The Company leases office space in Pembroke, Bermuda where the Company’s principal executive office is located. Additionally, the Company and its subsidiaries lease office space in the United States, the United Kingdom, Switzerland and Singapore sufficient for the operation of its Insurance and Reinsurance segments. We renew and enter into new leases in the ordinary course of business. For further discussion of our leasing commitments at December 31, 2012, please see Note 11-“Commitments and Contingencies” to our Audited Consolidated Financial Statements.
We derived the following selected consolidated financial information for the years ended December 31, 2012, 2011, 2010, 2009 and 2008 from our Audited Consolidated Financial Statements and related notes. These historical results are not necessarily indicative of results to be expected from any future period.
The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the Company’s consolidated financial statements and related notes included elsewhere in this Form 10-K.
Endurance Specialty Insurance Ltd. (“Endurance Bermuda”), domiciled in Bermuda with branch offices in Switzerland and Singapore;
American Agri-Business Insurance Company (“American Agri-Business”), domiciled in Texas and managed by ARMtech Insurance Services, Inc. (together with American Agri-Business, “ARMtech”).
The Company’s Insurance and Reinsurance segments both include property related coverages, which provide insurance or reinsurance of an insurable interest in tangible property for property loss, damage or loss of use. In addition, the Company’s Insurance and Reinsurance segments include various casualty insurance and reinsurance coverages, which are primarily concerned with the losses caused by injuries to third parties, i.e., not the insured, or to property owned by third parties and the legal liability imposed on the insured resulting from such injuries.
The Company’s revenues also include income generated from its investment portfolio. The Company’s investment portfolio is comprised of fixed maturity investments, short-term investments and equity securities that are held as available for sale and Other Investments, comprised of alternative and specialty funds that are accounted for under the equity method of accounting. In accordance with generally accepted accounting principles in the United States (“U.S. GAAP”), the available for sale investments are carried at fair market value and unrealized gains and losses on the Company’s investments are generally excluded from earnings. These unrealized gains and losses are included on the Company’s balance sheet in accumulated other comprehensive income as a separate component of shareholders’ equity. If unrealized losses are considered to be other-than-temporary due to the Company’s intent to sell, requirement to sell such securities or credit related factors, such losses are included in earnings as net impairment losses recognized in earnings (losses). For Other Investments, the Company increases or decreases the value of these investments for the Company’s share of income or loss, less dividends, which is included in net investment income.
Marketplace Conditions and Trends. In general, at the end of 2012, we believe operating conditions continued to be competitive. In most classes of property and casualty business, we experienced mixed pricing, with increases in some catastrophe exposed property insurance and reinsurance lines of business due to recent loss activity and in certain small risk casualty classes of business due to the continued low interest rate environment. These positive rate trends have been tempered by relatively high levels of underwriting capacity and competition. In our agriculture business, pricing was relatively stable across our portfolio, although the underlying exposure base has varied with commodity price movements. We continued to maintain our adherence to underwriting standards by declining business when pricing, terms and conditions did not meet our underwriting criteria.
In 2013, we believe the following five primary influences may affect the market for our insurance and reinsurance products - the continuation of the challenging global economy, continued pricing competition in many of our markets, increased volatility in agriculture commodity prices and production levels, the high level of global catastrophe losses incurred by the industry over the last several years, and a low interest rate environment. The United States and other markets around the world have continued to experience unsettled economic conditions, including high levels of unemployment, significant governmental regulation initiatives and continued uncertainty in the financial markets. Although economies are slowly recovering, the lower levels of economic activity are likely to continue to suppress growth in demand for insurance and reinsurance. This is likely to result in a continued competitive global insurance and reinsurance market in 2013. Potentially offsetting these factors is the increased volatility of agriculture commodity prices and production, which could lead to increased risk exposure and higher demand in our agriculture insurance business. In addition, the high level of global catastrophe losses incurred by the industry in 2011 and 2012 may mitigate the pressure for meaningfully lower prices for catastrophe exposed property insurance and reinsurance in 2013 resulting from existing and new capacity in the market. Lastly, the current low interest rate environment will likely encourage a lower appetite for risks that are not adequately priced as there will be reduced investment earnings from underwriting cash flows.
Proportional reinsurance contracts accounted for approximately 20%, 19%, and 22% of the Company’s gross premiums written during the years ended December 31, 2012, 2011, and 2010, respectively.
The following summarizes the Company’s net proportional premium estimates within premiums receivable, net on the Company’s Audited Consolidated Balance Sheet as of December 31, 2012 and 2011:
As a result of recognizing the estimated gross premium written at the inception of the policy and collecting that premium over an extended period, we include a premiums receivable asset on our balance sheet. We actively monitor our premiums receivable asset to consider whether we need an allowance for doubtful accounts. As part of this process, we consider the credit quality of our cedants and monitor premium receipts versus expectations. At December 31, 2012, the Company has an allowance for estimated uncollectible premiums receivable of $3.4 million (2011 - $3.4 million).
Information Used in Determining the Reserve for Losses and Loss Expenses. In order to estimate the Company’s reserve for losses and loss expenses, management uses information either developed from internal or independent external sources, or pricing information created by the Company or provided to the Company by insureds and brokers at the time individual contracts and policies are bound. In addition, we use a commercially available risk analysis model, contract by contract review by our underwriting teams, other data and estimates provided by our clients, and, to a limited extent, overall market share assumptions to estimate our loss and loss expense reserves related to specific loss events.
Actuarial Methods Used to Estimate Loss and Loss Expense Reserves. The Company uses a variety of actuarial methods to estimate the ultimate losses and loss expenses incurred by the Company. One actuarial method used by the Company to estimate its reserve for losses and loss expenses is the expected loss ratio approach, which is based on expected results independent of current loss reporting activity. This approach is typically used for immature loss periods (i.e., the current accident year). Another actuarial method used by the Company is known as the Bornhuetter-Ferguson method. The Bornhuetter-Ferguson method uses an initial loss estimate (expected loss technique) for each accident year by business line and type of contract. Under this method, IBNR is set equal to the initial loss estimate multiplied by the expected percent of loss yet to be reported at each valuation date. In a given quarter, if reported losses are less than expected, then the difference would result in a decrease in estimated ultimate losses. If losses for the quarter are greater than expected, then the difference would result in an increase in estimated ultimate losses. Management uses these multiple actuarial methods, supplemented with its own professional judgment, to establish its best estimate of reserves for losses and loss expenses.
Factors Creating Uncertainty in the Estimation of the Reserve for Losses and Loss Expenses. While management does not at this time include an explicit or implicit provision for uncertainty in its reserve for losses and loss expenses, certain of the Company’s business lines are by their nature subject to additional uncertainties, including the Company’s casualty, property, catastrophe, and other specialty lines in the Reinsurance segment and the Company’s casualty and professional lines in the Insurance segment, which are discussed in detail below. In addition, the Company’s Reinsurance segment is subject to additional factors which add to the uncertainty of estimating loss and loss expense reserves. Time lags in the reporting of losses can also introduce further ambiguity to the process of estimating loss and loss expense reserves.
Due to the large volume of potential transactions that must be recorded in the insurance and reinsurance industry, backlogs in the recording of the Company’s business activities can also impair the accuracy of its loss and loss expense reserve estimates. As of December 31, 2012, there were no significant backlogs related to the processing of policy or contract information in the Company’s Insurance or Reinsurance segments.
