We derived the following selected consolidated financial information for the years ended December 31, 2011, 2010, 2009, 2008 and 2007 from our Audited Consolidated Financial Statements and related notes. These historical results are not necessarily indicative of results to be expected from any future period.
Endurance Holdings and its wholly-owned subsidiaries are collectively referred to in this discussion and analysis as the “Company.”
The Company writes specialty lines of property and casualty insurance and reinsurance on a global basis and seeks to create a portfolio of specialty lines of business that are profitable and have limited correlation with one another. The Company’s portfolio of specialty lines of business is organized into two business segments, Insurance and Reinsurance.
In the Insurance segment, the Company writes agriculture, professional lines, casualty, property, healthcare liability, and surety and other specialty insurance. In the Reinsurance segment, the Company writes catastrophe, casualty, property, aerospace and marine, and surety and other specialty reinsurance.
Revenues. The Company derives its revenues primarily from premiums from its insurance policies and reinsurance contracts. The premiums the Company charges for the risks assumed are priced based on many assumptions and are a function of the amount and type of policies and contracts the Company writes as well as prevailing market prices, and in the case of agricultural insurance contracts, federally mandated pricing and commodity price levels. The Company prices these risks before its ultimate costs are known, which may extend many years into the future.
Marketplace Conditions and Trends. In general, at the end of 2011, we believe operating conditions continued to be competitive. In most classes of property and casualty business, we experienced neutral to downward pricing driven largely by relatively high levels of underwriting capacity and competition. In the catastrophe exposed property business, we experienced pricing increase on international and peak zone exposures underwritten due to the recent high level of worldwide catastrophe losses and from changes to catastrophe risk management models commonly used in the industry. In our agriculture business, pricing was stable, although the underlying exposure base increased with the rise in commodity prices. We continued to maintain our adherence to underwriting standards by declining business when pricing, terms and conditions did not meet our underwriting criteria.
In 2012, we believe the following five primary influences may affect the market for our insurance and reinsurance products - the continuation of the challenging global economy, continued pricing competition in many of our markets, increased volatility in agriculture commodity prices, the high level of global catastrophe losses incurred by the industry, and a low interest rate environment. The United States and other markets around the world have continued to experience unsettled economic conditions, including high levels of unemployment, significant governmental regulation initiatives and continued uncertainty in global financial markets. Although economies are slowly recovering, the lower levels of economic activity are likely to continue to suppress growth in demand for insurance and reinsurance. This is likely to result in a continued competitive global insurance and reinsurance market in 2012. Potentially offsetting these factors is the increased volatility of agriculture commodity prices which could lead to increased risk exposure and higher demand in our agriculture insurance business. In addition, the high level of global catastrophe losses incurred by the industry in 2010 and 2011 will likely result in increased prices for catastrophe exposed property insurance and reinsurance in 2012. Lastly, the current low interest rate environment will likely encourage a lower appetite for risks that are not adequately priced as there will be reduced investment earnings from underwriting cash flows.
Premiums. The Company’s insurance premiums are earned pro rata over the terms of the applicable risk period specified in the insurance policy. The Company’s insurance policies are written on a losses occurring or claims made basis during the term of the policy. Generally, the Company receives a fixed premium which is identified in the policy and is recorded on the inception date of the contract or when premiums are determinable and earned evenly over the policy term. This premium will only adjust if the underlying insured basis adjusts. Accordingly, we monitor the underlying insured basis and record additional or return premiums in the period in which amounts are reasonably determinable. Insurance premiums written accounted for 60%, 54%, and 57% of the Company’s gross premiums written during the years ended December 31, 2011, 2010, and 2009, respectively.
The Company’s reinsurance premiums are earned in proportion to the amount of reinsurance protection provided over the terms of the applicable risk period established in the reinsurance contract. Reinsurance contracts written on a losses occurring basis cover losses which occur during the term of the reinsurance contract, typically 12 months. Accordingly, the Company earns the premium on a losses occurring reinsurance contract evenly over the reinsurance contract term. Losses occurring reinsurance contracts accounted for approximately 21%, 25%, and 21% of the Company’s gross premiums written during the years ended December 31, 2011, 2010, and 2009, respectively. Reinsurance contracts written on a policies attaching basis cover losses from the underlying insurance policies incepting during the terms of the reinsurance contracts. Losses under a policies attaching reinsurance contract may occur after the end date of the reinsurance contract, so long as they are losses from policies which began during the reinsurance contract period. The Company typically earns the premiums for policies attaching reinsurance contracts over a 24 month period in proportion to the amount of reinsurance protection provided to reflect the extension of the risk period past the term of the contract and the varying levels of reinsurance protection provided during the reinsurance contract period. Policies attaching reinsurance contracts accounted for approximately 19%, 21%, and 22% of the Company’s gross premiums written during the years ended December 31, 2011, 2010, and 2009, respectively.
In addition to determining the applicable risk period, the Company’s estimate of its reinsurance premiums written is based on the type of reinsurance contracts underwritten. For excess of loss reinsurance contracts, the deposit premium, as defined in the contract, is generally considered to be the best estimate of the reinsurance contract’s written premium at inception. The Company earns reinstatement premiums upon the occurrence of a loss under the reinsurance contract. Reinstatement premiums are calculated in accordance with the contract terms based upon the ultimate loss estimate associated with each contract. Excess of loss reinsurance contracts accounted for approximately 21%, 24%, and 23% of the Company’s gross premiums written during the years ended December 31, 2011, 2010, and 2009, respectively. For proportional reinsurance contracts, the Company estimates premiums, commissions and related expenses based on broker and ceding company estimates. In addition to ceding company estimates, the Company also utilizes its judgment in establishing proportional reinsurance contract premium estimates after considering the following factors:
Proportional reinsurance contracts accounted for approximately 19%, 22%, and 20% of the Company’s gross premiums written during the years ended December 31, 2011, 2010, and 2009, respectively.
As a result of recognizing the estimated gross premium written at the inception of the policy and collecting that premium over an extended period, we include a premiums receivable asset on our balance sheet. We actively monitor our premiums receivable asset to consider whether we need an allowance for doubtful accounts. As part of this process, we consider the credit quality of our cedants and monitor premium receipts versus expectations. At December 31, 2011, the Company has an allowance for estimated uncollectible premiums receivable of $3.4 million (2010 - $4.9 million).
Under U.S. GAAP, the Company is not permitted to establish loss reserves until the occurrence of an actual loss event. Once such an event occurs, the Company establishes reserves based upon estimates of total losses incurred by the ceding companies or insureds as a result of the event, its estimate of the potential losses incurred, and its estimate of the portion of such loss the Company has insured or reinsured. As a result, only loss reserves applicable to losses incurred up to the financial statement date may be recorded, with no allowance for the provision of a contingency reserve to account for expected future losses. Losses arising from future events will be estimated and recognized at the time the loss is incurred and could be substantial. See “Reserve for Losses and Loss Expenses” below for further discussion.
Information Used in Determining the Reserve for Losses and Loss Expenses. In order to estimate the Company’s reserve for losses and loss expenses, management uses information either developed from internal or independent external sources, or pricing information created by the Company or provided to the Company by insureds and brokers at the time individual contracts and policies are bound. In addition, we use commercially available risk analysis models, contract by contract review by our underwriting teams and, to a limited extent, overall market share assumptions to estimate our loss and loss expense reserves related to specific loss events.
Factors Creating Uncertainty in the Estimation of the Reserve for Losses and Loss Expenses. While management does not at this time include an explicit or implicit provision for uncertainty in its reserve for losses and loss expenses, certain of the Company’s business lines are by their nature subject to additional uncertainties, including the Company’s casualty, property, catastrophe, aerospace and marine and surety and other specialty lines in the Reinsurance segment and the Company’s casualty and professional lines in the Insurance segment, which are discussed in detail below. In addition, the Company’s Reinsurance segment is subject to additional factors which add to the uncertainty of estimating loss and loss expense reserves. Time lags in the reporting of losses can also introduce further ambiguity to the process of estimating loss and loss expense reserves.
initial and ongoing evaluation of methodologies used by outside parties to calculate fair value; and
To the extent the Company determines that the amortized cost of the Company’s fixed maturity and short-term investments is likely to be recovered and related to non-credit factors (such as interest rates, market conditions, etc.) and not due to credit related factors, that remaining non-credit portion of the unrealized loss is recorded as a part of accumulated other comprehensive income in the shareholders’ equity section of the Company’s balance sheet.
