The following table of selected financial data should be read in conjunction with our audited consolidated financial statements and the notes thereto and with “Item 5 - Management’s Discussion and Analysis of Financial Condition and Results of Operations,” each contained herein.
The following is a discussion and analysis of our results of operations for the year ended December 31, 2011 compared to the year ended December 31, 2010 and for the year ended December 31, 2010 compared to the year ended December 31, 2009, and also a discussion of our financial condition as of December 31, 2011. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report on Form 10-K.
The financial measures that we believe are most meaningful in analyzing our performance and assessing whether we are achieving our objectives are growth in book value per share, net operating income, combined ratio, return on average shareholders’ equity and net operating return on average shareholders’ equity. The table below shows the key performance indicators as of December 31, 2011 and 2010 and for the years ended December 31, 2011, 2010 and 2009.
(3) Combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned for property and casualty business.
Property catastrophe losses resulting from natural disasters in Thailand in the fourth quarter, in the United States in the second and third quarters, and in Japan, New Zealand and Australia in the first quarter, had a significant effect on our results of operations for the year ended December 31, 2011. We incurred losses from these events of $253.4 million, net of reinsurance and reinstatement premiums, for the year ended December 31, 2011. These events are currently estimated to have caused industry losses exceeding $100.0 billion dollars; however, our strategy of diversified underwriting and a measured catastrophe risk appetite resulted in what we believe was a manageable level of property catastrophe losses and limited the capital impact to 8.7% of our shareholders’ equity as of December 31, 2010.
We seek to manage and monitor our exposure so that the estimated maximum impact of a catastrophic event in any geographic zone is less than 25% of our beginning of year shareholders’ equity for a modeled 1 in 250 year event. As of December 31, 2011, our aggregate exposure was below this target. We continue to monitor the pricing environment and believe we have the capital and operational flexibility to adjust our aggregate exposure should market conditions change over the course of 2012.
Despite the incurred losses from catastrophe events, our net operating income was $96.6 million for the year ended December 31, 2011, with a combined ratio of 98.2%. The catastrophe losses principally affected our reinsurance and Alterra at Lloyd’s segments. Our reinsurance segment still reported positive underwriting income for the year ended December 31, 2011. Net favorable development on prior year loss reserves was $153.3 million for the year ended December 31, 2011, reducing the combined ratio by 10.8 percentage points. The net favorable development was principally in our insurance and reinsurance segments.
Insurance and reinsurance premiums are a function of the amount and type of contracts written as well as prevailing market prices and conditions. Property and casualty premiums are earned over the terms of the underlying coverage. Life and annuity reinsurance premiums are generally earned when the premium is due from policyholders. Each of our insurance and reinsurance contracts contain different pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying contracts, data received from clients and from premium audits. Changes in premium estimates are expected and may result in significant adjustments in any period. These estimates change over time as additional information regarding the underlying business volume of our clients is obtained. There is often a delay in the receipt of updated premium information from clients due to the time lag in preparing and reporting the data to us. After review by our underwriters and finance staff, we increase or decrease premium estimates as updated information from our clients is received.
Our net investment income is a function of the average invested assets and the average yield that we earn on those invested assets. The investment yield on our fixed maturities investments is a function of market interest rates as well as the credit quality and duration of our fixed maturities portfolio. Our net realized and unrealized gains or losses on investments includes realized gains and losses on our fixed maturity securities and changes in fair value of our trading securities and other investments. We recognize the realized gains and losses at the time of sale, and they, along with the changes in fair value of our trading securities, reflect the results of changing market values and conditions, including changes in market interest rates and changes in the market’s perception of the credit quality of our fixed maturities holdings. The change in fair value of other investments is principally a function of the success of the funds in which we are invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies and general economic and investment market conditions.
Our principal expenses are losses and benefits, acquisition costs, interest expense and general and administrative expenses. Losses and benefits are based on the amount and type of insurance and reinsurance contracts written by us during the current reporting
period and information received during the current reporting period from clients pertaining to contracts written in prior years. We record losses and benefits based on actuarial estimates of the expected losses and benefits to be incurred on each contract written. The ultimate losses and benefits depend on the actual costs to settle these liabilities. We increase or decrease losses and benefits estimates as actual claim reports are received. Our ability to make reasonable estimates of losses and benefits at the time of pricing our contracts is a critical factor in determining profitability.
Interest expense principally reflects interest on any bank loans and interest on our senior notes. Interest expense also includes the net interest charge on funds withheld from reinsurers under reinsurance and retrocessional contracts. Interest expense on funds withheld from other reinsurers under reinsurance and retrocessional contracts will vary principally due to changes in the balance of funds withheld. In addition, interest expense also includes interest on deposit contracts.
Case Reserves. Case reserves are established for individual claims that have been reported to us or, in the case of reinsurance, have been reported by our cedants.
For our insurance operations, we are generally notified of insured losses by our insureds and/or their brokers. Based on this information, we establish case reserves by estimating the expected ultimate losses from the claim (including any administrative costs associated with settling the claim). Our claims personnel use their knowledge of the specific claim along with internal and external experts, including underwriters, actuaries and legal counsel, to estimate the expected ultimate losses.
For our reinsurance operations, case reserves are generally established based on reports received from ceding companies and/or their brokers. For excess of loss contracts, we are typically notified of insurance losses on specific contracts and record a case reserve for the estimated expected ultimate losses from the claim. For proportional contracts, we typically receive aggregated claims information and record a case reserve based on that information. As with insurance business, we evaluate this information and estimate the expected ultimate losses.
IBNR. IBNR reserves are reserves that are statistically estimated for losses that have occurred but not yet been reported to us. Consistent with industry practice, we utilize a variety of standard actuarial methods together with management judgment to estimate IBNR. The loss reserve selection from these methods is based on the loss development characteristics of the specific line of business and contracts, which take into consideration coverage terms, type of business, maturity of loss data, reported claims and paid claims. We do not necessarily utilize the same actuarial method or group of actuarial methods for all contracts within a line of business or segment as variations between contracts result in a number of different methods or groups of methods being appropriate.
Initial Expected Loss Ratio Method. To estimate ultimate losses under the expected loss ratio method, we multiply earned premiums by an expected loss ratio. The expected loss ratio is selected utilizing industry data, historical client data, frequency-severity and rate level forecasts and professional judgment. This method is often useful when there is limited historical data due to few losses being incurred.