Investments. The Company currently classifies its fixed maturity investments, short-term investments and equity securities, as “available for sale” and, accordingly, they are carried at estimated fair value, with related net unrealized gains or losses excluded from earnings and included in shareholders’ equity as a component of accumulated other comprehensive income. The Company determines the fair value of its fixed maturity, short-term and equity investments in accordance with current accounting guidance, which defines fair value and establishes a fair value hierarchy based on inputs to the various valuation techniques used for each fair value measurement. The use of valuation techniques for any given investment requires a significant amount of judgment and consideration of factors specific to the underlying investment. Fair value measurements determined by the Company seek to maximize observable inputs and minimize the use of unobservable inputs. Current accounting guidance establishes three levels as follows:
The Company determines the estimated fair value of each individual security utilizing the highest level inputs available. The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed maturity, short-term and equity portfolios. The Company obtains multiple prices for its securities where available. Pricing sources used in pricing the Company’s fixed maturity, short-term and equity portfolios at December 31, 2012 were as follows:
Pricing Services and Index Providers. Pricing services, including index providers, provide pricing for less-complex, liquid securities based on market quotations in active markets. For securities that do not trade on a listed exchange, these pricing services may use a matrix pricing consisting of observable market inputs to estimate the fair value of a security. These observable market inputs include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data, and industry and economic factors. Additionally, pricing services may use a valuation model such as an option adjusted spread model commonly used for estimating fair values of mortgage-backed and asset-backed securities. At December 31, 2012, the Company has not adjusted any pricing provided by independent pricing services and index providers and have classified all such securities as Level 2.
Broker/Dealers. Generally, the Company obtains quotes directly from broker/dealers who are active in the corresponding markets when prices are unavailable from independent pricing services or index providers. Broker/dealer quotes may also be used if the pricing from pricing services or index providers is not reflective of current market levels, as detected by our pricing control tolerance procedures. Generally, broker/dealers value securities through their trading desks based on observable market inputs. Their pricing methodologies include mapping securities based on trade data, bids or offers, observed spreads and performance on newly issued securities. They may also establish pricing through observing secondary trading of similar securities. Quotes from broker/dealers are all non-binding. At December 31, 2012, the Company has not adjusted any pricing provided by broker/dealers and has classified all such securities as Level 2.
As described above, independent pricing services, index providers and broker/dealers have their own method for determining the fair value of securities. As such, prices provided by independent pricing services, index providers and independent broker quotes can vary widely, even for the same security, and may have a material effect on the estimated fair values of the Company’s securities. If the Company determines that there has been a significant decrease in the volume and level of trading activity for the securities in relation to the normal market activity for such security (or similar securities), then transactions or quoted prices may not accurately reflect fair value and, if there is evidence that the transaction for the security is not orderly, the Company may place less weight on the transaction price as an indicator of fair value. To validate the techniques or models used by pricing sources, the Company’s review process includes, but is not limited to:
Other than Temporary Impairment. Following a determination of fair value, the Company reviews its fixed maturity, short-term and equity portfolios to determine whether any declines in the fair value below the amortized cost basis of these securities are other-than-temporary. If the Company determines that a decision to sell the security has been made or that it is more likely than not that the Company will be required to sell the security, the Company deems the security to be other-than-temporarily impaired and writes it down to fair value, thereby establishing a new cost basis. The amount of the write-down is recognized in earnings as an other-than-temporary impairment (“OTTI”) loss.
For equity securities in an unrealized loss position for which a decision to sell has not been made and it is not more likely than not that the Company will be required to sell the equity security, the Company considers its ability and intent to hold an equity security in an unrealized loss position for a reasonable period of time to allow for a full recovery. When the Company determines that the decline in value of an equity security is other-than-temporary, the Company reduces the cost of the equity security to its fair value and recognizes the loss in the Consolidated Statements of Income (Loss) and Comprehensive Income (Loss). The new cost basis is not changed for subsequent recoveries in fair value.
In making an assessment of the value of its goodwill, the Company uses both market based and non-market based valuations. Assumptions underlying these valuations include forecasts of discounted future cash flows and future profits in addition to an analysis of the Company’s stock price relative to both its book value and its net income. Significant changes in the data underlying these assumptions could result in an assessment of impairment of the Company’s goodwill asset. In addition, if the current economic environment and/or the Company’s financial performance were to deteriorate significantly, this could lead to an impairment of goodwill, the write-off of which would be recorded against net income in the period such deterioration occurred. If a 5% decline in the fair value of the reporting units occurred, this would not result in an impairment of the goodwill asset at December 31, 2012.
Reclassifications. Certain comparative information has been reclassified to conform to current year presentation. The Company identified immaterial mis-classifications of certain tax and foreign exchange effects on the Company’s investment portfolio in the 2008 and 2009 financial statements. The Company reclassified these tax and foreign exchange effects on the investment portfolio between accumulated other comprehensive income and retained earnings within the Consolidated Balance Sheet for the year ended December 31, 2011. The reclassifications had no impact on earnings or total shareholders’ equity for the year ended December 31, 2011.
ASU 2013-02 will be effective for fiscal years and interim periods beginning after December 15, 2012, with early adoption permitted.
Gross premiums written in 2012 were $2,549.0 million, an increase of $81.9 million, or 3.3%, compared to 2011 and an increase of $495.8 million, or 24.1% compared to 2010. The following table provides the distribution of gross premiums written by the geographic location in which the risk originated for the years ended December 31, 2012, 2011 and 2010:
Net premiums written in 2012 were $2,029.5 million, an increase of $49.7 million, or 2.5%, compared to 2011 and an increase of $265.8 million, or 15.1% compared to 2010. The change in net premiums written for 2012 compared to 2011 and 2010 was driven primarily by the following factors:
Increased catastrophe premiums in the Reinsurance segment as a result of improved pricing during renewals together with reinstatement premiums recorded in relation to the catastrophe loss events experienced in 2011 and 2012;
A decline in premiums in the property line of the Insurance segment compared to 2011 as the Company curtailed the underwriting of several insurance products in order to reallocate capital to more profitable lines of business; and
Decreased professional lines premiums in the Insurance segment compared to 2010 due to the non-renewal of a large program relationship.
Ceded premiums written by the Company increased in 2012 as compared to 2011 principally in the agriculture line of the Insurance segment as the Company increased the amount of reinsurance placed with the Federal Crop Insurance Corporation. In addition, the Company purchased additional protection in the catastrophe line of the Reinsurance segment while ceded premiums declined in the property line of the Insurance segment in line with the reduction in gross premiums. Ceded premiums were higher in 2012 than 2010 principally as a result of the growth in cessions in the agriculture line of the Insurance segment in line with the increase in gross premiums.
The components of net investment income for the years ended December 31, 2012, 2011 and 2010 are as follows:
The Company’s 2012 net investment income of $173.3 million represents an increase of 17.9% or $26.3 million as compared to 2011 and a decrease of 13.5% or $27.0 million as compared to 2010. Net investment income during 2012 included net mark to market gains of $49.1 million on Other Investments as compared to mark to market losses of $0.7 million in 2011 and mark to market gains of $40.3 million in 2010. Investment income generated by the Company’s available for sale investments decreased by $24.7 million in 2012 compared to 2011 and by $38.7 million compared to 2010 due to lower reinvestment rates. The cash and cash equivalents and investment (including pending investment settlements) balances as of December 31, 2012 increased 4.1% from 2011 and 6.1% from 2010. The increase in cash and cash equivalents and investments during 2012 and 2011 resulted from increases in market valuations of investments, positive net operating cash flows, and proceeds from the sale of investments. The decrease in investment expenses in 2012 compared to 2011 and 2010 was due to a change in the investment mix.
(3) The internal rate of return of the investment portfolio based on the given market price or the single discount rate that equates a security price (inclusive of accrued interest) for the portfolio with its projected cash flows. Excludes Other Investments and operating cash.
(4) Includes only cash and cash equivalents and fixed income investments held by the Company’s investment managers.
During 2012, 2011 and 2010, the Company identified available for sale securities that were considered to be other-than-temporarily impaired. Net impairment losses recognized in earnings (losses) for the years ended December 31, 2012, 2011 and 2010 as a result of other-than-temporarily impaired securities were as follows:
For the years ended December 31, 2012, 2011 and 2010, the Company recorded $0.8 million, $3.5 million and $3.9 million of OTTI losses in earnings (losses), respectively. The other-than-temporary impairment losses recognized by the Company in 2012, 2011 and 2010 relating to specific credit events occurred primarily due to reductions in expected recovery values on mortgage and asset backed securities during the period, along with certain credit related downgrades in corporate securities.
