverable is $141,030 and $142,213 at December 31, 2009 and December 31, 2008, respectively, representing the present value of amounts due from insurance companies from which the Company has purchased annuities to settle certain claim liabilities.
The effect of prospective corporate aggregate reinsurance on components of the Company’s consolidated statements of income follows ((decrease) increase in indicated component):
The second contract was 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 was on a funds held basis with interest credited at 7.5%. In March 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.
An analysis of activity in deferred income related to retroactive corporate aggregate reinsurance contracts follows:
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, 2009. 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, 2009, the Company had ceded cumulative losses of $349,000, which is comprised of $(20,000) in 2008, $(3,577) million in 2007, and $372,577 prior to 2007 and paid premiums of $143,848, which is comprised of $(8,186) million in 2008, $(1,273) in 2007 and $153,307 prior to 2007, related to this contract. At December 31, 2009 and 2008, the Company had a reinsurance recoverable balance of $349,000, and funds held balances of $236,302 and $220,843, respectively, related to this agreement.
The premiums for the contract which remains in effect at December 31, 2009 is 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 is 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 $14,883 in 2009, $9,955 in 2008, $13,259 in 2007 and $60,661 prior to 2007. This amortization of deferred income is included as a reduction of losses and LAE in the consolidated statements of income.
On May 7, 2007, the Company issued pursuant to a private offering (the “Offering”) $330,000 aggregate principal amount of 7-3/4% senior notes due May 1, 2017 (the “2017 Notes”) at an issue price of 100%. The 2017 Notes are redeemable at the option of the Company beginning May 1, 2012, at prices set forth in the indenture governing the 2017 Notes. Net proceeds of the Offering to the Company, after commissions and expenses, were approximately $325,100. In connection with the sale of the 2017 Notes, the Company entered into a registration rights agreement under which the Company agreed to use its reasonable best efforts to register with the SEC notes having substantially the same terms as the 2017 Notes, as part of an offer to exchange freely tradeable exchange notes for the 2017 Notes. Pursuant to an exchange offer which was completed on August 16, 2007, the Company issued $330,000 aggregate principal amount of registered notes with substantially the same terms as the 2017 Notes, in exchange for all of the outstanding 2017 Notes. Concurrent with the Offering, the Company completed a cash tender offer (the “Tender Offer”) to purchase any and all of its outstanding $300,000 aggregate principal amount of 10-3/8% senior notes due June 15, 2013 (the “2013 Notes”). Pursuant to the Tender Offer, all but $4,270 aggregate principal amount of the 2013 Notes were purchased and cancelled. The purchase of the 2013 Notes was funded with proceeds from the sale of the aforementioned 2017 Notes and available cash on hand. On June 16, 2008, the Company redeemed the remaining outstanding $4,270 aggregate principal amount of the 2013 Notes.
At December 31, 2009 and 2008, the book value of the long-term debt, net of unamortized discount, was $312,114 and $310,502, respectively, and the fair value of the long-term debt, as determined from quoted market prices, was $323,400 and $244,200, respectively.
Income tax expense shown on the consolidated statements of income excludes $43, $(250) and $12,548 of deferred income tax expense (benefit) on equity in earnings of investees in 2009, 2008 and 2007, respectively. Total income tax expense in 2009, 2008 and 2007, inclusive of these amounts, was $63,673, $88,353 and $152,535, respectively. Income taxes paid in 2009, 2008 and 2007 were $207,333, $99,514 and $35,024, respectively. Included in accounts payable and other liabilities on the consolidated balance sheets at December 31, 2009 and 2008, respectively, is $11,108 and $165,622 in respect of current income taxes payable.
Management believes it is more likely than not that the Company will realize the benefits of its net deferred tax assets and, accordingly no valuation allowance has been recorded at December 31, 2009 and 2008.
