ROACE was 8.1% for 2008 compared to 24.6% and 26.7% for 2007 and 2006, respectively. Our ROACE in 2008 was negatively impacted by Hurricanes Ike and Gustav as well as investment losses relating to the financial market crisis. In comparison, our ROACE in 2007 and 2006 benefited from an absence of major catastrophe losses and stable financial market conditions.
Diluted book value per common share (“DBV per common share”): DBV per common share represents total common shareholders’ equity divided by the number of common shares and diluted common share equivalents outstanding, using the treasury stock method. We consider DBV per common share an appropriate measure of our returns to common shareholders, as we believe growth in our book value on a diluted basis ultimately translates into growth of our stock price. DBV per common share was $25.79, $28.79 and $23.45 at December 31, 2008, 2007 and 2006, respectively.
The reduction in DBV per common share in the current year was primarily due to an increase in net unrealized losses on our investment portfolio of $735 million, share repurchases of $291 million, and dividends to common and preferred shareholders of $158 million. This was partially offset by net income of $387 million. The increase in DBV per common share in 2007 as compared with 2006 was primarily due to net income in the year of $1.0 billion.
Cash dividends per common share: Our dividend policy is an integral part of the value we create for our shareholders. Our cash dividends declared in 2008 were $0.755 per common share compared to $0.68 and $0.615 per common share in 2007 and 2006, respectively. Our Board of Directors reviews our dividend policy on a regular basis and in December 2008, they authorized an 8% increase in our quarterly dividend.
2008 versus 2007: Total underwriting income in 2008 decreased $431 million, or 58%, compared to 2007. The reduction was driven by net losses of $384 million, net of related earned reinstatement premiums, incurred from Hurricanes Ike and Gustav. Almost three-quarters of these hurricane losses were incurred within our reinsurance segment.
2008 versus 2007: Net investment income and net realized investment gains/losses in 2008 decreased $326 million compared to 2007. This reduction was driven by a combination of lower investment income from our other investment portfolio ($255 million) coupled with higher realized investment losses ($90 million). Our other investments were impacted by significant valuation declines in credit funds and hedge funds, resulting from the unprecedented disruption to the global markets. Our fixed maturities produced $432 million of net investment income in 2008, an increase of 17% over the prior year, reflecting higher average investment balances.
2007 versus 2006: Total net investment income and net realized investment gains/losses in 2007 increased $107 million compared to 2006. This increase was primarily due to a $78 million increase in investment income from our fixed maturities, reflecting higher average investment balances. In addition, we experienced an increase of $31 million in net realized investment gains.
Refer to “Net Investment Income and Net Realized Gains/Losses”, below, for further discussion.
Corporate expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned, corporate expenses were 2.7%, 2.1% and 2.2% for 2008, 2007, and 2006 respectively. The increase in our corporate expense ratio in 2008 was primarily due to higher share-based compensation costs, principally associated with the renewed employment contract for our CEO and a higher grant date fair value on issued awards year over year (refer to Item 8, Note 15 “Stock Compensation Plans” to the Consolidated Financial Statements).
Foreign exchange gains: Some of our business is written in currencies other than U.S. dollars. The foreign exchange gain in 2008 was primarily due to the remeasurement of net liability balances denominated in Euro, following its depreciation against the U.S. dollar during the year. The foreign exchange gains in 2007 and 2006 were driven by the revaluation of net asset balances denominated in several foreign currencies, following their appreciation against the U.S. dollar over this period.
The increase in premiums ceded in 2008 primarily reflects the purchase of additional quota share coverage within our casualty and professional lines business this year. This additional reinsurance protection has allowed us to reduce our overall risk exposures cost-effectively.
2007 versus 2006: Gross premiums written in 2007 were largely flat relative to 2006. In our insurance segment, increases in credit and political risk, professional lines and U.S. exposed catastrophe property premium were offset by the impact of competitive market conditions and rate pressures in our other lines. In our reinsurance segment, although we increased our market penetration in the U.S. and European reinsurance markets during the January 1 renewal season, this was largely offset by the impact of increased client retention in our professional lines business and the change in renewal date of a large property pro rata contract.
The increase in our ceded premiums ratios was partially due to a change in business mix towards lines with higher levels of ceded premium. We also purchased additional quota share reinsurance on our professional lines business and expanded our worldwide property program in 2007.
2007 versus 2006: Although net premiums earned in 2007 were largely flat with 2006, we experienced a shift in mix from insurance to reinsurance business. Our reinsurance segment benefited from growth of its underwriting operations in recent years, while changes in business mix and an expansion of our reinsurance coverage had the effect of reducing net premiums earned in our insurance segment.
The 15.3 ratio point increase in our current year loss ratio this year was driven by higher catastrophe losses, primarily emanating from net losses incurred on Hurricanes Ike and Gustav of $408 million, or 15.2 ratio points.
On September 12, Hurricane Ike made landfall on Galveston Island in the State of Texas as a category 2 hurricane causing widespread flooding and wind damage throughout the Galveston and Houston areas. Prior to making landfall, Hurricane Ike moved through offshore energy production areas in the Gulf of Mexico. The industry losses estimated by Risk Management Solutions, a risk modeling agency, currently stand at $13 billion to $21 billion, and include wind-related damages, flood-related damages and business interruption. Our estimate of net losses from Hurricane Ike is $377 million, of which $98 million emanates from our insurance segment and $278 million from our reinsurance segment.