During 2012, the Company remeasured its monetary assets and liabilities denominated in foreign currencies, which resulted in net foreign exchange gains of $15.9 million compared to gains of $7.4 million for 2011 and gains of $3.0 million for 2010. The gains recorded in the current period resulted from a decrease in the value of Japanese Yen net liabilities as the U.S. dollar strengthened against the Yen over the period. In addition, foreign exchange gains were recognized in income as revaluations on investments recorded in other comprehensive income were realized. The net foreign exchange gains recorded in 2011 resulted from net gains realized as the U.S. dollar fluctuated over the year. The net foreign exchange gains recorded in 2010 resulted from the weakening of the U.S. dollar compared to other currencies over that period.
The Company’s reported net losses and loss expenses are significantly impacted by the occurrence or absence of catastrophic events and subsequent loss emergence related to such events.
For 2012, catastrophe related losses added 10.6 percentage points to the Company’s net loss ratio after adjustment for reinstatement premiums and other loss sensitive accruals compared to 24.8 percentage points in 2011 and 4.8 percentage points in 2010. Additionally, the Company recorded higher reserves for attritional losses in the Insurance segment’s agriculture line in the year ended December 31, 2012 compared to 2011 and 2010 due to extreme drought conditions experienced in the U.S. Midwest in the second half of 2012.
The Company incurred a tax expense for the year ended December 31, 2012 of $3.3 million compared to a tax benefit of $23.0 million and expense of $7.2 million for the years ended December 31, 2011 and 2010. The Company incurred a tax expense in 2012 compared to a benefit in 2011 due to a decrease in net losses experienced in its United States taxable jurisdictions. The tax expense recorded in 2010 was higher than the current year as a result of higher net income in the Company’s United States taxable jurisdictions in that year.
The Company produced net income of $162.5 million in 2012 compared to a net loss of $93.7 million in 2011 and net income of $364.7 million in 2010. The increase in net income compared to 2011 was primarily due to the decrease in catastrophe losses, improved investment returns and growth in net premiums earned, partially offset by agriculture insurance losses from the Midwestern drought. Net income was lower in 2012 than in 2010 due to the lower incidence of catastrophe and agriculture insurance losses in 2010.
The following table summarizes the underwriting results and associated ratios for the Company’s Insurance segment for the years ended December 31, 2012, 2011 and 2010:
An increase in the casualty and other line compared to 2010 primarily driven by growth in our contract binding authority business launched at the end of 2010.
Ceded premiums written by the Company in the Insurance segment increased in 2012 compared to 2011 and 2010 principally in the agriculture line as the Company increased the amount of reinsurance placed with the Federal Crop Insurance Corporation. Ceded premiums also increased across the current period in the casualty and other and professional lines in tandem with growth in gross premiums. The increases were partially offset by declines in the property line associated with the reduction in gross premiums in 2012.
Net Losses and Loss Expenses. The increase in the net loss ratio in the Company’s Insurance segment for the year ended December 31, 2012 compared to 2011 and 2010 was primarily driven by increased crop related losses experienced in the agriculture line resulting from the extreme drought conditions in the Midwest United States. In addition, losses incurred in the property line were higher in 2012 compared to the prior years as a result of catastrophe losses incurred from Superstorm Sandy in the fourth quarter.
Acquisition Expenses. The Company’s acquisition expense ratio in the Insurance segment for the year ended December 31, 2012 was comparable to 2011 and 2010.
Growth in the property line as a result of new premiums and growth in renewal premiums written by the Company’s U.S., Zurich and Singapore offices; and
Ceded premiums written by the Company in the Reinsurance segment amounted to $32.0 million in 2012 as compared to $23.0 million and $7.2 million in 2011 and 2010, respectively. The increase in ceded premiums in 2012 compared to 2011 and 2010 resulted from the Company entering into a new worldwide property catastrophe quota share retrocession contract in 2011 and increasing that protection in 2012.
Net losses and Loss Expenses. The net loss ratio in the Company’s Reinsurance segment for 2012 decreased compared to 2011 and increased over 2010 primarily as a result of varying levels of catastrophe losses incurred across the three years.
Acquisition Expenses. The Company’s acquisition expense ratio in the Reinsurance segment for the year ended December 31, 2012 was comparable to 2011 and 2010.
General and Administrative Expenses. The general and administrative expense ratio experienced by the Reinsurance segment in 2012, as compared to 2011 and 2010 reduced due to modest growth in net premiums earned and lower annual incentive compensation expense.
Residential Mortgage-Backed Securities. The majority of the residential mortgage-backed securities in our investment portfolio are issued by Freddie Mac and Fannie Mae. The principal risks inherent in holding agency mortgage-backed securities are prepayment and extension risks, which will affect the timing of when principal cash flows will be received. Non-agency mortgage-backed securities also have credit risk should losses on the underlying collateral exceed the credit protection provided by subordinated tranches.
Short-term investments are investments which mature within no more than one year or no less than 90 days at the time of purchase. The Company’s short-term investments generally consist of U.S. government and agencies securities.
Equity securities in the Company’s investment portfolio consist of publicly traded common and preferred stocks. Of the Company’s equity securities, 30.2% represent investments in an exchange traded fund that seeks to track the performance of a benchmark index of common stocks of companies that have a record of increasing dividends over time. A portion of our equity securities are comprised of shares of institutional mutual funds which are invested in emerging market debt, convertible bonds and other targeted strategies.
The contractual maturity distribution for our fixed maturity portfolio held as of December 31, 2012 and 2011 was as follows:
The Company’s investments in (i) hedge funds and private investment funds that generally invest in senior secured bank debt, high yield debt securities, distressed debt, distressed real estate, derivatives and equity long/short strategies (“alternative funds”) and (ii) high yield loan and convertible debt funds (“specialty funds”) are recorded on the Company’s balance sheet as “Other Investments.” As of December 31, 2012, our Board of Directors had approved investments in alternative funds at the time of commitment of capital of up to the lesser of (x) 20% of total shareholders’ equity, or (y) $600 million. This restriction does not apply to investments in specialty funds which are typically long only structures. As of December 31, 2012, the Company had invested, net of capital returned, a total of $275.0 million in alternative funds. As of December 31, 2012, the market value of alternative funds represented $372.4 million or approximately 72.0% of Other Investments, and specialty funds represented $145.1 million or approximately 28.0% of Other Investments. As of December 31, 2012, our $517.5 million of Other Investments represented 7.9% of the Company’s investment portfolio.
Our investment returns for the years ended December 31, 2012, 2011 and 2010 were as follows:
The Company’s diversified portfolio of investments includes exposures to the debt of various European countries. The Company continuously monitors its exposures through review of its portfolio and has established investment guidelines that restrict the amount of investment exposure to any one issuer or country to depending on specific ratings of such issuer or country as stated by credit rating agencies. The Company has remained relatively consistent in its aggregate direct exposure to the indebtedness and equity securities of those countries whose currency is the Euro or whose sovereign debt rating is below AAA (except the U.S.), with $239.8 million of exposure at the beginning of 2012 and $247.1 million of exposure at the end of 2012.
(1) Structured securities includes residential non-agency mortgage-backed securities, commercial non-agency mortgage-backed securities, and asset-backed securities.
(2) European Supranational securities are issued by entities formed by two or more central governments to promote economic development for the member countries, such as the World Bank, the European Bank for Reconstruction and Development and the European Investment Bank.
The following table shows the fair value as of December 31, 2012 based on the ratings of the securities held by country of risk in those countries whose currency is the Euro or whose sovereign debt rating is below AAA (except the U.S.) by any of the recognized rating agencies at December 31, 2012:
In addition to the direct exposures above, the Company has indirect exposure to sovereign and non-sovereign investments held within certain alternative funds in its Other Investments. The Company has one investment in the Other Investments category in a hedge fund with a primary focus on European indebtedness, principally focused on the declining value of European sovereign indebtedness. The Company’s initial investment in the fund was $20.0 million and its fair market value as of December 31, 2012 was in excess of that amount. The remainder of the Company’s investment within its Other Investments do not have a primary investment focus on Europe or the sovereign indebtedness of lower rated nations outside of Europe. The Company has no unfunded European exposures.
