Max USA, Max Specialty Services and Max Managers USA, as applicable, have leased office space in the following states for our U.S. specialty activities:
MCS USA leases space in Florham Park, NJ to facilitate the provision of intercompany services.
The following is a discussion and analysis of our results of operations for the year ended December 31, 2008 compared to the year ended December 31, 2007 and for the year ended December 31, 2007 compared to the year ended December 31, 2006, and also a discussion of our financial condition as of December 31, 2008. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report on Form 10-K.
Overall property and casualty combined ratio of 91.9%, compared to 88.2% in 2007;
Net loss of $175.3 million, for a net loss per diluted share of $3.10;
Gross premiums written in our property and casualty businesses totaled $1,012.1 million, an increase of 30.4% over 2007, largely as a result of the expansion in our U.S. specialty segment and diversification into new lines of business. Max Specialty, our U.S. specialty platform, demonstrated the strength of its team’s distribution relationships and produced $194.4 million in gross premiums written at an attractive loss ratio of 69.4% on predominately short-tail business. Our Bermuda/Dublin reinsurance and insurance segments operated at combined ratios of 87.4% and 88.2%, respectively, in markets generally considered to have experienced a soft pricing year.
We added our fourth key underwriting platform with our fourth quarter acquisition of a Lloyd’s managing agent, Max at Lloyd’s, which manages three syndicates at Lloyd’s. We expect our entry into the world’s oldest insurance marketplace to be a substantial complement to our existing specialty insurance and reinsurance businesses, and to be accretive to our operating results in 2009.
negative return and volatility of our portfolio was significantly worse than previously modeled. Although 2008 was the first year in our history that we had net losses on our alternative investments, in late 2008, we made the decision to reduce our invested assets allocation to alternative investments to between 10% and 15%. At December 31, 2008, 14.1% of our invested assets are in alternative investments, and we expect this to decrease to 12.0% or below by March 31, 2009 based on redemptions already requested.
Reinsurance and insurance premiums are a function of the amount and type of contracts written as well as prevailing market prices. Property and casualty premiums are earned over the terms of the underlying coverage. Life and annuity reinsurance premiums are generally earned when the premium is due from policyholders. Each of our reinsurance and insurance contracts contain different pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying contracts, data received from clients and from premium audits. Changes in premium estimates are expected and may result in significant adjustments in any period. These estimates change over time as additional information regarding the underlying business
volume of our clients is obtained. There is often a delay in the receipt of updated premium information from clients due to the time lag in preparing and reporting the data to us. After review by our underwriters and finance staff, we increase or decrease premium estimates as updated information from our clients is received.
Our net investment income is a function of the average invested assets and the average yield that we earn on those invested assets. The investment yield on our fixed maturities investments is a function of market interest rates as well as the credit quality and maturity of our fixed maturities portfolio. We recognize realized capital gains or losses on our available for sale and trading fixed maturities investments at the time of sale, and recognize the change in unrealized fair value of our trading investments as a realized gain or loss. The realized capital gains or losses reflect the results of changing market conditions, including changes in market interest rates and changes in the market’s perception of the credit quality of our fixed maturities holdings. Our net gains on alternative investments are a function of the success of the funds in which we are invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies, general economic and investment market conditions.
General and administrative expenses are principally employee salaries, bonuses and related personnel costs, office rent, amortization of leasehold improvements and other operating costs. These costs generally do not vary with the amount of premiums written.
Our reinsurance premiums are recorded at the inception of each contract, based upon contract terms and information received from ceding clients and their brokers. For excess of loss contracts, the amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is posted to amend the minimum and/or deposit premium, when notified, if there are changes in underlying exposures insured. For quota share or proportional reinsurance contracts, gross premiums written are normally estimated at inception based on information provided by cedants and/or brokers. We generally account for such premiums using the client’s initial estimates, and then adjust them as more current information becomes available, with such adjustments recorded as premiums written in the period they are determined. We believe that the ceding clients’ estimate of the volume of business they expect to cede to us represents the best estimate of gross premium written at the beginning of the contract. As the contract progresses, we monitor actual premium received in conjunction with correspondence from the ceding client in order to refine our estimate. Variances from original premium estimates are normally greater for quota share contracts than excess of loss contracts. Premiums are earned on a pro rata basis over the coverage period. The net adjustments to gross premiums written as a result of changes in premium estimates for the years ended December 31, 2008 and 2007 were $46.0 million and $9.3 million, respectively. Such adjustments are generally the result of changing market conditions experienced by our clients.
Additional premiums assumed and ceded, related additional acquisition costs, related net losses and the net impact on operating results for each of the three years to December 31, 2008 are as follows:
For each of the years ended December 31, 2008, 2007 and 2006, additional premiums relate to contracts where the coverage period had expired. Therefore, these additional premiums, representing revisions to our initial estimate of ultimate premiums as a result of changes in the estimate of loss reserves, were fully earned since the exposure period has ended.