Our current year loss ratio in 2008 was also negatively impacted by, among other things, a higher frequency and severity of property losses in our insurance segment as well as increased accident year initial loss ratios within many of our lines of business as a result of pricing deterioration. Offsetting these factors, our 2008 current year loss ratio benefited from the incorporation of more of our own loss experience within a number of our short-tail lines of business, relative to the prior year. In addition, we had a relatively higher level of loss recoveries in 2008 within our Insurance segment, as a result of our expanded reinsurance coverage.
We generally use the Bornhuetter-Ferguson (“B-F”) actuarial method on our short-tail lines of business which gives progressively more weighting to our actual loss experience as each accident year matures. In each of the last three years, the application of the B-F method has resulted in a reduction to our ultimate loss estimates, due to the fact that our actual experience has included less than expected late reporting and reduced deterioration on previously reported claims, relative to our previous expectations. This partly stems from the fact that historically we had relied heavily upon industry based profiles. Due to the inherent limitations of this, our loss reserves in prior years have also included a provision for reporting delays and other uncertainties specific to our business. These include the inherent delays we expect to arise from obtaining loss information on excess layers of business across our diverse worldwide exposures. As it has transpired, our actual claims experience in the last three years has been better than we projected, with late reporting being less prevalent than we anticipated. Refer to our “Critical Accounting Estimate on Loss Reserves” for further discussion.
In addition to this broader claims experience, favorable prior period reserve development has also occurred as a result of our take down of provisions relating to specific catastrophe events. On contracts that respond to highly visible, major events, we establish IBNR where potential exposure has been identified. However, in a number of instances, mainly within our excess of loss catastrophe reinsurance business, it transpired that claims did not develop to a sufficient level to reach our attachment points.
As we continue to incorporate more of our own historical loss experience into our current year loss ratios (see above), we expect that the level of favorable prior period reserve development on our short-tail lines will be less than recorded in prior years. However, we caution that conditions and trends that impacted the development of our liabilities in the past may not necessarily occur in the future.
In 2008, we also recorded prior period reserve development from certain medium and long-tail lines of business. First, we experienced $65 million of net favorable development on the credit and political risk lines in our insurance segment. This was generated from our credit related classes, partially in recognition of lower than expected loss activity and also due to adopting a more accelerated loss development profile on these lines. We also recognized favorable prior period reserve development from our traditional political risk book from accident years 2004 and prior.
Second, we experienced net adverse development of $10 million on our professional lines and liability business. This was the result of several favorable and adverse reserve developments, the most significant of which were as follows:
For further discussion on our current and prior year loss ratios, refer to the insurance and reinsurance segment discussions below.
2008 versus 2007: In 2008, underwriting income in our insurance segment decreased $187 million, or 50%, over the prior year, primarily due to losses incurred of $127 million from Hurricanes Ike and Gustav. These losses contributed 10.7 points to our 2008 combined ratio. Underwriting income in our insurance segment was also impacted by a $41 million increase in the estimated fair value of an insurance derivative contract liability, which is included in other insurance related income.
2007 versus 2006: In 2007, underwriting income in our insurance segment increased 3% over the prior year, primarily due to higher levels of prior period favorable reserve development. Our current year loss ratio was largely comparable with limited large loss activity in both years. Net premiums earned in 2007 were down 7% versus 2006, primarily reflecting changes in business mix along with an expansion of our reinsurance coverage.
Partially offsetting these decreases, we experienced growth in our professional lines business this year. In 2008, this line benefited from renewal rights we acquired in conjunction with our purchase of the Media Pro business in the second quarter of 2007. In addition, in the later part of the year, the growth was driven by new business arising from disruptions in the financial institutions sector together with some rate increases on renewal business.
2007 versus 2006: In general, market conditions globally were increasingly competitive during 2007 and, as a result, we experienced increased pricing pressure across many of our insurance lines. The overall stability of gross premiums written in 2007 versus 2006 reflects our breadth of products and markets worldwide, which gave us the flexibility to allocate capacity within other lines of business. Credit and political risk premium can vary considerably between periods depending on the timing of transactions. However, additional underwriters in this line allowed us to increase the number of contracts written in 2007, the majority of which were related to emerging market sovereign and corporate credit insurance. The other notable increase in 2007 was on our professional lines book. This was largely associated with renewal rights acquired in the May 2007 purchase of the Media Pro business. Other than U.S. exposed catastrophe property business, which continued to present good opportunities, market conditions in our other lines of business continued to be less favorable during 2007. This largely limited our ability to expand these lines, although we continued to seek out the better priced and structured opportunities.