Ability of Subsidiaries to Pay Dividends. The ability of Endurance Bermuda to pay dividends is dependent on its ability to meet the requirements of applicable Bermuda law and regulations. Under Bermuda law, Endurance Bermuda may not declare or pay a dividend if there are reasonable grounds for believing that Endurance Bermuda is, or would after the payment be, unable to pay its liabilities as they become due, or the realizable value of Endurance Bermuda’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. Further, Endurance Bermuda, as a regulated insurance company in Bermuda, is subject to additional regulatory restrictions on the payment of dividends or distributions. As of December 31, 2012, Endurance Bermuda could pay a dividend or return additional paid-in capital totaling approximately $623.1 million without prior regulatory approval based upon the Bermuda insurance and corporate regulations. In 2011, Endurance Holdings loaned Endurance Bermuda $200.0 million, which remains outstanding and is callable on demand.
Endurance U.S. Reinsurance, Endurance American, Endurance American Specialty and Endurance Risk Solutions are subject to regulation by the State of Delaware Department of Insurance and American Agri-Business is subject to regulation by the Texas Department of Insurance. Dividends for each U.S. operating subsidiary are limited to the greater of 10% of policyholders’ surplus or statutory net income, excluding realized capital gains. In addition, dividends may only be declared or distributed out of earned surplus. At December 31, 2012, Endurance U.S. Reinsurance, Endurance American, Endurance Risk Solutions, and Endurance American Specialty did not have earned surplus; therefore, these companies are precluded from declaring or distributing dividends during 2013 without the prior approval of the applicable insurance regulator. At December 31, 2012, American Agri-Business (with notice to the Texas Department of Insurance) could pay dividends of $4.3 million without prior regulatory approval from the applicable regulators. In addition, any dividends paid by Endurance American, Endurance American Specialty and Endurance Risk Solutions would be subject to the dividend limitation of their respective parent insurance companies.
Cash and Invested Assets. The Company’s aggregate invested assets as of December 31, 2012 totaled $6.6 billion compared to aggregate invested assets of $6.3 billion as of December 31, 2011. The increase in invested assets since December 31, 2011 resulted from collections of premiums on insurance policies and reinsurance contracts, investment income, and the change in market value of invested assets offset in part by losses and loss expenses paid, acquisition expenses paid, reinsurance premiums paid, general and administrative expenses paid, interest and dividends paid, and the repurchase of the Company’s ordinary shares.
As of December 31, 2012 and 2011, the Company had pledged cash and cash equivalents and fixed maturity investments of $224.4 million and $171.4 million, respectively, in favor of certain ceding companies to collateralize obligations. As of December 31, 2012 and 2011, the Company had also pledged $380.0 million and $517.2 million of its cash and fixed maturity investments to meet collateral obligations for $320.4 million and $447.3 million in secured letters of credit outstanding under its credit facility, respectively. In addition, at December 31, 2012 and 2011, cash and fixed maturity investments with fair values of $280.0 million and $370.4 million were on deposit with U.S. state regulators, respectively, and cash and fixed maturity investments with fair values of nil and $7.6 million were on deposit with Canadian regulators, respectively.
Cash flows used in financing activities. The Company’s cash flows used in financing activities for the twelve months ended December 31, 2012 were $97.6 million, compared to $234.1 million and $331.9 million in 2011 and 2010, respectively. The 2012 cash flows used in financing activities decreased compared to 2011 and 2010 principally due to the decrease in ordinary share repurchase activity.
During 2012, the Company repurchased $1.0 million of its 6.15% Senior Notes due October 15, 2015 (2011: $0.5 million; 2010: nil). On January 28, 2011, the Company repurchased 7,143,056 ordinary shares and options to purchase 10,000 ordinary shares from two affiliated funds of Perry Corp., a founding shareholder of Endurance. The aggregate repurchase price for the shares and the options was $321.5 million. The ordinary shares acquired by the Company represented approximately 15% of its ordinary shares outstanding at December 31, 2010. Endurance Holdings funded the repurchase of these shares primarily from calling an outstanding loan between Endurance Holdings and Endurance Bermuda. Endurance Bermuda funded the settlement of the loan from its existing cash and investments. The repurchase did not impact the disclosed dividend payment capacity of Endurance Bermuda as of December 31, 2012.
Credit Facility. On April 19, 2012 the Company and certain designated subsidiaries of the Company entered into a $700.0 million four-year revolving credit facility with JPMorgan Chase Bank, N.A. (“JPMorgan”) as administrative agent (“Credit Facility”). Upon entering into the Credit Facility, the Company terminated its existing $1,175.0 million amended and restated credit agreement dated May 8, 2007 with JPMorgan as administrative agent. As of December 31, 2012, there were no borrowings under the Credit Facility and letters of credit outstanding under the Credit Facility were $320.4 million.
The Company’s contractual obligations as of December 31, 2012 are summarized as follows:
The following table summarizes the components of our capital resources at December 31, 2012 and 2011:
(1) The Company also has credit facility capacity of $379.6 million and $727.7 million as at December 31, 2012 and 2011, respectively.
Senior Notes. On October 17, 2005, Endurance Holdings issued $200.0 million principal amount of 6.15% Senior Notes due October 15, 2015. The 6.15% Senior Notes were offered by the underwriters at a price of 99.639% of their principal amount, providing an effective yield to investors of 6.199%. Endurance Holdings used net proceeds from the offering to repay a $143.5 million revolving loan then outstanding under the Company’s then existing credit facility as well as to provide additional capital to its subsidiaries and for other general corporate purposes. During 2012 and 2011, the Company repurchased $1.0 million and $0.5 million, respectively, of its 6.15% Senior Notes.
On July 15, 2004, the Company issued $250.0 million principal amount of 7% Senior Notes due July 15, 2034. On March 23, 2010, the Company issued an additional $85.0 million principal amount of 7% Senior Notes. The additional 7% Senior Notes issued have terms identical to the previously issued notes in the series, other than the date of issue, the initial purchase price to the public and the first interest payment date. The additional 7% Senior Notes trade interchangeably with and vote together with, the previously issued 7% Senior Notes. The 7% Senior Notes were offered by the underwriters at a price of 99.108% (original issuance) and 94.976% (additional issuance) of their principal amount, providing an effective yield to investors of 7.072% (original issuance) and 7.449% (additional issuance).
The 6.15% Senior Notes and the 7% Senior Notes (collectively, the “Senior Notes”) are senior unsecured obligations of Endurance Holdings and rank equally with all of Endurance Holdings’ existing and future unsecured and unsubordinated debt. The Senior Notes are also effectively junior to claims of creditors of Endurance Holdings’ subsidiaries, including policyholders, trade creditors, debt holders, and taxing authorities.
Upon any voluntary or involuntary liquidation, dissolution or winding-up of Endurance Holdings, holders of the Series A Preferred Shares, Series B Preferred Shares and any parity shares are entitled to receive out of Endurance Holdings’ assets available for distribution to shareholders, before any distribution is made to holders of Endurance Holdings’ common equity securities, a liquidating distribution in the amount of $25.00 per Series A Preferred Share and per Series B Preferred Share, plus any declared and unpaid dividends, without accumulation of any undeclared dividends. Distributions will be made pro rata as to the Series A Preferred Shares, Series B Preferred Shares and any parity shares and only to the extent of Endurance Holdings’ assets, if any, that are available after satisfaction of all liabilities to creditors.
On an ongoing basis, the Company expects its internally generated funds, together with borrowings available under the Credit Facility, capital generated from the offering and sale of its Senior Notes, Series A Preferred Shares, Series B Preferred Shares and ordinary shares, to be sufficient to operate its business. However, there can be no assurance that the Company will not incur additional indebtedness or issue additional equity or hybrid securities in order to implement its business strategy or pay claims.
The Company’s functional currencies are U.S. dollars for its U.S. and Bermuda operations and British Sterling for its U.K. operations. The reporting currency for all entities is U.S. dollars. The Company maintains a portion of its investments and liabilities in currencies other than the U.S. dollar. The Company has made a significant investment in the capitalization of Endurance U.K which was valued at £96.9 million as of December 31, 2012 ($157.5 million in U.S. dollars). Endurance U.K. is subject to the United Kingdom’s Financial Services Authority rules concerning the matching of the currency of its assets to the currency of its liabilities. Depending on the profile of Endurance U.K.‘s liabilities, it may be required to hold some of its assets in currencies corresponding to the currencies of its liabilities. The Company may, from time to time, experience losses resulting from fluctuations in the values of foreign currencies, which could have a material adverse effect on the Company’s results of operations.
