The following table sets forth our selected consolidated financial information for the years ended and as of the dates indicated. As described in Note 1 to our Audited Consolidated Financial Statements included elsewhere in the Company’s Annual Report on Form 10-K, our Audited Consolidated Financial Statements include the accounts of Endurance Holdings, Endurance Bermuda, Endurance U.K., Endurance U.S. Reinsurance, Endurance American, Endurance American Specialty, American Merchants and ARMtech.
We derived the following selected consolidated financial information for the years ended December 31, 2008, 2007, 2006, 2005 and 2004 from our Audited Consolidated Financial Statements and related notes. These historical results are not necessarily indicative of results to be expected from any future period.
Endurance Holdings and its wholly-owned subsidiaries are collectively referred to in this discussion and analysis as the “Company”.
In the Insurance segment, the Company writes property, casualty, agriculture, healthcare liability, workers’ compensation and professional lines insurance. In the Reinsurance segment, the Company writes casualty, property, catastrophe, agriculture, aerospace and marine and surety and other specialty reinsurance.
Marketplace Conditions and Trends. In general, at the end of 2008, we believe operating conditions continue to be competitive. In certain catastrophe-exposed classes of property business, we experienced a pricing environment that was flat to slightly upward; however, for the remaining insurance and reinsurance lines of property and casualty business we experienced downward pricing driven largely by relatively high levels of underwriting capacity and competition driven by distressed insurers. We continue to maintain our adherence to underwriting standards by declining business when pricing, terms and conditions did not meet our underwriting criteria.
In 2009, we believe the following two primary influences may affect the market for our insurance and reinsurance products - continuing unsettled and deteriorating global economic conditions and the financial condition of certain of our competitors. The United States and other markets around the world have been experiencing worsening economic conditions, including substantial and continuing disruptions to financial market and asset valuations. These dislocations in the investment markets have in turn eroded capital and surplus positions of many of our competitors, in places limiting their ability to compete effectively for business. We believe these two factors have and will continue to contribute to changes in market conditions within both the reinsurance and insurance market places.
Premiums. The Company’s insurance premiums are earned pro rata over the terms of the applicable risk period specified in the insurance policy. The Company’s insurance policies are written on a losses occurring or claims made basis during the term of the policy. Generally, the Company receives a fixed premium which is identified in the policy and is recorded on the inception date of the contract or when premiums are determinable and earned evenly over the policy term. This premium will only adjust if the underlying insured basis adjusts. Accordingly, we monitor the underlying insured basis and record additional or return premiums in the period in which amounts are reasonably determinable. Insurance premiums written accounted for 63%, 42%, and 32% of the Company’s gross premiums written during the years ended December 31, 2008, 2007, and 2006, respectively.
The Company’s reinsurance premiums are earned in proportion to the amount of reinsurance protection provided over the terms of the applicable risk period established in the reinsurance contract. Reinsurance contracts written on a losses occurring basis cover losses which occur during the term of the reinsurance contract, typically 12 months. Accordingly, the Company earns the premium on a losses occurring reinsurance contract evenly over the reinsurance contract term. Losses occurring reinsurance contracts accounted for approximately 19%, 32%, and 33% of the Company’s gross premiums written during the years ended December 31, 2008, 2007, and 2006, respectively. Reinsurance contracts written on a policies attaching basis cover losses from the underlying insurance policies incepting during the terms of the reinsurance contracts. Losses under a policies attaching reinsurance contract may occur after the end date of the reinsurance contract, so long as they are losses from policies which began during the reinsurance contract period. The Company typically earns the premiums for policies attaching reinsurance contracts over a 24 month period in proportion to the amount of reinsurance protection provided to reflect the extension of the risk period past the term of the contract and the varying levels of reinsurance protection provided during the reinsurance contract period. Policies attaching reinsurance contracts accounted for approximately 18%, 26%, and 35% of the Company’s gross premiums written during the years ended December 31, 2008, 2007, and 2006, respectively.
In addition to determining the applicable risk period, the Company’s estimate of its reinsurance premiums written is based on the type of reinsurance contracts underwritten. For excess of loss reinsurance contracts, the deposit premium, as defined in the contract, is generally considered to be the best estimate of the reinsurance contract’s written premium at inception. The Company earns reinstatement premiums upon the occurrence of a loss under the reinsurance contract. Reinstatement premiums are calculated in accordance with the contract terms based upon the ultimate loss estimate associated with each contract. Excess of loss reinsurance contracts accounted for approximately 23%, 31%, and 36% of the Company’s gross premiums written during the years ended December 31, 2008, 2007, and 2006, respectively. For proportional reinsurance contracts, the Company estimates premiums, commissions and related expenses based on broker and ceding company estimates. In addition to ceding company estimates, the Company also utilizes its judgment in establishing proportional reinsurance contract premium estimates after considering the following factors:
The Company’s limited historical experience has shown that estimated premiums from proportional contracts have varied and have been adjusted by up to approximately 10%, although larger variations, both positive and negative, are possible as a result of changes in one or more of the premium assumptions as noted above. A 10% variation in the Company’s proportional premiums receivable, net as of December 31, 2008, after considering the related expected losses and loss expenses, acquisition expenses and taxes, would result in an impact of approximately $2.0 million on the Company’s net income (loss).
For the year ended December 31, 2008, the Company entered into a small number of reinsurance contracts that did not fall within the criteria for reinsurance accounting under SFAS No. 113. The Company has accounted for these contracts by the deposit method of accounting specified by Statement of Position 98-7 - ''Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk.’’ Consequently, these contracts were accounted for as contracts which either transfer only significant timing risk or transfer only significant underwriting risk. The determination of the appropriate method of accounting for these contracts requires significant judgment and analysis, particularly with respect to assumptions about the variability and likelihood of potential future losses. Under the deposit method of accounting, revenues and expenses from reinsurance contracts are not recognized as written premium and incurred losses. Instead, income or loss associated with contracts determined to transfer only significant timing risk is recognized as a component of net other underwriting income (loss) over the estimated claim settlement period while income or loss associated with contracts determined to transfer only significant underwriting risk is recognized as net other underwriting income (loss) over the contract risk period.
Although management has determined that accounting for these contracts as deposits is the most appropriate treatment, the Company considers the risk of loss resulting from any one of these contracts to be more than remote, and such loss could be material. For the years ended December 31, 2008, 2007, and 2006, the Company recorded deposit accounting adjustments to gross premiums written of $5.1 million, $28.6 million, and $159.0 million, respectively, associated with contracts not qualifying for reinsurance accounting treatment as noted above.
