We earned $304.8 million or $2.64 per diluted share in 2008, compared to $395.4 million or $3.38 per diluted share in 2007. The reductions are due to catastrophic losses from hurricanes occurring in 2008 and lower income from investment-related items, which are discussed in the Results of Operations section. Profitability from our underwriting operations remains at acceptable levels despite rate pressure from competitors on certain lines of business and losses from the 2008 hurricanes. During 2008, we had $82.4 million of positive reserve development, of which 70% was offset by increases in ultimate loss ratios in accident year 2008 above those set at the beginning of the year for certain of our business written in 2007 and 2008, due to higher notices of claims stemming from recent credit market issues. We had $26.4 million of positive reserve development in 2007, of which 50% was offset by increases in ultimate loss ratios in accident year 2007 for certain business written in 2006 and 2007. Our 2008 combined ratio was 85.4%, which included 1.2 percentage points for the 2008 hurricane losses, compared to 83.4% for 2007. Investment income on our fixed income securities grew $24.1 million in 2008, but our alternative investments, consisting mainly of fund-of-fund hedge fund investments, incurred losses of $30.8 million, and we had realized investment losses of $27.9 million from the sale or other-than-temporary impairment of fixed income securities with credit-related issues.
We underwrite a variety of specialty lines of business identified as diversified financial products; group life, accident and health; aviation; London market account; and other specialty lines of business. Products in each line are marketed by our insurance companies and agencies, through a network of independent agents and brokers, directly to customers or through third party administrators. The majority of our business is low limit or small premium business that has less intense price competition, as well as lower catastrophe and volatility risk. We reinsure a significant portion of our catastrophic exposure to hurricanes and earthquakes to minimize the impact on our net earnings and shareholders’ equity.
ceding commissions in excess of policy acquisition costs earned by our insurance companies,
We produced $2.3 billion of total revenue in 2008, which was 5% lower than in 2007. Total revenue decreased $109.0 million year-over-year due to certain investment-related items discussed in the Results of Operations section.
During the past several years, we substantially increased our shareholders’ equity by retaining most of our earnings. With this additional equity, we increased the underwriting capacity of our insurance companies and made strategic acquisitions, adding new lines of business or expanding those with favorable underwriting characteristics. During the past three years, we acquired two insurance businesses for total consideration of $152.2 million and eight underwriting agencies for total consideration of $100.2 million. Net earnings and cash flows from each acquired entity are included in our operations beginning on the effective date of each transaction.
The following section discusses our key operating results. The reasons for any significant variations between 2007 and 2006 are the same as those discussed for variations between 2008 and 2007, unless otherwise noted. Amounts in the following tables are in thousands, except for earnings per share, percentages, ratios and number of employees.
Net earnings were $304.8 million ($2.64 per diluted share) in 2008 compared to $395.4 million ($3.38 per diluted share) in 2007. The decrease in net earnings primarily resulted from hurricane losses and the investment-related items described below. Diluted earnings per share benefited from the repurchase of 3.0 million shares of our common stock in 2008. Both the share repurchases and our lower stock price in 2008 caused the reduction in our diluted weighted-average shares outstanding from 117.0 million in 2007 to 115.5 million in 2008.
Our alternative investments generated $30.8 million of market-related losses in 2008, compared to $23.9 million of income in 2007. The related income or loss is included in net investment income. We gave notice to redeem all of the alternative investments in the third quarter of 2008. We received $48.6 million of cash through February 2009, which we reinvested in fixed income securities. We had $46.0 million of alternative investments at year-end 2008, for which we will receive the funds in 2009.
We recognized other-than-temporary impairments on securities in our available for sale securities portfolio of $11.1 million in 2008, which we recorded in net realized investment loss. There were no such impairments recorded in 2007.
Our trading portfolio had losses of $11.7 million in 2008, compared to gains of $3.9 million in 2007. These gains and losses are reported in other operating income. We discontinued the active trading of securities in late 2006 and sold the remaining two positions in 2008.
We sold strategic investments in 2008 and 2007 and realized gains of $9.2 million and $21.6 million, respectively. These gains are reported within other operating income.
Total revenue decreased 5% to $2.3 billion in 2008 and increased 15% to $2.4 billion in 2007. The 2008 decrease was due to lower income and losses from the investment-related items discussed in the Results of Operation section. The 2007 increase was driven by significant growth in net earned premium and higher investment income. Approximately 55% of the increase in revenue in 2007 was due to the acquisition of businesses.
