Total gross premiums written of $1,375.0 million, compared to $1,254.3 million in 2008, an increase of 9.6%;
Net income per diluted share of $4.26, compared to a net loss per diluted share of $3.10 in 2008;
Shareholders’ equity at December 31, 2009 of $1,564.6 million, compared to $1,280.3 million at December 31, 2008, an increase of 22.2%;
Combined ratio on property and casualty business of 88.1%, compared to 91.9% in 2008; and
Gross premiums written in our property and casualty business totaled $1,331.2 million, an increase of 31.5% over 2008. Approximately 62.4%, or $199.0 million, of this growth came from our Bermuda/Dublin insurance, Bermuda/Dublin reinsurance and U.S. specialty segments, with a relatively balanced mix of short tail and long tail growth (short tail lines increased by $95.9 million, long tail lines increased by $102.6 million). The remaining 37.6% of our gross premium written increase came from our newest segment, Max at Lloyd’s, which was acquired as a pre-existing operation in November 2008 and, therefore, the premium is additive to Max’s results but is not entirely newly underwritten business.
Max at Lloyd’s was acquired in late 2008 for $16.3 million over its recorded net book value. For the year ended December 31, 2009 this segment has contributed $25.7 million of income before taxes to the group, writing a mix of property and casualty business at an attractive 86.3% combined ratio.
Underwriting results for all of our property and casualty segments were favorable in 2009. Our overall combined ratio improved from 91.9% in 2008 to 88.1% in 2009. This improvement is principally due to our increase in short tail lines of business and a lower level of property catastrophe losses in 2009 compared to 2008. Combined ratios in our four property and casualty segments for 2009 were 75.6% for Bermuda/Dublin insurance, 92.1% for Bermuda/Dublin reinsurance, 99.5% for U.S. specialty, and 86.3% for Max at Lloyd’s.
We focused on taking advantage of opportunities where we believed market conditions were favorable. Our Bermuda/Dublin insurance and Bermuda/Dublin reinsurance segments took advantage of favorable market dislocations in the professional
liability arena to significantly increase our premium volume at attractive rates, while we also increased our premium volumes in short tail lines that were experiencing rate increases in the year, such as property and aviation.
We anticipate market conditions to be challenging in 2010 but continue to present select opportunities. We believe the improvement in the financial markets together with the relatively benign year for property catastrophe losses has resulted in increased insurance and reinsurance capacity in many lines of business. In some cases supply currently exceeds demand. However, whilst pricing is soft in several product markets, it is not uniform across all lines of business and market segments. We believe we can select and compete in those lines of business that remain attractively priced while shrinking our presence in the less profitable lines.
Consistent with our practice of identifying new opportunities and adding talented underwriting teams to the Company, we intend to begin underwriting reinsurance business in Latin America in 2010 through local offices in Brazil and Columbia, placing these risks with our Max at Lloyd’s and Max Re Europe entities. We believe that by expanding our global reach and geographic diversity, we will be better positioned in a growing reinsurance market.
Insurance and reinsurance premiums are a function of the amount and type of contracts written as well as prevailing market prices. Property and casualty premiums are earned over the terms of the underlying coverage. Life and annuity reinsurance premiums are generally earned when the premium is due from policyholders. Each of our insurance and reinsurance contracts contain different pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying 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.
Our net investment income is a function of the average invested assets and the average yield that we earn on those invested assets. The investment yield on our fixed maturities investments is a function of market interest rates as well as the credit quality and maturity of our fixed maturities portfolio. Our net realized and unrealized gains or losses on investments includes realized capital gains or losses on our fixed maturity securities and changes in fair value of our trading securities and other investments. We recognize the realized capital gains or losses at the time of sale, and they, along with the change in fair value of our trading securities, reflect the results of changing market values and conditions, including changes in market interest rates and changes in the market’s perception of the credit quality of our fixed maturities holdings. The change in fair value of other investments is a function of the success of the funds in which we are invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies, general economic and investment market conditions.
Acquisition costs consist principally of ceding commissions paid to ceding clients and brokerage expenses. These typically represent a negotiated percentage of the premiums on insurance and reinsurance contracts written. Acquisition costs are stated net of ceding commissions associated with premiums ceded to our quota share partners on our insurance and reinsurance business. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers. We defer and amortize these costs over the period in which the related premiums are earned.
Interest expense principally reflects interest on any bank loans and interest on our senior notes. In addition, 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. Finally, interest expense also includes interest on deposit contracts.
General and administrative expenses are principally employee salaries, bonuses and related personnel costs, office rent, amortization of leasehold improvements, information technology expenditure and other operating costs. These costs generally do not vary with the amount of premiums written.
Our insurance premiums are recorded at the inception of each contract, based upon contract terms. The amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is posted to amend the minimum and/or deposit premium if there are changes in underlying exposures insured, based on information received from our clients. Premiums are earned on a pro rata basis over the coverage period.
