The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes included on pages through of this Form 10-K and “Note on Forward-Looking Statements” on page 1 of this Form 10-K. Our consolidated financial statements have been prepared in accordance with U.S. GAAP.
We believe that the current adverse conditions in the financial markets have made debt and equity capital either unavailable or significantly more expensive to access than in the recent past. Since reinsurance can serve primary insurers as a replacement of dedicated capital, we believe demand for reinsurance will increase. We also believe that some reinsurers have been negatively impacted by the current adverse conditions in the financial markets and 2008 hurricane losses to such an extent that they may be reluctant to deploy their capacity without appropriate rate increases. We believe that these factors have begun to affect reinsurance market conditions positively. At January 1, 2009 rate adequacy stabilized or improved in most classes. We believe that these conditions may lead to further rate strengthening during 2009, particularly with respect to property and marine business.
For the Casualty segment, we believe that the market offers adequate returns on certain accounts and that pricing has been stabilizing. We believe that financial security is a significant concern for buyers of long-tailed reinsurance protection who typically seek reinsurers with strong balance sheets, quality ratings, and a proven claims-paying record. We believe that our rating, capitalization and reputation as a lead casualty reinsurer position us well to write profitable business as opportunities arise.
We found relatively more attractive opportunities in our Property and Marine segment and relatively fewer attractive opportunities in our Casualty segment. Therefore, Property and Marine business may represent a larger proportion of our overall book of business in future periods, which could increase the volatility of our results of operations.
Due to the nature of reinsurance, ceding companies routinely report and remit premiums subsequent to the contract coverage period. Consequently, reinsurance premiums written include amounts reported by the ceding companies, supplemented by estimates of premiums that are written but not reported ("WBNR"). The premium estimation process considers the terms and conditions of the reinsurance contracts and assumes that the contracts will remain in force until expiration. The estimation of written premiums could be affected by early cancellation, election of contract provisions for cut-off and return of unearned premiums or other contract disruptions. In addition to estimating WBNR, we estimate the portion of premiums earned but not reported ("EBNR"). The potential net impact on the results of operations of changes in estimated premiums earned is reduced by the accrual of losses and acquisition expenses related to such estimated premiums earned. The time lag involved in the process of reporting premiums is shorter than the lag in reporting losses. Premiums are generally reported within two years.
Premiums receivable include premiums billed and in the course of collection as well as WBNR. WBNR is the component of premiums receivable that is subject to judgment and uncertainty. Premiums receivable as of December 31, 2008 of $307,539,000 included $269,714,000 of WBNR that is based upon estimates. We evaluate the appropriateness of WBNR in light of the actual premium reported by the ceding companies. Any adjustments to WBNR and EBNR that represent premiums earned are accounted for as changes in estimates and are reflected in results of operations in the period in which they are made.
When estimating premiums written and earned, we segregate the business into classes by reinsurance subsidiary, by type of coverage and by type of contract (resulting in approximately 133 classes). Within each class, business is further segregated by the year in which the contract incepted (the “Underwriting Year”), starting with 2002. Classes that are similar in both their natures of business and estimation processes may be grouped for purposes of estimating premiums. Estimates are made for each class or group of classes and Underwriting Year. Premiums are estimated based on ceding company estimates and our own judgment after considering factors such as: (1) the ceding company’s historical premium versus projected premium, (2) the ceding company’s history of providing accurate estimates, (3) anticipated changes in the marketplace and the ceding company’s competitive position therein, (4) reported premiums to date and (5) the anticipated impact of proposed underwriting changes. Estimates of ultimate premium are made by our underwriters for each contract and Underwriting Year. Management reviews these estimates with our underwriters and actuaries and selects an ultimate premium estimate. Estimates of written premium and earned premium are then based on the selected ultimate premium estimate and the structure of the reinsurance contracts. The WBNR and EBNR are determined by subtracting the written and earned premium reported by the ceding companies from the estimated written and earned premium. As of December 31, 2008 WBNR was $269,714,000 and EBNR was $238,345,000. The selected estimates of WBNR and EBNR were lower than the initial estimates made by our underwriters by $29,803,000 or 11%, and $20,109,000 or 8%, respectively. We believe that we reasonably could have made an adjustment of between $0 and $29,803,000 for WBNR and between $0 and $20,109,000 for EBNR. Key factors that were considered by management in selecting premium estimates lower than the estimates provided by our underwriters include: (1) the increased competition and lower rate level in classes of business with little or no North American catastrophe exposure that make it difficult for ceding companies to achieve their premium targets, and (2) the lack of a historical track record for some ceding companies writing new programs. The actual premium ultimately recorded may differ materially from the estimates discussed above.
Estimated premiums receivable at December 31, 2008 was higher than at December 31, 2007 due to an increase in North American crop business written in 2008 as compared with 2007. Premiums from North American crop business are generally settled in the year following when they are underwritten and, therefore, estimated premiums equal to written premiums are established for the current year.
