The selected consolidated financial data shown below has been derived from the Consolidated Financial Statements. All information contained herein should be read in conjunction with the Consolidated Financial Statements and related Notes, the Schedules, and Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Report.
Our organization is focused on generating consistent, industry-leading combined ratios. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We rely on experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce risk. By focusing on underwriting profitability, we are able to accomplish our primary objectives of maximizing net earnings and growing book value per share.
Key facts about our consolidated group as of and for the year ended December 31, 2012 are as follows:
We recognized gross losses of $84.8 million and net losses, after reinsurance and reinstatement premium, of $52.8 million from accident year catastrophes, the largest being Superstorm Sandy, mainly in our International segment.
The following sections discuss our key operating results. The reason for any significant variations between 2011 and 2010 are the same as those discussed for variations between 2012 and 2011, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees. We adjusted certain prior period amounts to reflect our adoption of a new accounting standard in 2012 (see Note 1, “General Information and Significant Accounting and Reporting Policies - Accounting Guidance Adopted in 2012” to the Consolidated Financial Statements). We also adjusted all prior segment data to reflect our exit from two lines of business previously included in our Accident & Health segment (see Note 12, “Segments” to the Consolidated Financial Statements).
* 2011 and 2010 adjusted to reflect 2012 change in Exited Lines.
Our results include the impact of catastrophic events around the world, including these major events: 1) 2012 - Superstorm Sandy and United States storms, 2) 2011 - Japan earthquake and tsunami, Hurricane Irene, New Zealand earthquakes, United States tornados, Denmark storms and Thailand floods and 3) 2010 - Chile earthquake. These losses primarily impacted our International and U.S. Property & Casualty segments. We reinsure a portion of our exposure to catastrophic events, although we incur some additional cost for reinstatement premium to continue our reinsurance coverage for future loss events. The following table summarizes our accident year catastrophe losses, as well as the impact on our net earnings and key metrics.
We recognized net favorable loss development of $70.0 million in 2012, which included $21.4 million related to prior year catastrophes, compared to net adverse development of $10.1 million in 2011 and net favorable development of $22.7 million in 2010. See the “Segment Operations” section below for discussion of the impact of the catastrophe losses and the net loss development on each of our insurance underwriting segments.
Loss development represents an increase or decrease in estimates of ultimate losses related to business written in prior accident years. Such increases or decreases are recorded as loss and loss adjustment expense in the current reporting year. Favorable development means the original ultimate loss estimate was higher than the current estimate. Adverse development means the current ultimate loss estimate is higher than the original estimate. Loss development occurs as we review our loss exposure with our actuaries, increasing or decreasing estimates of our ultimate losses as a result of such reviews and as losses are finally settled or claims exposure changes.
The tables below detail our net loss and loss adjustment expense, the amount of net loss development included in our net loss and loss adjustment expense, and our net loss ratios on a consolidated basis and for our segments.
Loss and loss adjustment expense decreased 7% in 2012, compared to an increase of 15% in 2011. The 2012 decrease primarily related to: 1) net favorable loss development in 2012, compared to net adverse development in 2011, 2) lower
accident year catastrophe losses in 2012 and 3) a slightly lower accident year loss ratio, excluding catastrophes, in 2012. The 2011 increase was driven by: 1) higher accident year catastrophe losses, primarily in the International segment and 2) an increase in reserves in 2011 to reflect a higher ultimate loss ratio for accident year 2011 for our diversified financial products (DFP) line of business in the Professional Liability segment. Our accident year net loss ratio was higher in 2011 due to the catastrophe losses and increased DFP reserves in that year. Excluding catastrophes, our accident year net loss ratio was 59.1% for 2012, 60.0% for 2011 and 59.4% for 2010. See the “Segment Operations” section below for additional discussion of the changes in our loss and loss adjustment expense, net development and net loss ratios for each segment.
Our net paid loss ratio is the percentage of losses paid, net of reinsurance, divided by net earned premium for the year. The table below provides a reconciliation of our consolidated reserves for loss and loss adjustment expense payable, net of reinsurance ceded, the amount of our paid claims, and our net paid loss ratio.
Policy acquisition costs relate to direct costs we incur to issue insurance policies, including commissions, premium taxes and compensation of our underwriters. The percentage of policy acquisition costs to net earned premium was 12.5% in all three years. We record profit commissions due from reinsurers as an offset to policy acquisition costs, which impacted our policy acquisition cost percentages as follows:
After excluding profit commissions, the difference between years primarily relates to changes in the mix of business.