The Company and its subsidiaries have entered into various reinsurance arrangements with related parties. The approximate amounts by which income, expense, assets and liabilities are increased (decreased) in the consolidated financial statements, with respect to reinsurance assumed and ceded, are summarized as follows:
In the normal course of business, a Fairfax offshore reinsurance affiliate, Wentworth Insurance Company Ltd. (“Wentworth”), participates in reinsurance agreements covering several reinsured lines of business. In 2006 and prior, nSpire, also a Fairfax affiliate, participated in these agreements. For the years ended December 31, 2009 and 2008, the Company ceded premiums of $8,152 and $19,342, respectively, to Wentworth and had reinsurance recoverable balances of $19,207 and $13,850, respectively, at December 31, 2009 and 2008.
Reinsurance recoverable from TIG, a subsidiary of Fairfax, totaled $129,405 and $120,758 at December 31, 2009 and 2008, 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, and a BB+ financial strength rating from Standard and Poor’s, both nationally recognized rating agencies. TIG is a sizable regulated entity with policyholders’ surplus of approximately $786,637 at December 31, 2009 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 $171,487 at December 31, 2009. The Company has sixteen years of experience with TIG, during which the balances due from TIG have declined from approximately $267,000 to $129,405 at December 31, 2009, 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, 2009 and 2008, amounts recoverable from TIG included $91,427 and $95,240, 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 (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, 2009 and 2008, the Company had reinsurance recoverable of $37,694 and $38,237, respectively, from Fairmont, and $37,033 and $24,134, respectively, from TIG, related to these agreements.
Effective January 1, 2006, the Company, in connection with its assumption of the Fairmont business, entered into a reinsurance agreement with Markel Insurance Company of Canada (“Markel”), an affiliate of Fairfax, under which the Company has agreed to provide commercial auto coverage to U.S. or Canadian domiciled companies, for which Markel has written the Canadian auto coverage business, and to cede 100% of the coverage provided by the Company to Markel. During the years ended December 31, 2009, 2008 and 2007, the Company ceded premiums of $1,646, $2,128 and $1,966, respectively, to Markel and had a reinsurance recoverable balance of $1,444 and $1,959, respectively, at December 31, 2009 and December 31, 2008.
The Company and its subsidiaries have entered into agreements with Hamblin Watsa Investment Counsel Ltd. (“Hamblin Watsa”), a wholly-owned subsidiary of Fairfax, for investment management services, and with Fairfax for investment administration services. Pursuant to the agreements, fees, based upon assets under management, totaled $11,334, $11,150 and $7,134 for the years ended December 31, 2009, 2008 and 2007, respectively, and were included as investment expenses in the consolidated statements of income.
Under an agreement effective from January 1, 2001 through December 31, 2007, FITS was provided certain management and general services by the Company, for which the Company recorded $0, $0 and $172 for the years ended December 31, 2009, 2008 and 2007, respectively.
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 $771, $842 and $1,151 for the years ended December 31, 2009, 2008 and 2007, respectively.
Included in other expense for the years ended December 31, 2009, 2008 and 2007 are incurred charitable contributions of $2,720, $6,600 and $3,986, respectively, related to the Six Four Foundation, a not-for-profit entity affiliated with Fairfax.
The Company sponsors a qualified defined contribution plan pursuant to sections 401(k) and 401(a) of the Internal Revenue Code for which all employees are eligible. The Company makes an annual contribution equal to 3% of base salary and a matching contribution equal to one-half of each employee’s contribution up to the first 6% of base salary. Certain employees also have the opportunity to participate in a non-qualified plan that permits contributions that would otherwise be limited by IRS regulations. Total defined contribution plan expense was $5,431, $5,582 and $6,091 for the years ended December 31, 2009, 2008 and 2007, respectively.