An allowance for uncollectible premiums is established for possible non-payment of premiums receivable, as deemed necessary. As of December 31, 2008, based on our historical experience, the general profile of our ceding companies and our ability in most cases to contractually offset premium receivables against losses and LAE or other amounts payable to the same parties, we did not establish an allowance for uncollectible premiums receivable.
One of the most significant estimates made by management in the preparation of our financial statements is our liability for unpaid losses and LAE, also referred to as “loss reserves.” Unpaid losses and LAE are estimates of future amounts required to pay losses and LAE for reinsured claims for which we are liable and that have occurred at or before the balance sheet date. Unpaid losses and LAE include estimates of the cost of claims incurred that were reported but not yet paid, generally referred to as “case reserves.” Unpaid losses and LAE also includes estimates of the cost of claims incurred but not yet reported, generally referred to as “IBNR.”
Our actuaries prepare estimates of our ultimate liability for unpaid losses and LAE based on various actuarial methods including the loss ratio method, the Bornhuetter-Ferguson method and the chain ladder method, which are discussed below. We believe that the quantitative actuarial methods used to estimate our liabilities are enhanced by management’s professional judgment. We review the actuarial estimates of our liability and determine our best estimate of the liabilities to record as unpaid losses and LAE in our consolidated financial statements. We use the same processes and procedures for estimating losses for annual and interim periods.
The liabilities recorded on our consolidated balance sheets as of December 31, 2008 and 2007 for unpaid losses and LAE were $2,463,506,000 and $2,361,038,000, respectively. These amounts exclude any future recoveries from our retrocessionaires for coverage we purchased. The following table sets forth a breakdown between case reserves, additional case reserves and IBNR by segment as of December 31, 2008 and 2007 ($ in thousands):
Since we rely on information regarding paid losses, case reserves and sometimes IBNR provided by ceding companies in order to assist us in estimating our ultimate liability for unpaid losses and LAE, we perform certain procedures in order to help determine the completeness and accuracy of such information. Periodically, management assesses the reporting activities of these companies on the basis of qualitative and quantitative criteria. These procedures include conferring with ceding companies or brokers on claims matters. Our claims personnel may also conduct periodic audits of our ceding companies to: (1) review and establish validity of specific claims, (2) determine that case reserves established by the ceding company are reasonable, (3) that there is consistency in claim reporting from period to period, and (4) assess the overall claims practices and procedures of the ceding company. We also monitor the claims handling and reserving practices of ceding companies in order to help establish the proper reinsurance premium for reinsurance agreements.
Our actuaries calculate multiple point estimates of our liability for losses and LAE using a variety of actuarial methods for many, but not all, of our classes for each Underwriting Year. We do not believe that these multiple point estimates are or should be considered a range. Our actuaries consider each class and determine the most appropriate point estimate for each Underwriting Year based on the characteristics of the particular class including: (1) the expected percentage of reported losses derived from the loss development patterns, (2) the credibility of the selected loss development pattern, (3) the stability of the loss development patterns, and (4) the observed loss development of other underwriting years for the same class. Our actuaries consider other relevant factors, including: (1) historical ultimate loss ratios, (2) the presence of individual large losses and (3) known occurrences that have not yet resulted in reported losses.
We believe that a review of individual contract information improves the loss estimates for some classes of business. For example, individual contract review is particularly important for classes of business within the Finite Risk segment and for the accident and health class within the Casualty segment. Our actuaries make their determinations of the most appropriate point estimate loss for each class based on an evaluation of relevant information and do not ascribe any particular portion of the estimate to a particular factor or consideration. These estimates are aggregated for review by management and, after approval, are the basis for our liability for unpaid losses and LAE.
While we commenced operations in 2002, the business we write is sufficiently similar to the historical reinsurance business of St. Paul Re such that we review the historical loss experience of this business when we estimate our own initial expected ultimate losses and the expected patterns of reported losses. The historical loss experience of St. Paul Re is updated quarterly by St. Paul Re and is available to us. These patterns can span more than a decade and, given our own relatively limited history, the availability of the St. Paul Re data is a valuable supplement to our own and industry data. Patterns of reported losses are determined utilizing actuarial analysis, including management’s judgment, and are based on historical patterns of paid losses and reporting of case reserves to us, as well as industry patterns. Information that may cause future patterns of reported losses to differ from historical patterns of reported losses is considered and reflected in expected patterns as appropriate. A key assumption is that past patterns of reported losses are reasonably predictive of future patterns of reported losses. It is often difficult to identify differences in business reinsured from Underwriting Year to Underwriting Year and how such differences can affect loss development patterns. This difficulty adds to uncertainty in estimates that use these patterns. For property and health coverages these patterns indicate that a substantial portion of the ultimate losses are reported within two to three years after the contract is effective. Casualty patterns of reported losses can vary from three years to over twenty years depending on the type of business.
