We lease office space in Hamilton, Bermuda where our principal executive office is located. Additionally, we lease office space in the United States, Ireland, the United Kingdom and other jurisdictions sufficient for the operation of our insurance and reinsurance operations. We renew and enter into new leases in the ordinary course of business. For further discussion of our leasing commitments at December 31, 2012, see Note 19 of our audited consolidated financial statements.
Book value per share is calculated as shareholders’ equity divided by the number of common shares outstanding. Diluted book value per share is calculated as shareholders’ equity divided by the number of diluted common shares outstanding using the treasury stock method.
The increase in diluted book value per share, including dividends, is calculated by dividing adjusted diluted book value per share at the end of the year by diluted book value per share at the beginning of the year. Adjusted diluted book value per share is calculated by adding the amount of dividends declared during the year to ending shareholders' equity and dividing the result by the number of diluted common shares outstanding using the treasury method.
Net operating income and net operating return on average shareholders’ equity are non-GAAP financial measures as defined by SEC Regulation G. See “Non-GAAP financial measures” for reconciliation to the most directly comparable GAAP financial measure.
Return on average shareholders’ equity and net operating return on average shareholders’ equity are calculated by dividing net income and net operating income, respectively, by average shareholders’ equity (determined using the average of the quarterly average shareholders’ equity balances for the year).
We consider growth in book value per share to be the most important financial performance measure in assessing whether we are meeting our business objectives. We believe that a comparison of diluted book value per share growth should be adjusted for dividends to fully reflect the value created for shareholders. For the year ended December 31, 2012, our diluted book value per share including dividends increased by 7.5%. The increase was principally due to a combination of positive operating results, unrealized gains on our investment portfolio and share repurchases at a discount to diluted book value per share.
Our net operating income for the year ended December 31, 2012 improved compared with the prior year principally due to the significant decline in property catastrophe losses. Property catastrophe losses in the year ended December 31, 2012 were $127.8 million, net of reinsurance and reinstatement premiums. These losses were principally related to Hurricanes Sandy and Isaac. The results for the year ended December 31, 2011 included property catastrophe losses of $253.4 million, net of reinsurance and reinstatement premiums resulting from natural disasters in 2011. Our operating income for the year ended December 31, 2012 has also been adversely impacted by the recording of a valuation allowance related to deferred tax assets in our U.S. subsidiaries, which increased the tax expense for the year by $24.6 million, in addition to a decline in investment income principally due to lower reinvestment yields on new investment purchases.
We seek to manage and monitor our exposure so that the estimated maximum impact of a catastrophic event in any geographic zone is less than 25% of our beginning of year shareholders’ equity for a modeled 1 in 250 year event. As of December 31, 2012, our aggregate exposure was below this target. We continue to monitor the pricing environment and believe we have the capital and operational flexibility to adjust our aggregate exposure should market conditions change over the course of 2013.
On December 18, 2012 we entered into a Merger Agreement with Markel. The Merger is expected to close in the first half of 2013, subject to regulatory approvals and customary closing conditions, including shareholder approval. Shareholder approval was received on February 26, 2013.
contracts, data received from clients and from premium audits. Changes in premium estimates are expected and may result in significant adjustments in any period. These estimates change over time as additional information regarding the underlying business volume of our clients is obtained. There is often a delay in the receipt of updated premium information from clients due to the time lag in preparing and reporting the data to us. After review by our underwriters and finance staff, we increase or decrease premium estimates as updated information from our clients is received.
Interest expense principally reflects interest on our senior notes. Interest expense also includes the net interest charge on funds withheld from reinsurers under reinsurance and retrocessional contracts. Interest expense on funds withheld from other reinsurers under reinsurance and retrocessional contracts will vary principally due to changes in the balance of funds withheld. In addition, interest expense also includes interest on deposit contracts.
We categorize our loss reserves into two types: case reserves and incurred but not reported reserves, or IBNR.
There is normally a time lag between when a loss event occurs and when it is actually reported to us. The actuarial methods that we use to estimate losses have been designed to address the lag in loss reporting as well as the delay in obtaining information that would allow us to more accurately estimate future payments. There is also often a time lag between reinsurance clients establishing case reserves and re-estimating their reserves, and notifying us of the new or revised case reserves. As a result, reporting lag is more pronounced in our reinsurance contracts than in our insurance contracts due to the reliance on insurers to report their claims to us. On reinsurance transactions, the reporting lag will generally be 60 to 90 days after the end of a reporting period, but can be longer in some cases. Based on the experience of our actuaries and management, we select loss development factors and trending techniques to mitigate the problems caused by reporting lags. We regularly evaluate and update our loss development and trending factor selections using client specific and industry data.
The principal actuarial methods we use to perform our quarterly loss reserve analysis may include one or more of the following methods:
Paid Loss Development Method. This method estimates ultimate losses by calculating past paid loss development factors and applying them to exposure periods with further expected paid loss development. The paid loss development method assumes that losses are paid at a rate consistent with the historical rate of payment. It provides an objective test of reported loss projections because paid losses contain no reserve estimates. For many lines of business, claim payments are made slowly and it may take many years for claims to be fully reported and settled.
Frequency-Severity Method. This method is based on assumptions about the number of claims that will impact a contract and the average ultimate size of those claims. On excess of loss contracts, reported claims in lower layers provide insight to the expected number of claims that will likely impact the upper layers.
Our reserving methodologies use a loss reserving model that calculates a point estimate for our ultimate losses. Although we believe that our assumptions and methodologies are reasonable, we cannot be certain that our ultimate payments will not vary, potentially materially, from the estimates we have made.
We believe that the provision for outstanding losses and benefits is adequate to cover the ultimate net cost of losses incurred to the balance sheet date, but the provision is necessarily an estimate and could potentially be settled for a significantly greater or lesser amount. These estimates are reviewed regularly and any adjustments to the estimates are recorded in the period they are determined. See "Item 1A - Risk Factors-Our losses and loss adjustment expenses and benefits may exceed our loss and benefit reserves, which could significantly increase our liabilities and reduce our net income and could have a significant and negative effect on our financial condition and results of operations."
(1) Casualty includes accident & health, auto, credit, excess liability, financial institutions, general casualty, international
Our development of prior period loss reserves, net of reinsurance, as a percentage of beginning-of-year net loss reserves, has been 5.0% or less in each of the three years ending December 31, 2012, 2011 and 2010 and an average of 3.2% over the past ten years. Based on this experience, we currently believe that it is reasonably likely that net loss reserves could change 3.2% from the December 31, 2012 reported amounts. This change could be higher or lower depending on client reported data and changes in our assessment of known facts and circumstances. As of December 31, 2012, a 3.2% change in net loss reserves would impact our net income and shareholders’ equity by $109.8 million.
