The United States headquarters of OneBeacon is located in Canton, Massachusetts, while its principal executive office is located in Minnetonka, Minnesota. OneBeacon also maintains branch offices in various cities throughout the United States.
White Mountains Re’s headquarters is in Hamilton, Bermuda and its principal executive office is located in Guilford, Connecticut. Folksamerica is headquartered in New York, New York with branch offices in various cities throughout the United States and in Toronto, Canada. Sirius International is headquartered in Stockholm, Sweden with various branch offices in Europe and Asia. WMRUS maintains offices in Dublin, Ireland and Hamilton, Bermuda. Esurance is headquartered in San Francisco, California with various offices throughout the United States.
The Company’s headquarters, registered office, principal executive office and investment and corporate finance offices are leased. Sirius International’s home office in Sweden and substantially all of its branch offices, as well as WMRUS’s offices in Ireland and Bermuda, are leased. Folksamerica’s home office and its branch offices are leased as well. OneBeacon owns its home office. Most of OneBeacon’s branch offices are leased with the exception of branch offices located in New York. Esurance’s home office and its branch offices are leased. Management considers its office facilities suitable and adequate for its current level of operations.
Selected consolidated income statement data and ending balance sheet data for each of the five years ended December31, 2006, follows:
(a) In accordance with its adoption of Statement of Financial Accounting Standard (“SFAS”) No. 141, “Business Combinations”,the Company recognized all of its outstanding deferred credits on January 1,2002.
(c) Extraordinary gains in 2004 resulted from the excess of the fair value over the cost of net assets acquired in the Sirius, Symetra, Tryg-Baltica and Sierra transactions.
(d) Includes the dilutive effects of outstanding incentive options to acquire common shares (“Options”) and, for years prior to 2004, warrants to acquire common shares.
White Mountains ended 2006 with a fully converted tangible book value per common share of $406, which represented an increase of 21% (including dividends) over the fully converted tangible book value per common share of $343 as of December 31, 2005. This increase reflects favorable weather conditions and strong investment results when compared to 2005. Additionally, during the fourth quarter of 2006, White Mountains recognized an after-tax gain of $171 million, or $16 per common share, on the sale of 27.6% of its interest in OneBeacon through an initial public offering.
(1) 72.4% of remaining adjustment of subsidiary preferred stock to face value, which is representative of White Mountains’ ownership interest in OneBeacon.
A summary of White Mountains’ consolidated financial results for the years ended December 31, 2006, 2005 and 2004 follows:
Consolidated Results - Year Ended December 31, 2006 versus Year Ended December 31, 2005
White Mountains reported adjusted comprehensive net income of $734 million for 2006, compared to $68 million in 2005. Net income was $673 million in 2006, compared to $290 million in 2005. The increase in 2006 adjusted comprehensive net income resulted primarily from the gain on the sale of OneBeacon shares, favorable weather conditions, strong investment returns and a $21 million after-tax gain on the purchase of Mutual Service. In addition, the 2005 results included $288 million in after-tax losses from hurricanes Katrina, Rita and Wilma, while 2006 included $70 million in after-tax losses from adverse development on those storms and a $95 million after-tax loss from the Olympus reimbursement (see description on page 52). 2005 also included $104 million of after-tax comprehensive net loss from the Montpelier Re investment, compared to $10 million in after-tax comprehensive net income in 2006. Adjusted comprehensive net income for 2006 also benefitted from $59 million of after-tax unrealized foreign currency gains, compared to $70 million of after-tax unrealized foreign currency losses in 2005, primarily from currency fluctuations of the U.S. dollar against the Swedish Krona and the Euro.
White Mountains’ total revenues increased by 4% to $4,794 million in 2006 compared to $4,632 million in 2005, mainly due to the $171 million gain on the sale of OneBeacon shares and a $160 million increase in net realized investment gains, primarily due to $165 million of pre-tax losses in the value of the Company’s investment in Montpelier Re realized during 2005, compared to a $5 million pre-tax gain realized in 2006. These increases were
White Mountains reported adjusted comprehensive net income of $68 million for 2005, compared to $539 million in 2004. Net income was $290 million in 2005, compared to $419 million in 2004. The reduction in 2005 adjusted comprehensive net income resulted primarily from the aforementioned hurricane losses and Montpelier Re investment decline, as well as the impact of $181 million in transaction gains reported in 2004, primarily from the Sirius Acquisition.
White Mountains’ total revenues increased by 2% in 2005 compared to 2004, mainly from a $131 million increase in net investment income, primarily due to a $74 million special dividend from Montpelier Re in 2005. Earned premiums decreased by 1% in 2005, primarily due to a decrease at OneBeacon, which was partially offset by increases at White Mountains Re and Esurance. Net realized investment gains decreased by $69 million in 2005, primarily due to losses in the value of the Company’s investment in Montpelier Re during 2005.
Financial results for OneBeacon for the years ended December 31, 2006, 2005 and 2004 follow:
Beginning in the fourth quarter of 2006, OneBeacon includes OBSP within commercial lines and AutoOne within personal lines. Both OBSP and AutoOne were formerly reported in specialty lines. The reporting change was undertaken to better align the reported results of OneBeacon’s underwriting units with their product and management structure. Prior periods have been reclassified to conform to the current presentation. Additionally, during 2005, OneBeacon reallocated $34 million of IBNR reserves from ongoing lines of business to run-off. This reallocation had the effect of lowering the combined ratios for specialty, commercial and personal lines, but had no net impact on OneBeacon’s overall results.