Bornhuetter-Ferguson Paid and Reported Loss Methods. These methods are a weighted average of the initial expected loss ratio and the relevant development factor method. The weighting between the two methods depends on the maturity of the business. This means that for the more recent years a greater weight is placed on the initial expected loss ratio, while for the more mature years a greater weight is placed on the development factor methods. These methods avoid some of the distortions that could result from a large development factor being applied to a small base of paid or reported losses to calculate ultimate losses. This method will react slowly if actual paid or reported loss experience develops differently than historical paid or reported loss experience because of major changes in rate levels, retentions or deductibles, the forms and conditions of coverage, the types of risks covered or a variety of other factors.
The selection of appropriate actuarial methods to establish reserves may change over time as the underlying loss information becomes more seasoned. Our actuarial projections are based upon an assessment of known facts and circumstances, historical data, estimates of future trends in claims severity and frequency, changes in social attitudes, political and economic conditions, including the effects of inflation, and judicial theories of liability factors, including the actions of third parties, which are beyond our control.
Our development of prior period loss reserves, net of reinsurance, has been less than 6.0% in each of the three years ending December 31, 2011, 2010 and 2009 and an average of 3.9% over the past ten years. Based on this experience, we currently believe that it is reasonably likely that net loss reserves could change 4.0% from currently reported amounts. This change could be higher or lower depending on client reported data and changes in our assessment of known facts and circumstances. As of December 31, 2011, a 4.0% change in net loss reserves would impact our net income and shareholders’ equity by $127.3 million.
The uncertainty and degree of judgment used in our estimate of loss reserves varies depending on the nature of the contract and the line of business. For the purposes of the following discussion, we consider the losses for the following lines of business to be included within property losses: agriculture, aviation, marine & energy, property and other. We consider losses for the accident & health, auto, credit, excess liability, financial institutions, general casualty, international casualty, medical malpractice, professional liability, surety, whole account and workers compensation lines of business to be classified as casualty losses.
The determination of the amount of losses and benefits recoverable from reinsurers requires an estimate of the amount of loss reserves to be ceded to our reinsurers. This consists of recoverable amounts related to both our case and IBNR reserves. The reinsurance recoveries are estimated on a contract by contract basis by applying the terms of any applicable reinsurance coverage to our reserve estimates.
The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “net cumulative redundancy (deficiency)” represents the aggregate change to date from the original estimate on the third line of the table “reserve for property and casualty losses, originally stated, net of reinsurance.” The “gross cumulative redundancy (deficiency)” represents the aggregate change to date from the original gross estimate on the top line of the table. The table also shows the cumulative net paid amounts as of successive years with respect to the net reserve liability.
During 2011, our re-estimated balance sheet reserves for 2002 and each subsequent balance sheet decreased as a result of net favorable development on a large number of contracts from varied underwriting years and lines of business. The more significant development included:
Net favorable development of $1.2 million arising from decreases in premium estimates in our insurance segment.
Changes in loss estimates principally arise from changes in underlying reported, incurred and paid claims data on contracts. Other assumptions used in our process, such as inflation, change infrequently in the reserving process and we do not perform a sensitivity analysis of changes in these assumptions. Given the variety of assumptions and judgments involved in establishing reserves for losses and benefits, we have not designed and maintained a system to capture and quantify the financial impact of changes in each of our underlying individual assumptions and judgments.
For additional information on our reserves, including a reconciliation of losses and loss adjustment expense reserves for the years ended December 31, 2011, 2010 and 2009, refer to Note 7 of our audited consolidated financial statements included herein.
There have been no material reserve adjustments to our life and annuity reinsurance benefit reserves during the years ended December 31, 2011, 2010 and 2009.
We invest in a trading portfolio of fixed maturities securities, an available for sale portfolio of fixed maturities securities and a held to maturity portfolio of fixed maturities securities. We record the trading and available for sale portfolios at fair value on our balance sheet. For our trading portfolio, the unrealized gain or loss associated with the difference between the fair value and the amortized cost of the investments is recorded in net income. For our available for sale portfolio, the unrealized gain or loss (absent credit losses) is recorded in accumulated other comprehensive income in the shareholders’ equity section of our consolidated balance sheet.
Fixed maturities are subject to fluctuations in fair value due to changes in interest rates, changes in issuer specific circumstances such as credit rating and changes in industry specific circumstances such as movements in credit spreads based on the market’s perception of industry risks. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolio is to tailor the maturities of the portfolio to the timing of expected loss and benefit payments. At maturity, absent any credit loss, fixed maturities’ amortized cost will equal their fair value and no realized gain
We have designed ongoing due diligence processes with respect to funds and their managers. These processes are designed to assist us in assessing the quality of information provided by, or on behalf of, each fund and in determining whether such information continues to be reliable or whether further review is necessary. Certain funds do not provide full transparency of their underlying holdings; however, we obtain the audited financial statements for every fund annually, and regularly review and discuss the fund performance with the fund managers to corroborate the reasonableness of the reported net asset values. While reported net asset value is the primary input to the review, when the net asset value is deemed not to be indicative of fair value, we may incorporate adjustments to the reported net asset value. Such adjustments may involve significant management judgment.
Additional information about the fair values of our hedge fund portfolio can be found in Note 4 to our audited consolidated financial statements included herein.
The net adjustments to gross premiums written as a result of changes in premium estimates were an increase of $37.3 million, for the year ended December 31, 2011 and decreases of $24.8 million and $10.9 million, for the years ended December 31, 2010 and 2009, respectively. Such adjustments are generally the result of changing market conditions experienced by our clients.
Certain reinsurance contracts that we write are retrospectively rated and we are entitled to additional premium should losses exceed pre-determined, contractual thresholds. These additional premiums are based upon contractual terms and management judgment is involved with respect to the estimated amount of losses that we expect to be ceded to us. Additional premiums are recognized at the time loss thresholds specified in the contract are exceeded and are earned over the remaining coverage period, or are earned immediately if the period of risk coverage has passed. Changes in estimates of losses recorded on contracts with additional premium features will result in changes in additional premiums based on contractual terms.
For each of the years ended December 31, 2011, 2010 and 2009, additional premiums relate to contracts where the coverage period had expired. Therefore, these additional premiums, representing revisions to our initial estimate of ultimate premiums as a result of changes in the estimate of loss reserves, were fully earned since the exposure period had ended. As of December 31, 2011, the majority of retrospectively rated contracts have been settled and, therefore, we expect such adjustments to have an immaterial impact on future periods.