For the year ended December 31, 2012, 13.5% of the Company’s gross premiums were written in currencies other than the U.S. dollar. The portions of our cash and cash equivalents, investments and reserves for loss and loss expenses denominated in non-U.S. currencies at December 31, 2012 were approximately 38%, 3% and 12%, respectively. As of December 31, 2012, the Company’s principal foreign currency exposures are denominated in British Sterling and Euros. The Company measures and manages its exposure in these currencies, among others, by monitoring its estimated gross and net asset positions. In order to estimate such exposures, the Company considers currency specific investments, cash and cash equivalents, premiums receivable, reserve for losses and loss expenses, and unearned premiums. The total estimated gross and net asset balances denominated in Euros were $203.3 million and $60.1 million, respectively. The total estimated gross and net asset balances denominated in British Sterling were $225.0 million and $140.2 million, respectively. Assuming all other variables are held constant and disregarding any tax effects, a 10% change in the U.S. dollar relative to these currencies could result in a $20.0 million increase or decrease in the net assets held by the Company at December 31, 2012.
Losses and loss expenses for the year ended December 31, 2012 include $120.2 million in favorable development of reserves relating to prior accident years. The favorable loss reserve development experienced during the 2012 year benefited the Company’s 2012 reported loss ratio by approximately 6.0 percentage points. The net reduction in estimated losses for prior accident years reflects lower than expected loss emergence in each of the Company’s reserve categories within both the Insurance and Reinsurance segments.
Property. The Company recorded a modest amount of unfavorable prior period development within the property line of business during 2012 primarily due to higher than expected claims reported for 2011 loss events. The Company recorded favorable prior period development within the property line of business during 2011 primarily due to lower than expected claims reported.
Casualty. The Company recorded favorable prior period development within the casualty line of business during 2012 and 2011 primarily due to lower than expected claims reported.
Selected quarterly activity in the reserve for losses and loss expenses for the years ended December 31, 2012 and 2011 is summarized as follows:
The Company’s estimated reserve for losses and loss expenses can change over time due to unexpected changes in the external business environment in which the Company operates or changes in internal Company operations. For a discussion of the factors which can contribute to uncertainty in the reserving process and volatility in the reserve for losses and loss expenses, see “Critical Accounting Estimates - Reserves for Losses and Loss Expenses” above.
Two key inputs utilized in determining loss and loss expense reserves for the Company’s two business segments are the initial expected loss ratio and the speed of the loss reporting pattern. The following tables illustrate the possible percentage effects on current estimates of the reserve for losses and loss expenses due to 10% changes in the initial expected loss ratio and the speed of the loss reporting pattern as of December 31, 2012. The 10% changes in the initial expected loss ratio and the speed of the loss reporting pattern in the tables below were chosen to demonstrate the impact on the Company’s loss and loss expense reserves of variation in key inputs and, as described below, may not be reflective of actual changes in loss and loss expense reserves.
Ceded premiums written were $519.5 million for the year ended December 31, 2012, $487.3 million for the year ended December 31, 2011 and $289.5 million for the year ended December 31, 2010. The increase in ceded premiums written was due to decreased retentions in our U.S. insurance operations, specifically related to the agriculture and casualty and other specialty lines. The Company’s U.S. and Bermuda insurance operating subsidiaries use proportional and excess reinsurance to protect larger limits on certain business written by this segment. Our agriculture line of business participates in a crop reinsurance program sponsored by the U.S. federal government. Excess reinsurance coverage is often purchased in relation to the property insurance line to protect against catastrophic events.
At December 31, 2012 and 2011, the Company had reinsurance recoverables of $774.9 million and $666.9 million, respectively, related to its ceded reinsurance agreements. The Company remains obligated for amounts ceded in the event that its reinsurers or retrocessionaires do not meet their obligations, except for amounts ceded related to the agriculture line of business. Accordingly, the Company has evaluated the reinsurers and retrocessionaires that are providing reinsurance and retrocessional protection and will continue to monitor the stability of its reinsurers and retrocessionaires. The Company has an allowance of $0.1 million for estimated uncollectible reinsurance recoverable balances at December 31, 2012 (2011-$0.1 million). The balance of losses recoverable at December 31, 2012 was distributed as follows based on the ratings of the reinsurers:
The Company’s intangible assets and goodwill are tested at least annually for impairment and more often if a triggering event is deemed to have occurred. Impairment testing is performed based upon estimates of the fair value of the “reporting unit” to which the goodwill relates. The reporting unit is the operating segment or a business one level below that operating segment if discrete financial information is prepared and regularly reviewed by management at that level. The Company’s reporting units identified include the agriculture line of the Insurance segment, the remaining Insurance segment lines of business, and the Reinsurance segment. The fair value of the reporting unit is impacted by the performance of the business. The Company primarily uses discounted cash flow analyses to estimate fair value. There have been no significant changes in the Company’s methodologies from the prior year. If it is determined that the goodwill has been impaired, the Company must write down the goodwill by the amount of the impairment, with a corresponding charge to net income.
The Company is subject to income taxes on the operations of its subsidiaries and branch offices in the United States, United Kingdom, Switzerland, Singapore and Canada. The Canadian branch office was closed during the fourth quarter of 2012. The Company is not required to pay any income or capital gains taxes on its operations in Bermuda.
Of the 2012 current income tax (expense) benefit, $(4.6) million related to taxes incurred in the United States (2011 - $12.7 million; 2010 - $(27.7) million). Of the deferred income tax benefit, $1.6 million related to deferred income tax benefits in the United States (2011 - $9.6 million; 2010 - $21.4 million). A full valuation allowance has been recorded against the net asset position of Endurance Bermuda’s foreign branches and Endurance U.K.
Gross premiums written and earned by our non-U.S. and U.S. operations generally do not bear a proportionate relationship to the respective pre-tax income (loss) of these operations. The disproportionate relationship between gross premium written and net income (loss) between our operations occurs as a result of various factors, including but not limited to the differences in the underlying type of business underwritten, the underwriting profitability attributable to such business, and the applicable investment income generated.
The Company has operating subsidiaries and branch operations in the United States, United Kingdom, Switzerland and Singapore, which are subject to the relevant taxes in those jurisdictions. During 2012, the Internal Revenue Service (“IRS”), the Canada Revenue Agency, the Inland Revenue Authority of Singapore and Her Majesty’s Revenue and Customs in the United Kingdom conducted audits and inquiries of income tax returns of the Company’s U.S. subsidiary, former Canadian branch, Singapore branch, and U.K. subsidiary, respectively. The audit and inquiry results were immaterial to the operations of the Company. None of the Company’s other operating subsidiaries or branch operations are under an examination in any of the jurisdictions in which they operate. The Company remains subject to examination for tax years 2008-2012. As of December 31, 2012 and 2011, the Company had no uncertain tax positions.
The 2012 valuation allowance was established against net operating loss carryforwards in the Company’s United States subsidiaries, United Kingdom subsidiary and non-U.S. branches. The valuation allowance in 2011 was established against net operating loss carryforwards in the Company’s United States subsidiaries, United Kingdom subsidiary and non-U.S. branches. The increase in the valuation allowance was charged to the Company’s income tax expense during 2012. Management believes the net deferred tax assets, less the valuation allowance noted, are more likely than not to be fully realized in corresponding future periods, and the Company’s net deferred tax asset has been fairly stated as at December 31, 2012. In the event that management determines in the future that it is more likely than not that the net deferred tax assets will not be fully realized in the near term and prior to their expiration, the Company will reassess the valuation allowance against the net deferred tax assets and record any changes to income tax expense in the period determined.
In our opinion, Endurance Specialty Holdings Ltd. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Endurance Specialty Holdings Ltd. at December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.