Significant Assumptions Employed in the Estimation of Loss and Loss Expense Reserves. The most significant assumptions used as of December 31, 2008 to estimate the reserve for losses and loss expenses within the Company’s Insurance and Reinsurance segments are as follows:
1. the information developed from internal and independent external sources can be used to develop meaningful estimates of the likely future performance of business bound by the Company;
the lag in time between the time claims are reported to the ceding company and the time they are reported through one or more reinsurance broker intermediaries to the Company,
growth in new lines of business where exposure and loss development patterns are not well established; or
Level 3 Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the Company’s own assumptions about the assumptions that market participants would use in pricing the asset or liability. Level 3 assets and liabilities include financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
The Company determines the estimated fair value of each individual security utilizing the highest level inputs available. The adoption of SFAS No. 157 by the Company did not materially change the Company’s valuation of its available for sale investments. For further discussion of SFAS No. 157, see Note 4 of the notes to the audited consolidated financial statements contained herein.
The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed income investments. The Company obtains multiple prices for its securities where available. Pricing sources used by management in pricing the Company’s fixed income investments at December 31, 2008 were as follows:
Pricing Services. Pricing services, including index providers, provide pricing for less-complex, liquid securities based on market quotations in active markets. For securities that do not trade on a listed exchange, these pricing services may use a matrix pricing consisting of observable market inputs to estimate the fair value of a security. These observable market inputs include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, tow-side markets, benchmark securities, bids, offers, reference data, and industry and economic factors. Additionally, pricing services may use a valuation model such as an option adjusted spread model commonly used for estimating fair values of mortgage-backed and asset-backed securities. At December 31, 2008, the Company has not adjusted any pricing provided by independent pricing services and index providers and have classified all such securities as Level 2.
In accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and Financial Statement of Position 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” the Company periodically reviews its fixed income investments, to determine whether a decline in the fair value below the amortized cost basis is other-than-temporary. The Company considers a fixed income investment to be a candidate for further analysis if it meets any of the following thresholds or criteria:
the fixed income investment trades at a 5% or greater discount to amortized cost for 12 consecutive months or longer;
the fixed income investment trades at a 15% or greater discount to amortized cost for any length of time;
the issuer of the fixed income investment defaults on a material outstanding obligation;
the issuer of the fixed income investment proposes a voluntary reorganization pursuant to which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than the par value of their claims; or
in the judgment of management, the Company will not be able to realize a full recovery on the fixed income investment.
In the event one or more of the foregoing thresholds or criteria has been met, management conducts a further review of the fixed income investment to determine if it should be classified as other-than-temporarily impaired. This review is based upon the judgment of management, and involves the consideration of several factors including the following:
the time period in which there has been a significant decline in value;
an analysis of the liquidity, business prospects and overall financial condition of the issuer/sector; and
Recent Accounting Pronouncements. See note 2(q), “Summary of Significant Accounting Policies-Recent Accounting Pronouncements,” of the notes accompanying our audited consolidated financial statements.
The following is a discussion and analysis of the Company’s consolidated results of operations for the years ended December 31, 2008, 2007 and 2006.
Ceded premiums written increased in 2008 from 2007 and 2006 with the continued expansion of the Company’s Insurance segment. The increases in premiums ceded in 2008 primarily related to the Insurance segment’s agriculture line which cedes significant premiums to the U.S. government through a federally sponsored crop reinsurance program.
Net premiums earned increased in 2008 compared to 2007 due to growth in net premiums written by the Insurance segment. Net premiums earned declined in 2007 compared to 2006 consistent with declines in premiums written year over year.
Reconciles the Company’s gross premiums written to the Company’s financial statement presentation.
Net investment income decreased in 2008 compared to 2007 and 2006 principally due to net mark to market losses on alternative investments and high yield loan funds, included in other investments, of $111.6 million as compared to a gain of $21.3 million in 2007 and a gain of $29.1 million in 2006. Cash and cash equivalents and investments have decreased 4.1% from 2007 and 2.8% from 2006. The decrease in cash and cash equivalents and investments during 2008 resulted from declines in market valuations of investments and share repurchases, partially offset by positive net operating cash flows throughout 2008. Investment expenses, including investment management fees, for 2008 were $10.3 million compared to $9.5 million in 2007, and compared to $8.2 million in 2006. The increase in investment expenses was as a result of a shift in the composition of the investment portfolio during 2008 and increased monitoring activity conducted throughout the year.
The annualized net earned yield, total return of the investment portfolio for the years ended December 31, 2008, 2007 and 2006 and market yield and portfolio duration as of December 31, 2008 and 2007 were as follows:
Our investment portfolio is managed to generate attractive economic returns and income while providing the Company with liquidity. Movements in financial markets and interest rates influence the timing and recognition of net realized investment gains or losses as the portfolio is adjusted and rebalanced. Proceeds from sales of investments classified as available for sale for the year ended December 31, 2008 were $3,142.8 million compared to $3,112.8 million for the year ended December 31, 2007. Realized investment gains or losses for the years ended December 31, 2008, 2007 and 2006 were as follows:
As of December 31, 2008, the Company continued to maintain an investment portfolio with an average credit rating of AAA. The Company’s investment portfolio consists of both mortgage-backed and asset-backed securities, which comprised 43.7% of total invested assets, including pending securities transactions, fixed income investments, short term investments, preferred equity securities, cash and cash equivalents and other investments, at December 31, 2008. The Company, along with its investment managers, monitors the nature and type of assets underlying these types of securities. At December 31, 2008, the Company’s portfolio held no sub-prime mortgage exposure and the Company’s Alt-A exposure represented 2% of the Company’s fixed income investments. Of the Company’s Alt-A exposure, 84.7% are fixed rate securities. There were no significant changes to the credit ratings of the Company’s securities in 2008. However, the Company has experienced material downgrades of securities within its fixed income portfolio in early 2009 and may experience further write downs throughout 2009.
During 2008, the Company revalued its monetary assets and liabilities denominated in foreign currencies, which resulted in net foreign exchange losses of $53.7 million compared to $8.0 million for 2007 and gains of $21.0 million for 2006. The current year net foreign exchange losses resulted from the strengthening of the U.S. dollar and weakening of the U.K. Pound Sterling compared to other currencies during 2008. The Company had offsetting net unrealized foreign exchange gains of $54.8 million (2007 - $10.8 million, 2006 - losses of $12.2 million) from the revaluation of its foreign currency invested assets included in the change in net unrealized holding (losses) gains on investments within other comprehensive (loss) income.
The decrease in the acquisition expense ratio for 2008 compared to 2007 and 2006 was due to the increase in Insurance segment agriculture premiums written, which typically have lower acquisition costs.
The Company produced net income of $98.6 million in 2008 compared to $521.1 million in 2007 and $498.1 million in 2006. The decrease in net income for 2008 compared to 2007 and 2006 was primarily due to losses and loss expenses recorded for Hurricanes Gustav and Ike, a decline in net investment income from mark to market reductions in the value of the Company’s alternative investments and high yield loan funds, increased realized losses from investments and higher foreign exchange losses.