We accrue for reinstatement premiums resulting from losses recorded. Such accruals are based upon contractual terms and the only element of management judgment involved is with respect to the amount of losses recorded. Changes in estimates of losses recorded on contracts with reinstatement premium features will result in changes in reinstatement premiums based on contractual terms. Reinstatement premiums are recognized at the time we record losses and are earned on a pro-rata basis over the coverage period. Reinstatement premiums assumed and ceded for the year ended December 31, 2011 were $36.9 million and $6.3 million, respectively. Reinstatement premiums assumed and ceded were not material for the years ended December 31, 2010 and 2009.
For quota share, or proportional, contracts, we are entitled to receive premium as the ceding client collects the premium under contractual reporting and payment terms, which are usually quarterly. Premiums are usually collected over a two year period on our quota share or proportional contracts. For excess of loss contracts, premium is generally paid in contractually stipulated installments with payment terms ranging from payment at the inception of the contract to four quarterly payments. As a result of recognizing the estimated gross premium written at the inception of the policy and collecting that premium over an extended period, we include a premium receivable asset on our balance sheet. We actively monitor our premium receivable asset to consider whether we need an allowance for doubtful accounts. As part of this process, we consider the credit quality of our cedants and monitor premium receipts versus expectations. We also seek to include a right of offset in the contract terms. Since commencing our operations, premiums receivable written off have not been material and, currently, no material premiums receivable are significantly beyond their due dates or in dispute.
Insurance-We offer property and casualty excess of loss insurance from our offices in Bermuda, Dublin and the United States primarily to Fortune 1000 companies. Principal lines of business are aviation, excess liability, professional lines and property.
Alterra at Lloyd’s-We offer property and casualty quota share and excess of loss insurance and reinsurance from our London, Dublin and Zurich offices, primarily to medium- to large- sized international clients. We also provide reinsurance to clients in Latin America, operating locally in Rio de Janeiro, using Lloyd’s admitted status. This segment comprises our proportionate share of the underwriting results of the Syndicates, and the results of our managing agent, Alterra at Lloyd’s. The Syndicates underwrite a diverse portfolio of specialty risks, including accident & health, aviation, financial institutions, international casualty, marine, professional liability, property and surety.
Life and annuity reinsurance-We previously offered reinsurance products focusing on blocks of life and annuity business, which took the form of co-insurance transactions whereby the risks are reinsured on the same basis as the original policies. We have decided not to write any new life and annuity contracts for the foreseeable future.
We also have a corporate function that includes our investment and financing activities and all other items not allocated to the segments, including interest expense and corporate general and administrative expenses.
We monitor the performance of all of our segments other than life and annuity reinsurance on the basis of underwriting income, loss ratio, acquisition ratio, general and administrative expense ratio and combined ratio. We monitor the performance of our life and annuity reinsurance business on the basis of income before taxes for the segment, which includes revenue from net premiums earned, allocated net investment income and realized and unrealized gains on investments, and expenses from claims and policy benefits, acquisition costs and general and administrative expenses.
Effective January 1, 2011, we redefined two of our operating and reporting segments based on changes to our internal reporting structure. Insurance business written by Alterra Insurance USA, which was previously reported within the U.S. specialty segment, has been reclassified to the insurance segment. Alterra Insurance USA is a managing general underwriter for Alterra E&S and Alterra America, as well as various third party insurance companies, and is our principal insurance underwriting platform for retail distribution in the United States. Segment disclosures for comparative periods have been revised to reflect this reclassification.
(d) The combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned for the property and casualty business.
Gross premiums written for the year ended December 31, 2010 increased by 2.6% compared to the prior year. Our reinsurance segment was impacted in 2010 by the addition of premiums written by the former Harbor Point companies. Gross premiums written also increased in our U.S. specialty and Alterra at Lloyd’s segments as a result of our new product offerings, the addition of new underwriting teams, and our expansion into Latin America. These increases, and those resulting from the Amalgamation, were principally offset by decreases in the level of premiums written in our insurance, reinsurance (excluding Harbor Point) and life and
A discussion of pro forma reinsurance segment results including Harbor Point in the 2010 and 2009 comparative figures is in the section entitled Reinsurance Segment on a pro forma basis. On a pro forma basis, gross premiums written and net premiums earned for the years ended December 31, 2010 and 2009 would have been as follows:
(1) The above pro forma financial information for the years ended December 31, 2010 and 2009 is provided for informational purposes only and presents a summary of the combined gross premiums written and net premiums earned of the Company and the former Harbor Point companies assuming the Amalgamation occurred on January 1, 2010 and January 1, 2009, respectively.
On a pro forma comparative basis, gross premiums written for the year ended December 31, 2011 would have increased by 6.1%. The increase would have been principally due to growth in our Alterra at Lloyd’s segment resulting from expansion of our platform, partially offset by decreases in several lines of business in our reinsurance segment due to challenging market conditions and increased competition.
On a pro forma basis, the gross premiums written for the year ended December 31, 2010 would have decreased by 7.8%. This decrease would have principally been driven by lower premium volumes in our insurance and reinsurance segments, along with a decrease in our life and annuity reinsurance segment.
Net losses and loss expenses. The loss ratio increased by 10.4 percentage points for the year ended December 31, 2011 compared to the year ended December 31, 2010. Significant items impacting the 2011 loss ratio were:
Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, for the year ended December 31, 2011 of $153.3 million compared to $105.5 million for the year ended December 31, 2010;
The loss ratio decreased by 6.3 percentage points for the year ended December 31, 2010 compared to the year ended December 31, 2009. Significant items impacting the 2010 loss ratio were:
Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, for the year ended December 31, 2010 of $105.5 million compared to $78.3 million for the year ended December 31, 2009;
Excluding the net favorable loss development, the loss ratio was 65.1% for the year ended December 31, 2010 compared to 72.3% for the year ended December 31, 2009. The decrease in the loss ratio for the year ended December 31, 2010 compared to the prior year was principally due to the inclusion of net premiums earned from Harbor Point since May 12, 2010 at a significantly lower loss ratio, which reduced the average loss ratio despite the increase in property catastrophe losses discussed below. The loss ratio for the year ended December 31, 2010 on the net premiums earned related to the Harbor Point portfolio of contracts did not include any significant property catastrophe losses, other than from the New Zealand earthquake, as most of the significant property catastrophe loss events occurred prior to the Amalgamation;
The loss ratio for the year ended December 31, 2010 benefitted from the $14.4 million amortization of the fair value adjustment made to the acquired Harbor Point net loss reserves at the date of the Amalgamation. This fair value adjustment is being amortized over a weighted average period of 4.0 years; and
Claims and policy benefits. We did not write any new life and annuity reinsurance contracts in the years ended December 31, 2011 and 2010. We wrote one new life and annuity reinsurance contract in the year ended December 31, 2009. We do not intend to write any new life and annuity reinsurance contracts in our life and annuity reinsurance segment in the foreseeable future.