2007 versus 2006: Premiums ceded in 2007 were $713 million, or 34.9% of gross premiums written, compared with $610 million, or 29.5% of gross premiums written in 2006. The increase in premiums ceded was largely related to the impact of changes in business mix and additional reinsurance cover purchased during 2007. While we significantly reduced gross
premiums written on our aviation and terrorism lines during 2007, we offset these reductions with growth of our credit and political risk, property and professional lines business. Because we have historically purchased more reinsurance cover on our property and professional lines business relative to our aviation and terrorism lines, this change in business mix had the effect of increasing our ceded premium ratio. Furthermore, we also purchased additional coverage in 2007, both on our professional lines quota share reinsurance and also on our worldwide property program. These factors were partially offset by lower reinsurance costs within our property line of business this year, reflecting both rate reductions and increased retentions within certain parts of our book.
2008 versus 2007: The 2% decrease in net premiums earned in 2008 primarily reflects the decrease in net premiums written this year, although the rate of reduction has been less accelerated. This was partially due to growth of our credit and political risk line of business in prior years, which typically provides multi-year coverage, and therefore earns over a greater number of periods. The average duration of the unearned premium on our credit and political risk line of business at December 31, 2008 was 5.4 years. Net premiums earned in 2008 also benefited from growth in property premiums in prior years as well as lower ceded premium amortized costs on this business in 2008, as discussed above.
Higher catastrophe losses in 2008, driven by net losses incurred of $127 million, or 10.7 points, on Hurricanes Ike and Gustav.
An increase in the loss ratios of our professional lines business, primarily reflecting the impact of the sub-prime crisis on our portfolio.
The incorporation of more of our own historical loss experience within our short-tail lines of business. Because this experience has generally been better than we expected (see below) this had the impact of reducing our net IBNR reserves on several lines of business, relative to 2007. Refer to our “Critical Accounting Estimate-Reserves for Losses and Loss Expenses” for further information.
We experienced net favorable prior period reserve development in 2008 of $202 million, or 17.1 ratio points, the principal movements of which were as follows:
Net adverse development of $8 million on our liability business, predominately from accident years 2004 and prior.
We experienced net favorable prior period reserve development in 2007 of $214 million, or 17.7 ratio points, the principal movements of which were as follows:
Adverse development of $8 million on our 2006 accident and health business due to a higher than expected emergence of claims.
Adverse development of $16 million on our marine lines of business. This was driven by adverse development of $68 million on our accident year 2005 reserves, reflecting deteriorating KRW claims experience on our energy offshore business. This was partially offset by favorable development from older accident years.
Refer to “Prior Period Reserve Development” within our Group Underwriting Results, above, for discussion on the underlying reasons for these movements
The insurance markets generally remain highly competitive, with surplus capacity and consequent pricing pressure continuing to prevail in most lines. Although market conditions continue to soften, the rate at which this is occurring has slowed considerably. Terms and conditions as well as breadth of coverage generally remain stable with terms of trade holding firm. We are observing more positive change in catastrophe-exposed property lines. We started to observe the quantum of rate reductions in these property lines reduce and then stabilize towards the end of 2008 and through January 2009. We expect to see this momentum increase as we head into the key March 1st and April 1st property renewals. A number of our key competitors appear to be reducing critical catastrophe exposure which will have further positive impact on the market. We are particularly well-positioned in this market to capitalize on the upturn. Offshore energy is also hardening due to the impact of Hurricane Ike. We are observing price increases on non-Gulf of Mexico exposure in the range of 15 to 20%. Although there have not yet been any Gulf of Mexico renewals of note, we are expecting significant pricing improvements going forward.
Although the professional lines market remains competitive, we are observing new opportunities arising from the dislocation of business formerly placed with certain distressed insurers. Our continued financial strength has significantly improved our competitive position in the professional lines market. In the financial institutions class, rates in the fourth quarter of 2008 continued to increase and we expect this to continue throughout 2009. In the casualty lines, after brief stabilization in the marketplace towards the end of 2008, we have seen aggressive competition return driven by distressed insurers. We believe our areas of focus still contain good profit potential, but risk selection and overall execution strategy
2008 versus 2007: Total underwriting income in 2008 decreased $245 million, or 67%, versus 2007. The reduction was driven by net losses of $257 million, net of related earned reinstatement premiums, incurred from Hurricanes Ike and Gustav. Partially offsetting this, 2008 benefited from a higher level of prior year favorable reserve development.
2007 versus 2006: Total underwriting income in 2007 increased $52 million, or 17%, versus 2006. The increase was driven by $74 million of additional prior period net favorable reserve development. This was partially offset by a higher current accident year loss ratio in 2007, which was in large part due to changes in our business mix. Net premiums earned increased by 10% in 2007, reflecting the impact of expanding of our reinsurance operations in prior years.
2007 versus 2006: Gross premiums written in 2007 benefited from a weakened U.S. dollar relative to 2006. In particular, the U.S. dollar was weaker against the Euro and Sterling at our major renewal date of January 1. Gross premiums written otherwise decreased 3% in 2007, reflecting reductions in our property and professional lines business. The decrease in property premiums was primarily due to a large 16-month pro rata contract, written in the fourth quarter of 2006, not renewed until 2008. Our professional lines book was impacted by the non-renewal of several large contracts, driven by cedants opting to increase their retention of business. Our other lines of business mostly reported an increase in gross premiums written in 2007. These increases were largely generated from our increased participation in the U.S. and European reinsurance markets.
