We ended 2016 with a book value per share of $10.82, reflecting an 11.1% increase, including quarterly dividends of $0.21 per share, on an internal rate of return basis, for the year ended December 31, 2016.
Our net income for 2016 included a $16.3 million tax benefit resulting from the settlements of IRS examinations for tax years 2007 through 2012.
As a result of the elevated loss activity experienced in the extended care sub-line, in-depth claim file and actuarial reviews were performed in the middle of the year. The claim file review confirmed that the increased case incurred activity was driven by increased frequency, especially in the more recent prior accident years, as opposed to other potential considerations such as significant changes in claims-handling practices. The actuarial review included analysis related to the recent enhancements to the predictive model. Recent adverse financial results were primarily observed in high-risk categories of business and in difficult geographic venues identified by the predictive model data. As a result of these analyses, management increased its best estimate of prior accident year losses, and increased its loss provisions for the current accident year.
Since the increased level of loss and LAE activity continued into the early part of the fourth quarter of 2014, the high level of activity in the second and third quarters no longer seemed to be isolated occurrences. As such, during the fourth quarter of 2014, we enhanced our actuarial and claims review in several areas. We isolated the then-recent large loss activity in each of our underwriting operating segments and examined the emergence of large losses relative to the timing and amounts of expected large losses. We also conducted additional analyses in the lawyers' professional liability line within the Other Professional Lines underwriting operating segment. These new analyses included a claim level review and the application of additional actuarial methods and loss development assumptions. The results of these analyses indicated that the assumed tail risk included in the loss development patterns used to record IBNR reserves for this line were insufficient and needed to be increased for remaining long-tail exposures. Our claims and actuarial staff also conducted an in-depth review of coverage determination, litigation, and other claim-specific adjusting expenses as a result of an emerging trend of increased expenses in these areas over then-recent quarters, particularly coverage determination expenses. This review concluded that the ultimate costs of these loss adjustment expenses were larger than previously estimated, causing management to record an increase in estimated LAE, primarily in the Other Professional Lines, Management Liability and Financial Services underwriting operating units. Finally, we also recorded unfavorable prior year development in other underwriting units, including Entertainment and Government Risks. The unfavorable loss development in Entertainment and Government Risks resulted from heavier than expected claim activity during the fourth quarter of 2014, predominantly in the general liability and commercial auto liability lines.
As a result of these enhanced actuarial and claim reviews conducted during the fourth quarter of 2014 and in order to fully reflect these then-recent trends, we recorded a $109.2 million increase in loss and LAE reserves, which included a $75.5 million increase in prior accident year loss and LAE reserves and a $33.7 million increase in the current accident year loss and LAE reserves which were previously recorded at September 30, 2014. The components of the 2014 fourth quarter reserve increase and the net loss and LAE development for the full year are provided below:
As noted above, we increased our provision for 2014 current accident year losses and LAE by $33.7 million in the fourth quarter of 2014. In recording the change in estimate of our loss and LAE reserve provision for the 2014 accident year, we considered the results of the enhanced actuarial and claim review and the fact that reported large claims were approaching estimated ultimate large losses sooner than originally expected. Of the $33.7 million increase, $29.9 million reflects an increase in management's best estimate of current year loss and LAE as of December 31, 2014 from those amounts recorded in the first nine months of 2014. This increase primarily affected the Other Professional Lines and Management Liability underwriting operating segments, which represented $17.7 million of the total provision. The remaining increase was primarily related to a $3.8 million increase in estimated losses in the Crop underwriting operating segment from higher-than-expected reports of crop losses that emerged in the fourth quarter of 2014. We exited the Crop business in 2015.
Our total revenues of $1,194.4 million for 2016 increased $8.0 million from $1,186.4 million for 2015, due to the $77.5 million increase in pre-tax investment results compared to 2015, which was mostly offset by a decrease in earned premiums of $75.6 million, or 6.4%, driven by decreases at Healthcare, and to a lesser extent, Entertainment and Other Professional Lines. Additionally, there was a $6.1 million favorable change in net other revenues (expenses), driven by the factors discussed below in "Net Other Revenues (Expenses)." Total expenses decreased to $1,098.3 million for 2016 from $1,161.1 million for 2015, resulting primarily from a decrease in loss and LAE of $44.7 million to $656.0 million in 2016, commensurate with the decline in earned premiums, which also resulted in a $9.2 million decrease in other underwriting expenses as well as a $7.8 million decrease of policy acquisition expenses.