Our acquisition cost ratio for the year ended December 31, 2010 increased by 3.9 percentage points compared to the year ended December 31, 2009. The increase in the acquisition cost ratio was principally due to changes in the mix of business written, partially influenced by the additional net premiums earned from the former Harbor Point companies. The Harbor Point portfolio of contracts contained a higher proportion of quota share contracts, which generally carry higher acquisition cost ratios than excess of loss contracts. A decrease in the level of reinsurance purchased across all of our segments, but in particular our U.S. specialty segment, also contributed to the increase in the ratio for the year ended December 31, 2010.
Interest expense. Interest expense includes interest on funds withheld from reinsurers, interest on our senior notes outstanding and accretion of deposit liability contracts. Interest expense for the year ended December 31, 2011 increased by $15.4 million compared to the year ended December 31, 2010, and increased by $7.0 million for the year ended December 31, 2010 compared to the year ended December 31, 2009. The increase in both periods was principally a result of the issuance of senior notes in September of 2010. In addition, an adjustment to the deposit liability on a certain contract based on new information received resulted in an increase in interest expense in 2011. For the year ended December 31, 2010, an increase in funds withheld interest for one of our largest reinsurers contributed to the increase over the year ended December 31, 2009.
General and administrative expenses for the year ended December 31, 2010 increased by $66.6 million compared to the year ended December 31, 2009. The increase was principally related to the additional general and administrative expenses of the former Harbor Point companies. In addition, there was an increase in performance based compensation expense as a result of a larger cash component of the 2010 performance based compensation than in 2009. However, the corresponding increase in net earned premiums as a result of the Amalgamation resulted in no change in our general and administrative expense ratio for the year ended December 31, 2010 compared to the year ended December 31, 2009.
(a) The loss ratio is calculated by dividing net losses and loss expenses by net premiums earned.
Premiums. Gross premiums written for the year ended December 31, 2011 increased by 2.7% compared to the prior year. Significant factors affecting 2011 gross premiums written were:
An increase in property gross premiums written, principally due to improved pricing conditions; and
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 48.8%, compared to 45.2% and 48.9%, respectively, in the years ended December 31, 2010 and December 31, 2009. The amount of reinsurance that we purchase can vary significantly by line of business. The increase in the percentage of reinsurance premiums ceded is principally due to changes in the mix of business and an increase in the percentage of quota share reinsurance purchased on our property line of business to manage our aggregate exposures. A contributing factor to the decrease in 2010 was the reduction in property reinsurance premiums ceded to Harbor Point, which became fully eliminated intercompany transactions after the Amalgamation. We replaced those reinsurance premiums ceded with third parties over the course of the normal renewal periods.
The loss ratio for the year ended December 31, 2010 decreased by 4.9 percentage points compared to the year ended December 31, 2009. Significant items impacting the 2010 loss ratio were:
Excluding the net favorable loss development, the loss ratio was 79.0% for the year ended December 31, 2010 compared to 83.6% for the year ended December 31, 2009. The decrease was principally due to better current year loss experience in our aviation line of business during the year ended December 31, 2010; and
For the year ended December 31, 2010, our results included net losses of $12.1 million related to property catastrophe events and significant per-risk losses. Large events during the year ended December 31, 2010 included the Chile earthquake and flooding in Australia. These losses were contained within our annual loss expectations for the property line of business. There were no significant property catastrophe events and significant per-risk losses occurring in the year ended December 31, 2009.
Changes in premium estimates for contracts that incepted before 2011 resulted in a decrease in prior year loss reserves of $1.2 million in 2011 and an increase in prior year loss reserves of $2.8 million in 2010 and $2.4 million in 2009.
Gross premiums written for the year ended December 31, 2010 increased by 4.1% compared to the year ended December 31, 2009. Significant factors affecting 2010 gross premiums written were:
Gross premiums written increased in the auto, general casualty, professional liability and property lines of business principally due to the inclusion of premiums written by the former Harbor Point companies from May 12, 2010;
Gross premiums written decreased in our agriculture line of business principally due to the non-renewal of a contract as a result of a client merger in 2010;
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 9.6% compared to 12.6% in the prior year. The decrease was principally due to the Amalgamation, which resulted in an increase in gross premiums written with a smaller percentage increase in ceded premiums written. In addition, there was an increase in auto business, which is not reinsured, and property business, which had a lower retrocession rate than the prior year. We monitor our need for reinsurance based on aggregate exposures.
Net premiums earned is a function of the earning of gross premiums written and reinsurance premiums ceded over the last several quarters and, therefore, changes in net premiums earned generally lag quarterly increases and decreases in gross premiums written and reinsurance premiums ceded. As a result, net premiums earned tend to be less volatile than gross premiums written and reinsurance premiums ceded. The increase in net premiums earned for the year ended December 31, 2011 compared to the prior year was principally due to the incremental earnings of the Harbor Point portfolio of contracts, which are included within the entire 2011 period but are only included for a portion of the comparable 2010 period. The increase in net premiums earned for the year ended December 31, 2010 compared to the year ended December 31, 2009 was also principally due to the incremental earnings of the Harbor Point portfolio of contracts written before the Amalgamation, which are included in the 2010 year but have no equivalent in the comparable 2009 year.
Net favorable loss development of prior year reserves in the year ended December 31, 2011 was $80.6 million, compared to $44.6 million in the year ended December 31, 2010;
The net favorable development in the year ended December 31, 2011 reflected better than expected loss emergence. Favorable loss development principally emerged on the 2010 and prior years for the property line of business, on the 2001 year for workers’ compensation relating to the favorable settlement of a contract, on the 2008 and 2007 years for aviation and on the 2009 and prior years for the professional liability line of business. This favorable loss development was partially offset by unfavorable development principally on the 2010 and 2009 years for the medical malpractice line of business.