Endurance Specialty Holdings Ltd. (“Endurance Holdings”) was organized as a Bermuda holding company on June 27, 2002. Endurance Holdings writes specialty lines of insurance and reinsurance on a global basis through its wholly-owned operating subsidiaries:
In addition to the applicable risk period, the Company’s estimate of its reinsurance premiums written is based on the type of reinsurance contracts underwritten. For excess of loss reinsurance contracts, the deposit premium, as defined in the contract, is generally considered to be the best estimate of the reinsurance contract’s written premium at inception. The Company earns reinstatement premiums upon the occurrence of a loss under the reinsurance contract. Reinstatement premiums are calculated in accordance with the contract terms based upon the ultimate loss estimate associated with each contract. For proportional reinsurance contracts, the Company estimates premium, commissions and related expenses based on broker and ceding company estimates and also utilizes judgment in establishing proportional reinsurance contract estimates.
The Company’s reserve for losses and loss expenses includes case reserves and reserves for losses incurred but not reported (referred to as “IBNR reserves”). Case reserves are established for losses that have been reported, but not yet paid. IBNR reserves represent the estimated ultimate cost of events or conditions that have not been reported to or specifically identified by the Company, but have occurred. Case reserves and IBNR reserves are established by management based on reports from reinsurance intermediaries, ceding companies and insureds, and consultations with independent legal counsel. In addition, reserves for IBNR losses and loss expenses are established by management based on reported losses and loss expenses, and actuarially determined estimates of ultimate losses and loss expenses.
Other investments within the Company’s investment portfolio, which are comprised of (i) hedge funds and private investment funds that generally invest in senior secured bank debt, high yield debt securities, distressed debt, distressed real estate, derivatives and equity long/short strategies (“alternative funds”) and (ii) high yield loan and convertible debt funds (“specialty funds”) are accounted for using the equity method of accounting whereby the initial investment is recorded at cost. The carrying values of these investments are increased or decreased to reflect the Company’s share of income or loss, which is included in net investment income, and are decreased for dividends. Due to the timing of the delivery of the final valuations reported by the managers of certain of our alternative and specialty funds, our investments in those funds are estimated based on the most recently available information including period end valuation statements, period end estimates, or, in some cases, prior month or quarter valuation statements.
Assumptions underlying these valuations include forecasts of discounted future cash flows and future profits in addition to an analysis of the Company’s stock price relative to both its book value and its net income (loss).
Assets and liabilities of foreign operations whose functional currency is not the United States dollar are translated at exchange rates in effect at the balance sheet date. Revenues and expenses of such foreign operations are translated at weighted average exchange rates during the year. The effect of the translation adjustments for foreign operations is included in accumulated other comprehensive income, net of applicable deferred income taxes. Other monetary assets and liabilities denominated in foreign currencies are revalued at the exchange rates in effect at the balance sheet date with the resulting net foreign exchange gains and losses included in earnings (losses). Revenues and expenses denominated in foreign currencies are translated at the prevailing exchange rate on the transaction date.
The Company accounts for income taxes for its subsidiaries operating in taxable jurisdictions. Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. The accounting guidance allows for the recognition of tax benefits of uncertain tax positions only where the position is more likely than not to be sustained assuming examination by tax authorities. A liability is established for any tax benefit claimed in a tax return in excess of this threshold. Income tax related interest and penalties are included as income tax expense (benefit).
The two-class method utilized by the Company is an earnings allocation formula that determines earnings (losses) per share for the holders of Endurance Holdings’ ordinary shares (also referred to as “common shares”) and participating common shares, which includes unvested restricted shares that receive cash dividends, according to dividends declared (or accumulated) and participation rights in undistributed earnings. Net income (loss) available (attributable) to common and participating common shareholders is reduced by the amount of dividends declared in the current period and by the contractual amount of dividends that must be paid for the current period related to the Company’s common and participating common shares. Any remaining undistributed earnings are allocated to the common and participating common shareholders to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. In periods of loss, no losses are allocated to participating common shareholders. Instead, all such losses are allocated solely to the common shareholders.
In July 2012, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2012-02 “Intangibles - Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment” (“ASU 2012-02”). Under ASU 2012-02, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. In addition, an entity has the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing a quantitative impairment test.
In February 2013, the FASB issued ASU 2013-02 “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income” (“ASU 2013-02”). ASU 2013-02 requires entities to report, in one location, information about reclassifications out of accumulated other comprehensive income (“AOCI”). ASU 2013-02 also requires companies to report changes in AOCI balances. For significant items reclassified out of AOCI into net income in their entirety in the same reporting period, reporting (either on the face of the statement where net income is presented or in the notes to the financial statements) is required about the effect of the reclassifications on the respective line items in the statement where net income is presented. For items that are not reclassified into net income in their entirety in the same reporting period, a cross reference to other disclosures currently required under US GAAP is required in the notes. The above information must be presented in one place (parenthetically on the face of the financial statements by income statement line item or in a note to the financial statements).
Contractual maturities of the Company’s fixed maturity and short-term investments are shown below as of December 31, 2012 and 2011. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
In addition to the Company’s fixed maturity, short-term and equity investments, the Company invests in (i) hedge funds and private investment funds that generally invest in senior secured bank debt, high yield debt securities, distressed debt, distressed real estate, derivatives and equity long/short strategies (“alternative funds”) and (ii) high yield loan and convertible debt funds (“specialty funds”). The Company’s alternative funds and specialty funds are recorded on the Company’s balance sheet as “other investments”. At December 31, 2012 and 2011, the Company had invested, net of capital returned, a total of $394.5 million and $336.3 million, respectively, in other investments. At December 31, 2012 and 2011, the carrying value of other investments was $517.5 million and $432.7 million, respectively. The following table summarizes the composition and redemption restrictions of other investments as of December 31, 2012 and 2011:
(1) For additional information on the Company’s derivative financial instruments, see Note 8.
(1) Balances include amounts related to collateralized debt obligations held with total fair values of $27.7 million.
The analysis of OTTI for the years ended December 31, 2012, 2011 and 2010 is as follows:
Of the $0.8 million (2011-$3.5 million; 2010-$3.9 million) of OTTI losses recognized by the Company for the year ended December 31, 2012, the majority of it was related to reductions in expected recovery values on mortgage-backed securities during the period. At December 31, 2012, the Company did not have the intent to sell securities in an unrealized loss position and determined that it was unlikely that the Company would be required to sell securities in an unrealized loss position.
The following table provides a roll-forward of the amount related to credit losses for the Company’s available for sale investments recognized in earnings (losses) for which a portion of an OTTI loss was recognized in accumulated other comprehensive income for the years ended December 31, 2012, 2011 and 2010:
Government guaranteed corporate fixed maturity securities - These securities are generally priced by pricing services or index providers. The pricing service or index providers may use current market trades for securities with similar quality, maturity and coupon. If no such trades are available, the pricing service typically uses analytical spread models which may incorporate inputs from the U.S treasury curve or LIBOR. The Company generally classifies the fair values of its government guaranteed corporate securities in Level 2.
Common equity securities - The Company invests in equity securities through an equity investment manager and exchange traded funds. These funds and underlying securities are generally priced by pricing services based on quoted market prices in active markets. The Company generally classifies the fair values of its common equity securities in Level 1.
Structured securities including agency and non-agency, residential and commercial mortgage and asset-backed securities - These securities are generally priced by broker/dealers. Broker/dealers may use current market trades for securities with similar qualities. If no such trades are available, inputs such as bid and offer, prepayment speeds, the U.S. treasury curve, swap curve and cash settlement may be used in a discounted cash flow model to determine the fair value of a security. The Company generally classifies the fair values of its structured securities in Level 2.
The carrying values of cash and cash equivalents, accrued investment income, net receivable on sales of investments, net payable on purchases of investments, and other financial instruments not described above approximated their fair values at December 31, 2012 and 2011.
During 2012, there were no transfers into Level 1; however, the Company purchased current issue U.S. government securities and exchange traded equity securities, which are classified as Level 1 securities. Short-term investments were transferred from Level 1 to Level 2 as they no longer qualified as on the run U.S. treasury securities.