Additional premiums assumed and ceded, related additional acquisition costs, related net losses and the net impact on operating results for each of the three years to December 31, 2009 are as follows:
We accrue for reinstatement premiums resulting from losses recorded. Such accruals are based upon contractual terms and the only element of management judgment involved is with respect to the amount of losses recorded. Changes in estimates of losses recorded on contracts with reinstatement premium features will result in changes in reinstatement premiums based on contractual terms. Reinstatement premiums are recognized at the time we record losses and are earned on a pro-rata basis over the coverage period. Reinstatement premiums assumed and ceded for each of the three years to December 31, 2009 are not material to our financial results.
In estimating reserves we, consistent with industry practice, utilize a variety of standard actuarial methods together with management judgment. The loss reserve selection from these various methods is based on the loss development characteristics of the specific line of business and specific contracts which take into consideration coverage terms, type of business, maturity of loss data, reported claims and paid claims. We do not necessarily utilize the same actuarial method or group of actuarial methods for all contracts within a line of business or segment, as variations between contracts result in a number of different methods or groups of methods being appropriate. These actuarial methods have been designed to address the lag in loss reporting in the insurance industry as well as the delay in obtaining information that would allow us to more accurately estimate future payments. There is 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. Reporting lag is more pronounced in our reinsurance contracts than in our insurance contracts and more pronounced in casualty business, which generally has a longer claims pay-out period, than property business, which generally has a shorter claims pay-out period. On casualty reinsurance transactions the reporting lag will generally be 60-90 days after the end of a reporting period, but can be longer than this 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 and claims tails. 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 coverages, claim payments are made very slowly and it may take years for claims to be fully reported and settled.
incurred but not reported reserves (which we refer to as IBNR), which include reserves for the following:
Our Bermuda/Dublin casualty insurance loss reserves, which include case reserves, amount for IBNR reserves and loss adjustment expenses, are compiled on a portfolio basis and are computed on an undiscounted basis. The majority of our Bermuda/Dublin insurance reserves are related to casualty business. Historically, losses associated with casualty business have had a long claim-tail, which is the time period between the occurrence of a loss and the time it is settled by the insurer. Casualty losses are also generally more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. Due to the long claim-tail nature of casualty business, a high degree of judgment is involved in establishing loss reserves.
With respect to our reinsurance products, we rely on loss data reported by our clients when calculating our reserves. The quality of the loss data varies from client to client. On a periodic basis, the clients’ loss data is analyzed by our actuarial and claims management teams to ascertain its quality and credibility. This process may involve comparisons with submission data and industry loss data, claim audits and inquiries about the methods of establishing case reserves or reserves associated with large industry events. There is often a time lag between our clients establishing case reserves and re-estimating their reserves, and notifying us of the new or revised case reserves. On casualty reinsurance transactions, the reporting lag will generally be 60-90 days after the end of a reporting period, but can be longer in some cases. Appropriate selection of loss development factors is used to mitigate these problems. We utilize the latest information received from our clients and work to ensure that the loss data is current. However, due to the varying quality
of data from our reinsureds and the inherent reporting delays, our Bermuda/Dublin reinsurance reserves will have more uncertainty than our Bermuda/Dublin insurance reserves, where we receive loss information directly from our insureds.
As of December 31, 2009 and December 31, 2008, approximately 29% and 30%, respectively, of the total Bermuda/Dublin reinsurance reserves were on contracts that are recorded at contractual aggregate limits. Mitigating the uncertainty inherent in the reserves of our Bermuda/Dublin reinsurance portfolio is the fact that a large portion of our recorded reinsurance reserves are attributable to contracts that are recorded at contractual aggregate limits.
We determine our IBNR reserves by first projecting the ultimate expected losses by product within each line of business. We then subtract paid losses and case reserves from the ultimate loss reserves. The remainder is our incurred but not reported reserves. The level of IBNR reserves in relation to total reserves depends upon the characteristics of the line of business, particularly with respect to the speed that losses are reported and outstanding loss reserves are adjusted. Lines for which losses are reported quickly will have a lower percentage of IBNR reserves than lines for which losses are reported more slowly, and lines for which reserve volatility is low will have a lower percentage of IBNR reserves than higher volatility lines.
We establish and review our U.S. specialty IBNR loss and loss expense reserves on a quarterly basis. We use a variety of actuarial techniques and methods in estimating our ultimate liability for excess and surplus lines insurance losses and loss expenses, together with management judgment. These methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods. Industry loss experience is also used to supplement our own data in selecting loss reporting and payment patterns and expected loss ratios. The table below breaks our U.S. specialty reserves as of December 31, 2009 and 2008 into casualty and property components.
Our Max at Lloyd’s property and casualty reinsurance loss reserves, which include case reserves, amounts for IBNR reserves and loss adjustment expenses, are compiled on a portfolio basis and are computed on an undiscounted basis. The majority of the reinsurance business written by the Syndicates is property business. These reserves are adjusted for losses reported by our clients and for our estimate of losses resulting from catastrophe events, based on a detailed, location specific analysis of our clients’ properties impacted by the events.