Excluding net favorable loss development, the loss ratio was 73.9% for the year ended December 31, 2011 compared to 62.5% for the prior year periods (61.6% after adding back a $9.5 million reduction to net premiums earned for a workers’ compensation contract discussed below). The increase in the loss ratio for the year ended December 31, 2011 compared to December 31, 2010 was due principally to the increase in property catastrophe and significant per-risk losses; and
The year ended December 31, 2011 included $151.3 million in significant property catastrophe-related losses compared to $27.8 million for the year ended December 31, 2010. For the year ended December 31, 2011, property catastrophe losses included losses resulting from the Australia floods, Cyclone Yasi, the New Zealand earthquake, the Japan earthquake and tsunami, tornadoes and flooding in the United States , Hurricane Irene and the Thailand floods. For the year ended December 31, 2010, property catastrophe losses included losses for the Deepwater Horizon oil spill, Europe Windstorm Xynthia, Australia hailstorms, the New Zealand earthquake and floods in Australia.
The loss ratio decreased by 10.2 percentage points for the year ended December 31, 2010 compared to the year ended December 31, 2009. Significant items impacting the 2010 loss ratio were:
The loss ratio for the year ended December 31, 2010 benefitted from the $14.4 million amortization of the fair value adjustment made to the acquired Harbor Point net loss reserves at the date of the Amalgamation. This fair value adjustment is being amortized over a weighted average period of 4.0 years, and
General and administrative expenses. General and administrative expenses for the year ended December 31, 2011 increased by $13.3 million compared to the year ended December 31, 2010. This increase was principally due to 2011 being the first full fiscal year following the Amalgamation. In addition, an increase in the number of retirement eligible employees, whose stock-based compensation awards are fully expensed when granted, and the transfer of some corporate function employees and expenses to the reinsurance segment as part of the Amalgamation integration also contributed to the increase. This impact was partially offset by a decrease in performance based compensation expense. Growth in net premiums earned exceeded the increase in general and administrative expenses, resulting in a decrease of 0.9 percentage points in the general and administrative loss ratio.
(b) Long tail includes general casualty, medical malpractice, professional liability, whole account and workers’ compensation lines of business.
Premiums. Gross premiums written for the year ended December 31, 2011 were 2.5% lower than gross premiums written in the prior year period would have been. Significant factors affecting 2011 gross premiums written were:
Gross premiums written in our agriculture line of business would have decreased principally due the non-renewal of a $29.9 million contract resulting from the client retaining more business partially offset by an increase in gross premiums written due to two significant new contracts;
Gross premiums written in our aviation, general casualty, marine & energy and professional liability lines of business decreased principally due to contracts not being renewed or reductions in our participation due to a more competitive pricing environment;
Gross premiums written in our medical malpractice line of business decreased principally due to the non-renewal of two contracts that accounted for $23.1 million. This was partially offset by an increase in premium estimates of $8.4 million in the year ended December 31, 2011 compared to a decrease in premium estimates of $4.4 million in the year ended December 31, 2010;
Gross premiums written for the year ended December 31, 2010 would have been 15.8% lower than the year ended December 31, 2009. Significant factors affecting pro forma 2010 gross premiums written would have been:
The increase in our credit/surety and whole account lines of business would have been principally due to new business written;
The decrease in property premiums would have been principally due to increased selectivity in our renewals, focusing on business that meets our rate of return requirements; and
Workers’ compensation premiums would have decreased principally due to the non-renewal of a contract written in the prior year period, resulting in a decrease of $45.7 million, as well as a downwards net premium adjustment of $9.5 million on a prior year contract triggered by a similar downwards revision to losses on the contract.
Net premiums earned is a function of the earning of gross premiums written and reinsurance premiums ceded over the last several quarters and, therefore, changes in net premiums earned generally lag quarterly increases and decreases in gross premiums written and reinsurance premiums ceded. As a result, net premiums earned tend to be less volatile than gross premiums written and reinsurance premiums ceded.
Net losses and loss expenses. The loss ratio for the year ended December 31, 2011 would have increased by 6.4 percentage points compared to the year ended December 31, 2010. Significant items impacting the 2011 loss ratio were:
Net favorable loss development of prior year reserves in the year ended December 31, 2011 was $80.6 million, compared to $73.0 million in the year ended December 31, 2010;
The loss ratio for the year ended December 31, 2010 would have increased by 7.5 percentage points compared to the year ended December 31, 2009. Significant items impacting the 2010 pro forma loss ratio would have been:
Net favorable loss development of prior year reserves in the year ended December 31, 2010 would have been $73.0 million compared to $57.4 million in the year ended December 31, 2009;
The year ended December 31, 2010 would have included $94.8 million in property catastrophe-related and significant per-risk losses, principally as a result of the Deepwater Horizon oil spill, Europe Windstorm Xynthia, the Chile earthquake, Australia storms, the New Zealand earthquake and Australia floods. The year ended December 31, 2009 would have included $8.9 million of property catastrophe-related net losses, principally related to Windstorm Klaus.
Acquisition costs. The ratio of acquisition costs to net premiums earned would have increased 1.3 percentage points for the year ended December 31, 2011, compared to the prior year period. The ratio of acquisition costs to net premiums earned would have increased 0.8 percentage points for the year ended December 31, 2010 compared to the year ended December 31, 2009. The reinsurance contracts that we write have a wide range of acquisition cost ratios. The increase in the acquisition cost ratio would have been due principally to changes in the mix of business earned.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2011 would have increased compared with the prior year period principally due to the transfer of some corporate function employees and expenses to
the reinsurance segment as part of the Amalgamation integration and an increase in the number of retirement eligible employees whose stock-based compensation awards are fully expensed when granted. This impact would have been partially offset by a decrease in performance based compensation expense.
(b) Long tail includes general liability and professional liability lines of business.
Premiums. Gross premiums written for the year ended December 31, 2011 increased 12.1% compared to the prior year period. The increase in 2011 gross premiums written was principally due to:
Growth in our general liability line of business due to the addition of excess casualty business to our product offerings in this line.
Gross premiums written for the year ended December 31, 2010 increased 10.8% compared to the year ended December 31, 2009. The increase in 2010 gross premiums written was principally due to:
The addition of professional liability to our product line in the fourth quarter of 2009;
Focused growth of our general liability line written through the brokerage distribution channel; and
Moderate growth of 3% to 10% in our marine and property lines of business.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 37.5% compared to 30.1% in the prior year period. The increase in the percentage of premiums ceded in the year ended December 31, 2011 was principally due to the 100% cession of our contract binding business starting from August 1, 2011. Excluding this additional amount of premiums ceded, the percentage of premiums ceded for the year ended December 31, 2011 was 30.4%. The prior year period was impacted by the cancellation of a property quota share treaty that resulted in $20.6 million of returned ceded premium. Excluding this treaty, the ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2010 was 37.0%. The decrease from 37.0% to 30.4% was consistent with our planned increase in risk retention during the year.