Management measures the Company’s results on the basis of the combined ratio, which is obtained by dividing the sum of the losses and loss expenses, acquisition expenses and general and administrative expenses by net premiums earned. The Company’s historic combined ratios may not be indicative of future underwriting performance. When purchased within a single line of business, ceded reinsurance and recoveries are accounted for within that line of business. When purchased across multiple lines of business, ceded reinsurance and recoveries are allocated to the lines of business in proportion to the related risks assumed. The Company does not manage its assets by business segment; accordingly, investment income and total assets are not allocated to the individual business segments. General and administrative expenses incurred by business segments are allocated directly. Remaining general and administrative expenses not directly incurred by the segments are allocated primarily based on estimated consumption, headcount and other variables deemed relevant to the allocation of such expenses. Ceded reinsurance and recoveries are recorded within the segment to which they apply.
The following table summarizes the underwriting results and associated ratios for the Company’s Insurance segment for the years ended December 31, 2008, 2007 and 2006.
The increase in the Insurance segment net premiums written in 2008 compared to 2007, and 2007 compared to 2006 was largely driven by the addition of $359.6 million and $21.1 million, respectively of net agricultural premiums written by ARMtech, which was acquired in the fourth quarter of 2007. In addition, compared to 2007 and 2006, the Company wrote and retained more professional lines premiums from new business written by the Company’s U.S. insurance operations in 2008. The Company also experienced growth in the property line for 2008 compared to 2007. Growth in the Insurance segment net premiums written in 2008 was partially offset by declines in premiums of $22.5 million related the Company’s worker’s compensation line of business. Partially offsetting the growth in the Insurance segment net premiums written was a decline in the healthcare liability line of business for 2008 as compared to 2007 and 2006. Based on current pricing considerations and increased competition, the Company expects to cease underwriting new business in its workers compensation line as of February 2009. In addition, as of February 2009, the Company entered into a renewal rights transaction for the sale of the property insurance previously operated from Endurance U.K. For the full year of 2008, this line generated $38.7 million of net premiums written that will no longer be written by the Company.
The following table summarizes the underwriting results and associated ratios for the Company’s Reinsurance segment for the years ended December 31, 2008, 2007 and 2006.
Net premiums earned by the Company in 2008 in the Reinsurance segment decreased compared to 2007 and 2006 due to the lower levels of total premiums written.
Acquisition Expenses. The Company’s acquisition expense ratio in the Reinsurance segment increased for 2008 as compared to 2007 and 2006 due to decreases in premiums earned within the catastrophe and agriculture lines which typically have lower associated acquisition expenses as compared to other property and casualty lines, which are often written on a quota share basis.
General and Administrative Expenses. The general and administrative expense ratio experienced by the Reinsurance segment in 2008 as compared to 2007 and 2006 increased as a result of lower premiums earned.
Endurance Holdings is a holding company that does not have any significant operations or assets other than its ownership of the shares of its direct and indirect subsidiaries, including Endurance Bermuda, Endurance U.K., Endurance U.S. Reinsurance, Endurance American, Endurance American Specialty, American Merchants and ARMtech. Endurance Holdings relies primarily on dividends and other permitted distributions from its insurance subsidiaries to pay its operating expenses, interest on debt and dividends, if any, on its common shares and Series A Preferred Shares. There are restrictions on the payment of dividends by Endurance Bermuda, Endurance U.K., Endurance U.S. Reinsurance, Endurance American, Endurance American Specialty, American Merchants and ARMtech to Endurance Holdings, which are described in more detail below.
As of December 31, 2008 and December 31, 2007, the Company had pledged cash and cash equivalents and fixed maturity investments of $147.9 million and $223.2 million, respectively, in favor of certain ceding companies to collateralize obligations. As of December 31, 2008 and December 31, 2007, the Company had also pledged $591.9 million and $594.7 million of its cash and fixed maturity investments as required to meet collateral obligations for $550.8 million and $532.3 million in letters of credit outstanding under its credit facility, respectively. In addition, at December 31, 2008 and December 31, 2007, cash and fixed maturity investments with fair values of $234.8 million and $120.3 million were on deposit with U.S. state regulators, respectively, and cash and fixed maturity investments with fair values of $14.2 million and $33.8 million were on deposit with Canadian regulators, respectively.
Variable Delivery Forward. On September 11, 2007, Endurance Holdings consummated a variable delivery equity forward sale arrangement under which Endurance Holdings is entitled to sell ordinary shares to an affiliate of Deutsche Bank Securities, Inc. (the “forward counterparty”) for proceeds of approximately $150 million pursuant to a prospectus supplement to the Shelf Registration Statement on Form S-3ASR (Registration No. 333-130464) filed with the U.S. Securities and Exchange Commission on September 12, 2007. Under the terms of the forward sale agreement, Endurance Holdings will sell an aggregate of between 2,984,772 and 4,786,827 ordinary shares to the forward counterparty, subject to Endurance Holdings’ right to cash settle or net share settle all or a portion of such agreement.
Endurance Holdings did not receive any proceeds from the sale of the ordinary shares by the forward counterparty, but Endurance Holdings will receive proceeds upon any prepayment, and may receive proceeds upon settlement of the forward sale agreement. Subject to Endurance Holdings’ right to elect cash or net share settlement of, or to terminate early, all or a portion of the forward sale agreement, the forward sale agreement will be physically settled by delivery of the requisite number of Endurance Holdings’ ordinary shares beginning July 20, 2010. The forward counterparty will pay Endurance Holdings approximately $150 million upon settlement of the forward sale agreement. The number of Endurance Holdings’ ordinary shares to be delivered to the forward counterparty varies depending upon the price of Endurance Holdings’ ordinary shares over a forty trading-day period beginning July 15, 2010 subject to an aggregate maximum of 4,786,827 and an aggregate minimum of 2,984,772 ordinary shares.
The full amount of the 2007 Credit Facility is available for revolving credit borrowings and for the issuance of letters of credit. The proceeds of the facility may be used for general corporate and working capital purposes, to finance potential acquisitions and for the repurchase of Endurance Holdings’ outstanding publicly or privately issued securities. So long as the Company is not in default under the terms of the facility, the Company may request that the size of the facility be increased by $500 million, provided that no participating lender is obligated to increase its commitments under the facility.
The estimated expected contractual obligations related to our reserves for losses and loss expenses, including reserves related to deposit accounted contracts of $57.2 million, are presented on a gross basis. Due to the inherent complexity of the assumptions used in establishing the Company’s reserve for losses and loss expenses estimates, final claim settlements made by the Company may vary significantly from the present estimates in timing and amount. Approximately 64% of our net reserves were incurred but not reported at December 31, 2008. For a discussion of these uncertainties, see “Critical Accounting Estimates - Reserve for Losses and Loss Expenses.”