The uncertainty and degree of judgment used in our estimate of loss reserves varies depending on the nature of the contract and the line of business.
As of December 31, 2012, 85.5% of our losses and benefits recoverable were with reinsurers rated “A” or above by A.M. Best Company, 7.7% were rated “A-”, 0.4% were rated "B++" and the remaining 6.4% were with “NR-not rated” reinsurers. Grand Central Re, a Bermuda domiciled reinsurance company in which Alterra Bermuda has a 7.5% equity investment, is our largest “NR-not rated” retrocessionaire and accounted for 2.7% of our losses and benefits recoverable as of December 31, 2012. As security for outstanding loss obligations, we retain funds from Grand Central Re amounting to 135.5% of its loss recoverable obligations. Of the remaining amounts with “NR-not rated” retrocessionaires, we retain collateral equal to 82.5% of the losses and benefits recoverable. Our losses and benefits recoverable are not due for payment until the underlying loss has been paid. As of December 31, 2012, 96.2% of our losses and benefits recoverable were not due for payment.
The following table presents the development of balance sheet property and casualty loss reserves calculated in accordance with GAAP, as of December 31, 2003 through December 31, 2012. This table does not present accident or policy year development data. The top line of the table shows the gross reserves at the balance sheet date for each of the indicated years and is reconciled to the net reserve by adjusting for reinsurance recoverables. This represents the estimated amount of net claims and claim 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 reserves as adjusted for new information received as of the end of each succeeding year.
Gross and net reserve for property and casualty losses includes, for the first time, Alterra E&S, which we acquired in April 2007.
Gross and net reserve for property and casualty losses includes, for the first time, Alterra America, which we acquired in June 2008.
During 2012, our re-estimated balance sheet reserves for 2003 and each subsequent balance sheet decreased as a result of net favorable development on a large number of contracts from varied underwriting years and lines of business. The more significant development included:
Net favorable development for the insurance segment of $44.3 million, excluding the development associated with changes in insurance premium estimates described below, of which $19.8 million was recognized on professional liability and $11.5 million on general casualty lines of business, primarily on the 2006 and 2007 years, and $9.3 million on the property line of business primarily on the 2010 and 2011 years;
Net favorable development for our Alterra at Lloyd's segment of $1.2 million;
Our balance sheet reserves for 2003 and 2004 in the above table shows the effects of the development on one specific contract recorded in 2005. The development on this contract in the years subsequent to 2004 has not been significant. The contract increased 2003 reserves by $64.8 million and 2004 reserves by $15.3 million, for a total increase of $80.1 million. The unfavorable development triggered additional premiums and interest on such additional premiums of $70.7 million, which are not reflected in the table above.
Our life and annuity reinsurance benefit and claim reserves are compiled by our actuaries on a reinsurance contract-by-contract basis and are computed on a discounted basis using standard actuarial techniques and cash flow models. We establish and review our life and annuity reinsurance reserves regularly based upon cash flow projection models utilizing data provided by clients and actuarial models. We establish and maintain our life and annuity reinsurance reserves at a level that we estimate will, when taken together with future premium payments and investment income expected to be earned on associated premiums, be sufficient to support all future cash flow benefit obligations and third party servicing obligations as they become payable.
Since the development of our life and annuity reinsurance reserves is based upon cash flow projection models, we make estimates and assumptions based on cedant experience and industry mortality tables, longevity, expense and investment experience, including a provision for adverse deviation. The assumptions used to determine policy benefit reserves are best estimate assumptions that are determined at the inception of the contracts and are locked-in throughout the life of the reinsurance contract unless a premium deficiency develops. The assumptions are reviewed no less than annually and are un-locked if they result in a material reserve change. We establish these estimates based upon transaction specific historical experience, information provided by the ceding company and industry experience studies. Actual results could differ materially from these estimates. As the experience on the contracts emerges, the assumptions are reviewed by management. We determine whether actual and anticipated experience indicates that existing policy reserves, together with the present value of future gross premiums, are sufficient to cover the present value of future benefits, settlement and maintenance costs and to recover unamortized acquisition
costs. If such a review produces reserves in excess of those currently held then the lock-in assumptions are revised and an additional life and annuity benefit reserve is recognized at that time.
There have been no material reserve adjustments to our life and annuity reinsurance benefit reserves during the years ended December 31, 2012, 2011 and 2010.
We perform regular reviews of our available for sale and held to maturity fixed maturities portfolios and utilize a process that considers numerous indicators in order to identify investments that are showing signs of potential other than temporary impairments. These indicators include the length of time and extent of the unrealized loss, any specific adverse conditions, historic and implied volatility of the security, failure of the issuer of the security to make scheduled interest payments, expected cash flow
analysis, significant rating changes and recoveries or additional declines in fair value subsequent to the balance sheet date. The consideration of these indicators and the estimation of credit losses involve significant management judgment.
Any other-than-temporary impairment, or OTTI, related to a credit loss is recognized in earnings, and the amount of the OTTI related to other factors (e.g. interest rates, market conditions, etc.) is recorded as a component of other comprehensive income. If no credit loss exists but either we have the intent to sell the fixed maturity security or it is more likely than not that we will be required to sell the fixed maturity security before its anticipated recovery, then the entire unrealized loss is recognized in earnings. In periods after the recognition of an OTTI loss on fixed maturity securities, we account for such securities as if they had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the net impairment loss recognized in earnings.
We recognized other than temporary impairment charges through earnings of $6.9 million, $2.9 million and $2.6 million during the years ended December 31, 2012, 2011 and 2010, respectively.
The independent pricing services used by our investment custodians, investment accounting service provider and investment managers obtain actual transaction prices for securities that have quoted prices in active markets. Each pricing service has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing service uses observable market inputs, including reported trades, benchmark yields, broker/dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from market sources to determine a reasonable fair value. In addition, pricing services use valuation models, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage-backed and asset-backed securities. The ability to obtain quoted market prices is reduced in periods of decreasing liquidity, which generally increases the use of matrix pricing methods and generally increases the uncertainty surrounding the fair value estimates. This could result in the reclassification of a security between levels of the hierarchy.