In the North American casualty excess of loss classes, the expected patterns of reported losses are primarily based on our historical reported loss data and that of St. Paul Re, both of which are supplemented by industry data from the Reinsurance Association of America (“RAA”) and Insurance Services Offices, Inc. (“ISO”). Due to the long reporting pattern in general liability, various sources are used to estimate the end of the reporting pattern referred to as the “tail”. To estimate the tail we supplement our historical data and that of St. Paul Re available to us, with industry data, generally from the RAA.
We analyze historical patterns of reported losses and may adjust them for observed anomalies. For example, we observed that patterns of reported losses were much slower in Underwriting Years that were characterized by especially intense competition, known as the “soft market”, particularly in the North American excess-of-loss claims made class. We believe this is due to multiple year policies written by ceding companies and the deterioration in underwriting standards during these periods. In determining our patterns of reported losses for certain classes we may exclude certain historical data from the soft market years as none of our business was written in these soft market periods. One of the risks of excluding some of the years is that we could be obscuring trends in patterns of reported losses. Our actuaries consider this when determining the credibility of indications that use these patterns. For a small number of reinsurance contracts appropriate historical patterns of reported losses must be developed from ceding company data or other sources.
Generally, an event must cause more than $1 billion of property losses to the insurance industry or $10 million of property losses to the Company to be considered and tracked as a major catastrophe. Unpaid losses and LAE related to major catastrophes total $218,335,000 which represents 9% of our total unpaid losses and LAE as of December 31, 2008.
The process of estimating ultimate losses for primary insurance business is not precise due to the inherent uncertainty of future developments. Primary insurers must estimate their own losses, often based on incomplete and changing information. The estimation process for reinsurance business introduces further uncertainties compared with reserving for primary insurance business. There are numerous factors that add uncertainty to our estimates of losses, the more significant of which include: (1) our estimates are based on predictions of future developments and estimates of future trends in claim severity and frequency, (2) the reliance that we necessarily place on ceding companies for claims reporting, (3) the associated time lag in reporting losses, (4) the low frequency/high severity nature of some of the business that we underwrite, and (5) the varying reserving practices among ceding companies. The time lag in reporting can be several years in some cases and may be attributed to a number of reasons, including the time it takes to investigate a claim, delays associated with the litigation process, and the deterioration in a claimant’s physical condition many years after an accident occurs. As a predominantly broker market reinsurer for both excess-of-loss and proportional contracts, we are subject to a potential additional time lag in the receipt of information as the primary insurer reports to the broker who in turn reports to us. As of December 31, 2008, we did not have any significant back-log related to our processing of assumed reinsurance information. In the reserving process, we assume that time lags in reporting are predictable over time and therefore the lags are contemplated in the loss reporting patterns used in our actuarial methods. Ceding company reserving practices can vary and our actuaries consider this when determining the credibility of indications that use this information.
Uncertainty of estimates also results from significant variations in the patterns of paid and reported losses from event to event. In the table below, the paid and reported losses are shown as a percentage of the current estimated ultimate loss for Hurricane Ike in 2008, our most significant catastrophe in 2008, and compared with losses from catastrophe events of 2004 and 2005 at nearly similar points of their respective development:
Paid losses for Hurricane Ike are a higher percentage of estimated ultimate loss than for the 2004 and 2005 Hurricanes at similar points of their respective development. This reflects the advance payments on certain large catastrophe covers for Hurricane Ike. Reported losses for Hurricane Ike are a lower percentage of estimated ultimate loss than for the 2004 and 2005 Hurricanes at similar points of their respective development. While we review this type of data to help us determine the reasonableness of our estimate of ultimate loss we recognize that the pattern of paid and reported losses varies significantly by event.
In order to limit the effect on our financial condition of large and multiple losses, we may buy retrocessional reinsurance, which is reinsurance for our own account. Reinsurance recoverable, also referred to as “ceded loss reserves”, includes estimates of the recoveries from our retrocessional reinsurance that arise from claims from our reinsurance business. These assets are estimates of future amounts recoverable from retrocessionaires for claims that have occurred at or before the balance sheet date. Each quarter, after estimating the amount of gross loss reserves, our actuaries review all retrocessional contracts. Based on the structure of each retrocessional contract and the gross incurred loss, a recovery amount is estimated.
Fixed maturity securities for which we may not have the positive intent to hold until maturity are classified as available-for-sale and reported at fair value, with unrealized gains and losses excluded from net income and reported in other comprehensive income as a separate component of shareholders' equity, net of deferred taxes. Fixed maturity securities for which we have the intent to sell prior to maturity or for which we have elected the fair value measurement attributes of SFAS 159 are classified as trading securities and reported at fair value, with mark-to-market adjustments included in net realized investment gains or losses in the consolidated statement of operations and the related deferred income tax included in income tax expense.