Consolidated net written premiums decreased $35.9 million, or 3.2%, to $1,100.7 million in 2016, resulting from decreases at Programs ($32.3 million), as we have exited two underperforming accounts, Entertainment ($26.5 million) due to a refinement of our underwriting appetite, and Healthcare ($14.7 million), reflecting the impact of refocusing our sales activity
Our pre-tax underwriting income was $29.6 million for 2016, reflecting a combined ratio of 97.3%, compared to pre-tax underwriting income of $43.5 million for 2015, reflecting a combined ratio of 96.3%.
The 2016 loss and LAE ratio of 59.6% was consistent with 2015 resulting from a 1.3 point decrease in current accident year non-catastrophe losses, a 1.6 point unfavorable change in prior year loss reserve development, and a 0.3 point decrease in catastrophe losses. Current accident year non-catastrophe losses for 2016 were $628.2 million, or 57.1 points, compared to $685.9 million, or 58.4 points for 2015, driven by the improved relative performance by many of our businesses in 2016, most notably Accident, Inland Marine and Ocean Marine which were partially offset by an increased current accident year provision within Healthcare, which was driven by heavy activity in the extended care subline, as well as the medical excess subline.
Net unfavorable prior year loss and LAE reserve development was $15.4 million, or 1.4 points for 2016 driven by Healthcare ($40.7 million), resulting from the Healthcare Development Impact, and to a lesser extent, unfavorable development in the architects and engineers sub-line within Other Professional Lines, and Programs, primarily as a result of two larger auto-related programs, in addition to smaller amounts of unfavorable development in several other businesses. This unfavorable development was partially offset by favorable development primarily in Accident, Entertainment, Technology and Financial Services. This compared with $1.8 million or 0.2 points for 2015, of net favorable loss reserve development primarily attributable to favorable development from several businesses, most notably Technology, and to a lesser extent, from the exited Collector Cars and Boats business, Specialty Property and Financial Services, along with certain other businesses. This favorable development was mostly offset by unfavorable development due to several large losses and an increase in small to mid-size claims in Entertainment, and to a lesser extent, unusually heavy loss activity of both large and small claims in Ocean Marine, as well as moderate unfavorable development from certain other businesses.
Catastrophe losses were $12.4 million, or 1.1 points, for 2016, primarily resulting from wind and thunderstorms in the southern United States impacting Inland Marine and Ocean Marine, compared to $16.6 million, or 1.4 points, for 2015, primarily resulting from wind and thunderstorms in the southern United States, particularly Texas, and winter storms in the northeastern United States.
The expense ratio increased 1.0 point to 37.7% for 2016, driven by the negative impact of lower earned premiums and increased commissions due to business mix in 2016 more than offsetting reduced salary and incentive compensation expense driven by headcount reductions and lower relative incentive compensation performance factors. Additionally, the 2015 ratio was negatively impacted by the exit of the Crop business, separation costs associated with senior management restructuring and severance costs.
Our income tax benefit related to pre-tax income from continuing operations for 2016 and 2015 represented net effective tax rates of (13.0)% and (51.0)%, respectively. The effective tax rate for 2016 and 2015 were lower than the U.S. statutory rate
There was a $1.0 million net favorable after-tax change in benefit plan obligations impact to comprehensive income in 2016 compared to no net after-tax impact in 2015, which substantially relates to the amortization of the net periodic benefit cost for our defined benefit pension plan (Non-qualified Plan) as the previously sponsored OneBeacon qualified pension plan (Qualified Plan) was terminated during 2016. As of December 31, 2015, the projected benefit obligations of the terminated Qualified Plan were estimated using termination assumptions and the termination was completed in 2016 by purchasing a group annuity contract and making lump sum distributions to Qualified Plan participants electing such payments. We no longer have a benefit obligation related to the Qualified Plan after its settlement. See Note 8-"Retirement Plans."
For 2016 and 2015, our net combined ratio was higher than our gross combined ratio by 3.6 points and 1.2 points, respectively, as a result of the cost of our reinsurance programs more than offsetting the benefits from ceded losses.
Our 2015 comprehensive income attributable to OneBeacon's common shareholders of $36.8 million increased $15.9 million compared to 2014, with the change driven primarily by an increase of $64.0 million in pre-tax underwriting results and favorable changes of $20.4 million related to discontinued operations (see "Results of Operations-Discontinued Operations Results") and $12.0 million in other comprehensive income related to our pension plans, which were significantly offset by a $73.0 million decrease in pre-tax investment results.