As of December 31, 2012, certain of our funds had either imposed a gate on redemptions or segregated a portion of the underlying assets into a side-pocket (whereby the funds are assigned to a separate memorandum capital account or designated account). A gate refers to funds which provide for periodic redemptions, however, in accordance with the funds’ governing documents, a fund with a gate has the ability to deny or delay a redemption request. Based on the review process applied by
management on such funds, in the year ended December 31, 2010 we made an adjustment of $2.5 million to the reported net asset value of a hedge fund to reduce its fair value to $nil. We continued to carry this fund at a value of $nil as of December 31, 2012 (2011 - $nil), which is our best estimate of the fund's fair value. No adjustments to reported net asset values of any funds have been made during the years ended December 31, 2012 and 2011.
A review of fair value hierarchy classifications is conducted on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification for certain financial assets and liabilities. Reclassifications impacting Level 3 of the fair value hierarchy are reported as transfers in/out of the Level 3 category as of the beginning of the quarter in which the reclassifications occur.
The net adjustments to gross premiums written as a result of changes in premium estimates were an increase of $6.3 million for the year ended December 31, 2012, an increase of $37.3 million for the year ended December 31, 2011 and a decrease of $24.8 million for the year ended December 31, 2010. Such adjustments are generally the result of changing market conditions experienced by our clients.
Certain contracts we write, particularly property catastrophe reinsurance contracts, provide for reinstatements of coverage. Reinstatement premiums are the premiums for the restoration of the insurance or reinsurance limit of a contract to its full amount after a loss occurrence by the insured or reinsured. The purpose of optional and required reinstatements is to permit the insured / reinsured to reinstate the insurance coverage at a pre-determined price level once a loss event has penetrated the insured layer. In addition, required reinstatement premiums permit the insurer / reinsurer to obtain additional premiums to cover the additional loss limits provided.
We monitor the performance of our underwriting operations in five segments:
Reinsurance - We offer property and casualty quota share and excess of loss reinsurance from our offices in Bermuda, Bogotá, Buenos Aires, Dublin, London, Rio de Janeiro and the United States to insurance and reinsurance companies worldwide. Principal lines of business include agriculture, auto, aviation, credit/surety, general casualty, marine & energy, medical malpractice, professional liability, property, whole account and workers’ compensation.
We manage our invested assets on an aggregated basis, and do not allocate investment income and realized and unrealized gains on investments to the property and casualty segments. However, due to the longer duration of liabilities on life and annuity reinsurance business, and the accretion of the discounted carrying value of life and annuity benefits, investment returns are important in evaluating the profitability of this segment. Consequently, we allocate investment returns to this segment based on a notional allocation of invested assets from the consolidated portfolio using durations that are determined based on estimated cash
flows for the life and annuity reinsurance segment. The balance of investment returns from this consolidated portfolio is allocated to the corporate function for the purposes of segment reporting.
Effective January 1, 2012, we redefined certain of our operating and reporting segments. Insurance business written by Alterra Insurance USA, which was previously reported within the global insurance segment, has been reclassified to the U.S. insurance segment. Alterra Insurance USA is a managing general underwriter for Alterra E&S and Alterra America, as well as various third party insurance companies, and is our principal insurance underwriting platform for retail distribution in the United States. Reinsurance business written for clients in Latin America through our offices in Rio de Janeiro, Bogotà and Buenos Aires was reclassified from our reinsurance and Alterra at Lloyd's segments into a new Latin America segment.
Effective July 1, 2012, we further redefined our reporting segments by combining the reinsurance and Latin America segments into a single reinsurance segment. Our Latin America business is now combined with and reported as part of the reinsurance segment.
The changes in reporting segments reflect changes in the monitoring of our underwriting operations and information regularly reviewed by our senior management. Segment disclosures for comparative periods have been re-presented to reflect our segment structure as of July 1, 2012.
The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned for the property and casualty business.
The general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned for the property and casualty business.
The combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned for the property and casualty business.
The growth in gross premiums written for the year ended December 31, 2011 was primarily in short-tail lines of business resulting in a change in mix of gross premiums written from 50.7% short-tail lines and 49.3% long-tail lines for the year ended December 31, 2010 to 56.4% short-tail lines and 43.6% long-tail lines.
Net premiums earned is a function of the earning of gross premiums written and reinsurance premiums ceded over the last several quarters and, therefore, changes in net premiums earned generally lag quarterly increases and decreases in gross premiums written and reinsurance premiums ceded. As a result, net premiums earned tend to be less volatile than gross premiums written and reinsurance premiums ceded. The increase in net premiums earned for the year ended December 31, 2011 compared to the prior year was principally due to the incremental earnings as a result of the Amalgamation. In addition, organic growth in our Alterra at Lloyd’s segment contributed to the increase in net premiums earned.
Net investment income for the year ended December 31, 2011 increased by 5.6% compared to the prior year. The increase in net investment income was principally attributable to the increase in cash and invested assets as a result of the Amalgamation, with some additional benefit from shifting cash into higher yielding fixed maturity securities.
Our results for the year ended December 31, 2010 included an increase in fair value of hedge funds of $14.3 million and a $10.4 million loss on an interest rate forward transaction entered into in the second quarter of 2010 in contemplation of a possible long term debt issuance.
During the year ended December 31, 2011, Alterra E&S sold the renewal rights to our contract binding business. We recognized a net gain on sale of $0.8 million, which included the derecognition of goodwill of $1.0 million. Also included in other income for the year ended December 31, 2011 are fees earned for the management of New Point Re IV.
Net losses and loss expenses. The loss ratio increased for the year ended December 31, 2012 by 1.5 percentage points
compared to the prior year. Significant items impacting the 2012 loss ratio were:
Net favorable development of $44.3 million was recognized in our global insurance segment, $53.4 million in our reinsurance segment and $1.2 million in our Alterra at Lloyd's segment for the year ended December 31, 2012. This was partially offset by net unfavorable development of $8.0 million in our U.S. insurance segment;
For the year ended December 31, 2012, our results included $124.5 million of net losses related to significant property catastrophe events, principally resulting from Hurricane Sandy and Hurricane Isaac. The year ended December 31, 2012 also included a net underwriting loss (net of premiums and acquisition costs earned) of $17.5 million on our agriculture line of business. These agriculture losses relate to the severe drought conditions experienced in many parts of the United States in 2012. For the year ended December 31, 2011, our results included $269.4 million of net losses related to significant property catastrophe events.