For equity securities in an unrealized loss position for which a decision to sell has not been made and it is not more likely than not that the Company will be required to sell the equity security, the Company considers its ability and intent to hold an equity security in an unrealized loss position for a reasonable period of time to allow for a full recovery. When the Company determines that the decline in value of an equity security is other-than-temporary, the Company reduces the cost of the equity security to its fair value and recognizes the loss in the Consolidated Statements of Income and Comprehensive Income. The new cost basis is not changed for subsequent recoveries in fair value.
Goodwill. The Company is required to make an annual assessment as to whether the value of the Company’s goodwill asset is impaired. Impairment, which can be either partial or full, is based on a fair value analysis by individual reporting unit. Based upon the Company’s assessment at the reporting unit level, there was no impairment of its goodwill asset of $90.5 million as of December 31, 2011.
In making an assessment of the value of its goodwill, the Company uses both market based and non-market based valuations. Assumptions underlying these valuations include forecasts of discounted future cash flows and future profits in addition to an analysis of the Company’s stock price relative to both its book value and its net income. Significant changes in the data underlying these assumptions could result in an assessment of impairment of the Company’s goodwill asset. In addition, if the current economic environment and/or the Company’s financial performance were to deteriorate significantly, this could lead to an impairment of goodwill, the write-off of which would be recorded against net income in the period such deterioration occurred. If a 5% decline in the fair value of the reporting units occurred, this would not result in an impairment of the goodwill asset at December 31, 2011.
Gross premiums written in 2011 were $2,467.1 million, an increase of $413.9 million, or 20.2%, compared to 2010 and an increase of $445.7 million, or 22.0% compared to 2009. The following table provides the distribution of gross premiums written by the geographic location in which the risk originated for the years ended December 31, 2011, 2010 and 2009:
Modest growth in the property and catastrophe lines of the Reinsurance segment and the casualty line of the Insurance segment as a result of new business written, increased shares and improved pricing on renewals and reinstatement premiums related to the catastrophes occurring during 2011; and
Ceded premiums written by the Company increased in 2011 compared to 2010 and 2009 principally in the agriculture line of the Insurance segment consistent with the growth experienced in gross premiums written. In addition, the Company chose to retain a lower level of premiums in the property, casualty and professional lines of the Insurance segment and purchased additional protection in the catastrophe line of the Reinsurance segment. Ceded premiums written were higher in 2011 than 2009 principally as a result of the growth in cessions in the agriculture line of the Insurance segment. Net premiums earned increased in 2011 compared to 2010 and 2009 as a result of the growth in net premiums written experienced over the last two years.
2010 and 5.5% from 2009. The increase in cash and cash equivalents and investments during 2011 and 2010 resulted from increases in market valuations of investments, positive net operating cash flows, and proceeds from the issuance of Series B Preferred Shares, partially offset by share repurchases. The increase in investment expenses in 2010 and 2011 compared to 2009 was due to an overall increase in invested assets and changes in the Company’s external investment managers.
The annualized net earned yield, total return of the investment portfolio for the years ended December 31, 2011, 2010 and 2009 and market yield and portfolio duration as of December 31, 2011, 2010 and 2009 were as follows:
(1) The actual net earned income from the investment portfolio after adjusting for expenses and accretion and amortization from the purchase price divided by the average book value of assets.
(4) Includes only cash and cash equivalents and fixed maturity securities held by the Company’s investment managers.
incorporation of the Company’s own loss reporting patterns and loss history related to its short tail business, including catastrophe reinsurance and property insurance and reinsurance business lines, the Company would expect its prior year loss reserve development and adjustments for short tail business to be less than recorded in prior years. Reserve adjustments, if any, are recorded in earnings in the period in which they are determined. The overall loss reserves were established by the Company’s actuaries and reflect management’s best estimate of ultimate losses. See “Reserve for Losses and Loss Expenses” below for further discussion.
The Company’s general and administrative expense ratio for 2011 was comparable to that of 2010 as higher net earned premiums offset increased expenditures. The general and administrative ratio in 2011 was lower than that of 2009 as the impact of higher net earned premiums outweighed an increase in expenditures. The increase in expenditures in 2011 compared to 2010 and 2009 was due to higher personnel costs resulting from increased headcount, increased facilities costs and increased professional service fees related to information systems consulting. At December 31, 2011, the Company had a total of 844 employees as compared to 820 employees at December 31, 2010 and 759 employees at December 31, 2009.
The Company produced a net loss of $93.7 million in 2011 compared to net income of $364.7 million in 2010 and $536.1 million in 2009 primarily due to the increase in catastrophe losses experienced in the current year and from lower net investment income.
The following table summarizes the underwriting results and associated ratios for the Company’s Insurance segment for the years ended December 31, 2011, 2010 and 2009:
Growth in agriculture net premiums written due to increased commodity prices for corn, cotton, wheat and soybeans partially offset by a slight reduction in policy counts;
A decline in surety and other specialty premiums written as a result of the Company’s exit from its workers’ compensation business in the first quarter of 2009.
Ceded premiums written by the Company in the Insurance segment increased in 2011 compared to 2010 and 2009 as the Company increased agriculture premiums ceded to the Federal Crop Insurance Corporation in line with the growth experienced in gross premiums written. In 2010, ceded premiums were significantly lower as the Company retained more agriculture premiums due to favorable growing conditions during 2010. In addition, the Company reduced premium retentions in the property and professional lines.
Net premiums earned by the Company in the Insurance segment in 2011 were higher than in both 2010 and 2009. The increases were primarily due to the growth in net premiums written in the agriculture line in 2011 compared to the prior years.
Net Losses and Loss Expenses. The increase in the net loss ratio in the Company’s Insurance segment for year ended December 31, 2011 compared to 2010 reflected higher levels of current accident year losses in the agriculture line as a result of drought conditions experienced in the Southwest United States and excess moisture in the Midwest United States in the spring. Higher current year losses also impacted the property line as a result of several small loss events related to storms and flooding. Offsetting these loss increases was a reduction in the current accident year loss ratio in the casualty line which experienced fewer individual risk loss events in 2011 than in 2010. In addition, higher favorable prior year loss reserve development recorded in the agriculture line in 2011 partially offset the overall increase in losses incurred. The net loss ratio in the Company’s Insurance segment was higher in 2011than in 2009 primarily as a result of the shift in the mix of business toward the agriculture line which experienced higher loss ratios than the other lines of business in the Insurance segment.
The net loss ratio reflected higher favorable prior year loss reserve development recorded for 2011 as compared to 2010 and lower favorable prior year loss reserve development than in 2009. Prior year loss reserves were reduced in 2011 by $70.8 million as compared to reductions of $46.9 million and $92.1 million for the years ended December 31, 2010 and 2009. Of the lines of business in the Company’s Insurance segment, the short tail property, long tail healthcare liability and other agriculture lines experienced significant net reductions in the Company’s estimated losses for prior accident years in 2011 as claims have not materialized as originally estimated by the Company. These reductions were offset by increases in the long tail workers’ compensation business within the surety and other specialty line.
Premiums. Net premiums written in the Reinsurance segment increased in 2011 by 4.3% over 2010 and 12.5% over 2009, respectively. Gross and net premiums written for each line of business in the Reinsurance segment for the years ended December 31, 2011, 2010 and 2009 were as follows:
The change in the Reinsurance business segment net premiums written during 2011 compared to 2010 and 2009 was driven by the following factors:
Catastrophe premiums increased as a result of renewals at higher rates and new business recorded on international catastrophe programs. Part of this growth in new business was attributable to relationships established following the assumption of business from Glacier Reinsurance AG in a quota share and renewal rights transaction in the third quarter of 2010. The growth in catastrophe premiums was also attributable to reinstatement premiums of $21.9 million recorded in 2011 related to the various catastrophes;
Growth in the property line of business from the Company’s international operations through new business and increased shares of renewals. In addition, a significant favorable premium adjustment on a 2010 incepting policy contributed $13.2 million to net written premium in 2011 and additional growth upon its renewal in the latter part of the year; and
Declines in the casualty and surety and other specialty lines compared to 2010 as a result of non-renewed business. Increased premiums in the casualty line of business compared to 2009 as elements of growth generated in 2010 through new and renewal business were sustained in 2011.