Net favorable prior year loss and LAE reserve development was $1.8 million, or 0.2 points for 2015 primarily attributable to favorable development from several businesses, most notably Technology, and to a lesser extent, from the exited Collector Cars and Boats business, Specialty Property and Financial Services, along with certain other businesses. This favorable development was mostly offset by unfavorable development due to several large losses and an increase in small to mid-size claims in Entertainment, and to a lesser extent, unusually heavy loss activity of both large and small claims in Ocean Marine, as well as moderate unfavorable development from certain other businesses. This compared with $89.8 million or 7.6 points, of net unfavorable loss reserve development of which $75.5 million, or 6.4 points, related to the 2014 fourth quarter reserve increase. Of the net unfavorable loss and LAE reserve development resulting from the 2014 fourth quarter reserve increase, $31.9 million related to Other Professional Lines driven primarily by lawyers professional liability and $11.6 million related to Entertainment resulting from several large losses. The remaining net unfavorable prior year loss and LAE reserve development for 2014 primarily related to unfavorable development recognized prior to the 2014 fourth quarter also in our Other Professional Lines (including lawyers professional liability) and Management Liability businesses, offset in part by favorable development in our Healthcare business.
Catastrophe losses were $16.6 million, or 1.4 points, for 2015, primarily resulting from wind and thunderstorms in the southern United States, particularly Texas, and winter storms in the northeastern United States, compared to $13.8 million, or 1.2 points, for 2014, primarily resulting from wind and thunderstorms in the southern, central and eastern United States, as well as ice and snow storms in the midwestern and northeastern United States.
The expense ratio increased 4.2 points to 36.7% for 2015, which was primarily driven by 2014 benefiting from a 2.4 point reduction in the incentive compensation accrual resulting from the 2014 fourth quarter reserve increase and from a transition services agreement with the buyer of our legacy personal lines business, which was terminated on June 30, 2014. Additionally, 2015 was negatively impacted by the exit of the Crop business, separation costs associated with senior management restructuring, and severance costs.
For 2015 and 2014, our net combined ratio was higher than our gross combined ratio by 1.2 points and 1.5 points, respectively, as a result of the cost of our reinsurance programs more than offsetting the benefits from ceded losses.
The 2016 results also reflected catastrophe losses of 0.5 points primarily resulting from wind and thunderstorms in Texas impacting Financial Services compared with fairly benign catastrophe losses of 0.3 points in 2015.
underwriting operating segments in 2015. The 23.2 point decrease in the loss and LAE ratio was comprised of a 7.7 point decrease in current accident year non-catastrophe losses, a 14.8 point favorable change in net prior year loss reserve development, and a 0.7 point decrease in catastrophe losses.
The 5.3 point increase in the expense ratio for 2015, compared to 2014, was primarily driven by lower incentive compensation expense in 2014 resulting from the 2014 fourth quarter reserve increase, the adverse impact from the exit of the Crop business, and 2014 benefiting from a transition services agreement with the buyer of our legacy personal lines business, which was terminated on June 30, 2014. Additionally, the 2015 ratio was adversely impacted by separation costs associated with senior management restructuring and severance costs.
The Specialty Industries combined ratio for 2016 decreased to 88.1% compared to 101.3% for 2015, as the loss and LAE ratio decreased by 14.6 points to 48.7% and the expense ratio increased 1.4 points to 39.4%.
The current accident year non-catastrophe loss ratio for 2016 was 52.5%, compared to 57.4% for 2015, driven by the strong performance of our Accident business and the improved performance of Inland Marine and Ocean Marine which were significantly impacted by heavy claim activity in 2015.
The 2016 results included $31.3 million, or 5.5 points, of net favorable prior year loss reserve development driven by Accident, Entertainment and Technology due to lower than expected loss activity. The 2015 results included $21.8 million, or 3.5 points, of net unfavorable prior year loss reserve development primarily driven by Entertainment due to several large losses and an increase in small to mid-size claims, and to a lesser extent, unusually heavy loss activity of both large and small claims in Ocean Marine which were partially offset by favorable prior year loss reserve development in Technology, and to a lesser extent Government Risks.