Other operating expense included $13.2 million, $12.4 million and $13.6 million of stock-based compensation expense in 2012, 2011 and 2010, respectively. Stock-based compensation expense was lower in 2012 and 2011 due to the timing of vesting and forfeitures of awards. In 2012, we granted $11.2 million of restricted stock awards and units, with a weighted-average life of 3.2 years. At December 31, 2012, there was approximately $24.8 million of total unrecognized compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 3.0 years. In 2013, we expect to recognize $9.9 million of expense for all stock-based awards outstanding at year-end 2012.
Interest expense on debt and short-term borrowings was $25.6 million, $23.1 million and $21.3 million in 2012, 2011 and 2010, respectively. Our interest expense has increased due to a higher amount of outstanding borrowings on our $600.0 million Revolving Loan Facility, primarily to fund purchases of our common stock. Interest expense included $19.3 million per year for our Senior Notes.
Our U.S. Property & Casualty segment pretax earnings increased 2% in 2012 due to higher net earned premium and a lower net loss ratio. The segment’s pretax earnings decreased 40% in 2011 primarily due to: 1) lower net earned premium, 2) a reduced amount of favorable development in 2011 compared to 2010, 3) $6.2 million of catastrophe losses in 2011, 4) higher operating expenses and 5) the effect of a $5.0 million gain in 2010 related to termination of a derivative contract.
Net earned premium was higher in 2012 due to $14.3 million of additional premium from our new technical property, primary casualty and excess casualty underwriting teams, as well as increases in aviation, public risk, contingency, residual value and other premium. Premium grouped in Other includes numerous types of specialty insurance products, including the technical property, primary casualty and excess casualty lines of business. These new teams wrote $57.0 million of gross premium in 2012, compared to $16.7 million in 2011 and a minimal amount in 2010. In 2011 and again in 2012, we wrote less premium in some lines of business, particularly aviation and E&O, due to continued competition. Our public risk premium has grown primarily due to increased participation in one particular area of this business, as well as higher retention of the business beginning in 2011. Changes in the segment’s net written premium relative to gross written premium are due to changes in timing and the amount of our reinsurance programs.
The segment’s expense ratio was higher in 2012 and 2011, primarily due to increasing compensation costs. In 2010, we terminated our interest in a derivative contract, which generated $8.0 million of other revenue and $3.0 million of other direct expenses in that year. The segment’s remaining other revenue relates to fee and commission income earned by our agencies from third party insurance companies.
Gross written premium decreased 4% in 2012, primarily due to reduced writings in our DFP line of business (included in U.S. D&O) as we re-underwrote the DFP book of business in 2012. Gross written premium decreased 6% in 2011 because we wrote less D&O business in the United States due to pricing competition. Net written premium fluctuated year-over-year due to a change in our reinsurance program in both years.
The fluctuations in the expense ratio primarily related to profit commissions of $5.1 million in 2012 and $13.5 million in 2011, recognized in conjunction with the favorable development in those years. The profit commissions, which offset the segment’s other expense, reduced the 2012 and 2011 expense ratio by 1.3 and 3.3 percentage points, respectively. There were minimal profit commissions in 2010.
The Accident & Health segment pretax earnings increased 20% in 2012 and 3% in 2011. These increases directly related to higher net earned premium in our medical stop-loss product line and the impact of favorable loss development in 2012. Medical stop-loss premium increased in 2012 and 2011 due to growth in new business and rate increases on renewal business, which were in line with medical loss cost trends.
The 2011 and 2010 information shown above has been adjusted to reflect our exit from two lines of business in 2012. See Note 12, “Segments” to the Consolidated Financial Statements.
Our U.S. Surety & Credit segment pretax earnings increased 24% in 2012, compared to 2011, due to a higher amount of favorable loss development in 2012, partially offset by a decrease in net earned premium. Segment earnings increased 21% in 2011, compared to 2010, primarily due to higher net earned premium.
Gross written premium for our surety line of business decreased in 2012, primarily due to competition and economic conditions impacting the construction industry. This reduction was partially offset by growth in premium in our credit line of business. In 2011, increased pricing for commercial surety bonds written by a company we acquired in 2009 contributed to the growth in gross written premium. Our credit premium has grown due to improved market pricing following the 2008 world-wide credit market crisis.
Our International segment had net adverse non-catastrophe development in 2012 and net favorable non-catastrophe development in 2011 and 2010. The non-catastrophe development in 2012 included favorable development on the 2010 and prior accident years for our energy and U. K. professional liability (included in Liability) lines of business and adverse development for our surety & credit line of business related to a specific class of Spanish surety bonds, the majority of which were written prior to 2006. The non-catastrophe development in 2011 included favorable development on the 2010 and prior accident years for our U.K. professional liability and energy lines. Partially offsetting this was adverse development on our employers’ liability and public liability lines for the 2010 accident year, as well as the specific class of Spanish surety bonds discussed above. The non-catastrophe favorable development for 2010 was for our U.K. professional liability and energy lines, in both cases related to the 2004 - 2008 underwriting years.