Credit Facility. On May 8, 2007, Endurance Holdings amended its existing credit facility among Endurance Holdings, various designated subsidiary borrowers, various lending institutions and JPMorgan Chase Bank, N.A. as Administrative Agent to, as described above under the section entitled “Liquidity and Capital Resources.”
On July 15, 2004, the Company issued $250 million principal amount of 7% Senior Notes. The 7% Senior Notes were offered by the underwriters at a price of 99.108% of their principal amount, providing an effective yield to investors of 7.072%, and, unless previously redeemed, will mature on July 15, 2034.
Preferred Shares. On October 10, 2005, Endurance Holdings issued 8,000,000 shares of its 7.75% Non-Cumulative Preferred Shares, Series A (the “Series A Preferred Shares”). The Series A Preferred Shares sold in the offering were registered under the Securities Act of 1933, as amended, and are traded on the New York Stock Exchange. The Series A Preferred Shares were issued at a price to the public of $25.00 per share. Endurance Holdings received net proceeds from this offering of $193.5 million after expenses and underwriting discounts. The proceeds from this offering were used to provide additional capital to Endurance Holdings’ subsidiaries and for other general corporate purposes.
On an ongoing basis, the Company expects its internally generated funds, together with borrowings available under the 2007 Credit Facility, capital generated from the exercise of the Company’s variable delivery forward, offering and sale of its Senior Notes, Series A Preferred Shares and ordinary shares, to be sufficient to operate its business. However, there can be no assurance that the Company will not incur additional indebtedness or issue additional equity or hybrid securities in order to implement its business strategy or pay claims.
The effects of inflation could cause the severity of claims to rise in the future. The Company’s estimates for losses and loss expenses include assumptions about future payments for settlement of claims and claims handling expenses, such as medical treatments and litigation costs. To the extent inflation causes these costs to increase above reserves established for these claims, the Company will be required to increase the reserve for losses and loss expenses with a corresponding reduction in its earnings in the period in which the deficiency is identified.
In order to capture the key dynamics of loss development and expected volatility that may arise within the disclosed amounts for the reserve for losses and loss expenses, the key lines of business within each business segment are aggregated based on their potential expected length of loss emergence. The period over which loss emergence occurs is typically referred to as the tail. The Company has classified its lines of business as either having a “short,” “long” or “other” tail pattern. The Company views short tail business as that for which development typically emerges within a period of several quarters while long tail business would emerge over many years. The Company’s short tail line of business in the Insurance segment includes property; long tail lines of business include casualty, healthcare liability, workers’ compensation and professional lines. The Company’s short tail lines of business in the Reinsurance segment include catastrophe, property, marine, aerospace and surety while the long tail line of business is casualty related business. Within the Company’s Reinsurance segment, the Company writes certain specialty lines of business for which the loss emergence is considered unique in nature and thus, has been included as “other” in the table below.
Differences between actual reported losses and expected losses are anticipated to occur in any individual period and such deviations may influence future initial expected loss ratios and/or expected loss reporting patterns as the recent actual experience becomes part of the historical data utilized as part of the ongoing reserve estimation process. The Company has demonstrated the impact of changes in the speed of the loss reporting patterns, as well as changes in the expected loss ratios, within the table under the heading “Potential Variability in Reserves for Losses and Loss Expenses” beginning on page 91.
Reconciles the Company’s incurred losses by business segment to the Company’s financial statement presentation.
Long Tail Reinsurance. The lower than expected losses and loss expenses related to prior years in the long tail reinsurance reserve category were principally due to favorable development in the Company’s treaty casualty line of business.
Losses and loss expenses for the year ended December 31, 2007 include $159.4 million in favorable development of reserves relating to prior accident years. The favorable loss reserve development experienced during the 2007 year benefited the Company’s 2007 reported loss ratio by approximately 10.0 percentage points. The net reduction in estimated losses for prior accident years reflects lower than expected emergence of catastrophic and attritional losses. Favorable development of prior year reserves for 2007 relates primarily to the Company’s short and long tail lines included in its Insurance segment, as well as the short tail line of business in the Reinsurance segment. The favorable development of reserves related to prior years was primarily due to lower than expected claims across the Company’s reserve categories. For the year ended December 31, 2007, the Company did not materially alter the two key inputs it utilizes to establish its reserve for losses and loss expenses, initial expected loss ratios or loss reporting patterns, for business related to prior years for the insurance and reinsurance reserve categories as the variances in reported losses in 2007 for those reserve categories were within the range of possible results anticipated by the Company.
Other Reinsurance. Loss settlement activity related to the 2006 year in the Company’s agriculture line was modestly higher than expected resulting in the Company increasing its estimated losses and loss expenses during 2007 in this reserve category for prior years.
Selected quarterly activity in the reserve for losses and loss expenses for the year ended December 31, 2008 is summarized as follows:
The following table represents the development of GAAP balance sheet reserve for losses and loss expenses, net of losses and loss expenses recoverable, for 2002 through December 31, 2008. This table does not present accident or policy year development data. The top line of the table shows the gross and net reserve for losses and loss expenses at the balance sheet date for each of the indicated years. This represents the estimated amounts of gross and net losses and loss expenses arising in the current year and all prior years that are unpaid at the balance sheet date, including IBNR reserves. The table also shows the re-estimated amount of the previously recorded reserve based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “cumulative redundancy” represents the aggregate change to date from the original estimate.
During 2006, we acquired Endurance American and as a result of that transaction recorded an indefinite lived intangible asset of $3.5 million related to state insurance licenses acquired.
The Company has established a valuation allowance of $15.7 million (2007 - $10.3 million) against realized capital losses, including securities write downs, and certain operating loss carryforwards at December 31, 2008. Of the $15.7 million valuation allowance, $7.8 million was established against realized investment losses as the Company cannot reasonably predict the occurrence of future realized investment gains and $7.9 million was established against net operating loss carryforwards in the United Kingdom as the Company does not expect to generate enough operating income in the short term to offset the full amount of the carryforwards. The increase in the valuation allowance was charged to the Company’s income tax expense during 2008. Management believes the net deferred tax assets, less the valuation allowance noted, are more likely than not to be fully realized in corresponding future periods, and the Company’s net deferred tax asset has been stated appropriately as at December 31, 2008. In the event that management determines in the future that it is more likely than not that the net deferred tax assets will not be fully realized in the near term and prior to their expiration, the Company will reassess the valuation allowance against the net deferred tax assets and record any changes to income tax expense in the period determined.
