Our headquarters are located at 14 Wesley Street, 5th Floor, Hamilton HM 11, Bermuda. Our U.S. headquarters are located at 1 Beacon Lane, Canton, Massachusetts 02021, our principal executive office is located at 601 Carlson Parkway, Minnetonka, Minnesota 55305 and our registered office is located at Clarendon House, 2 Church Street, Hamilton HM 11, Bermuda. We also maintain branch offices in various cities throughout the United States. Our U.S. headquarters is owned by us. Our headquarters, principal executive office and our branch offices are leased. Management considers our office facilities suitable and adequate for our current level of operations.
The following tables set forth our selected consolidated financial information for the dates indicated. We have derived the selected consolidated financial information presented below as of and for the years ended December 31, 2009, 2008, 2007, 2006 and 2005 from our consolidated financial statements, which have been prepared in accordance with GAAP.
The following discussion contains "forward-looking statements." Statements that are not historical in nature are forward-looking statements. OneBeacon cannot promise that its expectations in such forward-looking statements will turn out to be correct. OneBeacon's actual results could be materially different from and worse than its expectations. See "Forward-Looking Statements" on page 105 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements.
Book Value and Adjusted Book Value Per Share-December 31, 2008 versus December 31, 2007
Under such arrangements, the members share substantially all insurance business that is written, and allocate the combined premiums, losses and expenses. In the year ended December 31, 2009, our net written premiums totaled $1.9 billion and we had total assets of $7.5 billion and total OneBeacon's shareholders' equity of $1.4 billion at December 31, 2009.
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. Our ability to collect our reinsurance recoverables is subject to the solvency of the reinsurers with whom we have entered into reinsurance contracts. We are selective in regard to our reinsurers, principally placing reinsurance with those reinsurers with strong financial condition, industry ratings and underwriting ability. Management monitors the financial condition and ratings of our reinsurers on an ongoing basis.
We had two classes of mandatorily redeemable preferred stock of subsidiaries which were redeemed in the years ended December 31, 2008 and 2007. These instruments were classified as liabilities and were carried at their historical carrying values. All dividends and accretion on our mandatorily redeemable preferred stock have been recorded as interest expense. See Note 10-"Mandatorily Redeemable Preferred Stock of Subsidiaries" of the accompanying consolidated financial statements.
For these cycles, OneBeacon revised the design of its long-term incentive plans from prior plan designs principally to use OneBeacon performance units instead of White Mountains performance shares, with performance targets primarily tied to OneBeacon's adjusted combined ratio. Each unit was initially valued at $100 and compounds in value over the performance period by the underwriting return on capital achieved by OneBeacon. In the case of certain senior officers of our Insurance Operations segment, a portion of their long-term incentive compensation in these periods had been denominated in White Mountains performance shares. As a result of the shift from White Mountains performance shares to OneBeacon performance units, OneBeacon's incentive compensation expense associated with these performance cycles is no longer significantly impacted by changes in the market price of White Mountains common shares. Prior to February 2007, the value of OneBeacon's performance shares was based upon the market price of an underlying White Mountains common share (WTM Performance Shares). In February 2007, the Compensation Committee canceled all of OneBeacon's WTM Performance Shares outstanding (for the 2005-2007 and 2006-2008 performance cycles) and replaced the awards with two performance share grants, a one-year 2007 performance cycle and a two-year 2007-2008 performance cycle, whose value is based upon the market price of an underlying OneBeacon common share (OB Performance Shares). In the 2007 performance cycle, a total of 117,363 performance shares were earned based upon a performance factor of 63%. In the 2007-2008 performance cycle, a total of 137,400 performance shares were earned based upon a performance factor of 1.4%.
In February 2007, the Compensation Committee approved the principal performance share goal of the OneBeacon Long-Term Incentive Plan (the Incentive Plan) to be growth in its intrinsic business value per share (GIBVPS). GIBVPS is defined by the Compensation Committee with respect to each award cycle. For the 2007-2009 performance cycle, the Compensation Committee defined GIBVPS to be a weighted measure comprised of growth in adjusted book value per share, underwriting return on equity and growth in our price per common share. As of December 31, 2009, 682,344 performance shares were outstanding with respect to the 2007-2009 performance cycle.
In connection with purchase accounting for the OneBeacon Acquisition, we were required to adjust to fair value our loss and LAE reserves and the related reinsurance recoverables by $646.9 million and $346.9 million, respectively, on our balance sheet as of June 1, 2001. This net change to loss and LAE reserves of $300.0 million is being accreted through an income statement charge ratably with and over the period the claims are settled. Accordingly, we recognized $5.4 million, $12.0 million and $16.0 million of such charges, recorded as loss and LAE, in the years ended December 31, 2009, 2008 and 2007, respectively. As of December 31, 2009, the outstanding pre-tax unaccreted adjustment was $0.