Lower adverse development on prior accident year losses caused OneBeacon’s 2006 combined ratio to decrease four points from 2005. OneBeacon’s 2006 results included $23 million of adverse development on prior accident years compared to $95 million in 2005, which primarily related to 2002 and prior accident years. Lower current accident year catastrophe losses also caused OneBeacon’s 2006 combined ratio to decrease two points from 2005. OneBeacon’s 2006 results included $29 million in current accident year catastrophe losses compared to $81 million in 2005, which included $69 million in from hurricanes Katrina, Rita and Wilma. Offsetting these decreases was a one point increase from higher incentive compensation expenses in 2006 and a one point increase from $20 million of expenses associated with actions taken to reduce long-term occupancy costs, including OneBeacon’s move to its new U.S. headquarters in Canton, Massachusetts. In addition, OneBeacon’s 2005 results included a $54 million gain from the settlement of its retiree medical plan, which reduced the 2005 combined ratio by three points. The retiree medical plan, which had been frozen in 2002, was terminated and an independent trust was established and funded to provide benefits to covered participants. These actions relieved OneBeacon of its future retiree medical obligations and triggered recognition of the gain. The majority of the gain was recorded as a reduction of other underwriting expenses with a portion of the gain reflected as a reduction in loss and LAE because a portion of the expense of the retiree medical program was allocated to the claims department.
Specialty Lines. The specialty lines combined ratio for 2006 was 89% compared to 85% for 2005. The increase was primarily due a higher expense ratio, which rose to 34% in 2006 from 31% in 2005. The increased expense ratio was primarily due to a one point increase in incentive compensation expense in 2006 and the favorable impact in 2005 of the settlement of the retiree medical plan, which lowered that year’s expense ratio by two points. The loss and LAE ratio for 2006 was essentially flat when compared to 2005. Excluding the impact of the aforementioned reallocation of reserves to run-off, which reduced the 2005 loss ratio by three points, the loss and LAE ratio improved in 2006.
Commercial Lines. The commercial lines combined ratio for 2006 was 95% compared to 97% for 2005. Lower catastrophe losses caused the commercial lines 2006 combined ratio to decrease six points from 2005. Commercial lines 2006 results included $31 million in current and prior accident year catastrophe losses, which included $21 million in losses incurred from hurricanes Katrina, Rita and Wilma, compared to $64 million in 2005, which included $56 million in losses incurred from hurricanes Katrina, Rita and Wilma. Partially offsetting this decrease was the favorable impact of one point related to the benefit of the settlement of the retiree medical plan in 2005 and two points related to the reallocation in 2005 of IBNR reserves to run-off.
Net written premiums for commercial lines increased by 10% to $718 million in 2006 compared to $654 million in 2005, as net written premiums increased for both the middle market division and the small business division. The increase in net written premiums in the middle market division was experienced in property and inland marine products as well as at OBSP. The increase in small business was experienced in small business package products.
OneBeacon’s pre-tax income for 2005 was $332 million, compared to pre-tax income of $223 million for 2004, and its combined ratio was 98% for 2005, compared to 99% for 2004.
Net realized investment gains for 2005 included a realized loss of $55 million due to an other-than-temporary impairment with respect to OneBeacon’s investment in Montpelier Re common shares. During 2005, the market value of Montpelier Re common shares decreased from $38.45 per share to $18.90 per share. OneBeacon’s original cost of this investment in 2001 was $105 million, which was subsequently increased by $65 million in equity in earnings recorded from 2001 to March 2004, the period in which OneBeacon accounted for the investment under the equity method of accounting. The impairment charge represented the difference between OneBeacon’s GAAP cost of $170 million and the investment’s fair value of $116 million at December 31, 2005.
As a result of an actuarial review completed in the fourth quarter of 2005, OneBeacon reallocated some of its IBNR reserves from some of the ongoing lines of business to run-off operations. This shifted $34 million of IBNR reserves from specialty lines ($10 million), commercial lines ($12 million) and personal lines ($12 million) to run-off operations. This adjustment had no impact on OneBeacon’s total combined ratio.
Financial results and GAAP combined ratios for White Mountains Re for the years ended December 31, 2006, 2005 and 2004 follows:
White Mountains Re Results - Year Ended December 31, 2006 versus Year Ended December 31, 2005
White Mountains Re’s pre-tax income for 2006 was $237 million compared to a pre-tax loss of $17 million for 2005, and its GAAP combined ratio was 102% for 2006 compared to 118% for 2005. The improved combined ratio and the increase in pre-tax income resulted primarily from significantly lower catastrophe losses. During 2006, White Mountains Re recorded $86 million of unfavorable development, net of reinstatement premiums and reinsurance, related to hurricanes Katrina, Rita and Wilma and $137 million in losses and $9 million of forgone override commissions related to the Olympus reimbursement. During 2005, White Mountains Re recognized $351 million in pre-tax losses, net of reinstatement premiums and reinsurance from hurricanes Katrina, Rita and Wilma. 2005 also included $57 million of other significant property catastrophe losses, primarily from European storm Erwin and floods in Europe.