The loss ratio increased by 10.4 percentage points for the year ended December 31, 2011 compared to the year ended December 31, 2010. Significant items impacting the 2011 loss ratio were:
Net favorable development of $65.4 million was recognized in our global insurance segment, $80.6 million in our reinsurance segment and $17.3 million in our Alterra at Lloyd's segment in the year ended December 31, 2011. This was partially offset by net unfavorable development of $10.0 million in our U.S. insurance segment. The unfavorable reserve development in our U.S. insurance segment principally related to the contract binding business, for which we sold the renewal rights for all renewals after August 1, 2011;
The prior year loss reserve development reduced the loss ratio by 10.8 percentage points for the year ended December 31, 2011, compared to 9.0 percentage points for the year ended December 31, 2010. Excluding the impact of net favorable loss development, the loss ratio was 77.3% for the year ended December 31, 2011 compared to 65.1% for the year ended December 31, 2010. The increase in the loss ratio for the year ended December 31, 2011 compared to the prior year was principally due to the increase in significant property catastrophe losses in 2011; and
Our loss estimates for the property catastrophe losses are based on proprietary modeling analyses, industry assessments of exposure, claims information obtained from our clients and brokers to date, and a review of in-force contracts. Our actual losses from these events may vary materially from the estimates due to the inherent uncertainties in making such determinations resulting from several factors, including the preliminary nature of available information, the potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques employed and the application of such techniques, the contingent nature of business interruption exposures, the effects of any resultant demand surge on claims activity, and the attendant coverage issues.
Claims and policy benefits. We did not write any new life and annuity reinsurance contracts in the years ended December 31, 2012, 2011 and 2010. We do not intend to write any new life and annuity reinsurance contracts in our life and annuity reinsurance segment in the foreseeable future.
Our acquisition cost ratio for the year ended December 31, 2011 increased by 2.3 percentage points compared to the prior year. The increase in the acquisition cost ratio was principally due to changes in the mix of business written. Our relative mix of insurance and reinsurance business moved towards more reinsurance, with 66.9% of net premiums earned being from reinsurance business for the year ended December 31, 2011 compared to 60.4% for the year ended December 31, 2010. This resulted in an increase in the acquisition cost ratio as reinsurance business tends to have higher acquisition costs compared to insurance. A decrease in the level of reinsurance purchased across our segments also contributed to the increase in the ratio for the year ended December 31, 2011.
compared to the prior year principally due to a reduction in the funds withheld from Grand Central Re.
Interest expense for the year ended December 31, 2011 increased by $15.4 million compared to the year ended December 31, 2010. The increase was principally a result of the issuance of senior notes in September of 2010. In addition, an adjustment to the deposit liability on a certain contract based on new information received resulted in an increase in interest expense in 2011.
The Company’s income before taxes, income tax expense (benefit) and effective income tax rate for the years ended December 31, 2012, 2011 and 2010 were:
Our effective tax rate and our tax expense increased significantly for the year ended December 31, 2012 compared to the prior year due principally to the recording of a valuation allowance related to deferred tax assets in our U.S. subsidiaries, which increased the tax expense for the year by $24.6 million.
Long tail includes excess liability and professional liability lines of business.
Premiums. Gross premiums written for the year ended December 31, 2012 increased by 1.6% compared to the prior year. Significant factors affecting 2012 gross premiums written were:
We have seen modest improvements in market conditions in our excess liability, professional liability and property lines of business with gross premiums written in theses lines generally flat to slightly increased; and
Gross premiums written for the year ended December 31, 2011 decreased 1.2% compared to the prior year. Significant factors affecting 2011 gross premiums written were:
Net losses and loss expenses. The loss ratio for the year ended December 31, 2012 increased by 11.7% percentage points compared to the year ended December 31, 2011. The net favorable and (unfavorable) development of prior year reserves in the year ended December 31, 2012, 2011 and 2010 by line of business was as follows:
Net favorable loss development in the year ended December 31, 2012 reflected better than expected loss emergence and was principally in the following lines of business and accident years: professional liability (2006), excess liability (2006 and 2007) and property (2010 and 2011);
Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, in the year ended December 31, 2011 of $65.4 million compared to $45.2 million in the year ended December 31, 2010;
The prior year loss reserve development reduced the loss ratio by 34.6% percentage points for the year ended December 31, 2011, compared to 20.7% percentage points for the year ended December 31, 2010. Excluding the impact of net favorable loss development, the loss ratio was 83.2% for the year ended December 31, 2011 compared to 79.6% for the year ended December 31, 2010. The increase was principally due to higher losses related to property catastrophe and significant per-risk losses during the year ended December 31, 2011 compared to the year ended December 31, 2010; and
For the year ended December 31, 2011, our results included net losses of $15.4 million related to property catastrophe events and significant per-risk losses compared to $12.1 million for the year ended December 31, 2010. A portion of these losses fell within our attritional loss ratio, as we expect a certain level of property losses in each period. Large events during the year ended December 31, 2011 included losses resulting from the Australia floods, Cyclone Yasi, the New Zealand earthquake, the Japan earthquake and tsunami, tornadoes and flooding in the United States and Hurricane Irene.
General and administrative expenses. General and administrative expenses in this segment have remained consistent over the past three years.
The combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned.
Premiums. Gross premiums written for the year ended December 31, 2012 increased 6.5% compared to the prior year. Excluding the contract binding business which we ceased writing in the quarter ended June 30, 2012, gross premiums written increased 23.8% for the year ended December 31, 2012 compared to the prior year. Significant factors affecting gross premiums written were:
Growth in wholesale excess casualty business (which is included within our general/excess liability line of business) of $36.2 million compared to the prior year. We commenced writing wholesale excess casualty business in the third quarter of 2011;
Continued expansion of our retail Alterra Insurance USA platform, principally in the professional liability line of business;
A decrease in general liability insurance written through the brokerage distribution channel of $15.0 million for the year ended December 31, 2012 compared to the prior year. We ceased writing this product line in the first quarter of 2012.
Gross premiums written for the year ended December 31, 2011 increased 15.7% compared to the prior year period. Excluding the contract binding business, which we ceased writing in the quarter ended June 30, 2012, gross premiums written increased 31.8% for the year ended December 31, 2011 compared to 2010. The increase in 2011 gross premiums written was principally due to:
Growth in our general liability line of business due to the addition of wholesale excess casualty business to our product offerings in this line.