The income tax expense (benefit) related to pre-tax income or loss for the years ended December 31, 2009, 2008 and 2007 represented effective tax rates of 24.7%, (36.6)% and 36.8%, respectively. Our effective tax rate for the year ended December 31, 2009 was lower than the U.S. statutory rate of 35% primarily due to income generated in jurisdictions other than the United States and the settlement of federal income tax audits for 2003 and 2004. Our effective tax rate for the year ended December 31, 2008 was higher than the U.S. statutory rate of 35% due to a pre-tax loss from operations in the United States and income generated in jurisdictions other than the United States, partially offset by non-deductible dividends and accretion on the Berkshire Preferred Stock. Our effective tax rate for the year ended December 31, 2007 was higher than the U.S. statutory rate of 35% primarily due to withholding taxes payable on dividends paid from income generated in the United States and non-deductible dividends and accretion on the Berkshire Preferred Stock and Zenith Preferred Stock, partially offset by income generated in jurisdictions other than the United States at lower tax rates.
On December 3, 2009, we sold the renewal rights to approximately $490 million in premiums from our non-specialty commercial lines business to The Hanover. The transaction includes small commercial accounts and the non-specialty portion of the middle-market business, beginning with January 1, 2010 effective dates. As consideration, we received $23.2 million, and will receive an additional 10% of premiums renewed in excess of $200 million for the first renewal period. We will continue to manage claims from business written prior to the Commercial Lines Transaction and for business written by The Hanover through June 30, 2010. The Hanover will reimburse us for our expenses incurred to provide the claims administration services.
On February 2, 2010, we entered into a definitive agreement to sell our personal lines business to Tower. The transaction includes two insurance companies containing the personal lines business, and two attorneys-in-fact managing the reciprocals that write the personal lines business in New York and New Jersey. Net written premiums for the affected books total approximately $420 million for the year ended December 31, 2009. As consideration, we will receive an amount equal to the statutory surplus in the reciprocals (approximately $103 million at December 31, 2009, including the par value of the surplus notes issued by the reciprocals), the GAAP equity in the insurance companies and attorneys-in-fact (approximately $45 million at December 31, 2009), plus $32.5 million. AutoOne is not being sold as part of this transaction. The sale is subject to certain state regulatory approvals and is expected to close in the second quarter of 2010.
Our total expenses increased 1.4% in the year ended December 31, 2009 to $1,921.4 million, compared to $1,894.2 million in the year ended December 31, 2008. Loss and LAE decreased by 0.4% to $1,121.9 million in the year ended December 31, 2009 due to lower current accident year catastrophe losses and slightly more favorable loss reserve development. Interest expense decreased by 11.6%, primarily due to the interest expense related to the Berkshire Preferred Stock which was redeemed in the second quarter of 2008. Partially offsetting these decreases were increased policy acquisition costs, other underwriting expenses and general and administrative expenses. Policy acquisition expenses increased by 8.1% to $398.3 million in the year ended December 31, 2009 mainly due to higher acquisition costs associated with our newer specialty lines businesses and changes in mix of business. Other underwriting expenses increased 13.5% to $330.0 million in the year ended December 31, 2009. The year ended December 31, 2008 included lower incentive compensation costs resulting from changes in assumptions on our long-term incentive compensation plans. General and administrative expenses increased 40.3% to $26.1 million primarily related to higher operating expenses of our non-insurance operations.
Our total revenues decreased 43.1% to $1,293.6 million in the year ended December 31, 2008, compared to $2,273.0 million in the year ended December 31, 2007. The decrease was mainly due to a $492.6 million decrease in net realized investment (losses) gains to $(318.9) million and the inclusion of a $(444.7) million change in net unrealized investment gains and losses in the year ended December 31, 2008. During the year ended December 31, 2008, we recognized realized losses of $239.8 million for
During the year ended December 31, 2007, we reallocated reserves of our insurance operations from ongoing lines of business to legacy run-off claims, particularly reserves for construction defect and workers compensation related to accident years 2001 and prior. The reallocation shifted $116.7 million of our reserves from specialty lines ($87.4 million) and personal lines ($23.3 million) to run-off claims (net $110.7 million). The reallocation included reserves from commercial lines ($6.0 million) that are now presented within run-off. This adjustment had no impact on our total combined ratio for the year ended December 31, 2007. The ratio discussions by line of business that follow are based on the ratios as computed prior to the reallocation of reserves. We believe that a presentation excluding the effect of the reserve reallocation on specialty lines, personal lines and run-off loss and LAE ratios and GAAP combined ratios is meaningful for investors to understand the performance of its underwriting units during 2007.
Our GAAP combined ratio for the year ended December 31, 2008 increased to 95.0% from 92.8% for the year ended December 31, 2007. The loss and LAE ratio increased 1.7 points to 59.9% while the expense ratio increased 0.5 points to 35.1%. The increase in the loss and LAE ratio was due to 3.1 points of current accident year catastrophe losses mainly from hurricanes Ike and Gustav, and weather in the southeastern United States experienced in the first quarter of 2008. The loss and LAE ratio was also higher due to large losses in specialty lines at IMU and in the non-specialty middle market
commercial businesses. These increases were partially offset by $62.0 million or 3.3 points of favorable loss reserve development due primarily to lower than expected severity on non-catastrophe losses as described above. The year ended December 31, 2007 included $48.3 million or 2.6 points of favorable loss reserve development due to lower than expected frequency for professional liability lines and lower than expected severity for personal automobile liability partially offset by adverse loss reserve development for multiple peril lines and workers compensation lines primarily for accident years 2001 and prior. The increase in the expense ratio was from an increase in policy acquisition expenses, offset by a decrease in other underwriting expenses as described above. The year ended December 31, 2007 included a 1.0 point benefit from the partial settlement of our qualified pension plan and a 0.4 point benefit from a state premium tax refund, partially offset by 0.7 points of office consolidation costs.