The 2016 results also included 1.7 points of catastrophe losses, primarily resulting from wind and thunderstorms in the southern United States impacting Inland Marine and Ocean Marine. This compared to 2.4 points of catastrophe losses in 2015, primarily related to winter storms in the northeastern United States impacting Ocean Marine, Entertainment and Inland Marine, as well as wind and thunderstorms in the midwestern, eastern and southern United States, particularly Texas, impacting Government Risks, Ocean Marine and Inland Marine.
Net written premiums for Specialty Industries decreased $6.4 million, or 1.0%, to $603.6 million for 2015 from $610.0 million for 2014. The decrease in 2015 was driven by modest decreases at most of the underwriting operating segments, most notably a $5.8 million decrease in our Technology business, but was partially offset by a $5.4 million increase in our Accident business.
The 2015 results also included 2.4 points of catastrophe losses, primarily related to winter storms in the northeastern United States impacting Ocean Marine, Entertainment and Inland Marine, as well as wind and thunderstorms in the midwestern, eastern and southern United States, particularly Texas, impacting Government Risks, Ocean Marine and Inland Marine. This compared to 1.3 points of catastrophe losses in 2014, primarily related to wind and thunderstorms in the southern, central and eastern United States impacting Ocean Marine and Inland Marine, as well as ice and snow storms in the midwestern United States impacting Technology, Ocean Marine and Inland Marine.
During the year ended December 31, 2014, we reported $20.6 million, or $(0.21) per share, after-tax net loss in discontinued operations related to the Runoff Transaction, which included an $18.8 million after-tax loss from sale of the Runoff Business (further described below) and a $1.8 million after-tax loss from the underwriting results of the Runoff Business.
OneBeacon invests to maximize long-term total returns (after-tax) while taking prudent levels of risk and maintaining a diversified portfolio, subject to OneBeacon's investment guidelines and various regulatory restrictions. Investments include fixed maturity investments, short-term investments, common equity securities and other investments.
Gross investment returns exclude investment expenses of $4.8 million, $5.0 million and $7.0 million for the years ended December 31, 2016, 2015 and 2014, respectively.
The impact of excluding high-yield fixed maturity investments from the GAAP fixed maturity investment returns was insignificant in 2016.
Our total pre-tax investment results were $88.3 million, a return on average invested assets of 3.6% for 2016, compared to $10.8 million, a return of 0.6% for 2015. The significant increase was due in part to a higher return on our other investments
portfolio, driven by changes in credit spreads, which contributed to a positive valuation impact on the surplus notes of $20.4 million in 2016 compared to a negative valuation impact of $13.6 million in 2015, and to a lesser extent, less negative returns in energy sector exposed private equity funds in 2016 compared to 2015. Our fixed maturity investments portfolio also generated a higher return in 2016, driven by narrowing credit spreads in the current period compared to widening credit spreads in the prior period. Finally, our common equity securities portfolio generated a higher return in 2016, benefiting from stronger market performance (as measured by the S&P 500 total return index) as compared to 2015.
We maintain a portfolio of common equity securities and other investments, including surplus notes hedge funds and private equity funds. We believe that prudent levels of these investments are likely to enhance long-term after-tax total returns. OneBeacon’s portfolio of common equity securities and other investments represented approximately 12.9% and 17.0% of total invested assets as of December 31, 2016 and 2015, respectively. Including high-yield fixed maturity investments OneBeacon’s portfolio of common equity securities, other investments and high-yield fixed maturity investments represented approximately 16.4% and 17.0% of total invested assets as of December 31, 2016 and 2015, respectively.
Our common equity securities portfolio returned 7.7% in 2016, underperforming the S&P 500 Index return of 12.0%, compared to 2.3% in 2015, outperforming the S&P 500 Index return of 1.4%. Both variances to the S&P 500 Index return can largely be attributed to the results of our actively-managed publicly traded common equity securities portfolio.
Our other investments portfolio returned 16.1% in 2016, outperforming the S&P 500 Index return of 12.0%, compared to (11.8)% in 2015, underperforming the S&P 500 Index return of 1.4%. Both variances to the index returns are primarily due to the return on the surplus notes, for which a $20.4 million positive valuation adjustment was recorded in 2016 and a $13.6 million negative valuation adjustment was recorded in 2015. The surplus note valuation changes for both periods were driven primarily by changes in below investment grade credit spreads. Additionally, the return on other investments for 2015 was adversely impacted by lower returns in energy sector exposed private equity funds as compared to 2016.
The following summarizes OneBeacon's investments in ETFs by exposure to each index:
In both 2016 and 2015, the ETF investments earned the effective market return, before expenses, over the period in which OneBeacon was invested in each respective fund.
Our total pre-tax investment results were $10.8 million, a return on average invested assets of 0.6% for 2015, compared to $83.8 million, a return of 3.5% for 2014. The decrease was principally driven by other investments, which were impacted by significantly lower returns in energy exposed private equity funds relative to 2014 and negative valuation adjustments on the surplus notes, lower equity market performance, and decreased returns for the fixed maturity investment portfolio, driven by interest rate movements.
Our fixed income portfolio, which includes fixed maturity investments and short-term investments, returned 1.4% in 2015, outperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 1.2% compared to 2.4% in 2014, underperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 4.1%. Our fixed income portfolio was adversely impacted by an increase in interest rates in 2015.
Our common equity securities and other investments portfolio returned (3.0)% in 2015, compared to 8.0% in 2014, underperforming the S&P 500 Index returns of 1.4% and 13.7% in 2015 and 2014, respectively.
(1) Includes $288.0 million at amortized cost and $286.6 million at carrying value for U.S. government agency obligations.
In 2016, OneBeacon purchased high-yield fixed maturity investments, which are U.S. dollar denominated publicly traded and 144A debt securities issued by corporations with generally at least one rating between "B-" and "BB+" inclusive by Standard & Poor's or similar ratings from other agencies. Given the risk profile of these investments, OneBeacon has included returns on high-yield fixed maturity investments with returns on common equity securities and other investments. A reconciliation of these returns follows:
Insurance companies typically collect premiums on policies that they write prior to paying claims made under those policies. During periods of premium growth, insurance companies typically experience positive cash flow from operations, as premium receipts typically exceed claim payments and other operating expenses. When this happens, positive cash flow from operations is usually offset by negative cash flow from investing activities, as the positive operating cash flow is used to purchase investments. Conversely, during periods of premium decline, insurance companies typically experience negative cash flow from operations, even during periods in which they report net income, as the claims and other operating expenses that they pay exceed the premiums that they collect. When this happens, negative cash flow from operations is typically offset by positive cash flow from investing activities, as invested assets are sold to fund current claim payments.
In addition, Split Rock has the ability to pay dividends without the prior notification of regulatory authorities of up to 25% of its previous financial year's total statutory capital and surplus, subject to meeting all appropriate liquidity and solvency requirements as specified in the Insurance Act and the Companies Act. As of December 31, 2016, Split Rock had $210.1 million of total statutory capital and $60.1 million of surplus for total statutory capital and surplus of $270.2 million.
As of December 31, 2016, OneBeacon Ltd. and its intermediate subsidiaries held $64.5 million of net unrestricted cash, short-term investments and fixed maturity investments and $11.9 million of common equity securities outside of its regulated and unregulated insurance operating subsidiaries.
The following table summarizes our debt to total capital ratio as of December 31, 2016 and 2015:
On September 29, 2015 the Company and OBH, as co-borrowers and co-guarantors, entered into a revolving credit facility administered by U.S. Bank N.A. and also including BMO Harris Bank N.A., which has a total commitment of $65.0 million and has a maturity date of September 29, 2019. As of December 31, 2016 the Credit Facility was undrawn.
In December 2011, the Company sold the majority of its then owned fixed assets and capitalized software. The Company entered into lease financing arrangements with US Bancorp Equipment Finance, Inc. (US Bancorp) and Fifth Third Equipment Finance Company (Fifth Third) whereby it sold furniture and equipment and capitalized software, respectively, at a cost equal to net book value. The Company then leased the fixed assets back from US Bancorp for a lease term of five years and leased the capitalized software back from Fifth Third for a lease term of four years which expired in December 2015. The Company received cash proceeds of $23.1 million as a result of entering into the sale-leaseback transactions.
Includes expected future cash outflows under our Non-qualified, non-contributory, defined benefit pension plan and our 401(k) savings and employee stock ownership plan. Our pension plans were curtailed in 2002. See Note 8-"Retirement Plans" of the accompanying consolidated financial statements.
The balances included in the table above regarding our long-term incentive compensation plans include amounts payable for performance shares and units, as well as deferred compensation balances. Exact amounts to be paid cannot be predicted with certainty as the ultimate amounts of these liabilities are based on future performance. The estimated payments reflected in the table are based on current accrual factors (common share price and pay-out percentage) and assume that all outstanding balances were 100% vested as of December 31, 2016.
There are no provisions within our material operating lease agreements that would trigger acceleration of future lease payments. We do not finance our operations through the securitization of trade receivables, special purpose entities or synthetic leases. Further, we have not entered into any material arrangement requiring us to guarantee payment of third-party debt, lease payments or to fund losses of an unconsolidated special purpose entity.
On August 22, 2007, our Board authorized us to repurchase up to $200.0 million of OneBeacon's Class A common shares from time to time, subject to market conditions. Shares may be repurchased on the open market or through privately negotiated transactions. This authorization does not have a stated expiration date. Since the inception of this authorization, the Company has repurchased and retired 6.7 million of its Class A common shares. During the year ended December 31, 2016, 850,349 shares were repurchased under the share repurchase authorization for $10.6 million at an average share price of $12.42. During the year ended December 31, 2015, 166,368 shares were repurchased under the share repurchase authorization for $2.1 million at an average price of $12.62. No shares were repurchased under the share repurchase authorization during the year ended December 31, 2014. The amount of authorization remaining is $75.0 million as of December 31, 2016.
During 2016, 2015, and 2014, we repurchased 64,981, 112,051, and 106,366 common shares, respectively, to satisfy employee income tax withholding, pursuant to employee benefit plans. Shares repurchased pursuant to employee benefit plans do not fall under the board authorizations referred to above.
Detailed information concerning our cash flows during the years ended December 31, 2016, 2015 and 2014 follows:
For 2016, net cash flows provided from operations were $47.3 million. For 2015, net cash flows provided from operations were $191.9 million. For 2014, net cash flows provided from operations was $97.5 million, consisting of $152.0 million provided from continuing operations and $54.5 million used for discontinued operations. Net cash flows provided from operations in 2014 were reduced by the run-off of reserves related to the Runoff Business, which are included in discontinued operations.
During 2016, we made payments with respect to our long-term incentive compensation plans totaling $9.3 million, in cash or by deferral into certain of our non-qualified compensation plans. These payments were made primarily with respect to 126,900 performance units, 3,825,000 long-term cash awards, and 167,300 performance shares for the 2013-2015 performance cycle.
During 2016, we repurchased and retired 850,349 shares of our Class A common stock for $10.6 million at an average share price of $12.42 under the board authorization referred to above, as well as 64,981 common shares for $0.9 million to satisfy employee income tax withholding, pursuant to employee benefit plans that do not fall under the board authorization.
During 2015, we repurchased and retired 166,368 shares of our Class A common stock for $2.1 million at an average share price of $12.62 under the board authorization referred to above, as well as 112,051 common shares for $1.6 million to satisfy employee income tax withholding, pursuant to employee benefit plans that do not fall under the board authorization.
We measure certain assets at estimated fair value in our consolidated financial statements, with changes therein recognized in current period earnings. In addition, we disclose estimated fair value for certain assets and liabilities measured at historical or amortized cost. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price). Fair value measurements are categorized into a hierarchy that distinguishes between inputs based on market data from independent sources (observable inputs) and a reporting entity's internal assumptions based upon the best information available when external market data is limited or unavailable (unobservable inputs). Quoted prices in active markets for identical assets or liabilities have the highest priority (Level 1), followed by observable inputs other than quoted prices, including prices for similar but not identical assets or liabilities (Level 2) with unobservable inputs, including the reporting entity's estimates of the assumptions that market participants would use, having the lowest priority (Level 3).
As of December 31, 2016 and 2015, approximately 95% and 92%, respectively, of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. Investments valued using Level 1 inputs include fixed maturity investments, primarily investments in U.S. Treasuries, common equity securities and short-term investments, which include U.S. Treasury Bills. Investments valued using Level 2 inputs are comprised primarily of fixed maturity investments, which have been disaggregated into classes, including debt securities issued by corporations, municipal obligations, mortgage and asset-backed securities, foreign government obligations and preferred stocks. Certain ETFs that track U.S. stock indices such as the S&P 500 but are traded on foreign exchanges are also considered Level 2 measurements, as management values such investments using the fund’s published net asset value (NAV) to account for the difference in market close times. Fair value estimates for investments that trade infrequently and have few or no observable market prices are classified as Level 3 measurements. Level 3 fair value estimates based upon unobservable inputs include our investments in surplus notes, as well as certain investments in fixed maturity investments and common equity securities where quoted market prices are unavailable or not considered reasonable. We determine when transfers between levels have occurred as of the beginning of the period.
Our process to assess the reasonableness of the market prices obtained from the outside pricing sources covers substantially all of our fixed maturity investments and includes, but is not limited to, the evaluation of pricing methodologies and a review of the pricing services' quality control processes and procedures on at least an annual basis, a comparison of our invested asset market prices to prices obtained from different independent pricing vendors on at least a semi-annual basis, monthly analytical reviews of certain prices and a review of the underlying assumptions utilized by our pricing services for selected measurements on an ad hoc basis throughout the year. We also perform back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price on an ad-hoc basis throughout the year. Prices provided by the pricing services that vary by more than 5% and $1.0 million from the expected price based on these assessment procedures are considered outliers. Also considered outliers are prices that have not changed from period to period and prices that have trended unusually compared to market conditions. In circumstances where the results of our review process do not appear to support the market price provided by the pricing services, we challenge the pricing services' price. If we cannot gain satisfactory evidence to support the challenged price, we rely upon our own pricing methodologies to estimate the fair value of the security in question.
Municipal obligations: The fair value of municipal obligations is determined from a pricing evaluation technique that uses information from market makers, broker-dealers, buy-side firms, and analysts along with general market information. Key inputs include benchmark yields, reported trades, issuer financial statements, material event notices and new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including type, coupon, credit quality ratings, duration, credit enhancements, geographic location and market research publications.
Foreign government obligations: The fair value of foreign government obligations is determined from a pricing evaluation technique that uses feeds from data sources in each respective country, including active market makers and inter-dealer brokers. Key inputs include benchmark yields, reported trades, broker-dealer quotes, two-sided markets, benchmark securities, bids, offers, local exchange prices, foreign exchange rates and reference data including coupon, credit quality ratings, duration and market research publications.
Level 3 valuations are generated from techniques that use assumptions not observable in the market. These unobservable assumptions reflect OneBeacon's assumptions that market participants would use in valuing the investment. Generally, certain securities may start out as Level 3 when they are originally issued but as observable inputs become available in the market, they may be reclassified to Level 2.
fund’s pricing with the fund manager throughout the year. In the event we believe that our estimate of NAV differs from that reported by the fund due to illiquidity or other factors, we will adjust the fund's reported NAV to more appropriately represent the fair value of our interest in the investment. As of December 31, 2016 and 2015, we recorded negative adjustments of $5.0 million and $2.4 million, respectively, to the reported NAV of certain investments in private equity funds.
See Note 5-"Investment Securities" of the accompanying consolidated financial statements for tables that summarize the changes in OneBeacon's fair value instruments by level for the years ended December 31, 2016 and 2015 and for the amount of total gains (losses) included in earnings attributable to net change in unrealized investment gains for Level 3 investments for the years ended December 31, 2016, 2015 and 2014.
Under the contractual terms of both the seller priority and pari passu notes, scheduled interest payments accrue at 6% until the scheduled maturity date of March 15, 2020 and at a floating interest rate thereafter, should any principal remain outstanding. As required by the PID, interest on the notes is not compounding. The notes restrict the Issuer's ability to make distributions to the holders of its equity interest. All such distributions are prohibited while the seller priority note is outstanding, and while the pari passu note is outstanding, distributions are permitted only if the Issuer concurrently repays a pro rata amount of any outstanding principal on the pari passu note.
Pursuant to the notes, the Issuer shall seek to redeem the notes annually each March 15 at a requested redemption amount such that the Issuer’s total adjusted capital following the proposed redemption payment would equal 200% of the Issuer’s “authorized control level RBC,” as such term is defined by the insurance laws of the Commonwealth of Pennsylvania and as prescribed by the PID. All redemptions or repayments of principal and payments of interest on the notes are subject to approval by the PID. Below is a table illustrating the valuation adjustments taken to arrive at estimated fair value as of December 31, 2016 and 2015:
Represents the sensitivity to changes in the estimate of the timing of the first interest payment received by OneBeacon. The fair value model assumes a delay in the receipt of interest cash flows as a result of the regulatory approval required before such payments may occur; and assuming repayments are made with a graduated impact on statutory surplus.
As of December 31, 2016 and 2015, other investments reported at fair value represented approximately 6% and 5%, respectively, of the total investment portfolio and consisted of the following:
Consists of 17 private equity funds as of both December 31, 2016 and 2015.
The increase in the fair value of the surplus notes during the year ended December 31, 2016 was driven primarily by the narrowing of non-investment grade credit spreads, partially offset by the impact of a change in estimates and assumptions regarding the timing of regulatory approval of principal and amount of interest payments on the notes.
We perform an actuarial review of our recorded reserves each quarter. As part of that review, our actuaries compare the previous quarter's projections of paid and case reserve activity to amounts experienced in the quarter. Differences between previous estimates and actual experience are evaluated. While some variance is expected each quarter due to the inherent
Upon completion of each quarterly review, our actuaries select indicated reserve levels based on the results of the actuarial methods described in Note 3-"Unpaid Loss and Loss Adjustment Expense ("LAE") Reserves," which are the primary consideration in determining management's best estimate of required reserves. However, in making its best estimate, management also considers other qualitative factors that may lead to a difference between held reserves and the actuarial central estimate of reserves. Typically, these factors exist when management and our actuaries conclude that there is insufficient historical incurred and paid loss information or that there is particular uncertainty about whether trends included in the historical incurred and paid loss information are likely to repeat in the future. Such factors include, among others, recent entry into new markets or new products, improvements in the claims department that are expected to lessen future ultimate loss costs, legal and regulatory developments, or other volatilities that may arise.
See Note 3-"Unpaid Loss and Loss Adjustment Expense ("LAE") Reserves" of the accompanying consolidated financial statements for prior loss and LAE development discussions for the years ending December 31, 2016, 2015 and 2014.
Unpaid loss and LAE reserves, net of reinsurance recoverable on unpaid losses, by line of business as of December 31, 2016 and 2015 were as follows:
The following discussion includes disclosure of possible variations from current estimates of loss reserves due to changes in a few of the many key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among key assumptions. Further, there is uncertainty around other assumptions not explicitly quantified in the discussion below. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for our reserves in total. It is important to note that the volatilities and variations discussed below are not meant to be worst-case scenarios or an all-inclusive list, and therefore it is possible that future volatilities and variations may be more than amounts discussed below.
Various sources of inflation volatility impact all of our reserves in different ways. Using our internal economic capital model we have derived a distribution of future loss payments under the range of inflation scenarios and related claim cost trends in our economic scenario set, holding all other sources of reserve volatility constant. At the 75th percentile of modeled outcomes, the estimated impact of claim cost inflation above our actuarially indicated reserves is $34 million, net of reinsurance. The following are intended to provide additional insight into the impact of inflation on key lines of business:
The volatility associated with the frequency and severity of large losses, defined as claims greater than or equal to $2.5 million, can have a material impact on our results. The frequency and severity of large claims is driven primarily by the random nature of the insurance process but also by claim cost inflation and parameter risk. These large losses often emerge over a long time period potentially leading to a material impact on our reserves. One way we consider this sensitivity is by examining the volatility of large losses in the current accident year using our economic capital model. At the 75th percentile of modeled outcomes we estimate that large losses could exceed the mean by $18 million gross of reinsurance and $8 million net of the current reinsurance structure.
As we start up new businesses, our initial loss estimates and development patterns are often based on industry data. As actual losses develop, we will revise our initial expectations with our actual experience. However, depending on the tail for the specific business it can be a few years before we have sufficient internal data to rely on. As of December 31, 2016, we have $311 million of inception-to-date premium from our newer businesses (Programs, Environmental and Financial Institutions). A 10% error in our initial loss ratio estimates could result in approximately $31 million of adverse net variance in loss reserves.
Expansion of coverage definitions on existing policies, new theories of liability and emerging risks all could cause adverse development in our loss reserves. One example of an emerging risk is cyber claims, for which courts have yet to fully address the potential liaility and coverage issues presented. As of December 31, 2015 we had provided aggregate limit of $7 billion on in force policies that offer cyber coverage. If our incurred-but-not-reported cyber losses had been 1% of the exposed limits on those policies, our gross liability would be $70 million.
The information contained in this report may contain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report that address activities, events or developments which we expect will or may occur in the future are forward-looking statements. The words "will," "believe," "intend," "expect," "anticipate," "project," "estimate," "predict," "may," "anticipate" and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to our:
incurred loss and LAE and the adequacy of our loss and LAE reserves and related reinsurance;