Gross written premium, net written premium and net earned premium are detailed below. Premium increased in 2008 principally from growth in our diversified financial products and other specialty lines of business and our recent acquisitions. Net written premium and net earned premium increased for the same reasons, as well as from higher retentions and lower reinsurance costs. The 2007 increases in written and earned premium were primarily due to our 2006 acquisition of the Health Products Division and organic growth in our surety, credit and other specialty lines of business. See the Insurance Company Segment section for further discussion of the relationship and changes in our premium revenue.
Net investment income decreased 20% in 2008 and increased 35% in 2007. The 2008 decrease was primarily due to lower short-term interest rates and losses on our alternative investments, which are primarily fund-of-fund hedge fund investments compared to alternative investment income in 2007. These investments were impacted by the severe decline in the equity and debt markets. During the third quarter of 2008, we notified the fund managers that we planned to liquidate all of our alternative investments. At December 31, 2008, we recorded a $52.6 million receivable for redemption proceeds in the process of liquidation, of which we had collected cash of $48.6 million through February 2009. We expect the remaining cash will be received later in 2009. At December 31, 2008, the value of our remaining alternative investments was $46.0 million, for which we expect the liquidation process to be completed in 2009. In 2009, we expect to invest the majority of our funds in fixed income securities. Our 2008 investment expense decreased due to the lower or negative investment returns on alternative investments.
In 2008, we had a $27.9 million net realized investment loss, compared to a net gain of $13.2 million in 2007 and a net loss of $0.8 million in 2006. The 2008 loss included other-than-temporary impairment losses of $11.1 million and $16.8 million of net realized losses related to bonds and preferred stock sold during the year. The 2007 gain included $13.4 million of embedded currency conversion gains on certain available for sale fixed income securities that we sold in December 2007. This realized gain was offset by a $13.4 million foreign currency loss recorded in other operating expense.
Other operating expense includes $13.7 million, $12.0 million and $13.1 million in 2008, 2007 and 2006, respectively, of stock-based compensation expense, after the effect of the deferral and amortization of policy acquisition costs related to stock-based compensation for our underwriters. At December 31, 2008, there was approximately $31.8 million of total unrecognized compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 2.8 years.
Our effective income tax rate was 30.1% for 2008, compared to 32.5% for 2007 and 32.9% for 2006. The lower rate in 2008 related to the increased benefit from more tax-exempt investment income on a lower pretax base.
We operate our businesses in three segments: insurance company, agency and other operations. Our Chief Executive Officer, as chief decision maker, monitors and evaluates the individual financial results of each subsidiary in the insurance company and agency segments. Each subsidiary provides monthly reports of its actual and budgeted results, which are aggregated on a segment basis for management review and monitoring. The operating results of our insurance company, agency, and other operations segments are discussed below.
Gross written premium increased 2% in 2008 to $2.5 billion and 10% in 2007. Net written premium increased 4% to $2.1 billion and net earned premium increased 1% to $2.0 billion in 2008 compared to increases of 10% and 16%, respectively, in 2007. Premium increased in 2008 due to the 2008 acquisitions. However, decreased writings and lower prices in lines impacted by competitive market pressures moderated the effect of more demand and increased prices in certain products. We elected to write less premium in 2008 in certain lines affected by competition. We wrote more business than planned in our diversified financial products lines, particularly in directors’ and officers’ liability and domestic credit, as prices increased in late 2008 and the market reacted to financial issues with other insurance companies. A majority of this additional written premium will be earned in 2009. The 2007 increases in written and earned premium were primarily due to our 2006 acquisition of the Health Products Division and organic growth in our surety, credit and other specialty lines of business. The overall percentage of retained premium of 82% in 2008 essentially remained constant compared to 81% in 2007 and 2006.
Aviation - Our domestic aviation written premium volume is down over the three-year period due to competition and lack of growth in the general aviation industry. Underwriting margins continue to be good. Our international aviation premium increased in late 2008 as rates are beginning to rise for the first time in several years, allowing us to write more profitable business.
Annually, we analyze our threshold for risk in each line of business and on an overall consolidated basis, based on a number of factors, including market conditions, pricing, competition and the inherent risks associated with each business type, and then we structure our reinsurance programs. Based on our analysis of these factors, we may determine not to purchase reinsurance for some lines of business. We generally purchase reinsurance to reduce our net liability on individual risks and to protect against catastrophe losses and volatility. We purchase reinsurance on a proportional basis to cover loss frequency, individual risk severity and catastrophe exposure. Some of the proportional reinsurance agreements may have maximum loss limits, most of which are at or greater than a 200% loss ratio. We also purchase reinsurance on an excess of loss basis to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type and amount of reinsurance we purchase varies year to year based on our risk assessment, our desired retention levels based on profitability and other considerations, and on the market
availability of quality reinsurance at prices we consider acceptable. Our reinsurance programs renew throughout the year, and the price changes in recent years have not been material to our net underwriting results. Our reinsurance generally does not cover war or terrorism risks, which are excluded from most of our policies.