In connection with our ongoing analysis of our Bermuda/Dublin insurance, Bermuda/Dublin reinsurance, U.S. specialty, and Max at Lloyd’s loss reserves, we review loss notifications and reports received from our clients to confirm that submitted claims are covered under the contract terms. Disputes with clients arise in the ordinary course of business due to coverage issues such as classes of business covered and interpretation of contract wording. We typically resolve any disputes through negotiations that could vary from a simple exchange of email correspondence to arbitration with a panel of experts. Our contracts generally provide for dispute resolution through arbitration. We are not currently involved in any coverage disputes that we believe would, individually or in the aggregate, be material to us.
The following table presents the development of balance sheet property and casualty loss reserves calculated in accordance with U.S. GAAP, as of December 31, 2000 through December 31, 2009. 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. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “net cumulative redundancy (deficiency)” represents the aggregate change to date from the original estimate on the third line of the table “reserve for property and casualty losses, originally stated, net of reinsurance.” The “gross cumulative redundancy (deficiency)” represents the aggregate change to date from the original gross estimate on the top line of the table. The table also shows the cumulative net paid amounts as of successive years with respect to the net reserve liability.
(2) The difference between the reinsurance recoverable included above and that reflected in the reconciliation of losses and loss adjustment expenses in Note 7 to the consolidated financial statements of $498 relates to the remaining net deferred charge on retroactive reinsurance.
(4) Gross and net reserve for property and casualty losses includes, for the first time, Max Specialty, which we acquired in April 2007.
During 2009 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 with varied underwriting years and lines of business. The more significant development included:
Net favorable development for the Bermuda/Dublin reinsurance segment of $32.0 million, excluding the development associated with changes in reinsurance premium estimates described below. We recorded net favorable development on long tail lines of business, including $10.5 million from general casualty primarily on 2005 and prior years, $8.6 million on professional liability primarily on 2006 and prior years, $7.9 million on medical malpractice primarily on 2007 and prior years, and $3.3 million on other long tail lines of business. We recorded net favorable development on short tail lines of business
For additional information on our reserves, including a reconciliation of losses and loss adjustment expense reserves for the years ended December 31, 2009, 2008 and 2007 refer to Note 7 of our audited consolidated financial statements included herein.
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 contract unless a premium deficiency develops. We
The assumptions used to determine claim reserves are best estimate assumptions and are reviewed no less than annually. The assumptions are un-locked if they result in a material reserve change. We establish these assumptions based upon transaction specific historical experience, information provided by the ceding company and industry experience studies. Actual results could differ materially from these estimates.
We own a trading portfolio, an available for sale portfolio and a held to maturity portfolio of fixed maturities securities. The trading portfolio comprises the fixed maturities securities held by our Max at Lloyd’s segment. We record the trading and available for sale portfolios at fair value on our balance sheet. For our trading portfolio, the unrealized gain or loss associated with the difference between the fair value and the amortized cost of the investments is recorded in net income. For our available for sale portfolio, the unrealized gain or loss (absent credit losses) is recorded in other comprehensive income in the shareholders’ equity section of our consolidated balance sheet.
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: (a) we have the intent to sell the debt security or (b) it is more likely than not that we will be required to sell the debt security before its anticipated recovery, the entire unrealized loss is recognized in earnings. In periods after the recognition of an OTTI loss on debt 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 $3.1 million, $16.9 million and $1.1 during the years ended December 31, 2009, 2008 and 2007, respectively.
Level 3-Model derived valuations in which one or more significant inputs or significant value drivers are unobservable.
Fair value prices for all securities in our fixed maturities portfolio are independently provided by both our investment custodians and our investment managers, which each utilize internationally recognized independent pricing services. We record the unadjusted price provided by the investment custodians and our validation process includes, but is not limited to: (i) comparison to the price provided by the investment manager, with significant differences investigated; (ii) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (iii) evaluation of methodologies used by external parties to calculate fair value; and (iv) comparing the price to our knowledge of the current investment market.
Our hedge fund portfolio comprises a portfolio of limited partnerships and stock investments in trading entities, or funds, which invest in a wide range of financial products. Investments in the funds are carried at fair value. The change in fair value is included in net realized and unrealized gains on investments and recognized in net income. The units of account that we fair value are our interests in the funds and not the underlying holdings of such funds. Thus, 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. Based upon information provided by the fund managers, at December 31, 2009, we estimate that over 74% of the underlying assets in the funds are publicly traded securities or have broker quotes available.
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. During the year ended December 31, 2009, we reclassified $206.7 million of our hedge fund portfolio investments from Level 3 to Level 2. This reclassification was made as a result of developing interpretation and guidance regarding the U.S. GAAP treatment in this area.