During the quarter ended September 30, 2011, Alterra E&S sold the renewal rights to our contract binding business. However, under an agreement with the purchaser, commencing August 1, 2011, the contract binding business continued to be written by Alterra E&S and 100% of the premiums and losses were ceded to the purchaser. The 100% quota share reinsurance of this business meant that we did not retain any written and earned premium or net losses, but earned a ceding commission on new and renewal policies incepting after August 1, 2011. During the quarter ended June 30, 2012 we stopped writing and ceding this business.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2012 was 54.6% compared to 38.0% in the prior year. The increase in the percentage of premiums ceded was impacted by $15.0 million of ceded reinstatement premiums, principally related to Hurricane Sandy, for the year ended December 31, 2012 compared to minimal ceded reinstatement premiums in the prior year. Excluding the impact of these ceded reinstatement premiums, the ratio of reinsurance premiums ceded to gross premiums written would have been 50.9% for the year ended December 31, 2012. In addition, the 100% cession of $18.4 million of gross premiums written from the contract binding business affected both general liability and property lines for the year ended December 31, 2012. For the year ended December 31, 2011, $23.5 million of contract binding business gross premiums written was 100% ceded. Excluding these additional amounts of premiums ceded (and the reinstatement premiums discussed above), the percentage of premiums ceded for the year ended December 31, 2012 was 46.2% compared to 31.8% for the year ended December 31, 2011. The remaining increase resulted from a new quota share reinsurance treaty covering our brokerage-sourced property business that was entered into in the first quarter of 2012 and an increase in excess liability business written, which is ceded at a higher percentage than the general liability business written in the prior year period. Overall, our ratio of reinsurance premiums ceded to gross premiums written is increasing due to a shift in business mix within the segment to newer product lines, including our wholesale excess casualty line and our retail Alterra Insurance USA platform, on which we purchase more reinsurance than on our more established lines of business.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 38.0% compared to 30.4% in the year ended December 31, 2010. The increase in the percentage of premiums ceded in the year ended December 31, 2011 was principally due to the 100% cession of our contract binding business starting from August 1, 2011. Excluding this additional amount of premiums ceded, the percentage of premiums ceded for the year ended December 31, 2011 was 31.8%. The prior year period was impacted by the cancellation of a property quota share treaty that resulted in $20.6 million of returned ceded premium. Excluding this treaty, the ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2010 was 36.8%. The decrease from 36.8% to 31.8% was consistent with our planned increase in risk retention during the year.
Net unfavorable prior year loss development of $8.0 million for the year ended December 31, 2012 compared to net unfavorable loss development of $10.0 million for the year ended December 31, 2011. Net unfavorable development in our general/excess liability and property lines of business in both of the years ended December 31, 2012 and 2011 principally related to our discontinued contract binding business. This development was from policies written prior to our sale of this business in 2011;
The prior year loss reserve development increased the loss ratio by 4.1 percentage points for the year ended December 31, 2012, and increased the loss ratio by 4.5 percentage points for the year ended December 31, 2011. Excluding the impact of prior year loss development, the loss ratio was 102.1% for the year ended December 31, 2012 compared to 64.3% for the year ended December 31, 2011. The increase in loss ratio was due principally to the property catastrophe losses resulting from Hurricane Sandy and Hurricane Isaac and an increase in significant per risk losses exceeding our attritional loss ratio in the current year. In addition, changes in the mix of business, particularly an increase in the marine, excess casualty and professional liability lines of business contributed to the increase. These lines of business have a higher average loss ratio than property lines, which declined as a percentage of net premiums earned; and
Net unfavorable loss development of prior year reserves in the year ended December 31, 2011 was $10.0 million compared to net favorable development of $0.9 million in the year ended December 31, 2010. Net unfavorable loss development in our general liability and property lines of business related to business written by the contract binding business (2007-2010 years). As described previously, the renewal rights for this business were sold during 2011. In addition, there was net unfavorable development in our marine line of business relating to the 2010 year. The net favorable development in the year ended December 31, 2010 principally was on our property line of business;
Our results for the year ended December 31, 2011 include net losses of $19.6 million for property catastrophe losses compared to $7.0 million for the year ended December 31, 2010. The significant property catastrophe event net losses for the year ended December 31, 2011 included losses resulting from tornadoes and flooding in the United States and Hurricane Irene. The year ended December 31, 2010 included losses resulted from Tennessee flooding and northeastern U.S. storms. These losses fell within our attritional loss ratio, as we expect a certain level of property losses each period.
General and administrative expenses. General and administrative expenses increased $1.5 million compared to the prior year. The increase was principally due to increased compensation costs resulting from the growth of our wholesale excess casualty and professional liability teams.
The underwriting results of the former Harbor Point companies have been included within the reinsurance segment for the period from May 12, 2010.
The general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned.
Long tail includes general casualty, medical malpractice, professional liability, whole account and workers’ compensation lines of business.
Premiums. Gross premiums written for the year ended December 31, 2012 decreased by 1.0% compared to the prior year. Significant factors affecting the gross premiums written were:
Gross premiums written in our whole account line of business decreased $29.5 million principally due to the non-renewal of two contracts totaling $27.0 million due to unfavorable pricing;
Gross premiums written in our credit/surety line of business increased $23.8 million principally relating to growth in our Latin America business and the renewal of two multi-year residential mortgage reinsurance contracts that were originally written two years ago;
The decrease in gross premiums written in our medical malpractice line of business of $14.6 million was principally due to negative premium estimate adjustments recorded in 2012 compared to positive adjustments in 2011;
The increase in our aviation line of business of $12.3 million was principally due to new client business; and
Gross premiums written across all lines of business increased due to the inclusion of premiums written by the former Harbor Point companies for a full year in 2011 compared to only from May 12 in 2010;
An increase in gross premiums written in our aviation, general casualty, marine & energy and professional liability lines of business resulting from the Amalgamation was offset by contracts not being renewed or reductions in our participation due to a more competitive pricing environment.
The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 9.3% compared to 12.1% in the year ended December 31, 2010. The decrease was principally due to the Amalgamation, which resulted in an increase in gross premiums written with a smaller percentage increase in ceded premiums written. In addition, there was an increase in auto business, which is not reinsured, and property business, which had a lower retrocession rate than the prior year.
Net premiums earned is a function of the earning of gross premiums written and reinsurance premiums ceded over the last several quarters and, therefore, changes in net premiums earned generally lag quarterly increases and decreases in gross premiums written and reinsurance premiums ceded. The increase in net premiums earned for the year ended December 31, 2011 compared to the prior year was principally due to the incremental earnings of the Harbor Point portfolio of contracts, which are included within the entire 2011 year but are only included for a portion of the comparable 2010 year.