The fair value of our fixed maturity securities, preferred stocks, short-term investments and debt obligations are based on prices obtained from independent sources for those or similar investments using quoted prices in active markets and standard market valuation pricing models. The inputs used in index pricing may include but are not limited to: benchmark yields, transactional data, broker-dealer quotes, security cash flows and structures, credit ratings, prepayment speeds, loss severities, credit risks and default rates. Standard inputs used by pricing vendors may include but are not limited to: benchmark yields, reported trades, broker-dealer quotes, issuer spreads, bids, offers and industry and economic events. Broker-dealers value securities through trading desks primarily based on observable inputs. Our derivative instruments, which are included in other liabilities in the consolidated balance sheet, are priced at fair value primarily using unobservable inputs through the application of our own assumptions and internal valuation pricing models.
We routinely review our available-for-sale investments to determine whether unrealized losses represent temporary changes in fair value or were the result of “other-than-temporary impairments.” The process of determining whether a security is other than temporarily impaired is subjective and involves analyzing many factors. These factors include but are not limited to: the overall financial condition of the issuer, the length and magnitude of an unrealized loss, specific credit events, the collateral structure and credit support that may be applicable to asset-backed and mortgage-backed securities. We also consider the projected cash flows of asset-backed and mortgage-backed securities as well as a sensitivity analysis of the variables that may result in a loss to us. We also consider our ability and intent to hold a security for a sufficient period of time for the value to recover the unrealized loss, which is based, in part, on current and anticipated future positive net cash flows from operations that generate sufficient liquidity in order to meet our obligations. If we determine that an unrealized loss on a security is other than temporary, we write down the carrying value of the security and record a realized loss in net realized investment gains or losses in the consolidated statement of operations in the period during which the write down occurred.
The decrease in net income in 2008 as compared to 2007 was primarily due to a decrease in net underwriting income of $132,855,000 and a decrease in net investment income of $27,648,000. These decreases were offset by a favorable change in net realized investment gains (losses) of $27,790,000. Net underwriting income consists of net premiums earned, less net losses and LAE, net acquisition expenses and operating costs related to underwriting operations.
Diluted earnings per common share decreased due primarily to the decrease in net income. Diluted earnings per common share was also favorably impacted by the decrease in weighted average shares outstanding. The weighted average shares outstanding decreased as a result of repurchasing 7,763,000 and 6,935,000 common shares during 2008 and 2007, respectively.
The net favorable loss development related to prior years emerged from all segments and was related to both catastrophe and non-catastrophe losses. The most significant portion of net favorable development was in the Property and Marine segment and certain classes in the Casualty segment. Actual reported losses in these classes were significantly less than expected and gained sufficient credibility in the current period to reduce estimated ultimate losses. We do not believe that the net favorable loss development experienced in 2008 is indicative of prospective net development of unpaid losses and LAE as of December 31, 2008 because conditions and trends that affected the net favorable development of prior years’ unpaid losses and LAE may not necessarily exist in the future.
We conduct our worldwide reinsurance business through three operating segments: Property and Marine, Casualty and Finite Risk. In managing our operating segments, management uses measures such as underwriting income and underwriting ratios to evaluate segment performance. We do not allocate assets or certain income and expenses such as investment income, interest expense and certain corporate expenses by segment. Segment underwriting income is reconciled to the U.S. GAAP measure of income before income taxes in Note 13 to the Consolidated Financial Statements contained elsewhere in this Form 10-K. The measures we used in evaluating our operating segments should not be used as a substitute for measures determined under U.S. GAAP.
Other underwriting expenses for the years ended December 31, 2008 and 2007 were $38,492,000 and $42,422,000, respectively. The decrease in 2008 as compared with 2007 was primarily due to a decrease in performance based compensation accruals in 2008 and the expiration on September 30, 2007 of the RenRe Agreement. In 2007, we incurred fees of $7,787,000 pursuant to the RenRe Agreement. Partially offsetting these decreases in 2008 were $4,339,000 of fees and expenses related to a derivative contract we entered into with Topiary Capital Limited (“Topiary”) that provides us with catastrophe loss protection. See “Financial Condition, Liquidity and Capital Resources” for additional discussion of Topiary.
The Casualty operating segment generated 41.5% and 52.2% of our net premiums written for the years ended December 31, 2008 and 2007, respectively. The following table summarizes underwriting activity and ratios for the Casualty segment for the years ended December 31, 2008 and 2007 ($ in thousands):
The decrease in net premiums written in 2008 as compared with 2007 was primarily due to decreases in business underwritten in 2007 and 2008 across most North American casualty classes, with the most significant decreases in the umbrella, occurrence based excess-of-loss and accident and health classes. The decreases were the result of fewer opportunities that met our underwriting standards. The decrease in net premiums earned was the result of the decrease in net premiums written. Net premiums written and earned were also affected by changes in the mix of business and the structure of the underlying reinsurance contracts.