White Mountains Re’s net investment income increased by $34 million in 2006 as a result of higher overall yields and a larger investment asset base, principally due to contributions from White Mountains. Other underwriting expenses decreased in 2006 by $12 million, or 11%, from 2005, primarily due to a reduction in unallocated loss adjustment expense reserves of approximately $7 million during the first quarter of 2006 resulting from an evaluation of the remaining run-off contracts at Scandinavian Re, as well as a reduction in incentive compensation accruals. General and administrative expenses increased to $24 million in 2006 from $12 million in 2005. The increase is primarily due to accruals related to the relocation of the underwriting advisory operations from Ireland to Bermuda and costs associated with expanding the Bermuda advisory operations.
White Mountains Re recognized fee income of $12 million from Olympus and Helicon in 2006, $9 million of which was recorded as other revenues, compared to $61 million of fee income from Olympus in 2005, $28 million of which was recorded as other revenues. The decrease in fee income was primarily the result of a reduction in amounts ceded to Olympus and Helicon in 2006 compared to 2005 and due to FHC waiving $9 million of override commission due from Olympus in accordance with the Olympus reimbursement. Other revenues in 2006 also included a $14 million gain from the sale of Sirius America and $21 million of realized foreign exchange gains. In 2005, other revenue also included a $5 million gain from the sale of California Indemnity Insurance Company, a wholly-owned subsidiary of White Mountains Re acquired in 2004 as part of the Sierra acquisition.
White Mountains Re’s pre-tax loss for 2005 was $17 million, compared to pre-tax income of $87 million for 2004, and its GAAP combined ratio was 118% for 2005, compared to 104% for 2004. White Mountains Re’s 2005 results included pre-tax losses, net of reinstatements and reinsurance, of $351 million from hurricanes Katrina, Rita and Wilma and $57 million of other significant property catastrophe losses, primarily from European storm Erwin and floods in Europe, which added a total of 30 points to the combined ratio. In addition, White Mountains Re recorded $51 million of net unfavorable loss reserve development in 2005 (discussed below), which contributed 4 points to the loss ratio. During 2005, earnings from business segments not impacted by the property catastrophe events and increased net investment income partially offset these losses. Additionally, White Mountains Re’s expense ratio decreased to 28% in 2005, from 31% in 2004, due mainly to a decrease in incentive compensation accruals. White Mountains Re’s 2004 results included $135 million of pre-tax losses, net of reinstatements and reinsurance, from the four hurricanes that affected the southeastern United States and the tsunami that impacted South Asia, which added a total of 11 points to the combined ratio.
White Mountains Re’s 2005 gross written premiums increased by 3% to $1,981 million and net written premiums increased by 5% to $1,304 million from 2004. The increase was due primarily to Sirius International, which was acquired in the second quarter of 2004 and contributed nine months of premiums in 2004 versus twelve months in 2005, partially offset by decreased premium volume at both Sirius International and Folksamerica as a result of the general softness in the reinsurance market prior to hurricanes Katrina, Rita and Wilma.
Esurance Results - Year Ended December 31, 2006 versus Year Ended December 31, 2005
Net written premium increased to $596 million, a 71% increase from 2005. As of December 31, 2006, Esurance’s in-force policy count totaled 372,688, a 76% increase over 2005. During 2006, Esurance continued to expand through national and local television advertising, online marketing, direct mail, and online agency channels. More site traffic and improved conversion rates lowered the costs of acquiring new customers during 2006.
Esurance Results - Year Ended December 31, 2005 versus Year Ended December 31, 2004
Other Operations Results - Year Ended December 31, 2006 versus Year Ended December 31, 2005
White Mountains’ Other Operations segment reported pre-tax income of $3 million for 2005, compared to a pre-tax loss of $55 million for 2004. The following items contributed to the improved results in 2005: (1) an $84 million decrease in incentive compensation expense in 2005; (2) the special dividend from Montpelier Re in the 2005 first quarter, $39 million of which was reported in this segment; (3) $26 million of gains recorded in other revenues in 2005 from the settlement of two lawsuits in which White Mountains was a plaintiff; and (4) a $14 million increase in other net investment income. Additionally, the 2004 results included a $20 million realized loss from the impact that currency fluctuations had on hedging the cost of funding for the Sirius Acquisition. These loss-reducing factors were partially offset by a $126 million decrease in net realized investment gains from the valuation of the Montpelier Re warrants (a $110 million loss in 2005 versus a $16 million gain in 2004).
Investment Returns -Year Ended December 31, 2006 versus Year Ended December31, 2005
Net investment income of $436 million during 2006 decreased 11% from $492 million during 2005, principally due to the receipt of a $74 million special dividend on the Montpelier Re investment during 2005. Net realized investment gains of $273 million during 2006 increased by 142% from $113 million during 2005, primarily due to a $170 million increase in realized gains from the Montpelier Re investment (a $5 million realized gain in 2006 period versus a $165 million realized loss in 2005). Net unrealized gains on investments of $120 million during 2006 improved from net unrealized losses of $275 million during 2005, primarily due to the effect of interest rate movements and foreign currency fluctuations, as described above. In addition, 2005 included a $65 million pre-tax unrealized loss from the Montpelier Re common share investment.
Net investment income of $492 million during 2005 increased 36% from $361 million during 2004, principally due to the receipt of a $74 million special dividend on the Montpelier Re investment during 2005. Net realized investment gains of $113 million during 2005 decreased by 38% from $181 million during 2004, primarily due to a $165 million realized loss from the Montpelier Re investment, partially offset by realized gains generated by reducing our positions in certain highly appreciated securities. Net unrealized losses on investments of $275 million during 2005 deteriorated from net unrealized gains of $156 million during 2004, primarily due to the effect of interest rate movements and foreign currency fluctuations, as described above. In addition, 2005 included a $65 million pre-tax unrealized loss from the Montpelier Re common share investment.