Ceded premiums written by the Company in the Reinsurance segment amounted to $23.0 million in 2011 as compared to $7.2 million and $3.6 million in 2010 and 2009, respectively. The increase in ceded premiums in 2011 compared to 2010 and 2009 resulted from the Company entering into a new worldwide property catastrophe quota share retrocession contract in 2011.
Net premiums earned increased in 2011 compared to 2010 and 2009 primarily due to the growth in gross premiums written.
Government Guaranteed Corporate Securities. Corporate issued securities backed by the full faith and credit of the sponsor country. In the U.S., government guaranteed corporates were issued under the Temporary Liquidity Guarantee Program program and issued with maturities of up to three years.
Corporate Securities. Corporate securities are comprised of bonds issued by corporations, primarily rated A-/A3 or higher and are diversified across a wide range of issuers and industries. Corporate securities also include high yield securities comprised of bonds issued by corporations rated below BBB-. The principal risk of corporate securities is the potential loss of income and potential realized and unrealized principal losses due to insolvencies or deteriorating credit. The largest corporate security in our portfolio represented less than 0.78% of the fixed maturity portfolio at December 31, 2011. We had minimal realized credit related losses during 2011.
Residential Mortgage-Backed Securities. The majority of the residential mortgage-backed securities in our investment portfolio are issued by FreddieMac and FannieMae. The principal risks inherent in holding agency mortgage-backed securities are prepayment and extension risks, which will affect the timing of when principal cash flows will be received. Non-agency mortgage-backed securities also have credit risk should losses on the underlying collateral exceed the credit protection provided by subordinated tranches. Endurance has no exposure to subprime mortgages and Alt-A mortgages represented 0.5% of the fixed maturity portfolio as of December 31, 2011.
Commercial Mortgage-Backed Securities. Our commercial mortgage-backed securities (“CMBS”) portfolio is diversified both geographically and by the types of underlying properties. Our portfolio is primarily backed by office and retail buildings. We have limited exposure to lodging and industrial properties. The majority of commercial mortgage-backed securities in our portfolio are non-agency and in the super senior tranche with average credit support in excess of approximately 31.7%. The principal risks inherent in holding agency commercial mortgage-backed securities are prepayment and extension risks, which will affect the timing of when cash flows will be received. Non-agency CMBS also have credit risk should losses on the underlying collateral exceed the credit protection provided.
(1) The credit rating for each asset reflected above was determined based on the rating assigned to the individual security by Standard & Poor’s. If a rating is not supplied by Standard & Poor’s, the equivalent rating supplied by either Moody’s Investor Service or Fitch Ratings is used.
(2) Includes agency mortgage-backed securities of $993.8 million and $906.8 million at December 31, 2011 and 2010, respectively.
The contractual maturity distribution for our fixed maturity portfolio held as of December 31, 2011 and 2010 was as follows:
Our investment returns for the years ended December 31, 2011, 2010 and 2009 were as follows:
The Company participated in a securities lending program until July of 2011. Under this program, fixed maturity investments were loaned by the Company to third parties, primarily major brokerage firms and commercial banks. The borrowers of the Company’s securities provided the Company with collateral, typically cash, which the Company separately maintained. The Company typically invested such cash collateral in overnight repurchase agreements. As of December 31, 2010, the fair value of the investments purchased with the cash collateral received from the borrower was $59.9 million. All securities on loan were issued on a term or overnight basis and were subject to daily recall at the Company’s discretion. Upon termination of the securities lending program in July of 2011, the Company recalled all securities on loan and refunded all collateral previously held as part of the program. At December 31, 2010, securities with an estimated fair value of $58.7 million were on loan under the program and the Company was liable for cash collateral under the Company’s control of $59.9 million.
The Company’s diversified portfolio of investments includes exposures to the debt of various European countries. The Company continuously monitors its exposures through review of its portfolio and has established investment guidelines that restrict the amount of investment exposure to any one issuer or country to depending on specific ratings of such issuer or country as stated by credit rating agencies. The Company has reduced its aggregate direct exposure to the indebtedness and equity securities of those countries whose currency is the Euro or whose sovereign debt rating is below AAA (except the U.S.) from $335.8 million at the beginning of 2011 to $239.8 million at the end of 2011.
(1) Structured securities includes residential non-agency mortgage-backed securities, commercial non-agency mortgage-backed securities, and asset-backed securities
The following table shows the fair value as of December 31, 2011 based on the ratings of the securities held by country of risk in those countries whose currency is the Euro or whose sovereign debt rating is below AAA (except the U.S.) by any of the recognized rating agencies at December 31, 2011:
In addition to the direct exposures above, the Company has indirect exposure to sovereign and non-sovereign investments held within certain alternative funds in its Other Investments. The Company has one investment in the Other Investments category in a hedge fund with a primary focus on European indebtedness, principally focused on the declining value of European sovereign indebtedness. The Company’s initial investment in the fund was $20.0 million and its fair market value as of December 31, 2011 was in excess of that amount. The remainder of the Company’s investment within its Other Investments do not have a primary investing focus on Europe or the sovereign indebtedness of lower rated nations outside of Europe. The Company has no unfunded European exposures.
Endurance Holdings is a holding company that does not have any significant operations or assets other than its ownership of the shares of its direct and indirect subsidiaries. Endurance Holdings relies primarily on dividends and other permitted distributions from its subsidiaries to pay its operating expenses, interest on debt and dividends on its Preferred Shares and common shares, if any. There are restrictions on the payment of dividends by Endurance Holdings’ operating subsidiaries to Endurance Holdings, which are described in more detail below.
The ability of Endurance Bermuda to pay dividends is dependent on its ability to meet the requirements of applicable Bermuda law and regulations. Under Bermuda law, Endurance Bermuda may not declare or pay a dividend if there are reasonable grounds for believing that Endurance Bermuda is, or would after the payment be, unable to pay its liabilities as they become due, or the realizable value of Endurance Bermuda’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. Further, Endurance Bermuda, as a regulated insurance company in Bermuda, is subject to additional regulatory restrictions on the payment of dividends or distributions. As of December 31, 2011, Endurance Bermuda could pay a dividend or return additional paid-in capital totaling approximately $605.6 million without prior regulatory approval based upon the regulations of the Bermuda Insurance and Companies Acts. In addition, in December 2009, Endurance Holdings loaned Endurance Bermuda $300.0 million which was repaid by Endurance Bermuda in January 2011. In 2011, Endurance Holdings loaned a further $200 million to Endurance Bermuda which is callable on demand.
Endurance U.S. Reinsurance, Endurance American, Endurance American Specialty and Endurance Risk Solutions are subject to regulation by the State of Delaware Department of Insurance. ARMtech is subject to regulation by the Texas Department of Insurance. Dividends for each U.S. operating subsidiary are limited to the greater of 10% of policyholders’ surplus or statutory net income, excluding realized capital gains. In addition, dividends may only be declared or distributed out of earned surplus. At December 31, 2011, Endurance U.S. Reinsurance, Endurance American, Endurance Risk Solutions, and Endurance American Specialty did not have earned surplus; therefore, these companies are precluded from declaring or distributing dividends during 2012 without the prior approval of the applicable insurance regulator. At December 31, 2011, ARMtech (with notice to the Texas Department of Insurance) could pay dividends of $3.9 million without prior regulatory approval from the applicable regulators. In addition, any dividends paid by Endurance American, Endurance American Specialty and Endurance Risk Solutions would be subject to the dividend limitation of their respective parent insurance companies.