The Board of Directors and Shareholders of Endurance Specialty Holdings Ltd.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Endurance Specialty Holdings Ltd. as of December 31, 2008 and 2007, and the related consolidated statements of income and comprehensive (loss) income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008 and our report dated February 27, 2009 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of Endurance Specialty Holdings Ltd. as of December 31, 2008 and 2007, and the related consolidated statements of income and comprehensive (loss) income, changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Endurance Specialty Holdings Ltd. at December 31, 2008 and 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
Endurance Holdings’ wholly-owned subsidiary, Endurance Specialty Insurance Ltd. (“Endurance Bermuda”), was organized in Bermuda on November 30, 2001. On December 14, 2001, Endurance Bermuda completed a private offering of 60 million common shares for gross cash proceeds of $1.2 billion. Under the terms of an Exchange Offer dated July 22, 2002, the shareholders of Endurance Bermuda transferred their interest in Endurance Bermuda to Endurance Holdings in exchange for an identical shareholding in Endurance Holdings. The Exchange Offer represented a business combination of companies under common control and was accounted for at historical cost. On March 5, 2003, Endurance Holdings consummated the initial public offering of its ordinary shares resulting in the issuance of an additional 9.6 million ordinary shares for net proceeds of $201.5 million.
The Company’s insurance premiums are earned pro rata over the terms of the applicable risk period specified in the insurance policy. The Company’s insurance policies cover losses occurring or claims made during the term of the policy. Generally, the Company receives a fixed premium which is identified in the policy and is recorded on the inception date of the contract or when premiums are determinable and earned evenly over the policy term. This premium will only adjust if the underlying insured values adjust. Accordingly, the Company monitors the underlying insured values and records additional or return premiums in the period in which amounts are reasonably determinable.
The Company’s reinsurance premiums are earned in proportion to the amount of reinsurance protection provided over the terms of the applicable risk period established in the reinsurance contract. Reinsurance contracts written on a losses occurring basis cover losses which occur during the term of the reinsurance contract, typically 12 months. Accordingly, the Company earns the premium on a losses occurring reinsurance contract evenly over the reinsurance contract term. Reinsurance contracts written on a policies attaching basis cover losses from the underlying insurance policies incepting during the terms of the reinsurance contracts. Losses under a policies attaching reinsurance contract may occur after the end date of the reinsurance contract, so long as they are losses from policies which began during the reinsurance contract period. The Company typically earns the premiums for policies attaching reinsurance contracts over a 24 month period in proportion to the amount of reinsurance protection provided to reflect the extension of the risk period past the term of the contract and the varying levels of reinsurance protection provided during the reinsurance contract period.
For the years ended December 31, 2008, 2007 and 2006, the Company entered into a small number of reinsurance contracts that did not fall within the criteria for reinsurance accounting under SFAS No. 113. The Company has accounted for these contracts by the deposit method of accounting specified by Statement of Position 98-7 - ‘‘Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk.’’ Consequently, these contracts were accounted for as contracts which either transfer only significant timing risk or transfer only significant underwriting risk. The determination of the appropriate method of accounting for these contracts requires significant judgment and analysis, particularly with respect to assumptions about the variability and likelihood of potential future losses. Under the deposit method of accounting, revenues and expenses from reinsurance contracts are not recognized as written premium and incurred losses. Instead, income or loss associated with contracts determined to transfer only significant timing risk is recognized as a component of net other underwriting (loss) income over the estimated claim settlement period while income or loss associated with contracts determined to transfer only significant underwriting risk is recognized as net other underwriting (loss) income over the contract risk period.
The Company currently classifies all of its fixed income investments, which consist of fixed maturity investments, short-term investments and preferred equity securities, as “available for sale” and, accordingly, they are carried at estimated fair value, with related net unrealized gains or losses excluded from earnings and included in shareholders’ equity as a component of accumulated other comprehensive (loss) income. The Company determines the fair value of its fixed income securities in accordance with Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”), which defines fair value and establishes a fair value hierarchy based on inputs to the various valuation techniques used for each fair value measurement. The use of valuation techniques for any given investment requires a significant amount of judgment and consideration of factors specific to the underlying investment. Fair value measurements determined by the Company seek to maximize observable inputs and minimize the use of unobservable inputs.
For mortgage-backed and other asset-backed debt securities, fair value includes estimates regarding prepayment assumptions, which are based on current market conditions. Amortized cost in relation to these securities is calculated using a constant effective yield based on anticipated prepayments and estimated economic lives of the securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date. Changes in estimated yield are recorded on a retrospective basis, which results in future cash flows being used to determine current book value.
Realized investment gains and losses are recognized in earnings using the specific identification method. Interest on fixed maturity securities is recorded in net investment income when earned and adjusted for any amortization of premium or discount.
Investments are reviewed for declines in value that are considered to be other-than-temporary. This review involves consideration of several factors including (i) the time period in which there has been a significant decline in value, (ii) the expected maturity of the investment, (iii) the significance of the decline, (iv) an analysis of the liquidity, business prospects and overall financial condition of the issuer, and (v) the Company’s intent and ability to hold the investment for a period of time sufficient for the value to recover. If the decline in fair value is determined to be other-than-temporary, the cost of the security is written down to fair value and the amount is included in net realized investment losses in the Consolidated Statements of Income and Comprehensive (Loss) Income.
Other investments are accounted for using the equity method of accounting whereby the initial investment is recorded at cost. The carrying amounts of these investments are increased or decreased to reflect the Company’s share of income or loss, which is included in net investment income, and are decreased for dividends. Due to the timing of the delivery of the final valuations reported by the managers of certain of our alternative funds, our investments in those alternative funds are estimated based on the most recently available information including period end valuation statements, period end estimates, or, in some cases, prior month or quarter valuation statements.
SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities,” as amended on January 1, 2001, requires the recognition of all derivative financial instruments including embedded derivative instruments, as either assets or liabilities in the Consolidated Balance Sheets and measurement of those instruments at fair value. The accounting for gains and losses associated with changes in the fair value of a derivative and the effect on the financial statements depends on its hedge designation and whether the hedge is highly effective in achieving offsetting changes in the fair value of the asset or liability hedged.
The Company has a stock-based employee and non-employee Director incentive plan (“2007 Equity Incentive Plan”) and other stock plans which are described more fully in Note 16. The Company accounts for issuances under its stock plans in accordance with the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” prospectively to all employee awards granted, modified, or settled after January 1, 2002, as subsequently amended by SFAS No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure.” Awards under the 2007 Equity Incentive Plan vest over periods of up to four years. Effective January 1, 2006, the Company implemented SFAS No. 123(R) under the modified prospective method with no material impact on the Company’s financial position or results of operations.
Basic earnings per common share are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding. Diluted earnings per common share are based on net income available to common shareholders divided by the weighted average number of common shares and dilutive potential common shares outstanding during the period of calculation using the treasury stock method.