Net favorable development of prior year loss reserves, excluding the effect of premium adjustments, in the year ended December 31, 2012 of $53.4 million compared to $80.6 million in the year ended December 31, 2011;
Prior year loss reserve development in the year ended December 31, 2012 was principally related to: net favorable development on our general casualty line of business due to better than expected loss emergence along with the favorable settlement of a large underlying claim on the 2002 year; on our property line of business due to better than expected loss emergence principally on the 2010 and 2011 years; and in our whole account line of business due to favorable claims experience on the 2006-2007 years principally on one large quota share contract. This was partially offset by unfavorable development in our medical malpractice line of business principally related to worse than expected claims experience from two cedants principally relating to the 2008-2011 years. We did not renew these contracts in 2012. The remainder of our medical malpractice line of business experienced net favorable development in 2012;
The prior year loss reserve development reduced the loss ratio by 6.9 percentage points for the year ended December 31, 2012 compared to 9.5 percentage points for the year ended December 31, 2011. Excluding the impact of net favorable loss development, the loss ratio was 64.8% for the year ended December 31, 2012 compared to 73.6% for the year ended December 31, 2011. The decrease in the loss ratio for the year ended December 31, 2012 was due principally to the significant decrease in property catastrophe and significant per-risk losses; and
The year ended December 31, 2012 included $50.7 million of losses related to significant property catastrophe events, principally Hurricanes Isaac and Sandy. The year ended December 31, 2012 also included a net underwriting loss (net of premiums and acquisition costs earned) of $6.0 million on our agriculture line of business related to the severe drought conditions experienced in many parts of the United States in 2012. The year ended December 31, 2011 included $151.3 million in net losses related to significant property catastrophe events including losses resulting from the Australia floods, Cyclone Yasi, the New Zealand earthquake, the Japan earthquake and tsunami, tornadoes and flooding in the United States, Hurricane Irene and the Thailand floods.
Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, in the year ended December 31, 2011 was $80.6 million, compared to $44.6 million in the year ended December 31, 2010;
The net favorable development in the year ended December 31, 2011 reflected better than expected loss emergence principally on the 2010 and prior years for the property line of business, on the 2001 year for workers’ compensation relating to the favorable settlement of a contract, on the 2008 and 2007 years for aviation and on the 2009 and prior years for the professional liability line of business. This favorable loss development was partially offset by unfavorable development principally on the 2010 and 2009 years for the medical malpractice line of business.
Acquisition costs. Acquisition costs for the year ended December 31, 2012 decreased $0.8 million compared to the prior year, however, the acquisition cost ratios for the year ended December 31, 2012 increased 2.2 percentage points compared to the prior year. The reinsurance contracts we write have a wide range of acquisition cost ratios and the variance is the result of shifts in the mix of business written and earned. In addition, the year ended December 31, 2011 included $20.1 million of reinstatement premiums related to catastrophe events compared to $8.9 million in the current year. These reinstatement premiums had low acquisition costs associated with them thereby reducing the acquisition cost ratio by a greater extent in 2011 than 2012.
Other income. Other income for the years ended December 31, 2012 and 2011 principally related to underwriting fees and profit commission earned from New Point Re IV. New Point Re IV commenced underwriting in July of 2011.
Long tail includes financial institutions, international casualty and professional liability lines of business.
Premiums. Gross premiums written for the year ended December 31, 2012 increased 18.3% compared to the prior year. The increase in gross premiums written was primarily due to:
An increase of $18.3 million in our agriculture line of business. Our Alterra at Lloyd’s segment commenced writing agriculture business in the first quarter of 2012. This business was written previously in our reinsurance segment and was renewed in 2012 in our Alterra at Lloyd’s segment;
The addition of a marine underwriting team to Alterra at Lloyd's towards the end of 2011, increasing gross premiums written by $7.8 million for the year ended December 31, 2012.
The prior year loss reserve development decreased the loss ratio by 10.6 percentage points for the year ended December 31, 2011 compared to a reduction of 11.6 percentage points for the year ended December 31, 2010. Excluding the impact of prior year loss development, the loss ratio was 107.3% for the year ended December 31, 2011 compared to 54.4% for the year ended December 31, 2010. The increase in the loss ratio was principally due to catastrophe-related and significant per-risk losses; and
Net losses and loss expense for the year ended December 31, 2011 included $83.2 million in catastrophe-related and significant per-risk losses. Property catastrophe losses for the year ended December 31, 2011 included losses resulting from the Australia floods, Cyclone Yasi, the New Zealand earthquake, the Japan earthquake and tsunami, tornadoes and flooding in the United States, Hurricane Irene and the Thailand floods. Net losses and loss expense for the year ended December 31, 2010 include $8.1 million in significant property catastrophe-related and significant per risk losses, which included net losses from the New Zealand earthquake, the Deepwater Horizon oil spill, the Chile earthquake, Europe Windstorm Xynthia and Australia hail storms and floods. A portion of these losses fell within our attritional loss ratio, as we expect a certain level of property losses each period.
Acquisition expenses. The acquisition cost ratio for the year ended December 31, 2012 decreased 4.4 percentage points compared to the prior year. The decrease was principally attributable to changes in the mix of business written with a higher proportion of net premiums earned from our international casualty and agriculture lines of business, which generally have lower acquisition cost ratios compared to other lines, and a decrease in the proportion from professional liability which generally has a higher acquisition cost ratio.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2012 increased $1.7 million compared to the prior year. However, the significant increase in net premiums earned in 2012 compared to 2011 resulted in the general and administrative expense ratio decreasing 3.7 percentage points for the year ended December 31, 2012 compared to the prior year.
There were no new life and annuity contracts written during the years ended December 31, 2012, 2011 and 2010. In 2010 we decided not to write any new life and annuity contracts for the foreseeable future. This decision does not affect our existing life and annuity reinsurance contracts and we continue to service our existing life and annuity customer base.
Investment income is allocated to this segment based on a notional allocation of invested assets from our consolidated investment portfolio. For years prior to January 1, 2012 this allocation included net investment income from fixed maturities
and net realized and unrealized gains/losses from hedge fund investments. For the year ended December 31, 2012, this allocation comprised net investment income from fixed maturities only. Losses for the years ended December 31, 2011 and 2010 were principally due to low rates of return on our hedge fund investments.
Net investment income and net realized and unrealized gains (losses) on investments are discussed within the investing activities section as we manage investments for this segment on a consolidated basis with our other segments.
Change in fair value of other investments. Our investments in hedge funds comprises the majority of other investments. The increase in fair value of the hedge fund portfolio was $13.9 million, or a 4.32% rate of return, for the year ended December 31, 2012, compared to a decrease of $11.8 million, or a negative 3.57% rate of return, for the year ended December 31, 2011. The rate of return of 4.32% for the year ended December 31, 2012 compares to the HFRI Fund of Funds Composite Index returning 4.81% over the same period, which we believe is our most relevant benchmark.