Our Reinsurance Security Committee carefully monitors the credit quality of the reinsurers with which we do business on all new and renewal reinsurance placements and on an ongoing, current basis. The Reinsurance Security Committee uses objective criteria to select and retain our reinsurers, which include requiring: 1) minimum surplus of $250 million; 2) minimum capacity of £100 million for Lloyd’s syndicates; 3) financial strength rating of “A−” or better from A.M. Best Company, Inc. or Standard & Poor’s Corporation; 4) an unqualified opinion on the reinsurer’s financial statements from an independent audit; 5) approval from the reinsurance broker, if a party to the transaction; and 6) a minimum of five years in business for non-U.S. reinsurers. The Committee approves exceptions to these criteria when warranted. Our recoverables are due principally from highly-rated reinsurers.
We decided for the 2006 underwriting year to retain more underwriting risk in certain lines of business in order to retain a greater proportion of expected underwriting profits. In doing so, we purchased less reinsurance and converted some reinsurance from proportional to excess of loss, which significantly reduced the amount of ceded premium in 2006. Since then, ceded premium as a percentage of gross written premium has essentially remained constant. We have chosen not to purchase any reinsurance on business where volatility or catastrophe risks are considered remote and limits are within our risk tolerance.
In our proportional reinsurance programs, we generally receive an overriding (ceding) commission on the premium ceded to reinsurers. This compensates our insurance companies for the direct costs associated with production of the business, the servicing of the business during the term of the policies ceded, and the costs associated with placement of the related reinsurance. In addition, certain of our reinsurance treaties allow us to share in any net profits generated under such treaties with the reinsurers. Various reinsurance brokers, including subsidiaries, arrange for the placement of this proportional and other reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers.
Our reinsurance recoverables decreased in amount and as a percentage of our shareholders’ equity during 2007, as we reinsured less business, especially on a proportional basis, and as 2005 hurricane losses were paid and we collected amounts due from our reinsurers for their portion of these paid losses. The amount of reinsurance recoverables increased in 2008 due to reinsured losses from the 2008 hurricanes and several other large individual losses that were highly reinsured. Additionally, we continued to write and reinsure more professional liability business where it takes longer for claims reserves to result in paid claims. The percentage of reinsurance recoverables compared to our shareholders’ equity remained constant at 40% and 39% at December 31, 2008 and 2007.
We continuously monitor our financial exposure to the reinsurance market and take necessary actions in an attempt to mitigate our exposure to possible loss. We have a reserve of $8.4 million at December 31, 2008 for potential collectibility issues related to reinsurance recoverables, including disputed amounts and associated expenses. We review the level and adequacy of our reserve at each quarter-end. While we believe the year-end reserve is adequate based on information currently available, conditions may change or additional information might be obtained that may require us to change the reserve in the future.
We have no material exposure to environmental or asbestos losses. We believe we have provided for all material net incurred losses as of December 31, 2008.
Aviation - The 2008 hurricanes increased losses by $1.4 million and increased the 2008 loss ratio by 1.0 percentage point. Underwriting results in 2006 were better than expected, due in part to the release of redundant reserves on the 2004 and 2005 accident years.
The net paid loss ratio is the percentage of losses paid, net of reinsurance, divided by net earned premium for the period. Our net paid loss ratios were 54.0%, 49.3% and 36.3% in 2008, 2007 and 2006, respectively. The ratio has increased steadily over the past three years due to a variety of factors. In the fourth quarter of 2008, it was particularly high at 62.1% due to quarterly volatility of claims payments in our London market account and our diversified financial products line of business. The factors driving the year-over-year increases included the following:
a higher percentage of medical stop-loss business, which has a higher paid loss ratio than other lines,
earlier payment of claims in 2008 due to shortening the required reporting period, bringing claims processing in-house, and responding to faster reporting of claims by insureds on certain lines of business,
Policy acquisition costs, which are reported net of the related portion of commissions on reinsurance ceded, increased to $381.4 million in 2008 from $366.6 million in 2007 and $319.9 million in 2006. Policy acquisition costs as a percentage of net earned premium increased to 19.0% in 2008 from 18.5% in 2007 and 18.7% in 2006. The changes are due to changes in the mix of business and commission rates on certain lines of business. In addition, net earned premium has grown on our surety and credit businesses that have higher acquisition rates. The GAAP expense ratio of 25.0% in 2008 changed in comparison to 23.8% in 2007 and 25.0% in 2006 for the same reasons.