The decrease in net acquisition expenses in 2008 as compared with 2007 was due to the decrease in net premiums earned. The increase in the net acquisition expense ratio in 2008 as compared with 2007 was due, in part, to differences in commissions relating to prior years and to deteriorating terms and conditions that have generally resulted in higher commission and brokerage rates. Net acquisition expenses in 2008 included an increase in commissions relating to prior years of $4,770,000, representing 0.9% of net premiums earned as compared with a decrease of $4,912,000 in 2007, representing 0.8% of net premiums earned. Net acquisition expense ratios were also impacted by changes in the mix of business.
Other underwriting expenses for the years ended December 31, 2008 and 2007 were $23,982,000 and $29,194,000, respectively. The decrease in other underwriting expenses in 2008 as compared with 2007 was primarily due to a decrease in performance based compensation accruals allocated to the segment.
The Finite Risk segment generated 1.4% and 2.7% of our net premiums written for the years ended December 31, 2008 and 2007, respectively. Due to the often significant inverse relationship between losses and commissions for this segment, we believe it is important to evaluate the overall combined ratio, rather than its component parts of net loss and LAE ratio and net acquisition expense ratio. The following table summarizes underwriting activity and ratios for the Finite Risk segment for the years ended December 31, 2008 and 2007 ($ in thousands):
The decrease in net losses, LAE and acquisition expenses in 2008 as compared with 2007 was primarily due to the decrease in net premiums earned. The increase in the net loss, LAE and acquisition expense ratio was primarily due to the decrease in net favorable development in 2008 as compared with 2007. Net favorable development was $412,000 and $6,658,000 in 2008 and 2007, respectively. Net favorable development and premium adjustments related to prior years’ losses decreased the net loss and LAE ratios in 2008 and 2007 by 3.4 points and 20.5 points, respectively. Net favorable development in 2008 included $20,220,000 of net favorable loss development resulting in negative losses and LAE in 2008. The net favorable loss development was substantially offset by increased acquisition expenses also relating to prior years. Exclusive of net favorable development, the decrease in the net loss, LAE and acquisition expense ratio is the result of the expiration of a contract that experienced greater than expected loss activity in 2007 and the recognition of premiums relating to prior years for which there were no related losses.
Other underwriting expenses for the years ended December 31, 2008 and 2007 were $1,270,000 and $2,696,000, respectively. The decrease in other underwriting expenses in 2008 as compared with 2007 was due to a decline in underwriting activity in the segment and a lower percentage of underwriting expenses allocated to the segment.
Net investment income for the years ended December 31, 2008 and 2007 was $186,574,000 and $214,222,000, respectively. Net investment income decreased in 2008 as compared with 2007 primarily due to a decrease in yields on invested assets and cash and cash equivalents. Net investment income included interest earned on funds held of $3,476,000 and $5,279,000 in 2008 and 2007, respectively. Interest on funds held relates primarily to business in the Finite Risk segment which has declined over the past several years.
We sold approximately $207,305,000 of corporate bonds and cash equivalents issued by financial institutions resulting in a net loss on the sale of investments of $4,225,000. We also sold positions in U.S. treasuries, U.S. agency debt, and U.S. agency residential mortgage-backed securities that resulted in net gains on the sale of investments of $52,046,000. The mark-to-market adjustments on trading securities in 2008 were comprised of $8,433,000 of changes in the fair value of non-U.S. dollar denominated securities and $1,249,000 of changes in the fair value of U.S. treasury inflation-protected securities (“TIPS”). The non-U.S. dollar denominated securities in our trading portfolio included primarily European government and U.K. government bonds whose yields decreased resulting in an increase in fair value. Net investment gains (losses) also include charges for other-than-temporary impairment of investments. The other-than-temporary impairments we recorded during 2008 included $10,891,000 of non-agency residential mortgage-backed securities, $7,636,000 of corporate bonds, $6,512,000 of Alt-A residential mortgage-backed securities and subprime asset-backed securities, and $5,647,000 of perpetual preferred stocks.
Operating expenses for the years ended December 31, 2008 and 2007 were $88,208,000 and $103,593,000, respectively. Operating expenses include costs such as salaries, rent and like items. The decrease in 2008 as compared with 2007 was due, in part, to the expiration of the RenRe Agreement on September 30, 2007. In 2007, we incurred fees of $7,787,000 pursuant to the RenRe Agreement. Also contributing to this decrease was a decrease in performance based compensation in 2008 of $8,545,000 as compared with 2007. Offsetting these decreases were one-time fees and expenses of $4,339,000 related to a derivative agreement with Topiary.
Net foreign currency exchange losses for the year ended December 31, 2008 were $6,760,000 compared to net foreign currency exchange gains of $2,775,000 for the year ended December 31, 2007. We routinely transact business in currencies other than the U.S. dollar. The net foreign currency exchange losses in 2008 were the result of us holding more non-U.S. dollar denominated assets than non-U.S. dollar denominated liabilities, primarily the Euro and the British pound sterling, as the U.S. dollar strengthened against these currencies.
Net underwriting income in 2007 included the net adverse impact of $38,721,000 from several major catastrophes, the most significant being $27,368,000 from European windstorm Kyrill and $8,453,000 from floods in the United Kingdom. In 2006, the net adverse impact of major catastrophes was $5,155,000. Gross premiums written in 2007 decreased as compared with 2006 due primarily to decreases in gross premiums written across most classes in the Casualty segment, reflecting fewer opportunities that met our underwriting standards. Partially offsetting the decrease in casualty gross written premiums was an increase in property catastrophe gross written premiums. Net losses and LAE decreased in 2007 as compared to 2006 due primarily to the decrease in net premiums earned. Net favorable development also contributed to underwriting income in both 2007 and 2006. Net favorable development was $77,806,000 and $55,768,000 in 2007 and 2006, respectively.
The Property and Marine operating segment generated 45.1% and 36.1% of our net premiums written in 2007 and 2006, respectively. The following table summarizes underwriting activity and ratios for the Property and Marine segment for the years ended December 31, 2007, and 2006 ($ in thousands):
The increases in the net losses and LAE and related ratios in 2007 as compared with 2006 were due to the increase in catastrophe losses as well as to less net favorable loss development. Net losses in 2007 included major catastrophe losses of $44,585,000 in 2007, which, with related premium adjustments, increased the net loss and LAE ratio by 8.5 points, as compared with major catastrophe losses of $5,536,000 in 2006, which, with premium adjustments, increased the net loss and LAE ratio by 1.2 points. Major catastrophe losses in 2007 included $32,804,000 from European windstorm Kyrill and $8,881,000 from floods in the United Kingdom. Net favorable loss development and premium adjustments related to prior years’ losses decreased the net loss and LAE ratios in 2007 and 2006 by 9.7 points and 12.2 points, respectively. Exclusive of the major catastrophe losses and net favorable loss development, the net loss and LAE ratio decreased by approximately 3.3 points in 2007 as compared to 2006 due to the increase in the proportion of catastrophe excess business which, because of the low level of catastrophes, had a lower net loss and LAE ratio than the remainder of the segment. The net loss and LAE ratios were also affected by other changes in the mix of business.
The decreases in net acquisition expenses and the net acquisition expense ratio in 2007 as compared with 2006 were primarily due to the continued decrease in property proportional business and an increase in property catastrophe excess business, which had a lower net acquisition expense ratio than property proportional business. Net acquisition expenses included increases in adjustable commissions of $1,677,000 in 2007, representing 0.3% of net premiums earned, related to favorable net loss development from prior years as compared with increases of $3,067,000 in 2006, representing 0.7% of net premiums earned. The net acquisition expense ratios were also impacted by other changes in the mix of business.
The Casualty operating segment generated 52.2% and 64.4% of our net premiums written for the years ended December 31, 2007 and 2006, respectively. The following table summarizes underwriting activity and ratios for the Casualty segment for the years ended December 31, 2007, and 2006 ($ in thousands):
The decrease in net premiums written in 2007 as compared with 2006 was primarily due to decreases in business underwritten in 2007 and 2006 across most North American casualty classes, with the most significant decreases in the umbrella, occurrence based excess-of-loss and first dollar general liability classes. The decreases were the result of fewer opportunities that met our underwriting standards. The decrease in net premiums written in 2007 as compared with 2006 was also due to increases in estimates of net written premiums in 2006 of $68,937,000 in the North American excess casualty classes related to business written in prior underwriting years. Net premiums earned decreased in 2007 as compared with 2006 due to the declines in net premiums written in 2007 and 2006. Net premiums written and earned were also affected by changes in the mix of business and the structure of the underlying reinsurance contracts.
The decrease in net losses and LAE in 2007 as compared with 2006 was primarily due to the decrease in net premiums earned, partially offset by an increase in the net loss and LAE ratio. The increase in the net loss and LAE ratio in 2007 as compared with 2006 was due to higher initial expected loss ratios in certain significant classes reflecting a decline in price adequacy. The net loss and LAE ratio in 2007 compared with 2006 was also affected by the changes in the mix of business within the segment toward contracts with higher loss and LAE ratios and lower acquisition expense ratios. Net losses and LAE included net favorable loss development of approximately $19,474,000 in 2007, which, inclusive of related premium adjustments, decreased the net loss and LAE ratio by 3.1 points, compared with $9,424,000 of net favorable loss development in 2006, which, inclusive of related premium adjustments, decreased the net loss and loss expense ratio by 1.2 points. Net favorable loss development in 2007 included $15,474,000 from certain long-tailed casualty classes with the remaining net favorable loss development from casualty classes with short loss development periods. The net loss and LAE ratio was also affected by the changes in the mix of business within the segment.
The Finite Risk segment generated 2.7% and (0.5%) of our net premiums written for the years ended December 31, 2007, and 2006, respectively. The following table summarizes underwriting activity and ratios for the Finite Risk segment for the years ended December 31, 2007 and 2006 ($ in thousands):
The decrease in net losses, LAE and acquisition expenses in 2007 as compared with 2006 were primarily due to the decrease in net premiums earned. The decrease in the net loss, LAE and acquisition expense ratio was primarily due to the difference in net favorable development from prior years. Net favorable development was $6,658,000 in 2007 as compared with net unfavorable development of approximately $2,531,000 in 2006. Net favorable development and premium adjustments related to prior years’ losses decreased the net loss, LAE and acquisition expense ratios in 2007 by 20.4 points, while net unfavorable development increased the net loss, LAE and acquisition expense ratios in 2007 by 1.0 points. Also contributing to the decrease in the net loss, LAE and acquisition ratio in 2007 was the expiration of a significant finite casualty proportional contract that had a higher combined ratio than the remainder of the Finite Risk segment.
Other underwriting expenses for the years ended December 31, 2007 and 2006 were $2,696,000 and $4,387,000, respectively. The decrease in other underwriting expenses was due to the allocation of a greater percentage of direct and common operating costs to the other two segments due to a decline in underwriting activity in the Finite Risk segment.
Net investment income for the years ended December 31, 2007 and 2006 was $214,222,000 and $187,987,000, respectively. Net investment income increased in 2007 as compared with 2006 primarily due to increased invested assets as well as a slight increase in yields on invested assets. The increase in invested assets was attributable to positive net cash flows provided by operations excluding trading securities activities, which was $491,483,000 in 2007. Positive net cash flows provided by operations were partially offset by $240,672,000 of common share repurchases during 2007. Net investment income included interest earned on funds held of $5,279,000 and $7,998,000 in 2007 and 2006, respectively. Interest on funds held relates primarily to business in the Finite Risk segment which has declined over the past several years.
Net realized investment losses were $1,222,000 and $1,131,000 in 2007 and 2006, respectively. Net losses on the sale of investments were $1,806,000 and $1,090,000 in 2007 and 2006, respectively. The mark-to-market adjustments on trading securities were a gain of $1,393,000 in 2007 and a loss of $2,221,000 in 2006. Net realized investment gains (losses) also include charges for other-than-temporary impairment of investments. The other-than-temporary impairments we recorded during 2007 included $809,000 of preferred stocks.
Interest expense for the years ended December 31, 2007 and 2006 was $21,470,000 and $21,805,000, respectively, and was primarily related to our Series B Notes. Interest expense also included interest related to $42,840,000 of Senior Notes. Interest expense in 2007 was less than interest expense in 2006 as Platinum Finance repaid the outstanding $42,840,000 of the Senior Notes when they came due in November 2007.
Income taxes and the effective tax rate for the years ended December 31, 2007 and 2006 were as follows ($ in thousands):
The decrease in income tax expense was due to the decrease in the effective income tax rate in 2007 as compared with 2006. The effective tax rate in any given year is based on income before tax expense of our subsidiaries that operate in several jurisdictions with varying corporate income tax rates. Platinum Holdings and Platinum Bermuda are not subject to corporate income tax. The decrease in the effective income tax rate was the result of a greater portion of income before income tax expense in 2007 than in 2006 being generated by Platinum Holdings and Platinum Bermuda, which are not subject to corporate income tax. In 2007, the combined income before income taxes derived from Platinum Holdings and Platinum Bermuda was 79.8%, as compared to 73.1% in 2006.
On a consolidated basis, our aggregate cash and invested assets totaled $4,259,939,000 at December 31, 2008 as compared with $4,461,503,000 at December 31, 2007. Our fixed maturity securities are primarily composed of diversified, high quality, predominantly publicly-traded fixed maturity securities. The investment portfolio, excluding cash and cash equivalents and short term investments, had a duration of 3.2 years as of December 31, 2008.
The primary objective of our investment strategy is to generate investment income by maintaining a portfolio that consists primarily of diversified, high quality, predominantly publicly traded fixed maturity securities. We maintain investment guidelines that contain limits on the portion of the portfolio that may be invested in the securities of any single issue or issuer, with the exception of U.S. government securities, and provide that financial futures and options and foreign exchange contracts may not be used in a speculative manner but may be used only as part of a defensive hedging strategy. We do not invest in instruments such as credit default swaps or collateralized debt obligations. As of December 31, 2008, we did not hold any common equities in our investment portfolio. In October 2008 our board of directors authorized investments in common equities up to a maximum of 10% of the investment portfolio.