During 2012, the Company included its other investments within the fair value hierarchy as required by ASU 2011-04, which the Company adopted on January 1, 2012. These securities are generally priced on NAV received from the fund managers or administrators. As this valuation technique incorporates both observable and significant unobservable inputs, these investments are classified in Level 3.
During 2012, the Company included its Senior Notes within the fair value hierarchy as required by ASU 2011-04. The fair value of the Senior Notes is obtained from a third party pricing service and pricing is based on the spread above the risk-free yield curve. As the spreads and the yields for the risk-free yield curve are observable market inputs, the fair value of the Senior Notes are classified as Level 2 securities.
At December 31, 2011, the carrying value of the Company’s other investments was $432.7 million, which approximates fair value. At December 31, 2011, the carrying value of the Company’s Senior Notes was $528.0 million, and the fair value was $535.3 million.
Impairment losses on Level 3 securities of $0.1 million were recognized in earnings for the year ended December 31, 2012. Impairment losses of $0.6 million were recognized for the year ended December 31, 2011, representing realized losses due to OTTI.
There were no material changes in the Company’s valuation techniques for the year ended December 31, 2012.
The following tables present a reconciliation of the beginning and ending balances for all available for sale investments, other investments and derivative instruments measured at fair value on a recurring basis using Level 3 inputs during the years ended December 31, 2012 and 2011.
Activity in the reserve for losses and loss expenses for the years ended December 31, 2012, 2011 and 2010 is summarized as follows:
During 2012, the Company’s estimated ultimate losses for prior accident years were reduced by $120.2 million (2011 - $180.0 million; 2010 - $126.8 million) due to lower claims emergence than originally estimated by the Company. During 2012, the Company experienced favorable development in the Reinsurance segment of $74.0 million in the catastrophe, casualty and other specialty lines of business. In the Insurance segment, the Company experienced $46.2 million of favorable development across the agriculture, casualty and other specialty, professional lines, and property lines of business. During 2011, the Company experienced favorable development in the Reinsurance segment of $109.2 million in the catastrophe, property, casualty and other specialty lines of business. In the Insurance segment, the Company experienced $70.8 million of favorable development across the agriculture, casualty and other specialty, professional lines, and property lines of business. During 2010, the Company experienced favorable development in the Reinsurance segment of $79.9 million in the catastrophe, property, and casualty and other specialty lines of business. In the Insurance segment, the Company experienced $46.9 million of favorable development across the agriculture, casualty and other specialty, professional lines, and property lines of business during 2010.
During the year ended December 31, 2012, the Company recorded ceded losses of $737.8 million (2011 - $667.0 million; 2010 - $139.1 million). At December 31, 2012, the Company has an allowance for estimated uncollectible premiums receivable of $3.4 million (2011 - $3.4 million) and an allowance for estimated uncollectible losses recoverable of $0.1 million (2011 - $0.1 million). The balance of losses recoverable at December 31, 2012 was distributed as follows based on the ratings of the reinsurers:
On April 19, 2012, the Company and certain designated subsidiaries of the Company entered into a $700.0 million four-year revolving credit facility with JPMorgan Chase Bank, N.A. (“JPMorgan”) as administrative agent (“Credit Facility”). Upon entering into the Credit Facility, the Company terminated its existing $1,175.0 million amended and restated credit agreement dated May 8, 2007 with JPMorgan as administrative agent. As of December 31, 2012, there were no borrowings under the Credit Facility and letters of credit outstanding under the Credit Facility were $320.4 million.
The Credit Facility consists of two tranches: (i) a tranche 1 secured credit facility in an aggregate principal amount of $560.0 million (the “Tranche 1 Facility”), which is secured on a several basis by the respective entity incurring such obligation by cash and securities deposited into collateral accounts from time to time with Deutsche Bank Trust Company Americas and (ii) a tranche 2 unsecured facility in an aggregate principal amount of $140.0 million (the “Tranche 2 Facility”). The proceeds of the Credit Facility may be used for general corporate purposes, to finance potential acquisitions and for the repurchase of the Company’s outstanding publicly or privately issued securities. So long as the Company is not in default under the terms of the Credit Facility, the Company may request that the size of the Credit Facility be increased by $350.0 million, provided that no participating lender is obligated to increase its commitments under the Credit Facility.
The Company made aggregate interest payments of $35.7 million during the year ended December 31, 2012 (2011 - $35.8 million, 2010 - $32.8 million).
In 2004, prior to the issuance of the 7% Senior Notes, the Company entered into an interest rate lock on a notional amount of $125.0 million to protect against interest rate increases before the anticipated issuance of the Senior Notes. The objective of the interest rate lock was to protect 50% of the forecasted receipt of proceeds from the issuance of the 7% Senior Notes offering, which was subject to change prior to issuance due to fluctuations in the benchmark 30 year U.S. Treasury rate. Upon issuance of the 7% Senior Notes, the interest rate lock was settled through payment by the Company of $2.7 million. The interest rate lock agreement was designated as a “cash flow hedge” under the current accounting guidance and accordingly, the fair value of the derivative was recorded in other comprehensive income and is being recognized as a component of interest expense in the statement of income as the interest expense related to the 7% Senior Notes affects earnings. The net income effect of the interest rate lock was not material.
During 2012, the Company entered into the weather risk management business through its newly formed unit, Endurance Global Weather. Endurance Global Weather regularly transacts in certain derivative-based risk management products primarily to address weather and energy risks. The trading markets for these derivatives are generally linked to energy and agriculture commodities, weather and other natural phenomena. Generally, the Company’s current portfolio of such derivative contracts is of short duration and such contracts are predominantly seasonal in nature.
None of the Company’s derivatives are designated as hedges under current accounting guidance, with the exception of the interest rate lock. The Company may enter derivative transactions directly or as part of strategies employed by its external investment managers. The Company’s objectives for holding these derivatives are as follows:
Foreign Exchange Forwards, Futures and Options-as part of its overall currency risk management and investment strategies.
Energy and Weather Contracts-to address weather and energy risks. The Company may purchase or sell contracts with financial settlements based on the performance of an index linked to a quantifiable weather element, such as temperature, precipitation, snowfall or windspeed, or combinations thereof.
The fair values and the related notional values of derivatives at December 31, 2012 and 2011 are noted below.
The following table provides a summary of the segment revenues and results for the year ended December 31, 2012, reserve for losses and loss expenses as of December 31, 2012 and the carrying value of goodwill as of December 31, 2012:
The following table provides a summary of the segment revenues and results for the year ended December 31, 2011, reserve for losses and loss expenses as of December 31, 2011 and the carrying value of goodwill as of December 31, 2011:
The following table provides a summary of the segment revenues and results for the year ended December 31, 2010, reserve for losses and loss expenses as of December 31, 2010 and the carrying value of goodwill as of December 31, 2010:
The following table provides gross premiums written by line of business for the years ended December 31, 2012, 2011 and 2010:
The following table shows an analysis of goodwill and intangible assets for the years ended December 31, 2012 and 2011:
As of December 31, 2012, substantially all the Company’s cash and investments were held by three custodians.
Letters of credit. As of December 31, 2012, the Company had issued letters of credit of $320.4 million (2011 - $447.3 million) under its credit facility in favor of certain ceding companies to collateralize obligations.
The Company is subject to certain commitments with respect to other investments at December 31, 2012 and 2011. See Note 3.
Legal Proceedings. The Company is party to various legal proceedings generally arising in the normal course of its business. While any proceeding contains an element of uncertainty, the Company does not believe that the eventual outcome of any litigation or arbitration proceeding to which it is presently a party could have a material adverse effect on its financial condition, results of operations or business. Pursuant to the Company’s insurance and reinsurance agreements, disputes are generally required to be finally settled by arbitration.
The Company’s share capital at December 31, 2012 and 2011 is comprised as follows:
During 2012, the Company issued restricted shares under its equity compensation plans (Note 15). The common shares issued, outstanding and fully paid for 2012 includes 684,805 restricted shares.