The 18.7 ratio point increase in our current year loss ratio was driven by net losses incurred on Hurricanes Ike and Gustav of $281 million. Other catastrophe losses in 2008, which included flood, hail and tornado losses in the U.S., an earthquake in China and storms in Australia, were broadly in line with our annual expectations for such losses. This was similar to 2007, which included a number of mid-sized catastrophes, including Windstorm Kyrill and flooding and storm damage in Australia and U.K.
The 2.6 ratio point in our current year loss ratio in 2007 mostly reflected changes in business mix. We experienced a shift towards liability business, which typically has a higher initial expected loss ratio compared to our other lines. Although there was a higher incidence of mid-sized catastrophes in 2007, as noted above, our exposure to these events did not have a substantial impact on our total estimated current year losses relative to 2006.
We experienced net favorable prior period reserve development in 2008 of $174 million, or 11.6 ratio points, the principal movements of which were as follows:
Net favorable development of $11 million from our professional lines business. This was driven by favorable development of $25 million on accident years 2003 and 2004, partially offset by adverse development on accident year 2007.
We experienced net favorable prior period reserve development in 2007 of $123 million, or 8.1 ratio points, the principal movements of which were as follows:
$14 million of favorable prior period reserve development on our accident year 2005 and 2006 crop reserves.
$62 million of net favorable prior period reserve development on our catastrophe line of business, the majority of which was generated from accident year 2004.
$6 million favorable development on our accident year 2004 crop reserves.
Adverse development of $9 million on our accident year 2004 and 2005 motor liability lines of business due to higher than expected loss emergence.
Our 2009 treaty reinsurance renewals are progressing well and we are satisfied with the quality, diversity and balance of the portfolio we reassembled at January 1, 2009. Typically, approximately 50% of our reinsurance gross premiums written within any calendar year renews on this date. Although we have not yet finalized all the business we expect to bind, we anticipate that our first quarter treaty reinsurance renewals in 2009 will represent over 11% growth in premium relative to the same period in 2008.
Driving the growth was our credit and bond reinsurance business in Continental Europe and our U.S. professional liability and general casualty reinsurance business. We were able to gain strategic share on attractive treaties due to concerns over the financial strength of distressed reinsurers, particularly for U.S. casualty reinsurance business. The credit and bond reinsurance market in Continental Europe experienced significant dislocation at renewal and we were able to consolidate our position at our required pricing and terms.
During the latter part of 2007 and into 2008, there has been a slowdown in the global economy precipitated primarily by increased defaults on sub-prime mortgages in the U.S. and elsewhere, falling house prices and contracting consumer spending. The significant increase in default rates negatively impacted the value of mortgage backed securities held by foreign and domestic institutions. The defaults have led to a corresponding increase in foreclosures, which have driven down house values, resulting in additional losses in mortgage-backed and asset-backed securities. During the current year, the credit markets deteriorated dramatically, as evidenced by widening credit spreads and reduced availability of credit. Many financial institutions experienced liquidity crises due to immediate demands for deposit withdrawals or collateral, combined with falling asset values and their inability to sell assets or meet the increased demands. As a result, several financial institutions have failed or been acquired at distressed prices, while others have received financial assistance from the U.S. government to continue operations. The liquidity crisis significantly increased the spreads on certain fixed maturities and, at the same time, had a dramatic negative impact on the global stock markets. As described in more detail below, these events had a material negative impact on our net investment income and net realized gains/losses in 2008.
Consolidated Statements of Comprehensive Income for the years ended December 31, 2008, 2007 and
We have audited the accompanying consolidated balance sheets of AXIS Capital Holdings Limited and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of AXIS Capital Holdings Limited and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
Certain reclassifications have been made to prior period amounts to conform to the current period presentation. Tabular dollars and share amounts are in thousands, except per share amounts. All amounts are reported in U.S. dollars. Our significant accounting policies are as follows.
Level 1 - Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Valuation adjustments and block discounts are not applied to Level 1 instruments. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
Examples of assets and liabilities utilizing Level 1 inputs include: exchange-traded equity securities, U.S. Treasury securities, and listed derivatives that are actively traded.
Examples of assets and liabilities utilizing Level 2 inputs include: exchange-traded equity securities and listed derivatives that are not actively traded; U.S. government-sponsored agency securities; non-U.S. government obligations; corporate and municipal bonds; mortgage-backed securities (“MBS”) and asset-backed securities (“ABS”); short-duration high yield fund, and over-the-counter (“OTC”) derivatives (e.g. foreign currency options and forward contracts).
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own assumptions about assumptions that market participants might use.
In February 2008, the FASB issued FASB Staff Position (FSP) FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”), which permits a one-year deferral of the application of FAS 157 for all 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 (at least annually). FSP FAS 157-2 is effective in conjunction with FAS 157 for interim and annual financial statements issued after January 1, 2008. Accordingly, we have not applied the provisions of FAS 157 to our goodwill and other intangible assets which are measured annually for impairment testing purposes only. We will adopt FSP FAS 157-2 on January 1, 2009, and do not anticipate this adoption will have a material impact on our results of operations, financial position or liquidity.