The following table presents the composition of White Mountains’ investment portfolio as of December 31, 2006 and 2005:
The breakdown of White Mountains’ fixed maturity investments, including trust account investments, at December 31, 2006 by credit class, based upon issue credit ratings provided by Standard and Poor’s, or if unrated by Standard and Poor’s, long term obligation ratings provided by Moody’s, is as follows:
During 2006, White Mountains recorded $4 million in pre-tax dividends from Montpelier Re in net investment income. During 2005, Montpelier Re declared a special dividend of $5.50 per share, payable to holders of both its common shares and warrants to acquire its common shares. White Mountains recorded pre-tax dividend income of $74 million in 2005 for this special dividend, in addition to $16 million in dividend income from Montpelier’s normal quarterly dividends.
White Mountains sold a portion of its investment in Montpelier Re common shares during 2004 resulting in a $35 million pre-tax realized gain and, as a result, changed the method of accounting for its remaining Montpelier common shares to the fair value method, resulting in a $33 million increase in after-tax unrealized gains in the first quarter of 2004. During 2006, White Mountains sold an additional 5.4 million shares of its common share investment in Montpelier Re and realized a pre-tax gain of $5.5 million on the sale.
Total capital at White Mountains is comprised of common shareholders’ equity, minority interest in OneBeacon Ltd., debt and, through December31, 2005, preferred stock subject to mandatory redemption. As a result of the OneBeacon Offering, the preferred stock was economically defeased and, therefore, was not included in total capital as of December 31, 2006. Tangible capital is a non-GAAP measure which excludes from total capital the unamortized goodwill and the equity in net unrealized gains from Symetra’s fixed maturity portfolio. The reconciliation of total capital to total tangible capital is included on page 62.
Subsequent to the OneBeacon Offering, the Company and its intermediate holding companies expect to receive regular dividends from OneBeacon Ltd. The board of OneBeacon Ltd. has authorized quarterly dividend payments of $0.21 per share, commencing in the first quarter of 2007.
Generally, OneBeacon’s regulated insurance operating subsidiaries have the ability to pay dividends during any 12-month period without the prior approval of regulatory authorities in an amount equal to the greater of prior year statutory net income or 10% of prior year end statutory surplus, subject to the availability of unassigned funds. As a result, based on 2006 statutory net income, OneBeacon’s top tier regulated insurance operating subsidiaries have the ability to pay approximately $234 million of dividends during 2007 without prior approval of regulatory authorities, subject to the availability of unassigned funds. As of December 31, 2006, OneBeacon’s top tier regulated insurance operating subsidiaries had $1.6 billion of unassigned funds.
In addition, as of December 31, 2006, Esurance had $3 million of unrestricted cash and fixed maturity investments outside of its regulated insurance operating subsidiaries. During 2006, Esurance did not pay any cash dividends to its immediate parent.
As of December 31, 2006, White Mountains had $497 million of unrestricted cash and fixed maturity investments at the Company and its intermediate holding companies included in its other operations segment.
In accordance with provisions of Swedish law, Sirius International is permitted to transfer up to the full amount of its pre-tax income, subject to certain limitations, into an untaxed reserve referred to as a safety reserve, which amounted to $1.3 billion at December 31, 2006. Under GAAP, an amount equal to the safety reserve, net of the related deferred tax liability established at the Swedish tax rate of 28%, is classified as shareholders’ equity. Generally, this deferred tax liability is only required to be paid by Sirius International if it fails to maintain predetermined levels of premium writings and loss reserves in future years. As a result of the indefinite deferral of these taxes, Swedish regulatory authorities do not apply any taxes to the safety reserve when calculating solvency capital under Swedish insurance regulations. Accordingly, under local statutory requirements, an amount equal to the deferred tax liability on Sirius International’s safety reserve ($351 million at December 31, 2006) is included in solvency capital.
(3) Excludes funds held by White Mountains under reinsurance treaties for which White Mountains does not provide interest credits.
White Mountains has historically obtained its insurance float primarily through acquisitions, as opposed to organic growth. In recent years, White Mountains has had negative cash flows from operations but has grown float from its insurance and reinsurance operations. This is due to the fact that White Mountains’ cash flow from operations does
not reflect cash and investments generated by the acquisition of insurance and reinsurance businesses in recent years. Post-acquisition, such companies are often placed into partial or complete run-off, thereby resulting in negative cash flows from operations as the investments acquired are liquidated over time to pay claims.
The following table summarizes White Mountains’ capital structure as of December 31, 2006 and 2005:
In connection with the OneBeacon Offering, White Mountains and Fund American terminated their existing $400 million credit facility, under which they were both permitted borrowers, and replaced it with two distinct credit facilities, as described below.
The Senior Notes were issued under an indenture which contains restrictive covenants that, among other things, limit the ability of the Company, Fund American and their respective subsidiaries to create liens and enter into sale and leaseback transactions and limits the ability of Fund American and its respective subsidiaries to consolidate, merge or transfer their properties and assets. The indenture does not contain any financial ratios or specified levels of net worth or liquidity to which the Company or Fund American must adhere. At December 31, 2006, White Mountains was in compliance with all of the covenants under the Senior Notes, and anticipates it will continue to remain in compliance with these covenants for the foreseeable future.
