Pre-tax net losses (net of related reinstatement premiums) of $331 million in relation to Storm Sandy
Net financial impact of Storm Sandy of $301 million, after consideration of reinstatement premiums, ceding commissions and the associated income tax benefit
No material change in our aggregate estimate for losses related to 2011 and 2010 calendar year natural catastrophe and weather-related events
Reserve for losses and loss expenses of $9.1 billion and reinsurance recoverable of $1.9 billion
Total debt of $995 million and a debt to total capital ratio of 14.7%
Our mission is to provide our clients and distribution partners with a broad range of risk transfer products and services and meaningful capacity, backed by significant financial strength. We manage our portfolio holistically, aiming to construct the optimum consolidated portfolio of funded and unfunded risks, consistent with our risk appetite and development of our franchise. We nurture an ethical, entrepreneurial and disciplined culture that promotes outstanding client service, intelligent risk taking and the achievement of superior risk-adjusted returns for our shareholders. We believe that the achievement of our objectives will position us as a leading global, diversified specialty insurance and reinsurance company, as measured by quality, sustainability and profitability. Our execution on this mission in 2012 included:
the focus on lines of business with attractive rates, generating premium growth in our insurance segment.
In addition, we effectively lowered the weighted average annual dividend rate on our preferred equity capital base by 42 basis points, to 6.953%, at a book value cost of $7 million. This was achieved via the issuance of $400 million of 6.875% Series C shares, in conjunction with the redemption of $150 million of our 7.25% Series A preferred shares and the repurchase of $247 million of our 7.50% Series B preferred shares via tender offer.
Our insurance segment's underwriting income for 2011 included aggregate pre-tax net losses (inclusive of premiums to reinstate reinsurance protection) of $157 million related to the 2011 events noted above. Comparatively, underwriting income for 2012 included pre-tax net losses (inclusive of related premiums to reinstate reinsurance protection) of $178 million for Storm Sandy and an aggregate $44 million for Hurricane Isaac and first and second quarter 2012 U.S. weather events. Despite increased catastrophe and weather-related losses in 2012, underwriting income for the segment improved due to growth in net premiums earned (driven by the expansion of our business over the past year), an improvement in the current accident year loss ratio exclusive of catastrophe and weather activity and a $19 million increase in net favorable prior year reserve development. This was partially offset by commensurate growth in acquisition costs and general and administrative expenses.
The $560 million improvement in the reinsurance segment's underwriting result was primarily attributable to the significantly lower level of natural catastrophe and weather-related losses; the majority of our 2011 natural catastrophe and weather-related losses emanated from our reinsurance segment and drove the underwriting loss for that year. The segment's underwriting loss for 2011 included aggregate pre-tax net losses (net of related reinstatement premiums) of $774 million for the events noted above, with the most significant amounts being for New Zealand II, the Japanese earthquake and tsunami and the first quarter Australian weather events. Comparatively, in 2012, we recognized pre-tax net losses (net of related reinstatement premiums) of $153 million for Storm Sandy and an aggregate $60 million for the impact of severe drought conditions on U.S. crops, Hurricane Isaac and first and second quarter 2012 U.S. weather events. An improvement in the current accident year loss ratio, exclusive of these catastrophe and weather-related losses, further contributed to the improvement in 2012. Partially offsetting these improvements was a $32 million reduction in net favorable prior year reserve development, a reduction in net premiums earned and increases in acquisition costs and general and administrative expenses.
Our insurance segment’s 2011 underwriting income included $157 million in pre-tax net losses (inclusive of related premiums to reinstate reinsurance protection) related to the events of 2011 noted above, while catastrophe losses in 2010 were insignificant. A $15 million reduction in net favorable prior year reserve development and an increase in acquisition costs also contributed to the reduction in underwriting income; reductions in ceded reinsurance costs and increases in gross premiums written contributed to higher net premiums earned and partially offset these reductions.
Our reinsurance segment's 2011 underwriting loss included aggregate pre-tax net losses (net of related reinstatement premiums) of $774 million for the events of 2011 noted above. Substantially all of our natural catastrophe-related pre-tax net losses in 2010 emanated from the reinsurance segment. A $40 million reduction in net favorable prior period reserve development also contributed to the variance in the underwriting result between periods.
Excluding income from our other investments, net investment income decreased by $12 million and $37 million, respectively, in 2011 and 2012. These decreases were primarily attributable our fixed maturity portfolio, where lower reinvestment yields drove reductions in income despite higher investment balances.
Appreciation in the Sterling and euro against the U.S. dollar drove foreign exchange losses of $30 million in 2012, related to the remeasurement of our foreign-denominated net insurance-related liabilities. In 2011 and 2010, depreciation in these currencies resulted in foreign exchange gains of $45 million and $16 million, respectively. Excluding these foreign exchange-related amounts, other expenses were $170 million, $155 million and $195 million, respectively in 2010, 2011 and 2012.
The $15 million decrease in 2011 was driven by a $23 million reduction in income tax expense, as taxable income declined due to the significant catastrophe activity previously noted. This was partially offset by an increase in interest expense following our March 2010 senior note issuance.
A $53 million increase in corporate expenses drove the increase in other expenses in 2012. Separation payments and accelerated and incremental share-based compensation costs related to our second quarter 2012 senior leadership transition totaled $34 million and were the primary driver of this increase. Partially offsetting the increase in corporate expenses was a $12 million reduction in tax expense, as the impact of Storm Sandy led to minimal taxable income in the U.S. for 2012.
In conjunction with the effective reduction of the dividend rate on our preferred equity base previously discussed, we repurchased $150 million of our 7.25% Series A preferred shares and $247 million of our 7.50% Series B preferred shares during the first half of 2012. While the Series A shares were redeemed at liquidation value, we paid a $7 million premium to repurchase the Series B shares in advance of the first eligible redemption date. This premium, combined with the recognition of the proportionate share of issue costs for both series as an expense, resulted in a $14 million loss. As the issue costs for these shares were recognized in shareholders' equity in the period the shares were originally issued, the only impact on book value related to the $7 million premium on the Series B repurchase. Refer to Item 8, Note 13 to the Consolidated Financial Statements for further details.
Management expects gross premiums written to increase across both of our segments in 2013. The primary insurance market continues to see favorable pricing momentum. We see ongoing improvement across most classes and geographies within our insurance segment and will pursue opportunities to expand our reach in areas where we believe returns are most attractive.
We believe that the global reinsurance market is generally at equilibrium with acceptable levels of profitability. There is some pressure in lines that have shown strong profitability and have attracted new capacity in recent years. On the other hand, there is some upside pressure on pricing for loss-affected property treaties and lines with recent major loss activity, including Sandy-affected treaties, agriculture and marine, and Management expects that these areas will contribute to growth in reinsurance premiums.
2012 versus 2011: The improvement in our underwriting result, driven by the lower level of catastrophe and weather-related losses previously discussed, was the primary contributor to the improved operating ROACE; the increase in net investment income also contributed. These favorable variances were partially offset by the increase in corporate expenses previously discussed.
In addition to the items noted above for operating ROACE, ROACE is also impacted by net realized investment gains, foreign exchange losses (gains) and the loss on repurchase of preferred shares. The magnitude of our net realized investment gains resulted in these amounts contributing favorably, in aggregate, to our results for both periods; thus ROACE exceeded operating ROACE.
Our combined net realized investment gains and foreign exchange gains for 2011 were sufficient for us to recognize net income for the period; as such, our ROACE for the year was marginally positive. Net realized investment gains and foreign exchange gains in 2010 also contributed to a higher ROACE, in comparison to operating ROACE.
to common shareholders, an overall improvement in valuations for our available-for-sale securities and, to a lesser extent, the execution of common share repurchases at a discount to book value.
We believe in returning excess capital to our shareholders by way of dividends (as well as share repurchases) and, accordingly, our dividend policy is an integral part of the value we create for our shareholders. Our cumulatively strong earnings have permitted our Board of Directors to approve nine successive annual increases in quarterly common share dividends.
Taken together, we believe that growth in diluted book value per common share and common share dividends declared represent the total value created for our common shareholders. Despite the impact of catastrophe events, our net income combined with valuation improvements on our available-for-sale securities and common share repurchases executed at a discount to book value led to an increases in diluted book value per common share during 2010 and 2012; dividends declared provided additional value for our shareholders. The global frequency and severity of catastrophe activity in 2011 drove a small reduction in shareholder value for that year.