Our segments consist of the following: (1) Insurance Operations, formerly known as Primary Insurance Operations, and (2) Other Operations. Specialty lines includes OBPI, IMU, EBI, A&H, OBGR, OBEG, Dewar, collector cars and boats and, as described above, Technology, Financial Services, OBSP and PIM which were formerly reported in commercial lines. Personal lines includes our traditional personal lines business and AutoOne. Run-off includes non-specialty commercial lines business subject to the Commercial Lines Transaction and other run-off business. Prior periods have been reclassified to conform to the current presentation.
Our investments are managed by our affiliate, WM Advisors, and by Prospector. A discussion of our consolidated investment operations is included after the discussion of operations by segment. Our segment information is presented in Note 13-"Segment Information" of the accompanying consolidated financial statements.
Financial results for our Insurance Operations segment for the years ended December 31, 2009, 2008 and 2007, were as follows:
(2)Run-off includes non-specialty commercial lines business subject to the renewal rights agreement with The Hanover and other run-off business. Prior periods have been reclassified to conform to the current presentation.
(5)Prior accident year development, including development on catastrophes, for the years ended December 31, 2009, 2008 and 2007 decreased our loss and LAE and total combined ratios by 4.3 points, 3.3 points and 2.6 points, respectively.
(6)Represents a non-GAAP financial measure. During 2007, we reallocated reserves from our ongoing lines of business to run-off which had the effect of lowering the loss and LAE ratios and combined ratios of our ongoing businesses. The reallocation had no impact on total Insurance Operations. For further discussion, see "Consolidated Results-Year ended December 31, 2008 versus year ended December 31, 2007." The table above for the year ended December 31, 2007 reflects our loss and LAE ratios and total combined ratios prior to the reserve reallocation and reconciles these non-GAAP financial measures to their most comparable GAAP measures.
Insurance Operations-Year ended December 31, 2009 versus year ended December 31, 2008
OneBeacon Insurance Company (OBIC) and its subsidiary companies, along with Adirondack Insurance Exchange and New Jersey Skylands Insurance Association in New York and New Jersey, respectively. Excluding the impact of the homeowners quota share, traditional personal lines net written premiums decreased by 4.0%. Further, net written premiums at AutoOne decreased by 25.9% to $88.9 million primarily due to changes in New York's assigned risk pool and lower writings of voluntary private passenger automobile risks in New York. With respect to the New York assigned risk pool, market trends indicate that assigned risk volumes are expected to increase to approximately $150 million in 2010, which is up from $135 million in 2009 and $143 million in 2008 but down from $176 million in 2007. Market trends indicate that the assigned risk pool in New Jersey is expected to increase to approximately $67 million in 2010, which is up from $52 million in 2009 and $46 million in 2008, but down from $72 million in 2007.
Run-off. Net written premiums for run-off decreased by 11.0% to $451.8 million in the year ended December 31, 2009, compared with $507.5 million in the year ended December 31, 2008. Net written premiums from non-specialty commercial businesses were $451.6 million in the year ended December 31, 2009, compared with $507.1 million in the year ended December 31, 2008. The decrease was primarily due to a $42.4 million decrease in the non-specialty middle market commercial businesses and a $13.1 million decrease in the small business division. Net written premiums from legacy run-off business were $0.2 million in the year ended December 31, 2009, compared with $0.4 million in the year ended December 31, 2008.
Insurance Operations-Year ended December 31, 2008 versus year ended December 31, 2007
Specialty lines. Net written premiums for specialty lines increased by 28.0% to $836.9 million in the year ended December 31, 2008 from $654.0 million in the year ended December 31, 2007. The increase was primarily due to $110.0 million in net written premiums from our collector cars and boats business that we began writing in the second quarter of 2008. The increase compared to prior year was also due to writings from EBI which we acquired in the third quarter of 2008, as well as growth in A&H and OBGR. In addition, net written premiums at OBPI increased $26.0 million.
2007. Additionally, the year ended December 31, 2008 included 2.6 points of current accident year catastrophe losses primarily related to hurricane Ike, compared to 0.9 points of current accident year catastrophe losses in the year ended December 31, 2007. The increase in the expense ratio was mainly due to changes in mix of business within the specialty lines businesses and the mix of products offered within those businesses and the related costs incurred to acquire those businesses. Our collector cars and boats business and some of our other newer specialty lines businesses receive higher compensation than the previous mix of business. Also, at OBPI, increased writings of our long-term care product and decreased writings of our provider excess insurance product carry a higher and lower commission ratio, respectively, and shifted the expense ratio upward. In addition, during the year ended December 31, 2008, we incurred additional transition costs associated with the new management team at OBPI. The expense ratio for the year ended December 31, 2007 included a 0.7 point favorable impact from the partial settlement of our qualified pension plan liabilities, partially offset by 0.5 points of office consolidation costs.