We have attempted to construct our hedge fund portfolio to have less risk, as measured by standard deviation of return, than a common stock portfolio, which is the equity investment choice of many insurance organizations. For the five years ended December 31, 2009, our hedge fund portfolio has produced an annual standard deviation of return of 6.87% compared to the annual standard deviation of return of 12.58% for the HFRI Fund of Funds Composite Index and 16.01% for the S&P 500 Index. The annualized five year total return on our hedge fund portfolio of 3.37% compares to the HFRI Fund of Funds Composite Index return of 2.77% and the S&P 500 Index return of negative 0.21% for the same period, and with lower volatility as measured by standard deviation. There is significant risk in all our investment activities, and the results of our hedge fund portfolio will vary over time with the investment markets. With the exception of 2008, our hedge fund portfolio has produced positive results for every annual period since inception and has shown approximately one-half the volatility of the S&P 500 Index.
Despite the lower volatility of the hedge fund portfolio there is potential for losses, as there is for any investment portfolio. We approach our investment strategies based on long term performance and believe the annualized five year total return of our hedge fund portfolio of 3.37% compares favorably to the return profile of other alternative investment vehicles.
Investments in reinsurance private equities, where we have a meaningful ownership position and the ability to exercise significant influence over operating and financial policies of the investee, are carried under the equity method of accounting. Under this method, we initially record the investments at cost and periodically adjust the carrying values to
Bermuda/Dublin insurance-This segment offers property and casualty excess of loss capacity from our Bermuda and Dublin offices on specific risks related to individual insureds.
Invested assets relating to the Bermuda/Dublin insurance, Bermuda/Dublin reinsurance and life and annuity segments are managed on a consolidated basis. Consequently, investment income on this consolidated portfolio and gains on the hedge fund portfolio are not directly captured in any one of these segments. However, because of the longer duration of liabilities on casualty insurance and reinsurance business (as compared to property), and life and annuity reinsurance business, investment returns are important in evaluating the profitability of these segments. Accordingly, we allocate investment returns from the consolidated portfolio to each of these three segments. This is based on a notional allocation of invested assets from the consolidated portfolio using durations that are determined based on estimated cash flows into and out of each segment. The balance of investment returns from this consolidated portfolio is allocated to our corporate function for the purposes of segment reporting.
The loss ratio is calculated by dividing net losses and loss expenses (shown as (b)) by net premiums earned (shown as (a)). The combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses (shown as (c)) by net premiums earned (shown as (a)).
The combined ratio for 2009 was 75.6% compared to 88.2% in 2008. This 12.6 percentage point decrease was primarily due to a 13.8 percentage point decrease in the loss ratio.
Gross premiums written increased in 2009 by 9.9% to $427.8 million from $389.4 million in 2008. The increase in premiums in 2009 has principally been in our professional liability, aviation and property lines, where we have seen favorable market pricing and reduced market capacity, particularly in professional liability. In the excess liability line of business we have continued to see a more competitive pricing environment with additional capacity entering the market place. As a result we have been more selective in our excess liability renewals, focusing on business that meets our rate of return requirements. Gross
premiums written were relatively stable in 2008 compared to 2007, with an increase of 1.7%. This was due to growth in our aviation and modest growth in our professional liability business which was partially offset by the impact of increased competition on our excess liability business which has continued into 2009.
Net favorable development of $41.3 million; $21.0 million of which was recognized on professional liability and $7.1 million on general casualty lines of business, primarily on the 2005 and prior years, and $13.3 million on the short tail property and aviation lines of business from the 2008 and 2007 years. The net favorable development in 2008 was principally related to the property ($18.3 million) and aviation ($2.0 million) lines of business;
Excluding net favorable loss development, the 2009 loss ratio is 84.3% compared to 90.6% for the 2008 year;
The ratio of reinsurance premiums ceded to gross premiums written has continued to decrease from 52.8% in 2007 to 50.9% in 2008 and 49.6% in 2009. Reinsurance premiums ceded are principally related to our quota share treaties and tend to fluctuate in line with gross premiums written. The decrease in the percentage of reinsurance premiums ceded is principally due to changes in the mix of business.
General and administration expenses for the year ended December 31, 2009 increased $3.5 million compared to the same period in 2008. The improvement in the segment’s income before taxes in 2009 compared to the corresponding 2008 period resulted in increased incentive based compensation for the 2009 year. The 2009 year also includes increased expenses related to information technology, compared to the comparable 2008 period. The increase of $1.7 million in general and administrative
The 2009 loss ratio increased over the 2008 year by 1.6 percentage points to 65.6%. The increase in the 2009 loss ratio was principally attributable to lower net favorable prior year reserve development, offset by lower property catastrophe and per-risk losses compared to 2008. Significant items impacting the loss ratio were:
Excluding net favorable loss development, the 2009 loss ratio is 73.9% compared to 83.9% for the 2008 year;
There were $2.0 million of catastrophe-related losses in 2009, (representing 0.5 loss ratio points), compared to $47.0 million in 2008 (or 13.8 loss ratio percentage points).