Investments that are considered “available for sale” as defined in FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“FAS 115”), are reported at fair value at the balance sheet date.
We use quoted market values and other relevant observable market data provided by nationally recognized independent pricing sources (pricing services and broker-dealers) as inputs into our process for estimating fair values of our fixed maturities. When there is no available quoted market price in active markets, a pricing service will use a pricing matrix model to estimate fair value using the following significant inputs, which include reported trades, benchmark yields, broker-dealer quotes, bids, offers, credit risks and spreads, and prepayment speeds. When pricing is not available from pricing services, we obtain non-binding quotes from broker-dealers or prices from independent administrators. During times of market illiquidity, we exercise significant judgment in establishing fair values.
The fair value for our equities is based upon quoted market prices in active markets.
The net unrealized gain or loss on available-for-sale investments, net of tax, is included as accumulated other comprehensive income (loss) in shareholders’ equity, subject to an other-than-temporary impairment (“OTTI”) review. We assess quarterly whether declines in fair value of our available-for-sale investments represent impairments that are other than temporary. There are several factors that are considered in the assessment of a security, which include (i) the time period during which there has been a significant decline below cost, (ii) the extent of the decline below cost, (iii) our intent and ability to hold the security, (iv) the potential for the security to recover in value, (v) an analysis of the financial condition of the issuer and (vi) an analysis of the collateral structure and credit support of the security, if applicable. Where we have determined that there is an OTTI in the fair value of the security, the cost of the security is written down to the fair value and the unrealized loss at the time of the determination is charged to net realized investment gains (losses) in the Consolidated Statement of Operations. In January 2009, the FASB issued FASB FSP EITF 99-20-1, Amendments to the Impairment and Interest Income Measurement Guidance of EITF Issue No. 99-20, (“FSP EITF 99-20-1”) effective December 31, 2008. This FSP retains fair value as its measurement attribute for OTTI on securitized financial assets but it removes the market participant notion as required under EITF 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to be Held by a Transferor in Securitized Financial Assets, and it requires a probability assessment for adverse changes in cash flows consistent with the impairment model in FAS 115. We have adopted this FSP during our OTTI review for the December 31, 2008 valuation of our securitized financial assets.
For our investment in CLOs - equity tranche, we estimate fair value based on observable relevant trades in active secondary markets where available or the use of an internal valuation model where market is inactive. Our internal valuation model includes the following significant inputs: market default and recovery rates, collateral spreads, and prepayments. As some of these significant inputs cannot be corroborated with observable market data, the fair value estimation process is inherently more subjective. Income distribution from these CLOs is also reported in net investment income.
Insurance premiums written are recorded in accordance with the terms of the underlying policies. For multi-year policies for which premiums are payable in annual installments, premiums written are recorded at the inception of the policy based on management’s best estimate of total premiums to be received. We do not include premiums for later periods during which the insured/reinsured has the ability to unilaterally commute or cancel coverage. Reinsurance premiums are recorded at the inception of the policy and are estimated based upon information received from ceding companies. Any subsequent differences arising on insurance and reinsurance premium estimates are recorded in the period they are determined.
Insurance and reinsurance premiums are earned over the terms of the policies in proportion to the risks to which they relate. Unearned premiums represent the portion of premiums written that is applicable to the unexpired portion of the policies in force.
Reinstatement premiums for our insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and earned on a pro-rata basis over the remaining risk period. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment, as described in Note 2 (f) below.
Reinsurance recoverables are based on contracts in force and are presented net of a reserve for uncollectible reinsurance. The method for determining the reinsurance recoverable on unpaid losses and loss expenses involves actuarial estimates of unpaid losses and loss expenses as well as a determination of our ability to cede unpaid losses and loss expenses under our reinsurance treaties.
We may enter into derivative instruments such as futures, options, interest rate swaps and foreign currency forward contracts as part of our overall foreign currency risk management strategy or to obtain exposure to a particular financial market and for yield enhancement. From time to time we may enter into insurance and reinsurance contracts that meet the definition of a derivative contract under FAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”).
We may designate a currency derivative as a hedge on the fair value of certain investment portfolios attributable to changes in foreign currency exchange rates. This is referred to as a fair value hedge. Changes in the fair value of a derivative that is designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk, are recorded in net realized investment gains (losses), including any hedge ineffectiveness.
In accordance with FAS No. 142, Goodwill and Other Intangible Assets, we classify intangible assets into three categories: (1) intangible assets with finite lives subject to amortization, (2) intangible assets with indefinite lives not subject to amortization, and (3) goodwill. For intangible assets with finite lives, we amortize the value of the assets over their useful lives. The estimated remaining useful lives for these assets range from 3 to 11 years. We also test assets for impairment if conditions exist that indicate the carrying value may not be recoverable. Such conditions may include an economic downturn in a geographic market or change in the assessment of future operations. We record an impairment charge when the carrying value of the finite lived intangible assets is not recoverable by the cash flows generated from the use of the asset.