The Company applies the guidance in FASB Interpretation No. 46 (Revised December 2004) “Consolidation of Variable Interest Entities” (“FIN 46(R)”), which defines a variable interest entity as a corporation, partnership, trust or any other legal structure used for business purposes that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. Based on the criteria included in FIN 46(R), the Company determined that it has a relationship with a variable interest entity. FIN 46(R) requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. The Company’s relationship with the variable interest entity, described in more detail in Note 6, does not meet the requirements for consolidation as established under FIN 46(R) nor does the Company have any exposure to or risk of loss from its involvement with the variable interest entity.
In December 2007, the FASB issued FAS No. 141(R), Business Combinations (“FAS 141(R)”) and FAS No. 160, Noncontrolling Interests in Consolidated Financial Statements-an amendment of Accounting Research Bulletin No. 51 (“FAS 160”). FAS 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to provide additional disclosures on the nature and financial effect of the business combination. FAS 141(R) applies to all transactions or other events in which the acquirer obtains control of one or more businesses, even if control is not obtained by purchasing equity interests or net assets. FAS 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. Both FAS 141(R) and FAS 160 apply prospectively to business combinations for which the acquisition date is on or after December 15, 2008, except for the presentation and disclosure requirements of FAS 160, which will be applied retrospectively for all periods presented. The Company does not expect the adoption of theses statements to have a material impact on the Company’s financial condition or results of operations.
Statement of Financial Accounting Standards No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement of No. 115” was effective January 1, 2008. The Company did not elect the fair value option for any of its financial assets or financial liabilities under this statement.
In February 2008, the FASB issued Financial Staff Position SFAS 157-2 “Effective Date of FASB Statement No. 157,” which permits a one-year deferral of the application of SFAS 157 to non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company will adopt the provisions of SFAS 157 for non-financial assets and non-financial liabilities on January 1, 2009 and is currently evaluating the impact of these provisions on its results of operations and financial condition.
In April 2008, the FASB issued FASB Staff Position 142-3, “Determination of the Useful Lives of Intangible Assets,” which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of an intangible asset. Staff Position 142-3 is effective for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. The Company is currently evaluating the impact of Staff Position 142-3 on its results of operations and financial condition.
In June 2008, the FASB issued Financial Staff Position (“FSP”) Emerging Issues Task Force (“EITF”) 03-06-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities,” which clarifies which securities are to be considered participating securities prior to vesting and as such included in the calculation of earnings per share under the two-class method. FSP EITF 03-6-1 is effective for fiscal periods beginning after December 15, 2008 and requires retrospective adjustment of all prior period earnings per share data presented. The Company is currently evaluating the impact of FSP EITF 03-06-1 on its results of operations and financial condition.
In January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20,” which modifies the basis on which securities are deemed to be other-than-temporarily impaired under EITF Issue No. 99-20. Under FSP EITF 99-20-1, management may exercise judgment in its assessment of impairments regarding the probability of future cash flows and not rely exclusively on market participant assumptions regarding future cash flows. FAS EITF 99-20-1 is effective for interim and annual periods ending after December 15, 2008, and shall be applied prospectively. The Company adopted FSP EITF 99-20-1 and applied the guidance to the financial statements as at December 31, 2008. The adoption of FSP EITF 99-20-1 did not materially impact the Company’s results of operations or financial position.
The following tables summarize, for all available for sale securities in an unrealized loss position at December 31, 2008 and 2007, the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position.
At December 31, 2008, 672 available for sale securities were in an unrealized loss position. Of those, 174 securities had been in a continuous unrealized loss position for twelve months or greater. The unrealized loss position of these securities was principally a result of credit spread widening. During the year ended December 31, 2008, the Company identified securities which were considered to be other-than-temporarily impaired and wrote down the cost of such securities to fair value at the time of impairment, resulting in realized losses of $82.1 million during the period.
At December 31, 2008, the remaining unrealized losses on the Company’s available for sale securities and short term investments were primarily due to widening of credit spreads relating to market illiquidity, rather than any significant credit downgrades on these securities. Because the Company has the ability and intent to hold these securities until recovery, the Company currently believes it is probable that it will collect all amounts due according to their respective contractual terms. Therefore, the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2008.
At December 31, 2008, the Company held insurance enhanced bonds (asset-backed and municipal securities), in the amount of approximately $30.3 million, which represented approximately 0.8% of our available for sale fixed income portfolio. The overall credit quality of the insured bond portfolio was an average rating of “A” from Moody’s and “A” from Standard & Poor’s. The overall credit quality of the financial guarantors had an average rating of “Ba” by Moody’s and “BBB” by Standard & Poor’s. The financial guarantors of the Company’s insurance enhanced bonds include Financial Guarantee Insurance Company ($10.5 million), Ambac Financial Group, Inc. ($10.6 million), Financial Security Assurance Inc. ($4.9 million), MBIA Insurance Corporation ($4.0 million), and Syncora Holdings Ltd. ($0.3 million).
Contractual maturities of available for sale securities are shown below as of December 31, 2008 and 2007. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
In addition to the Company’s available for sale investment portfolio, the Company invests in a portfolio of alternative investments and high yield loan funds (the “Funds”). The Funds invest largely in senior secured distressed debt, derivatives, equity long and short positions, senior secured bank debt and high yield securities and are included in the Company’s balance sheet under other investments. At December 31, 2008 and 2007, the Company had invested, net of capital returned, a total of $326.5 million and $285.6 million, respectively, in the Funds. At December 31, 2008 and 2007, the carrying value of the Funds was $284.3 million and $358.1 million, respectively. Certain of the Funds are subject to redemption restriction provisions (see Note 12).
Under SFAS No. 157, a company must determine the appropriate level in the fair value hierarchy for each fair value measurement. The fair value hierarchy in SFAS No. 157 prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels, which are described in detail below. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.
The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The three levels of the hierarchy are as follows:
Level 3 assets represented less than 1% of the Company’s total assets at December 31, 2008.
At December 31, 2008 and 2007, the fair value of the Company’s senior notes was $334.2 million and $431.7 million, respectively (See Note 8).
During 2008, the Company’s estimated ultimate losses for prior accident years were reduced by $156.5 million (2007 - $159.4 million; 2006 - $57.7 million) due to lower claims emergence than originally estimated by the Company. During 2008, the Company experienced favorable development in the Reinsurance segment of $85.5 million in the short tail, long tail and other lines of business. In the Insurance segment, the Company experienced $71.0 million of favorable development primarily in relation to the long tail healthcare line of business during 2008. During 2007, the Company experienced favorable development in the Insurance segment of $80.4 million in both the Company’s short and long tail lines of business and $79.0 million of favorable development in the Company’s Reinsurance segment primarily in relation to the short tail lines of business. The Insurance segment experienced favorable development in 2006 of $54.4 million across all accident years with the short tail property line and the long tail healthcare liability and professional lines of business representing the largest net reductions, and the Reinsurance segment experienced favorable development of $3.4 million.