Run-off. Net written premiums for run-off decreased by 2.4% to $507.5 million in the year ended December 31, 2008 from $520.0 million in the year ended December 31, 2007. Net written premiums from non-specialty middle market commercial businesses were $507.1 million in the year ended December 31, 2008, compared with $519.7 million in the year ended December 31, 2007. The decrease was primarily due to a $30.3 million decrease in non-specialty middle market commercial businesses, partially offset by an increase of $17.7 million in the small business division, principally driven by our small business package products. Net written premiums from legacy run-off business were $0.4 million in the year ended December 31, 2008, compared with $0.3 million in the year ended December 31, 2007.
primarily related to hurricane Ike in our non-specialty middle market commercial businesses and small business division and losses from tornadoes in the southeastern United States in our non-specialty middle market commercial businesses in the first quarter of 2008, compared to 1.0 point of catastrophe losses in the year ended December 31, 2007. Additionally, current accident year non-catastrophe losses increased 1.5 points in the year ended December 31, 2008, compared with the year ended December 31, 2007. These increases were partially offset by 1.4 points of favorable loss reserve development in the year ended December 31, 2008, compared with 0.1 point of adverse loss reserve development in the year ended December 31, 2007 due to higher large losses related to winter weather in the northeastern United States. The decrease in the expense ratio was primarily due to a 4.4 point decrease in other underwriting expenses, partially offset by a 1.7 point increase in policy acquisition expenses. The year ended December 31, 2007 included a 1.6 point benefit from the partial settlement of our qualified pension plan liabilities, which was partially offset by 1.0 point of office consolidation costs.
Our Other Operations segment consists of the activities of OneBeacon Insurance Group, Ltd. and our intermediate subsidiary holding companies which include OneBeacon U.S. Enterprises Holdings, Inc. and OneBeacon U.S. Holdings, Inc., both U.S.-domiciled companies, as well as various intermediate holding companies domiciled in the United States, Gibraltar, Luxembourg and Bermuda. Our Other Operations segment primarily consists of financing activities, purchase accounting adjustments relating to the OneBeacon Acquisition, other assets and liabilities, and general and administrative expenses incurred at the holding company level.
The Other Operations segment results are affected by purchase accounting over time as the fair value adjustments made at our acquisition unwind. Fair value adjustments other than those related to loss and LAE reserves and related reinsurance recoverables have been fully recognized in our financial statements in periods prior to those presented below. The fair value adjustment to net loss and LAE reserves is expensed through income as our net loss and LAE reserves at the time of the OneBeacon Acquisition are settled.
Other Operations Results-Year ended December 31, 2009 versus year ended December 31, 2008
Our Other Operations segment reported a pre-tax loss of $53.1 million in the year ended December 31, 2009, compared to a pre-tax loss of $86.6 million in the year ended December 31, 2008. The decrease in loss was primarily related to a decrease in interest expense related to the Berkshire Preferred Stock which was redeemed in the second quarter of 2008. Further, net other revenues increased mainly due to a $5.4 million gain related to the purchase of a portion of our senior notes. The decrease in interest expense was partially offset by a decrease in net investment (expense) income to $(1.9) million in the year ended December 31, 2009 compared to $11.6 million in the prior year, due to a lower average invested asset base and lower investment yields. Net investment income in the year ended December 31, 2008 included $6.2 million related to assets held in trust for the Berkshire Preferred Stock.
Other Operations Results-Year ended December 31, 2008 versus year ended December 31, 2007
(1)Gross investment income returns exclude investment expenses of $10.9 million, $14.1 million and $16.1 million for the years ended December 31, 2009, 2008 and 2007, respectively.
(2)Includes $6.2 million and $15.9 million of net investment income for assets held in trust for the years ended December 31, 2008 and 2007, respectively.
stabilize, we are gradually shifting back from a focus on capital preservation to our traditional total return investment philosophy.
Our total pre-tax investment results were $(599.2) million, a return of (13.0)% for the year ended December 31, 2008, compared to $374.3 million, a return of 7.5%, for the year ended December 31, 2007. Net investment income in the year ended December 31, 2008 was $164.4 million, a decrease of 21.2%, compared to $208.5 million in the year ended December 31, 2007. The decrease was principally due to a lower average invested asset base and lower investment yields. Net investment income in the year ended December 31, 2008 included $6.2 million related to assets held in trust whereas the year ended December 31, 2007 included $15.9 million related to assets held in trust. Net realized investment (losses) gains were $(318.9) million in the year ended December 31, 2008, a decrease of $492.6 million, compared to $173.7 million in the year ended December 31, 2007, mainly due to $239.8 million of impairment charges taken in the year ended December 31, 2008 and $97.5 million of realized losses on sales of equity investments, compared to realized gains on sales in the year ended December 31, 2007 of certain convertible fixed maturity and equity securities in industry sectors that experienced significant appreciation, principally energy and natural resources. The change in net unrealized investment gains and losses was a decrease of $444.7 million in the year ended December 31, 2008, compared to a decrease of $7.9 million in the year ended December 31, 2007. Losses reflected in the change in net unrealized investment gains and losses are a result of the crisis that occurred in the financial markets during the third and fourth quarters of 2008 as described above. We recorded a pre-tax decrease in the change in net unrealized investment gains and losses in our fixed income portfolio of $171.8 million, mainly driven by a general widening of credit spreads. We recorded a pre-tax decrease in the change in net unrealized investment gains and losses in our common stock portfolio of $157.0 million; the majority of this decline was driven by investments within the financials, utilities and materials sectors.