As of December 31, 2008, the fair value of our available-for-sale securities was $3,066,649,000 with a net unrealized loss of $204,009,000. The following table sets forth the fair values, net unrealized gain (loss) and average credit quality of our fixed maturity securities December 31, 2008 ($ in thousands):
Platinum Holdings is a holding company, the assets of which consist primarily of shares of its subsidiaries. Platinum Holdings depends primarily on its available cash resources and liquid investments, and dividends, interest and other distributions from its subsidiaries, to make payments, including operating expenses, debt service obligations, dividends on its common shares and repurchases of its securities. Applicable laws and statutory requirements of the jurisdictions in which our regulated reinsurance subsidiaries operate, including Bermuda, the United States and the United Kingdom, limit the payment of dividends and other distributions from these subsidiaries. Based on the regulatory restrictions of the applicable jurisdictions, we estimate the maximum amount available for payment of dividends or other distributions by our reinsurance subsidiaries without prior regulatory approval in 2009 to be $386,380,000. The ability of our reinsurance subsidiaries to pay dividends is also constrained by our dependence on the financial strength ratings of our reinsurance subsidiaries by A.M. Best, which depend to a large extent on the capitalization levels of reinsurance subsidiaries. We believe that Platinum Holdings has sufficient cash resources and available dividend capacity to service its current outstanding obligations. Platinum Holdings received dividends from its subsidiaries of $305,000,000 during the year ended December 31, 2008.
At December 31, 2008, our capital of $2,059,397,000 consisted of $250,000,000 of Series B Notes, representing 12.1% of the total, $167,509,000 of preferred share equity, representing 8.1% of the total, and common shareholders’ equity of $1,641,888,000, representing the balance. At December 31, 2007, our capital of $2,248,377,000 consisted of $250,000,000 of Series B Notes, $167,509,000 of preferred share equity, and common shareholders’ equity of $1,830,868,000. The decrease in capital during 2008 was primarily attributable to share repurchase activity and an after-tax decrease in the fair value of our investment portfolio, partially offset by net income during the period.
We monitor our capital adequacy on a regular basis and seek to adjust our capital according to the needs of our business. In particular, we require capital sufficient to meet or exceed (i) the surplus requirements established by our ceding companies, (ii) the capital adequacy ratios established by rating agencies for maintenance of appropriate financial strength ratings, and (iii) the capital adequacy tests performed by regulatory bodies. We actively manage our capital and may seek to raise additional capital or return capital to our shareholders through share repurchases and cash dividends (or a combination of such methods).
Platinum Finance has outstanding $250,000,000 aggregate principal amount of Series B Notes due June 1, 2017, unconditionally guaranteed by Platinum Holdings. Interest at a rate of 7.5% per annum is payable on the Series B Notes on each June 1 and December 1. Platinum Finance may redeem the Series B Notes, at its option, at any time in whole, or from time to time in part, prior to maturity. The Series B Notes can be redeemed by us prior to maturity subject to a “make-whole” provision. We have no current expectations of calling the Series B Notes prior to maturity.
As of December 31, 2008, we held investments with a carrying value of $78,840,000 and cash and cash equivalents of $57,624,000 in trust to collateralize obligations under the Quota Share Retrocession Agreements. In addition, as of December 31, 2008 we held investments with a carrying value of $76,602,000 and cash and cash equivalents of $167,195,000 in trust to collateralize obligations under various other reinsurance contracts. We held investments with a carrying value of $140,312,000 and cash and cash equivalents of $83,384,000 as of December 31, 2008 to collateralize letters of credit issued under our credit facility. The letters of credit were also issued primarily to collateralize obligations under various reinsurance contracts.
In August 2008, we entered into a derivative agreement with Topiary. Under the terms of our agreement with Topiary, we will pay to Topiary approximately $9,650,000 during each of the three annual periods commencing August 1, 2008. In return the agreement provides us with the ability to recover up to $200,000,000 should two catastrophic events involving U.S. wind, U.S. earthquake, European wind, or Japanese earthquake occur that meet specified loss criteria during any of three annual periods. Both the initial activation event and the qualifying second event must occur in the same annual period. The maximum amount that we can recover over the three-year period is $200,000,000. Topiary’s limit of loss is collateralized with high quality investment grade securities in a secured collateral account. The performance of the securities in the collateral account is guaranteed under a total swap agreement with Goldman Sachs International whose obligations under the swap agreement are guaranteed by Goldman Sachs Group, Inc. Any recovery we make under this contract is based on an index using insured property industry loss estimates that are compiled by Property Claim Services, a division of Insurance Services Offices, Inc., for certain U.S. perils, and parametric triggers for certain non-U.S. perils, and is not based on actual losses we may incur. The net liability of $4,753,000 related to this agreement was included in other liabilities on our consolidated balance sheet.
We do not have any material commitments for capital expenditures as of December 31, 2008.
We do not have any off-balance sheet arrangements, as defined for purposes of SEC rules, which are not accounted for or disclosed in the consolidated financial statements as of December 31, 2008.
See Note 7 of the Notes to the Consolidated Financial Statements.
See Note 14 of the Notes to the Consolidated Financial Statements.