The 2008 loss ratio was 8.6 percentage points higher than the 2007 loss ratio of 55.4%. The increase in the 2008 loss ratio was principally attributable to greater property catastrophe and per-risk losses compared to 2007, partly offset by greater favorable development on prior year loss reserves. Significant items impacting the 2008 loss ratio were:
The prior year net favorable loss development in 2008 was principally related to our professional liability ($25.8 million), property ($22.1 million), whole account ($15.1 million), and general casualty ($9.5 million) lines of business. The net favorable development in 2007 was principally related to our medical malpractice, professional liability and workers compensation lines of business, all of which had between $5.0 million and $10.0 million in favorable development, with most other lines of business having between $nil and $5.0 million in favorable development. . In both years the favorable development was partially offset by adverse development in the marine and energy line of business of $13.5 million in 2008 and $20.0 million in 2007. The majority of loss development in 2008 occurred on 2005 and prior years;
Excluding net favorable loss development, the 2008 loss ratio was 83.9% compared to 71.1% for the 2007 year;
Changes in reinsurance premium estimates resulted in a decrease in loss reserves of $17.0 million in 2008 compared to a decrease of $5.6 million in 2007.
General and administration expenses for the year ended December 31, 2009 increased $3.1 million compared to 2008. The improvement in the segment’s income before taxes in 2009 compared to 2008 resulted in increased incentive based compensation for 2009. The year ended December 31, 2009 also includes increased expenses related to information technology, compared to 2008. General and administrative expenses for the year ended December 31, 2008 were stable compared to the 2007 year.
Net investment income and net realized and unrealized gains on investments are discussed within the corporate function results of operations as we manage investments for this segment on a consolidated basis with the Bermuda/Dublin insurance and life and annuity reinsurance segments.
The combined ratio for the year ended December 31, 2009 was 99.5% compared to 138.5% in 2008. The significant improvement in the combined ratio is principally due to the growth of net premiums earned exceeding the growth in general and administrative expenses, as well as improvement in underwriting results.
Gross premiums written reflect the continued expansion of our U.S. platform including the writing of business in the full suite of licensed states during 2009. This build out of business resulted in a 46.9% increase in gross premiums written for 2009 over 2008. We anticipate gross premiums written to grow at a slower pace over the next few years. Reinsurance premiums ceded reflect the purchase of quota share and excess of loss reinsurance coverage to manage our retained exposure for risks underwritten. The ratio of
Gross premiums written and ceded increased substantially in 2008 compared to 2007 reflecting the initial growth of this segment in its first full year of operations.
General and administrative expenses principally comprise personnel and infrastructure costs. As expected, with the increasing scale of this segment, general and administrative expenses continue to decrease as a percentage of net premiums earned. Compared to our other segments this segment writes a higher volume of smaller-sized transactions. Due to the greater number of personnel required to generate and process the high volume of transactions we expect a higher general and administrative expense ratio in this segment compared to our other segments.
Our Max at Lloyd’s segment comprises all of our Lloyd’s-based operating businesses acquired on November 6, 2008. Because the 2008 comparative period was less than two months, any comparison between 2008 and 2009 may not be representative of future growth rates. Results for the Max at Lloyd’s segment include the underwriting operations of the Syndicates for which we record our proportionate share.
quarter of 2009 we added international casualty reinsurance and aviation insurance product lines, both written by Syndicate 1400. We expect these lines to be an area of profitable growth for the segment in 2010.
The loss ratio for the year ended December 31, 2009 was in line with our expectations for this segment. During the year there was net favorable development of prior year loss reserves of $6.1 million, with the majority from our professional liability line of business and the remainder from the property, financial institutions and accident and health lines of business. Net losses from property catastrophe events were $1.4 million during the year. In the absence of catastrophe losses, our property line of business, which is principally property catastrophe risks, and our accident and health lines of business, tend to have lower loss ratios than our financial institutions and professional liability lines of business. In this segment, the higher proportion of property and accident and health premiums compared to financial institutions and professional liability premiums generally results in a lower loss ratio than our other segments.
Net investment income, which excludes realized and unrealized gains and losses on Max at Lloyd’s trading portfolio, is comprised principally of interest on cash and fixed maturities investments held by the Syndicates. The average annualized investment yield on cash and fixed maturities for year ended December 31, 2009 was 1.48%. This segment held a higher ratio of cash and cash equivalents to fixed maturity securities than the rest of our group for the majority of 2009, resulting in a lower investment yield than our other segments. Late in the fourth quarter of 2009 we began to deploy some of this segment’s cash and cash equivalents into fixed maturity securities, which should improve the investment yield for this segment.
Apart from the components related to the contracts incepting during the years ended December 31, 2009, 2008 and 2007, gross premiums written, reinsurance premiums ceded, net premiums earned, acquisition costs and general and administrative expenses represent ongoing premium receipts or adjustments and related administration expenses on existing contracts. Interest expense relates to interest on funds withheld on the variable quota share retrocession agreement with Grand Central Re and on certain deposit liabilities. The interest expense on funds withheld from Grand Central Re is based on the average of two total return fixed maturity indices, which varies from period to period.
Claims and policy benefits were $101.1 million for the year ended December 31, 2009 compared to $301.5 million and $345.6 million for the years ended December 31, 2008 and 2007, respectively. Excluding the reinsurance contracts incepting during each year, claims and policy benefits were $59.0 million for the year ended December 31, 2009 compared to $61.9 million and $46.3 million for the years ended December 31, 2008 and 2007, respectively.
All other items represent the portion not allocated or discussed in the results of operations of our other segments.
All but one of the hedge fund portfolio strategies we employed experienced negative returns during the year ended December 31, 2008. The largest contributors by investment strategy to the loss in 2008 were the long/short equity and the event-driven arbitrage strategies. As of December 31, 2008, 38.5% and 9.9% of our hedge fund portfolio was allocated to long/short equity and event-driven arbitrage strategies, respectively.
Our available for sale portfolio is recorded at fair value with unrealized gains and losses recorded in other comprehensive income as part of total shareholders’ equity. Our available for sale fixed maturities investment strategy is not intended to generate significant realized gains and losses as more fully discussed below in the Financial Condition section. Our held to maturity portfolio includes securities for which we have the ability and intent to hold to maturity or redemption, and is recorded at amortized cost. There should be no realized gains or losses related to this portfolio unless there is an other than temporary impairment loss. Our trading portfolio is recorded at fair value with unrealized gains and losses recorded in net income, all of which are reported within our Max at Lloyd’s segment. Net realized and unrealized gains (losses) on our fixed maturities portfolios for the years ended December 31, 2009, 2008 and 2007, were $4.5 million, $(2.0) million and $(2.9) million, respectively.
Net realized and unrealized losses on fixed maturities for the year ended December 31, 2007 includes $1.7 million of realized losses resulting from the sale of fixed maturities triggered by the closing of a restricted account upon the commutation of a reinsurance contract.
The change in fair value of investment derivatives for the year ended December 31, 2009 of $0.8 million related to equity call options embedded in certain convertible fixed maturity securities.
Interest expense. Interest expense principally reflects interest on our bank loans and senior notes outstanding. The 51.4% decrease in interest expense for the year ended December 31, 2009 compared to 2008, is principally attributable to the repayment of $150.0 million in bank loans in April 2009 and the $225.0 million repayment of the swap loan in August 2009. The remaining debt at December 31, 2009 comprises $90.6 million in senior notes outstanding that bear interest at 7.20%.
Interest expense for 2008 decreased by 8.8% compared to 2007 primarily due to the impact of decreased LIBOR interest rates, partially offset by the $36.6 million increase in outstanding debt as of December 31, 2008 compared to December 31, 2007.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2009 increased $1.4 million compared to 2008, principally due to a higher level of expense related to information technology. We consider information technology to be a critical component of our business and we expect to make recurring and often significant investments in upgrading and maintaining our technology infrastructure in future years. Some of these costs are retained in the corporate function; however the majority of these costs are allocated to the relevant segments.
Cash and invested assets. Aggregate invested assets, comprising cash and cash equivalents, fixed maturities and other investments, were $5,259.1 million at December 31, 2009 compared to $5,356.9 million at December 31, 2008, a decrease of 1.8%. The decrease in cash and invested assets resulted principally from the settlement of claims and the repayment of bank loans during the period, partially offset by positive cash flow from the growth in net premiums written.
We own an available for sale portfolio, a trading portfolio, and a held to maturity portfolio of fixed maturities securities.
To match the more predictable cash flow requirements of our long term liabilities, we invest a portion of our fixed maturities investments in long duration securities. Because we have the intent to hold certain of these securities to maturity, we reclassified those securities into a held to maturity portfolio during 2009. This held to maturity portfolio is recorded at amortized cost rather than at fair value, which should reduce the impact on shareholders’ equity of fluctuations in fair value of those investments.
Fixed maturities are subject to fluctuations in fair value due to changes in interest rates, changes in issuer specific circumstances, such as credit rating changes, and changes in industry specific circumstances, such as movements in credit spreads based on the market’s perception of industry risks. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolios is to tailor the maturities of the portfolios to the timing of expected loss and benefit payments. At maturity, absent any credit loss, a fixed maturity’s amortized cost will equal its fair value and no realized gain or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell available for sale fixed maturity securities before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period.
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 regular reviews of our fixed maturities portfolio and utilize a process that considers numerous indicators in order to identify investments that are showing 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 is a greater risk of defaults on mortgage-backed and asset-backed securities and collateralized mortgage obligations, especially those that are non-investment grade. These factors make the estimate of fair value 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 at December 31, 2009.
A discussion of our process for estimating other-than-temporary impairments is included in Note 3 of our audited consolidated financial statements.
Fair value prices for all securities in our fixed maturities portfolio, which are carried at fair value, are independently provided by both our investment custodians and our investment managers, which each utilize internationally recognized independent pricing services. We record the unadjusted price provided by the investment custodians and our validation process includes, but is not limited to: (i) comparison to the price provided by the investment manager, with significant differences investigated; (ii) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (iii) evaluation of methodologies used by external parties to calculate fair value; and (iv) comparing the price to our knowledge of the current investment market.
The independent pricing services used by our investment custodians 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, but not limited to, reported trades, benchmark yields, broker/dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from
We have designed ongoing due diligence processes with respect to funds 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. Such adjustments may involve significant judgment. We obtain the audited financial statements for every fund annually, and regularly review and discuss the fund performance with the fund managers to corroborate the reasonableness of the reported net asset values.
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. Based upon information provided by the fund managers, as of December 31, 2009, we estimate that over 74% (2008-87.0%) of the underlying assets held by our hedge fund investment portfolio are traded securities or have broker quotes available. Typically, the imposition of a gate delays a portion of the requested redemption, with the remaining portion settled in cash shortly after the redemption date. Of our December 31, 2009 outstanding redemptions receivable of $79.1 million (2008-$98.1 million), none of which are gated, $64.0 million were received in cash prior to February 12, 2010. The fair value of our holdings in funds with gates imposed as at December 31, 2009 was $41.8 million (2008-$42.7 million).
Certain funds may be allowed to invest a portion of their assets in illiquid securities, such as private equity and convertible debt. In such cases, a common mechanism used is a side-pocket, whereby the illiquid security is assigned to a separate memorandum capital account or designated account. Typically, the investor loses its redemption rights to the designated account. Only when the illiquid security is sold, or otherwise deemed liquid by the fund, may investors redeem their interest. As at December 31, 2009, the fair value of our hedge funds held in side-pockets is $99.8 million (2008-$113.4 million).
Due to the uncertainty surrounding the timing of the redemption of the underlying assets within side-pockets and funds with gates imposed we have included these funds in the greater than 365 days category in the table below.
Had 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, 2009, on which such redemptions might be received. This estimate is based on available information from the funds and is subject to significant change.
Additional information about the hedge fund portfolio can be found in Note 3 and Note 4 to our audited consolidated financial statements included herein.
Losses and benefits recoverable from reinsurers. Losses and benefits recoverable from reinsurers totaled $1,001.4 million at December 31, 2009 compared to $846.6 million at December 31, 2008, an increase of 18.3%, principally reflecting losses ceded under our reinsurance and retrocessional agreements resulting from net earned premiums during the year ended December 31, 2009.
At December 31, 2009, 83.6% of our losses recoverable were with reinsurers rated “A” or above by A.M. Best and 5.3% are rated “A-”. Grand Central Re, a Bermuda domiciled reinsurance company in which Max Bermuda has a 7.5% equity investment, is our largest “NR-not rated” retrocessionaire and accounted for 10.1% of our losses recoverable at December 31, 2009. As security for outstanding loss obligations, we retain funds from Grand Central Re amounting to 108.0% of its loss recoverable obligations. The remaining 1.0% of losses recoverable are with “B+” rated or lower reinsurers.
Liabilities for property and casualty losses. Property and casualty losses totaled $3,178.1 million at December 31, 2009 compared to $2,938.2 million at December 31, 2008, an increase of 8.2%. The increase in property and casualty losses was principally attributable to estimated losses associated with premiums earned during the year ended December 31, 2009 partially offset by amounts paid on property and casualty losses and releases of
Liabilities for life and annuity benefits. Life and annuity benefits totaled $1,372.5 million at December 31, 2009 compared to $1,367.0 million at December 31, 2008. The increase was principally attributable to the reinsurance contract written in the year ended December 31, 2009, which increased life and annuity benefits by $42.1 million, together with foreign exchange movements, partially offset by benefit payments. During the year ended December 31, 2009, we paid $126.0 million of benefit payments.
Bank loans. As described in Note 11 to our consolidated financial statements included herein, we repaid $375.0 million of bank loans during the year. The $150.0 million borrowed under our revolving credit facility was fully repaid in April 2009 and the swap loan, which had a balance of $225.0 million at December 31, 2008 was repaid in full by September 30, 2009.
Senior notes. On April 16, 2007, Max 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 Max USA’s senior unsecured obligations and rank equally in right of payment with all existing and future senior unsecured indebtedness of Max USA. The senior notes are fully and unconditionally guaranteed by Max Capital. The effective interest rate related to the senior notes, based on the net proceeds received, was approximately 7.27%. The net proceeds from the sale of the senior notes were $99.5 million, and they were used to repay the $100.0 million short-term borrowing of Max USA under the revolving credit facility.
On December 10, 2009, Max USA repurchased $0.9 million principal amount of these notes for a purchase price of $0.8 million, recognizing a gain of $0.1 million. The principal amount of the senior notes outstanding at December 31, 2009 is $90.6 million. On December 30, 2008, Max USA repurchased $8.5 million principal amount of these notes, recognizing a gain of $2.2 million.
Shareholders’ equity. Our shareholders’ equity increased to $1,564.6 million at December 31, 2009 from $1,280.3 million at December 31, 2008, an increase of 22.2%, principally due to the net income of $246.2 million and an increase in accumulated other comprehensive income of $70.8 million. The increase in accumulated other comprehensive income was due to improvements in fair value of our available for sale investment portfolio, and the impact of the weakening of the US dollar against the Euro and British pound during the year. These increases were partially offset by the payments of dividends of $21.7 million and the repurchase of common shares of $34.3 million during the year ended December 31, 2009.
The casualty business we write generally has a long claim-tail, and we expect that we will generate significant operating cash flow as we accumulate property and casualty loss reserves and life and annuity benefit reserves on our balance sheet. As we continue to diversify into property business, which generally has a short claim-tail, and as losses are incurred, we expect potential volatility in our operating cash flow levels. We believe that our property and casualty loss reserves and life and annuity benefit reserves currently have an average duration of approximately 5.1 years and we expect to see increases in the amount of expected loss payments in future periods with a resulting decrease in operating
cash flow. We do not expect loss payments to exceed the premiums generated and therefore expect to have continued positive cash flow. However, actual premiums written and collected and losses and loss expenses paid in any period could vary from our expectations and could have a significant and adverse effect on operating cash flow.
While we tailor our fixed maturities portfolios to match the duration of expected loss and benefit payments, increased loss amounts or settlement of losses and benefits earlier than anticipated can result in greater cash needs. We maintain a significant working cash balance and have generated positive cash flow from operations in each of our last eight years of operating history. In recent years our allocation of invested assets to cash has increased as we have elected to maintain a larger cash position in the current investment environment. Our cash and cash equivalents balance is $702.3 million at December 31, 2009. We believe that we currently maintain sufficient liquidity to cover existing requirements and provide for contingent liquidity. Nonetheless, it is possible that significant deviations in expected loss and benefit payments can occur, potentially requiring us to liquidate a portion of our fixed maturities portfolios. If we need to liquidate our fixed maturities securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated at December 31, 2009. We believe that most of our portfolio has sufficient liquidity to mitigate this risk, and we believe that we can continue to hold any potentially illiquid position until we can initiate an appropriately priced transaction.
As a holding company, Max Capital’s principal assets are its investments in the common shares of its principal subsidiary, Max Bermuda, and its other subsidiaries. Max Capital’s principal source of funds is from interest income on cash balances and cash dividends from its subsidiaries, including Max Bermuda. The payment of dividends is limited under Bermuda insurance laws. In particular, Max 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. At December 31, 2009, Max Bermuda had approximately $1,425.0 million in statutory capital and surplus and met all minimum solvency and liquidity requirements. Max Bermuda returned $50.0 million of capital and surplus to Max Capital during the year ended December 31, 2009.
In December 2009 we entered into a pre-arranged stock trading plan to repurchase our common shares through a brokerage account. The stock trading plan is intended to be in accordance with guidelines specified under Rule 10b5-1 of the Securities and Exchange Act of 1934. Rule 10b5-1 allows public companies to adopt written, pre-arranged stock trading plans when they do not have material, non-public information in their possession. Pursuant to the plan, we may purchase up to $35.0 million of our common shares on the open market from time to time until April 30, 2010, subject to market conditions and other factors.
Max Capital’s board of directors declared the following dividends during 2009 and the first quarter of 2010:
ASU 2009-05, Fair Value Measurements and Disclosures (820)-Measuring Liabilities at Fair Value
ASU 2009-05 allows companies determining the fair value of a liability to use the perspective of an investor that holds the related obligation as an asset. The guidance was effective for interim and annual periods beginning after August 27, 2009 and applied to all fair value measurements of liabilities. This accounting standards update did not have a material impact on our consolidated financial statements.
On July 1, 2009, the FASB launched its Accounting Standards Codification (the “Codification”). The Codification became the sole source of authoritative U.S. GAAP for interim and annual periods ending after September 15, 2009. Other than resolving certain minor inconsistencies in current U.S. GAAP, the Codification does not change U.S. GAAP, but is intended to make it easier to find and research U.S. GAAP applicable to a particular transaction or specific accounting issue. The Codification did not have a material impact on our consolidated financial statements.
In April 2009, the FASB issued guidance regarding the recognition and presentation of other-than-temporary impairments. This guidance amends the other-than-temporary impairment guidance in U.S. GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. The guidance changes the amount of other-than-temporary impairment that is recognized in earnings when there are credit losses on a debt security for which management does not intend to sell and for which it is more-likely-than-not that the entity will not have to sell prior to recovery of the non-credit impairment. In those situations, the portion of the total impairment that is attributable to the credit loss would be recognized in earnings, and the remaining difference between the debt security’s amortized cost basis and its fair value would be included in other comprehensive income. The guidance was effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We adopted the FASB guidance on April 1, 2009 and it did not have a material impact on our consolidated financial statements.
Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly
In April 2009, the FASB issued guidance regarding the determination of fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly. This guidance also provides additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased and for identifying circumstances that indicate a transaction is not orderly. The guidance was effective for interim and annual reporting periods ending after June 15, 2009, to be applied prospectively. We adopted the FASB guidance on April 1, 2009 and it did not have a material impact on our consolidated financial statements.