Revenue from our agency segment increased to $188.4 million in 2008 from $178.6 million in 2007 and $180.0 million in 2006, primarily due to underwriting agencies acquired in 2008. However, Agency segment earnings decreased to $28.4 million in 2008 from $33.9 million in 2007 and $42.3 million in 2006, primarily due to higher interest expense and operating expense in 2007 and 2008 related to acquired underwriting agencies. In addition, over the past two years, a higher percentage of business is being written directly by our insurance companies, rather than being underwritten on behalf of third party insurance companies by our
During 2008, there were significant disruptions in the world-wide and U.S. financial markets. A number of large financial institutions failed, received substantial capital infusions and loans from the U.S. and various other governments, or were merged into other companies. The market disruptions have resulted in a tightening of available sources of credit, increases in the cost of credit and significant liquidity concerns for many companies. We believe we have sufficient sources of liquidity at a reasonable cost at the present time, based on the following:
We held $524.8 million of cash and liquid short-term investments at December 31, 2008. We have generated an annual average $588.2 million in cash from our operating activities, excluding cash from commutations, in the three-year period ended December 31, 2008.
Our available for sale bond portfolio had a fair value of $4.1 billion at December 31, 2008 and has an average rating of AA+. We have the intent and ability to hold these securities until their maturity; however, should we have to sell certain securities in the portfolio earlier to generate cash, given the current credit market volatility, it is possible we might not recoup the full year-end fair value of the securities sold.
We have a committed line of credit, led by Wells Fargo, through a syndicate group of large domestic banks and one large foreign bank. Our Revolving Loan Facility provides borrowing capacity to $575.0 million through December 2011. At February 20, 2009, we had $340.0 million of unused capacity, which we can draw against at any time at our request. We believe that the banks will be able and willing to perform on their commitments to us.
Our 1.3% Convertible Notes are subject to redemption anytime after April 4, 2009, or holders may require us to repurchase the Notes on April 1, 2009. Our available capacity on the Revolving Loan Facility is sufficient to cover the $124.7 million of Notes outstanding at December 31, 2008. If the notes are not put to us by the holders, we can select a date for redemption in 2009 at our choosing or elect not to redeem the notes. The next put date by the holders would be April 1, 2014.
Our domestic insurance subsidiaries have the ability to pay $199.2 million in dividends in 2009 to our holding company without obtaining special permission from state regulatory authorities. Our
underwriting agencies have no restrictions on the amount of dividends that can be paid to our holding company. The holding company can utilize these dividends to pay down debt, pay dividends to shareholders, fund acquisitions, repurchase common stock and pay operating expenses. Cash flow available to the holding company in 2009 is expected to be more than ample to cover the holding company’s required cash disbursements.
Cash provided by operating activities can fluctuate due to timing differences in the collection of premiums and reinsurance recoverables and the payment of losses and premium and reinsurance balances payable and the completion of commutations. We generated cash from operations of $506.0 million in 2008, $726.4 million in 2007 and $653.4 million in 2006. Factors that contributed to our strong cash flow include the following:
Cash provided by operating activities decreased $220.5 million in 2008 and increased $73.0 million in 2007. Cash received from commutations, included in cash provided by operating activities, totaled $7.5 million, $101.0 million, and $12.8 million in 2008, 2007 and 2006, respectively. Excluding the commutations and cash flow from liquidating our trading portfolio in 2008 and 2007, cash provided by operating activities was
We engage independent investment advisors to oversee our fixed income investments, based on the investment policies promulgated by our Investment and Finance Committee of the Board of Directors, and to make investment recommendations. We invest our funds principally in highly-rated fixed income securities. Our historical investment strategy has been to maximize interest income and yield, within our risk tolerance, rather than to maximize total return. Our investment portfolio turnover will fluctuate, depending upon opportunities. Realized gains and losses from sales of securities are usually minimal, unless we sell securities for investee credit-related reasons or to capture gains to enhance statutory capital and surplus of our insurance company subsidiaries, or because we can take gains and reinvest the proceeds at a higher effective yield.
This table summarizes our investments by type, substantially all of which are reported at fair value, at December 31, 2008.