The increase in fair value of the hedge fund portfolio was $14.3 million, or a 4.27% rate of return, for the year ended December 31, 2010.
The majority of the loss for the year ended December 31, 2011 came from interest rate swaps and the majority of the loss for the year ended December 31, 2010 came from interest rate forward contracts.
As of December 31, 2012, we held an index-linked structured deposit. The deposit has a guaranteed minimum redemption amount of $24.3 million and a scheduled redemption date of December 18, 2013. The fair value of the structured deposit varies due to changes in the reference index.
Income from equity method investments for the years ended December 31, 2012 and 2011 principally comprised our equity share of net income from New Point IV, which had no reinsurance losses in 2012.
Net realized and unrealized gains on our fixed maturities portfolios for the year ended December 31, 2012 were $30.1 million compared to gains of $13.5 million for the year ended December 31, 2011 and gains of $11.0 million for the year ended December 31, 2010. Most of the realized gains in the year ended December 31, 2012 related to sales of longer duration
Net impairment losses recognized in earnings. As a result of our quarterly review of securities in an unrealized loss position, we recorded other-than-temporary impairment losses through earnings of $6.9 million for the year ended December 31, 2012 compared to losses of $2.9 million and $2.6 million for the years ended December 31, 2011 and 2010, respectively. These impairment losses are presented separately from all other net realized and unrealized gains and losses on investments. Of the $6.9 million of impairment losses during the year ended December 31, 2012, $0.5 million were due to estimated credit losses. The remaining $6.4 million was recognized as impairment losses due to our decision in March 2012 to sell our holdings of convertible bond securities prior to any recovery in value. Most of our convertible bond portfolio was sold in April 2012 for a net realized gain. A discussion of our process for estimating other-than-temporary impairments is included in Note 3 of our consolidated financial statements included herein.
We hold an available for sale portfolio, a trading portfolio and a held to maturity portfolio of fixed maturities securities. In an effort to match the expected cash flow requirements of our long-term liabilities, we invest a portion of our fixed maturity investments in longer duration securities. Because we intend to hold a number of these longer duration securities to maturity, we classify these securities as held to maturity in our consolidated balance sheet. This held to maturity portfolio is recorded at amortized cost. As a result, we do not record changes in the fair value of this portfolio, which should reduce the impact on shareholders’ equity of fluctuations in fair value of those investments.
In order to reduce the likelihood of needing to sell investments before maturity, especially given the unpredictable and potentially significant cash flow requirements of our property catastrophe business, we maintain significant cash and cash equivalent balances. We believe it is more likely than not that we will not be required to sell those fixed maturities securities in an unrealized loss position until such time as they reach maturity or the fair value increases.
We perform quarterly reviews of our fixed maturities portfolio and utilize a process that considers numerous indicators in order to identify investments that show signs of potential other than temporary impairments. The indicators include the issuer’s financial condition and ability to make future scheduled interest and principal payments, benchmark yield spreads, the nature of collateral or other credit support and significant economic events that have occurred that affect the industry in which the issuer participates.
Our portfolio of investment grade fixed maturities includes mortgage-backed and asset-backed securities and collateralized mortgage obligations. These types of securities have cash flows that are backed by the principal and interest payments of a group of underlying mortgages or other receivables. As a result of the increasing default rates of borrowers, there currently is a greater risk of defaults on mortgage-backed and asset-backed securities and collateralized mortgage obligations than historically existed, especially those that are non-investment grade. These factors make estimating the fair value of these securities more uncertain. We obtain fair value estimates from multiple independent pricing sources in an effort to mitigate some of the uncertainty surrounding the fair value estimates. If we need to liquidate these securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated as of December 31, 2012.
We continue to monitor the ongoing uncertainty over the financial health of certain European governments and corporate institutions and our exposure to the credit risk of investments in these entities. As of December 31, 2012, we held European government securities with a fair value of $835.3 million, distributed as follows:
As of December 31, 2012, we held European corporate securities with a fair value of $808.1 million. The distribution by country was as follows:
As of December 31, 2012, we held corporate securities issued by European banking institutions with a fair value of $489.7 million, distributed as follows:
All of our European government and corporate holdings are included within our review procedures for other-than-temporary impairments.
Investments in hedge funds comprise a portfolio of limited partnerships and stock investments in trading entities, or funds, which invest in a wide range of financial products. The units of account that we value are our interests in the funds and not the underlying holdings of such funds. As a result, the inputs we use to value our investments in each of the funds may differ from the inputs used to value the underlying holdings of such funds. These funds are stated at fair value, which ordinarily will be the most recently reported net asset value as advised by the fund manager or administrator, where the fund’s underlying holdings can be in various quoted and unquoted investments. We believe the reported net asset value represents the fair value market participants would apply to an interest in the fund. The fund managers value their underlying investments at fair value in accordance with policies established by each fund, as described in each of their financial statements and offering memoranda.
We have designed ongoing due diligence processes with respect to funds in which we invest and their managers. These processes are designed to assist us in assessing the quality of information provided by, or on behalf of, each fund and in determining whether such information continues to be reliable or whether further review is necessary. While reported net asset value is the primary input to the review, when the net asset value is deemed not to be indicative of fair value, we may incorporate adjustments to the reported net asset value. These adjustments may involve significant judgment. We obtain the audited financial statements for each fund annually and regularly review and discuss the fund performance with the fund managers to corroborate the reasonableness of the reported net asset values.
We are able to redeem the hedge fund portfolio on the same terms that the underlying funds can be liquidated. In general, the funds in which we are invested require at least 30 days notice of redemption, and may be redeemed on a monthly, quarterly, semi-annual, annual or longer basis, depending on the fund. The timing of the redemption maybe be impacted if the funds in which we invest have a lock up period (this refers to the initial amount of time an investor is contractually required to invest before having the ability to redeem), a gate imposed (where the fund has denied or delayed a redemption in order to allow the execution of an orderly redemption process) or the fund has invested a portion of their assets in illiquid securities, such as private equity and convertible debt, through a side pocket. The majority of our hedge fund portfolio is redeemable within one year, and the imposition of gates by certain funds is not expected to significantly impact our cash flow needs. As of December 31, 2012 the fair value of our holdings in funds with gates imposed was $7.0 million and the fair value of our hedge funds held in side-pockets was $37.2 million. Based upon information provided by the fund managers, as of December 31, 2012, we estimate that over 84% of the underlying assets held by our hedge fund portfolio are traded securities or have broker quotes available.