In 2012, we began investing in bank loans (classified as Corporate securities), which we expect will generate attractive yields and lower our overall duration without altering the weighted-average rating of the portfolio. We also began investing in global publicly traded equity securities. These investments in equity securities are focused on stable companies with a track record of above-market dividend yields. At December 31, 2012, our investments included $132.8 million of bank loans and $284.6 million of equity securities. The weighted-average duration of our fixed maturity securities portfolio dropped during the past three years, primarily due to the impact of lower market interest rates on our municipal securities with call options and structured securities with prepayment options. The decline in the weighted-average rating of our fixed maturity securities portfolio at year-end 2011 was a direct result of Standard & Poor’s Corporation’s downgrade of the U.S. government debt rating in August 2011.
The methodologies used to determine the fair value of our investments are described in Note 3, “Fair Value Measurements” in the Consolidated Financial Statements. This table summarizes our investments by type, substantially all of which are reported at fair value, at December 31, 2012 and 2011.
Our total investments increased $900.6 million in 2012, principally from: 1) operating cash flow, 2) consolidation of our Lloyd’s of London Syndicate 4040 upon its merger into Syndicate 4141 as of January 1, 2012 and 3) a $105.6 million increase in the pretax net unrealized gain associated with our available for sale securities in 2012. At December 31, 2012, the net unrealized gain on our available for sale portfolio was $436.7 million, compared to $331.1 million at December 31, 2011. We held $363.1 million of short-term investments at December 31, 2012 as certain long-term securities purchases were pending settlement at year-end.
The average tax equivalent yield of our fixed maturity securities portfolio was 4.7%, 4.8% and 5.0% in 2012, 2011 and 2010, respectively. These yields reflect general declines in market interest rates over this period, partially offset by longer average duration of our new investments. Our general policy has been to hold our available for sale securities through periods of fluctuating interest rates. We sell securities and recognize realized gains and losses from these sales if we can reinvest the proceeds at a higher effective yield or if the security has credit-related issues. We recognized net realized investment gains of $31.1 million in 2012, $3.7 million in 2011 and $12.1 million in 2010. We realized other-than-temporary impairment credit losses through pretax earnings of $1.0 million in 2012, $4.7 million in 2011 and $0.4 million in 2010.
The ratings of our individual securities within our fixed maturity securities portfolio at December 31, 2012 were as follows:
The table below indicates the contractual or expected maturity distribution of our fixed maturity securities at December 31, 2012. In the table, we allocated the maturities of our mortgage-backed and asset-backed securities based on the expected future principal payments. The weighted-average life of our mortgage-backed and asset-backed securities is approximately 5.5 years based on expected future cash flows.
At December 31, 2012, we held $2.2 billion of special purpose revenue bonds, as well as $1.1 billion of general obligation bonds, which are issued by states, municipalities and political subdivisions and collectively referred to, in the investment market, as municipal bonds. The overall rating of our municipal bonds was AA at December 31, 2012. Within our municipal bond portfolio, we held $386.2 million of pre-refunded bonds, which are supported by U.S. government debt obligations. Our special purpose revenue bonds are secured by revenue sources specific to each security. At December 31, 2012, the percentages of our special purpose revenue bond portfolio supported by these major revenue sources were as follows: 1) education - 24%, 2) transportation - 21%, 3) water and sewer - 18% and 4) electric - 15%.
At December 31, 2012, we held a commercial mortgage-backed securities portfolio with a fair value of $524.3 million, an average rating of AA+ and an average loan-to-value ratio of 67%. We owned no collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), and we are not counterparty to any credit default swap transactions.
At December 31, 2012, we held corporate securities issued by foreign corporations with an aggregate fair value of $533.6 million. In addition, we held securities issued by foreign governments, agencies or supranational entities with an aggregate fair value of $278.4 million. The following table details our holdings of foreign debt at December 31, 2012.