At year-end 2008, within our portfolio of fixed income securities, we held a portfolio of residential mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs) with a fair value of $813.0 million. Within our residential MBS/CMO portfolio, $723.5 million of securities were issued by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which are backed by the U.S. government, while $79.6 million, $7.6 million and $2.3 million of bonds are collateralized by prime, Alt A and subprime mortgages, respectively. All of these securities were
current as to principal and interest. The prime securities have an average rating of AA and a weighted-average life of approximately 4.1 years, and the subprime and Alt A securities have an average rating of AA+ and a weighted-average life of approximately 3.2 years.
amount by which the security’s fair value is less than its cost;
whether the impairment is due to an issuer-specific event, credit issues or change in market interest rates, and
During 2008, we transferred $108.9 million of foreign-denominated bonds from our available for sale portfolio to a new held to maturity portfolio. This portfolio includes foreign-denominated securities for which we have the ability and intent to hold the securities to maturity or redemption. We hold these securities to hedge the foreign exchange risk associated with insurance claims that we will pay in foreign currencies. At December 31, 2008, we held bonds with an amortized cost of $123.6 million and a fair value of $125.6 million. The majority of these bonds mature in March 2009. Any foreign exchange gain/loss on these bonds will be recorded through income and will substantially offset any foreign exchange gain/loss on the related liabilities. Conversely, the foreign exchange gain/loss on available for sale securities is recorded as a component of accumulated other comprehensive income within shareholders’ equity until the related bonds mature or are sold and, therefore, does not offset the opposite foreign currency movement on the hedged liabilities that is recorded through income.
At December 31, 2008, we had cash and short-term investments of $524.8 million, of which $289.1 million was held by our insurance companies. We maintain cash and liquid short-term instruments in our insurance companies in order to be able to fund losses of our insureds. Cash and short-term investments were higher than normal at December 31, 2007 due to proceeds from the sale of fixed income securities that hedged certain foreign currency denominated liabilities. We reduced our short-term investments in 2008 and reinvested in fixed income securities to take advantage of higher yields.
This table shows a profile of our fixed income and short-term investments. The table shows the average amount of investments, income earned and the related yield.
At December 31, 2008, the net unrealized gain on our available for sale fixed income securities portfolio was $14.6 million, compared to $25.0 million at December 31, 2007. The change in the net unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income and fluctuates principally due to changes in market interest rates on our available for sale bond portfolio and conditions in the credit markets, particularly with respect to our corporate bonds and our asset-backed and mortgage-backed securities, which have been impacted by the recent credit crisis. During 2008, the net unrealized gain (loss) was
$26.2 million at March 31, 2008, ($34.1) million at June 30, 2008, and ($98.1) million at September 30, 2008, which caused fluctuations in our consolidated shareholders’ equity throughout the year. The net unrealized gain on our available for sale fixed income securities portfolio at January 31, 2009 was $64.4 million.
Some of our fixed income securities have call or prepayment options. In addition, mortgage-backed and certain asset-backed securities have prepayment or other market-related credit risk. Prepayment risk exists if the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. Credit risk exists if mortgagees default on the underlying mortgages. Net investment income and/or cash flows from investments that carry call or prepayment options and prepayment or credit risk may differ from those anticipated at the time of investment. Calls and prepayments subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. Conversely, lower interest rates subject us to extension risk on the portfolio’s duration if interest rates rise. For asset-backed and mortgage-backed securities, prepayment or credit risk could reduce the yield or the return of the remaining principal of these securities. We mitigate this risk by investing in investment grade securities with varied maturity dates so that only a portion of our portfolio will mature at any point in time.
Effective January 1, 2008, we adopted Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, for financial assets and financial liabilities measured at fair value on a recurring basis (at least annually). SFAS 157 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. SFAS 157 also established a hierarchy that prioritizes the inputs used to measure fair value into three levels, as described below. Our adoption of SFAS 157 did not did not impact our 2008 or prior years’ consolidated financial position, results of operations or cash flows.
In determining fair value, we generally apply the market approach, which uses prices and other relevant data based on market transactions involving identical or comparable assets and liabilities. The degree of judgment used to measure fair value generally correlates to the type of pricing and other data used as inputs, or assumptions, in the valuation process. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our own market assumptions using the best information available to us. Based on the type of inputs used to measure the fair value of our financial instruments, we classify them into the three-level hierarchy established by SFAS 157:
Our Level 1 investments are primarily U.S. Treasuries listed on stock exchanges. We use quoted prices for identical instruments to measure fair value.
We use independent pricing services to assist us in determining fair value for over 99% of our Level 1 and Level 2 investments. We use data provided by our third party investment managers to value the remaining Level 2 investments. We did not apply the criteria of FSP FAS 157-3, since no markets for our investments were judged to be inactive. To validate quoted and modeled prices, we perform various procedures, including evaluation of the underlying methodologies, analysis of recent sales activity, and analytical review of our fair values against current market prices, other pricing services and historical trends.