The Company provides postretirement health care and life insurance benefits to certain retired employees. Medical benefits are provided to employees who were at least age 50 on January 1, 1994, and upon retirement are at least age 55 and have at least 15 years of service. Employees hired before August 1, 1990 are eligible for retiree life insurance coverage based on defined age, service and salary criteria. During the second quarter of 2009, the Company increased the required retiree contributions for the optional supplemental life insurance coverage. This change was treated as a negative plan amendment and reduced the accumulated postretirement benefit obligation by $1,109 in 2009. During the fourth quarter of 2008, the Company announced that effective January 1, 2009, retiree medical benefits for age 65 and older Medicare eligible participants would be provided by individual “Medicare Advantage Plan” insurance policies and participants under age 65 would be covered by a group insurance policy. This change, from self-insurance was treated as a negative plan amendment and reduced the accumulated postretirement benefit obligation by $3,401 in 2008.
The Company has established various long term incentive plans for certain employees who hold senior management or officer positions. These plans provide for the payment of cash bonuses in the future, the value of which is either fixed or based on the book value of the Company. For 2009, 2008 and 2007, expenses relating to these plans, which are included in the consolidated statements of income were $6,496, $4,944 and $7,260, respectively.
All employees of the Company are eligible to participate in the Fairfax Financial Holdings Limited Employee Share Ownership Plan (the “Plan”). The Plan provides an opportunity to purchase Fairfax subordinate voting shares through a combination of employee and company contributions. Employees may elect to contribute from 1% to 10% of base salary through regular payroll deductions, and the Company is required to make matching contributions equal to 30% of the employee contributions. In addition, the Company is required to make an annual contribution equal to 20% of employee contributions upon Fairfax and the Company achieving certain financial objectives. The Plan expense of $462, $370 and $213 for the years ended December 31, 2009, 2008 and 2007, respectively, is included in the consolidated statements of income.
Rental expense under these operating leases was $13,073, $13,023 and $13,178 in 2009, 2008 and 2007, respectively. The Company recognized $4, $83 and $163 in 2009, 2008 and 2007, 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 present value of these annuities included in reinsurance recoverable in the consolidated balance sheets at December 31, 2009 and 2008 was approximately $141,030 and $142,213, respectively. Approximately 82.8% of this balance is due from insurance companies rated A- or better by A.M. Best Company.
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 court heard oral arguments on April 21, 2009 in Philadelphia, Pennsylvania. The court took the matter under submission and has not yet issued a ruling. Crum & Forster Holdings Corp. and US Fire continue to be named as defendants and intend to vigorously defend the action.
In the ordinary course of their business, Crum & Forster’s subsidiaries receive claims asserting alleged injuries and damages from asbestos and other hazardous waste and toxic substances and are subject to related coverage litigation. The conditions surrounding the final resolution of these claims and the related litigation continue to change. Currently, it is not possible to predict judicial and legislative changes and their impact on the future development of asbestos and environmental claims and litigation. This trend will be affected by future court decisions and interpretations, as well as changes in applicable legislation. As a result of these uncertainties, additional liabilities may arise for amounts in excess of current reserves for asbestos, environmental and other latent exposures. These additional amounts, or a range of these additional amounts, cannot currently be reasonably estimated. As a result of these claims, management continually reviews required reserves and reinsurance recoverable. In each of these areas of exposure, the Company litigates individual cases when appropriate and endeavors to settle other claims on favorable terms.
GAAP differs in certain respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities for the Company’s insurance subsidiaries. Prescribed statutory accounting practices include state laws, regulations and general administrative rules, as well as a variety of publications of the NAIC. Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state and may change in the future.
The Company operates in the commercial property and casualty insurance business. Premiums earned for the Company’s lines of business are summarized as follows:
The Company does not allocate investment results or certain corporate expenses for purposes of evaluating financial performance of each line of business. For additional information on current accident year losses and prior years’ development, see Note 5 to the consolidated financial statements.
The increase in investment income in the fourth quarter of 2009 as compared to the fourth quarter of 2008 was primarily attributable to higher earnings from investments at equity.
The decrease in net realized investment gains in the fourth quarter of 2009 as compared to the fourth quarter of 2008 was primarily attributable to lower gains on total return swaps.