Under the jurisdiction of the United Kingdom’s Financial Services Authority (“FSA”), Endurance U.K. must maintain a margin of solvency at all times, which is determined based on the type and amount of insurance business written. The FSA regulatory requirements impose no explicit restrictions on Endurance U.K.’s ability to pay a dividend, but Endurance U.K. would have to notify the FSA 28 days prior to any proposed dividend payment. Dividends may only be distributed from profits available for distributions. At December 31, 2011, Endurance U.K. did not have profits available for distributions.
Cash flows provided by operating activities. Cash flows provided by operating activities for the year ended December 31, 2011 were $281.3 million compared to $407.2 million for the year ended December 31, 2010 and $471.9 million for the year ended December 31, 2009. The decrease in cash flows provided by operating activities during 2011 was primarily due to lower net income and higher claim payments which was partially offset by increased premium collections.
Cash flows provided by investing activities. During the twelve months ended December 31, 2011, cash flows provided by investing activities were $238.1 million, compared to cash flows provided by investing activities of $6.2 million for 2010 and cash flows used in investment activities of $782.2 million in 2009. The Company manages it investment portfolio to generate attractive economic returns and income while providing the Company with liquidity. Movements in financial markets and interest rates influence the timing of investment sales and purchases. The cash flows provided by investing activities in 2011 principally reflected $194.5 million in net proceeds from the sale and maturity of investments held within our investment portfolio, while 2010 reflected net sales and maturities of $6.3 million and 2009 reflected net purchases of $817.3 million.
During the years ended December 31, 2011 and 2010, the Company used its capital to repurchase its ordinary shares and share equivalents in open market and private transactions. On January 28, 2011, the Company repurchased 7,143,056 ordinary shares and options to purchase 10,000 ordinary shares from two affiliated funds of Perry Corp., a founding shareholder of Endurance. The aggregate repurchase price for the shares and the options was $321.5 million. The ordinary shares acquired by the Company represented approximately 15% of its ordinary shares outstanding at December 31, 2010. Endurance Holdings funded the repurchase of these shares primarily from calling an outstanding loan between Endurance Holdings and Endurance Bermuda. Endurance Bermuda funded the settlement of the loan from its existing cash and investments. The repurchase did not impact the disclosed dividend payment capacity of Endurance Bermuda as of December 31, 2011. During the three months ended December 31, 2011, the Company repurchased $0.5 million of its 6.15% Senior Notes due October 15, 2015.
Variable Delivery Forward. On September 11, 2007, Endurance Holdings entered into a variable delivery equity forward sale agreement under which Endurance Holdings was entitled to sell ordinary shares to an affiliate of Deutsche Bank Securities, Inc. for proceeds of approximately $150 million. The equity forward sale agreement was originally scheduled to be settled or terminate commencing on July 20, 2010. On June 18, 2010, Endurance Holdings, Deutsche Bank AG, London Branch and Deutsche Bank Securities Inc. entered into an agreement to terminate the equity forward sale agreement. The Company did not issue any of its ordinary shares in connection with the transaction, nor did the Company incur any early termination penalties in connection with the termination of the agreement.
Credit Facility. On May 8, 2007, Endurance Holdings amended its credit facility among Endurance Holdings, various designated subsidiary borrowers, various lending institutions and JPMorgan Chase Bank, N.A. as Administrative Agent to, among other things, increase the size of the facility to $1,175 million from $925 million and to extend the maturity of the facility to May 8, 2012 (the “Credit Agreement”). On July 18, 2007, the Company entered into the First Amendment to the Credit Agreement, to, among other things, modify the restrictive covenants in the Credit Agreement to permit the Company to pay dividends on its preferred equity securities following the occurrence of certain defaults as defined pursuant to the terms of the Credit Agreement. As amended, the credit facility is referred to as the “2007 Credit Facility.”
The interest rate for revolving loans under the 2007 Credit Facility is either (i) the higher of (a) the Federal Funds Effective Rate plus 0.5% and (b) the prime commercial lending rate of JPMorgan Chase Bank or (ii) LIBOR, plus additional interest ranging from 0.165% to 0.375% depending on the Company’s leverage ratio and if the loan is collateralized or uncollateralized. For letters of credit issued on a collateralized basis, the Company is required to pay a fee ranging from 0.165% to 0.29% on the daily stated amount of such letters of credit. For letters of credit issued on an uncollateralized basis, the Company is required to pay a fee ranging from 0.275% to 0.375% on the daily stated amount of such letters of credit. In addition, the 2007 Credit Facility requires the Company to pay to the lenders a facility fee and a utilization fee.
Contractual Obligations. At December 31, 2011, letters of credit totaling $447.3 million were outstanding, $199.5 million face value of 6.15% Senior Notes due October 15, 2015 (the “6.15% Senior Notes”) were outstanding and $335 million face value of 7% Senior Notes due July 15, 2034 (the “7% Senior Notes”) were outstanding.
The Company’s contractual obligations as of December 31, 2011 are summarized as follows:
(1) The Company entered into investment agreements to invest additional amounts in Other Investments.
(1) The Company also has credit facility capacity of $727.7 million and $735.7 million as at December 31, 2011 and 2010 , respectively.
Preferred Shares. On October 10, 2005, Endurance Holdings issued 8,000,000 shares of its 7.75% Non-Cumulative Preferred Shares, Series A (the “Series A Preferred Shares”) and on June 1, 2011, Endurance Holdings issued 9,200,000 shares of its 7. 5% Non-Cumulative Preferred Shares, Series B (the “Series B Preferred Shares”). The Series A Preferred Shares and Series B Preferred Shares sold were registered under the Securities Act of 1933, as amended, and are traded on the New York Stock Exchange. The Series A Preferred Shares and Series B Preferred Shares were both issued at a price to the public of $25.00 per share. Endurance Holdings received net proceeds of $193.5 million from its offering of Series A Preferred Shares and $224.0 million from its offering of Series B Preferred Shares, in each case after expenses and underwriting discounts. The proceeds from both offerings were used to provide additional capital to Endurance Holdings’ subsidiaries and for other general corporate purposes.
The Series A Preferred Shares and Series B Preferred Shares have no stated maturity date and are redeemable in whole or in part at the option of Endurance Holdings any time after December 15, 2015 (in the case of the Series A Preferred Shares) and after June 1, 2016 (in the case of the Series B Preferred Shares) in each case at a redemption price of $25.00 per share plus any declared and unpaid dividends, without accumulation of any undeclared dividends. Endurance Holdings may redeem all but not less than all of the Series A Preferred Shares or Series B Preferred Shares before their respective redemption dates at a redemption price of $26.00 per share, plus any declared and unpaid dividends, to the date of redemption, if Endurance Holdings is required to submit a proposal to the holders of the Series A Preferred Shares or Series B Preferred Shares concerning an amalgamation, consolidation, merger, similar corporate transaction or change in Bermuda law.
On an ongoing basis, the Company expects its internally generated funds, together with borrowings available under the 2007 Credit Facility, capital generated from the offering and sale of its Senior Notes, Series A Preferred Shares, Series B Preferred Shares and ordinary shares, to be sufficient to operate its business. However, there can be no assurance that the Company will not incur additional indebtedness or issue additional equity or hybrid securities in order to implement its business strategy or pay claims.
For the year ended December 31, 2011, 11.3% of the Company’s gross premiums were written in currencies other than the U.S. dollar. The portions of our cash and cash equivalents, investments and reserves for loss and loss expenses denominated in non-U.S. currencies at December 31, 2011 were approximately 29%, 3% and 13%, respectively. As of December 31, 2011, the Company’s principal foreign currency exposures are denominated in Japanese Yen and British Sterling. The Company measures and manages its exposure in these currencies, among others, by monitoring its estimated gross and net asset positions. In order to estimate such exposures, the Company considers currency specific investments, cash and cash equivalents, premiums receivable, reserve for losses and loss expenses, and unearned premiums. The total estimated gross asset and net liability balances denominated in Japanese Yen were $50.2 million and $106.9 million, respectively. The total estimated gross and net asset balances denominated in British Sterling were $199.0 million and $129.5 million, respectively. Assuming all other variables are held constant and disregarding any tax effects, a 10% change in the U.S. dollar relative to these currencies could result in a $2.3 million increase or decrease in the net assets held by the Company at December 31, 2011.