Our fixed income portfolio, which includes both fixed maturity and short-term investments, returned (1.8)% for the year ended December 31, 2008, compared to 6.2% for the year ended December 31, 2007. As previously discussed, the performance was primarily driven by pre-tax losses reflected in the change in net unrealized investment gains and losses of $171.8 million as a result of a general widening of credit spreads. We recorded $40.1 million in net realized losses in the year ended December 31, 2008, which included $58.4 million of impairment charges, primarily in the financials sector. Our fixed income portfolio had minimal exposure to adverse credit events occurring in the second half of 2008. Our short duration mortgage-backed and asset-backed securities also performed relatively well in difficult times. During the years ended December 31, 2008 and 2007, we maintained a high quality fixed maturity portfolio with a relatively short duration of approximately 3 years for both periods, which performed consistent with its characteristics and worse than the longer-duration Barclays U.S. Aggregate Index benchmark.
The weighted average duration of our fixed maturity portfolio, including convertible bonds, at December 31, 2009 is approximately 3 years. The maturity distribution for fixed maturity investments, including convertible bonds, held at December 31, 2009 is as follows:
We purchase commercial and residential mortgage-backed securities to maximize our fixed income portfolio's risk adjusted returns and diversify the portfolio risk from primarily corporate credit risk to a mix of credit and cash flow risk. Our non-agency commercial mortgage-backed portfolio is generally of short tenor and structurally senior, with more than 30 points of credit enhancement on average. We are not an originator of residential mortgage loans and held $0.1 million of residential mortgage-backed securities categorized as sub-prime as of December 31, 2009. In addition, our investments in hedge funds and private equity funds contain negligible amounts of sub-prime mortgage-backed securities as of December 31, 2009. We consider sub-prime mortgage-backed securities to be those that are issued from dedicated sub-prime shelves, dedicated second-lien shelves (i.e., we consider investments backed primarily by second-liens to be a sub-prime risk regardless of credit score or other metrics) or otherwise have underlying loan pools that exhibit weak credit characteristics.
There are also mortgage-backed securities that we categorize as "non-prime" (also called "Alt A" or "A-") that are backed by collateral that has overall credit quality between prime and sub-prime, as determined based on a review of the characteristics of their underlying mortgage loan pools, such as credit scores and financial ratios. As of December 31, 2009, we did not hold any mortgage-backed securities classified as non-prime. We did not own any collateralized debt obligations, including residential mortgage-backed collateralized debt obligations.
The following table summarizes the carrying value of our mortgage-backed and other asset-backed securities holdings as of December 31, 2009 and 2008:
(1)Represents publicly-traded residential mortgage-backed securities which carry the full faith and credit guaranty of the U.S. government.
(2)Approximately 98% and 97% of our mortgage-backed securities as of December 31, 2009 and 2008, respectively, have the highest ratings ascribed by Moody's ("Aaa") or Standard & Poor's ("AAA").
We participated in a securities lending program as a mechanism for generating additional investment income on our fixed maturity and common equity portfolios. Under the securities lending arrangements, certain of our fixed maturity and common equity investments were loaned to other institutions for short periods of time through a lending agent. We maintained control over the securities we loaned, retained the earnings and cash flows associated with the loaned securities and received a fee from the borrower for the temporary use of the asset. Collateral, in the form of cash and United States government securities, was required at a rate of 102% of the fair value of the loaned securities. An indemnification agreement with the lending agent protected us in the event a borrower became insolvent or failed to return any of the securities on loan. In the event of a shortfall in the collateral amount required to be returned to the securities lending counterparty (e.g., as a result of investment losses), we were obligated to make up any deficiency.
At December 31, 2008, prior to the amendment of the terms of the securities lending program, the total market value of our securities on loan was $107.7 million with corresponding collateral of $100.7 million, resulting in an unrealized loss of $7.0 million recorded in change in net unrealized investment gains and losses, a component of net realized and unrealized investment gains (losses). In 2009 prior to exiting the securities lending program, we recorded $3.9 million of net realized and unrealized gains. Subsequent to exiting the program, we recorded $0.8 million of net realized and unrealized gains on the securities returned to us, resulting in a total of $2.3 million of net realized and unrealized losses in connection with our exiting from the program. The securities lending program has generated $18.1 million of additional investment income for us since inception in 2001.
Adjusted OneBeacon's shareholders' equity, which is used in calculating adjusted book value per share (a non-GAAP financial measure described above), is derived by excluding the impact of economically defeasing the Company's mandatorily redeemable preferred stock from OneBeacon's
shareholders' equity, the most closely comparable GAAP measure. The reconciliation of OneBeacon's shareholders' equity to adjusted OneBeacon's shareholders' equity is included on page 48.
Holding company level. The primary sources of cash for OneBeacon Insurance Group, Ltd. and certain of our intermediate holding companies are expected to be dividends and tax sharing payments received from our insurance operating subsidiaries, capital raising activities and net investment income and proceeds from sales and maturities of holding company investments. The primary uses of cash are expected to be share repurchases, interest payments on our debt obligations, repurchases of debt, dividend payments on our common shares, purchases of investments, payments made to tax authorities, contributions to subsidiaries and holding company operating expenses.
Operating subsidiary level. The primary sources of cash for our operating subsidiaries are expected to be premium collections, net investment income, capital raising activities and proceeds from sales and maturities of investments. The primary uses of cash are expected to be claim payments, policy acquisition costs, debt obligations, operating expenses, the purchase of investments and dividends and tax sharing payments made to parent holding companies.
In connection with our initial public offering, two of our subsidiaries, OBH and OBEH, each established an irrevocable grantor trust. The assets of each trust were solely dedicated to the
satisfaction of the payment of dividends and redemption amounts on, respectively, the $300 million liquidation preference of OBH's Berkshire Preferred Stock and $20 million liquidation preference of OBEH's Zenith Preferred Stock. OBH and OBEH funded their respective trusts with cash and purchased a portfolio of fixed maturity securities issued by the U.S. government and government-sponsored enterprises. The scheduled interest and principal payments were sufficient to pay when due all amounts required under the terms of the Berkshire Preferred Stock and the Zenith Preferred Stock. The creation and funding of the trusts did not legally defease the preferred stock nor create any additional rights for the holders of the preferred stock either in the trusts or otherwise, although the assets in the trusts were segregated from OBH's and OBEH's other general assets and were not available to OBH or OBEH for any use other than the payment of the Berkshire Preferred Stock and the Zenith Preferred Stock. Assets held in one of the trusts were used to redeem the Zenith Preferred Stock in June 2007, while assets held in the other trust were used to redeem the Berkshire Preferred Stock in May 2008. White Mountains Capital, Inc., a subsidiary of White Mountains, served as the trustee for the irrevocable grantor trusts. Pre-tax net investment income earned on these investments totaled $6.2 million and $15.9 million, respectively, for the years ended December 31, 2008 and 2007.
The 5.875% Senior Notes due 2013 of our subsidiary OBH are currently rated "Baa2" (Medium Grade, the ninth highest of twenty-one creditworthiness ratings) with a negative outlook by Moody's, "BBB" (Adequate, the ninth highest of twenty-two creditworthiness ratings) on watch negative by Standard & Poor's, "bbb" (Good, the ninth highest of twenty-two creditworthiness ratings) with a stable outlook by A.M. Best and "BBB" (Good, the ninth highest of twenty-three creditworthiness ratings) with a negative outlook by Fitch. During 2009, OBH repurchased $10.6 million of outstanding Senior Notes for $8.1 million, which resulted in a $2.5 million gain. During 2009, OBIC purchased $58.3 million of outstanding Senior Notes for $55.0 million, which resulted in a $2.9 million gain. During 2008, OBH repurchased $24.0 million of the outstanding Senior Notes for $22.3 million, which resulted in a $1.6 million gain.
The Senior Notes were issued under an indenture which contains restrictive covenants that, among other things, limit the ability of White Mountains, OBH and their respective subsidiaries, which includes us, as a subsidiary of White Mountains, to create liens and enter into sale and leaseback transactions and substantially limits the ability of OBH and its respective subsidiaries to consolidate, merge or transfer their properties and assets. The indenture does not contain any financial ratios or
The indenture also contains a cross default provision which provides that if White Mountains as guarantor has a payment default in excess of $25 million under a credit agreement, mortgage or similar debt agreement, the default provisions under the indenture to the Senior Notes will be triggered. White Mountains has two revolving credit facilities which provide for borrowing up to a maximum of $450.8 million and which contain restrictive financial covenants. As of December 31, 2009, the facilities were undrawn. See Note 16-"Related Party Disclosures" of the accompanying consolidated financial statements.
In November 2006, OBH established a $75.0 million revolving credit facility that would have matured in November 2011. The credit facility was terminated in December 2008.
Below is a schedule of our material contractual obligations and commitments as of December 31, 2009:
maintain a portfolio of marketable investments with varying maturities and a substantial amount of short-term investments to provide adequate cash flows for the payment of claims.
We also have future binding commitments to fund certain limited partnership and hedge fund investments. These commitments, which total $46.5 million as of December 31, 2009, do not have fixed funding dates and are therefore excluded from the table above.
During 2009, we declared and paid $79.9 million in regular quarterly cash dividends to holders of OneBeacon's common shares.
During the first quarter of 2009, OBH repurchased a portion of the Senior Notes for $8.1 million.
During the second quarter of 2009, we repaid the $40.6 million outstanding balance on our mortgage note.
During 2008, we declared and paid $275.5 million in cash dividends to holders of OneBeacon's common shares, including $195.3 million of a special dividend and $80.2 million of regular quarterly dividends.
During 2007, we declared and paid $83.7 million in regular quarterly cash dividends to holders of OneBeacon's common shares.
On January 1, 2008, we adopted SFAS No. 157, "Fair Value Measurements", subsequently codified as ASC 820. ASC 820 provides a revised definition of fair value, establishes a framework for measuring fair value and expands financial statement disclosure requirements for fair value information. Under ASC 820, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an "exit price"). ASC 820 establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources ("observable inputs") and a reporting entity's internal assumptions based upon the best information available when external market data is limited or unavailable ("unobservable inputs"). The fair value hierarchy in ASC 820 prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets or liabilities have the highest priority ("Level 1"), followed by observable inputs other than quoted prices, including prices for similar but not identical assets or liabilities ("Level 2") and unobservable inputs, including the reporting entity's estimates of the assumptions that market participants would use, having the lowest priority ("Level 3").
As of December 31, 2009 and 2008, other investments represented approximately 4% and 5%, respectively, of the investment portfolio recorded at fair value. Other investments accounted for at fair value as of December 31, 2009 and 2008 were comprised of $74.2 million and $117.3 million, respectively, in hedge funds, $58.0 million and $65.2 million, respectively, in private equity funds and $14.1 million for both periods of an investment in a community reinvestment vehicle. At December 31, 2009 and 2008, we held investments in 15 and 20 hedge funds, respectively, and 15 and 16 private equity funds, respectively. The largest investment in a single fund was $10.8 million and $26.1 million at December 31, 2009 and 2008, respectively.
As of December 31, 2009 and 2008, approximately 93% and 92%, respectively, of the investment portfolio recorded at fair value was priced based upon observable inputs.
The fair value measurements at December 31, 2009 and 2008 for assets for which we adopted ASC 825 and any related Level 3 inputs are as follows:
At December 31, 2009 and 2008, we held one private preferred stock that represented approximately 98% and 97%, respectively, of our preferred stock portfolio. We used quoted market prices for similar securities that were adjusted to reflect management's best estimate of fair value; this security is classified as a Level 3 measurement.
In addition to the investment portfolio described above, we had $27.2 million and $20.2 million, respectively, of liabilities recorded at fair value and included in other liabilities as of December 31, 2009 and 2008. These liabilities relate to securities that have been sold short by a limited partnership that we invest in and are required to consolidate in accordance with GAAP. All of the liabilities included in the $27.2 million and $20.2 million, respectively, have been deemed to have a Level 1 designation as of December 31, 2009 and 2008. As of December 31, 2008, other liabilities also included $10.4 million related to the fair value of the interest rate swap on the mortgage note. The interest rate swap was deemed to have a Level 2 designation at December 31, 2008. During the second quarter of 2009, we repaid the outstanding balance on the mortgage note and settled the interest rate swap. See Note 6-"Debt" of the accompanying consolidated financial statements.
The changes in Level 3 fair value measurements for the year ended December 31, 2009 are as follows:
Uncertainties in estimating ultimate loss and LAE are magnified by the time lag between when a claim actually occurs and when it is reported and settled. This time lag is sometimes referred to as the "claim-tail". The claim-tail for most property coverages is typically short (usually a few days up to a few months). The claim-tail for liability/casualty coverages, such as automobile liability, general liability, products liability, multiple peril coverage, and workers compensation, can be especially long as claims are often reported and ultimately paid or settled years, even decades, after the related loss events occur. During the long claims reporting and settlement period, additional facts regarding coverages written in prior accident years, as well as about actual claims and trends may become known and, as a result, we may adjust our reserves. If management determines that an adjustment is appropriate, the adjustment is booked in the accounting period in which such determination is made in accordance with GAAP. Accordingly, should reserves need to be increased or decreased in the future from amounts currently established, future results of operations would be negatively or positively impacted, respectively.
and asbestos-related bankruptcies. The cost of administering A&E claims, which is an important factor in estimating loss and LAE reserves, tends to be higher than in the case of non-A&E claims due to the higher legal costs typically associated with A&E claims.
Historically, most asbestos claims have been asserted as product liability claims. Recently, insureds who have exhausted the available products liability limits of their insurance policies have sought from insurers such as us payment for asbestos claims under the premises and operations coverage of their liability policies, which may not be subject to similar aggregate limits. We expect this trend to continue. However, to date there have been fewer of these premises and operations coverage claims than product liability coverage claims. This may be due to a variety of factors, including that it may be more difficult for underlying plaintiffs to establish losses as stemming from premises and operations exposures, which requires proof of the defendant's negligence, rather than products liability under which strict legal liability applies. Premises and operations claims may vary significantly and policyholders may seek large amounts, although such claims frequently settle for a fraction of the initial alleged amount. Accordingly, there is a great deal of variation in damages awarded for the actual injuries. As of December 31, 2009, there were approximately 240 active claims by insureds against us without product liability coverage asserting operations or premises coverage, which may not be subject to aggregate limits under the policies.
result, the Third Party Recoverables serve to protect the $2.5 billion limit of NICO coverage for the benefit of us. Any amounts uncollectible from third party reinsurers due to dispute or the reinsurers' financial inability to pay are covered by NICO under its agreement with us. Third Party Recoverables are typically for the amount of loss in excess of a stated level each year. Of claim payments from 1999 through 2009, approximately 46% of A&E losses have been recovered under the historical third party reinsurance.
As part of our previously described actuarial review process, we review A&E activity each quarter and compare that activity to what was assumed in the most recently completed study. As of December 31, 2009, we noted no change in the range of reasonable outcomes around our best estimate described above.
Our reserves for A&E losses, net of Third Party Recoverables but prior to NICO recoveries, were $0.9 billion at December 31, 2009. An industry benchmark of reserve adequacy is the "survival ratio", computed as a company's reserves divided by its historical average yearly loss payments. This ratio indicates approximately how many more years of payments the reserves can support, assuming future yearly payments are equal to historical levels. Our survival ratio was 11.6 at December 31, 2009. This was computed as the ratio of A&E reserves, net of Third Party Recoverables prior to the NICO Cover of $0.9 billion plus the remaining unused portion of the NICO Cover of $320.2 million, to the average A&E loss payments over the three-year period ended December 31, 2009, net of Third Party Recoverables. Our survival ratio was 12.7 at December 31, 2008. We believe that as a result of the NICO Cover and our historical third party reinsurance programs, we should not experience material financial loss from A&E exposures under current coverage interpretations and that our survival ratio compares favorably to industry survival ratios. However, the survival ratio is a simplistic measure estimating the number of years it would be before the current ending loss reserves for these claims would be paid using recent annual average payments. Many factors, such as aggressive settlement procedures, mix of business and coverage provided, have a significant effect on the amount of A&E reserves and payments and the resultant survival ratio. Thus, caution should be exercised in attempting to determine reserve adequacy for these claims based simply on this survival ratio.
Our reserves for A&E losses at December 31, 2009 represent management's best estimate of its ultimate liability based on information currently available. However, significant uncertainties, including but not limited to case law developments, medical and clean-up cost increases and industry settlement practices, limit our ability to accurately estimate ultimate liability and we may be subject to A&E losses beyond currently estimated amounts. In addition, we remain liable for risks reinsured in the event that a reinsurer does not honor its obligations under reinsurance contracts. See Note 3-"Reserves for Unpaid Loss and LAE-Asbestos and environmental loss and LAE reserve activity" of the accompanying consolidated financial statements for more information regarding our A&E reserves.
For loss and allocated loss adjustment expense reserves, excluding A&E, the key assumption as of December 31, 2009 was that the impact of the various reserving factors, as described below, on future
paid losses would be similar to the impact of those factors on the historical loss data with the following exceptions:
•Increases in case reserve adequacy over the 2001-2004 calendar periods have resulted in trends in case incurred activity that we believe will not continue into the future. Case incurred activity can be the result of underlying changes in expected claim costs or changes in the adequacy of the case reserves relative to the underlying expected claim cost. If the activity is the result of underlying changes in expected costs, it is more likely to repeat in the future, and would likely result in prior year reserve development, as the change in ultimate claim costs would not have been considered when making the previous selection of IBNR reserves. If the activity is the result of changes in case reserve adequacy, it would not indicate any change in the ultimate claim costs and would not be expected to repeat in the future. In these cases, it is unlikely that prior year reserve development would occur, as the change in case reserves would be offset by a corresponding change in IBNR reserves (i.e., deficiency or redundancy in case reserves was implicitly captured when making the previous selection of IBNR reserves).
Our range of reserve estimates at December 31, 2009 was evaluated to consider the strengths and weaknesses of the actuarial methods applied against our historical claims experience data. The following table shows the recorded reserves and the high and low ends of our range of reasonable loss
and LAE reserve estimates at December 31, 2009. The high and low ends of our range of reserve estimates in the table below are based on the results of various actuarial methods described above.
The percentages shown in the following table represent the linear interpolation of where our recorded loss and LAE reserves are within the range of reserves estimates by line of business at December 31, 2009 and 2008, where the low end of the range equals zero, the middle of the range equals 50% and the high end of the range equals 100%.
•Multiple peril liability: Recorded reserves for multiple peril were $191.7 million at December 31, 2009. Reported loss development patterns are a key assumption for these lines of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g. construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. If case reserve adequacy for non-construction defect claims changed by 10.0 points this would have changed the estimated net reserve by approximately $19 million at December 31, 2009, in either direction.
When we acquire another company, our management must estimate the fair values of the assets and liabilities acquired, in accordance with GAAP at the time of the acquisition. See Note 1-"Nature of Operations and Summary of Significant Accounting Policies-Recent Accounting Pronouncements" of the accompanying consolidated financial statements.) Certain assets and liabilities require little judgment to estimate their fair values, particularly those that are quoted on a market exchange, such as publicly-traded investment securities. Other assets and liabilities, however, require a substantial amount of judgment to estimate their fair values. The most significant of these is the estimation required to fair value loss and LAE reserves. We estimate the fair value of loss and LAE reserves obtained in an acquisition following the principles contained within FASB Statement of Financial Accounting Concepts No. 7: "Using Cash Flow Information and Present Value in Accounting Measurements" (CON 7). Under CON 7, the fair value of a particular asset or liability essentially contains five elements: (1) an estimate of the future cash flows; (2) expectations about possible variations in the amount or timing of those cash flows; (3) the time value of money, represented by the risk-free rate of interest; (4) the price for bearing the uncertainty inherent in the asset or liability; and (5) other, sometimes unidentifiable, factors including illiquidity and market imperfections.
scenario and the expected cash flow scenario. The scenario selected has typically been between 1.5 and 2 standard deviations from the expected cash flow outcome. The fair value of the acquired company's loss and LAE reserves is determined to be the sum of the expected cash flow scenario (i.e., the acquired company's discounted loss and LAE reserves) and the uncertainty "price."
•claims arising from catastrophic events, such as hurricanes, windstorms, earthquakes, floods, fires, explosions, terrorist attacks or severe winter weather;
•an economic downturn or other economic conditions adversely affecting our financial position, including stock market volatility;
•business opportunities (or lack thereof) that may be presented to us and pursued;