We early adopted FAS No. 161, Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133 (“FAS 161”), which was issued in March 2008. This Statement expands the disclosure requirements of FAS 133 and requires the reporting entity to provide enhanced disclosures about the objectives and strategies for using derivative instruments, quantitative disclosures about fair values and amounts of gains and losses on derivative contracts, and credit-risk related contingent features in derivative agreements.
We adopted FASB Staff Position No. FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities, effective for our calendar year ended December 31, 2008. This Staff Position requires additional disclosures and applies to transferors, sponsors, services, primary beneficiaries, and holders of significant variable interests in a variable interest entity (VIE) or qualifying special purpose entity (QSPE). Refer to Note 9 for additional disclosures provided in relation to our significant implicit variable interest in the SPE associated with our insurance derivative contract.
In April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors considered in developing assumptions used to determine the useful life of an intangible asset under FAS No. 142, Goodwill and Other Intangible Assets (“FAS 142”). The intent of FSP FAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under FAS 142 and the period of expected cash flows used to measure the fair value of the asset under FAS 141(R) and other applicable accounting literature. FSP FAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and must be applied prospectively to intangible assets acquired after the effective date. We adopted FSP FAS 142-3 on January 1, 2009, and we do not anticipate this will have a material impact on our results of operations, financial condition or liquidity.
Our reinsurance segment provides treaty and facultative property and casualty reinsurance to insurance companies on a worldwide basis. The product lines in this segment are catastrophe, property, professional liability, credit and bond, motor, liability, engineering and other.
In 2007, we acquired the assets and operations of the Media Professional Division of MPI Insurance Agency, Inc., which resulted in recording $24 million and $10 million of goodwill and intangible assets with a finite life, respectively.
The contractual maturities of our fixed maturities are shown below. Actual 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 2008, we recorded an OTTI charge for two equity securities in the amount of $7 million (2007 and 2006: nil). The valuation for the remaining equity securities which are below cost is believed to be correlated with the volatility in the equity markets that existed at December 31, 2008. The majority of our equity securities that were priced at less than 80% of cost were for a period of less than three months. We do not consider the remaining equities with an unrealized loss position to be other-than-temporarily impaired at December 31, 2008, as we have the ability and intent to hold these securities for a reasonable period of time until a recovery of fair value to cost.
The movement in our hedge funds and credit funds in the year reflect net subscriptions of $47 million and $57 million, respectively, offset by a decrease in fair value of $73 million and $150 million, respectively.
Net investment income on our other investments includes interest, dividend income, income distributions, and net realized and unrealized gains and losses. During 2008, we recorded net realized losses on our other investments of $42 million (2007: $4 million and 2006: nil).
Proceeds from sales of fixed maturities classified as available for sale were $10,027 million, $6,755 million and $4,436 million in 2008, 2007 and 2006 respectively. The gross realized losses include OTTI charges of $78 million (2007: $9 million, 2006: $5 million).
At December 31, 2008, we classified our financial instruments measured at fair value on a recurring basis in the following valuation hierarchy:
Hedge funds, credit funds and equity tranches of CLOs are included within Level 3. The fair value for hedge funds and credit funds are based on the reported net asset value as advised by the external fund manager or third party administrator. For these funds we do not have full access to the underlying investment holdings to enable us to corroborate the fair value measurement used by the fund managers. However, we regularly review performance directly with the fund managers and perform qualitative analysis to corroborate the reasonableness of the net asset values.
We classified our indemnity contract with longevity risk exposure (see Note 9) within Level 3 due to the use of significant unobservable inputs in our internal valuation model for estimating its fair value. To determine the potential indemnity payment on the insured Note (as defined in Note 9), we reviewed all the cash flows relating to the SPE, the issuer and collateral for the insured Note. The estimated indemnity payment with an appropriate risk margin, net of our contractual premiums for providing the indemnity, are then discounted using the risk free yield curve, adjusted for counterparties’ credit risk.
The most significant and subjective inputs in our valuation model are:
the proceeds of selling the unmatured life settlement contracts in 2017; and
the risk margin that a market participant would require for providing this indemnity.
From the inception of our insurance policy to December 31, 2008, we observed that the actual experience for the above portfolio was lagging our expectations. This lag contributed $53 million to the increase of the derivative liability balance at December 31, 2008 from December 31, 2007, which was partially offset by $12 million of favorable movements in interest rates and credit spreads as well as other items.
We exercised significant judgment in estimating the fair value of our indemnity contract; accordingly, the actual indemnity payment, if any, may differ materially from the $63 million derivative liability recorded at December 31, 2008.
Net loss and loss expenses incurred include net favorable prior period reserve development of $376 million, $337 million and $217 million for the years ended December 31, 2008, 2007 and 2006, respectively. Prior period development arises from changes to loss estimates recognized in the current year that relate to loss reserves first reported in previous calendar years. The table below summarizes net favorable prior period reserve development by segment:
In 2008, we also recorded adverse development of $48 million on our accident year 2007 professional lines reserves. During the year, a number of large financial institutions incurred significant financial losses and, in some cases, bankruptcy precipitated by the continued deterioration in the U.S. sub-prime residential mortgage market and the ensuing dislocation in the credit markets. These market driven events triggered claims against directors and officers of impacted institutions as well as providers of professional services of these institutions. As part of our reserving process, we considered the potential impact of market events on our financial institutions insurance portfolio. This included a review for exposure to known notifications of potential loss, as well as a review of accounts that may have exposure in this area, but have not yet provided notice of a claim. We also performed a similar review in our reinsurance segment, where potential exposure primarily exists within financial institution classes underwritten by our cedants. As a result, we strengthened our accident year 2007 reserves by $37 million in our insurance segment and by $11 million in our reinsurance segment. Although our reserves provide for potential future deterioration in our exposure to the credit crisis, while the crisis prevails and as new information is reported, actual losses may ultimately differ materially from our current estimates.