The following table presents our assets and liabilities that were measured at fair value as of December 31, 2008.
We classified our residential MBS/CMO portfolio, substantially all of which is either backed by U.S. government agencies or collateralized by prime mortgages, as Level 2 assets because the fair value of the securities is derived from industry-standard models using observable market-based data. These securities have an average rating of AAA and a weighted-average life of approximately 2.1 years based on expected future cash flows.
Unrealized gains and losses on our Level 3 fixed income securities and other investments are reported in other comprehensive income within shareholders’ equity, and unrealized gains and losses on our Level 3 other assets are reported in other operating income.
The estimated loss and loss adjustment expense payments for future periods assume that the percentage of ultimate losses paid from one period to the next will be relatively consistent over time. Actual payments will be influenced by many factors and could vary from the estimated amounts.
While the 1.30% Convertible Notes mature in 2023, they are shown in the 2009 column since the holders may require us to repurchase the Notes on April 1, 2009. The Notes have various put and redemption dates as disclosed in Note 7 to the Consolidated Financial Statements. Amounts include interest payable in respective periods.
The $575.0 million Revolving Loan Facility expires on December 19, 2011. Interest on $200.0 million of the facility is included at an effective fixed rate of 4.60% through November 2009 and interest on $105.0 million of the facility is included at an effective interest rate of 2.94% from December 2009 through November 2010 due to interest rate swaps. Interest on the remaining facility is included at 30-day LIBOR plus 25 basis points (0.69% at December 31, 2008).
The average duration of claims in many of our lines of business is relatively short, and, accordingly, our investment portfolio has a relatively short duration. The average duration of all claims was approximately 2.5 years in 2008 and 2007. In recent years, we have expanded the directors’ and officers’ liability and professional indemnity components of our diversified financial products line of business, which have a longer claims duration than our other lines of business. We consider these different claims payment patterns in determining the duration of our investment portfolio.
Our 1.30% Convertible Notes are due in 2023. We pay interest semi-annually on April 1 and October 1. Each one thousand dollar principal amount of notes is convertible into 44.1501 shares of our common stock, which represents an initial conversion price of $22.65 per share. The initial conversion price is subject to standard anti-dilution provisions designed to maintain the value of the conversion option in the event we take certain actions with respect to our common stock, such as stock splits, reverse stock splits, stock dividends and extraordinary dividends, that affect all of the holders of our common stock equally and that could have a dilutive effect on the value of the conversion rights of the holders of the notes or that confer a benefit upon our current shareholders not otherwise available to the Convertible Notes. Holders may surrender notes for conversion if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 consecutive trading days during the period of 30 consecutive trading days ending on the last trading day of that quarter is more than 130% ($29.45 per share) of the conversion price per share of our common stock. This condition was not met at December 31, 2008. We must settle any conversions by paying cash for the principal amount of the notes and issuing our common stock for the value of the conversion premium. We can redeem the notes for cash at any time on or after April 4, 2009. Holders may require us to repurchase the notes on April 1, 2009, 2014 or 2019, or if a change in control of HCC Insurance Holdings, Inc. occurs on or before April 4, 2009. The repurchase price to settle any such put or change in control provisions will equal the principal amount of the notes plus accrued and unpaid interest and will be paid in cash.
In 2007, we entered into three interest rate swap agreements to exchange 30-day LIBOR (0.44% at December 31, 2008) for a 4.60% fixed rate on $200.0 million of our Revolving Loan Facility. The swaps qualify for cash flow hedge accounting treatment. The three swaps expire in November 2009. As of December 31, 2008, we had entered into two additional swaps for $105.0 million, which will begin when the original swaps expire in November 2009 and will expire in November 2010. The fixed rate on the new swaps is 2.94%. These swaps were entered into in 2008 with a future effective date to minimize our exposure to expected interest rate increases due to the recent credit and market conditions. All of our swaps were in a total unrealized loss position of $8.0 million at December 31, 2008.
former owners with an offsetting increase to goodwill. Accrued amounts are paid according to the contractual requirements, with the majority of the payments in the next year. At December 31, 2008, unpaid accrued earnout totaled $20.2 million, of which $18.8 million will be paid in 2009. The total amount of all future earnout cannot be finally determined until all future losses are paid. Our 2008 acquisition of MultiNational Underwriters, LLC includes a possible additional earnout depending upon achievement of certain underwriting profit levels. At December 31, 2008, we accrued $4.2 million for this earnout, with an offsetting increase to goodwill, which will be paid in 2009.