Net unfavorable loss development of prior year reserves in the year ended December 31, 2011 was $11.5 million compared to net favorable development of $0.9 million in the year ended December 31, 2010. Net unfavorable loss development in our general liability and property lines of business related to business written by the contract binding business (2007-2010 years). As described above, this business was sold during 2011 and we did not retain on our balance sheet any of the business written following the sale. In addition, there was net unfavorable development in our marine line of business relating to the 2010 year. The net favorable development in the year ended December 31, 2010 principally was on our property line of business;
Our results for the year ended December 31, 2011 include net losses of $19.6 million for property catastrophe losses compared to $7.0 million for the year ended December 31, 2010. The significant property catastrophe event net losses for the year ended December 31, 2011 included losses resulting from tornadoes and flooding in the United States and Hurricane Irene. The year ended December 31, 2010 included losses resulted from Tennessee flooding and northeastern U.S. storms. These losses fall within our attritional loss ratio, as we expect a certain level of property losses each period.
The loss ratio for the year ended December 31, 2010 increased 2.3 percentage points compared to the year ended December 31, 2009. Significant items impacting the 2010 loss ratio were:
Net favorable loss development of prior year reserves in the year ended December 31, 2010 was $0.9 million compared to net unfavorable development $1.1 million in the year ended December 31, 2009. Favorable development in our property line of business in 2010 and 2009 represented better than expected loss emergence. Unfavorable development in our marine and general liability lines of business were the result of increased loss estimates on specific claim reserves;
General and administrative expenses increased in 2010 compared to 2009; however, our general and administrative expense ratio decreased. The decrease in the ratio was principally due to the increases in net premiums earned during 2010.
An increase of $46.5 million in our property line of business for the year ended December 31, 2011 due to growth in our Latin America operations for this segment. Our Latin America operations generated $30.6 million of property gross premiums written in 2011 compared to $17.4 million in the prior year. The year ended December 31, 2011 also benefitted from the addition of our direct and facultative property insurance underwriting team and improved market conditions, as well as $13.1 million of gross reinstatement premiums principally related to property catastrophe events;
An increase of $26.2 million in our international casualty line of business for the year ended December 31, 2011. We began underwriting this business in the quarter ended March 31, 2010 and the increase reflects the expansion of our client base as well as favorable market conditions;
The addition of international casualty product lines in the first quarter of 2010, which generated $26.2 million of gross premiums written in the year ended December 31, 2010; and
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 22.2% compared to 18.5% for the prior year. For the year ended December 31, 2011, the increase was impacted by reinstatement premiums ceded as a result of the catastrophe losses during the year.
Net losses and loss expense. The loss ratio for the year ended December 31, 2011 increased by 48.4 percentage points compared to the year ended December 31, 2010. The net favorable and (unfavorable) development of prior year reserves in the years ended December 31, 2011, 2010 and 2009 by line of business was as follows:
Net favorable loss development of prior year reserves in the year ended December 31, 2011 was $17.3 million compared to net favorable loss development of $14.9 million in the year ended December 31, 2010. The net favorable development in the year ended December 31, 2011 was principally on pre-2009 financial institutions business and on the property line of business related to pre-2008 years. The net favorable development in the year ended December 31, 2010 was principally on our property, financial institutions and professional liability lines of business;
Net losses and loss expense for the year ended December 31, 2011 included $83.2 million in catastrophe-related and significant per-risk losses. Property catastrophe losses for the year ended December 31, 2011 included losses resulting from the Australia floods, Cyclone Yasi, the New Zealand earthquake, the Japan earthquake and tsunami, tornadoes and flooding in the United States, Hurricane Irene and the Thailand floods. Net losses and loss expense for the year ended December 31, 2010 include $8.1 million in significant property catastrophe-related and significant per risk losses, which included net losses from the New Zealand earthquake, the Deepwater Horizon oil spill, the Chile earthquake, Europe Windstorm Xynthia and Australia hail storms and floods. A portion of these losses fall within our attritional loss ratio, as we expect a certain level of property losses each period.
Net favorable loss development of prior year reserves in the year ended December 31, 2010 was $14.9 million compared to net favorable development of $6.1 million in the year ended December 31, 2009. The net favorable development in the year ended December 31, 2010 was principally on our property, financial institutions and professional liability lines of business. The net favorable development in the years ended December 31, 2010 and 2009 reflected better than expected loss emergence;
Excluding the net favorable loss development, the loss ratio was 55.4% for the year ended December 31, 2010 compared to 52.7% for the year ended December 31, 2009. The increase in the loss ratio was principally due to changes in the mix of business, which included aviation and international casualty lines of business, and an increase in catastrophe - related and significant per risk losses.
General and administrative expenses for the year ended December 31, 2010 increased $8.5 million compared to the year ended December 31, 2009. However, the general and administrative expense ratio for the year ended December 31, 2010 remained consistent with the year ended December 31, 2009 as net premiums earned increased at almost the same rate. General and administrative expenses for this segment included profit commission income earned by Alterra at Lloyd’s from the Syndicates that were not wholly owned by Alterra, which partially offset the costs of managing the Syndicates. Profit commission income in the year ended December 31, 2010 benefitted from a non-recurring gain of $4.9 million resulting from the closing of a year of account on one of these third-party Syndicates. Partially offsetting this profit commission income was an increase in information technology expenses, performance-based compensation, and expenses related to our new office in Brazil.
Losses for the years ended December 31, 2011 and 2010 were principally due to low rates of return on our hedge fund investments. Net realized and unrealized gains and losses on investments for this segment consist entirely of net gains or losses on hedge fund investments. If hedge fund investments provide a positive rate of return over the long term, we expect that the combination of net investment income from fixed maturities and net gains from hedge funds would exceed the discount rate on our reserves and, therefore, provide positive income for this segment.
Gross premiums written, reinsurance premiums ceded, net premiums earned, acquisition costs and general and administrative expenses represent ongoing premium receipts or adjustments and related administration expenses on existing contracts. Claims and policy benefits in each period represent reinsured policy claims payments net of the change in policy and claim liabilities.
The results of investing activities discussed below include net investment income, net realized and unrealized gains (losses) on investments and net impairment losses recognized in earnings for the consolidated group, including amounts that are allocated to the life and annuity segment.
Net realized and unrealized (losses) gains on investments include the following:
(a) An increase in fair value of derivatives of $8.1 million from a wholly-owned hedge fund is included in the increase (decrease) in fair value of hedge funds for the year ended December 31, 2009.
The increase in fair value of the hedge fund portfolio was $75.8 million, or a 12.27% rate of return, for the year ended December 31, 2009.
The fair value of derivatives decreased by $12.0 million for the year ended December 31, 2010 compared to an increase of $0.8 million for the year ended December 31, 2009. During the second quarter of 2010, we considered replacing our revolving bank loan with longer term debt. In contemplation of this plan, we entered into two interest rate forward contracts indexed to the U.S. treasury rate. Due to market volatility at that time, we elected not to replace our revolving bank loan and the forward contracts were settled for a loss of $10.4 million in the second quarter, which resulted in the majority of the loss for the year ended December 31, 2010.
Nearly all of the decrease in fair value of the catastrophe bonds for the year ended December 31, 2011 was due to a $25.0 million loss on one catastrophe bond with exposure to the earthquake and tsunami in Japan. During the second quarter of 2011, we disposed of all remaining catastrophe bond holdings. At December 31, 2010, we had $47.2 million invested in catastrophe bonds, with a par value of $45.3 million. The increase in fair value of the catastrophe bonds was $0.4 million during the year ended December 31, 2010.
Our available for sale portfolio is recorded at fair value with unrealized gains and losses recorded in other comprehensive income as part of total shareholders’ equity. Our available for sale fixed maturities investment strategy is not intended to generate significant realized gains and losses as more fully discussed below in the Financial Condition section. Our held to maturity portfolio includes securities for which we have the ability and intent to hold to maturity or redemption, and is recorded at amortized cost. There should be no realized gains or losses related to this portfolio unless there is an other than temporary impairment loss. Our trading portfolio is recorded at fair value with unrealized gains and losses recorded in net income. Net realized and unrealized gains on our fixed maturities portfolios for the years ended December 31, 2011, 2010 and 2009 were $13.5 million, $11.0 million and $4.5 million, respectively.
We hold an available for sale portfolio, a trading portfolio and a held to maturity portfolio of fixed maturities securities. In an effort to match the expected cash flow requirements of our long-term liabilities, we invest a portion of our fixed maturity investments in long duration securities. Because we intend to hold a number of these long duration securities to maturity, we classify these securities as held to maturity in our consolidated balance sheet. This held to maturity portfolio is recorded at amortized cost. As a result, we do not record changes in the fair value of this portfolio, which should reduce the impact on shareholders’ equity of fluctuations in fair value of those investments.
We perform regular reviews of our fixed maturities portfolio and utilize a process that considers numerous indicators in order to identify investments that show signs of potential other than temporary impairments. The indicators include the issuer’s financial condition and ability to make future scheduled interest and principal payments, benchmark yield spreads, the nature of collateral or other credit support and significant economic events that have occurred that affect the industry in which the issuer participates.
We continue to monitor the ongoing uncertainty over the financial health of certain European governments and European financial institutions and our exposure to the credit risk of these investments. As of December 31, 2011, we hold European government securities with a fair value of $727.1 million, distributed as follows:
We hold no securities issued by the governments of Greece, Italy, Portugal or Spain.
Potential risks associated with sovereign debt of European Union member states and Euro denominated investments are discussed in “Item 1A - Risk Factors - The Financial crisis in Europe, including the threat of default on European sovereign debt, the devaluation of the Euro and the dissolution of the European Union, could adversely affect our results of operations, liquidity and financial condition.”
As described in Note 4 of our audited consolidated financial statements, our available for sale and trading fixed maturities investments and the majority of our other investments are carried at fair value.
The independent pricing services used by our investment custodians, investment accounting service provider and investment managers obtain actual transaction prices for securities that have quoted prices in active markets. Each pricing service has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing service uses observable market inputs including, but not limited to, reported trades, benchmark yields, broker/dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from market sources to determine a reasonable fair value. In addition, pricing services use valuation models, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage-backed and asset-backed securities. The ability to obtain quoted market prices is reduced in periods of decreasing liquidity, which generally increases the use of matrix pricing methods and the uncertainty surrounding the fair value estimates.
Certain funds in which we invest have a lock-up period. A lock-up period refers to the initial amount of time an investor is contractually required to invest before having the ability to redeem. Funds that provide for periodic redemptions may, depending on the funds’ governing documents, have the ability to deny or delay a redemption request, called a gate. The fund may implement this restriction because the aggregate amount of redemption requests as of a particular date exceeds a specified level, generally ranging from 15% to 25% of the fund’s net assets. The gate is a method for executing an orderly redemption process, which allows for redemption requests to be executed in a timely manner to reduce the possibility of adversely affecting the remaining investors in the fund.
Certain funds may be allowed to invest a portion of their assets in illiquid securities, such as private equity and convertible debt. In such cases, a common mechanism used is a side-pocket, whereby the illiquid security is assigned to a separate memorandum capital account or designated account. Typically, the investor loses its redemption rights to the designated account. Only when the illiquid security is sold, or otherwise deemed liquid by the fund, may investors redeem their interest. As of December 31, 2011, the fair value of our hedge funds held in side-pockets was $37.4 million.
Due to the uncertainty surrounding the timing of the redemption of the underlying assets within funds with gates and side-pockets, we have included these funds in the greater than 365 days category in the table below. If we requested full redemptions for all of our holdings in the funds, the table below indicates our best estimate of the earliest date from December 31, 2011 on which such redemptions might be received. This estimate is based on available information from the funds and is subject to significant change.
We also hold an index-linked structured deposit. The deposit has a guaranteed minimum redemption value of $24.3 million and a scheduled redemption date of December 18, 2013. The interest earned on the deposit is a function of the performance of the reference index over the term of the deposit.
Losses and benefits recoverable from reinsurers. Losses and benefits recoverable from reinsurers totaled $1,068.1 million as of December 31, 2011 compared to $956.1 million as of December 31, 2010, an increase of 11.7%. This increase resulted principally from recoveries on losses for the significant catastrophes during the year and additional losses ceded under our reinsurance and retrocessional agreements resulting from net earned premiums during the year ended December 31, 2011.
Losses recoverable from reinsurers on property and casualty business were $1,034.9 million and $921.0 million as of December 31, 2011 and December 31, 2010, respectively. Benefits recoverable from reinsurers on life and annuity business were $33.2 million and $35.1 million as of December 31, 2011 and December 31, 2010, respectively.