During 2008, we entered into foreign currency forward contracts to mitigate the foreign currency exposure of two AFS fixed maturity portfolios denominated in Euros. The hedges were designated and qualified as a fair value hedge. Accordingly, we recorded $8 million of unrealized losses on the two hedged AFS portfolios in net realized investment
In September 2007, we issued a policy which indemnifies a third party in the event of a non-payment of the full $400 million asset-backed note (“Note”). This security has a 10 year term with the full principal amount due at maturity and is collateralized by a portfolio of life settlement contracts and cash held by a special purpose entity (SPE). We have concluded that the indemnity contract was a derivative instrument and accordingly we have recorded it at its fair value (see Note 6).
Through the issuance of our indemnity contract, we hold a significant implicit variable interest in the SPE and have concluded that the Company is not its primary beneficiary in accordance with FSP FIN 46(R)-5, Implicit Variable Interests under FASB Interpretation No. 46 (revised December 2003). To make this determination, we identified all significant creators of volatility generated from the SPE, which are longevity and interest rate risks, and the variable interests of the SPE. We absorbed the downside longevity risk up to an aggregate limit of $400 million; whereas, the insured party absorbed the tail end of the longevity downside risk and the upside risk as well as the majority of the downside and upside of the interest rate risk. In accordance with FIN 46(R), we calculated the expected losses and expected residual returns using cash flow scenario techniques to determine which party absorbed the majority of the expected losses. Based on these quantitative analyses and other qualitative factors, we concluded that the insured party was the primary beneficiary. The determination of the primary beneficiary required significant management judgment.
During 2006, we entered into a $100 million Total Return Swap Facility (the “Facility”) with a financial institution for the purpose of accessing and isolating natural peril exposures embedded in capital market instruments. We utilized half of the Facility to enter into a $50 million catastrophe-related total return swap transaction to assume losses from qualifying earthquake events. As a result of this swap, the Facility was collateralized by a lien over a portfolio of the Company’s investment grade securities. During 2008, we earned payments on the swap, net of the Facility fee, which are included in other insurance related income. The Facility will terminate on September 15, 2009.
On November 15, 2004, we issued $500 million of senior unsecured debt (“Senior Notes”) at an issue price of 99.785%, generating net proceeds of $496 million. The Senior Notes bear interest at a rate of 5.75%, payable semi-annually in arrears on June 1 and December 1 of each year, beginning on June 1, 2005. Unless previously redeemed, the Senior Notes will mature on December 1, 2014. We may redeem the Senior Notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The Senior Notes indenture contains various covenants, including limitations
on liens on the stock of restricted subsidiaries, restrictions as to the disposition of the stock of restricted subsidiaries and limitations on mergers and consolidations. We were in compliance with all the covenants contained in the Senior Notes indenture at December 31, 2008 and 2007.
We lease office space in the countries in which we operate under operating leases which expire at various dates. We renew and enter into new leases in the ordinary course of business as required. During 2008, total rent expense with respect to these operating leases was $15 million (2007: $12 million: 2006: $10 million). Future minimum lease payments under our leases are expected to be as follows:
In 2005, a putative class action lawsuit was filed against our U.S. insurance subsidiaries. In re Insurance Brokerage Antitrust Litigation was filed on August 15, 2005 in the United States District Court for the District of New Jersey and includes as defendants numerous insurance brokers and insurance companies. The lawsuit alleges antitrust and Racketeer Influenced and Corrupt Organizations Act (“RICO”) violations in connection with the payment of contingent commissions and manipulation of insurance bids and seeks damages in an unspecified amount. On October 3, 2006, the District Court granted, in part, motions to dismiss filed by the defendants, and ordered plaintiffs to file supplemental pleadings setting forth sufficient facts to allege their antitrust and RICO claims. After plaintiffs filed their supplemental
On December 4, 2008 the Board of Directors declared a dividend of $0.20 per common share to shareholders of record at December 31, 2008 and payable on January 15, 2009. Additionally, the Board of Directors declared a dividend of $0.453125 per Series A 7.25% Preferred share and a dividend of $1.875 per Series B 7.5% Preferred share. The Series A Preferred share dividend is payable on January 15, 2009, to shareholders of record at December 31, 2008 and the Series B Preferred share dividend is payable on March 2, 2009 to shareholders of record at February 17, 2009.