Due to the uncertainty surrounding the timing of the redemption of the underlying assets within funds with gates and side-pockets, we have included these funds in the greater than 365 days category in the table below. If we requested full redemptions for all of our holdings in the funds, the tables below indicate our best estimate of the earliest date from December 31, 2012 on which such redemptions might be received. This estimate is based on available information from the funds and is subject to significant change.
Liabilities for life and annuity benefits. Life and annuity benefits totaled $1,159.5 million at December 31, 2012 compared to $1,190.7 million as of December 31, 2011. The decrease was principally attributable to benefits payments exceeding the change in estimate of the life and annuity benefits liability balance. We paid $103.1 million of benefit payments during the year ended December 31, 2012.
Senior notes. On September 27, 2010, Alterra Finance, a wholly-owned indirect subsidiary of Alterra, issued $350.0 million principal amount of 6.25% senior notes due September 30, 2020 with interest payable on March 30 and September 30 of each year. The 6.25% senior notes are Alterra Finance’s senior unsecured obligations and rank equally in right of payment with all of Alterra Finance’s future unsecured and unsubordinated indebtedness and rank senior to all of Alterra Finance’s future subordinated indebtedness. The 6.25% senior notes are fully and unconditionally guaranteed by Alterra on a senior unsecured basis. The guarantee ranks equally with all of Alterra’s existing and future unsecured and unsubordinated indebtedness and ranks senior to all of Alterra’s future subordinated indebtedness. The effective interest rate related to the 6.25% senior notes, based on the net proceeds received, was 6.37%.
On April 16, 2007, Alterra USA privately issued $100.0 million principal amount of 7.20% senior notes due April 14, 2017 with interest payable on April 16 and October 16 of each year. The senior notes are Alterra USA’s senior unsecured obligations and rank equally in right of payment with all existing and future senior unsecured indebtedness of Alterra USA. The senior notes are fully and unconditionally guaranteed by Alterra. The principal amount of the senior notes outstanding as of December 31, 2012 was $90.6 million.
As a holding company, Alterra’s principal source of funds is from interest income on cash balances and cash dividends from its subsidiaries, including Alterra Bermuda. The payment of dividends by Alterra Bermuda is limited under Bermuda insurance laws. In particular, Alterra Bermuda may not declare or pay any dividends if it is in breach of its minimum solvency or liquidity levels under Bermuda law or if the declaration or payment of the dividends would cause it to fail to meet the minimum solvency or liquidity levels under Bermuda law. As of December 31, 2012, Alterra Bermuda met all minimum solvency and liquidity requirements. Alterra Bermuda returned $450.0 million of capital and surplus to Alterra during the year ended December 31, 2012 through dividends and distribution of additional paid-in capital.
Capital resources. As of December 31, 2012, total shareholders’ equity was $2,839.7 million compared to $2,809.2 million as of December 31, 2011, an increase of 1.1%. On May 21, 2010, we filed a shelf registration statement on Form S-3 (File No. 333-167035) with the SEC, that permits us to periodically issue debt securities, common shares, preferred shares, depository shares, warrants, share-purchase contracts and share purchase units. The shelf registration statement also covers debt securities of Alterra Finance and trust preferred securities of Alterra Capital Trust I.
The reserves for losses and benefits together with deposit liabilities represent management’s estimate of the ultimate cost of settling losses, benefits and deposit liabilities. As more fully discussed in “- Critical Accounting Policies-Reserve for property and casualty losses and life and annuity reinsurance benefit reserves” above, the estimation of losses and benefits is based on various complex and subjective judgments. Actual losses and benefits paid may differ, perhaps significantly, from the reserve estimates reflected in our financial statements. Similarly, the timing of payment of our estimated losses and benefits is not fixed and there may be significant changes in actual payment activity. The assumptions used in estimating the likely payments due by period are based on our historical claims payment experience and industry payment patterns, but due to the inherent uncertainty in the process of estimating the timing of such payments, there is a risk that the amounts paid in any such period can be significantly different from the amounts disclosed above.
The amounts in the above table represent our gross estimates of known liabilities as of December 31, 2012 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts paid out in the time periods shown will be greater than those indicated in the table. Furthermore, life and annuity benefits and deposit liabilities recorded in the audited consolidated financial statements as of December 31, 2012 are computed on a net present value basis, whereas the expected payments by period in the table above are the estimated payments at a future time and do not reflect a discount of the amount payable.
In this Annual Report on Form 10-K, we have presented net operating income and annualized net operating return on average shareholders’ equity, which are “non-GAAP financial measures” as defined in Regulation G. We believe that these non-GAAP financial measures, which may be defined differently by other companies, allow for a more complete understanding of the performance of our business. These measures, however, should not be viewed as a substitute for those determined in accordance with GAAP. A reconciliation of the non-GAAP financial measures to their respective most directly comparable GAAP financial measures is as follows:
Average shareholders’ equity is computed as the average of the quarterly average shareholders’ equity balances. The average for the year ended December 31, 2010 has been weighted to include Harbor Point from May 12, 2010, the date of the consummation of the Amalgamation.
modifies the existing guidance to require that only costs associated with the successful acquisition of a new or renewal
insurance contract should be capitalized as deferred acquisition costs. Costs that fall outside the proposed definition, such as
ASU 2011-04, Fair Value Measurements and Disclosures (820)-Amendments to Achieve Common Fair Value
include requiring additional disclosures relating to transfers between Level 1 and Level 2 of the fair value hierarchy,
quantitative information and discussion about significant unobservable inputs and the sensitivity of the fair value measurement
for fiscal periods beginning on or after December 15, 2011 with prospective application. This standard did not have a material
ASU 2011-05 increases the prominence of items reported in other comprehensive income and eliminates the option to
present components of other comprehensive income as part of the statement of changes in shareholders’ equity. ASU 2011-05
comprehensive income or in two separate but consecutive statements. ASU 2011-05 was effective for fiscal periods on or after
December 15, 2011 with early adoption permitted. The requirement to present reclassification adjustments on the face of the
financial statements has been deferred and no effective date has been determined. We have reflected the disclosure
unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. If an entity concludes it
is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two step
impairment test. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years
beginning after December 15, 2011. This standard did not have a material impact on our consolidated financial statements.
ASU 2012-02, Intangibles-Goodwill and Other (350)-Testing Indefinite-Lived Intangible Assets for Impairment
ASU 2012-02 permits an entity to first assess qualitative factors to determine whether it is necessary to perform the
required to perform the quantitative impairment test for an indefinite-lived intangible asset if it is more likely than not that the
September 15, 2012. We do not expect this standard to have a material impact on our consolidated financial statements.
Information with respect to this item is set forth under "Item 15 - Exhibits and Financial Statement Schedules."