For quota share or proportional contracts, we are entitled to receive premium as the ceding client collects the premium under contractual reporting and payment terms, which are usually quarterly. Premiums are usually collected over a two year period on our quota share or proportional contracts. For excess of loss contracts, premium is generally paid in contractually stipulated installments with payment terms ranging from payment at the inception of the contract to four quarterly payments. 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 premium receivable asset on our balance sheet. We actively monitor our premium 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. We also seek to include a right of
The liability for losses, including loss adjustment expenses, represents estimates of the ultimate cost of all losses incurred but not paid as of the balance sheet date. In estimating reserves, we utilize a variety of standard actuarial methods. Although these actuarial methods have been developed over time, assumptions about anticipated size of loss and loss emergence patterns are subject to fluctuations. Newly reported loss information from clients is the principal contributor to changes in the loss reserve estimates. These estimates, which generally involve actuarial projections, are based upon an assessment of known facts and circumstances, as well as estimates of future trends in claims severity and frequency and judicial theories of liability factors, including the actions of third parties, which are beyond our control.
We rely on data reported by clients when calculating reserves. The quality of the data varies from client to client. On a periodic basis, the clients’ loss data is analyzed by our actuarial and claims management teams to ascertain its quality and credibility. This process may involve comparisons with submission data and industry loss data, claims audits and inquiries about the methods of establishing case reserves associated with large industry events.
In estimating reserves we, consistent with industry practice, utilize a variety of standard actuarial methods together with management judgment. The loss reserve selection from these various methods is based on the loss development characteristics of the specific line of business and specific contracts which take into consideration coverage terms, type of business, maturity of loss data, reported claims and paid claims. We do not necessarily utilize the same actuarial method or group of actuarial methods for all contracts within a line of business or segment, as variations between contracts result in a number of different methods or groups of methods being appropriate. These actuarial methods have been designed to address the lag in loss reporting in the insurance industry as well as the delay in obtaining information that would allow us to more accurately estimate future payments. There is often a time lag between reinsurance clients establishing case reserves and re-estimating their reserves, and notifying us of the new or revised case reserves. Reporting lag is more pronounced in our reinsurance contracts than in our insurance contracts and more pronounced in casualty business, which generally has a longer claims pay-out period (long claim-tail), than property business, which generally has a shorter claims pay-out period (short claim-tail). On casualty reinsurance transactions the reporting lag will generally be 60-90 days after the end of a reporting period, but can be longer than this in some cases. Based on the experience of our actuaries and management, we select loss development factors and trending techniques to mitigate the problems caused by reporting lags and claims tails. We regularly evaluate and update our loss development and trending factor selections using client specific and industry data. The principal actuarial methods we use to perform our quarterly loss reserve analysis may include one or more of the following methods:
Our Bermuda/Dublin reinsurance loss reserves include case reserves, amounts for IBNR reserves and loss adjustment expenses. The reserves are compiled on a contract-by-contract basis and are computed on an undiscounted basis. The majority of our Bermuda/Dublin reinsurance reserves are related to casualty business. Historically, losses associated with casualty business have had a long claim-tail, the time period between the occurrence of a loss and the time it is settled by the insurer we reinsure. Casualty losses are also more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. Due to the long claim-tail nature of casualty business, a high degree of judgment is involved in establishing loss reserves.
Our Bermuda/Dublin property reinsurance loss reserves are established on a contract-by-contract basis, based on expected loss ratios, losses reported by clients and our assessment of potential losses from catastrophe events. After a catastrophe event, our initial estimate is based upon a combination of internal and external catastrophe models, and client- and location-specific assessments and reports, when and as available. Loss estimates are subsequently refined based on broker advices and client notifications.
Our Bermuda/Dublin property insurance loss reserves, which include case reserves, amounts for IBNR reserves and loss adjustment expenses, are compiled on a portfolio basis and are computed on an undiscounted basis. These reserves are adjusted for losses reported by our clients and for our estimate of losses resulting from catastrophe events, based on a detailed, location specific analysis of our clients’ properties impacted by the events.
On a gross of reinsurance basis, the majority of the U.S. specialty business we have written is property business. On a net of reinsurance basis, the earned premium is approximately equally split between property and casualty. Our U.S. specialty property and casualty loss reserves, which include case reserves, amounts for IBNR reserves and loss adjustment expenses, both allocated and unallocated, are compiled on a portfolio basis and are computed on an undiscounted basis.
The reserves for reported losses related to our U.S. specialty business are initially set by our claims personnel or independent claims adjusters we retain. The loss reserves are subject to our review, with a goal of setting them at the ultimate expected loss amount as soon as possible when the information becomes available.