Commencing on March 1, 2016, the dividend rate on the series B Preferred shares will be payable at a floating rate. During a floating rate period, the floating rate per annum will be reset quarterly at a rate equal to 3.4525% plus the 3-month LIBOR Rate. Dividends on the series B Preferred shares are non-cumulative. Consequently, if the board of directors does not declare a dividend for any dividend period, holders of the series B Preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividends will not accumulate and will not be payable. For 2008 and 2007, the total dividends declared on series B Preferred share was $7.50 per share.
In connection with our formation, we issued warrants to founding shareholders which entitle them to purchase up to 12% of the aggregate number of outstanding shares at the date of issuance, calculated on a fully diluted basis, on the exercise
During 2007, under the 2006 repurchase plan, we repurchased 2,786,611 common shares for cancellation for a total cost of $103 million. The total share repurchases made in 2007, including those held in treasury (noted in the above table), include 5,263,445 shares repurchased from Trident II, L.P and affiliated entities, for a total purchase price of $201 million.
We have several defined contribution plans that are self directed. Generally, mutual funds are made available pursuant to which employees and we contribute a percentage of the employee’s gross salary into the plan each month. During 2008, our total contribution expenses were $10 million (2007: $10 million and 2006: $8 million).
At December 31, 2008, the fair value of the SERPs assets was $16 million (2007: $14 million), which include $4 million contributions we made during the year to cover primarily the cumulative actuarial losses experienced on the SERPs. The actuarial losses are primarily due to the less than expected investment return on the SERPs assets as a result of the turmoil in the financial markets experienced in 2008. Our investment strategy is to maintain a conservative and diversified asset allocation strategy to yield a 5.75% annualized return over the life of the SERPs. The plan assets consist of a money-market fund and global debt and equity mutual funds.
We have issued stock options, restricted stocks, restricted stock units, and phantom stock units to our employees and non-management directors but none of these awards were subject to performance and market conditions. At December 31, 2008, 2,285,277 equity-based awards remain available for grant under the 2007 Plan. Subsequent to December 31, 2008, we granted 29,060 unrestricted common shares and phantom stock units to our non-management directors on January 15, 2009, at a fair value of $27.77 per share. We also granted 1,179,000 restricted shares and units to our employees on February 9, 2009, at a fair value of $26.26 per share. These awards carry a vesting period of four years with 25% of the award to be vested annually.
The total intrinsic value of stock options exercised during 2008 was $35 million (2007: $5 million) and we received proceeds of $24 million (2007: $8 million). At December 31, 2007, there was no remaining unrecognized compensation cost related to stock options and accordingly we incurred no related compensation costs during 2008.
We have determined the fair value of all stock and unit grants using the closing price of our common shares on the New York Stock Exchange on the day of the grant. The following table provides a reconciliation of the beginning and ending balance of unvested restricted stock for the year ended December 31, 2008:
During 2008, we also realized additional tax benefits for certain vested restricted stocks and exercised stock options of $1 million (2007: $1 million; 2006: negligible). These excess tax benefits are included in our cash flows from financing activities in the Consolidated Statements of Cash Flows.
Our non-management directors may also elect to receive their meeting and other fees in common shares or phantom stock units rather than cash, based on the fair value of our common shares at the time of the grant. At December 31, 2008, we had 62,091 (2007: 53,463) phantom stock units outstanding and we have issued a cumulative total of 72,189 (2007: 52,816) common shares in lieu of fees.
Under current Bermuda law, we are not required to pay any taxes in Bermuda on its income or capital gains. We have received an undertaking from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, we will be exempt from taxation in Bermuda until March 2016. Our Bermuda subsidiary has a branch operation in Singapore, which is subject to the relevant taxes in that jurisdiction. The branch is not under examination in this tax jurisdiction, but remains subject to examination for tax year 2008.
We also have operating subsidiaries and branch operations in Ireland, the United Kingdom, Switzerland and Australia which are subject to the relevant taxes in those jurisdictions. Our various European operating subsidiaries and branch operations in Ireland, the United Kingdom, Switzerland and Australia are not under examination in any of these tax jurisdictions, but generally remain subject to examination for tax years 2004-2008.
At December 31, 2007, we determined that a valuation allowance for the deferred tax assets arising from capital loss carryforwards was not necessary due to sufficient unrealized gains in the investment portfolio which could be used to realize the capital loss carryforwards.
Although realization is not assured, management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized. There were no unrecognized tax benefits at December 31, 2008 and 2007.
The tax benefit of existing capital loss carryforwards at December 31, 2008 by expiration date is as follows: $2 million expire in 2010, $4 million expire in 2011 and $67 million expire in 2013.
The following table is a reconciliation of the actual income tax rate to the amount computed by applying the effective tax
rate of 0% under Bermuda law to income before income taxes:
The unaudited statutory capital and surplus, for our principal operating subsidiaries at December 31, 2008 and 2007 was as follows:
Total statutory net income of our operating subsidiaries was $408 million, $1,137 million and $980 million for 2008, 2007 and 2006, respectively. The difference between statutory financial statements and statements prepared in accordance with U.S. GAAP vary by jurisdiction; however, the primary difference is that statutory financial statements do not reflect
deferred acquisition costs, certain net deferred tax assets, goodwill and intangible assets, unrealized appreciation on debt securities or certain unauthorized reinsurance recoverables.