The effects of inflation could cause the severity of claims to rise in the future. The Company’s estimates for losses and loss expenses include assumptions about future payments for settlement of claims and claims handling expenses, such as medical treatments and litigation costs. To the extent inflation causes these costs to increase above reserves established for these claims, the Company will be required to increase the reserve for losses and loss expenses with a corresponding reduction in its earnings in the period in which the deficiency is identified. In addition, inflation could lead to higher interest rates causing the current unrealized gain position on the Company’s fixed maturity portfolio to decrease. The current short duration of the Company’s fixed maturity portfolio has the potential to help reduce the negative effects of higher interest rates on the Company’s fixed income portfolio. The Company may also choose to hold its fixed maturity portfolio to maturity which would result in the unrealized gains largely amortizing through net investment income.
Short Tail Insurance. The favorable loss emergence within the short tail insurance reserve category during 2011 was primarily due to lower than expected claims reported and favorable case reserve development related to the property line of business.
Long Tail Reinsurance. The Company recorded favorable prior period development within this reserve category primarily due to lower than expected claims reported within the casualty line of business.
Other Reinsurance. The Company recorded a modest amount of favorable prior period development in this reserve category due to lower than expected claims reported within the agriculture line of business.
Other Insurance. Lower than anticipated claims settlements for the 2009 crop year resulted in a reduction in prior years’ estimated loss and loss expenses within this reserve category during 2010.
Long Tail Reinsurance. The Company recorded a modest amount of favorable prior period development within this reserve category overall, primarily within the casualty line of business due to lower than anticipated claim activity.
Reserves for losses and loss expenses were comprised of the following at December 31, 2011:
Selected quarterly activity in the reserve for losses and loss expenses for the year ended December 31, 2011 is summarized as follows:
The following table represents the development of GAAP balance sheet reserve for losses and loss expenses, net of losses and loss expenses recoverable, for 2002 through December 31, 2011. This table does not present accident or policy year development data. The top line of the table shows the gross and net reserve for losses and loss expenses at the balance sheet date for each of the indicated years. This represents the estimated amounts of gross and net losses and loss expenses arising in the current year and all prior years that are unpaid at the balance sheet date, including IBNR reserves. The table also shows the re-estimated amount of the previously recorded reserve based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “cumulative redundancy” represents the aggregate change to date from the original estimate.
The table also shows the cumulative paid amounts as of successive years with respect to the reserve liability. All amounts reflect the conversion from the original currency of the underlying business if not initially denominated in U.S. dollars. The data in the table has been restated using the rate of exchange to U.S. dollars as of December 31, 2011. Information presented herein may differ materially from that reported in the Company’s financial statements due to differences in foreign currency exchange rates.
(1) The Other reserve category of the Insurance segment includes agricultural business written by the Company. Reporting pattern changes are not applicable to the agricultural business as it is typically settled at an established time each year.
Ceded premiums written were $487.3 million for the year ended December 31, 2011, $289.5 million for the year ended December 31, 2010 and $415.4 million for the year ended December 31, 2009. The increase in ceded premiums written was due to decreased retentions in our U.S. insurance operations, specifically related to the agriculture, property, casualty and professional lines. The Company’s U.S. and Bermuda insurance operating subsidiaries use proportional and excess reinsurance to protect larger limits on certain business written by this segment. Our agriculture line of business participates in a crop reinsurance program sponsored by the U.S. federal government. Excess reinsurance coverage is often purchased in relation to the property insurance line to protect against catastrophic events.
During the fourth quarter of 2011, the Company performed its annual impairment testing of goodwill. The Company has two primary sources of goodwill - goodwill obtained from a renewal rights transaction completed in 2003 with HartRe and goodwill obtained from the Company’s acquisition of ARMtech in 2007. The Company determined that the appropriate reporting units for evaluation were the Reinsurance segment in relation to HartRe goodwill and the agriculture line of business of the Insurance segment. The Company used a discounted cash flow approach to estimate the fair value of these reporting units. The fair value determined was in excess of the carrying value including goodwill for both transactions noted. As a result of the impairment testing, no write-downs were deemed necessary at December 31, 2011 and 2010.
Income tax refunds received in 2011 totaled $15.7 million. The Company paid income taxes and received refunds totaling $24.3 million and $6.8 million for the years ended December 31, 2010 and 2009, respectively. Net operating loss carryforwards in the amount of $45.5 million, $59.1 million, $41.6 million, and $26.7 million are available for application against future taxable income in the United States, United Kingdom, Singapore and Switzerland respectively. These net operating loss carry forwards have no expiration date in the United Kingdom and Singapore. In Switzerland and the United States the net operating loss carry forwards expire through 2018 and 2031, respectively. There were no income taxes payable in the United Kingdom as at December 31, 2011 or 2010.
The Company’s (loss) income before income taxes (benefits) was distributed as follows for the years ended December 31, 2011, 2010 and 2009, respectively:
Gross premiums written and earned by our non-U.S. and U.S. operations generally do not bear a proportionate relationship to the respective pre-tax (loss) income of these operations. The disproportionate relationship between gross premium written and net (loss) income between our operations occurs as a result of various factors, including but not limited to the differences in the underlying type of business underwritten, the underwriting profitability attributable to such business, and the applicable investment income generated.
Pre-tax (loss) income for our non-U.S. operations was favorable compared to U.S. operations for the year ending December 31, 2011 because our U.S. operations were impacted by losses resulting from severe drought conditions within our agriculture line of business which is underwritten by the Company’s ARMtech U.S. subsidiary. Pre-tax income for our non-U.S. operations was higher compared to our U.S. operations for the years ending December 31, 2010 and 2009 primarily as a result of the more volatile catastrophe business underwritten in our non-U.S. operations during these periods being relatively free of losses and thus generating higher levels of net underwriting income than our U.S. operations, which underwrite less volatile business and as a result produce lower levels of net underwriting income in benign loss years. In addition, our non-U.S. operations hold a substantial amount of our invested assets and thus a larger portion of the Company’s investment income is earned in our non-U.S. operations as compared to our U.S. operations.
In February 2012, the IRS notified the Company that it would be conducting an audit of the Company’s U.S. subsidiaries’ 2010 tax return. In addition, the Canada Revenue Agency has commenced an examination of income tax returns for 2008 and 2009 for the Canadian branch of one of the Company’s U.S. subsidiaries. Due to the uncertainty of the outcome of these audits, the Company cannot estimate the range of reasonably possible changes to its unrecognized tax benefits at this time. The Company does not expect to receive any adjustments that would result in a material change to its financial position.
The Company is subject to income taxes in certain jurisdictions in which the Company operates; however, since the majority of the Company’s income is currently earned in Bermuda, a jurisdiction with no corporate income tax, the tax impact to the Company’s operations has historically been minimal. In 2011, the Company generated cumulative losses before income taxes in its subsidiaries, which generated a consolidated (19.7)% effective income tax rate. In 2010, certain subsidiaries of the Company in the U.S. generated taxable income largely contributing to the Company’s income tax expense.
The Company’s balance sheet at December 31, 2011 contains a net deferred tax asset in the amount of $33.4 million (2010-$33.7 million deferred tax asset). The current year net deferred tax asset consists of gross deferred tax assets of $150.1 million, gross deferred tax liabilities of $85.4 million and a valuation allowance of $31.4 million. Of the Company’s gross deferred tax assets, $41.6 million (2010-$24.1 million) relates to net operating loss carryforwards that are available to offset future taxable income generated by the Company’s subsidiaries. The Company’s net operating losses may be carried forward indefinitely in the United Kingdom and Singapore. In Switzerland and the United States the net operating loss carryforwards expire through 2018 and 2031, respectively.