The 2011 and 2010 amounts for net earned premium, loss and loss adjustment expense, and other expense - Exited Lines have been adjusted to reflect the addition of two product lines previously included in the Accident & Health segment. Net earned premium decreased year-over-year as we wrote less business related to our exited HMO and medical excess
Our Corporate expenses not allocable to the segments increased $8.1 million in 2012, compared to 2011, principally due to higher employee compensation and benefit costs, including increased bonus expense due to higher profitability, and incremental expense related to our new technology systems. Corporate expenses not allocable to the segments increased $4.8 million in 2011, compared to 2010, due to higher information technology costs related to implementation of a company-wide financial reporting system and higher salary and employee benefit costs. Our interest expense increased year-over-year due to a higher amount of outstanding borrowings on our $600 million Revolving Loan Facility.
We believe we have sufficient sources of liquidity at a reasonable cost to pay claims and meet our other contractual obligations and liabilities as they become due in the short-term and long-term. Our current sources of liquidity include: 1) significant operating cash flow, 2) a $7.0 billion investment portfolio that is available for sale, 3) our revolving loan and standby letter of credit facilities, 4) the availability of dividends from our subsidiaries and 5) a $1.0 billion shelf registration, which are discussed below.
We generated cash from operations of $661.1 million in 2012, $421.3 million in 2011 and $415.2 million in 2010. The components of our net operating cash flows are summarized in the following table.
We generated $239.9 million more cash flow from operating activities in 2012 than in 2011. The increase was primarily from additional premium collections. In addition, certain collateral held by our surety businesses, for which we record a liability within accounts payable and accrued liabilities, provided a net $96.6 million of cash flow from operating activities in 2012 and $32.7 million in 2010, compared to a net reduction of $8.3 million in 2011. Our cash flow from operating activities was reduced $27.5 million in 2012 and $26.7 million in 2011 for payments we made to commute large contracts in our assumed accident and health reinsurance business reported in Exited Lines.
We maintain a $600.0 million Revolving Loan Facility (Facility), of which $305.1 million of available capacity remained at December 31, 2012. During 2012 and 2011, we used the Facility to fund repurchases of our common stock. We expect to continue to use the Facility to opportunistically repurchase stock in 2013. We also have a $90.0 million Standby Letter of Credit Facility (Standby Facility) that is used to guarantee our performance in our Lloyd’s of London syndicate. The Facility expires in 2015, and the Standby Facility expires in 2016. See Note 7, “Notes Payable” to the Consolidated Financial Statements for additional information related to the Facilities and our long-term indebtedness.
restrictions and will depend on the surplus and future earnings of these subsidiaries. HCC’s direct U.S. insurance company subsidiaries can pay an aggregate of $293.5 million in dividends in 2013 without obtaining special permission from U.S. state regulatory authorities.
On August 23, 2012, the Board authorized a new $300.0 million stock purchase plan (the Plan) and cancelled $98.0 million remaining under a previous authorization. Purchases under the Plan may be made in the open market or in privately negotiated transactions from time-to-time in compliance with applicable laws, rules and regulations, including Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Purchases under the Plan will be made subject to market and business conditions, the level of cash generated from our operations, cash required for acquisitions, our debt covenant compliance, and other relevant factors. The Plan does not obligate us to purchase any particular number of shares, has no expiration date, and may be suspended or discontinued at any time at the Board’s discretion.
We have a “Universal Shelf” registration statement that expires in March 2015. The Universal Shelf provides for the issuance of $1.0 billion of securities, which may be debt securities, equity securities, or a combination thereof. The Universal Shelf provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial markets.
Our insurance companies have sufficient resources to pay potential claims. Based on historical payment patterns and claims history, we project that our insurance companies will pay approximately $1.4 billion of claims in 2013. We also project that they will collect approximately $0.4 billion of reinsurance recoveries in 2013. In addition to expected cash flow from their 2013 operations, these companies have $6.4 billion of investments as of December 31, 2012 that are available to fund claims payments, if needed.
The average duration of claims in many of our lines of business is relatively short. However, we write D&O, E&O and casualty insurance, all of which have a longer claims duration than our other products. We consider these different claims payment patterns in determining the duration of our investment portfolio. The weighted-average duration of all claims was approximately 2.2 years in 2012 and 2.5 years in both 2011 and 2010. The weighted-average duration of our fixed maturity securities was 4.7 years, 5.0 years and 5.5 years in 2012, 2011 and 2010, respectively. The longer duration of our fixed maturity securities reflects the effects of the investment of our capital.
(3) The $600.0 million Revolving Loan Facility expires in March 2015. In the above table, the outstanding borrowings of $285.0 million at December 31, 2012 are shown in 2015 with the annual interest of 137.5 basis points on the outstanding balance and the annual commitment fee of 20 basis points on the unused balance shown in each applicable year.
(4) See Note 5, “Goodwill” to the Consolidated Financial Statements for information related to our earnout liability.