We establish and review our U.S. specialty IBNR loss and loss expense reserves on a quarterly basis. We use a variety of actuarial techniques and methods in estimating our ultimate liability for excess and surplus lines insurance losses and loss expenses, together with management judgment. These methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods. Industry loss experience is also used to supplement our own data in selecting loss reporting and payment patterns and expected loss ratios. The table below breaks our U.S. specialty reserves as of December 31, 2008 and 2007 into casualty (long claim-tail) and property (short claim-tail) components.
The table below breaks our Max at Lloyd’s loss reserves as of December 31, 2008 into casualty (long claim-tail) and property (short claim-tail) components.
The following table presents the development of balance sheet property and casualty loss reserves calculated in accordance with GAAP, as of December 31, 2000 through December 31, 2008. This table does not present accident or policy year development data. The top line of the table shows the gross reserves at the balance sheet date for each of the indicated years and is reconciled to the net reserve by adjusting for reinsurance recoverables. This represents the estimated amount of net claims and claim expenses arising in the current year and all prior years that are unpaid at the balance sheet date, including IBNR reserves. The table also shows the re-estimated amount of the previously recorded reserves as adjusted for new information received as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “net cumulative redundancy (deficiency)” represents the aggregate change to date from the original estimate on the third line of the table “reserve for property and casualty losses, originally stated, net of reinsurance.” The “gross cumulative redundancy (deficiency)” represents the aggregate change to date from the original gross estimate on the top line of the table. The table also shows the cumulative net paid amounts as of successive years with respect to the net reserve liability.
(2) The difference between the reinsurance recoverable included above and that reflected in the reconciliation of losses and loss adjustment expenses in Note 6 to the consolidated financial statements of $785 relates to the remaining net deferred loss on retroactive reinsurance.
(3) Gross and net reserve for property and casualty losses includes, for the first time, Max Specialty, which we acquired in April 2007.
(5) Gross and net reserve for property and casualty losses includes, for the first time, Max UK, which we acquired in November 2008.
Favorable development of $17.0 million arising from reductions in reinsurance premium estimates of $46.0 million. Changes in premium estimates occur on prior year contracts each year as we receive additional information on the underlying exposures insured and the associated loss is recorded, at the original loss ratio, concurrently with the premium adjustment. The favorable development is offset by a decrease in earned premium net of acquisition costs of $24.2 million, resulting in a net loss of $7.2 million.
Our life and annuity reinsurance benefit and claim reserves are compiled by our life and annuity actuaries on a contract-by-contract basis and are computed on a discounted
There have been no material reserve adjustments to our life and annuity reinsurance benefit reserves during the years ended December 31, 2008, 2007 and 2006.
We adopted Financial Accounting Standard No. 157, “Fair Value Measurements”, or FAS 157, as of January 1, 2008. FAS 157 establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value, and enhances disclosure requirements for fair value measurements. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under FAS 157 are described below:
The independent pricing services used by our investment custodian and investment managers obtain actual transaction prices for securities that have quoted prices in active markets. Each pricing service has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing service uses observable market inputs including, but not limited to, reported trades, benchmark yields, broker/dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from market sources to determine a reasonable fair value. In addition, pricing services use valuation models, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage-backed and asset-backed securities. The ability to obtain quoted market prices is reduced in periods of decreasing liquidity, which generally increases the use of matrix pricing methods and generally increases the uncertainty surrounding the fair value estimates. This could result in the reclassification of a security between levels of the FAS 157 hierarchy.
Certain of our funds have either imposed a gate on redemptions, or have segregated a portion of the underlying assets into a side-pocket. Based on the review process applied
A review of fair value hierarchy classifications is conducted on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification for certain financial assets and liabilities. Reclassifications impacting Level 3 of the fair value hierarchy are reported as transfers in/out of the Level 3 category as of the beginning of the quarter in which the reclassifications occur. During the year ended December 31, 2008, we reclassified all of our alternative investments from Level 2 to Level 3. The increase in the use of gates, side-pockets, and a decline in the level of observable activity resulted in an increase in the use of unobservable inputs and management judgment in estimating fair value.
As at December 31, 2008, our Max Diversified alternative investment portfolio contained 37 underlying investments in 10 different strategies. We focus on risk, as opposed to return, in the selection of each of our alternative investments. This causes us to select individual alternative investments that have exhibited attractive risk/reward characteristics and low correlation to other investments in the portfolio, as opposed to individual investments that have shown the highest return, but also higher volatility of return. We then combine the selected individual alternative investments into a portfolio of alternative investments. By combining investments with moderate volatility and low correlations, we aim to achieve an alternative investment portfolio within Max Diversified that has overall lower volatility relative to investing in a common stock portfolio or a typical fund of hedge funds portfolio.
We have attempted to construct our alternative investment portfolio to have less risk, as measured by standard deviation of return, than a common stock portfolio, which is the equity investment choice of many insurance organizations. For the five years ended December 31, 2008, our Max Diversified alternative investment portfolio has produced an annual standard deviation of return of 6.81% compared to the annual standard deviation of return of 11.86% for the HFRI Fund of Funds Composite Index and 12.81% for the S&P 500 Index. The annualized five year return on our Max Diversified alternative investment portfolio of 3.08% compares to the HFRI Fund of Funds Composite Index return of 2.02% and the S&P 500 Index return of negative 2.80% for the same period, and with lower volatility as measured by standard deviation. There is significant risk in all our investment activities, and the results of our alternative investment portfolio will vary over time with the investment markets. With the exception of 2008, our Max Diversified alternative investments have produced positive results for every annual period since inception and have shown approximately one-half the volatility of the S&P 500 Index.
Despite the lower volatility of the alternative investment portfolio there is potential for losses, as there is for any investment portfolio. We approach our investment strategies
based on long term performance and believe the annualized five year return of our Max Diversified portfolio of 3.08% demonstrates a superior return profile compared to other alternative investment vehicles.
Bermuda/Dublin reinsurance-This segment generally offers property and casualty quota share and excess of loss capacity from our Bermuda and Dublin offices, providing coverage for underlying risks written by our clients.
Bermuda/Dublin insurance-This segment generally offers property and casualty excess of loss capacity from our Bermuda and Dublin offices on specific risks related to individual insureds.
U.S. specialty-This segment generally offers property and casualty coverage from offices in the United States on specific risks related to individual insureds.
We also have a corporate function that manages our investment, financing and other administrative activities.
The U.S. specialty and the Max at Lloyd’s segments each have their own portfolio of fixed maturities investments. The investment income earned by each of these segments is reported in the respective segment.
Invested assets relating to the Bermuda/Dublin reinsurance, Bermuda/Dublin insurance and life and annuity segments are managed on a consolidated basis. Consequently, investment income on this consolidated portfolio and gains on the alternative investment portfolio are not directly captured in any one of these segments. However, because of the longer duration of liabilities on casualty insurance and reinsurance business (as compared to property), and life and annuity reinsurance business, investment returns are important in evaluating the profitability of these segments. Accordingly, we allocate investment returns from the consolidated portfolio to each of these three segments. This is based on a notional allocation of invested assets from the consolidated portfolio using durations that are determined based on estimated cash flows into and out of each segment. The balance
The loss ratio is calculated by dividing losses (shown as (b)) by net premium earned (shown as (a)). The combined ratio is calculated by dividing the sum of losses, acquisition costs and general and administrative expenses (shown as (c)) by net premiums earned (shown as (a)).
Reinsurance premiums ceded. The increase in reinsurance premiums ceded for the year ended December 31, 2008 compared to the year ended December 31, 2007 was principally attributable to increases of $13.1 million, $9.2 million and $8.1 million of quota share premiums ceded for our workers compensation, medical malpractice, and agriculture product lines, respectively, corresponding to the associated growth in gross premiums written for those product lines. Reinsurance premiums ceded generally relate to the purchase of specific reinsurance to manage risks associated with our reinsurance underwriting and to manage the exposure retained by us on certain transactions. Reinstatement premiums ceded triggered by property catastrophe losses during the year ended December 31, 2008 were $1.7 million, compared to $nil for the year ended December 31, 2007.
Net favorable loss reserve development of $68.1 million arising from the re-estimation of liabilities from our quarterly and annual actuarial review process and the final settlement of prior period reinsurance reserves. Favorable development reflects the lower than expected claims emergence on prior year contracts. The majority of the favorable development occurred on 2005 and prior years. Lines of business with the largest favorable development were professional liability ($25.8 million), whole account ($15.1 million), property and property catastrophe ($22.1 million), and general liability ($9.5 million). The only line of business with adverse development was marine and energy, with $13.5 million;
For 2007, the increase in our property and property catastrophe business as a percentage of total net earned premiums in a year with lower than expected large loss events resulted in a decline in our average loss ratio for the segment, partially offset by the purchase of additional excess of loss reinsurance in 2007.
Net losses and loss expenses for the year ended December 31, 2006 included net favorable development on prior year reserves of $10.2 million. This included $4.3 million arising from changes in premium estimates and $6.7 million from the re-estimation of liabilities. The $6.7 million net favorable development principally related to our 2003 excess liability insurance products, which developed more favorably than originally estimated. Accordingly, we reduced gross reserves by $35.5 million and losses recoverable from reinsurers by $15.0 million, to reflect the change in estimates. In addition, there was partially offsetting adverse development on the property and casualty reinsurance business, including $8.6 million in relation to 2005 hurricane losses.