Underwriting-related general and administrative expenses is a non-GAAP measure as defined in SEC Regulation G. Our total general and administrative expenses also included $129,660, $77,089 and $75,449 of corporate expenses for 2012, 2011 and 2010, respectively; refer to 'Other Expenses (Revenues), Net' for additional information related to these corporate expenses. Also, refer to 'Non-GAAP Financial Measures' for further information.
Partially offsetting this growth was a reduction in gross premiums written in our reinsurance segment, primarily related to the repositioning of our catastrophe reinsurance portfolio throughout 2012. We reduced catastrophe exposure in certain zones, including the Northeast and Mid-Atlantic regions of the U.S.; this was partially offset by exposure increases in other areas, where we believe risk and return characteristics are more attractive. Property business also contributed to the overall reduction in gross premiums written for the reinsurance segment, with the drivers being reduced purchasing by certain of our clients and our evaluation of risk/return characteristics. In addition, our trade credit and bond reinsurance premiums also decreased, as we managed our European exposure base in light of current economic conditions and changes in contract terms.
The three point increase in the ceded premium ratio for our insurance segment was driven by changes in our reinsurance purchasing, primarily higher cession rates on our professional lines quota share reinsurance program on renewal during the second quarter. Business mix changes, driven by growth in our liability business, also contributed.
2012 versus 2011: Growth in net premiums earned for our insurance segment was primarily driven by recent growth in gross premiums written in our accident & health line; net premiums earned also increased due to growth in our professional lines business in recent quarters, though this was tempered by the previously mentioned increase in quota share cessions. The reduction in catastrophe gross premiums written during 2012, described above, was the primary driver of the decline in net premiums earned for our reinsurance segment.
The general and administration expense ratio includes corporate expenses not allocated to underwriting segments of 3.8%, 2.4% and 2.5% for 2012, 2011 and 2010, respectively. These costs are further discussed in the ‘Other Expenses (Revenues), Net’ section.
The most significant catastrophe event of 2012 was Storm Sandy, which made landfall as a post-tropical cyclone with hurricane-force winds near Atlantic City, New Jersey on October 29th. Storm Sandy impacted numerous U.S. states, with particularly severe wind, flooding and storm surge damage in New Jersey and New York. We recognized estimated pre-tax net losses (net of related reinstatement premiums) of $331 million in relation to this event, with approximately half of this amount recognized in each of our insurance and reinsurance segments. In addition, during 2012 we recognized pre-tax net losses of $37 million in relation to the impact of severe drought conditions on U.S. crops and an aggregate $68 million (net of related reinstatement premiums) for first and second quarter U.S. weather events and Hurricane Isaac. While the crop-related losses were exclusive to our reinsurance segment, the other events impacted both of our segments.
these events during 2011. Of this amount, $774 million and $157 million, respectively, emanated from our reinsurance and insurance segments.
Exclusive of the impact of the catastrophe and weather-related losses noted above, the current accident year loss ratio for each of our segments improved in 2012:
Reduced exposure and loss experience related to aggregate property reinsurance of regional insurance companies in the U.S. drove an improvement in our reinsurance segment, though this was partially offset by a higher ratio for our trade credit and bond reinsurance business and business mix changes; and
Exclusive of the impact of the catastrophe and weather-related losses noted above, the current accident year loss ratio increased in each of our segments during 2011:
Business mix changes and rate reductions contributed to an increase in our reinsurance segment, though partially offset by a reduction in the ratio for our trade credit and bond reinsurance business, as global economic conditions improved.
For further discussion on current accident year loss ratios, refer to the insurance and reinsurance segment discussions below.
The frequency and/or severity of natural catastrophe activity in each of 2010 through 2012 was high and our December 31, 2012 net reserve for losses and loss expenses continues to include estimated amounts for numerous natural catastrophe events that occurred during this period. We caution that the magnitude and/or complexity of losses arising from certain of these events, in particular Storm Sandy, the Japanese earthquake and tsunami, the three New Zealand earthquakes and the Thai floods, inherently increases the level of uncertainty and, therefore, the level of management judgment involved in arriving at our estimated net reserves for losses and loss expenses. As a result, our actual losses for these events may ultimately differ materially from our current estimates.
The majority of the net favorable prior year reserve development related to short-tail lines of business, with our professional lines business also contributing notably.
The underlying exposures in the property, marine and aviation reserving classes within our insurance segment and the property reserving class within our reinsurance segment largely relate to short-tail business. Development from these classes contributed $186 million, $178 million and $181 million of the total net favorable prior year reserve development in 2012, 2011 and 2010, respectively, and primarily reflected the recognition of better than expected loss emergence.
Our professional lines insurance and reinsurance business contributed further net favorable prior year reserve development of $54 million, $105 million and $117 million, respectively in 2012, 2011 and 2010. This prior year reserve development was driven by increased weight being given to experience-based actuarial methods in selecting our ultimate loss estimates for accident years 2009 and prior. As our loss experience has generally been better than expected, this resulted in the recognition of favorable prior year reserve development. Given the significance of the global financial crisis, we expect that loss development patterns for the 2007 through 2009 accident years may ultimately differ from other years; as a result, we are exercising a greater degree of caution in recognizing potential favorable loss emergence for these years.
During the fourth quarter of 2012, we began to give weight to actuarial methods that incorporate our own favorable historical claims experience for our oldest accident year liability business. Refer to the 'Critical Accounting Estimate - Reserve for Losses and Loss Expenses' section for further details.
In 2011, we recognized $103 million of net favorable prior year reserve development, the principal components of which were:
$56 million of net favorable prior year reserve development on our property and other business, the majority of which related to the 2010 ($27 million), 2009 ($9 million) and 2008 ($10 million) accident years. While the 2010 and 2009 amounts primarily related to better than expected loss emergence, the 2008 amount largely related to updated information from our client with respect to one large loss event.
$52 million of net favorable prior year reserve development on our property and other business, the majority of which emanated from the 2005 through 2009 accident years and related to better than expected loss emergence.
$23 million of net favorable prior year reserve development on marine business, largely related to the 2007 through 2009 accident years and driven by better than expected loss emergence. The majority of this, $20 million, related to offshore energy business.
$12 million of net favorable prior year reserve development on aviation business, spanning several accident years and largely related to better than expected loss emergence.
$57 million of net favorable prior year reserve development on professional lines business, primarily generated from the 2004 through 2006 accident years, for the reasons discussed in the overview.
$90 million of net favorable prior year reserve development on property and other business largely consisting of:
$71 million of net favorable prior year reserve development on catastrophe and property business. This development primarily related to the 2007 through 2009 accident years and reflected better than expected loss emergence.
$40 million of net favorable prior year reserve development on trade credit and bond reinsurance business, largely related to the 2009 and 2010 accident years, in recognition of better than expected loss emergence and updated information from our cedants.
$94 million of net favorable prior year reserve development on property and other business largely consisting of:
$21 million of net favorable prior year reserve development on crop reserves, principally related to the 2009 accident year and largely resulting from the reduction in reserves for Canadian crop losses following updated information from the cedant.
2011 versus 2010: Our ceded premium ratios for 2011 and 2010 were comparable at 31% and 30% of gross premiums written, respectively.
2012 versus 2011: Growth in our accident & health line, commensurate with gross premiums written growth since the launch of this product offering, accounted for 61% of the overall growth in net premiums earned. Growth in professional lines business in recent quarters, arising from geographic expansion (including our European, Australian and Canadian operations) and targeted initiatives, also contributed to the increases; however, the impact of this growth was tempered in the second half of 2012 by the aforementioned increase in quota share cessions.
2011 versus 2010: The 18% growth in net premiums earned was primarily reflective of the 11% growth in gross premiums written discussed above. Further contributing were reinsurance purchasing changes effected during the second quarter of 2010.
Natural catastrophe and weather-related losses impacted the current accident year loss ratios for both periods.
$40 million in relation to the series of severe U.S. storms in April and May;
an aggregate $35 million in relation to Hurricane Irene and Tropical Storm Lee.
Exclusive of these catastrophe and weather-related losses, our 2012 current accident year loss ratio improved relative to 2011 primarily due to:
a lower level of loss activity in our property and marine lines of business; and
Acquisition Cost Ratio: Growth in accident & health gross premiums written introduced some upward movement in the acquisition cost ratio for the segment starting in 2011; excluding this business, the 2012 and 2011 acquisition cost ratios were 13.0% and 13.2%, respectively.
2012 versus 2011: Gross premiums written decreased by $144 million, primarily driven by the $104 million reduction in catastrophe business. We repositioned our catastrophe portfolio throughout 2012, reducing exposure in certain zones (including the Northeast and Mid-Atlantic regions of the U.S.); this was partially offset by exposure increases in other areas, including Florida and Japan, where we believe risk and return characteristics are more attractive. The decline in property premiums was driven by reductions in reinsurance purchasing by certain of our clients, as well as our evaluation of risk/return characteristics. Our trade credit and bond reinsurance premiums also decreased, driven by management of our
European exposure base in light of current economic conditions and changes in contract terms. While motor premiums were down slightly for the year, there was an underlying shift in business mix; we reduced our participation in uncapitalized U.K. excess of loss business in light of recent settlement trends, which was partially offset by an increase in proportional business.
The following table provides net premiums earned by line of business:
2011 versus 2010: Growth was primarily driven by the increased motor and trade credit and bond writings during 2011, outlined above.
During 2012, we recognized estimated pre-tax net losses (net of related reinstatement premiums) of $153 million for Storm Sandy. In addition, we recognized aggregate pre-tax net losses (net of related reinstatement premiums) of $60 million for the impact of severe drought conditions on U.S. crops, Hurricane Isaac and first and second quarter 2012 U.S. weather events.
Comparatively, during 2011, we recognized estimated pre-tax net losses (net of related reinstatement premiums) for the following natural catastrophe and weather-related events:
Exclusive of these catastrophe and weather-related losses, our 2012 current accident year loss ratio improved relative to 2011 largely due to reduced exposure and loss experience related to aggregate property reinsurance of regional insurance companies in the U.S. This was partially offset by a higher ratio for our trade credit and bond reinsurance business (up 12 percentage points to 62% in 2012, reflecting uncertainty around the economic environment in Europe) and business mix changes (including growth in motor reinsurance).
Natural catastrophe and weather-related losses were the primary driver of the increase in the 2011 current accident year loss ratio, in comparison to 2010. While the 2011 current accident year loss ratio was impacted by the events noted above, during 2010 we recognized pre-tax net losses (net of related reinstatement premiums) of $136 million for New Zealand I and $110 million for the Chilean earthquake. In addition, there were a number of other weather-related loss events of note in 2010, including Australian and U.S. storms and European Windstorm Xynthia in the first quarter and further Australian storms and flooding and U.S. storms in the fourth quarter.
Changes in business mix and rate reductions also contributed to the increase in 2011; however, these increases were partially offset by a reduction in our current accident year loss ratio for trade credit and bond business, as updated information from our cedants suggested loss activity would continue to decrease from levels experienced during the global financial crisis. Our current accident year loss ratio for this business was 50% in 2011, compared to 61% in 2010.
Refer to the ‘Prior Year Reserve Development’ section for further details.
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 3.8%, 2.4% and 2.5% for 2012, 2011 and 2010, respectively. The increase in corporate expenses during 2012 was reflective of costs associated with our second quarter 2012 senior leadership transition; these costs included accelerated and incremental share-based compensation expenses of $20 million and separation payments of $14 million. Excluding these senior leadership transition amounts, corporate expenses were 2.8% of net premiums earned for 2012.
Interest Expense and Financing Costs: Interest expense primarily relates to interest due on our senior notes. The increase in 2011 noted above was driven by our issuance of senior notes on March 23, 2010. See Item 8, Note 10(a) to the Consolidated Financial Statements for further details.
Income Tax Expense: Income tax expense primarily results from income generated by our foreign operations in the United States and Europe. Our effective tax rate, which is calculated as income tax expense divided by income before tax, was 0.6%, 24.8% and 4.3% in 2012, 2011 and 2010, respectively. This effective rate can vary between periods depending on the distribution of net income (loss) amongst tax jurisdictions, as well as other factors.
2012 versus 2011: The improvement in the pre-tax return on our other investments portfolio was primarily driven by the strong rally in global equity markets and its impact on our hedge funds and funds of hedge funds. Performance of our credit funds also improved in 2012 due to modest improvements in the pricing of the underlying bank loans. Although CLO Equities provided less income in 2012, their continued strong performance is still a significant positive contributor to current year performance. The increase in fair value of our CLO Equities was driven primarily by lower than anticipated default rates and higher than anticipated recovery rates for the underlying collateral. Refer to the ‘Critical Accounting Estimates - Fair Value Measurements’ for further details on the fair value measurement.
2011 versus 2010: The lower pre-tax return on other investments in 2011 was primarily due to modest negative returns from our investments in hedge and credit funds, compared to positive returns provided by these holdings in 2010. The negative returns of these funds were reflective of the underperformance of both global equities and bank loans during 2011. Partially offsetting the decline in the pre-tax return was the increase in the fair value for our investment in CLO Equities which was driven primarily by higher cash distributions than previously expected.
2012 versus 2011: The increase was primarily due to increased third party investment manager fees relating to higher investment balances created by improved valuations and additional allocations to emerging market debt, short duration high yield debt and common stocks, which have higher management fees than core fixed income.
2011 versus 2010: The increase was due to asset class changes. Additionally, third party investment manager fees increased due to higher investment balances as a result of improved valuations and additional allocations.
2012 versus 2011: Improvements in global equity markets throughout 2012 also enabled us to realize gains on our equity holdings during 2012. The primary sources of the net realized gains on fixed maturities in 2012 were investment-grade corporate debt, agency MBS and non-U.S. governments compared to the primary sources of investment-grade corporate debt, agency MBS and U.S. government and agencies in 2011.
The level of OTTI losses increased in 2012 compared to 2011 and 2010 due mainly to losses recorded on equity exchange traded funds ("ETFs") where we no longer have the intent to hold the securities until full recovery of cost as it is likely that these investments will be reallocated to other asset classes.
From time to time, we may economically hedge the foreign exchange exposure of non-U.S. denominated securities by entering into foreign exchange contracts. During 2012, our economic hedges related to Canadian dollar, Sterling, euro and Australian dollar denominated securities. The net realized and unrealized loss for the year was primarily driven by our exposure to the euro, which gained 2% against the U.S. dollar during the year. These hedges did not qualify for fair value hedge accounting and accordingly, the corresponding net unrealized gains on the economically hedged securities are recorded as part of accumulated other comprehensive income in shareholders' equity.
The average cash and investments balance is calculated by taking the average of the month-end fair value balances held for the periods indicated.
At December 31, 2012, fixed maturities had a weighted average credit rating of AA- (2011: AA-) with a book yield of 2.6% (2011: 2.9%) and an average duration of 3.0 years (2011: 2.8 years). When incorporating short-term investments and cash and cash equivalents into this calculation (bringing the total to $12.9 billion), the average rating would be AA- (2011: AA-) and the average duration would be 2.8 years (2011: 2.5 years).
To calculate the weighted average credit rating for fixed maturities, we assign points to each rating with 29 points for the highest rating (AAA) and 2 points for the lowest rating (D) and then calculate the weighted average based on the fair values of the individual securities. Securities that are not rated by S&P, Moody’s or Fitch are excluded from the weighted average calculation. At December 31, 2012, the fair value of fixed maturities not rated was $7 million (2011: $2 million).
on the country of the obligor’s domicile. For debt securities issued by a foreign subsidiary with an implicit or explicit parental guarantee, the country of risk would be that of the parent.
The following is an analysis of our fixed maturity portfolio by major asset classes.
During 2012, we decreased our allocation in non-U.S. government debt securities as we actively reduced our exposure to eurozone sovereign debt. The primary driver of the growth in "other concentrations" is the $133 million funding of a portfolio of emerging market debt securities. At December 31, 2012, this portfolio had a weighted average credit rating of BBB+, a duration of 3.9 years and a yield-to-worst of 5.2%. The top four country exposures are Mexico, Russia, South Africa and Brazil. The securities in this portfolio are held in local currency and not currently hedged back to U.S. dollars.
During 2012, we added to our U.S. banking holdings as, despite the significant rally in investment-grade corporates, spreads in this sector remained attractive relative to historical averages. At December 31, 2012 and 2011, all of our holdings in this sector are investment-grade. Our holdings of non-U.S. government guaranteed corporates declined during 2012 due to the lack of new supply to replace securities that matured during the year.
Our RMBS portfolio consists primarily of AAA-rated U.S. agency issues and is supported by loans that are diversified across geographical areas. Due to a change in prepayment speed assumptions, the duration of our agency MBS holdings expanded from 1.8 years at December 31, 2011 to 2.6 years at December 31, 2012.
The average duration and weighted average life of our ABS portfolio at December 31, 2012 was 0.9 years (2011: 0.7 years) and 3.6 years (2011: 3.1 years), respectively.
Additionally, certain of our holdings in municipal debt are insured by financial guarantee companies. At December 31, 2012, we held insurance enhanced municipal bonds in the amount of $202 million (2011: $231 million), with a weighted average credit rating of AA- (2011: AA-). In the event the financial guarantors are unable to make good on their guarantee on a defaulted security, we would then be exposed to the credit loss. Excluding the insurance benefit from the financial guarantee companies, the weighted average credit quality of our insured bond holdings would be AA- (2011: AA-). At December 31, 2012, our largest exposures to financial guarantors were Assured Guaranty Corp. for $90 million (2011: $92 million), National Public Finance Guarantee Corporation for $58 million (2011: $63 million) and Ambac Financial Group, Inc. for $31 million (2011: $38 million). We had no direct investments in these companies at December 31, 2012 and 2011.
At December 31, 2012, the gross unrealized losses on our fixed maturities portfolio were $18 million (2011: $125 million).
The following table provides information on the severity of the unrealized loss position as a percentage of amortized cost for all non-investment grade fixed maturities in an unrealized loss position at December 31, 2012 and 2011:
The $4 million decrease in the fair value of the CLO - Equities since December 31, 2011, was due to $31 million of improved valuations, offset by $35 million in cash distributions received during 2012.
As a holding company, AXIS Capital has no operations of its own and its assets consist primarily of investments in its subsidiaries. Accordingly, AXIS Capital’s future cash flows depend on the availability of dividends or other statutorily permissible distributions, such as returns of capital, from its subsidiaries. The ability to pay such dividends and/or distributions is limited by the applicable laws and regulations of the various countries and states in which AXIS Capital’s subsidiaries operate (refer to Item 8, Note 18, to the Consolidated Financial Statements for further information), as well as the need to maintain capital levels to adequately support (re)insurance operations and to preserve financial strength ratings issued by independent rating agencies. During 2012, AXIS Capital received $525 million (2011: $385 million; 2010: $698 million) of distributions from its subsidiaries. AXIS Capital’s primary uses of funds are dividend payments to both common and preferred shareholders, share repurchases, interest and principal payments on debt, capital investments in subsidiaries and payment of corporate operating expenses. We believe the dividend/distribution capacity of AXIS Capital’s subsidiaries, which was over $1 billion at December 31, 2012, will provide AXIS Capital with sufficient liquidity for the foreseeable future.
The (re)insurance business of our operating subsidiaries inherently provides liquidity, as premiums are received in advance (sometimes substantially in advance) of the time claims are paid. However, the amount of cash required to fund claim payments can fluctuate significantly from period to period, due to the low frequency/high severity nature of certain types business we write.
Dividends paid to common and preferred shareholders are the primary source of recurring cash flows used in financial activities and totaled $159 million in 2012 (2011: $243 million, 2010: $145 million); this amount was higher for 2011 relative to the preceding and succeeding years largely due to the payment of deferred dividends to certain warrant holders upon exercise (refer to Item 8, Note 13 to our Consolidated Financial Statements). Financing cash outflows also included common share repurchases totaling $318 million, $66 million and $710 million, respectively in 2012, 2011 and 2010. We note that market share repurchases are completely discretionary (see ‘Capital Resources - Share Repurchases’ below). During 2012, financing cash flows also included a net $11 million outflow related to the three preferred share transactions discussed under 'Capital Resources - Preferred Shares' below. During 2010, cash outflows were partially offset by the $495 million net proceeds received from our senior notes issuance (discussed in Item 8, Note 10(a) of our Consolidated Financial Statements).
Should claim payment obligations accelerate beyond our ability to fund payments from operating cash flows, we would utilize our cash and cash equivalent balances and/or liquidate a portion of our investment portfolio. Our investment portfolio is heavily weighted towards conservative, high quality and highly liquid securities. We expect that, if necessary, approximately $13.4 billion of cash and invested assets at December 31, 2012 could be available in one to three business days under normal market conditions; of this amount, $2.9 billion relates to restricted assets, which primarily support our obligations in regulatory jurisdictions where we operate as a non-admitted carrier (see Item 8, Note 5(e) to the Consolidated Financial Statements for further details). For context, our largest 1-in-250 year return period, single occurrence, single-zone modeled probable maximum loss (Southeast U.S. Hurricane) is approximately $1 billion, net of reinsurance; our claim payments pertaining to such an event would be paid out over a period spanning many months. Our internal risk tolerance framework aims to limit both the loss of capital due to a single event, and the loss of capital that would occur from multiple but perhaps smaller events, in any year. Refer to the ‘Risk and Capital Management’ section of Item 1 for further information.
Our net paid losses may continue to increase in the short-term, due to the recent significant level of natural catastrophe activity. However, we continue to expect that cash flows generated from our operations, combined with the liquidity provided by our investment portfolio, will be sufficient to cover our required cash outflows and other contractual commitments through the foreseeable future. Refer to the ‘Contractual Obligations and Commitments’ section below for further information about the anticipated amounts and timing of our contractual obligations and commitments.
During March 2012, we issued 16 million newly designated 6.875% Series C preferred shares with a liquidation preference of $25.00 per share for gross proceeds of $400 million. Dividends on the Series C preferred shares are non-cumulative; to the extent declared, dividends will accumulate, with respect to each dividend period, in an amount per share equal to 6.875% of the liquidation preference per annum. We may redeem the shares on or after April 15, 2017 at a redemption price of $25.00 per share.
During April 2012, we closed a cash tender offer for any and all of our outstanding Series B preferred shares at a price of $102.81 per share. As a result, we repurchased 2,471,570 Series B Preferred shares, for $254 million. At December 31, 2012, 28,430 Series B preferred shares, representing $3 million in aggregate liquidation preference, remain outstanding. We may redeem these shares on or after December 1, 2015, at a redemption price of $100.00 per share.
On a combined basis, these three transactions resulted in a $7 million decrease in book value and a 42 basis point reduction in the weighted average annual dividend rate on our preferred equity.
Each of our existing facilities is described further below; refer to Item 8, Note 10(b) to our Consolidated Financial Statements for additional information.
We also have a revolving $500 million credit facility (the “Credit Facility”), which provides us with combined borrowing and letter of credit issuance capacity up to the aggregate amount of the facility. At our request, and subject to certain conditions, the aggregate commitment of this facility may be increased by up to $250 million. Interest on loans issued under this facility is payable based on underlying market rates at the time of loan issuance. While any loans are unsecured, we have the option to issue letters of credit on a secured basis in order to reduce associated fees. This facility is subject to certain non-financial covenants that we believe are customary for facilities of this type, including limitations on fundamental changes, the incurrence of additional indebtedness and liens and certain transactions with affiliates and investments, as defined in the facility documents.
Compliance with certain financial covenants that we believe are customary for (re)insurance companies in credit facilities of this type is also required. These covenants include:
Additionally, the facility allows for an adjustment to the level of pricing should AXIS Capital experience a change in its senior unsecured debt ratings.
On March 18, 2010, we filed an unallocated universal shelf registration statement with the SEC, which became effective upon filing. Pursuant to the shelf registration, we may issue an unlimited amount of equity, debt, trust preferred securities, warrants, purchase contracts or a combination of those securities. Our intent and ability to issue securities pursuant to this registration statement will depend on market conditions at the time of any proposed offering. We expect to renew this filing prior to its expiration.
“Opinions of the ability of insurance companies to pay punctually senior policyholder claims and obligations.”
Loss reserves are not an exact calculation of liability but instead are complex estimates. The process of estimating loss reserves involves a number of variables (see ‘Selection of Reported Reserves (Management’s Best Estimate)’ ) below for further details). We review our estimate of loss reserves each reporting period and consider all significant facts and circumstances then known. As additional experience and other data become available and/or laws and legal interpretations change, we may adjust our previous estimates of loss reserves; these adjustments are recognized in the period they are determined and, therefore, can impact that period’s underwriting results either favorably (when reserves established in prior years prove to be redundant) or adversely (when reserves established in prior years prove to be deficient).
Expected Loss Ratio Method (“ELR”): This method estimates ultimate losses for an accident year by applying an expected loss ratio to the earned premium for that accident year. Generally, expected loss ratios are based on one or more of (a) an analysis of historical loss experience to date, (b) pricing information and (c) industry data, adjusted as appropriate, to reflect changes in rates and terms and conditions. This method is insensitive to actual incurred losses for the accident year in question and is, therefore, often useful in the early stages of development when very few losses have been incurred. Conversely, the lack of sensitivity to incurred/paid losses for the accident year in question means that this method is usually inappropriate in later stages of an accident year’s development.
An important and distinguishing feature of many of these contracts, though, is our contractual right, subsequent to payment of a claim to our insured, to be subrogated to, or otherwise have an interest in, the insured’s rights of recovery under an insured loan or facility agreement. These estimated recoveries are recorded as an offset to our credit and political risk loss reserves. The lag between the date of a claim payment and our ultimate recovery from the corresponding security can result in negative case reserves at a point in time (as was the case at December 31, 2012 and 2011). The nature of the underlying collateral is specific to each transaction and we also estimate the value of this collateral on a contract-by-contract basis. This valuation process is inherently subjective and involves the application of management’s judgment because active markets for the collateral often do not exist. Our estimates of value are based on numerous inputs, including information provided by our insureds, as well as third party sources including rating agencies, asset valuation specialists and other publicly available information. We also assess any post-event circumstances, including restructurings, liquidations and possession of asset proposals/agreements.
losses for each event if there are developments that are different from our previous expectations; such adjustments are recorded in the period in which they are identified.
Our quarterly reserving process involves the collaboration of our underwriting, claims, actuarial, legal and finance departments, includes various segmental committee meetings and culminates with the approval of a single point best estimate by our Group Reserving Committee, which comprises senior management. In selecting this best estimate, management considers actuarial estimates and applies informed judgment regarding qualitative factors that may not be fully captured in these actuarial estimates. Such factors include, but are not limited to: the timing of the emergence of claims, volume and complexity of claims, social and judicial trends, potential severity of individual claims and the extent of internal historical loss data versus industry information. While these qualitative factors are considered in arriving at the point estimate, no specific provisions for qualitative factors are established.
The overall increase in our gross loss reserves during 2012 was driven by the impact of Storm Sandy, growth in our business and the continued accumulation of reserves for longer-tailed lines.
In order to capture the key dynamics of our loss reserve development and potential volatility, our reserving classes should be considered according to their potential expected length of loss emergence and settlement, generally referred to as the “tail”. We consider our business to consist of three claim tail classes: short-tail, medium-tail and long-tail. Below is a discussion of the specifics of our loss reserve process as they apply to each claim tail class, as well as commentary on the factors contributing to our historical loss reserve development for each class. Favorable development on prior accident year reserves indicates that our current estimates are lower than our previous estimates, while adverse development indicates that our current estimates are higher than our previous estimates.
Our short-tail business generally includes exposures for which losses are usually known and paid within a relatively short period of time after the underlying loss event has occurred. Our short-tail business primarily relates to property coverages and includes the majority of our property, terrorism and marine business and certain aviation business within our insurance segment, together with the property, catastrophe and crop business within our reinsurance segment.
Our medium-tail business primarily consists of professional lines (re)insurance and trade credit and bond reinsurance business. Certain other classes of business, including aviation hull and offshore energy insurance and engineering reinsurance, are also considered to have a medium-tail. Claim reporting and settlement periods on these classes are generally longer than those of our short-tail reserving classes. We also consider our credit and political risk insurance business to have a medium tail, due to the complex nature of claims and the potential additional time that may be required to realize our subrogation assets.
Loss reporting patterns for professional lines business tend to be volatile, causing instability in actuarial indications based on incurred loss data until an accident year matures for a number of years. Consequently, our initial loss reserves for an accident year are generally based upon an ELR method and the consideration of relevant qualitative factors. As accident years mature, we increasingly give more weight to methods that reflect our actual experience until our selections are based almost exclusively on experience-based methods. We evaluate the appropriateness of the transition to experience-based methods at the reserving class level, commencing this transition when we believe that our incurred loss development is sufficient to produce meaningful actuarial indications. The rate at which we transition fully to sole reliance on experience-based methods can vary by reserving class and by accident year, depending on our assessment of the stability and relevance of such indications.
For our trade credit and bond reinsurance business, our initial and most recent accident year loss reserves are generally based on the ELR method, with consideration given to qualitative factors. Given that there is a more stable reporting pattern for trade credit business, we generally commence the transition to experience-based methods sooner than for bond business.
The more significant weight given to industry benchmarks in forming our key actuarial assumptions;
To date, our key actuarial assumptions for our long-tail business have been derived almost exclusively from industry benchmarks, rather than our own historical experience. Given our relatively short operating history in comparison to the development tail for this business, we do not believe that our own historical loss development for our long-tail business has amassed an appropriate volume to serve as a credible input into the key actuarial assumptions previously outlined. While we utilize industry benchmarks that we believe reflect the nature and coverage of our business, our actual loss experience may differ from the benchmarks based on industry averages.
Commencing with our fourth quarter 2012 reserving process, we began to give weight to actuarial methods that reflect our actual experience for liability business as we believe that our oldest accident years are now at a stage of expected development where such methods will produce meaningful actuarial indications. As a result, we commenced a transition from the ELR method to the BF method for the oldest accident years for certain reserving classes within our insurance liability line of business and recognized corresponding net favorable prior year reserve development totaling $6 million for the 2003, and to a lesser extent the 2002, accident years during the quarter. We will continue to analyze our incurred loss emergence relative to expected emergence for all of our long-tail reserving classes and expect to commence transition to experience-based methods for those accident years where we believe the stage of expected development will produce meaningful actuarial indications.
While we believe that our loss reserves at December 31, 2012 are adequate, new information, events or circumstances may result in ultimate losses that are materially greater or less than provided for in our loss reserves. As previously noted, there are many factors that may cause our reserves to increase or decrease, particularly those related to catastrophe losses and long-tail lines of business.
The following tables show the effect on our estimate of gross loss reserves of reasonably likely changes in the two key assumptions used to estimate our gross loss reserves at December 31, 2012.
Reinsurance recoverable on unpaid losses as a percentage of gross loss reserves was comparable, at 20% and 21% for December 31, 2012 and 2011, respectively. At December 31, 2012 and 2011, respectively, 98.8% and 98.6% of our gross reinsurance recoverable (i.e. excluding the provision for uncollectible amounts) were collectible from reinsurers rated A- or better by A.M. Best. For an analysis of the credit risk associated with our reinsurance recoverable balances at December 31, 2012, refer to Item 8, Note 11 to the Consolidated Financial Statements.
We apply case-specific provisions against certain recoveries that we deem unlikely to be collected in full. In addition, we use a default analysis to estimate our provision for uncollectible amounts on the remainder of the balance. The principal components of the default analysis are reinsurance recoverable by reinsurer and default factors applied to estimate uncollectible amounts based on our reinsurers’ credit ratings. The default factors are based on a model developed by a major rating agency. The provision recorded against reinsurance recoverable was $16 million and $18 million at December 31, 2012 and 2011, respectively. We have not written off any significant reinsurance recoverable balances in the last three years. At December 31, 2012, the use of different assumptions within our approach could have a material effect on our provision for uncollectible reinsurance recoverable. To the extent the creditworthiness of our reinsurers was to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than our provision. Given the various considerations used to estimate our uncollectible provision, we cannot precisely quantify the effect a specific industry event may have on our provision.
A limited portion of our insurance business is written on a line slip or proportional basis, under which we assume a fixed percentage of the premiums and losses on a particular risk or group of risks along with numerous other unrelated insurers. Although premiums on this business are not contractually stated, we recognize gross premiums written based on an estimate provided by the client via the broker. For further details on the estimation process, see the discussion provided for the reinsurance segment below. We review these estimates on a quarterly basis and record significant adjustments in premium estimates when identified. Gross premiums written on a line slip/proportional basis comprised 7%, 8% and 3% of the segment’s total for the years ended December 31, 2012, 2011 and 2010, respectively, and therefore the associated impact of these estimates on our pre-tax net income was immaterial. The proportionate increase in 2012 and 2011, when compared to 2010, was driven by growth in our accident & health line, a large portion of which related to proportional reinsurance business.
In our credit and political risk line of business, we write certain policies on a multi-year basis with premiums generally payable in installments. We record premiums at the inception of the policy based on our best estimate of total premiums, including assumptions relating to prepayments/refinancings. Furthermore, certain contracts within this line of business meet the U.S. GAAP definition of a financial guarantee insurance contract. Premiums for such contracts are recognized as the present value of the contractual premiums due or expected to be collected using a discount rate that reflects the risk-free rate at the inception of contract. Due to the scope exemption for insurance contracts that are similar to financial guarantee insurance contracts, the determination of whether certain of our credit and political risk contracts fall within the scope of the U.S. GAAP definition for financial guarantee contracts requires significant management judgment. For the years ended December 31, 2012 and 2011, our total premiums from financial guarantee insurance contracts were immaterial in the context of total gross premiums written for the segment. At December 31, 2012, the average duration of the outstanding unearned premiums written for our credit and political line of business was 4.0 years (2011: 4.4 years).
For business written under proportional contracts, our initial recognition of gross premiums written is based on estimates of premiums written provided by the cedant (via a broker) at contract inception. We may exercise judgment to modify the initial premium estimates provided by the cedants based on our prior experience with the cedant. We review these premium estimates on a quarterly basis and evaluate their reasonability in light of actual premiums reported to date by cedants, communications between us and the cedants/brokers and our view of changes in the marketplace and the cedants’ competitive positions therein. Factors contributing to changes from the initial premium estimates may include:
As a result of this review process, any adjustments to estimates are recognized in gross premiums written during the period they are determined. Such changes in premium estimates could be material to gross premiums written and the resulting adjustments may directly and significantly impact net premiums earned favorably or unfavorably in the period they are determined because the adjustment may be substantially or fully earned. Gross premiums written for proportional contracts, including amounts related to the adjustment of premium estimates established in prior years, accounted for 53%, 47% and 45% of our reinsurance segment’s gross premiums written for the years ended December 31, 2012, 2011 and 2010, respectively.
Since inception, our historical experience has shown that cumulative adjustments to our annual initial premium estimates on proportional reinsurance contracts have ranged from a negative revision of 3% to a favorable revision of 9%. Giving more weight to recent years where premium volume was comparable to current levels, we believe that a reasonably likely change in our 2012 proportional reinsurance gross premiums written estimate would be 5% in either direction. Such a change would result in a variance in our gross premiums written of approximately $47 million and an immaterial impact on our pre-tax net income. However, larger variations, both positive and negative, are possible.
At December 31, 2012 and 2011, we have not adjusted any pricing provided by independent pricing services (see ‘Management Pricing Validation’ below). Additionally, our total Level 3 fixed maturities and equities amounted to $71 million (2011: $51 million), less than 1% of total fixed maturities and equities. Refer to Item 8, Note 6 to our Consolidated Financial Statements for further information.
We measure the fair value for hedge and credit funds by obtaining the net asset value (NAV) as advised by our external fund manager or third party administrator. For any funds for which we did not receive a December 31, 2012 net asset value, we have recorded an estimate of the change in fair value for the latest period based on return estimates obtained from the fund managers. Accordingly, we do not have a reporting lag in our fair value measurements for these funds. Historically, our estimated NAVs have not significantly diverged from the subsequent final audited NAVs. Where we have the ability to liquidate our holdings at the reported NAV in the near term, these hedge and credit funds are classified as Level 2 within the fair value hierarchy while the remaining funds are classified as Level 3.
We review quarterly whether a decline in the fair values of AFS securities below their amortized costs is other-than-temporarily impaired. The OTTI assessment is inherently judgmental, especially where securities have experienced severe declines in fair value in a short period. Our OTTI review process is based on both quantitative and qualitative approach. We identify securities for review based on credit quality, relative health of industry sector, yield analysis, security performance and topical issues. For identified securities, we prepare a fundamental analysis at the security level and consider the following factors:
The following provides further details regarding our OTTI recognition and processes for AFS fixed maturities and equity securities.
A security is “impaired” when the fair value is below its amortized cost. For an impaired fixed maturity, we recognize an OTTI in earnings when we:
For impaired investment-grade securities (i.e. rated BBB or above) that we do not intend to sell and it is more likely than not that we will not be required to sell, we have established some parameters for identifying securities with potential credit impairments. Our parameters focus primarily on the extent and duration of the decline, including but not limited to:
For impaired securities held within our high yield portfolios (i.e. managed under a mandate to invest exclusively in non-investment grade securities), we have established separate parameters for our credit loss assessment. Due to the additional volatility inherent in high yield securities relative to investment-grade securities, we focus on the severity of the impairment and work closely with our external high yield investment managers to identify securities with significant potential credit impairments.
If a security meets one of the above criteria, we then perform a fundamental analysis by considering the qualitative factors noted above. Our OTTI review process for credit impairment excludes all fixed maturities guaranteed by the U.S. government and its agencies because we anticipate these securities will not be settled below amortized costs.
From time to time, we may sell our AFS equities subsequent to the balance sheet date that were considered temporarily impaired at the balance sheet date. This may occur due to events occurring subsequent to the balance sheet date that result in a change in our intent or ability to hold an equity security. Such subsequent events that may result in a sale include significant deterioration in the financial condition of the issuer, significant unforeseen changes in our liquidity needs, or changes in tax laws or the regulatory environment.
A reconciliation of consolidated underwriting income (loss) to income before income taxes (the nearest GAAP financial measure) can be found in Item 8, Note 3 to the Consolidated Financial Statements. Underwriting-related general and administrative are reconciled to general and administrative expenses (the nearest GAAP financial measure) within 'Underwriting Results - Group'.
Consolidated Statements of Operations for the years ended December 31, 2012, 2011 and 2010
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2012, 2011 and 2010
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, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.
(Re)insurance premiums are earned over the period during which we are exposed to the underlying risk, which is generally one to two years with the exception of multi-year contracts. Unearned premiums represent the portion of premiums written which is applicable to the unexpired risks under contracts in force.
Reinstatement premiums are recognized at the time a loss event occurs and coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms; such premiums are earned over the remaining risk period. The accrual of reinstatement premiums is based on our estimate of losses and loss adjustment expenses, which reflects management’s judgment, as described in Note 2(d) - Losses and Loss Expenses below.
Our reserve for losses and loss expenses represents an estimate of the unpaid portion of our ultimate liability for losses and loss expenses for (re)insured events that have occurred at or before the balance sheet date. The balance reflects both claims
that have been reported to us (“case reserves”) and claims that have been incurred but not yet reported to us (“IBNR”). These amounts are reduced for estimated amounts of salvage and subrogation recoveries.
The Company is authorized to issue restricted stock awards and units, stock options and other equity-based awards to its employees and directors. The fair value of service-based awards is measured at the grant date, with the associated expense recognized on a straight-line basis over the service period. The fair value of performance-based awards is measured at the grant date, with the associated expense recognized on a straight-line basis over the applicable performance and vesting period, provided that the outcome of the underlying performance condition is considered probable. Forfeiture benefits are estimated at the time of grant and incorporated in the determination of share-based compensation expense.
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, to obtain exposure to a particular financial market or for yield enhancement. From time to time we may also enter into (re)insurance contracts that meet the FASB’s definition of a derivative contract.
We amortize intangible assets with finite lives over their estimated useful lives in proportion to the estimated economic benefits of the intangible assets. We also test these assets for impairment if circumstances indicate that the carrying value may not be fully recoverable. Such circumstances may include an economic downturn in a geographic market or a change in the assessment of future operations. If, as a result of such an evaluation, we determine that the carrying value of the finite-lived intangible assets is not recoverable, the value of the assets will be reduced to fair value with the difference being expensed in the Consolidated Statement of Operations.
We have recorded goodwill in connection with certain acquisitions. Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired and is assigned to applicable reporting unit(s) on the acquisition date, based upon the expected benefit to be received by the reporting unit. We determine the expected benefit based on several factors, including the purpose of the business combination, our strategy subsequent to the business combination and the structure of the acquired company subsequent to the business combination. Goodwill is not subject to amortization. We test goodwill for potential impairment during the fourth quarter each year and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit to a level below its carrying amount. We have the option to first make this assessment on a qualitative basis. Should we choose to forgo this option, or if our qualitative assessment indicates that fair value is more likely than not below carrying value, we conduct a quantitative two-step impairment evaluation at the reporting unit level. First, we identify potential impairment by comparing the estimated fair values of the reporting units to estimated book values, including goodwill. The fair value of each reporting unit is derived based upon valuation techniques and assumptions that we believe market participants would use to value our business. The estimated fair values are generally determined utilizing methodologies that incorporate discounted cash flow analyses. The values derived from the analyses are then compared to recent market transactions for reasonableness. We derive the net book value of our reporting units by estimating the amount of shareholders’ equity required to support the activities of each reporting unit. If the estimated fair value of a reporting unit exceeds the estimated book value, goodwill is not considered impaired. If the book value exceeds the estimated fair value, the second step compares the implied fair value of the reporting unit’s goodwill with the carrying amount of the goodwill in order to determine the magnitude of impairment to be recognized. The implied fair value of goodwill is determined by deducting the fair value of a reporting unit’s identifiable assets and liabilities from the fair value of the reporting unit as a whole. The excess of the carrying value of goodwill above the implied goodwill, if any, would be recognized as an impairment charge in the Consolidated Statement of Operations.
Effective January 1, 2012, we prospectively adopted FASB guidance amending existing fair value measurement guidance to:
clarify that the “valuation premise” and “highest and best use” concepts are not relevant to financial instruments,
prohibit the use of blockage factors to all three levels of the fair value hierarchy, and
During 2012, we adopted new guidance issued by the FASB providing entities with the option to perform a qualitative assessment prior to calculating the estimated fair value of indefinite-lived intangible assets (other than goodwill), as required for annual impairment tests. Entities able to qualitatively conclude that the fair value of an indefinite-lived intangible asset (other than goodwill) more likely than not (a likelihood of more than 50%) exceeds its carrying amount can bypass the existing requirement to perform the quantitative annual impairment test. The adoption of this guidance did not impact our results of operations, financial condition or liquidity.
The following tables summarize the underwriting results of our reportable segments, as well as the carrying values of allocated goodwill and intangible assets:
Asset-backed securities (ABS) include debt tranched securities collateralized primarily by auto loans, student loans, credit cards, and other asset types. This asset class also includes an insignificant position in collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs).
At December 31, 2012, 478 fixed maturities (2011: 791) were in an unrealized loss position of $18 million (2011: $125 million) of which $3 million (2011: $18 million) was related to securities below investment grade or not rated.
At December 31, 2012, 17 (2011: 10) securities have been in a continuous unrealized loss position for 12 months or greater and have a fair value of $12 million (2011: $4 million). Based on our impairment review process and our ability and intent to hold these securities for a reasonable period of time sufficient for a full recovery, we concluded that the above equities in an unrealized loss position were temporarily impaired at December 31, 2012 and 2011.
The following table provides an analysis of net realized investment gains:
Includes $37 million of gains (2011: $11 million of losses, 2010: $15 million of gains) related to previously unrealized foreign exchange currency amounts on the hedged investment portfolio.
Certain previously impaired medium-term notes (MTNs) held matured during 2011, resulting in a $52 million decrease in the accumulated credit loss impairments in the above credit loss table. These maturities also resulted in $15 million of realized gains. All previously impaired MTNs were sold or matured by December 31, 2011.
To estimate credit losses for corporate debt securities, our projected cash flows are primarily driven by our assumptions regarding the probability of default and the severity associated with those defaults. Our default and loss severity rates are based on credit rating, credit analysis, industry analyst reports and forecasts, Moody’s historical default data and any other data relevant to the recoverability of the security. In 2012, the OTTI charges on corporate debt securities were related to our intent to sell, as well as unrealized foreign exchange losses on certain securities where forecasted recovery was uncertain.
For non-agency RMBS, our projected cash flows incorporated underlying data from widely accepted third-party data sources along with certain internal assumptions and judgments regarding the future performance of the security. These assumptions included the following: default, delinquency, loss severity and prepayment rates. The assumptions used to calculate the credit losses in 2012 have not changed significantly since December 31, 2011. At December 31, 2012, the fair value of our non-agency RMBS was $95 million (2011: $166 million), consisting primarily of $65 million (2011: $128 million) of Prime and $22 million (2011: $23 million) of Alt-A MBS. At December 31, 2012, we had gross unrealized losses of $1 million (2011: $13 million) on these securities. We have concluded there are no credit losses anticipated for these securities at December 31, 2012, other than those already recorded.
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own judgments about assumptions that market participants might use.
The following describes the significant inputs generally used to determine the fair value of our fixed maturities by asset class.
U.S. government and agency securities consist primarily of debt securities issued by the U.S. Treasury and mortgage pass-through agencies such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. As the fair values of our U.S. Treasury securities are based on unadjusted market prices in active markets, they are classified within Level 1. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.
Non-U.S. government securities comprise debt securities issued by non-U.S. governments and their agencies along with supranational organizations (also known as sovereign debt securities). The fair value of these securities is based on prices obtained from international indices or a valuation model that includes the following inputs: interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the sovereign debt security we hold in terms of issuer, maturity and seniority. As the significant inputs are observable market inputs, the fair value of non-U.S. government securities are classified within Level 2.
spreads to determine the appropriate average life of the MBS. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As the significant inputs used to price MBS are observable market inputs, the fair values of the MBS are classified within Level 2. Where pricing is unavailable from pricing services, we obtain non-binding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. These securities are classified within Level 3.
Our municipal portfolio comprises debt securities issued by U.S. domiciled state and municipal entities. The fair value of these securities is determined using spreads obtained from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the municipals are observable market inputs, municipals are classified within Level 2.
As a practical expedient, we estimate fair values for hedge and credit funds using NAVs as advised by external fund managers or third party administrators. For each of our hedge and credit funds, the NAV is based on the manager's or administrator's valuation of the underlying holdings in accordance with U.S. GAAP. For any funds for which we have not yet received a NAV concurrent with our period end date, we record an estimate of the change in fair value for the period subsequent to the most recent NAV. Such estimates are based on return estimates for the period between the most recently issued NAV and the period end date; these estimates are obtained from the relevant fund managers. Accordingly, we do not have a reporting lag in our fair value measurements for these funds. Historically, our valuation estimates incorporating these return estimates have not significantly diverged from the subsequent NAVs.
For our hedge and credit fund investments with liquidity terms allowing us to fully redeem our holdings at the applicable NAV in the near term, we have classified these investments as Level 2. Certain investments in hedge and credit funds have redemption restrictions (see Note 3 for further details) that prevent us from redeeming in the near term and therefore we have classified these investments as Level 3.
The table below presents the financial instruments measured at fair value on a recurring basis:
Except for hedge funds and credit funds priced using NAV as a practical expedient and certain fixed maturities priced using broker-dealer quotes (underlying inputs are not available), the following table quantifies the significant unobservable inputs we have used in estimating fair value at December 31, 2012 for our investments classified as Level 3 in the fair value hierarchy:
ABS where fair value is estimated through the use of a discounted cash flow model (income approach) is limited to our holdings of CLO Debt. These securities represent primarily holdings of investment-grade debt tranches within collateralized loan obligations with underlying collateral of loans originated primarily by U.S. corporations. For estimating the fair values of the CLO Debt securities, in the absence of actively trading secondary markets for these securities, we discount the estimated cash flows based on current credit spreads for similar securities, derived from observable offer prices. As these securities are thinly traded in the secondary markets, we apply an illiquidity discount to these discounted cash flows in developing our estimate of fair value. Significant increases (decreases) in either of the significant unobservable inputs (credit spread, illiquidity discount) in isolation would result in lower (higher) fair value estimates for our CLO Debt. The interrelationship between these inputs is insignificant. These inputs are updated on a quarterly basis and the reasonableness of the resulting prices is assessed through a comparison to observable offer prices for similar securities.
maintain a current understanding of the market conditions, historical results, as well as emerging trends that may impact future cash flows. By maintaining this current understanding, we are able to assess the reasonableness of the inputs we ultimately use in our models.
The transfers into and out of fair value hierarchy levels reflect the fair value of the securities at the end of the reporting period.
At December 31, 2012, our senior notes are recorded at amortized cost with a carrying value of $995 million (2011: $995 million) and have a fair value of $1,091 million (2011: $1,039 million). The fair values of these securities were obtained from a third party pricing service and pricing was based on the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of our senior notes are classified within Level 2.
The following table presents a reconciliation of our beginning and ending gross reserve for losses and loss expenses and net reserve for unpaid losses and loss expenses for the periods indicated:
We write business with loss experience generally characterized as low frequency and high severity in nature, which can result in volatility in our financial results. During 2012, 2011 and 2010, respectively, we recognized aggregate net losses and loss expenses of $331 million, $789 million and $256 million in relation to significant natural catastrophe events. These amounts related to Storm Sandy for 2012, the Japanese earthquake and tsunami, the February and June earthquakes in New Zealand, first quarter Australian weather events and the Thai floods for 2011 and the September New Zealand earthquake and the Chilean earthquake for 2010.
The underlying exposures in our property, marine and aviation reserving classes within our insurance segment and the property reserving class within our reinsurance segment largely relate to short-tail business. Development from these classes contributed $186 million, $178 million and $181 million of the total net favorable prior year reserve development in 2012, 2011 and 2010, respectively, and primarily reflected the recognition of better than expected loss emergence.
Interest expense recognized in relation to our Senior Notes includes interest payable, amortization of the offering discounts and amortization of debt offering expenses. The offering discounts and debt offering expenses are amortized over the period of time during which the Senior Notes are outstanding. During 2012, we incurred interest expense of $59 million (2011: $59 million, 2010: $52 million).
Our investment portfolio is managed by external investment managers in accordance with our investment guidelines. We limit credit risk through diversification, issuer exposure limitation graded by ratings and, with respect to custodians, through contractual and other legal remedies. Excluding U.S. government and agency securities, we limit our concentration of credit risk to any single corporate issuer to 2% or less of our fixed maturities portfolio for securities rated A- or above and 1% or less of our fixed maturities portfolio for securities rated below A-. At December 31, 2012, we were in compliance with these limits.
risk assessments for potential new reinsurers, regularly monitors approved reinsurers with consideration for events which may have a material impact on their creditworthiness, recommends counterparty tolerance levels for different types of ceded business and monitors concentrations of credit risk. The assessment of each reinsurer considers a range of attributes, including a review of financial strength, industry position and other qualitative factors. Generally, the Committee requires that reinsurers who do not meet specified requirements provide collateral.
The three largest balances by reinsurer accounted for 13%, 10% and 10% of total reinsurance recoverable on unpaid and paid losses at December 31, 2012 (2011: 13%, 10% and 10%). Amounts related to our reinsurers with the ten largest balances comprised 72% of December 31, 2012 balance (2011: 70%) and had a weighted average A.M. Best rating of A+ (2011: A+).
Brokers and other intermediaries collect premiums from customers to be paid to us. We have policies and standards in place to manage and monitor credit risk from intermediaires with a focus on day-to-day monitoring of the largest positions.
We produce our business through brokers and direct relationships with insurance companies. During 2012, three brokers accounted for 61% (2011: 63%; 2010: 62%) of our total gross premiums written. Aon Corporation accounted for 27% (2011: 27%; 2010: 25%), Marsh, Inc. (including its subsidiary Guy Carpenter and Company) for 22% (2011: 23%; 2010: 24%), and Willis Group Holdings Ltd. for 12% (2011: 13%; 2010: 13%). No other broker and no one insured or reinsured accounted for more than 10% of our gross premiums written in any of the last three years.
The following table presents our common shares issued and outstanding, excluding restricted shares under our stock compensation plans (see Note 15 - Share-based Compensation):
On December 17, 2012, our Board of Directors authorized a new share repurchase plan for up to $750 million of our common shares through December 31, 2014. The new plan is effective January 1, 2013.
The following table presents our common share repurchase activities, which are held in treasury:
We privately negotiated with Trident II, L.P. and affiliated entities to repurchase 3,000,000 (2011: none; 2010: 3,062,824) of our common shares.
On March 19, 2012, we issued $400 million of 6.875% Series C preferred shares, par value $0.0125 per share, with a liquidation preference of $25.00 per share. We may redeem the Series C preferred shares on or after April 15, 2017 at a redemption price of $25.00 per share. Dividends on the Series C preferred shares are non-cumulative. Consequently, if the board of directors does not authorize and declare a dividend for any period, holders of the Series C preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accumulate and be payable. Holders of the Series C preferred shares will be entitled to receive, only when, as and if declared by the board of directors, non-cumulative cash dividends from the original issue date, quarterly in arrears on the fifteenth day of January, April, July and October of each year, commencing on July 15, 2012, without accumulation of any undeclared dividends. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 6.875% of the liquidation preference per annum. For 2012, the total dividends declared on Series C preferred shares was $1.413196 per share. Of this amount, $0.983508 was paid in 2012 and the remaining $0.429688 was subsequently paid in 2013.
We have granted stock options under the 2003 Plans; however, none have been issued since 2005. All outstanding stock options are fully vested and exercisable. These options expire ten years from the date of grant.
During 2012, we granted 2,447,700 restricted stock awards (2011: 1,839,250; 2010: 1,496,550) to our employees with a weighted average grant-date fair value per share of $32.20 (2011: $36.12; 2010: $28.91). At December 31, 2012, the total nonvested restricted stock in the above table included 401,438 of restricted stock units (2011: 378,937).
During 2012, we incurred a compensation cost of $68 million (2011: $39 million; 2010: $37 million) in respect of all restricted stock and restricted stock units, and recorded tax benefits thereon of $8 million (2011: $7 million; 2010: $6 million). Compensation costs incurred in 2012 includes $20 million of accelerated and incremental expenses associated with the the transition in our senior leadership. The retirement of one senior leader resulted in the modification of that leader's outstanding restricted stock awards to eliminate the previously existing service condition. The unanticipated termination without cause of another senior officer lead to the early satisfaction of employment obligations and resulted in the service condition associated with that officer's outstanding restricted stock awards being fully satisfied.
The following is a summary of stock options outstanding and exercisable at December 31, 2012 and related activity for the year ended:
The total intrinsic value of stock options exercised during 2012 was $11 million (2011: $9 million) and we received proceeds of $3 million (2011: $5 million). For these exercised stock options, we issued new shares from the authorized share capital pool rather than from our treasury pool.
In the ordinary course of business, we engage SKY Harbor Capital Management, LLC for asset management services for certain of our short duration high yield debt portfolios and StoneRiver RegEd for broker and adjuster licensing, appointment and compliance services. During 2012, total fees paid to these Stone Point Group companies were $2 million (2011: nil, 2010: nil).
provisions of the U.S. Internal Revenue Code and Regulations. Should the U.S. subsidiaries pay a dividend outside the U.S. group, withholding taxes will apply. Our U.S. subsidiaries are not under examination but remain subject to examination in the U.S. for tax years 2009 through 2012.
At December 31, 2012, the total operating loss carryforwards for our Singapore and Australian branches were $117 million (2011: $112 million) and $51 million (2011: $54 million), respectively. Such operating losses are currently available to offset future taxable income of the branches and may be carried forward indefinitely in each jurisdiction. At December 31, 2012, our European subsidiaries have a $3 million (2011: nil) foreign tax credit which can be carried forward indefinitely. In addition, at December 31, 2012, our U.S. companies have a $5 million (2011: $2 million) alternative minimum tax credit that can be carried forward indefinitely.
Our remaining capital loss carryforwards, in the U.S., were utilized by realizing capital gains during 2012.
Remaining disproportionate tax effect credit balance relating to elimination of valuation allowance
There were no unrecognized tax benefits at December 31, 2012 and 2011.
The statutory capital and surplus in each of our most significant regulatory jurisdictions at December 31, 2012 and 2011 was as follows:
Under the Insurance Act 1978, amendments thereto and Related Regulations of Bermuda, our Bermuda subsidiary, AXIS Specialty Bermuda is restricted as to the payment of dividends and/or distributions for amounts greater than 25% of the prior year’s statutory capital and surplus whereby a signed affidavit by at least two members of the Board of Directors attesting that a dividend and/or distribution in excess of this amount would not cause the company to fail to meet its relevant margins is required. At December 31, 2012, the maximum dividend/distribution AXIS Specialty Bermuda could pay, without a signed affidavit, having met minimum levels of statutory capital and surplus requirements, was approximately $1 billion.
Our operating subsidiaries in Bermuda and the United States maintain branch offices in Singapore and Canada, respectively. Our Irish operating subsidiaries maintain branch offices in Switzerland, Australia and the United Kingdom. As branch offices are not considered separate entities for regulatory purposes, the required and actual statutory capital and surplus amounts for each jurisdiction in the table above include amounts related to the applicable branch offices. Our Singaporean, Australian and Canadian branch offices are subject to additional minimum capital or asset requirements in their countries of domicile. At December 31, 2012 and 2011, the actual capital/assets for each of these branches exceeded the relevant local regulatory requirements.
Total statutory net income of our operating subsidiaries was $697 million, $99 million, $921 million for 2012, 2011 and 2010, 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.