We have audited Endurance Specialty Holdings Ltd.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Endurance Specialty Holdings Ltd.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
In our opinion, Endurance Specialty Holdings Ltd. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We have audited the accompanying consolidated balance sheets of Endurance Specialty Holdings Ltd. as of December 31, 2011 and 2010, and the related consolidated statements of (loss) income and comprehensive (loss) income, changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Endurance Specialty Holdings Ltd. at December 31, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
In addition to the applicable risk period, the Company’s estimate of its reinsurance premiums written is based on the type of reinsurance contracts underwritten. For excess of loss reinsurance contracts, the deposit premium, as defined in the contract, is generally considered to be the best estimate of the reinsurance contract’s written premium at inception. The Company earns reinstatement premiums upon the occurrence of a loss under the reinsurance contract. Reinstatement premiums are calculated in accordance with the contract terms based upon the ultimate loss estimate associated with each contract. For proportional reinsurance contracts, the Company estimates premium, commissions and related expenses based on ceding company estimates and also utilizes judgment in establishing proportional reinsurance contract estimates.
Premiums on the Company’s excess of loss and proportional reinsurance contracts are estimated by management at the time the business is underwritten. Accordingly, this is the amount the Company records as written premium in the period the reinsurance contract is underwritten. As actual premiums are reported by the ceding companies, management evaluates the appropriateness of the original premium estimates and any adjustments to these estimates are recorded in the period in which they become known.
The Company’s loss and loss expense reserves are reviewed regularly, and adjustments, if any, are reflected in earnings in the period in which they become known. The establishment of new loss and loss expense reserves or the adjustment of previously recorded loss and loss expense reserves could result in significant positive or negative changes to the Company’s financial condition for any particular period. While management believes the Company’s estimate of loss and loss expense reserves is reasonable, the ultimate loss experience may not be
as reliably predicted as may be the case with other insurance and reinsurance companies, and it is possible losses and loss expenses may be materially different than the total reserve for losses and loss expenses recorded by the Company.
The Company currently classifies its fixed maturity investments, short-term investments and equity securities, as “available for sale” and accordingly, they are carried at estimated fair value, with related net unrealized gains or losses excluded from earnings and included in shareholders’ equity as a component of accumulated other comprehensive income. The Company determines the fair value of its available-for-sale investments in accordance with current accounting guidance, which defines fair value and establishes a fair value hierarchy based on inputs to the various valuation techniques used for each fair value measurement. The use of valuation techniques for any given investment requires a significant amount of judgment and consideration of factors specific to the underlying investment. Fair value measurements determined by the Company seek to maximize observable inputs and minimize the use of unobservable inputs. Current accounting guidance establishes three levels as follows:
To the extent the Company determines that the amortized cost of the Company’s fixed maturity and short-term investments is likely to be recovered and the decline in value is related to non-credit factors (such as interest rates, market conditions, etc.) and not due to credit related factors, that remaining non-credit portion of the unrealized loss is recorded as a part of accumulated other comprehensive income in the shareholders’ equity section of the Company’s balance sheet.
For equity securities in an unrealized loss position for which a decision to sell has not been made and it is not more likely than not that the Company will be required to sell the equity security, the Company considers its ability and intent to hold the equity security in an unrealized loss position for a reasonable period of time to allow for a full recovery. When the Company determines that the decline in value of an equity security is other-than-temporary, the Company reduces the cost of the equity security to its fair value and recognizes the loss in the Consolidated Statements of (Loss) Income and Comprehensive (Loss) Income. The new cost basis is not changed for subsequent recoveries in fair value.
Other Investments within the Company’s investment portfolio, which are comprised of (i) hedge funds and private equity funds that generally invest in senior secured bank debt, high yield debt securities, distressed debt, distressed real estate, derivatives and equity long/short strategies (“alternative funds”) and (ii) high yield loan and convertible debt funds (“specialty funds”) are accounted for using the equity method of accounting whereby the initial investment is recorded at cost. The carrying values of these investments are increased or decreased to reflect the Company’s share of income or loss, which is included in net investment income, and are decreased for dividends. Due to the timing of the delivery of the final valuations reported by the managers of certain of our alternative and specialty funds, our investments in those funds are estimated based on the most recently available information including period end valuation statements, period end estimates, or, in some cases, prior month or quarter valuation statements.
The Company participated in a securities lending program until July 2011. Under this program fixed maturity investments were loaned by the Company to third parties, primarily major brokerage firms and commercial banks. The Company retained all economic interest in the securities it lent, retained the earnings and cash flows associated with the loaned securities and received a fee from the borrower for the temporary use of the securities. Collateral in the form of cash, government securities and letters of credit was required at a rate of 102% - 105% of the market value of the loaned securities and was monitored and maintained by the lending agent. The securities lending collateral, excluding letters of credit, was reported as a separate line item with a corresponding liability related to the Company’s obligation to return the collateral.
The Company may use various derivative instruments such as foreign exchange forward contracts, foreign currency option contracts, futures, options, interest rate swaps, total return swaps, swaptions, credit default swaps and foreign currency forward contracts and commodity futures and options to enhance the efficiency of the investment portfolio and economically hedge certain risks. These contracts do not qualify, and are not designated, as hedges. Thus, changes in fair value and any realized gains (losses) are recognized in net realized and unrealized gains or net foreign exchange gains (losses) in the Consolidated Statements of (Loss) Income and Comprehensive (Loss) Income. Margin balances required of counterparties are included in cash and cash equivalents. Where the Company has entered into master netting agreements with counterparties, or the Company has the legal and contractual right to offset positions, the derivative positions are generally netted by the counterparty and are reported accordingly in other assets and other liabilities.
Diluted (losses) earnings per common share are based on the weighted average number of common shares and assumes the exercise of all dilutive stock warrants and options and the vesting or conversion of all convertible securities such as unvested restricted shares using the two-class method described above.
ASU 2011-04 will be effective for interim and annual periods beginning after December 15, 2011, with early adoption prohibited. The Company will adopt this standard on January 1, 2012. The Company does not expect this standard to have a material impact on the Company’s consolidated financial statements.
In June 2011, the FASB issued ASU 2011-05 “Comprehensive Income (Topic 220): Presentation of Comprehensive Income” (“ASU 2011-05”). ASU 2011-05 eliminates the option in current GAAP to permit the presentation of other comprehensive income in the statement of changes in shareholders’ equity. The remaining two options are:
A single continuous statement of net income and comprehensive income; or
In September 2011, the FASB issued ASU 2011-08 “Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment” (“ASU 2011-08”). Under ASU 2011-08, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. In addition, an entity has the option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the two-step goodwill impairment test.
ASU 2011-08 will be effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted. The Company does not expect this standard to have a material impact on the Company’s consolidated financial statements.
The following table summarizes the composition of the investment portfolio by investment type at December 31, 2011 and 2010:
(1) The credit rating for each asset reflected above was determined based on the rating assigned to the individual security by Standard & Poor’s. If a rating is not supplied by Standard & Poor’s, the equivalent rating supplied by either Moody’s Investors Service or Fitch Ratings is used.
The amortized cost, fair value and related gross unrealized gains and losses and non-credit other-than-temporary impairment (“OTTI”) losses on the Company’s fixed maturity securities, short-term investments and equity securities at December 31, 2011 and 2010 are as follows:
(2) Represents total OTTI recognized in accumulated other comprehensive income. It does not include the change in fair value subsequent to the impairment measurement date. At December 31, 2010, the gross unrealized loss related to fixed income investments for which a non-credit OTTI was recognized in accumulated other comprehensive income was $6.2 million.
(1) Gross unrealized losses include unrealized losses on non-OTTI and non-credit OTTI securities recognized in accumulated other comprehensive income at December 31, 2011.
As of December 31, 2011, 556 available for sale securities were in an unrealized loss position aggregating $24.0 million. Of those, 94 securities with aggregated unrealized losses of $7.5 million at December 31, 2011 had been in a continuous unrealized loss position for twelve months or greater.
The analysis of OTTI for the years ended December 31, 2011, 2010 and 2009 is as follows:
The Company is involved in the normal course of business with VIEs primarily as a passive investor in residential and commercial mortgage-backed securities and through its interests in other investments in alternative and specialty funds that are structured as limited partnerships considered to be third party VIEs. The Company determined that it was not the primary beneficiary for any of these investments as of December 31, 2011 and 2010. The Company believes its exposure to loss with respect to these investments is generally limited to the investment carrying amounts reported in the Company’s consolidated balance sheet and any unfunded investment commitments.