In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. Other indemnifications agree to reimburse the purchasers for taxes or ERISA-related amounts, if any, assessed after the sale date but related to pre-sale activities. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires on December 31, 2009. We accrue a loss when a valid claim is made by a buyer and we believe we have potential exposure. We currently have several claims under an indemnification that covers certain net losses alleged to have been incurred in periods prior to our sale of a subsidiary. At December 31, 2008, we have recorded a liability of $15.8 million and have provided $6.7 million of letters of credit to cover our obligations or anticipated payments under this indemnification.
On June 20, 2008, our Board of Directors approved the repurchase of up to $100.0 million of our common stock, as part of our philosophy of building long-term shareholder value. The share repurchase plan authorizes repurchases to be made in the open market or in privately negotiated transactions from time-to-time. Repurchases under the plan will be subject to market and business conditions, as well as the level of cash generated from our operations, cash required for acquisitions, debt covenant compliance, trading price of our stock being at or below book value, and other relevant factors. The repurchase plan does not obligate us to purchase any particular number of shares and may be suspended or discontinued at any time at our discretion. In 2008, we repurchased 3.0 million shares of our common stock in the open market for a total cost of $63.3 million and a weighted-average cost of $21.02 per share.
Inflation can also affect interest rates. Any significant increase in interest rates could have a material adverse effect on the fair value of our investments. In addition, the interest rate payable under our Revolving Loan Facility fluctuates with market interest rates. Any significant increase in interest rates could have a material adverse effect on our net earnings, depending on the unhedged amount borrowed on that facility. We have entered into interest rate swap agreements that fix the interest rate at 4.60% on $200.0 million of the outstanding balance of our facility through November 2009 and additional swaps, which become effective on November 30, 2009, that will fix the interest rate at 2.94% on $105.0 million of our facility through November 2010.
Our net loss and loss adjustment expense reserves are composed of reserves for reported losses and reserves for incurred but not reported losses (which include provisions for potential movement in reported losses, as well as for claims that have occured but have not been reported to us), less a reduction for
reinsurance recoverables related to those reserves. Reserves are recorded by product line and are undiscounted, except for reserves related to acquisitions.
To record reserves on our lines of business, we utilize expected loss ratios, which management selects based on the following: 1) information used to price the applicable policies; 2) historical loss information where available; 3) any public industry data for that line or similar lines of business; 4) an assessment of current market conditions and 5) a claim-by-claim review by management, where actuarial homogenous data is unavailable. Management also considers the point estimates and ranges calculated by our actuaries, together with input from our experienced underwriting and claims personnel. Because of the nature and complexities of the specialized types of business we insure, management may give greater weight to the expectations of our underwriting and claims personnel, who often perform a claim by claim review, rather than to the actuarial estimates. However, we utilize the actuarial point and range estimates to monitor the adequacy and reasonableness of our recorded reserves.
reserve estimates. The actuarial ranges represent our actuaries’ estimate of a likely lowest amount and highest amount that will ultimately be paid to settle the net reserves we have recorded at a particular point in time. While there is still a possibility of ultimately paying an amount below the range or above the range, the actuarial probability is very small. The range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimates.
Direct insurance is coverage that is originated by our insurance companies and brokers in return for premium. Assumed reinsurance is coverage written by another insurance company, for which we assume all or a portion of the risk in exchange for all or a portion of the premium. Subscription business is direct insurance or assumed reinsurance where we only take a percentage of the total risk and premium and other insurers take their proportionate percentage of the remaining risk and premium. Assumed reinsurance represented 14% of our gross written premium in 2008 and 25% of our gross reserves at December 31, 2008. Approximately 41% of the assumed reinsurance reserves related to business in our discontinued lines, 26% related to assumed reinsurance in our London market account, aviation and diversified financial products lines of business, 14% related to assumed quota share surplus lines business in our other specialty lines, 12% related Lloyd’s of London business in our other specialty lines, and 5% related to assumed business in our group life, accident and health line of business. The remaining assumed reinsurance reserves covered various other reinsurance programs. The table above recaps the underwriting, claims characteristics and major actuarial assumptions for our assumed reinsurance business.
Group life, accident and health - Total net reserves decreased year-over-year due to the lower incurred loss ratio on this short-duration line of business. In addition, the length of time to pay claims decreased in 2008 due to shorter required reporting periods and more efficient claims processing.
London market account - Total net reserves and the percentage of incurred but not reported reserves both decreased due to the continued payment of long-tailed claims related to the 2005 hurricanes. In addition, redundant development more than offset the effect of the 2008 hurricanes.
Our net reserves historically have shown favorable development except for the effects of commutations, which we have completed in the past and may negotiate in the future. Commutations can produce adverse prior year development because, under generally accepted accounting principles, any excess of undiscounted reserves assumed over assets received must be recorded as a loss at the time the commutation is completed. Economically, the loss generally represents the discount for the time value of money that will be earned over the payout of the reserves; thus, the loss may be recouped as investment income is earned on the assets received. Based on our reserving techniques and our past results, we believe that our net reserves are adequate.
Throughout 2008, we conducted detailed reviews of our loss exposures stemming from the current U.S. and international economic environment, including issues related to subprime lending and credit market issues. We write directors’ and officers’ liability, professional indemnity and fiduciary liability coverage for public and private companies and not-for-profit organizations and continue to closely monitor our exposure to subprime and credit market related issues. We provide coverage for certain financial institutions, which have potential exposure to shareholder lawsuits. At December 31, 2008, we had 15 “Side A only” and 57 “non-Side A only” directors’ and officers’ liability, professional indemnity and fiduciary liability claims related to subprime and credit related issues. In reviewing our exposure, we considered the types of risks we wrote, the industry of our insured, attachment points with respect to excess business, types of coverage, policy limits, actual claims reported, and current legal interpretations and decisions. As part of our review, we increased certain ultimate loss ratios in the 2008 accident year for business written in 2007 and 2008 due to the continued uncertainty in the financial markets, which caused us to book $57.5 million of additional reserves. The largest portion of this was in our directors’ and officers’ liability business, primarily for policies written in 2007. Based on our present knowledge, we believe our ultimate losses from these coverages will be contained within our current overall loss reserves for these lines of business.
judgment about the collectibility of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required.
The reserve was $8.4 million at December 31, 2008, compared to $8.5 million at December 31, 2007. We assessed the collectibility of our year-end recoverables and believe amounts are collectible and any potential losses are adequately reserved based on currently available information.
amount by which the security’s fair value is less than its cost,
our ability and intent to hold the security for a period of time sufficient to allow full recovery or until maturity.
SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, issued by the FASB, was effective January 1, 2008. SFAS 159 allows a company to make an irrevocable election to measure eligible financial assets and financial liabilities at fair value that are not otherwise measured at fair value. Unrealized gains and losses for those items are reported in current earnings at each subsequent reporting date. As of December 31, 2008, we have not elected to value any additional assets or liabilities at fair value under the guidance of SFAS 159.
The FASB has issued SFAS No. 141 (revised 2007) (SFAS 141(R)), Business Combinations, and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51. SFAS 141(R) will change the accounting treatment for business combinations and will impact presentation of financial statements on the acquisition date and accounting for acquisitions in subsequent periods. SFAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of shareholders’ equity. SFAS 141(R) and SFAS 160 are effective January 1, 2009, and early adoption is not permitted. We will apply the guidelines of SFAS 141(R) to future acquisitions. We do not expect the adoption of SFAS 141(R) and SFAS 160 to have a material impact on our future consolidated financial statements.
The FASB has issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133, which expands the required disclosures about a company’s derivative and hedging activities. SFAS 161 will be effective January 1, 2009. We do not expect adoption to have a material impact on the notes to our consolidated financial statements.
The FASB has issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements in conformity with generally accepted accounting principles in the United States. SFAS 162 is effective 60 days after the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board’s amendments to AU 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” Our usage of the hierarchical guidance provided by SFAS 162 is not expected to have a material impact on our consolidated financial statements.
The FASB has issued FSP APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement). APB 14-1 clarifies that convertible debt instruments that may be settled in cash upon conversion are not totally debt and requires issuers to bifurcate and separately account for the liability and equity components. The pronouncement, which is effective
January 1, 2009, requires restatement of prior financial statements and does not permit early adoption. We expect that our adoption of APB 14-1 for our Convertible Notes will increase our consolidated shareholders’ equity by an immaterial amount at January 1, 2009 and we will have an immaterial reduction in net income in 2009. The adoption will not impact our past or future consolidated cash flows.
The FASB has issued FSP EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities. EITF 03-6-1 clarifies whether instruments, such as restricted stock, granted in share-based payments are participating securities prior to vesting, which must be included in computing earnings per share under the two-class method described in SFAS No. 128, Earnings per Share. EITF 03-6-1 is effective January 1, 2009, requires restatement of prior financial statements and does not permit early adoption. We must adopt EITF 03-6-1 for our restricted stock and anticipate that adoption will not have a material impact on our consolidated financial statements.