White Mountains also has future binding commitments to fund certain limited partnership investments. These commitments, which total approximately $109 million, do not have fixed funding dates and are therefore excluded from the table above.
During 2006, White Mountains declared and paid cash dividends of $86 million, $28 million and $2 million to holders of White Mountains' common shares, the Berkshire Preferred Stock and the Zenith Preferred Stock, respectively.
During 2006, OneBeacon and Folksamerica repaid $8 million and $7 million, respectively, of loans to Dowling and Partners Connecticut Fund III LP.
During 2005, White Mountains contributed $250 million to White Mountains Re (which, in turn, contributed $250 million to Folksamerica) and $10 million to Esurance.
During the first quarter of 2005, White Mountains made payments totaling $235 million, in cash or by deferral into certain non-qualified compensation plans of the Company or its subsidiaries, to participants in its long-term incentive compensation plans. These payments were made with respect to 212,611 performance shares at payout levels ranging from 113% to 200% of target.
See Note 2 - “Significant Transactions” of the accompanying Consolidated Financial Statements for further discussion of these transactions.
Loss and LAE reserves are typically comprised of (1) case reserves for claims reported and (2) reserves for losses that have occurred but for which claims have not yet been reported, referred to as incurred but not reported (“IBNR”) reserves, which include a provision for expected future development on case reserves. Case reserves are estimated based on the experience and knowledge of claims staff regarding the nature and potential cost of each claim and are adjusted as additional information becomes known or payments are made. IBNR reserves are derived by subtracting paid loss and LAE and case reserves from estimates of ultimate loss and LAE. Actuaries estimate ultimate loss and LAE using various generally accepted actuarial methods applied to known losses and other relevant information. Like case reserves, IBNR reserves are adjusted as additional information becomes known or payments are made.
Ultimate loss and LAE are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can reasonably be expected to persist into the future. In forecasting ultimate loss and LAE with respect to any line of business, past experience with respect to that line of business is the primary resource, but cannot be relied upon in isolation. OneBeacon’s own experience, particularly claims development experience, such as trends in case reserves, payments on and closings of claims, as well as changes in business mix and coverage limits, is the most important information for estimating its reserves. External data, available from organizations such as statistical bureaus, consulting firms and reinsurance companies, is sometimes used to supplement or corroborate OneBeacon’s own experience, and can be especially useful for estimating costs of new business. For some lines of business, such as “long-tail” coverages discussed below, claims data reported in the most recent accident year is often too limited to provide a meaningful basis for analysis due to the typical delay in reporting of claims. For this type of business, OneBeacon uses a selected loss ratio method for the initial accident year or years. This is a standard and accepted actuarial reserve estimation method in these circumstances in which the loss ratio is selected based upon information used in pricing policies for that line of business, as well as any publicly available industry data, such as industry pricing, experience and trends, for that line of business.
· Historical incurred loss development methods: These methods, like historical paid loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant in the future. However, instead of using paid losses, these methods use incurred losses (i.e., the sum of cumulative historical loss payments plus outstanding case reserves) over discrete periods of time to estimate future losses. Historical incurred loss development methods can be preferable to historical paid loss development methods because they explicitly take into account open cases and the claims adjusters’ evaluations of the cost to settle all known claims. However, historical incurred loss development methods necessarily assume that case reserving practices are consistently applied overtime. Therefore, when there have been significant changes in how case reserves are established, using incurred loss data to project ultimate losses can be less reliable than other methods.
In its selection of recorded reserves, OneBeacon historically gave greater weight to adjusted paid loss development methods, which are not dependent on the consistency of case reserving practices, over methods that rely on incurred losses. In recent years, the amount of weight given to methods based on incurred losses has increased with OneBeacon’s confidence that its case reserving practices have been more consistently applied.
Construction defect claims are a non-A&E exposure that has proven to have a greater degree of uncertainty when estimating loss and LAE using generally accepted actuarial methods. OneBeacon’s general liability and multiple peril lines of business have been significantly impacted by a large number of construction defect claims. Construction defect is a liability allegation relating to defective work performed in the construction of structures such as apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. Such claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. Much of the recent claims activity has been generated by plaintiffs’ lawyers who approach new homeowners, and in many cases homeowner associations with large numbers of homeowners in multi-residential complexes, about defects or other flaws in their homes. Claims for construction defects began with claims relating to exposures in California. Then, as plaintiffs’ lawyers organized suits in other states with high levels of multi-residential construction, construction defect claims were reported in nearby western states, such as Colorado and Nevada, and eventually throughout the country. The reporting of such claims can be quite delayed as the statute of limitations can be up to ten years. Court decisions have expanded insurers’ exposure to construction defect claims as well. For example, in 1995 California courts adopted a “continuous trigger” theory in which all companies that had ever insured a property that was alleged to have been damaged must respond to the claimant, even if evidence of the alleged damage did not appear until after the insurance period had expired. As a result, construction defect claims may be reported more than ten years after a project has been completed as litigation can proceed for several years before an insurance company is identified as a potential contributor. Claims have also emerged from parties claiming additional insured status on policies issued to other parties (e.g., such as contractors seeking coverage on a sub-contractor’s
policy). Further, in reserving for these claims, there is additional uncertainty due to the potential for further unfavorable judicial rulings and regulatory actions. The primary actuarial methods that are used to estimate loss and LAE reserves for construction defect claims are frequency and severity methods. These methods separately project the frequency of future reported claims and the average cost, or severity, of individual claims. The reserve is the product of the projected number of reported claims and the severity.
A large number of construction defect claims have been identified relating to coverages that OneBeacon had written in the past through Commercial Union Corporation and General Accident Corporation of America, which OneBeacon refers to as their legacy companies, and their subsidiaries in California, Colorado, Nevada, Washington and Oregon. OneBeacon’s management has sought to mitigate future construction defect risks in all states by no longer providing insurance to certain residential general contractors and sub-contractors involved in multi-habitational projects. Mitigating actions also included initiating the withdrawal from problematic sub-segments within OneBeacon’s construction book of business, such as street and road construction, water, sewer and pipeline construction. As a result of these actions, OneBeacon’s management believes that the number of reported construction defect claims relating to coverages written in the past peaked in 2004 and will continue to decline.
OneBeacon’s reserves include provisions made for claims that assert damages from A&E related exposures. Asbestos claims relate primarily to injuries asserted by those who allegedly came in contact with asbestos or products containing asbestos. Environmental claims relate primarily to pollution and related clean-up cost obligations, particularly as mandated by federal and state environmental protection agencies. In addition to the factors described above under “Non-Asbestos and Environmental Reserves” regarding the reserving process, OneBeacon estimates its A&E reserves based upon, among other factors, facts surrounding reported cases and exposures to claims, such as policy limits and deductibles, current law, past and projected claim activity and past settlement values for similar claims, as well as analysis of industry studies and events, such as recent settlements and asbestos-related bankruptcies. The cost of administering A&E claims, which is an important factor in estimating loss and LAE reserves, tends to be higher than in the case of non-A&E claims due to the higher legal costs typically associated with A&E claims.
More recently, since the 1990s, OneBeacon has experienced an increase in claims from commercial insureds, including many non-Fortune 500-sized accounts written during the 1970s and 1980s, who are named as defendants in asbestos lawsuits. As a number of large well-known manufacturers of asbestos and asbestos-containing products have gone into bankruptcy, plaintiffs have sought recoveries from peripheral defendants, such as installers, transporters or sellers of such products, or from owners of premises on which the plaintiffs’ exposure to asbestos allegedly occurred. At December 31, 2006, 520 policyholders had asbestos-related claims against OneBeacon. In 2006, 121 new insureds with such peripheral involvement presented asbestos claims under prior OneBeacon policies.
Historically, most asbestos claims have been asserted as product liability claims. Recently, insureds who have exhausted the available products liability limits of their insurance policies have sought from insurers such as OneBeacon payment for asbestos claims under the premises and operations coverage of their liability policies, which may not be subject to similar aggregate limits. OneBeacon expects this trend to continue. However, to date there have been fewer of these premises and operations coverage claims than product liability coverage claims. This may
favorably to industry survival ratios. However, the survival ratio is a simplistic measure estimating the number of years it would be before the current ending loss reserves for these claims would be paid using recent annual average payments. Many factors, such as aggressive settlement procedures, mix of business and coverage provided, have a significant effect on the amount of A&E reserves and payments and the resultant survival ratio. Thus, caution should be exercised in attempting to determine reserve adequacy for these claims based simply on this survival ratio.
· In 2004, OneBeacon established a separate claim group to manage run-off claims. Due to the recent nature of this event, OneBeacon does not believe that the impacts of this group on future losses have been reflected in historical losses. Therefore, OneBeacon has given considerable weight to the most recent loss experience for this segment.
Workers compensation is generally considered a long tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. While certain payments such as initial medical treatment or temporary wage replacement for the injured worker are made quickly, some other payments are made over the course of several years, such as awards for permanent partial injuries. In addition, some payments can run as long as the injured worker’s life, such as permanent disability benefits and ongoing medical care. Despite the possibility of long payment tails, the reporting lags are generally short, settlements are generally not complex, and most of the liability can be considered high frequency with moderate severity. The largest reserve risk generally comes from the low frequency, high severity claims providing lifetime coverage for medical expense arising from a worker’s injury. Examples of common reserving factors that can change and, thus, affect the estimated workers compensation reserves include:
In 2005, OneBeacon experienced $95 million of unfavorable development on prior accident year loss and LAE reserves, primarily due to higher than anticipated legal defense costs and higher damages from liability assessments in general liability and multiple peril reserves in its run-off operations.
Specifically, OneBeacon’s management had assumed at December 31, 2004 that the IBNR and known case development would be approximately 26% of actual case reserves for the 2001 and prior accident years for multiple peril and general liability. During 2005, case incurred loss and LAE was 72% of the entire future expected development which was unusually large for these long tail lines of business. As a result, OneBeacon’s management increased IBNR reserves for these lines so that as of year end 2005 the IBNR was approximately 40% relative to the remaining case reserves.
OneBeacon’s net loss and LAE reserves by line of business at December 31, 2006 and 2005 were as follows:
The probability that ultimate losses will fall outside of the ranges of estimates by line of business is higher for each line of business individually than it is for the sum of the estimates for all lines taken together due to the effects of diversification. The diversification effects result from the fact that losses across OneBeacon’s different lines of business are not completely correlated. Although OneBeacon believes its reserves are reasonably stated, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above the high end of the range of actuarial projections. This is because ranges are developed based on known events as of the valuation date, whereas the ultimate disposition of losses is subject to the outcome of events and circumstances that may be unknown as of the valuation date.
The percentages shown in the following table represent the linear interpolation of where OneBeacon’s recorded loss and LAE reserves are within the range of reserves estimates by line of business at December 31, 2006 and 2005, where the low end of the range equals zero, the middle of the range equals 50% and the high end of the range equals 100%.
For some types of claims, such as workers compensation, OneBeacon used forecasting models that consider the unique loss development characteristics of these types of claims. As a result of the trends suggested by these models, OneBeacon chose a point estimate that was at a lower point in the range at December 31, 2006 as compared to the prior year. OneBeacon selected a point estimate higher in the range for newer and/or growing segments of business, in part based on OneBeacon’s view that actuarial methods that rely on historical loss and LAE patterns may have a higher degree of uncertainty for these businesses. As these segments accumulate more historical data, OneBeacon’s selections place greater reliance on the emerging experience. For personal automobile liability, this resulted in OneBeacon recording reserves at the higher end of the range in 2006, reflecting a more conservative view of recently emerging favorable loss experience. OneBeacon also selected a point estimate higher in the range for general liability in 2006 as the reserves in this line are increasingly related to OneBeacon’s growing professional liability business. For homeowners and “other” (principally shorter tailed lines of business such as ocean and inland marine insurance) recorded reserves remain at the high end of their respective ranges, as OneBeacon’s selections reflect a conservative approach to recognition of recent favorable incurred loss development patterns.
· Workers compensation: Recorded reserves for workers compensation were $218 million at December 31, 2006. The two most important assumptions for workers compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately half of the workers compensation net reserves are related to future medical costs. Across the entire reserve base, a 0.5 point change in calendar year medical inflation would have changed the estimated net reserve by $54 million at December 31, 2006, in either direction.
· Multiple peril liability and general liability: Recorded reserves for multiple peril and general liability combined were $789 million at December 31, 2006. Reported loss development patterns are a key assumption for these lines of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g. construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. If the severity trend for construction defect claims changed by 3.0 points this would have changed the estimated net reserve by $11 million at December 31, 2006, in either direction. Separately, if case reserve adequacy for non construction defect claims changed by 10.0 points this would have changed the estimated net reserve by $23 million at December 31, 2006, in either direction.
In 2004, White Mountains Re experienced an increase in the number and amount of reported asbestos claims, primarily due to increased claim filings from uninjured claimants who may have been exposed to asbestos. This resulted in a change in its assumption regarding the level of projected future asbestos claims to be paid. During 2005, White Mountains Re completed a detailed, ground up asbestos study on all reported Folksamerica insureds that had over $250,000 of asbestos claims as well as a significant sample of all other insureds with reported asbestos claims of less than $250,000. Comparing estimates generated by the study to Folksamerica exposed limits by underwriting year led to an increase of approximately $50 million in IBNR during the third quarter of 2005.
Generally, White Mountains Re sets up claim files for each reported claim by each cedent for each individual insured. In many instances, a single claim notification from a cedent could involve several years and layers of coverage resulting in a file being set up for each involvement. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to pursue coverage under the reinsurance contract. Such notices do not contain an incurred loss amount, accordingly, an open claim file is not established. As of December 31, 2006, White Mountains Re had approximately 1,173 open claim files for asbestos and 512 open claim files for environmental exposures.
The costs associated with administering the underlying A&E claims by White Mountains Re’s clients tend to be higher than non A&E claims due to generally higher legal costs incurred by ceding companies in connection with A&E claims ceded to White Mountains Re under the reinsurance contracts.
White Mountains Re’s expected annual loss reporting assumptions are updated once a year, at year end. These assumptions are applied to year-end IBNR to generate expected reported losses for the subsequent year. Interpolation methods are applied to estimate quarterly reported losses, which are then compared to actual reported losses each quarter. Significant differences may result in a change in estimates or a revision in the loss reporting pattern. Expected loss ratios underlying the current accident year are updated quarterly, to reflect new business that is underwritten by the company.
During 2006, White Mountains Re increased its estimate for net losses from hurricanes Katrina, Rita, and Wilma by $86 million following the receipt of new claims information from several ceding companies and subsequent reassessment of ultimate loss exposures. The company also entered into an indemnity agreement with Olympus, which resulted in an additional $137 million in losses and loss expenses. Also in 2006, White Mountains Re increased prior year loss and LAE reserves by $55 million for casualty losses associated with the Risk Capital acquisition, primarily as a result of a detailed study of loss exposure by individual contract. Reserves for 2004 and prior years were decreased by $46 million at Sirius in 2006, as we have seen lower than expected loss emergence across all lines of business and have reduced IBNR accordingly.
White Mountains Re’s net loss and LAE reserves by class of business at December 31, 2006 and 2005 were as follows:
The actuarial methods described above are used to calculate a point estimate of loss and LAE reserves for each company within White Mountains Re. These point estimates are then aggregated to produce an actuarial point estimate for the entire segment. Once a point estimate is established, White Mountains Re’s actuaries estimate loss reserve ranges to measure the sensitivity of the actuarial assumptions used to set the point estimates. These ranges are calculated using similar methods to the point estimate calculation, but with different expected loss ratio and loss reporting pattern assumptions. For the low estimate, more optimistic loss ratios and faster reporting patterns are
The actuarial point estimate is management’s primary consideration in determining its best estimate of loss and LAE reserves. In making its best estimate, management also considers other qualitative factors that may lead to a difference between its best estimate of loss and LAE reserves and the actuarial point estimate. Typically, these factors exist when management and the company’s actuaries conclude that there is insufficient historical incurred and paid loss information or that trends included in the historical incurred and paid loss information are unlikely to repeat in the future. These factors may include, among others, changes in the techniques used to assess underwriting risk, more accurate and detailed levels of data submitted with reinsurance applications, the uncertainty of the current reinsurance pricing environment, the level of inflation in loss costs, changes in ceding company reserving practices, and legal and regulatory developments. At December 31, 2006 and 2005, total carried reserves were 2.2% and 0.7% above the actuarial point estimate, respectively.
The following table illustrates White Mountains Re’s recorded net loss and LAE reserves and high and low estimates for those classes of business for which a range is calculated, at December 31, 2006.
There is a time lag from the point when premium and related commission and expense activity is recorded by a ceding company to the point when such information is reported by the ceding company, through its reinsurance intermediary, to White Mountains Re. This time lag can vary from one to several contractual reporting periods (i.e. quarterly/monthly). This lag is common in the reinsurance business, but slightly longer when a reinsurance intermediary is involved.
As a result of this time lag in reporting, White Mountains Re estimates a portion of its written premium and related commissions and expenses. Given the nature of White Mountains Re’s business, estimated premium balances, net of related commissions and expenses, comprise a large portion of total premium balances receivable. The estimation process begins by identifying which major accounts have not reported activity at the most recent period end. In general, premium estimates for excess of loss business are based on minimum deposit premium information included in the contractual terms. For proportional business, White Mountains Re’s estimates are derived based on a variety of factors and assumptions, including: expected premium volume based on contractual terms or ceding company reports and other correspondence and communication with underwriters, intermediaries and ceding companies, prior reporting from the intermediary or ceding company and historical reporting patterns. Once premium estimates are determined, related commission and expense estimates are derived using contractual terms.
White Mountains’ insurance and reinsurance subsidiaries purchase reinsurance from time to time to protect their businesses from losses due to exposure aggregation, to manage their operating leverage ratios and to limit ultimate losses arising from catastrophic events. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. Amounts related to reinsurance contracts are recorded in accordance with SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts” (“SFAS 113”).
The collectibility of reinsurance recoverables is subject to the solvency and willingness to pay of the reinsurer. The Company is selective in choosing its reinsurers, placing reinsurance principally with those reinsurers with a strong financial condition, industry ratings and underwriting ability. Management monitors the financial condition and ratings of its reinsurers on an ongoing basis. See Note 4 - “Third Party Reinsurance” in the accompanying Consolidated Financial Statements for additional information on White Mountains’ reinsurance programs.
When White Mountains acquires another company, management must estimate the fair values of the assets and liabilities acquired, as prescribed by SFAS No. 141, “Business Combinations.” Certain assets and liabilities require little judgment to estimate their fair values, particularly those that are quoted on a market exchange, such as publicly-traded investment securities. Other assets and liabilities, however, require a substantial amount of judgment to estimate their fair values. The most significant of these is the estimation required to fair value loss and LAE reserves. White Mountains estimates the fair value of loss and LAE reserves obtained in an acquisition following the principles contained within FASB Statement of Financial Accounting Concepts No. 7: “Using Cash Flow Information and Present Value in Accounting Measurements” (“CON 7”). Under CON 7, the fair value of a particular asset or liability essentially contains five elements: (1) an estimate of the future cash flows, (2) expectations about possible variations in the amount or timing of those cash flows; (3) the time value of money, represented by the risk-free rate of interest; (4) the
price for bearing the uncertainty inherent in the asset or liability; and (5) other, sometimes unidentifiable, factors including illiquidity and market imperfections.
White Mountains’ actuaries estimate the fair value of loss and LAE reserves obtained in an acquisition by taking the acquired company’s recorded reserves and discounting them based on expected reserve payout patterns using the current risk-free rate of interest. Then, White Mountains’ actuaries develop additional cash flow scenarios that use different payout and ultimate reserve assumptions deemed to be reasonably possible based upon the inherent uncertainties present in determining the amount and timing of payment of such reserves. In each scenario, the risk-free rate of interest is used to discount future cash flows. These scenarios are put in a statistical model that assigns a probability to each cash flow scenario. White Mountains’ actuaries then choose the scenario that best represents the price for bearing the uncertainty inherent within the acquired company’s recorded reserves. The “price” for bearing the uncertainty inherent within the acquired company’s reserves is measured as the difference between the selected cash flow scenario and the expected cash flow scenario. The scenario selected has typically been between 1.5 and 2 standard deviations from the expected cash flow outcome. The fair value of the acquired company’s loss and LAE reserves is determined to be the sum of the expected cash flow scenario (i.e., the acquired company’s discounted loss and LAE reserves) and the uncertainty “price”.
The information contained in this report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21 E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report which address activities, events or developments which White Mountains expects or anticipates will or may occur in the future are forward-looking statements. The words “will”, “believe,” “intend,” “expect,” “anticipate,” “project,” “estimate,” “predict” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to White Mountains’:
· the risks discussed in Item 1A of this Form 10-K;
· changes in domestic or foreign laws or regulations, or their interpretation, applicable to White Mountains, its competitors or its clients;
The financial statements and supplementary data have been filed as a part of this Annual Report on Form 10-K as indicated in the Index to Consolidated Financial Statements and Financial Statement Schedules appearing on page 97 of this report.