A significant portion of the Company’s contracts and policies cover excess layers for high severity exposures. Underwriting results and ultimate claims payments for this type of coverage are therefore not typically reported to the Company until later in the contract and policy lives. As a result, the level of losses paid to date is not necessarily indicative of expected future results.
During the year ended December 31, 2008, the Company recorded ceded losses of $574.4 million (2007 - $58.6 million; 2006 - $31.1 million). At December 31, 2008, the Company has an allowance for estimated uncollectible premiums receivable of $2.4 million (2007 - Nil) and no allowance for estimated uncollectible losses recoverable (2007 - Nil).
Shackleton was a variable interest entity under the provisions of FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities.” The Company was not the primary beneficiary of Shackleton and was therefore not required to consolidate Shackleton in its consolidated financial statements. The Company had no exposure to loss as a result of its involvement with Shackleton.
For the year ended December 31, 2008, 2007 and 2006, the Company entered into contracts accounted for as deposits with gross premiums of $5.1 million, $28.6 million and $159.0 million, respectively, and recorded other underwriting (loss) income of ($4.0) million, $1.6 million and $1.4 million, respectively, related to such contracts. Gross premiums associated with treaties deemed to transfer only significant underwriting risk were $2.9 million, $17.5 million and $135.9 million during 2008, 2007 and 2006, respectively. Gross premiums associated with treaties deemed to transfer only significant timing risk were $2.2 million, $11.1 million and $23.1 million during 2008, 2007 and 2006, respectively.
The 2007 Credit Facility requires the Company’s compliance with certain customary restrictive covenants. These include certain financial covenants, such as maintaining a leverage ratio (no greater than 0.35:1.00 at any time) and a consolidated tangible net worth (no less than $1.4 billion at any time). In addition, each of the Company’s regulated insurance subsidiaries that have a claims paying rating from A.M. Best must maintain a rating of at least B++ at all times. The terms of the facility generally restrict the declaration or payment of dividends on the Company’s common shares if the Company is already in default or the payment or declaration would cause a default under the terms of the credit facility.
On October 17, 2005, Endurance Holdings issued $200 million principal amount of 6.15% Senior Notes due 2015 (the “6.15% Senior Notes”). The 6.15% Senior Notes were offered by the underwriters at a price of 99.639% of their principal amount, providing an effective yield to investors of 6.199%, and, unless previously redeemed, will mature on October 15, 2015. Endurance Holdings used the net proceeds from the offering to repay the $143.5 million then outstanding under Endurance Holdings’ revolving credit facility as well as to provide additional capital to its subsidiaries and for other general corporate purposes.
The indentures governing each of the Senior Notes contain customary covenants and events of default for senior unsecured indebtedness, including events of default for non-payment of principal or interest, breaches of covenants, insolvency of the Company or a default by the Company under other outstanding indebtedness. At December 31, 2008, the carrying value of the Senior Notes stood at $447.3 million (2007 - $447.3 million) while the fair value as determined by quoted market valuation was $334.2 million (2007 - $431.7 million). The Company was in compliance with all covenants contained within the indentures governing the Senior Notes as of December 31, 2008.
The Company made aggregate interest payments of $29.9 million during the year ended December 31, 2008 (2007 - $29.8 million, 2006 - $29.7 million).
The Company currently uses foreign currency forward contracts in its investment portfolios to minimize the effect of fluctuating foreign currencies and to gain exposure to interest rate differentials between differing market rates. For the years ended December 31, 2008, 2007 and 2006, the Company recognized a realized foreign exchange gain (loss) on forward contracts of approximately $544,000, ($527,100), and $17,900, respectively.
The following table provides gross premiums written, by line of business, for the year ended December 31, 2008, 2007 and 2006:
No impairment of the Company’s goodwill or intangible assets was noted following the annual impairment review for the years ended December 31, 2008 and 2007. The Company expects the amortization of the intangible assets with finite lives to approximate $10.4 million for years 2009 to 2011, $9.6 million for 2012, $6.3 million for 2013 and $51.5 million for all years thereafter.
As of December 31, 2008, substantially all the Company’s cash and investments were held by four custodians. The Company’s investment guidelines limit the amount of credit exposure to any one issuer other than the U.S. Treasury and certain other foreign government obligations rated AAA.
Major production sources. The following table shows the percentage of gross premiums written before deposit accounting adjustments generated through the Company’s largest brokers for the years ended December 31, 2008, 2007 and 2006:
The Company is subject to certain commitments with respect to other investments at December 31, 2008 and 2007. The Company is generally subject to redemption restriction provisions of between one to five years from the date of acquisition and rolling redemption restrictions on a one or two year basis thereafter. The Company requested redemptions of $15.2 million at December 31, 2008 to be received during 2009 subject to the funds discretion on the next available redemption date. No redemptions were requested at December 31, 2007. Due to redemption restrictions, the Company was prohibited from requesting redemptions during 2008 of $69.7 million (2007 - $157.9 million) of its other investments held at December 31, 2008. In addition, as of December 31, 2008, the Company was committed to investing a further $1.7 million (2007 - $29.4 million) in various investment funds classified as other investments.
Legal Proceedings. The Company is party to various legal proceedings generally arising in the normal course of its business. While any proceeding contains an element of uncertainty, the Company does not believe that the eventual outcome of any litigation or arbitration proceeding to which it is presently a party could have a material adverse effect on its financial condition or business. Pursuant to the Company’s insurance and reinsurance agreements, disputes are generally required to be finally settled by arbitration.
The Company’s share capital at December 31, 2008 and 2007 is comprised as follows:
During 2008, the Company repurchased its common shares through open market transactions authorized by the Company’s Board of Directors. The repurchases were accomplished in open market or privately negotiated transactions, from time to time, depending on market conditions. The Company’s initial share repurchase program was authorized in May 2004 and expired in February 2007, at which time the Company’s Board of Directors authorized the repurchase of up to 2,000,000 ordinary shares or share equivalents. In May 2007, the Company’s Board of Directors approved an increase in the number of ordinary shares authorized for repurchase to 18 million ordinary shares or share equivalents through May 2009. In February 2009, the Company’s Board of Directors approved an extension of the existing share repurchase authorization through May 13, 2011. During 2008 and 2007, the Company repurchased 4,600,279 and 8,081,199 of its ordinary shares and share equivalents under this program in open market and privately negotiated transactions at an average price of $33.20 and $38.61 per share, respectively. Total authorized repurchases remaining under the plan at December 31, 2008 was 5,565,322 shares (2007 - 10,165,601).
On September 11, 2007, Endurance Holdings consummated a variable equity forward sale arrangement under which Endurance Holdings is entitled to sell ordinary shares to an affiliate of Deutsche Bank Securities, Inc. (the “forward counterparty”) for proceeds of approximately $150 million pursuant to a prospectus supplement to the Shelf Registration Statement on Form S-3ASR (Registration No. 333-130464) filed with the U.S. Securities and Exchange Commission on September 12, 2007. Under the terms of the forward sale agreement, Endurance Holdings will sell an aggregate of between 2,984,772 and 4,786,827 ordinary shares to the forward counterparty, subject to Endurance Holdings’ right to cash settle or net share settle all or a portion of such agreement.
During 2008, the Company repurchased 1,500,000 (2007 - 107,620) of outstanding warrants at an average price of $34.14 (2007 - $25.42), net of the average warrant strike price of $15.45 (2007 - $16.10) per warrant. In addition during 2008, 500,000 warrants with an exercise price of $15.12 were exercised for the purchase of the Company’s ordinary shares at a price of $25.68. The warrant holders elected the net settlement option, and thus the Company delivered 205,607 ordinary shares in settlement. The outstanding warrants at December 31, 2008, which have an exercise price of $14.87 (2007 - $15.87) per share, expire on December 14, 2011.
Diluted earnings per common share are based on the weighted average number of common shares and dilutive potential common shares outstanding during the period of calculation using the treasury stock method.
The following tables set forth the computation of basic and diluted earnings per share for the years ended December 31, 2008, 2007 and 2006.
Certain founding shareholders, including Aon Corporation and its affiliates (“Aon”), received warrants in conjunction with the capitalization of the Company. During 2006, Aon transferred all of the warrants it had received from the Company to third parties and thus, was no longer an affiliate of the Company at December 31, 2006.
During the year ended December 31, 2006, the Company was party to agreements with various affiliates of Aon as follows:
Under the terms of the 2007 Plan, and after the consolidation of the Company’s previous plans, a total of 2,100,000 ordinary shares have been reserved for issuance. The Company issues new ordinary shares upon the exercise of outstanding options or settlement of a vested restricted share unit. As of December 31, 2008, 1,136,109 ordinary shares remained available for issuance under the 2007 Plan.
The Company issued stock options to employee and non-employee directors, with exercise prices equal to the fair market values of the Company’s ordinary shares on the grant dates. Options generally vest at a rate of 20% per year over a five year term. Option awards have a 10-year contractual life.
A summary of option activity, including options held by employees and non-employee directors, during the year ended December 31, 2008 is presented below:
No options were granted during the years ended December 31, 2008, 2007 and 2006. The total intrinsic value of options exercised during the years ended December 31, 2008, 2007, and 2006 was $0.6 million, $11.3 million, and $8.1 million, respectively. The Company received proceeds of $0.7 million from the exercise of options during the year ended December 31, 2008. The Company issued new ordinary shares in connection with the exercise of the above options.
On July 1, 2006, the Company created a second option agreement for U.S. taxpayers in order to comply with Section 409A of the U.S. Internal Revenue Code and the regulations promulgated by the U.S. Internal Revenue Service under Section 409A. The new form of option agreement eliminates the reductions in strike price for dividends paid by the Company relating to unexercised options and instead grants restricted share units in an amount equal to the strike price adjustments for dividends paid by the Company. These units generally vest and settle on the first March 1st following the six-month anniversary of the date of issuance of the unit.
For the years ended December 31, 2008, 2007 and 2006, compensation costs recognized in earnings for all restricted shares and restricted share units were $17.3 million, $10.9 million, and $6.2 million, respectively. At December 31, 2008, compensation costs not yet recognized related to non-vested awards was $15.6 million (2007 - $16.4 million). This expense is expected to be recognized between 2009 and 2012, with approximately 64% expected to be recognized during 2009.
Our insurance and reinsurance operations are subject to insurance and/or reinsurance laws and regulations in the jurisdictions in which they operate, including Bermuda, United States and the United Kingdom. These regulations include certain restrictions on the amount of dividends or other distributions, such as loans or cash advances, available to shareholders without prior approval of the insurance regulatory authorities.
Endurance U.S. Reinsurance, Endurance American, Endurance American Specialty and American Merchants are subject to regulation by the Delaware Department of Insurance. ARMtech is subject to regulation by the Texas Department of Insurance. Dividends for each U.S. operating subsidiary are limited to the greater of 10% of policyholders’ surplus or statutory net income, excluding realized capital gains. In addition, dividends may only be declared or distributed out of earned surplus. At December 31, 2008, Endurance U.S. Reinsurance, Endurance American and Endurance American Specialty did not have earned surplus and thus were precluded from declaring or distributing dividends during 2009 without the prior approval of the applicable insurance regulator. If the parent company is also an insurer, as is the case with Endurance American, Endurance American Specialty and American Merchants, the parent company or companies must also meet their own dividend eligibility requirements in order to pass along any dividends received from subsidiary insurance companies. At December 31, 2008, American Merchants and ARMtech (with notice to the Texas Department of Insurance) could pay dividends of $5.7 million and $3.5 million (2007 - $5.4 million and $6.3 million), respectively, without prior regulatory approval.
Of the 2008 current income tax expense, $22.8 million related to taxes incurred in the United States (2007 - $10.8 million; 2006 - $7.4 million) and $11.0 million related to current income tax benefits in the United Kingdom (2007 and 2006 - Nil). Of the deferred income tax benefit (expense), $22.0 million and $Nil related to deferred income tax benefits (expenses) in the United States and the United Kingdom, respectively (2007 - $3.0 million and ($11.8) million; 2006 - ($15.9) million and ($5.7) million).
Deferred income taxes represent the tax effect of the differences between the book and tax bases of assets and liabilities. Net deferred income tax assets and liabilities consisted of the following as of December 31, 2008 and 2007:
The Company paid income taxes totaling $29.6 million, $25.7 million and $7.1 million for the years ended December 31, 2008, 2007 and 2006, respectively. Net operating loss carryforwards in the amount of $82.0 million are available for application against future taxable income in the United Kingdom. These net operating loss carry forwards have no expiration date. There were no income taxes payable at December 31, 2008 or 2007.
A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. At December 31, 2008, management has established a valuation allowance of $15.7 million (2007 - $10.3 million) against realized investment losses and other items for which the Company does not have current plans to produce future realized investment gains and other income.
The following is a summary of the unaudited quarterly data for the year ended December 31, 2008:
Certain comparative information in the unaudited quarterly financial data for the years ended December 31, 2008 and 2007 have been reclassified to conform to current year presentation.