Acquisition costs decreased by 21.2% for the year ended December 31, 2007 compared to the same period in 2006. The percentage decrease in acquisition costs is lower than the percentage decrease in net premiums earned due to the adjustment of the ceding commission on a number of contracts as described in the losses section above.
Interest expense for the year ended December 31, 2007 includes $9.3 million of interest expense pertaining to the funds withheld on the variable quota share retrocession agreement with Grand Central Re for the year ended December 31, 2007 compared to $7.0 million for the year ended December 31, 2006. Offsetting the interest expense for the year ended December 31, 2006 was a reduction of $12.0 million in interest expense related to a non risk-bearing contract for which the ultimate loss estimate was reduced.
General and administrative expenses increased 20.9% for the year ended December 31, 2007 compared to the 2006 year. The increase partially reflected an increasingly mature book of business and the additional claims and underwriting staff hired
since December 31, 2006, in order to service a larger client base. The increase also reflected higher incentive based compensation stemming from the net income generated by this segment for the year ended December 31, 2007.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2007 was 52.8% compared to 49.0% for the year ended December 31, 2006. The increase in premiums ceded, despite the decrease in gross premiums written, were principally related to increasing the percentage ceded to our property quota share treaty and to reinstatement premiums recognized in relation to our aviation excess of loss reinsurance contracts that were triggered by aviation losses, including a Brazilian airline crash, in 2007.
Net losses and loss expenses. The increase in the loss ratio in 2008 is principally attributable to higher property catastrophe and per-risk losses, partly offset by a greater amount of favorable prior year loss reserve development compared to 2007. Hurricanes in the United States resulted in net losses of $5.4 million and $nil for the years ended December 31, 2008 and 2007, respectively. For the year ended December 31, 2008, net favorable loss reserve development on prior year reserves was $22.6 million, compared to $8.8 million in 2007. The lines of business with the largest favorable development in 2008 were property ($18.3 million) and aviation ($2.0 million). In 2007 the lines of business with the largest favorable development were property ($5.7 million) and excess liability ($1.7 million). The greater proportion of aviation business written in 2008 has also resulted in an increase in our current accident year loss ratio for this segment.
Losses were $153.8 million for the year ended December 31, 2007 compared to $124.2 million for the year ended December 31, 2006, an increase of 23.8%. During the year ended December 31, 2007, we recorded $8.8 million net favorable development on reserves compared to net favorable development of $20.5 million on reserves for the year ended December 31, 2006. The favorable development in 2007 was partially offset by a net loss of $5.6 million stemming from aviation losses in 2007.
Acquisition costs. Acquisition costs are net of ceding commissions associated with premiums ceded to our quota share partners. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers.
Income before taxes. The decrease in income before taxes for the year ended December 31, 2008 compared to the year ended December 31, 2007 is principally attributable to the year-over-year decrease in gains on alternative investments of $37.8 million, together with the 2.0 percentage point increase in the combined ratio resulting principally from the increase in general and administrative expenses.
The decrease in income before income taxes for the year ended December 31, 2007 compared to the year ended December 31, 2006 is principally attributable to the 15.6% percentage point increase in the combined ratio resulting principally from increased net losses and loss expenses and general and administrative expenses, partially offset by the year-over-year increase in gains on alternative investments of $9.2 million.
Our U.S. specialty segment, which comprises the underwriting operations of our U.S.-based business, commenced underwriting activities in April 2007, with 2008 being the first full year of operations. Comparisons between periods are difficult due to the start-up nature of this segment, may not be meaningful and are not necessarily representative of future trends.
Net investment income. Net investment income relating to the U.S. specialty segment, which excludes realized and unrealized gains and losses, is comprised principally of interest on cash and fixed maturities investments held by Max Specialty and Max America. The average annualized investment yield on cash and fixed maturities for the year ended December 31, 2008 was 4.59% compared to 5.08% for the year ended December 31, 2007.
Net losses and loss expenses. The absolute increase in net losses and loss expenses of $27.1 million is consistent with the increase in net premiums earned, while the loss ratio of 69.4% has improved by 12.6 percentage points, compared to the year ended December 31, 2007. As our U.S. specialty segment has grown, we have purchased substantial reinsurance coverage in order to protect our capital base. Accordingly, our reinsurance premiums ceded have been a significant proportion of gross premiums written, which has the effect of increasing the net loss ratio. We believe this effect will naturally decrease as gross premiums written volume increases and the ratio of reinsurance ceded to gross premiums written decreases. Losses in this segment typically comprise a larger volume of smaller dollar value losses compared to our Bermuda/Dublin reinsurance and insurance segments. Losses recognized in the years ended December 31, 2008 and 2007 related to hurricane events were $5.0 million and $nil, respectively, net of reinsurance recoveries.
General and administrative expenses. General and administrative expenses principally comprise personnel and infrastructure costs, which have grown in line with the growth in gross premiums written, but have also decreased throughout 2008 as a percentage of net earned premiums, as expected. Compared to our other segments, we expect this segment to have a higher volume of smaller-sized transactions. Due to the greater number of personnel required to generate and process the high volume of transactions, we expect a higher general and administrative expense ratio in this segment compared to our other segments.
Loss before taxes. In line with expectations for this segment, net premiums earned grew at a significantly higher rate than general and administrative expenses during the year ended December 31, 2008, bringing the combined ratio down to 138.5%. As a result, the net loss before taxes has improved by $1.3 million compared to the year ended December 31, 2007. As our net earned premium grows, we expect the combined ratio to move more in line with our other segments.
Our Max at Lloyd’s segment comprises all of our UK-based operating businesses acquired on November 6, 2008, which are primarily the underwriting operations of our proportionate share of Syndicates 1400, 2525 and 2526. The results of operations for the Max at Lloyd’s segment are consolidated only from the November 6, 2008 date of acquisition. We provide 100%, 2.0% and 36.4% of the capacity for Syndicates 1400, 2525 and 2526, respectively, for the 2008 year of account.
Given the November 6, 2008 timing of the acquisition date, the results of this segment were not significant to us for the year ended December 31, 2008. Pursuant to a pre-existing quota share reinsurance agreement, 70% of Syndicate 1400’s net results for the 2007 and 2008 years of account are reinsured with the previous owner of Max UK.
Net investment income and net (losses) gains on alternative investments. The overall performance of our fixed maturities portfolio and alternative investment portfolio is discussed within the corporate function results of operations as we manage investments for this segment on a consolidated basis with the Bermuda/Dublin reinsurance and Bermuda/Dublin insurance segments.
For the years ended December 31, 2007 and 2006, excluding the contracts incepting during each year, benefits were $46.3 million and $36.0 million, respectively. The increase reflected the additional reinsured policy claims payments associated with the six reinsurance contracts written during 2007.
Net investment income from our cash and fixed maturities portfolio for the year ended December 31, 2007 increased $38.2 million compared to the year ended December 31, 2006. The increase was principally attributable to the growth in the cash and fixed maturities portfolio from $3,470.0 million at December 31, 2006 to $4,060.9 million at December 31, 2007, together with an increase in yield on the fixed maturities portfolio. The average annualized investment yield on the cash, fixed maturities investments and funds withheld by clients for the year ended December 31, 2007 was 4.96% compared to 4.73% for the year ended December 31, 2006.
Net (losses) gains on alternative investments. Net losses on the alternative investment portfolio were $233.0 million, or a negative 19.27% rate of return, for the year ended December 31, 2008 compared to a net gain of $186.7 million, or a 16.97% rate of return, for the year ended December 31, 2007. These returns include gains of $0.5 million and $2.4 million from our private equity reinsurance investment for the year ended December 31, 2008 and 2007, respectively. The remainder of our alternative investments comprises the Max Diversified portfolio.
All but one of the alternative investment strategies we employed experienced negative returns during the year ended December 31, 2008. The largest contributors by investment strategy to the loss for the current period were the long/short equity and the event-driven arbitrage strategies. As of December 31, 2008, 38.5% and 9.9% of our alternative investments were allocated to long/short equity and event-driven arbitrage strategies, respectively. The long/short equity strategy typically entails the purchase of common stock of companies in a particular sector with perceived strong fundamentals and sell common stock of companies in the same sector that are perceived to have deteriorating fundamentals. The strategy attempts to create investment returns through superior stock selection based upon fundamental analysis rather than creating returns based simply upon upward price direction of the overall stock market. The event-driven arbitrage strategy typically entails the purchase of securities of a company involved in a significant corporate event. Event-driven arbitrage funds will typically employ merger arbitrage techniques along with traditional arbitrage techniques for companies that are spinning off divisions, going through reorganizations or undergoing other significant corporate events. In previous periods these strategies contributed to significant out-performance; however, this growth also led to increasing concentration in these strategies. We began to reduce our concentration in these strategies at the start of the third quarter, but market conditions
Interest expense. Interest expense principally reflects interest on our bank loans and senior notes outstanding. The Max Bermuda $225.0 million swap loan and the Max Capital $150.0 million revolving credit facility loan, both described below under “Financial Condition-Bank Loans,” each bear interest at a rate based on LIBOR plus a spread. We also had $100.0 million in senior notes outstanding throughout 2008 that were issued in April 2007, mature in April 2017 and bear interest at 7.20%. Interest expense for 2008 decreased compared to 2007 primarily due to the impact of decreased LIBOR interest rates, partially offset by the $36.6 million increase in outstanding debt as of December 31, 2008 compared to December 31, 2007.
Interest expense was $23.9 million for the year ended December 31, 2007 compared to $12.4 million for the year ended December 31, 2006. Interest expense for the year ended December 31, 2007 increased primarily due to the $219.8 million increase in outstanding debt at December 31, 2007 compared to the same period in 2006.
Cash and invested assets. Aggregate invested assets, comprising cash and cash equivalents, fixed maturities and alternative investments, were $5,356.9 million at December 31, 2008 compared to $5,122.6 million at December 31, 2007, an increase of 4.6%. The increase in cash resulted principally from the acquisition of Max UK, which had significant cash balances in excess of the purchase price; net redemptions from alternative investments during the year; life and annuity gross premiums written, which are fully received at inception; and a reduced level of fixed maturities purchases.
tailor the maturities of the portfolios to the timing of expected loss and benefit payments. At maturity, absent any credit loss, a fixed maturity’s amortized cost will equal its fair value and no realized gain or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell available for sale fixed maturity securities before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period.
Our portfolio of investment grade fixed maturities includes mortgage-backed and asset-backed securities and collateralized mortgage obligations. These types of securities have cash flows that are backed by the principal and interest payments of a group of underlying mortgages or other receivables. During the years ended December 31, 2008 and 2007, delinquency and default rates have increased on these types of securities, and particularly on securities backed by sub-prime mortgages. Generally, sub-prime mortgages are considered to be those made to borrowers who do not qualify for market interest rates for one or more possible reasons, such as a low credit score, a limited or lack of credit history or a lack of earnings documentation. As a result of the increasing default rates of sub-prime borrowers, there is a greater risk of defaults on mortgage-backed and asset-backed securities and collateralized mortgage obligations, especially those that are non-investment grade. Therefore, fixed maturities securities backed by sub-prime mortgages have exhibited significant declines in fair value and liquidity. These factors combined with the contraction in liquidity in the principal markets for these securities makes the estimate of fair value increasingly uncertain. The fair values of our holdings in securities exposed to sub-prime borrowers are generally not based on quoted prices for identical securities, but are based on model-derived valuations from independent pricing sources as described below. We obtain fair value estimates from multiple independent pricing sources in an effort to mitigate some of the uncertainty surrounding the fair value estimates. If we need to liquidate these securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated at December 31, 2008. We believe our investment exposure to sub-prime credit risk is limited although there can be no assurance that events in the sub-prime mortgage sector will not adversely affect the value of our investments. At December 31, 2008, securities with significant exposure to sub-prime borrowers totaled $34.3 million in fair value, $45.6 million in amortized cost and $45.7 million in par value for a net unrealized loss of $11.3 million. By fair value, 61.7% of these securities are AAA-rated, 20.2% AA-rated, and 18.1% are A-rated. The weighted average life of these securities is 2.7 years. As of December 31, 2008, we have determined that a write-down for impairment of these securities is not necessary based on a consideration of relevant factors, including prepayment rates, subordination levels, default rates, credit ratings, weighted average life and cash flow testing. Together with our investment managers, we continue to monitor our potential exposure to sub-prime borrowers, and we will make adjustments to the investment portfolio, if and when deemed necessary.
Generally, Alt-A mortgages are considered to be those made to borrowers who do not qualify for market interest rates but who are considered to have less credit risk than sub-prime borrowers.
Fair value prices for all securities in our fixed maturities portfolio are independently provided by both our investment custodian and our investment managers, which each utilize nationally recognized independent pricing services. We record the unadjusted price provided by the investment custodian and our validation process includes, but is not limited to: (i) comparison to the price provided by the investment manager, with significant differences investigated; (ii) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (iii) evaluation of methodologies used by external parties to calculate fair value; and (iv) comparing the price to our knowledge of the current investment market.
We, together with Alstra, have designed ongoing due diligence processes with respect to funds and their managers, which processes are designed to assist us in assessing the quality of information provided by, or on behalf of, each fund and in determining whether such information continues to be reliable or whether further review is necessary. While reported net asset value is the primary input to the review, when the net asset value is deemed not to be indicative of fair value, we may incorporate adjustments to the reported net asset value. Such adjustments may involve significant judgment. We obtain the audited financial statements for every fund annually, and regularly review and discuss the fund performance with the fund managers to corroborate the reasonableness of the reported net asset values.
Had we requested full redemptions for all of our holdings in the funds, the table below indicates our best estimate of the earliest date from December 31, 2008 on which such redemptions might be received. This estimate is based on available information from the funds and is subject to significant change, particularly in the current economic environment.
Additional information about the alternative investments can be found in Note 3 to our audited consolidated financial statements included herein.
Liabilities for life and annuity benefits. Life and annuity benefits totaled $1,367.0 million at December 31, 2008 compared to $1,203.5 million at December 31, 2007. The increase was principally attributable to the reinsurance contracts written in the year ended December 31, 2008, which increased life and annuity benefits by $239.6 million, partially offset by movements in foreign exchange rates. During the year ended December 31, 2008, we paid $102.8 million of benefit payments.
Losses and benefits recoverable from reinsurers. Losses and benefits recoverable from reinsurers totaled $846.6 million at December 31, 2008 compared to $578.3 million at December 31, 2007, an increase of 46.4%, principally reflecting losses ceded under our reinsurance and retrocessional agreements resulting from net earned premiums during the year ended December 31, 2008, recoveries associated with hurricane losses, and the acquisition of Max UK.
Under GAAP, the non-controlling interest in Max Diversified and the total return swap are recorded on a combined basis and accounted for as a financing transaction. The effect of combining the transactions results in the notional amount being presented as a bank loan, or swap loan, with changes in the fair value of the Max Diversified shares increasing or decreasing this notional amount. At December 31, 2008, the notional amount of the swap loan was approximately $225.0 million.
On October 20, 2008, Max Capital borrowed $100.0 million under our revolving credit facility in connection with the acquisition and capitalization of Max UK. As of December 31, 2008, $100.0 million remains outstanding. This loan renews at intervals of 1 to 6 months at Max Capital’s option, at which time the interest rate is reset to LIBOR plus a premium based on Max Capital’s current debt rating. As of December 31, 2008, the interest rate was 4.63% and resets on April 20, 2009.
Senior notes. On April 16, 2007, Max USA privately issued $100.0 million principal amount of 7.20% senior notes, due April 14, 2017 with interest payable on April 16 and October 16 of each year. The senior notes are Max USA’s senior unsecured obligations and rank equally in right of payment with all existing and future senior unsecured
The casualty business we write generally has a long claim-tail, and we expect that we will generate significant operating cash flow as we accumulate property and casualty loss reserves and life and annuity benefit reserves on our balance sheet. As we continue to diversify into property and property catastrophe business, which generally has a short claim-tail, and as losses are incurred, we expect potential volatility in our operating cash flow levels. We believe that our property and casualty loss reserves and life and annuity benefit reserves currently have an average duration of approximately 5.0 years and we expect to see increases in the amount of expected loss payments in future periods with a resulting decrease in operating cash flow. We do not expect loss payments to exceed the premiums generated and therefore expect to have continued positive cash flow. However, actual premiums written and collected and losses and loss expenses paid in any period could vary from our expectations and could have a significant and adverse effect on operating cash flow.
Capital resources. At December 31, 2008, our capital structure consisted of common equity. Total capitalization amounted to $1,280.3 million as compared to $1,583.9 million at December 31, 2007, a decrease of 19.2%. On August 20, 2007, we filed an automatic shelf registration statement on Form S-3 with the SEC indicating that we may periodically issue up to $500.0 million in debt securities, common shares, preferred shares, depository shares, warrants, share-purchase contracts and share purchase units. The shelf registration statement also covers debt securities of Max USA and trust preferred securities of Max Capital Trust I. No securities have been issued under the shelf registration statement. We believe that we have sufficient capital to meet our financial obligations.
Furthermore, life and annuity benefits and deposit liabilities recorded in the audited consolidated financial statements at December 31, 2008 are computed on a net present value basis, whereas the expected payments by period in the table above are the estimated payments at a future time and do not reflect a discount of the amount payable.
In December 2007, the FASB issued Financial Accounting Standard No. 141(R), “Business Combinations,” or FAS 141(R). FAS 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. FAS 141(R) applies to all transactions or other events in which the reporting entity obtains control of one or more businesses, including those sometimes referred to as “true mergers” or “mergers of equals” and combinations achieved without the transfer of consideration, for example, by contract alone or through the lapse of minority veto rights. FAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We do not expect the adoption of FAS 141(R) will have a material impact on our consolidated financial statements.
In March 2008, the FASB issued Financial Accounting Standard No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an Amendment of FASB Statement 133,” or FAS 161. FAS 161 changes required disclosures for derivatives and hedging activities, including enhanced disclosures regarding (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under FAS 133 and its related interpretations and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. Specifically, FAS 161 requires: disclosure of the objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation; disclosure of the fair values of derivative instruments and their gains and losses in a tabular format; disclosure of information about credit-risk-related contingent features; and cross-reference from the derivative footnote to other footnotes in which derivative-related information is disclosed. The statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We are currently evaluating the impact that FAS 161 may have, if any, on the presentation of our consolidated financial statements.