On October 10, 2005, Endurance Holdings issued 8,000,000 shares of its 7.75% Non-Cumulative Preferred Shares, Series A (the “Series A Preferred Shares”) and on June 1, 2011, Endurance Holdings issued 9,200,000 shares of its 7.5% Non-Cumulative Preferred Shares, Series B (the “Series B Preferred Shares”). The Series A Preferred Shares and Series B Preferred Shares sold were registered under the Securities Act of 1933, as amended, and are traded on the New York Stock Exchange. The Series A Preferred Shares and Series B Preferred Shares were both issued at a price to the public of $25.00 per share. Endurance Holdings received net proceeds of $193.5 million from its offering of Series A Preferred Shares and $224.0 million from its offering of Series B Preferred Shares, in each case after expenses and underwriting discounts. The proceeds from both offerings were used to provide additional capital to Endurance Holdings’ subsidiaries and for other general corporate purposes.
In conjunction with the issuance by the Company of the Series A Preferred Shares, the Company entered into a “Declaration of Covenant” for the benefit of the holders of the 7% Senior Notes. The Covenant states that the Company will redeem its Series A Preferred Shares only if the total redemption price is less than or equal to the proceeds Endurance Holdings or its subsidiaries have received during the six months prior to the date of such redemption from the sale of certain qualifying securities that, among other things, are, with limited exceptions, pari passu with or junior to the Series A Preferred Shares upon the Company’s liquidation, dissolution or winding-up; perpetual, or have a mandatory redemption or maturity date that is not less than sixty years after the initial issuance of such securities; and provide for dividends or other income distributions that are non-cumulative.
On November 9, 2011, the Company’s Board of Directors authorized for repurchase up to 7.0 million ordinary shares or share equivalents through November 30, 2013. This authorization superseded previous authorizations. During 2012 and 2011, under programs authorized by the Company’s Board of Directors, the Company repurchased 251,309 and 7,563,469 of its ordinary shares and share equivalents in open market and privately negotiated transactions at an average price of $39.81 and $45.06 per share, respectively. Common shares repurchased by the Company are not cancelled and are classified as treasury shares. The Company’s treasury shares are recorded at cost as a reduction in common shares and additional paid-in capital within shareholders’ equity. Total authorized repurchases remaining at December 31, 2012 was 6,748,691 shares (2011 - 7,000,000).
At December 31, 2012 and 2011, no warrants were outstanding. During 2011, the Company repurchased 90,000 outstanding warrants at an average price of $36.72, net of the average warrant strike price of $12.87 per warrant. During 2011, 2,895,527 warrants with an exercise price of $11.97 were exercised for the purchase of the Company’s ordinary shares at an average price of $36.44. The holders of 2,308,482 warrants elected the net settlement option, and thus the Company delivered 2,143,396 ordinary shares in settlement of all exercises.
The following table sets forth dividends declared in the years ended December 31, 2012, 2011 and 2010, respectively:
Since 2002, subsidiaries of BlackRock Inc. (“BlackRock”) have provided the Company and its subsidiaries with various investment management, investment accounting and risk analysis services. BlackRock owned 2.2 million or 5.2% of Endurance Holdings’ ordinary shares outstanding at December 31, 2012 and were therefore considered a related party. The Company incurred expenses totaling $3.1 million (2011-$3.2 million; 2010 - $3.3 million) of which $1.5 million was accrued in relation to investment services rendered by BlackRock at December 31, 2012 (2011 - $2.1 million). At December 31, 2012, the Company owned BlackRock common shares with a fair value of $0.8 million (2011 - $0.5 million). As of January 31, 2013, BlackRock is no longer considered a related party as a result of reducing its ownership below 5% of the Company’s ordinary shares outstanding.
A summary of option activity, including options held by employees and non-employee directors, during the year ended December 31, 2012 is presented below:
During the years ended December 31, 2012, 2011 and 2010, the Company granted an aggregate of 437,284, 305,806 and 532,964 restricted shares and restricted share units with weighted average grant date fair values of $16.8 million, $14.8 million and $20.4 million, respectively. During the years ended December 31, 2012, 2011 and 2010, the aggregate fair value of restricted shares and restricted share units that vested was $11.7 million, $14.4 million and $13.5 million, respectively.
For the years ended December 31, 2012, 2011 and 2010, compensation costs recognized in earnings for all restricted shares and restricted share units were $11.2 million, $14.8 million, and $12.9 million, respectively. At December 31, 2012, compensation costs not yet recognized related to non-vested awards was $8.8 million (2011 - $9.9 million). This expense is expected to be recognized between 2013 and 2016, with approximately 68.6% expected to be recognized during 2013.
Under the terms of the ESPP, employees of Endurance Holdings and certain of its subsidiaries may purchase Endurance Holdings’ ordinary shares at a 15% discount to the closing market price on the purchase date. Participants are eligible to receive dividends on the shares purchased in the ESPP and are entitled to vote such shares at any Annual General or Special Meeting of Shareholders. These shares are restricted from sale, transfer or certification for one year from the purchase date.
Total expenses related to this plan for the year ended December 31, 2012 was approximately $165,000 (2011 - $200,000; 2010- $172,000).
Our insurance and reinsurance operations are subject to insurance and/or reinsurance laws and regulations in the jurisdictions in which they operate, the most significant of which are Bermuda, the United States and the United Kingdom. These regulations include certain restrictions on the amount of dividends or other distributions, such as loans or cash advances, available to shareholders without prior approval of the insurance regulatory authorities.
As a Bermuda holding company, Endurance Holdings is subject to the Companies Act 1981 which limits the Company’s ability to pay dividends and make distributions to its shareholders. The Company’s retained earnings are unrestricted; however, the Company is not permitted to declare or pay a dividend, or make a distribution out of contributed surplus, if it is, or would after the payment be, unable to pay its liabilities as they come due, or if the realizable value of its assets would be less than its liabilities. Endurance Holdings had, as of December 31, 2012, $2.0 billion in retained earnings, $0.2 billion in accumulated other comprehensive income and an additional $0.5 billion in contributed surplus available to declare or pay a dividend, or make a distribution out of contributed surplus, so long as Endurance Holdings remained in compliance with the Companies Act 1981 following such dividend or distribution. Endurance Holdings relies on dividends from Endurance Bermuda to provide cash flow required for debt service and dividends to shareholders.
Endurance U.S. Reinsurance, Endurance American, Endurance American Specialty and Endurance Risk Solutions are subject to regulation by the Delaware Department of Insurance. American Agri-Business is subject to regulation by the Texas Department of Insurance. Endurance’s Delaware and Texas domiciled entities must maintain a minimum level of statutory capital as established by such jurisdictions. The amount of required capital is determined through the use of the Risk Based Capital model established by the National Association of Insurance Commissioners and adopted by Delaware and Texas. The required capital noted in the table above has been based on the Risk Based Capital model and represents the authorized control level risk based capital for these entities.
The Singapore Branch is subject to Fund Solvency and Capital Adequacy requirements by the Monetary Authority of Singapore as a foreign company in Singapore and is regulated by the Monetary Authority of Singapore pursuant to the Insurance Act in Singapore. At December 31, 2012 and 2011, the Singapore Branch complied with the capital requirements promulgated by the Monetary Authority of Singapore.
The Company has operating subsidiaries and branch operations in the United States, United Kingdom, Switzerland and Singapore, which are subject to the relevant taxes in those jurisdictions. During 2012, the Internal Revenue Service (“IRS”), the Canada Revenue Agency, the Inland Revenue Authority of Singapore and Her Majesty’s Revenue and Customs in the United Kingdom conducted audits and inquiries of income tax returns of the Company’s U.S. subsidiary, former Canadian branch, Singapore branch, and U.K. subsidiary, respectively. The audit and inquiry results were immaterial to the operations of the Company. None of the Company’s other operating subsidiaries or branch operations were under examination in any of the jurisdictions in which they operate. The Company remains subject to examination for tax years 2008 - 2012.
The income tax (expense) benefit was as follows for the years ended December 31, 2012, 2011 and 2010, respectively:
The actual income tax (expense) benefit attributable to income (losses) for the years ended December 31, 2012, 2011 and 2010 differed from the amount computed by applying the combined effective rate of 0% under Bermuda law to income (loss) before income taxes, as a result of the following: