We maintain office facilities in the United States, Bermuda, Europe, Canada, Australia and Singapore. We own the property in which our offices are located in Dublin, Ireland, and we lease office space in the other countries. We renew and enter into new leases in the ordinary course of business as required. Our worldwide headquarters office is located at 92 Pitts Bay Road, Pembroke, Bermuda. We believe that our office space is sufficient for us to conduct our operations for the foreseeable future.
Total investments of $10.6 billion; fixed maturities and short-term securities comprise 93% of total investments, with an average credit rating of AA
Reserve for losses and loss expenses of $6.6 billion and reinsurance recoverable of $1.4 billion
Total debt of $499 million and a debt to total capitalization ratio of 8.3%
Common shareholders’ equity of $5.0 billion; diluted book value per common share of $33.65
(1) Operating income is a non-GAAP financial measure as defined in SEC Regulation G. See ‘Non-GAAP Financial Measures’ for reconciliation to nearest GAAP financial measure (net income available to common shareholders).
establishing infrastructure and resources related to the recent launch of our Global Accident & Health line of business, which focuses on specialty products rather than traditional medical coverages and began offering insurance and reinsurance products in January 2010;
expanding our geographic presence by securing the necessary licenses and approvals to begin full operations as branch insurers in Canada and Singapore; and
establishing a branch office in Latin America and a representative office in Spain to expand our reinsurance presence in these locations.
2009 versus 2008: Total underwriting income in 2009 of $525 million increased $218 million, or 71%, compared to underwriting income of $307 million in 2008. Overall, the increase was driven by lower catastrophe losses relative to the prior year. In particular, the North Atlantic hurricane season was benign in 2009 compared to 2008, which included net losses incurred of $384 million, net of related earned reinsurance premiums, on Hurricanes Ike and Gustav. Approximately three-quarters of these hurricane losses were incurred within our reinsurance segment.
Underwriting income in our reinsurance segment increased $321 million compared to 2008. This increase was driven by a lower level of catastrophe losses relative to the prior year, as discussed above. In addition, underwriting income in 2009 benefited from an additional $38 million of net favorable prior period reserve development relative to 2008. These factors were partially offset by increased loss activity on trade credit and bond reinsurance business this year.
2008 versus 2007: Total underwriting income in 2008 decreased $431 million, or 58%, compared to 2007. The reduction was primarily driven by net losses incurred from Hurricanes Ike and Gustav (see above).
Unprecedented volatility and turmoil in the global financial markets in the past two years led to significant impairment charges on our available-for-sale investments. In 2009 and 2008, net realized investment losses included other-than-temporary impairment (“OTTI”) charges of $337 million and $78 million, respectively.
(1) ROACE is calculated by dividing net income available to common shareholders for the period by the average shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period.
(2) Operating ROACE is calculated by dividing operating income for the period by the average common shareholders’ equity determined by using the common shareholders’ equity balances at the beginning and end of the period. Operating ROACE is a non-GAAP financial measure as defined in SEC Regulation G. See ‘Non-GAAP Financial Measures’ for reconciliation to the nearest GAAP financial measure (ROACE).
(3) DBV represents total common shareholders’ equity divided by the number of common shares and diluted common share equivalents outstanding, determined using the treasury stock method.
Our objective is to generate superior returns on capital that appropriately reward our common shareholders for the risks we assume and to grow revenue only when we deem the returns meet or exceed our requirements. We recognize that the nature of underwriting cycles may make it difficult to achieve short-term excess profitability and had, therefore, established a return on average common equity (“ROACE”) target of at least 15% over a full underwriting cycle. Our average annual ROACE since inception is approximately 16%, in-line with this long-term goal.
Our 2009 Operating ROACE improved significantly from 2008 for the same reasons noted above for ROACE excluding the impact of net realized investment losses, which were $226 million higher in 2009. Our 2007 Operating ROACE benefited from both strong underwriting and net investment income results.
We believe in returning excess capital to our shareholders by way of dividends (as well as stock repurchases) and accordingly our dividend policy is an integral part of the value we create for our shareholders. The strong earnings in recent years have permitted our Board of Directors to approve successive annual increases in quarterly common share dividends for the past three years.
2008 versus 2007: The 15.3 ratio point increase in our current accident year loss ratio for 2008 was driven by higher catastrophe losses, primarily emanating from net losses incurred on Hurricanes Ike and Gustav. The current accident year loss ratio in 2008 was also negatively impacted, by among other things, a higher frequency and severity of property losses in our insurance segment as well as the impact of pricing deterioration across many lines of business. Offsetting these factors, the 2008 current accident year loss ratio benefited from the incorporation of more of our own loss experience within a number of our short-tail lines of business, relative to the prior year. In addition, we had a relatively higher level of loss recoveries in 2008 within our insurance segment, as a result of our expanded reinsurance coverage.
Approximately 34% of the net favorable reserve development in 2009 was generated from professional lines insurance and reinsurance business. This favorable development was driven by the incorporation of more of our own claims experience into the loss ratios for accident years 2006 and prior, with less weighting given to the initial expected loss ratios, which were derived from industry benchmarks. We began to give weight to our own loss experience for professional lines business in 2008, on those earlier accident years which had developed a reasonable level of credible data. However last year, the impact of this was largely offset by adverse development on accident year 2007 business, emanating from exposure to the sub-prime credit crisis.
We caution that conditions and trends that impacted the development of our liabilities in the past may not necessarily occur in the future. The following sections provide further details on prior year reserve development by segment, line of business and accident year.
$35 million of net favorable prior period reserve development on credit and political risk business, driven by the recognition of lower than expected loss activity on 2005 through 2007 accident years.
$16 million of net adverse prior period reserve development on liability lines of business. This was driven by net adverse development of $24 million on Excess & Surplus (“E&S”) casualty business, primarily impacting accident year 2007, and to a lesser extent, accident year 2008. We adjusted our loss development profile on these accident years having observed higher than expected frequency and severity of claims emergence on this business over the last twelve months. This was partially offset by net favorable development on E&S umbrella business, predominately from accident years 2005 ($4 million) and 2004 ($5 million), reflecting the incorporation of more of our own actual experience with respect to reinsurance recoveries.
$151 million of net favorable prior period reserve development on our property ($90 million), aviation ($30 million), marine ($27 million) and terrorism ($4 million) lines of business. This development was largely generated from accident years 2007 ($70 million), 2006 ($40 million) and 2005 ($18 million). The favorable development was driven by the continued migration to our actual loss experience, which was better than we expected.
Net adverse development of $8 million on our liability business. This was largely due to higher than expected loss emergence on a specific program across several accident years.
In 2007, we experienced $214 million of net favorable prior period reserve development, the principal components of which were as follows:
$202 million of net favorable prior period reserve development on our property ($112 million), marine ($44 million), aviation lines ($38 million) and terrorism ($9 million) lines of business. This development was primarily generated from accident year 2006 ($127 million), 2004 ($44 million) and 2003 ($26 million). The favorable development was driven by the continued migration to our actual loss experience, which was better than we expected. Our accident year 2005 reserves were adversely impacted by the strengthening of our loss estimates for Hurricanes Katrina, Rita and Wilma by approximately $34 million.
$15 million of favorable development on our accident year 2003 professional lines business. This related to a specific claim, which we had previously made provision for, but removed following a favorable court ruling.
Adverse development of $8 million on our 2006 accident and health business (included in “Other”) due to a higher than expected emergence of claims.
$68 million of net favorable prior period reserve development on catastrophe business, generated from accident years 2008 ($46 million), 2007 ($16 million) and prior ($6 million), and emanating from property related catastrophe business ($63 million) and workers compensation catastrophe business ($5 million). The favorable development was driven by the continued migration to our actual loss experience, which was broadly better than we expected. As described in our ‘Critical Accounting Estimate on Loss Reserves’, the Bornhuetter-Ferguson actuarial method, which we primarily use for this business, provides for a transition between initial expected loss ratios to actual loss experience, as an accident year matures. For accident year 2008, the favorable development included a $7 million decrease in our estimate for Hurricanes Ike and Gustav due to a reduction in reported losses.
In 2008, we experienced $174 million of net favorable reserve development, the principal components of which were as follows:
$84 million of net favorable prior period reserve development on property business, generated from accident years 2007 ($26 million), 2006 ($21 million), 2005 ($20 million) and prior ($17 million), and emanating from property per risk business ($57 million) and property pro rata business ($27 million). The favorable development was driven by the continued migration to our actual loss experience, which was better than we expected.
Net adverse development of $4 million on our credit and bond lines of business, largely from accident year 2007, and reflecting the increased potential for loss in the deteriorating economic environment.
In 2007, we experienced $123 million of net favorable reserve development, the principal components of which were as follows:
$15 million of favorable prior period reserve development on our accident year 2005 and 2006 crop reserves.
2008 versus 2007: The global property and liability insurance markets were highly competitive during 2008 with surplus capacity and price deterioration remaining prevalent. Gross premiums written declined in most lines of business reflecting declining rates for new and renewal business and the non-renewal of business that did not meet our underwriting requirements. The reduction in property premiums also reflects our decision to reduce our overall risk exposure to this business while unfavorable market conditions persist. The decrease in credit and political risk premium reflected a reduction in available transactions associated with a slow down in capital flows amidst the global financial crisis.
2008 versus 2007: Premiums ceded in 2008 were $708 million, or 38% of gross premiums written, compared with $713 million, or 35%, in 2007. The increase in our ceded premium ratio primarily reflects a combination of business mix changes and the purchase of additional proportional coverage within liability and professional lines business during 2008.
The 1.8 ratio point decrease in our current accident year loss ratio was the net result of several factors. The most significant drivers for the decrease were as follows:
A reduced severity of property related losses in 2009 relative to 2008.
Higher catastrophe losses in 2008, driven by losses incurred on Hurricanes Ike and Gustav of $127 million, or 10.7 points.
A higher frequency and severity of property losses in 2008, including mining losses in Australia and several other worldwide property risk losses.
An increase in the overall expected loss ratios of our professional lines business from 72% in 2007 to 77% for accident year 2008, primarily reflecting the impact of the sub-prime crisis on our portfolio.
An increase in most of our initial expected loss ratio selections, reflecting the impact of pricing deterioration across most of our portfolio, partially offset by more favorable pricing on our ceded reinsurance.
Acquisition Cost Ratio: Acquisition costs in our insurance segment in 2008 had the non-recurring benefit of adjustments to sliding scale commissions, following prior year releases on our professional lines business. Acquisitions cost ratios were otherwise broadly comparable over the three year period.
General and Administrative Expense Ratio: The increase in the general and administrative ratio of our insurance segment in both 2008 and 2009 primarily reflects a combination of lower net premiums earned and additional headcount and IT costs over this period.
2009 versus 2008: The 17% increase in gross premiums written in 2009 was driven by improved market conditions and the select expansion of our business. Gross premiums written for liability and professional lines of business primarily benefited from new and opportunistic business opportunities, together with an increase in our share on certain treaty renewals this year. The growth of these lines was also partially due to the impact of premium adjustments on prior year proportional and excess of loss professional lines and liability contracts. In 2009, we recorded positive premium adjustments of $14 million on professional lines business and negative adjustments of $4 million on liability business, compared to negative adjustments of $18 million and $13 million, respectively in the prior year. Refer to the ‘Critical Accounting Estimate on Premiums’ for further discussion.
The trade credit and bond reinsurance market in Continental Europe experienced significant dislocation at the January 1 renewal and we were able to strengthen our market position at improved pricing, terms and conditions. In addition, at the first of July renewal, we entered the bond reinsurance market in Latin America. The increase in catastrophe gross premiums written was driven by a combination of rate increases in the U.S. property catastrophe market together with new business opportunities and an increase in our participation on certain renewals. The prior year included catastrophe reinstatement premiums of $28 million in connection with Hurricanes Ike and Gustav. The increase in property premiums in 2009 primarily reflects an improvement in rates and some new property pro rata business.
2008 versus 2007: Gross premiums written in 2008 benefited from a weakened U.S. dollar relative to 2007. In particular, the U.S. dollar was weaker against the Euro at our major renewal of January 1. This primarily impacted our property, credit and bond and motor lines of business. Gross premiums written otherwise decreased 3% in 2008, which was partially due to the impact of premium adjustments on prior year proportional and excess of loss professional lines and liability contracts. In 2008, we recorded negative premium adjustments of $18 million and $13 million on professional lines business and liability business, respectively, compared to positive adjustments of $8 million and $6 million, respectively in the prior year.
The opportunity for growth within our reinsurance portfolio was generally limited in 2008, reflecting a modest deterioration in global market conditions. In addition, we experienced an ongoing trend of higher risk retention by our clients, particularly on liability lines. These factors were partially offset by growth opportunities within engineering and crop line of business in 2008. We also recorded $28 million of reinstatement premiums in connection with Hurricanes Ike and Gustav on catastrophe line of business. Property premiums in 2008 benefited from the renewal of a significant 16-month pro-rata contract, which previously renewed in 2006.
The incorporation of more of our own historical loss experience within short-tail lines of business. Given that this experience has generally been better than we expected, this had the impact of reducing our net loss ratios on several lines of business, relative to 2008.
A more active North Atlantic hurricane season in 2008 compared to 2007, with losses primarily emanating from Hurricanes Ike and Gustav of $281 million, or 18.7 points. Other catastrophe losses in 2008, which included flood, hail and tornado activity in the U.S., an earthquake in China and storms in Australia were broadly in line with 2007, which included losses incurred on Windstorm Kyrill and flooding and storm damage in Australia and U.K.
Our initial expected loss ratios in 2008 were mostly higher than in 2007, reflecting the impact of pricing deterioration across many several lines of business. The impact of this was partially offset by the incorporation of more of our own historical loss experience in our loss picks, which has generally been better than the industry benchmarks that we also incorporate.
Acquisition Cost Ratio: The increase in the acquisition cost ratio of our reinsurance segment in 2009 versus 2008 primarily reflects changes in business mix and growth in lines with higher acquisition costs.
Our 2010 treaty reinsurance renewals are progressing well and we are satisfied with the quality, diversity and balance of the portfolio we reassembled at January 1, 2010. Typically, approximately 50% of our reinsurance gross premiums written within any calendar year renews on this date. Although we have not yet finalized all the business we expect to bind, we anticipate that our first quarter treaty reinsurance renewals in 2010 will represent over 7% growth in premium relative to the same period in 2009. The growth rate is 4% after adjusting for changes in foreign exchange rates.
Our liability and professional lines reinsurance business, reduced slightly at the January 1st renewal. Professional liability treaties that showed deterioration in experience received pricing increases as warranted. Conversely, there were moderate downward movements in areas with less loss experience, such as commercial directors’ and officers’ business. For general liability business, accounts were renewed as expiring with some exceptions where rate were up modestly. Those accounts warranting large increases because of poor experience generally renewed with rate increases.
The following table provides a breakdown of our other revenues and expenses:
Corporate Expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned, corporate expenses were 2.7%, 2.7% and 2.1% for 2009, 2008 and 2007, respectively. The increase in the corporate expense ratio from 2007 to 2008 was primarily due to higher share-based compensation costs, principally associated with the renewed employment contract for our CEO and a higher grant date fair value on issued awards year over year (refer to Item 8, Note 15 to the Consolidated Financial Statements). The corporate expense ratio for 2009 was largely unchanged from 2008.
Interest Expense and Financing Costs: Interest expense primarily includes interest due on the senior notes we issued in 2004. In 2007, it also included interest costs of $19 million incurred on a $400 million repurchase agreement we entered into in December 2006 to finance a life settlement investment. We terminated this agreement in September, 2007.
The increase in the effective tax rate in 2009 over 2008 was driven by an increase in the portion of total income generated by our U.S subsidiaries in 2009 relative to the prior year. In 2008, our U.S subsidiaries incurred significant losses related to Hurricanes Ike and Gustav. The increase in the effective tax rate in 2008 over 2007 was associated with the establishment of a full valuation allowance ($30 million) against net deferred tax assets arising from U.S. realized capital losses and investment impairments arising during the year, due to insufficient positive evidence for recognition.
2008 versus 2007: The increase in investment income from fixed maturities was primarily due to the impact of positive operating cash flows on our average investment balances, compounded with slightly higher yields.
2008 versus 2007: The reduction in net investment income from cash and cash equivalents in 2008 was due to a significant decline in global short-term interest rates and lower average cash and cash equivalents balances during the year. The reduction in our average cash and cash equivalents balances was largely associated with the funding of our share repurchases and investment portfolio during the first half of 2008. During the second half of 2008, we began to increase our allocation to cash and cash equivalents in response to the deteriorating financial market conditions.
The strong performance in 2009 was partially offset by a reduction in the fair value of the collateralized loan obligation (“CLO”) equity tranched securities due to lower recoveries on actual defaults and lower projected recovery rates on the underlying collateral. Actual default rates have stabilized and in some cases are currently trending lower in the second half of 2009. Refer to the ‘Critical Accounting Estimate - Fair Value Measurements’ section for further details.
During 2008, we began funding an allocation to global equities. The income from equities represents dividends received, net of applicable withholding taxes. To reduce our exposure to the financial sector in early 2009, we sold all of the non-redeemable preferred stocks. As a result, our dividend income declined by 52% in 2009 relative to 2008.
Our fixed maturities and equities are classified as available for sale and reported at fair value. The effect of market movements on our available for sale investment portfolio impacts net income (through net realized gains/losses) only when securities are sold or when OTTI are recorded on these assets. Additionally, net income is impacted (through net realized gains/losses) by changes in the fair value of investment derivatives, mainly foreign exchange forward contracts.
The realized gains on fixed maturities in 2008 primarily reflect gains on the sale of certain agency mortgage-backed securities, the price of which were positively impacted by the conservatorship of Fannie Mae and Freddie Mac. In addition, we also recognized gains on the repositioning of our high grade fixed income portfolio, taking advantage of dislocations in certain sectors of the fixed income markets.
Net realized investment losses on the sale of equities in 2009 were driven by the sale of preferred shares in the financial sector in the first quarter of the year.
The OTTI charges in 2009 were significantly higher than 2008, primarily due to an impairment charge of $263 million on our medium-term note (“MTN”) holdings held within our corporate debt portfolio during the third quarter. In response to the credit crisis, the MTN managers had to reduce their leverage levels which in turn lowered the credit duration of the MTNs. As credit markets recovered and credit spreads tightened in 2009, price appreciation was not as pronounced as the depreciation during 2008 due to the lower credit duration of the MTNs. The tightening of credit spreads was more significant and much quicker than anticipated which has hindered the ability of the MTN managers to reinvest the underlying cash flows at wider credit spreads. Consequently, based on updated cash flow projections, we concluded that we will not fully recover par on these MTNs and therefore we have recorded credit losses on these securities.
In 2008, we impaired $32 million of corporate debt securities held in Lehman Brothers following its bankruptcy and sale in September 2008. Additionally, the OTTI charges on residential MBS as well as ABS were primarily the result of the credit crisis and the higher risk of defaults on certain identified securities.
Consolidated Statements of Comprehensive Income for the years ended December 31, 2009, 2008 and
We have audited the accompanying consolidated balance sheets of AXIS Capital Holdings Limited and subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.
As discussed in Note 2 to the consolidated financial statements, on April 1, 2009 the Company adopted FSP FAS 115-2, Recognition and Presentation of Other-Than-Temporary Impairments (Codified in FASB ASC Topic 320, Investments - Debt and Equity Securities).
These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) and include the accounts of AXIS Capital and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated.
other-than-temporary-impairments (“OTTI”) to the carrying value of available-for-sale investment securities; and
Tabular dollars and share amounts are in thousands, except per share amounts. All amounts are reported in U.S. dollars. Our significant accounting policies are as follows.
Fixed maturities and equities classified as “available for sale” are reported at fair value at the balance sheet date. See Note 6 - Fair Value Measurements for additional information regarding the determination of fair value.
Purchases and sales of investments are recorded on a trade date basis. Realized gains or losses on sales of investments are determined based on the specific identification method. Net investment income is recognized when earned and includes interest and dividend income together with amortization of market premiums and discounts using the effective yield method and is net of investment management fees and other expenses.
The net unrealized gain or loss on available for sale investments, net of tax, is included as accumulated other comprehensive income (loss) as a component of shareholders’ equity. We assess quarterly whether available for sale investments with unrealized losses represent impairments that are other than temporary. There are several factors that are considered in the assessment of a security including, but not limited to: (i) the extent and duration of the decline, (ii) the reason for the decline (e.g. credit spread widening, credit event), (iii) the historical and implied future volatility of the fair value, (iv) the financial condition of, and near-term prospects of, the issuer and (v) the collateral structure and credit support of the security, if applicable.
Under the new guidance, if the impaired fixed maturity security meets one of the first two criteria above, the entire difference between the security’s fair value and its amortized cost is recorded as an OTTI charge in the Consolidated Statements of Operations. However, if the impairment arises due to an anticipated credit loss on the security (third criterion above), we recognize only the credit component of the OTTI amount in earnings with a corresponding adjustment to amortized cost (new cost basis). The non-credit component (e.g. interest rates, market conditions, etc.) of the OTTI amount is recognized in accumulated other comprehensive income (“AOCI”) in shareholders’ equity. The new amortized cost is accreted into net investment income.
In periods subsequent to the recognition of an OTTI for either a fixed maturity or equity security, the new cost basis is not adjusted for subsequent increases in estimated fair value.
Short-term investments primarily comprise highly liquid debt securities with maturity greater than three months but less than one year from the date of purchase. Short-term investments, which were previously included in fixed maturities, are now reported separately in the Consolidated Balance Sheets at December 31, 2009 and 2008, the Consolidated Statements of Cash Flows for the years ended December 31, 2009, 2008 and 2007, and in the related disclosures. These investments are carried at amortized cost, which fairly approximates fair value.
Reinstatement premiums for our insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and earned on a pro-rata basis over the remaining risk period. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment, as described in Note 2 (e) - Losses and Loss Expenses below.
Acquisition costs, which comprise primarily of fees and commissions paid to brokers and taxes, vary with and are directly related to the acquisition of policies. Acquisition costs are shown net of commissions earned on ceded business. These net costs are deferred and amortized over the periods in which the related premiums are earned. As part of our premium deficiency analysis, deferred acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed.
The reserve for uncollectible reinsurance is based on an estimate of the amount of the reinsurance recoverable balance that will ultimately not be recovered due to reinsurer insolvency, contractual disputes or some other reason. The valuation of this reserve includes several processes including case-specific allowances for coverage issues and a default analysis based on the financial strength rating of the reinsurers. These factors require considerable management judgment and the factors are reviewed in detail on a quarterly basis with any resulting adjustments reflected in losses and loss expenses in our Consolidated Statement of Operations in the period that collection issues are identified.
For reported losses, management primarily establishes case reserves based on amounts reported from insureds or ceding companies. Management may also establish additional case reserves on claims reported which are not considered adequately reserved. Case reserves are established on a case by case basis within the parameters of coverage provided in the insurance and reinsurance contracts. Our general IBNR reserves are calculated by projecting our ultimate losses on each class of business and subtracting paid losses and case reserves. Unlike case reserves, IBNR is generally calculated at an aggregate level and cannot usually be directly identified as reserves for a particular loss or contract.
While we believe that our reserves for losses and loss expenses are sufficient to pay losses that fall within the coverages we assume, actual losses and loss expenses may be materially greater or less than the reserve provided. Our losses and loss expense reserves are reviewed quarterly, and any adjustments are reflected in earnings in the period in which they become known.
Assets and liabilities of foreign operations whose functional currency is not the U.S. dollar are translated at exchange rates in effect at the balance sheet date. Revenues and expenses of such foreign operations are translated at weighted average exchange rates for the period. The effect of the translation adjustments is reported in accumulated other comprehensive income (loss) as a component of shareholders’ equity.
We may enter into derivative instruments such as futures, options, interest rate swaps and foreign currency forward contracts as part of our overall foreign currency risk management strategy or to obtain exposure to a particular financial market and for yield enhancement. From time to time we may enter into insurance and reinsurance contracts that meet the definition of a derivative contract, as defined by the Financial Accounting Standards Board (“FASB”).
We measure all derivative instruments at fair value (see Note 6 - Fair Value Measurements) and recognize them as either assets or liabilities in the Consolidated Balance Sheets. We record the change in fair value and realized gains or losses on derivative instruments in the Consolidated Statements of Operations.
We amortize intangible assets with finite lives over their estimated useful lives in proportion to the estimated economic benefits of the intangible assets. We also test these assets for impairment if conditions exist that indicate the carrying value may not be fully recoverable. Such conditions may include an economic downturn in a geographic market or a change in the assessment of future operations. If, as a result of such an evaluation, we determine that the carrying value of the finite lived intangible assets is not recoverable, the value of the assets will be reduced to fair value with the difference being charged to income.
Intangible assets with indefinite lives include licenses held by certain subsidiaries in various jurisdictions that allow such subsidiaries to write insurance and/or reinsurance business. These intangible assets are carried at or below estimated fair value and are tested on an annual basis for impairment, or more frequently if circumstances indicate that a possible impairment has occurred.
We have recorded goodwill in connection with certain acquisitions. Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired and is assigned to applicable reporting unit(s) on the acquisition date based upon the expected benefit to be received by the reporting unit. Reporting units are generally one level below our business segments. We determine the expected benefit based on several factors, including the purpose of the business combination, our strategy subsequent to the business combination and the structure of the acquired company subsequent to the business combination. Goodwill is not subject to amortization. We test goodwill for potential impairment annually during the fourth quarter and between annual tests if an event occurs or circumstances change that may indicate that potential exists for the fair value of a reporting unit to be reduced to a level below its carrying amount. We test for impairment at the reporting unit level and the impairment evaluation is a two step process. First, we identify potential impairment by comparing the fair value of the reporting units to estimated book values, including goodwill. The fair value of each reporting unit is derived based upon valuation techniques and assumptions that we believe market participants would use to value the business. The estimated fair values are generally determined utilizing methodologies that incorporate discounted cash flow analyses. The values derived from the analyses are then compared to recent market transactions for reasonableness. We derive the net book value of our reporting units by estimating the amount of shareholders’ equity required to support the activities of each reporting unit. If the estimated fair value of a reporting unit exceeds the estimated book value, goodwill is not considered impaired. If the book value exceeds the estimated fair value, the second step compares the implied fair value of the reporting unit’s goodwill with the carrying amount of the goodwill in order to determine the magnitude of impairment to be recognized. The implied fair value of goodwill is determined by deducting the fair value of a reporting unit’s identifiable assets and liabilities from the fair value of the reporting unit as a whole. The excess of the carrying value of goodwill above the implied goodwill, if any, would be recognized as an impairment charge in the Consolidated Statement of Operations.
Treasury shares are common shares repurchased by the Company and not subsequently cancelled. These shares are recorded at cost and result in a reduction of the shareholders’ equity in the Consolidated Balance Sheets.
Effective April 1, 2009, we adopted the following issued by FASB:
New guidance on determining fair value when the volume and level of activity for an asset or liability have significantly decreased and identifying transactions that are not orderly. In these circumstances, the use of alternative valuation models may be appropriate to determine fair value. The new accounting standard also expands disclosure requirements to include disaggregation of the fair value disclosures by defining major categories, and must be applied prospectively. Refer to Note 6 - Fair Value Measurements for required disclosures.
Effective January 1, 2009, we adopted new guidance issued by FASB for determination of the useful life of intangible assets, resulting in no significant impact on our results of operations or financial position. The guidance amends the factors considered in developing assumptions used to determine the useful life of an intangible asset, and its intent is to improve the consistency between the useful life of a recognized intangible asset and the period of expected cash flows used to measure the fair value of the asset.
Effective January 1, 2009, we adopted new guidance issued by FASB for financial guarantee insurance contracts issued by insurance enterprises, resulting in no significant impact on our results of operations or financial position. This guidance amends the previous recognition and measurement of premium revenue and claim liabilities. A claim liability is recognized prior to an event of default when there is evidence that credit deterioration has occurred in an insured financial obligation. The determination of the applicability of this new guidance to certain of our insurance contracts required significant management judgment due to the interpretation of the scope exemption for insurance contracts that are similar to financial guarantee insurance contracts.
Effective January 1, 2009, we adopted new guidance issued by FASB for the calculation of earnings per share, and the requirement that unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) be included in the computation of earnings per share pursuant to the two-class method. As the dividends on all of our outstanding unvested stock awards are restricted and forfeitable, the adoption of this guidance did not impact the calculation of our earnings per share.
Effective April 1, 2009, we adopted new accounting and disclosure guidance issued by FASB on management’s assessment of subsequent events. This new guidance clarifies that management must evaluate, as of each reporting period, events or transactions that occur after the balance sheet date through the date that the financial statements are issued or available to be issued. The adoption of this standard did not have an impact on our results of operations or financial position. In preparing our Consolidated Financial Statements, we have evaluated subsequent events through February 22, 2010, which is the date that these financial statements were issued.
In October 2009, we adopted new guidance issued by the FASB issued for measuring the fair value of liabilities. The fair value should be measured based on the price that would be paid to transfer the liability in an orderly transaction between market participants, including the company’s own non-performance risk. In the absence of a quoted price in an active market for an identical liability at the measurement date, an entity should use a valuation technique that is consistent with the fair value measurement principles (see Note 6 - Fair Value Measurements). As the loss reserves relating to our insurance and reinsurance contracts are not measured at fair value, the adoption of this guidance did not materially impact our results of operations, financial condition and liquidity.
In October 2009, we adopted new guidance issued by the FASB for measuring the fair value of certain alternative investments. As a practical expedient for measuring fair value, an entity may use the net asset value per share (“NAV”) if the NAV is calculated in accordance with AICPA Audit and Accounting Guide for investment companies. The adoption of this guidance did not impact our results of operations, financial condition and liquidity. Additionally, its adoption did not result in a change in the fair value hierarchy disclosure in Note 6 - Fair Value Measurements.
In June 2009, the FASB issued new guidance for accounting for transfers of financial assets, which amends the derecognition guidance and eliminates the exemption from consolidation for qualifying special-purpose entities (“QSPEs”). Consequently, a transferor will need to evaluate all existing QSPEs to determine whether they must now be consolidated in accordance with the new guidance on consolidations (see below). This new guidance is effective for financial asset transfers occurring after January 1, 2010 and early adoption is prohibited. We do not anticipate the adoption of this guidance will impact our results of operations, financial condition and liquidity.
In January 2010, the FASB issued guidance requiring additional disclosures about transfers into and out of Levels 1 and 2 of the fair value hierarchy and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. This guidance also clarified existing fair value disclosure requirements about the level of disaggregation and about inputs and valuation techniques used to measure fair value. This new guidance is effective for January 1, 2010, except for certain requirements related to Level 3, which will be effective for January 1, 2011. As these new requirements relate solely to disclosures, the adoption of this guidance will not impact our results of operations, financial conditions or liquidity.
In June 2009, the FASB amended the consolidation guidance applicable to variable interest entities (“VIEs”). The amendments will significantly affect the overall consolidation analysis, in particular it modifies the approach for determining the primary beneficiary of a VIE. The primary beneficiary is the party that has: (1) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance, and (2) the obligation to absorb the losses that could potentially be significant to the entity or the right to receive benefits from the entity that could potentially be significant to the entity. The amended guidance is effective as of January 1, 2010, and early adoption is prohibited. As we are not party to any significant VIEs at December 31, 2009, the adoption of this guidance will not impact our results of operations or financial condition on adoption.
We estimate that the annual amortization expense for our total intangible assets with a finite life will be approximately $3 million for the next two years, and $2 million for each of the following three years. The estimated remaining useful lives of these assets range from one to twenty-nine years.
Intangible assets with an indefinite life consist primarily of U.S. state licenses that provide a legal right to transact business indefinitely. Our impairment reviews for goodwill and indefinite lived intangibles did not result the recognition of impairment losses for the years ended December 31, 2009, 2008 and 2007.
(1) Residential mortgage-backed securities (“MBS”) include agency pass-through securities and collateralized mortgage obligations.
(2) Asset-backed securities (“ABS”) include debt tranched securities collateralized by sub-prime mortgages, auto loans, credit cards, and other asset types. This asset class also includes an insignificant position in collateralized loan obligations (“CLOs”) and collateralized debt obligations (“CDOs”).
(3) Represents the non-credit component of OTTI losses, adjusted for subsequent sales of securities. It does not include the change in fair value subsequent to the impairment measurement date.
At December 31, 2009, 312 securities have been in continuous unrealized loss position for 12 months or greater and have a fair value of $705 million. These securities were primarily corporate debt, non-agency residential MBS, non-agency commercial MBS, and ABS with a weighted average S&P credit rating of BBB+, A, AA and A-, respectively. We concluded these securities as well as the remaining securities in an unrealized loss position were temporarily impaired based on a detailed analysis of the underlying credit, projected cash flows to be collected, and other qualitative factors. Further, at December 31, 2009, we did not intend to sell these securities in an unrealized loss position and it is more likely than not that we will not be required to sell these securities before the anticipated recovery of their amortized costs.
The table below shows our portfolio of other investments reported at fair value:
The major category and related investment strategy for our investments in hedge and credit funds are as follows:
Seek to achieve attractive risk-adjusted returns primarily through multi-strategy and long/short equity approaches. Multi-strategy funds invest in a variety of asset classes on a long and short basis and may employ leverage. Long/short equity funds invest primarily in equity securities (or derivatives) on a long and short basis and may employ leverage.
Seek to achieve attractive risk-adjusted returns by executing a strategy which assesses the issuer’s ability to improve its operations and often attempts to influence the process by which the issuer restructures its debt.
Of our credit fund holdings, 58% of the carrying value has annual or semi-annual liquidity and 42% has quarterly liquidity, subject to prior written redemption notice varying from 65 to 95 days. Similar to hedge funds, credit funds may be subject to redemption restrictions such as lock-up periods or gates. No gates have been imposed on our redemption requests in 2009 and 2008. At December 31, 2009, outstanding redemptions receivable on credit funds were insignificant.
At December 31, 2009, we have no unfunded commitments relating to both hedge and credit funds.
The following table summarizes the net OTTI recognized in earnings by asset class:
As disclosed in Note 2 (a), on April 1, 2009, we adopted a new accounting standard which amended the previous OTTI recognition model for fixed maturities. Accordingly, for securities that we intended to sell at the end of each reporting period we recognized the entire unrealized loss in earnings. For the remaining impaired fixed maturities, from April 1, 2009, we have recorded only the estimated credit losses in earnings rather than the entire difference between the fair value and the amortized cost of fixed maturities. Because the new accounting standard does not allow for retrospective application, the OTTI amounts reported in the above table for the year ended December 31, 2009, are not measured on the same basis as prior period amounts and accordingly these amounts are not comparable. Furthermore, the net OTTI recognized in earnings for the first quarter of 2009 includes $26 million of OTTI charges calculated based on the former OTTI recognition model.
The following table provides a roll forward of the credit losses, before income taxes, for which a portion of the OTTI was recognized in AOCI:
Our projected cash flows for corporate debt securities are primarily driven by our assumptions regarding the probability of default and the timing and amount of recoveries associated with defaults. Our default and recovery rate assumptions are based on credit rating, credit analysis, industry analyst reports and forecasts, Moody’s historical default data and any other data relevant to the recoverability of the security. Additionally, our projected cash flows for MTNs include significant inputs such as future credit spreads and use of leverage over the expected duration of each MTN.
During the third quarter of 2009, we recognized $263 million of credit losses on the MTNs as there was considerable uncertainty regarding full recoverability. In response to the credit crisis, the MTNs managers reduced their leverage levels which in turn lowered the credit duration of the MTNs. As credit markets recovered and credit spreads tightened in 2009, price appreciation was not as pronounced as the depreciation during 2008 due to the lower credit duration of the MTNs. The tightening of credit spreads was more significant and much quicker than anticipated which has hindered the ability of the MTN managers to reinvest the underlying cash flows at wider credit spreads. Consequently, based on updated cash flow projections, we concluded that we will not fully recover par on these MTNs and therefore we have recorded credit losses on these securities.
During 2009, we sold corporate debt securities that were previously impaired, resulting in a decrease in credit loss impairments of $21 million, in the above table. Further, in the fourth quarter of 2009, we made the decision to redeem certain MTNs, of which some redemptions occurred prior to and after December 31, 2009. Accordingly the related credit loss amounts are reported in the above table as ‘Securities sold/redeemed during the period (realized)’ and ‘Intent to sell securities previously impaired’, respectively.
We utilized models to determine the estimated credit losses for structured debt securities. To project expected cash flows to be collected, we utilized underlying data from widely accepted third-party data sources as well as the following significant assumptions: expected defaults, delinquencies, recoveries, foreclosure costs, and prepayments. These assumptions require significant management judgment and vary for each structured security based on the underlying property type, vintage, loan to collateral value ratio, geographic concentration, and current level of subordination. For each structured debt security with a significant unrealized loss position we have also corroborated our principal loss estimate with the independent investment manager’s principal loss estimate.
The majority of the unrealized losses on ABS at December 31, 2009 were related to CLO debt tranched securities. We utilized the same internal model as for CLO equity tranched securities (see Note 6 - Fair Value Measurements) to project estimated cash flows to be collected on the various CLO debt tranched securities. The significant inputs used in the model include default and recovery rates and collateral spreads. Our assumptions on default and recovery rates are established based on an assessment of actual experience to date for each CLO and review of recent credit rating agencies’ default and recovery forecasts. Based on projected cash flows at December 31, 2009, we do not anticipate credit losses on the CLO debt tranched securities.
In 2009, we recorded an OTTI charge of $20 million (2008: $7 million) on equities due to the severity and duration of their unrealized loss positions, for which we concluded the forecasted recovery period was uncertain. The recognition of such losses does not necessarily indicate that sales will occur or that sales are imminent or planned.
We participate in a securities lending program whereby our securities, which are included in investments, are loaned to third parties, primarily major brokerage firms for short periods of time through a lending agent. We maintain control over the securities loaned, retain the earnings and cash flows associated with the loaned securities and receive a fee from the borrower for the temporary use of the securities. Collateral in the form of cash, government securities and letters of credit is required at a rate of 102.0% of the fair value of the loaned securities and is monitored and maintained by the lending agent. At December 31, 2009, we had $130 million (2008: $406 million) in securities on loan. As a response to credit crisis in late 2008, we decided to wind down the lending program in an orderly manner to further reduce our counterparty credit risk. For certain securities, we may hold these until they mature in 2010. We consider our securities lending activities to be non-cash investing and financing activities.
The availability of observable inputs can vary from financial instrument to financial instrument and is affected by a wide variety of factors, including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment.
Accordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This may lead us to change the selection of our valuation technique (from market to cash flow approach) or may cause us to use multiple valuation techniques to estimate the fair value of a financial instrument. This circumstance could cause an instrument to be reclassified between levels.
Our U.S. Treasury securities are classified within Level 1 as the fair values are based on unadjusted market prices. For the remaining fixed maturities, substantially all are classified within Level 2.
The short-duration high yield fund is classified within Level 2 as its fair value is estimated using the net asset value reported by Bloomberg and it has daily liquidity.
Our foreign currency forward contracts and options are customized to our hedging strategies and trade in the over-the-counter derivative market. We estimate the fair value for these derivatives using models based on significant observable market inputs from third party pricing vendors, non-binding broker-dealer quotes and/or recent trading activity. Accordingly, we classified these derivatives within Level 2.
In 2008, the fair value for this indemnity contract was based on an internal valuation model, which included the following significant unobservable inputs:
The proceeds of selling the unmatured life settlement contracts in 2017; and
The risk margin that a market participant would require for providing this indemnity.
The estimated indemnity payment, net of our contractual premium for providing the indemnity, was discounted using the risk free yield curve, adjusted for counterparties’ credit risk.
(1) Realized gains and losses on fixed maturities are included in net realized investment gains (losses). Realized gains and (losses) on other investments are included in net investment income. Losses on other liabilities are included in other insurance related (loss) income.
During the year ended December 31, 2009, certain fixed maturities with a fair value of $179 million were transferred into Level 3 from Level 2. The reclassifications were primarily related to residential MBS, private corporate debt securities and debt tranches of CLOs (included in ABS). The majority of the transfers into Level 3 occurred during the first half of the year and were due to a reduction in the volume of recently executed transactions and market quotations for these securities, or a lack of available broker quotes such that unobservable inputs had to be utilized for the valuation of these securities. The transfers into Level 3 were not as a result of changes in valuation methodology that we made.
We write business with loss experience generally characterized as low frequency and high severity in nature, which results in volatility in our financial results. Net loss and loss expenses incurred include net favorable prior period reserve development of $423 million, $376 million and $337 million for the years ended December 31, 2009, 2008 and 2007, respectively. Prior period development was the net favorable result of several underlying reserve developments on prior accident years, identified during our quarterly reserving process. The following table provides a break down of prior period development by segment:
The following table summarizes information on the location and amounts of derivative fair values on the consolidated balance sheet at December 31, 2009:
For the fair value hierarchy level, refer to Note 6 - Fair Value Measurements.
The following table provides the net earnings impact of the fair value hedges for the years ended December 31, 2009, 2008 and 2007:
Within our investment portfolio we are exposed to foreign currency risk. Accordingly, the fair values for our investment portfolio are partially influenced by the change in foreign exchange rates. We entered into foreign currency forward contracts to manage the effect of this foreign currency risk. These foreign currency hedging activities have not been designated as specific hedges for financial reporting purposes.
Our insurance and reinsurance subsidiaries and branches operate in various foreign countries and consequently our underwriting portfolio is exposed to significant foreign currency risk. We manage foreign currency risk by seeking to match our liabilities under insurance and reinsurance policies that are payable in foreign currencies with cash and investments that are denominated in such currencies. When necessary, we may also use derivatives to economically hedge un-matched foreign currency exposures, specifically forward contracts and currency options.
During 2006, we entered into a $100 million Total Return Swap Facility (the “Facility”) with a financial institution for the purpose of accessing and isolating natural peril exposures embedded in capital market instruments. We utilized half of the Facility to enter into a $50 million catastrophe-related total return swap transaction to assume losses from qualifying earthquake events. As a result of this swap, the Facility was collateralized by a lien over a portfolio of the Company’s investment grade securities. During 2009, we earned payments on the swap, net of the Facility fee, which are included in other insurance related income. The catastrophe-related total return swap expired with no loss and the Facility terminated in 2009.
On November 15, 2004, we issued $500 million of senior unsecured debt (“Senior Notes”) at an issue price of 99.785%, generating net proceeds of $496 million. The Senior Notes bear interest at a rate of 5.75%, payable semi-annually in arrears on June 1 and December 1 of each year, beginning on June 1, 2005. Unless previously redeemed, the Senior Notes will mature on December 1, 2014. We may redeem the Senior Notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The Senior Notes indenture contains various covenants, including limitations on liens on the stock of restricted subsidiaries, restrictions as to the disposition of the stock of restricted subsidiaries and limitations on mergers and consolidations. We were in compliance with all the covenants contained in the Senior Notes indenture at December 31, 2009 and 2008.
Interest expense on our Senior Notes includes interest payable, amortization of the offering discount and amortization of debt offering expenses. The offering discount and debt offering expenses are amortized over the period of time during which the Senior Notes are outstanding. We incurred interest expense for the Senior Notes of $29 million in each of the last three years.
At December 31, 2009, we had a $1.5 billion credit facility agreement with a syndicate of lenders. The credit agreement is an unsecured five-year facility that allows us to issue letters of credit up to the full amount of the facility and to borrow up to $500 million for general corporate purposes, with total usage not to exceed $1.5 billion. The credit facility will expire on August 25, 2010. On September 26, 2007, we amended the facility to modify certain definitions in order to permit dividend payments on existing and future preferred and hybrid securities notwithstanding certain events of default. All other terms and conditions remain unchanged.
We produce our business through brokers and direct relationships with insurance companies. During 2009, three brokers accounted for 64% (2008: 58%; 2007: 55%) of our total gross premiums written. Aon Corporation for 26% (2008: 23%, 2007: 21%), Marsh, Inc. (including its subsidiary Guy Carpenter and Company) accounted for 23% (2008: 23%, 2007: 23%), and Willis Group Holdings Ltd. for 15% (2008: 12%, 2007: 11%). No other broker and no one insured or reinsured accounted for more than 10% of our gross premiums written in any of the last three years.
During 2009, we purchased reinsurance coverage for our insurance lines of business. The minimum reinsurance premiums are contractually due on a quarterly basis in advance. Accordingly at December 31, 2009, we have an outstanding reinsurance purchase commitment of $50 million.
In 2005, a putative class action lawsuit was filed against our U.S. insurance subsidiaries. In re Insurance Brokerage Antitrust Litigation was filed on August 15, 2005 in the United States District Court for the District of New Jersey and includes as defendants numerous insurance brokers and insurance companies. The lawsuit alleges antitrust and Racketeer Influenced and Corrupt Organizations Act (“RICO”) violations in connection with the payment of contingent commissions and manipulation of insurance bids and seeks damages in an unspecified amount. On October 3, 2006, the District Court granted, in part, motions to dismiss filed by the defendants, and ordered plaintiffs to file supplemental pleadings setting forth sufficient facts to allege their antitrust and RICO claims. After plaintiffs filed their supplemental pleadings, defendants renewed their motions to dismiss. On April 15, 2007, the District Court dismissed without prejudice plaintiffs’ complaint, as amended, and granted plaintiffs thirty (30) days to file another amended complaint and/or revised RICO Statement and Statements of Particularity. In May 2007, plaintiffs filed (i) a Second Consolidated Amended Commercial Class Action complaint, (ii) a Revised Particularized Statement Describing the Horizontal Conspiracies Alleged in the Second Consolidated Amended Commercial Class Action Complaint, and (iii) a Third Amended Commercial Insurance Plaintiffs’ RICO Case Statement Pursuant to Local Rule 16.1(B)(4). On June 21, 2007, the defendants filed renewed motions to dismiss. On September 28, 2007, the District Court dismissed with prejudice plaintiffs’ antitrust and RICO claims and declined to exercise supplemental jurisdiction over plaintiffs’ remaining state law claims. On October 10, 2007, plaintiffs filed a notice of appeal of all adverse orders and decisions to the United States Court of Appeals for the Third Circuit, and a hearing was held in April 2009. We believe that the lawsuit is completely without merit and we continue to vigorously defend the filed action.
For year ended December 31, 2009, there were 756,365 (2008: 843,904) restricted shares, 1,118,209 (2008: nil) options and 41,000 (2008: nil) restricted stock units, which would have resulted in the issuance of common shares that were excluded in the computation of diluted earnings per share because the effect would be anti-dilutive.
Our authorized share capital is 800,000,000 common shares, par value of $0.0125 per share. At December 31, 2009, 132,139,701 (2008: 136,211,956) common shares were outstanding, which excludes restricted shares under our stock compensation plans (see Note 15 - Stock Compensation Plans).
At December 31, 2009, 19,762,574 common shares (2008: 19,710,390) would be issued pursuant to the warrants, if all warrants were exercised at an average price of $12.36 (2008: $12.40). All warrants were exercisable on November 20, 2001. At December 31, 2009, we accrued $70 million (2008: $56 million) of cash dividends relating to the anti-dilution provision in respect of the warrants. The expiration date for the warrants is November 20, 2011.
The warrants were granted to the founding shareholders as an inducement to purchase our stock and therefore no compensation expense has been recorded in connection with the warrants. The fair value of the warrants at November 20, 2001 of $65 million has been included in additional paid-in capital. This value was calculated using the Black-Scholes option-pricing model. The three significant assumptions used were: risk-free interest rate of 5.1%; expected life of seven years; and a dividend yield of nil.
(1) The rate is fixed at 3% for the duration of the SERPs.
We have granted stock options under the 2003 Plans. The stock options generally become exercisable over a three-year annual vesting period and expire ten years from the date of grant. We have determined the fair value of each stock option grant at the date of grant. We have not issued stock options in 2007, 2008, and 2009.
The following is a summary of stock options outstanding and exercisable at December 31, 2009, and related activity for the year ended:
We have determined the fair value of all stock and unit grants using the closing price of our common shares on the New York Stock Exchange on the day of the grant. The following table provides a reconciliation of the beginning and ending balance of unvested restricted stock for the year ended December 31, 2009:
Under current Bermuda law, we are not required to pay any taxes in Bermuda on income or capital gains. We have received an undertaking from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, we will be exempt from taxation in Bermuda until March 2016. Our Bermuda subsidiary has a branch operation in Singapore, which is subject to the relevant taxes in that jurisdiction. The branch is not under examination in this tax jurisdiction, but remains subject to examination for tax years 2008 and 2009.
Our U.S. subsidiaries are subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The provision for federal income taxes has been determined under the principles of the consolidated tax provisions of the U.S. Internal Revenue Code and Regulations. Should the U.S. subsidiaries pay a dividend outside the U.S. group, withholding taxes will apply. Our U.S. subsidiaries are not under examination but remain subject to examination in the U.S. for tax years 2006-2009. One of our U.S. subsidiaries has a branch operation in Canada, which is subject to the relevant taxes in that jurisdiction. The branch is not under examination in this tax jurisdiction, but remains subject to examination for tax years 2008 and 2009.
Relevant to making the valuation allowance determination, we considered that the U.S. consolidated group has no capital loss carryback ability, limited ability to generate U.S. capital gains during the carryforward period, or other strategies to generate U.S. capital gains sufficient to utilize the deferred tax assets relating the U.S. investment portfolio. We did take into account net unrealized capital gains of $24 million in computing the valuation allowance based on the assumption that the company would dispose of these securities to avoid expiration of the U.S. capital loss carryforwards. In addition, we established a valuation allowance against a $3 million deferred tax asset attributable to an Australian tax loss carryforward of $10 million. Tax losses in Australia may be carried forward indefinitely. However, we believe it is necessary to establish a valuation allowance against the deferred tax assets due to insufficient positive evidence regarding the utilization of these losses. The entity giving rise to the loss carryforward is not expected to generate future taxable income as the entity is a holding company with no significant ongoing operations.
Capital loss carryforwards at December 31, 2009 by expiration date are as follows: $2 million expire in 2010, $4 million expire in 2011, $50 million expire in 2013 and $6 million expire in 2014.
The following table is a reconciliation of the actual income tax rate to the amount computed by applying the effective tax rate of 0% under Bermuda law to income before income taxes:
The unaudited statutory capital and surplus, for our principal operating subsidiaries at December 31, 2009 and 2008 was as follows:
Under the Insurance Act 1978, amendments thereto and Related Regulations of Bermuda, our Bermuda subsidiary, AXIS Specialty Bermuda is restricted as to the payment of dividends for amounts greater than 25% of the prior year’s statutory capital and surplus whereby a signed affidavit by at least two members of the Board of Directors attesting that a dividend in excess of this amount would not cause the company to fail to meet its relevant margins is required. At December 31, 2009, the maximum dividend AXIS Specialty Bermuda could pay, without a signed affidavit, having met minimum levels of statutory capital and surplus requirements, was approximately $1 billion.
Total statutory net income of our operating subsidiaries was $685 million, $408 million, $1,137 million for 2009, 2008 and 2007, respectively. The difference between statutory financial statements and statements prepared in accordance with U.S. GAAP vary by jurisdiction; however, the primary difference is that statutory financial statements do not reflect deferred acquisition costs, certain net deferred tax assets, goodwill and intangible assets, unrealized appreciation on debt securities or certain unauthorized reinsurance recoverables.