Senior notes. On September 27, 2010, Alterra Finance, a wholly-owned indirect subsidiary of Alterra, issued $350.0 million principal amount of 6.25% senior notes due September 30, 2020 with interest payable on March 30 and September 30 of each year. The 6.25% senior notes are Alterra Finance’s senior unsecured obligations and rank equally in right of payment with all of Alterra Finance’s future unsecured and unsubordinated indebtedness and rank senior to all of Alterra Finance’s future subordinated indebtedness. The 6.25% senior notes are fully and unconditionally guaranteed by Alterra on a senior unsecured basis. The guarantee ranks equally with all of Alterra’s existing and future unsecured and unsubordinated indebtedness and ranks senior to all of Alterra’s future subordinated indebtedness. The effective interest rate related to the 6.25% senior notes, based on the net proceeds received, was 6.37%. The proceeds, net of all issuance costs, from the sale of the 6.25% senior notes were $346.9 million and were used to repay a $200.0 million revolving bank loan outstanding under a credit facility, that was subsequently replaced in December of 2011, with the remainder to be used for general corporate purposes.
On April 16, 2007, Alterra USA privately issued $100.0 million principal amount of 7.20% senior notes due April 14, 2017 with interest payable on April 16 and October 16 of each year. The senior notes are Alterra USA’s senior unsecured obligations and rank equally in right of payment with all existing and future senior unsecured indebtedness of Alterra USA. The 7.20% senior notes are fully and unconditionally guaranteed by Alterra. Following repurchases of $8.5 million and $0.9 million principal amount in December 2008 and December 2009, respectively, the principal amount of the senior notes outstanding as of December 31, 2011 was $90.6 million. The net proceeds for the sale of the 7.20% senior notes were used to repay a bank loan used to acquire Alterra E&S.
Shareholders’ equity. Our shareholders’ equity decreased to $2,809.2 million as of December 31, 2011 from $2,918.3 million as of December 31, 2010, a decrease of 3.7%, principally due to the repurchase of $225.1 million of common shares and the declaration of dividends of $54.5 million, partially offset by net income of $65.3 million in the year ended December 31, 2011. In addition, we recorded an increase in accumulated other comprehensive income of $68.0 million, principally from an increase in net unrealized gains on investments.
As a holding company, Alterra’s principal asset is its investment in the common shares of its principal operating subsidiary, Alterra Bermuda. Alterra’s principal source of funds is from interest income on cash balances and cash dividends from its subsidiaries, including Alterra Bermuda. The payment of dividends by Alterra Bermuda is limited under Bermuda insurance laws. In particular, Alterra Bermuda may not declare or pay any dividends if it is in breach of its minimum solvency or liquidity levels under Bermuda law or if the declaration or payment of the dividends would cause it to fail to meet the minimum solvency or liquidity levels under Bermuda law. As of December 31, 2011, Alterra Bermuda met all minimum solvency and liquidity requirements. Alterra Bermuda returned $450.0 million of capital and surplus to Alterra during the year ended December 31, 2011 through dividends and distribution of additional paid-in capital. Alterra Re USA may not pay dividends without the consent of the Connecticut Insurance Commissioner until May 12, 2012.
Capital resources. As of December 31, 2011, total shareholders’ equity was $2,809.2 million compared to $2,918.3 million as of December 31, 2010, a decrease of 3.7%. On May 21, 2010, we filed a shelf registration statement on Form S-3 (File No. 333-167035) with the SEC that permits us to periodically issue debt securities, common shares, preferred shares, depository shares, warrants, share-purchase contracts and share purchase units. The shelf registration statement also covers debt securities of Alterra Finance and trust preferred securities of Alterra Capital Trust I.
In September of 2010, Alterra Finance issued $350.0 million principal amount of 6.25% senior notes due September 30, 2020 with interest payable on March 30 and September 30 of each year pursuant to the shelf registration statement. The senior notes are guaranteed by Alterra.
In April 2007, Alterra USA issued $100.0 million aggregate principal amount of 7.20% senior notes due April 14, 2017, of which $90.6 million principal amount was outstanding as of December 31, 2011. The senior notes are guaranteed by Alterra.
(a) Net realized and unrealized losses (gains) on non-hedge fund investments includes realized and unrealized (gains) losses on trading securities, realized (gains) losses on available for sale securities, net impairment losses recognized in earnings, income from equity method investments and change in fair value of investment derivatives, catastrophe bonds and structured deposits.
We believe that net operating income provides a better indication of management performance than net income as realized and unrealized gains and losses on fixed maturities may fluctuate from period to period and foreign exchange gains and losses are typically outside the control of management. Merger and acquisition expenses are not indicative of expenses fundamental to the business and may fluctuate from period to period. We believe that net operating return on average shareholders’ equity allows management to assess how the company has performed in terms of wealth generated for our shareholders.
Accounting Standards Update, or ASU, 2010-06 requires additional disclosure, and clarifies existing disclosure requirements, about fair value measurements. The additional requirements include disclosure regarding the amounts and reasons for significant transfers in and out of Level 1 and 2 of the fair value hierarchy and also separate presentation of purchases, sales, issuances and settlements of items measured using significant unobservable inputs (i.e. Level 3). The guidance clarifies existing disclosure requirements regarding the inputs and valuation techniques used to measure fair value for measurements that fall in either Level 2 or Level 3 of the hierarchy. The requirements are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements, which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. We have reflected the disclosure requirements effective for the current period in the consolidated financial statements and they did not have a material impact.
ASU 2010-20 requires additional disclosures about the credit quality of financing receivables and allowances for credit losses. The additional requirements include disclosure of the nature of credit risks inherent in financing receivables, how credit risk is analyzed and assessed when determining the allowance for credit losses, and the reasons for the change in the allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. We have reflected the disclosure requirements effective for the current period in the consolidated financial statements and they have not had a material impact.
ASU 2011-05 requires companies to present the components of net income and other comprehensive income in either a single continuous statement or two separate but consecutive statements. This eliminates the option to report other comprehensive income and its components in the statement of changes in shareholders’ equity. Companies are also required to present reclassification adjustments from other comprehensive income to net income on the face of the financial statements. ASU 2011-05 is effective for fiscal periods beginning on or after December 15, 2011 with early adoption permitted. The requirement to present reclassification adjustments on the face of the financial statements has been deferred and no effective date has been determined. We do not expect this standard to have a material impact on our consolidated financial statements.