The Company determines the fair value of the fixed maturity, short-term and equity securities in its investment portfolio in accordance with current accounting guidance, which defines fair value and establishes a fair value hierarchy based on inputs to the various valuation techniques used for each fair value measurement. The Company determines the estimated fair value of each individual security utilizing the highest level inputs available. Valuation inputs by security type may include the following:
As of December 31, 2011, short-term investments were classified within Level 1 as they represented current issue or on the run U.S. treasury securities.
During the year ended December 31, 2011, fixed maturity and short-term investments were transferred from Level 1 to Level 2 as they no longer qualified as on the run U.S. treasury securities.
During the year ended December 31, 2011, fixed maturity investments were transferred from Level 2 to Level 3. The reclassifications were largely related to high yield commercial mortgage-backed and collateralized debt obligation securities. At times during the year, the market activity for these securities decreased and therefore observable inputs were no longer available at December 31, 2011 and the fair value of these securities was based on pricing models.
During the year ended December 31, 2011, fixed maturity investments and short-term investments were transferred from Level 3 to Level 2. The reclassifications were largely related to high yield commercial mortgage-backed securities. At times during the year, the market activity for these securities increased and therefore the fair value of these securities was based on observable inputs.
There were no material changes in the Company’s valuation techniques for the year ended December 31, 2011.
The following tables present the securities lending collateral reinvested by the Company in connection with its securities lending program, categorized by the level within the hierarchy in which the fair value measurements fall, on a recurring basis at December 31, 2011 and 2010, respectively. The Company participated in a securities lending program until July 2011.
At December 31, 2011 and 2010, the carrying value of the Company’s senior notes was $528.0 million and $528.3 million, respectively, and the fair value was $535.3 million and $536.9 million, respectively.
Activity in the reserve for losses and loss expenses for the years ended December 31, 2011, 2010 and 2009 is summarized as follows:
During 2011, the Company’s estimated ultimate losses for prior accident years were reduced by $180.0 million (2010 - $126.8 million; 2009 - $150.9 million) due to lower claims emergence than originally estimated by the Company. During 2011, the Company experienced favorable development in the Reinsurance segment of $109.2 million in the short tail, long tail and other reserve categories. In the Insurance segment, the Company experienced $70.8 million of favorable development across the long tail, short tail and other reserve categories. During 2010, the Company experienced favorable development in the Reinsurance segment of $79.9 million in the short tail, long tail and other reserve categories. In the Insurance segment, the Company experienced $46.9 million of favorable development across the long tail, short tail and other reserve categories. During 2009, the Company experienced favorable development in the Reinsurance segment of $58.8 million in the short tail, long tail and other reserve categories. In the Insurance segment, the Company experienced $92.1 million of favorable development across the long tail, short tail and other reserve categories during 2009.
Reserves for losses and loss expenses are based in part upon the estimation of losses resulting from catastrophic events. Estimation of these losses and loss expenses are based upon the Company’s historical claims experience and is inherently difficult because of the Company’s short operating history and the possible severity of catastrophe claims. Therefore, the Company uses both proprietary and commercially available models, as well as historical reinsurance industry catastrophe claims experience in addition to its own historical data for purposes of evaluating trends and providing an estimate of ultimate claims costs.
The Company purchases reinsurance to reduce its exposure to risk of loss in certain insurance and reinsurance lines of business. Loss recoverables are recorded as assets if the reinsurer is deemed able to meet its obligations. Ceded reinsurance contracts do not relieve the Company from its obligations to policyholders. The Company remains primarily liable to its policyholders for the portion reinsured to the extent that any reinsurer does not meet the obligations assumed under the reinsurance agreements.
During the year ended December 31, 2011, the Company recorded ceded losses of $667.0 million (2010 - $139.1 million; 2009 - $299.0 million). At December 31, 2011, the Company has an allowance for estimated uncollectible premiums receivable of $3.4 million (2010 - $4.9 million) and an allowance for estimated uncollectible losses recoverable of $0.1 million (2010 - Nil).
On May 8, 2007, Endurance Holdings amended its credit facility among Endurance Holdings, various designated subsidiary borrowers, various lending institutions and JPMorgan Chase Bank, N.A. as Administrative Agent, to, among other things; increase the size of the facility to $1,175.0 million from $925.0 million and to extend the maturity of the facility to May 8, 2012 (the “Credit Agreement”). On July 18, 2007, the Company entered into the First Amendment to the Credit Agreement, to, among other things; modify the restrictive covenants in the Credit Agreement to permit the Company to pay dividends on its preference shares following the occurrence of certain defaults as defined pursuant to the terms of the Credit Agreement. As amended, the credit facility is referred to as the “2007 Credit Facility.”
The 2007 Credit Facility also contains customary event of default provisions, including failure to pay principal or interest under the facility, insolvency of the Company, a change in control of the Company, a breach of the Company’s representations or covenants in the facility or a default by the Company under its other indebtedness. Upon the occurrence of an event of default under the 2007 Credit Facility, the lenders can terminate their commitments under the credit facility, require repayment of any outstanding revolving loans, give notice of termination of any outstanding letters of credit in accordance with their terms, require the delivery of cash collateral for outstanding letters of credit and foreclose on any security held by the lenders under the 2007 Credit Facility. See Note 11 for details related to outstanding letters of credit.
The indentures governing each of the Senior Notes contain customary covenants and events of default for senior unsecured indebtedness, including events of default for non-payment of principal or interest, breaches of covenants, insolvency of the Company or a default by the Company under other outstanding indebtedness. The Company was in compliance with all covenants contained within the indentures governing the Senior Notes as of December 31, 2011.
The Company made aggregate interest payments of $35.8 million during the year ended December 31, 2011 (2010 - $32.8 million, 2009 - $29.8 million).
The Company may use interest rate futures, swaps, swaptions and options within its portfolio of fixed maturity investments to manage its exposure to interest rate risk, which can include increasing or decreasing its exposure to this risk through modification of the portfolio composition and duration.
The Company may purchase protection through credit default swaps to mitigate the risk associated with its underwriting operations, most notably in the surety line of business, and to manage market exposures.
The Company may utilize commodity futures and options to economically hedge certain underwriting risks.
The gains and losses on the Consolidated Statements of (Loss) Income and Comprehensive (Loss) Income for derivatives for the year ended December 31, 2011 were as follows:
The following table reconciles total segment results to (loss) income before income tax benefit (expense) for the years ended December 31, 2011, 2010 and 2009:
The Company attributes gross premiums written to the geographic region in which the risks originate.
Concentrations of credit risk. The areas where significant concentrations of credit risk may exist include loss recoverables, investments and cash and cash equivalents. The Company’s reinsurance recoverables at December 31, 2011 and 2010 amounted to $666.9 million and $319.3 million, respectively, and resulted from reinsurance arrangements entered into in the normal course of operations. A credit exposure exists with respect to reinsurance recoverables as they may become uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound and, if necessary, the Company may hold collateral in the form of cash, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis. As of December 31, 2011, $299.7 million of losses recoverable (2010 - $206.6 million) was due from reinsurers rated A- or better by A.M. Best or Standard & Poor’s. An additional $364.8 million (2010 - $111.7 million) of losses recoverable was due from a U.S. government sponsored reinsurance program as of December 31, 2011.
The Company’s investment guidelines limit the amount of credit exposure to any one issuer other than the U.S. Treasury and certain other foreign government obligations rated AAA.
Letters of credit. As of December 31, 2011, the Company had issued letters of credit of $447.3 million (2010 - $439.3 million) under its credit facility in favor of certain ceding companies to collateralize obligations.
Investment commitments. As of December 31, 2011 and 2010, the Company had pledged cash and cash equivalents and fixed maturity investments of $171.4 million and $143.6 million, respectively, in favor of certain ceding companies to collateralize obligations. As of December 31, 2011 and 2010, the Company had also pledged $517.2 million and $500.9 million of its cash and fixed maturity investments as required to meet collateral obligations for $447.3 million and $439.3 million in secured letters of credit outstanding under its credit facility, respectively. In addition, at December 31, 2011 and 2010, cash and fixed maturity investments with fair values of $370.4 million and $369.1 million were on deposit with U.S. state regulators, respectively, and cash and fixed maturity investments with fair values of $7.6 million and $10.7 million were on deposit with Canadian regulators, respectively.
The Company is subject to certain commitments with respect to Other Investments at December 31, 2011 and 2010. The Company is generally subject to redemption restriction provisions of between one to five years from the date of the original commitment and rolling redemption restrictions on a one or two year basis thereafter. Due to redemption restrictions, the Company is prohibited from requesting redemptions during 2012 of $83.6 million of its Other Investments held at December 31, 2011. In addition, as of December 31, 2011 the Company was committed to investing a further $18.1 million (2010 - $11.7 million) in various investment funds classified as Other Investments.
Total lease expense under operating leases for the year ended December 31, 2011 was $12.2 million (2010 - $11.1 million; 2009 - $11.4 million).
The Company’s share capital at December 31, 2011 and 2010 is comprised as follows:
During 2011, the Company issued restricted shares under its equity compensation plans (Note 15). The common shares, issued, outstanding and fully paid for 2011 includes 719,961 restricted shares.
On November 9, 2011, the Company’s Board of Directors authorized for repurchase up to 7.0 million ordinary shares or share equivalents through November 30, 2013. This authorization superseded previous authorizations. During 2011 and 2010, under programs authorized by the Company’s Board of Directors, the Company repurchased 7,563,469 and 8,677,828 of its ordinary shares and share equivalents in open market and privately negotiated transactions at an average price of $45.06 and $38.96 per share, respectively. Common shares repurchased by the Company are not cancelled and are classified as treasury shares. The Company’s treasury shares are recorded at cost as a reduction in common shares and additional paid-in capital within shareholders’ equity. Total authorized repurchases remaining at December 31, 2011 was 7,000,000 shares (2010 - 2,808,354).
On June 18, 2010, Endurance Holdings, Deutsche Bank AG, London Branch and Deutsche Bank Securities Inc. entered into an agreement to terminate the variable delivery equity forward sale agreement. Prior to its termination, the equity forward sale agreement gave Endurance Holdings the ability to sell its ordinary shares to an affiliate of Deutsche Bank Securities, Inc. for proceeds of approximately $150.0 million. The equity forward sale agreement was originally scheduled to be settled or terminate commencing on July 20, 2010. The Company did not issue any of its ordinary shares in connection with the equity forward sale agreement, nor has the Company incurred any early termination penalties in connection with the termination of the agreement.
At December 31, 2010, 2,985,527 warrants were outstanding. At December 31, 2011, no warrants were outstanding. Such warrants were exercisable for ordinary and class A shares as follows:
During 2011, the Company repurchased 90,000 (2010 - 10,000) outstanding warrants at an average price of $36.72 (2010 - $26.04), net of the average warrant strike price of $12.87 (2010 - $13.37) per warrant. During 2011, 2,895,527 (2010 -Nil) warrants with an exercise price of $11.97 were exercised for the purchase of the Company’s ordinary shares at an average price of $36.44. The holders of 2,308,482 warrants elected the net settlement option, and thus the Company delivered 2,143,396 ordinary shares in settlement of all exercises.
Under the terms of the 2007 Plan as amended, and after the consolidation of the Company’s previous plans, a total of 2,100,000 ordinary shares were reserved for issuance. At a meeting on February 11, 2010, the Company’s Board of Directors adopted a resolution to add 1,795,000 ordinary shares to the 2007 Plan. The addition of 1,795,000 ordinary shares to the 2007 Plan was approved by the Company’s shareholders at the Annual General Meeting of Shareholders held on May 13, 2010. After the approval of the additional shares, a total of 3,895,000 ordinary shares were reserved for issuance. The Company issues new ordinary shares upon the issuance of share based equity incentives, such as restricted shares, or the exercise or settlement of outstanding derivative equity incentives, such as options or restricted share units. As of December 31, 2011, 2,592,134 (2010-3,789,012) ordinary shares remained available for issuance under the 2007 and prior Plans.
The Company grants restricted share units in an amount equal to the dividends that would have been paid on the notional amount of certain options held by employees of the Company. These restricted share units vest and settle on the first March 1st following the six-month anniversary of the date of issuance of the unit.
During the years ended December 31, 2011, 2010 and 2009, the Company granted an aggregate of 305,806, 532,964 and 326,671 restricted shares and restricted share units with weighted average grant date fair values of $14.8 million, $20.4 million and $7.6 million. During the years ended December 31, 2011, 2010 and 2009, the aggregate fair value of restricted shares and restricted share units that vested was $14.4 million, $13.5 million and $15.1 million, respectively.
On October 26, 2005, Endurance Holdings’ shareholders approved the Employee Share Purchase Plan (the “ESPP”). The ESPP is not subject to any provisions of the Employee Retirement Income Security Act of 1974 as amended, and is not a qualified plan within the meaning of Section 402(a) of the Internal Revenue Code of 1986, as amended (the “Code”). The ESPP is a qualified plan under 423 of the Code.
(1) Bermuda statutory capital and surplus includes an investment in affiliate asset, which represents its interest in the remaining insurance and reinsurance operations of the Company included in the United States and Other columns above.
(3) Endurance U.K. and the Company’s Singapore branch are currently completing 2011 statutory profit and loss statements. The Company’s Zurich branch had no statutory filing requirement at or for the years ended December 31, 2011, 2010 and 2009.
As a holding company, Endurance Holdings relies on dividends from Endurance Bermuda to provide cash flow required for debt service and dividends to shareholders. Endurance Bermuda’s ability to pay dividends and make capital distributions is subject to certain regulatory restrictions based on the enhanced capital requirement calculated using the Bermuda standard model in addition to limits on the amount of Endurance Bermuda’s premiums written and net reserves for losses and loss expenses, subject to an overall minimum capital and surplus requirement of $100.0 million. The Bermuda Solvency Capital Requirement (“BSCR”) employs a standard mathematical model that correlates the risk underwritten to the capital that is dedicated to the business. The regulatory requirements are designed to have insurers operate at or above a threshold capital level, which exceeds the BSCR. The Company is currently completing the 2011 BSCR for Endurance Bermuda and believes that Endurance Bermuda will exceed the target level of required capital as of December 31, 2011. At December 31, 2011, Endurance Bermuda can pay $605.6 million (2010-$640.4 million) to Endurance Holdings without prior approval under Bermuda law. In addition, Endurance Bermuda is required to maintain a minimum statutory liquidity ratio and solvency margin.
Under the jurisdiction of the United Kingdom’s Financial Services Authority (“FSA”), Endurance U.K. must maintain a margin of solvency at all times, which is determined based on the type and amount of insurance business written. The FSA regulatory requirements impose no explicit restrictions on Endurance U.K.’s ability to pay a dividend, but Endurance U.K. would have to notify the FSA 28 days prior to any proposed dividend payment. Dividends may only be distributed from profits available for distribution. At December 31, 2011 Endurance U.K likely will not have profits available for distribution.
The Company has operating subsidiaries and branch operations in the United States, United Kingdom, Switzerland, Singapore and Canada, which are subject to the relevant taxes in those jurisdictions. In February 2012, the IRS notified the Company that it would be conducting an audit of the Company’s U.S. subsidiaries’ 2010 tax return. In addition, the Canada Revenue Agency has commenced an examination of income tax returns for 2008 and 2009 for the Canadian branch of one of the Company’s U.S. subsidiaries. Due to the uncertainty of the outcome of these audits, the Company cannot estimate the range of reasonably possible changes to its unrecognized tax benefits at this time. However, the Company does not expect to receive any adjustments that would result in a material change to its financial position. The Company’s other operating subsidiaries and branch operations are not under examination in any jurisdictions. The Company remains subject to examination for tax years 2007 - 2011.
The actual income tax benefit (expense) attributable to income for the years ended December 31, 2011, 2010 and 2009 differed from the amount computed by applying the combined effective rate of 0% under Bermuda law to income before income tax benefit (expense), as a result of the following: