Due to the global financial crisis, during 2008 White Mountains experienced significant decreases in: realized and unrealized investment returns reported in revenues; net income; total assets; and adjusted book value per share.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2012, 2011 and 2010
OneBeacon's book value per share decreased 0.8% during 2012, including dividends. OneBeacon's 2012 results included $101 million of after-tax GAAP losses related to the sale of its Runoff Business, which resulted in a decrease of $12 to White Mountains’ adjusted book value per share (net of non-controlling interest). OneBeacon's GAAP combined ratio was 98% for 2012 compared to 92% for 2011. The increase was primarily driven by higher catastrophe losses, mainly from hurricane Sandy, lower favorable loss reserve development and higher expenses. Sirius Group's GAAP combined ratio was 90% for 2012 compared to 100% for 2011. Sirius Group’s combined ratio for 2012 included 13 points of catastrophe losses, 11 points of which were from hurricane Sandy, compared to 24 points of catastrophe losses for 2011. Additionally, Sirius Group’s combined ratio for 2012 included 3 points of losses from its agricultural line of business, primarily as a result of the drought in the midwestern United States.
White Mountains’ GAAP investment return was 4.9% in 2012. The fixed income portfolio return (in local currencies) of 3.8% was higher than the Barclay’s Intermediate Aggregate Bond Index return of 3.6%, despite significantly less duration risk, while the equity portfolio return was 7.7% compared to the S&P 500 Index return of 16.0%. In addition, adjusted book value per share increased $10 in 2012 from share repurchases and $3 from foreign currency translation.
Effective January 1, 2013, Sweden reduced its corporate tax rate from 26.3% to 22.0%, and Luxembourg increased its corporate tax rate from 28.8% to 29.2%. This resulted in a reduction in Sirius Group's net deferred tax liabilities in Sweden and an increase in Sirius Group's net deferred tax assets in Luxembourg at December 31, 2012. In addition, during the quarter Sirius Group had a net release of valuation allowances on deferred tax assets in Luxembourg and White Mountains established a valuation allowance on deferred tax assets of a group of U.S. companies reported in the Other Operations segment. In total, these changes resulted in an increase to adjusted book value per share of $13 in the fourth quarter of 2012.
Overview-Year Ended December 31, 2011 versus Year Ended December 31, 2010
White Mountains’ GAAP investment return was 2.9% in 2011. The fixed income portfolio return (in local currencies) of 3.1% was lower than the Barclay’s Intermediate Aggregate Bond Index return of 6.0%, as the fixed income portfolio trailed the longer-duration benchmark as rates declined. The equity portfolio return was 1.4% compared to the S&P 500 Index return of 2.1%.
In addition, adjusted book value per share increased $17 in 2011 from the release of a valuation allowance against deferred tax assets in two Luxembourg subsidiaries and $5 from share repurchases. Also, adjusted book value per share decreased $6 in 2011 from a GAAP other-than-temporary impairment write-down on the investment in Symetra common shares. White Mountains concluded that the accounting impairment on its investment in Symetra common shares existed due to the prolonged low interest rate environment in which life insurance companies operate and not from reasons specific to Symetra itself. As a result, White Mountains does not believe that the accounting impairment equates to an impairment in Symetra's long-term intrinsic business value. See CRITICAL ACCOUNTING ESTIMATES - White Mountains’ Investment in Symetra Common Shares on page 100 for a more detailed discussion. Foreign currency translation did not have a significant impact on adjusted book value per share in 2011.
(2) Adjusted comprehensive income is a non-GAAP measure. For a reconciliation to the most comparable GAAP measure (see NON-GAAP MEASURES on page 73).
White Mountains’ total expenses increased 5% to $2,173 million in 2012 compared to $2,075 million in 2011. Losses and LAE expenses increased 2% and insurance and reinsurance acquisition expenses increased by 7%, driven by increased business volume. The increase in loss and LAE expenses was partially offset by lower catastrophe losses. Other underwriting expenses increased 20%, driven by increased business volume, start-up costs for new specialty businesses at OneBeacon and the migration of OneBeacon’s corporate functions to Minnesota. General and administrative expenses were $172 million in 2012, which includes $20 million in expenses from the consolidation of BAM, compared to $167 million in 2011. Excluding the $20 million of expenses related to BAM, general and administrative expenses decreased 9% in 2012, primarily due to lower incentive compensation expenses. 2011 included a higher level of incentive compensation expenses as a result of the gain from the Esurance Sale and a 35% increase in White Mountains’ stock price during 2011 compared to a 14% increase in 2012. Interest expense on debt decreased 19% to $45 million in 2012 compared to $55 million in 2011, primarily due to reductions of outstanding debt resulting from repurchases of the 2003 OBH Senior Notes.
White Mountains’ total revenues decreased 7% to $2,173 million in 2011 compared to $2,334 million in 2010, primarily due to lower earned insurance premiums, net investment income, net investment gains and other revenues. Earned premiums were down 5% to $1,925 million in 2011, due primarily to a 14% decrease at OneBeacon, which was driven by the sale of its personal lines business in 2010. Excluding the $202 million of earned premiums in 2010 related to OneBeacon’s personal lines business, earned premiums were up 5% in 2011, with a 3% increase at OneBeacon and an 8% increase at Sirius Group. Net investment income was down 12% to $185 million in 2011, due primarily to lower fixed maturity yields and a reduction in invested assets from the sale of OneBeacon’s personal lines business in 2010, repurchases of a portion of the 2003 OBH Senior Notes and share repurchases. White Mountains reported net realized and unrealized investment gains of $74 million in 2011 compared to $78 million in 2010. Net realized and unrealized investment gains for both periods were significantly impacted by foreign currency translation on U.S. dollar-denominated investments at Sirius International, the effects of which are offset in other comprehensive income (see “Impact of Foreign Currency on Investment Returns” on page 59). Other revenues decreased to a loss of $10 million in 2011 from a gain of $18 million in 2010, due primarily to foreign currency translation losses and higher mark-to-market losses on the Symetra warrants, partially offset by lower losses reported by WM Life Re. Other revenues included a $16 million loss from WM Life Re in 2011 compared to a $45 million loss in 2010. Other revenues in 2011 also included a $7 million pre-tax gain from Sirius Group’s acquisition of Old Lyme, while other revenues in 2010 included a $13 million pre-tax gain from Sirius Group’s acquisition of Central National.
The Company and its Bermuda-domiciled subsidiaries are not subject to Bermuda income tax under current Bermuda law. In the event there is a change in the current law such that taxes are imposed, the Company and its Bermuda-domiciled subsidiaries would be exempt from such tax until March 31, 2035, pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966. The Company has subsidiaries and branches that operate in various other jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The jurisdictions in which the Company’s subsidiaries and branches are subject to tax are Australia, Belgium, Canada, Germany, Gibraltar, Luxembourg, the Netherlands, Singapore, Sweden, Switzerland, the United Kingdom and the United States.
The income tax expense related to pre-tax income for 2010 represented an effective tax rate of 16.0%, which was lower than the U.S. statutory rate of 35% due primarily to income generated in jurisdictions other than the United States.
White Mountains conducts its operations through four segments: (1) OneBeacon, (2) Sirius Group, (3) HG Global/BAM and (4) Other Operations. While investment results are included in these segments, because White Mountains manages the majority of its investments through its wholly-owned subsidiary, WM Advisors, a discussion of White Mountains’ consolidated investment operations is included after the discussion of operations by segment. White Mountains’ segment information is presented in Note 14 -“Segment Information” to the Consolidated Financial Statements.
Financial results and GAAP combined ratios for OneBeacon for the years ended December 31, 2012, 2011 and 2010 follow:
OneBeacon’s other revenues in 2012 included a $6 million loss related to the repurchase of its 2003 OBH Senior Notes, offset in part by a $5 million gain on the sale of a shell company, Pennsylvania General Insurance. OneBeacon’s other revenues in 2011 included a $12 million loss related to the partial redemption of a portion of the 2003 OBH Senior Notes.
OneBeacon’s losses and LAE expenses increased 19% and insurance and reinsurance acquisition expenses increased by 13%, driven by increased business volume. The increase in loss and LAE expenses was also partially due to higher catastrophe losses, driven by hurricane Sandy. Other underwriting expenses increased 26%, driven by increased business volume, start-up costs for new specialty businesses at OneBeacon and the migration of OneBeacon’s corporate functions to Minnesota. Interest expense decreased 18% to $17 million in 2012, reflecting lower outstanding debt.
Reinsurance protection. OneBeacon purchases reinsurance in order to minimize loss from large risks or catastrophic events. OneBeacon also purchases individual property reinsurance coverage for certain risks to reduce large loss volatility through property-per-risk excess of loss reinsurance programs and individual risk facultative reinsurance. OneBeacon also maintains excess of loss casualty reinsurance programs that provide protection for individual risk or catastrophe losses involving workers compensation, general liability, automobile liability, professional liability or umbrella liability. The availability and cost of reinsurance protection is subject to market conditions, which are outside of management’s control. Limiting risk of loss through reinsurance arrangements serves to mitigate the impact of large losses; however, the cost of this protection in an individual period may exceed the benefit.
OneBeacon’s net combined ratio for 2012 was lower than its gross combined ratio by 1 point, primarily due to the significant amount of reinsurance cessions related to hurricane Sandy, which were partially off-set by the impact of the cost of facultative reinsurance and property reinsurance, and also the cost of catastrophe reinsurance and marine reinsurance. OneBeacon’s net combined ratio for 2011 was higher than its gross combined ratio by 4 points, primarily due to the impact of the cost of facultative reinsurance and property reinsurance, and also the cost of catastrophe reinsurance and marine reinsurance.
OneBeacon Results-Year Ended December 31, 2011 versus Year Ended December 31, 2010
OneBeacon's other revenues in 2011 included a $12 million loss related to the repurchase of a portion of the 2003 OBH Senior Notes. OneBeacon's other revenues in 2010 included a $9 million net gain on the sale of OneBeacon’s personal lines business, partially offset by an $11 million loss related to the repurchase of a portion of the 2003 OBH Senior Notes.
Reinsurance protection. OneBeacon’s net combined ratio for 2011 was higher than its gross combined ratio by 4 points, primarily due to the impact of the cost of facultative reinsurance and property reinsurance, and also the cost of catastrophe reinsurance and marine reinsurance. OneBeacon’s net combined ratio for 2010 was higher than its gross combined ratio by 4 points, primarily due to the impact of the cost of catastrophe reinsurance and facultative reinsurance.
Sirius Group's GAAP combined ratio was 90% for 2012 compared to 100% for 2011. The decrease was primarily due to lower catastrophe losses, as the 2012 combined ratio included 13 points ($117 million) of catastrophe losses net of reinsurance and reinstatement premiums, primarily due to $98 million of losses from hurricane Sandy, compared to 24 points ($218 million) in 2011, primarily due to the Japan earthquake and tsunami, the New Zealand earthquakes and the floods in Thailand. Additionally, the 2012 combined ratio included 3 points of agricultural losses principally as a result of the drought in the midwestern United States. Favorable loss reserve development was 4 points for 2012. The major reductions in loss reserve estimates were recognized in casualty runoff ($32 million), property ($28 million), marine/energy ($12 million), trade credit ($7 million) and aviation/space ($5 million) lines, partially offset by a $46 million increase in asbestos and environmental loss reserves and a $4 million increase in accident and health. Favorable loss reserve development was 5 points for 2011 and was primarily attributable to $41 million of favorable development on property lines, partially offset by asbestos and environmental increases of $12 million.
Sirius Group's other revenues primarily consisted of $40 million of foreign currency translation gains recorded in 2012 compared to foreign currency translation losses of $6 million in 2011. (See Impact of Foreign Currency on Investment Returns of on page 59.) Additionally, Sirius Group recorded pre-tax transaction gains of $14 million from White Mountains Solutions’ acquisitions of PICO, Citation, American General and American General Property and $15 million on the sale of its interest in an affiliate, IMG, a managing general underwriter in the medical and travel business. In 2011, Sirius Group recorded a $7 million pre-tax gain from White Mountains Solutions’ acquisition of the loss reserve portfolio of Old Lyme.
(1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under Statutory accounting, they are classified as Surplus.
Surplus Notes until it has been approved for payment by insurance regulators.
A summary of White Mountains’ financial results from its Other Operations segment for the years ended December 31, 2012, 2011 and 2010 follows:
Other Operations Results-Year December 31, 2012 versus Year Ended December 31, 2011
White Mountains’ Other Operations segment reported pre-tax income of $8 million in 2012 compared to a pre-tax loss of $103 million in 2011. The improvement in the 2012 results was driven by an improvement in the mark-to-market performance of the Symetra warrants, higher pre-tax income from investments, lower incentive compensation expenses and lower losses from WM Life Re. 2011 included a higher level of incentive compensation expenses as a result of the gain from the Esurance Sale and a 35% increase in White Mountains’ stock price during 2011 compared to a 14% increase in 2012. The value of White Mountains' investment in Symetra warrants increased $18 million in 2012 compared to a decrease of $25 million in 2011. WM Life Re reported pre-tax loss of $19 million in 2012 compared to pre-tax loss of $27 million in 2011. See Note 8 - Variable Annuity Reinsurance for details regarding WM Life Re’s total impact on White Mountains’ statement of operations.
White Mountains’ Other Operations segment reported pre-tax loss of $103 million in 2011 compared to a pre-tax loss of $100 million in 2010. The increase in the pre-tax loss in 2011 was driven by higher mark-to-market losses on the Symetra warrants and higher incentive compensation expenses, partially offset by lower losses from WM Life Re.
The value of White Mountains’ investment in Symetra warrants decreased $25 million in 2011 compared to a decrease of $1 million in 2010. WM Life Re reported pre-tax losses $27 million 2011 compared to $61 million of pre-tax loss in 2010. During the fourth quarter of 2011, WM Life Re reported approximately $13 million of losses from changes in assumptions used to calculate the value of its variable annuity guarantee liabilities, including a $7 million loss due to lower surrender assumptions. During 2010, WM Life Re reported $48 million in losses from reductions in surrender assumptions.
Investment Returns-Year Ended December 31, 2012 versus Year Ended December 31, 2011
White Mountains’ GAAP pre-tax total return on invested assets was 4.9% for 2012, which includes 0.5% of foreign currency gains, compared to 2.9% for 2011, which includes 0.2% of foreign currency losses. White Mountains’ high-quality, short-duration, fixed income portfolio returned 4.4% (3.8% in local currencies) for 2012, outperforming the Barclays U.S. Intermediate Aggregate Index return of 3.6%. White Mountains’ fixed income portfolio returned 3.1% for 2011, trailing the benchmark of 6.0% as rates declined during 2011. White Mountains’ value-oriented equity portfolio, approximately 19% of GAAP invested assets at December 31, 2012, returned 7.7% for 2012, compared to the S&P 500 Index return of 16.0%, while the equity portfolio returned 1.4% in 2011, compared to the S&P 500 Index return of 2.1%. The underperformance against the benchmark in both periods reflects large positions in other long-term investments and convertible fixed maturity investments (as opposed to common equity securities), which tend to lag the index in strong markets. It also reflects underweight exposure in common equity and convertible securities to the technology, consumer discretionary, and industrial sectors and an overweight position in materials, in particular gold mining stocks, relative to the S&P 500 Index.
Net investment income was down 12% to $185 million in 2011, due primarily to lower fixed maturity yields and a lower invested asset base in the first nine months of 2011, partially offset by the effect of the increase in invested assets during the fourth quarter of 2011 as a result of the Esurance Sale.
During 2012, White Mountains recorded $30 million in after-tax equity in earnings from its investment in Symetra's common shares, which increased the value of the investment in Symetra's common shares used in the calculation of White Mountains' adjusted book value per share to $16.58 per Symetra common share at December 31, 2012, compared to Symetra's quoted stock price of $12.98 and Symetra's book value per common share excluding unrealized gains and losses from its fixed maturity investment portfolio of $18.97.
White Mountains accounts for its investment in common shares of Symetra using the equity method. Under the equity method, the GAAP carrying value of White Mountains' investment in Symetra common shares is normally equal to the percentage of Symetra's GAAP book value represented by White Mountains' common share ownership, which was 15% at December 31, 2012 and 2011. At December 31, 2011, White Mountains concluded that its investment in Symetra common shares was other-than-temporarily impaired and wrote down the GAAP book value of the investment to its estimated fair value of $261 million, or $15 per share at December 31, 2011, which resulted in $46 million of after-tax equity in losses of unconsolidated affiliates and $137 million of after-tax equity in net unrealized losses of unconsolidated affiliates. The write-down reduced adjusted book value per share by approximately $6. Under GAAP, a decline in the fair value of an investment is considered to be other-than-temporary when the fair value of the investment is not expected to recover to its GAAP carrying value in the near term. White Mountains concluded that the accounting impairment on its investment in Symetra common shares existed due to the prolonged low interest rate environment in which life insurance companies currently operate and not from reasons specific to Symetra itself. As a result, White Mountains does not believe that the accounting impairment equates to an impairment in Symetra's long-term intrinsic business value. See “White Mountains’ Investment in Symetra Common Shares” under CRITICAL ACCOUNTING ESTIMATES on page 100.
A summary of the impact of foreign currency translation on White Mountains’ consolidated financial results for the years ended December 31, 2012, 2011 and 2010 follows:
Net realized and unrealized investment (losses) gains - foreign currency (1)
Sirius International holds a large portfolio of investments that are denominated in U.S. dollars, but its functional currency is the Swedish kronor. When Sirius International prepares its stand-alone GAAP financial statements, it translates its U.S. dollar-denominated investments to Swedish kronor and recognizes the related foreign currency translation gains or losses through income. When White Mountains consolidates Sirius International, it translates Sirius International’s stand-alone GAAP financial statements to U.S. dollars and recognizes the foreign currency gains or losses arising from this translation, including those associated with Sirius International’s U.S. dollar-denominated investments, through other comprehensive income. Since White Mountains reports its financial statements in U.S. dollars, there is no net effect to adjusted book value per share or to investment returns from foreign currency translation on its U.S. dollar-denominated investments at Sirius International. However, net realized and unrealized investment gains, other revenues and other comprehensive income can be significantly affected during periods of high volatility in the foreign exchange rate between the U.S. dollar and the Swedish kronor.
The amount of foreign currency translation on Sirius International’s U.S. dollar denominated investments recognized as a decrease of net income and an increase of other comprehensive income was $40 million in 2012. The amount of foreign currency translation on Sirius International’s U.S. dollar denominated investments recognized as an increase of net income and decrease of other comprehensive income was $25 million in 2011. The amount of foreign currency translation on Sirius International’s U.S. dollar denominated investments recognized as a decrease of net income and an increase of other comprehensive income was $49 million in 2010.
(1) Carrying value includes $338.1 and $111.8 as of December 31, 2012 and 2011 that is classified as assets held for sale relating to discontinued operations.
The breakdown of White Mountains’ fixed maturity and convertible fixed maturity investments at December 31, 2012 by credit class, based upon issue credit ratings provided by Standard & Poor’s, or if unrated by Standard & Poor’s, long term obligation ratings provided by Moody’s, is as follows:
Includes mortgage-backed securities which carry the full faith and credit guaranty of the U.S. government (i.e., GNMA) or are guaranteed
White Mountains’ overall fixed maturity investment strategy is to purchase securities that are attractively priced in relation to their investment risks. White Mountains also actively manages the average duration of the portfolio. The weighted average duration of White Mountains’ fixed maturity portfolio at December 31, 2012 was approximately 2.4 years, including short-term investments, and approximately 2.7 years excluding short-term investments.
The cost or amortized cost and carrying value of White Mountains’ fixed maturity and convertible fixed maturity investments at December 31, 2012 is presented below by contractual maturity. Actual maturities could differ from contractual maturities because borrowers may have the right to call or prepay certain obligations with or without call or prepayment penalties.
The following tables list White Mountains’ investments in fixed maturities, common equities and convertible fixed maturities at December 31, 2012 categorized as financial or non-financial investments and by country of issue:
During 2012, OneBeacon's top tier regulated insurance operating subsidiaries paid $173 million of dividends to their immediate parent, which included the distribution of a regulated insurance subsidiary with a value of $34 million.
During 2012, OneBeacon Ltd. paid $80 million of regular quarterly dividends to its common shareholders. White Mountains received $60 million of these dividends.
At December 31, 2012, OneBeacon Ltd. and its intermediate holding companies had $272 million of net unrestricted cash, short-term investments and fixed maturity investments and $33 million of common equity securities and convertible fixed maturity investments outside of its regulated and unregulated insurance operating subsidiaries.
Sirius America has the ability to pay dividends during any twelve-month period without the prior approval of regulatory authorities in an amount set by formula based on the lesser of net investment income, as defined by statute, or 10% of statutory surplus, in both cases as most recently reported to regulatory authorities, subject to the availability of earned surplus. Based upon 2012 statutory net investment income, Sirius America has the ability to pay $15 million of dividends during 2013 without prior approval of regulatory authorities, subject to the availability of earned surplus. At December 31, 2012, Sirius America had $56 million of earned surplus and $528 million of statutory surplus. In 2012, Sirius America paid $55 million of dividends to its immediate parent.
· An intermediate holding company of Sirius Group contributed the remaining shares of Sirius America with a GAAP book value of $436 million to Sirius International, which subsequently owned 100% of the shares of Sirius America;
In connection with Sirius Group's reorganization in October 2011, Sirius International and Sirius America entered into a capital maintenance agreement, which obligates Sirius International to make contributions to Sirius America's surplus in order for Sirius America to maintain surplus equal to at least 125% of the company action level risk based capital as defined in the NAIC Property/Casualty Risk-Based Capital Report. The agreement provides for a maximum contribution to Sirius America of $200 million. Sirius International also provides Sirius America with accident year stop loss reinsurance, which protects Sirius America's accident year loss and allocated loss adjustment expense ratio in excess of 70%, with a limit of $110 million.
Insurance float as a multiple of White Mountains’ common shareholders’ equity
Net investment assets as a multiple of White Mountains’ common shareholders’ equity
(1) The non-controlling interest arising from White Mountains’ investments in consolidated limited partnerships has not been included in total capital because White Mountains does not have the ability to utilize the assets supporting this non-controlling interest in its insurance operations or in support of its debt obligations.
The non-controlling interest arising from White Mountains’ investments in consolidated limited partnerships has not been included in total
capital because White Mountains does not have the ability to utilize the assets supporting this non-controlling interest in its insurance
Reserve” on page 66) of $327 and $370 at December 31, 2012 and 2011,
Management believes that White Mountains has the flexibility and capacity to obtain funds externally as needed through debt or equity financing on both a short-term and long-term basis. However, White Mountains can provide no assurance that, if needed, it would be able to obtain additional debt or equity financing on satisfactory terms, if at all.
White Mountains has a revolving credit facility with a syndicate of lenders administered by Bank of America, N.A. with a total commitment of $375 million (the “WTM Bank Facility”) that has a maturity date of August 12, 2015. As of December 31, 2012, White Mountains had $75 million outstanding under the WTM Bank Facility, which the Company repaid in January 2013.
In December 2011, OneBeacon Insurance Company (“OBIC”), an indirect wholly-owned subsidiary of OneBeacon Ltd., sold the majority of its fixed assets and capitalized software to OneBeacon Services LLC (“OB Services”), another indirect wholly-owned subsidiary of OneBeacon Ltd. The fixed assets and capitalized software were sold at a cost equal to book value with no gain or loss recorded on the sale. Subsequent to purchasing the fixed assets and capitalized software from OBIC, OB Services entered into lease financing arrangements with US Bancorp Equipment Finance, Inc. (“US Bancorp”) and Fifth Third Equipment Finance Company (“Fifth Third”) whereby OB Services sold its fixed assets and its capitalized software, respectively, to US Bancorp and Fifth Third. The assets were sold at a cost equal to net book value. OB Services then leased the fixed assets back from US Bancorp for a lease term of five years and leased the capitalized software back from Fifth Third for a lease term of four years. OB Services received cash proceeds of $23 million as a result of entering into the sale-leaseback transactions. At the end of the lease terms, OB Services will be obligated to purchase the leased assets for a nominal fee, after which all rights, title and interest would transfer to OB Services. At December 31, 2012, OB Services has recorded a capital lease obligation of $18 million included within other liabilities and a capital lease asset of $16 million included within other assets.
unpaid losses of $1,800, loss and LAE reserves of $2,100 and the remaining purchase accounting fair value adjustment of $150 related to the OneBeacon Acquisition.
At December 31, 2012, White Mountains had $75 outstanding under its credit facility that was repaid in January 2013.
The SIG Preference Shares are not included in the table above as these perpetual preferred shares have no stated maturity date and are redeemable only at the option of SIG. See “Sirius Group’s Preference Shares and Senior Notes” on page 22 for more details.
The estimated payments reflected in the table are based on current accrual factors (including performance relative to targets and common share price) and assume that all outstanding balances were 100% vested as of December 31, 2012.
In 2006, White Mountains' board of directors authorized the Company to repurchase up to 1,000,000 of its common shares, from time to time, subject to market conditions. In 2010 and 2012, White Mountains' board of directors authorized the Company to repurchase an additional 600,000 and 1,000,000, respectively, of its common shares, for a total authorization of 2.6 million shares. Shares may be repurchased on the open market or through privately negotiated transactions. The repurchase authorizations do not have a stated expiration date. At December 31, 2012, White Mountains may repurchase an additional 685,496 shares under these board authorizations. In addition, from time to time White Mountains has also repurchased its common shares through tender offers that were separately approved by its board of directors.
During 2011, White Mountains repurchased a total of 646,502 of its common shares during for $253 million at an average share price of $390, which was 72% of White Mountains' adjusted book value per share of $542 at December 31, 2011. These repurchases were comprised of (1) 313,967 common shares repurchased under the board authorization for $114 million at an average share price of $364; (2) 332,346 common shares repurchased through two “modified Dutch auction” self-tender offers for $139 million at an average share price of $418; and (3) 189 common shares repurchased to satisfy employee income tax withholdings, pursuant to employee benefit plans.
Detailed information concerning White Mountains’ cash flows during 2012, 2011 and 2010 follows:
Cash flows from operations for the years ended 2012, 2011 and 2010
During 2012, the Company repurchased and retired 1,329,640 of its common shares for $669 million.
During 2012, OBH issued $275 million face value of senior unsecured debt through a public offering, at an issue price of 99.9%. The net proceeds from the issuance of the 2012 OBH Senior Notes were used to repurchase and retire the remaining $270 million principal outstanding on the 2003 OBH Senior Notes.
During 2012, OneBeacon paid a total of $16 million of interest on the 2003 OBH Senior Notes.
During 2012, White Mountains capitalized HG Global with approximately $600 million in cash and HG Global capitalized BAM by purchasing $503 million of BAM Surplus Notes.
In November 2012, White Mountains Solutions acquired PICO and Citation for a purchase price of $15 million and American General and American General Property for a purchase price of $35 million.
During 2011, OneBeacon Ltd. declared and paid $175 million of cash dividends to its common shareholders, including $80 million of regular quarterly dividends and a $95 million special dividend. White Mountains received a total of $132 million of these dividends.
During 2011, White Mountains contributed $20 million to WM Life Re.
During 2011, WM Advisors declared and paid $5 million of capital distributions to its immediate parent.
During the fourth quarter of 2011, Sirius Group acquired Old Lyme for $6 million in cash and a note of $2 million.
During the first quarter of 2010, the Company declared and paid a $9 million cash dividend to its common shareholders.
During 2010, OBH repurchased and retired a portion of the outstanding OBH Senior Notes for $196 million and OneBeacon Insurance Company purchased a portion of the outstanding OBH Senior Notes for $1 million. In addition, during the first quarter of 2010, OneBeacon repaid in full the $14 million outstanding under the Atlantic Specialty Note.
During 2010, Sirius Group declared and paid $225 million of capital distributions to its immediate parent.
During the third quarter of 2010, OneBeacon completed the sale of its traditional personal lines business and received consideration of approximately $167 million.
During the fourth quarter of 2010, White Mountains sold its interest in Delos for $22 million.
Total capital at White Mountains is comprised of White Mountains’ common shareholders’ equity, debt and non-controlling interest in OneBeacon Ltd and the SIG Preference Shares. Total adjusted capital excludes the equity in net unrealized gains and losses from Symetra’s fixed maturity portfolio, net of applicable taxes from total capital. The reconciliation of total capital to total adjusted capital is included on page 67.
White Mountains’ actuaries use several generally accepted actuarial methods to evaluate its loss reserves, each of which has its own strengths and weaknesses. Management places more or less reliance on a particular method based on the facts and circumstances at the time the reserve estimates are made.
Historical paid loss development methods: These methods use historical loss payments over discrete periods of time to estimate future losses. Historical paid loss development methods assume that the ratio of losses paid in one period to losses paid in an earlier period will remain constant. These methods necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use case reserves to estimate ultimate losses, they can be more reliable than the other methods discussed below that look to case reserves (such as actuarial methods that use reported losses) in situations where there are significant changes in how case reserves are established by a company’s claims adjusters. However, historical paid loss development methods are more leveraged, meaning that small changes in payments have a larger impact on estimates of ultimate losses, than actuarial methods that use reported losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative reported amounts. In addition, and for similar reasons, historical paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past.
Adjusted historical paid and reported loss development methods: These methods take traditional historical paid and reported loss development methods and adjust them for the estimated impact of changes from the past in factors such as inflation, the speed of claim payments or the adequacy of case reserves. Adjusted historical paid and reported loss development methods are often more reliable methods of predicting ultimate losses in periods of significant change, provided the actuaries can develop methods to reasonably quantify the impact of changes.
OneBeacon’s loss and LAE reserves, net of reinsurance recoverables, for its Ongoing Business by line of business at December 31, 2012 and 2011 were as follows:
The commercial automobile product line is a mix of property and liability coverages and, therefore, includes both short and long tail coverages. The payments that are made quickly typically pertain to auto physical damage (property) claims and property damage (liability) claims. The payments that take longer to finalize and are more difficult to estimate relate to bodily injury claims. Commercial automobile reserves are typically analyzed in two components; liability and collision/comprehensive claims. This second component has minimum reserve risk and fast payouts and, accordingly, separate reserving factors are not presented. The liability component includes claims for both bodily injury and property damage. In general, claim reporting lags are minor, claim complexity is not a major issue, and the line is viewed as high frequency, low to moderate severity.
During 2012, OneBeacon experienced $7 million of net favorable loss and LAE reserve development on prior accident year reserves. The favorable reserve development was primarily from workers' compensation, multiple peril liability and general liability lines. This favorable development was offset somewhat by unexpected adverse development on excess property claims.
In addition to the development described for the lines of business above, OneBeacon also recorded a $4 million net decrease in reserves in other lines of business as a result of its review of loss reserves at December 31, 2011.
In 2010, OneBeacon experienced $36 million of net favorable loss and LAE reserve development on prior accident year loss reserves. The favorable loss reserve development was primarily due to lower than expected severity on non-catastrophe losses related to professional liability lines, multiple peril liability lines and other general liability lines, as well as development on personal lines business. The favorable development also included an $8 million release of commercial catastrophe reserves associated with storms occurring in 2004 and 2005.
During 2010, OneBeacon experienced $23 million of net favorable loss and LAE reserve development on prior accident year loss reserves relating to the Runoff Business. The net favorable loss reserve development was primarily due to lower than expected severity on multiple peril liability lines and other general liability lines, particularly for accident years 2004 through 2009. As a result of the lower than expected case incurred loss and ALAE, actuarial methods based on case incurred losses produced lower estimated ultimate losses, resulting in lower estimates of required IBNR.
OneBeacon’s range of reserve estimates at December 31, 2012 was evaluated to consider the strengths and weaknesses of the actuarial methods applied against OneBeacon’s historical claims experience data. The following table shows the recorded unpaid loss and LAE reserves, net of reinsurance recoverables on unpaid losses, and the high and low ends of OneBeacon’s range of reasonable loss reserve estimates for its Ongoing and Runoff Business at December 31, 2012. The high and low ends of OneBeacon’s range of reserve estimates in the table below are based on the results of various actuarial methods described above.
(1) Includes substantially all OneBeacon’s net A&E reserves ($9, net of reinsurance recoverables at December 31, 2012). See A&E Reserves below for a further discussion.
The following table shows the recorded loss and LAE reserves, net of reinsurance recoverable on unpaid losses, and the high and low ends of OneBeacon’s range of reasonable loss reserve estimates for OneBeacon’s Ongoing Business by line of business at December 31, 2012.
In selecting its best estimate, management continues to monitor the impact of future increases in inflation, including adverse changes in tort liability. These types of changes could result in deterioration in the loss reserves. During 2012, inflation continued to emerge in the loss data for some lines of business which increased the actuarial indications and related estimated range of outcomes. Since these changes in inflation assumptions are now being partially reflected in the actuarial methods, management does not need to select reserves as high in the range of actuarial indications. This has had some impact on most lines but has a particular impact on general liability - claims made and medical malpractice within both OneBeacon’s Ongoing Business and its Runoff Business. Additionally, as OneBeacon continues to pay down the obligations associated with its Runoff Business, the uncertainty and volatility associated with those reserves is also declining such that carried reserves, which continue to exceed actuarial indications, are expectedly closer to the middle of the range.
OneBeacon’s reserves include provisions made for claims that assert damages from A&E related exposures. Substantially all of these reserves have been reclassified to liabilities held for sale as of December 31, 2012, as they relate to the Runoff Business. 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 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.
OneBeacon also incurred A&E losses via its participation in industry pools and associations. The most significant of these pools was Excess Casualty Reinsurance Association (“ECRA”), which provided excess liability reinsurance to U.S. insurers from 1950 until the early 1980s. ECRA incurred significant liabilities for A&E, of which OneBeacon bears approximately a 4.6% and 4.7% share, or $67 million and $77 million at December 31, 2012 and 2011, respectively, which is fully reflected in OneBeacon’s loss and LAE reserves.
More recently, since the 1990s, OneBeacon has experienced an influx of 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, 2012, 481 policyholders had asbestos-related claims against OneBeacon. In 2012, 106 new insureds with such peripheral involvement presented asbestos claims under prior OneBeacon policies.
OneBeacon has a reinsurance contract with NICO under which OneBeacon is entitled to recover from NICO up to $2.5 billion in the future for asbestos claims arising from business written by OneBeacon in 1992 and prior, environmental claims arising from business written by OneBeacon in 1987 and prior, and certain other exposures. Under the terms of the NICO Cover, NICO receives the economic benefit of reinsurance recoverables from certain of OneBeacon’s third-party reinsurers in existence at the time the NICO Cover was executed (“Third-Party Recoverables”). As a result, the Third-Party Recoverables serve to protect the $2.5 billion limit of NICO coverage for the benefit of OneBeacon. Any amounts uncollectible from third-party reinsurers due to dispute or the reinsurers’ financial inability to pay are covered by NICO under its agreement with OneBeacon. Third-Party Recoverables are typically for the amount of loss in excess of a stated level each year. Of claim payments from 2000 through 2012, approximately 47% of asbestos and environmental losses have been recovered under the historical third-party reinsurance.
OneBeacon’s A&E claims activity, substantially all of which relates to Runoff Business, the operations of which have been included in discontinued operations and the loss and LAE reserves of which are included in liabilities held for sale on the December 31, 2012 consolidated balance sheet, is illustrated in the table below:
Total accounts with A&E claims at the end of the year
Although loss and LAE reserves are initially determined based on underwriting and pricing analyses, Sirius Group regularly reviews the adequacy of its recorded reserves by using a variety of generally accepted actuarial methods, including historical incurred and paid loss development methods. If actual loss activity differs substantially from expectations, an adjustment to recorded reserves may be warranted. As time passes, loss reserve estimates for a given year will rely more on actual loss activity and historical patterns than on initial assumptions based on pricing indications.
Backlogs in the recording of assumed reinsurance can also complicate the accuracy of loss reserve estimation. As of December 31, 2012, there were no significant backlogs related to the processing of assumed reinsurance information at Sirius Group.
The following table illustrates Sirius Group’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, 2012.
Sirius Group's A&E exposure is primarily from reinsurance contracts written between 1974 through 1985 by acquired companies, mainly MONY Reinsurance Company and Christiania General Insurance Company. The exposures are mostly higher layer excess of loss treaty and facultative coverages with relatively low limits exposed for each claim. In 2012, Sirius Group increased its net A&E exposure through two incoming runoff portfolios acquired by White Mountains Solutions. These acquisitions added $11 million in net asbestos reserves and $1 million in net environmental reserves.
In addition to the $11 million increase in asbestos reserves from the two incoming portfolios acquired by White Mountains Solutions mentioned above, Sirius Group recorded $46 million and $10 million of asbestos-related incurred losses and LAE on its already existing asbestos reserves in 2012 and 2011, respectively. In the first six months of 2012, Sirius Group increased net asbestos reserves by $12 million in response to its quarterly monitoring of newly reported claims. Based on the monitoring trends noted in the first six months 2012, Sirius Group conducted an in-depth analysis of its asbestos exposure, which was completed in third quarter. The main focus of the analysis was on the internal claims analysis of all treaty and facultative contracts likely to have asbestos exposure. An external expert with extensive asbestos claims experience was utilized to enhance the review. This analysis entailed examining total expected asbestos losses and LAE from a variety of information sources, including previous asbestos studies, reported client data and external benchmarking scenarios. The analysis resulted in a net asbestos loss reserve increase of $33 million recognized in third quarter. An additional $2 million of asbestos losses were recognized in fourth quarter 2012. The 2011 incurred losses were primarily the result of management's monitoring of a variety of metrics including: actual paid and reported claims activity; net survival ratios; peer comparisons; and industry benchmarks.
Offsetting the $1 million increase in environmental reserves mentioned above, Sirius Group recorded a decrease of $1 million in 2012 of environmental-related losses on its already existing reserves in 2012. In 2011, Sirius Group recorded $2 million of environmental losses.
Sirius Group’s net reserves for A&E losses were $189 million and $163 million at December 31, 2012 and 2011, respectively. Sirius Group’s A&E three-year net loss paid survival ratio was approximately 9.0 years and 11.1 years at December 31, 2012 and 2011. The decrease in the paid survival ratio in 2012 was driven by an unusually high net paid loss of $9 million made in first quarter 2012 to commute one of Sirius Group's top five asbestos exposures.
The following tables show gross and net loss and LAE payments for A&E exposures for the years ending December 31, 2003 through December 31, 2012:
Sirius Group has a specialized unit that handles claims relating to A&E exposures. The issues presented by these types of claims require expertise and an awareness of the various trends and developments in relevant jurisdictions. Generally, Sirius Group sets up claim files for each reported claim by 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, 2012, Sirius Group had 1,859 open claim files for asbestos and 281 open claim files for environmental exposures.
As of December 31, 2012, approximately 95.0% of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. Investments valued using Level 1 inputs include fixed maturities, primarily investments in U.S. Treasuries, common equities and short-term investments, which include U.S. Treasury Bills. Investments valued using Level 2 inputs comprise fixed maturities including corporate debt, state and other governmental debt, convertible fixed maturity securities and mortgage and asset-backed securities. Fair value estimates for investments that trade infrequently and have few or no observable market prices are classified as Level 3 measurements. Level 3 fair value estimates based upon unobservable inputs include White Mountains’ investments in hedge funds and private equity funds, as well as investments in certain debt securities, including asset-backed securities, where quoted market prices are unavailable. White Mountains uses brokers and outside pricing services to assist in determining fair values. For investments in active markets, White Mountains uses the quoted market prices provided by outside pricing services to determine fair value. The outside pricing services used by White Mountains have indicated that if no observable inputs are available for a security, they will not provide a price. In those circumstances, White Mountains estimates the fair value using industry standard pricing models and observable inputs such as benchmark interest rates, matrix pricing, market comparables, broker quotes, issuer spreads, bids, offers, credit rating prepayment speeds and other relevant inputs. White Mountains performs procedures to validate the market prices obtained from the outside pricing sources. Such procedures, which cover substantially all of its fixed maturity investments include, but are not limited to, evaluation of model pricing methodologies and review of the pricing services’ quality control processes and procedures on at least an annual basis, comparison of market prices to prices obtained from a different independent pricing vendors on at least a semi-annual basis, monthly analytical reviews of certain prices, and review of assumptions utilized by the pricing service for selected measurements on an ad hoc basis throughout the year. White Mountains also performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price on an ad-hoc basis throughout the year. Prices provided by the pricing services that vary by more than 5% and $1 million from the expected price based on these procedures are considered outliers. In circumstances where the results of White Mountains’ review process do not appear to support the market price provided by the pricing services, White Mountains challenges the price. During the past year, approximately fifteen securities fell outside White Mountains’ expected results, thereby triggering the challenge with the pricing service. If White Mountains cannot gain satisfactory evidence to support the challenged price, it relies upon its own pricing methodologies to estimate the fair value of the security in question. The fair values of such securities are considered to be Level 3 measurements.
Carrying value includes $338.1 that is classified as assets held for sale relating to discontinued operations.
Excludes carrying value of $35.0 associated with other long-term investments accounted for using the equity method and $(.1) related to currency forward contracts.
The following tables summarize the changes in White Mountains’ fair value measurements by level for the year ended December 31, 2012 and December 31, 2011:
(1) Excludes carrying value of $33.0 and $35.0 at January 1, 2012 and December 31, 2012 associated with other long-term investments accounted for using the equity method and $(0.1) at December 31, 2012 related to forward contracts.
(2) Carrying value includes $111.8 and $338.1 at January 1, 2012 and December 31, 2012 that is classified as assets held for sale relating to discontinued operations.
(1) Excludes carrying value of $33.0 and $41.9 at December 31, 2011 and January 1, 2011 associated with other long-term investment limited partnerships accounted for using the equity method.
(2) Carrying value includes $111.8 that is classified as assets held for sale relating to AutoOne discontinued operations.
During 2012, two fixed maturity securities classified as Level 3 measurements in the prior period were recategorized as Level 2 measurements because quoted market prices for similar securities that were considered reliable and could be validated against an alternative source were available at December 31, 2012. These measurements comprise “Transfers out” of Level 3 and “Transfers in” to Level 2 of $61.8 million for the period ended December 31, 2012. For the year-ended December 31, 2012, “Transfers out” of Level 2 and “Transfers in” to Level 3 fixed maturity investments of $22.1 million consists of one asset-backed security for which the estimated fair value was determined using a single broker quote.
White Mountains’ investment portfolio includes investments in hedge funds and private equity funds. At December 31, 2012, the value of investments in hedge funds and in private equity funds was $115 million and $125 million, respectively. The underlying investments are typically publicly traded and private common equity investments, and, as such, are subject to market risks that are similar to White Mountains’ common equity securities. The following illustrates the estimated effect on December 31, 2012 fair value resulting from a 10% change and a 30% change in market value:
White Mountains has entered into agreements to reinsure death and living benefit guarantees associated with certain variable annuities in Japan. White Mountains carries the benefit guarantees at fair value. The fair value of the guarantees is estimated using actuarial and capital market assumptions related to the projected discounted cash flows over the term of the reinsurance agreement. The valuation uses assumptions about surrenders rates, market volatilities and other factors, and includes a risk margin which represents the additional compensation a market participant would require to assume the risks related to the business. The selection of surrender rates, market volatility assumptions, risk margins and other factors require the use of significant management judgment. Assumptions regarding future policyholder behavior, including surrender and lapse rates, are generally unobservable inputs and significantly impact the fair value estimate. Market conditions including, but not limited to, changes in interest rates, equity indices, market volatility and foreign currency exchange rates as well as variations in actuarial assumptions regarding policyholder behavior may result in significant fluctuations in the fair value of the liabilities associated with these guarantees that could materially affect results of operations. All of White Mountains' variable annuity reinsurance liabilities ($442 million) were classified as Level 3 measurements at December 31, 2012.
WM Life Re uses derivative instruments, including put options, interest rate swaps, total return swaps on bond and equity indices and forwards and futures contracts on major equity indices, currency pairs and government bonds, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. The types of inputs used to estimate the fair value of these derivative instruments, with the exception of actuarial assumptions regarding policyholder behavior and risk margins, are generally the same as those used to estimate the fair value of the variable annuity liabilities.
As of December 31, 2012, the value of bond funds tracking the WGBI was approximately ¥68 billion ($786 million). By country, the largest exposures, together comprising over 90% of the WGBI, were the United States (42%), France (10%), Germany (9%), the United Kingdom (8%), Italy (9%), Spain (4%), Canada (3%), the Netherlands (3%), and Belgium (3%). Eurozone countries together comprised approximately 41%. To reduce hedging basis risk (i.e., the risk that changes in the WGBI will cause WM Life Re's variable annuity guarantee liabilities to change in value at a different rate than the derivative hedges), in December 2009 WM Life Re entered into a series of total return swap contracts on the performance of the WGBI. As of December 31, 2010, approximately 49% of WM Life Re's WGBI-related liability was hedged with WGBI swaps. Because these swaps were denominated in US dollars, WM Life Re continued to hedge the results into Japanese yen to match the benchmark denominated in Japanese yen. In 2011, driven in large part by instability of Eurozone markets, WM Life Re significantly increased coverage of its WGBI exposure. Because the market for WGBI total return swaps was, and continues to be illiquid, WM Life Re entered into a series of total return swaps on the JP Morgan European Government Bond Index (JPM European GBI). Although the JPM European GBI is not an exact match for the European component of the WGBI, its construction rules and holdings are substantially similar. These swaps are denominated in Japanese yen and, therefore, need not be hedged into Japanese yen. As of December 31, 2012, the total notional amounts of WGBI and JPM European GBI swaps were $75 million and ¥28 billion ($324 million), respectively. At that date, approximately 64% and 96% of the total WGBI and European component of the WGBI, respectively, were hedged with total return swaps. All $75 million notional amount of WGBI swaps matured in January 2013, reducing coverage on the total WGBI by 3% to approximately 61%. The JPM European GBI total return swaps have maturities laddered during 2015 and 2016 to approximate the maturities of the policies reinsured. The residual WGBI exposure is hedged primarily with bond futures.
As of December 31, 2012, the value of bond funds tracking the Nomura BPI was approximately ¥73 billion ($844 million). In January 2010, because the types and tenors of liquid Japanese bond futures currently available are extremely limited, to more closely track the performance of bond funds tracking the Nomura BPI, WM Life Re entered into its first total return swap contract on the performance of that index. As of December 31, 2012, the total notional amount of Nomura BPI swaps was ¥57 billion ($662 million), covering approximately 90% of WM Life Re's Nomura BPI-related liability exposure. Of these swaps, ¥13 billion ($159 million), which mature between 2015 and 2016, track the government bond component of the index only (approximately 76% of the index), leaving WM Life Re exposed to credit spread risk on the non-government portion. However, WM Life Re was able to temporarily convert these swaps into swaps that track the complete index through August 2013, at which time they will revert back to swaps that track the government bond component only unless WM Life Re is able to roll the conversion for another period of time. The remaining ¥44 billion ($511 million) track the complete index. Of these, one with a notional amount of ¥10 billion ($130 million) matured in January 2013 and was replaced with a swap of equal size maturing January 2014. The remaining swaps on the complete index mature during 2013. WM Life Re will look for opportunities to replace these swaps as they mature; however, the market is extremely illiquid and there is no guaranty that WM Life Re will be able to do so. Under the contracts, WM Life Re receives cash flows based on a fixed return, reset at the beginning of each period (monthly for the complete index swaps and semi-annually for the government bond only swaps) based on current LIBOR and is required to pay cash flows based on the performance of the Nomura BPI during that period plus a fixed amount. Remaining Nomura BPI exposure is hedged with liquid Japanese bond futures and is subject to basis risk relating to the difference between the tenor of the bond futures and the tenor of the assets in the annuity funds covered by WM Life Re’s variable annuity guarantees.
As of December 31, 2012, the value of equity funds tracking the MSCI Kokusai was approximately ¥30 billion ($346 million). To reduce hedging basis risk, in 2011 WM Life Re entered into a series of total return swaps on the MSCI Kokusai, denominated in Japanese yen with maturities laddered during 2015 and 2016 to approximate the maturities of the policies reinsured. As of December 31, 2012, the total notional amount of MSCI Kokusai swaps was ¥14.5 billion ($177 million) and the percent of MSCI Kokusai fund exposure hedged by these swaps was approximately 60%. The remaining 40% of this exposure continues to be hedged with a variety of more liquid instruments, including exchange-traded futures. WM Life Re continues to assess ways to increase its coverage with total return swaps but there is no guaranty that WM Life Re will be able to do so.
The following table summarizes the estimated financial impact on WM Life Re's derivatives and benefit guarantee liabilities of instantaneous changes in individual market variables as of December 31, 2012, proforma for the unwinding or offsetting of Japanese interest rate swaps in January of 2013. Remaining hedging coverage of Japanese interest rate swap exposure was 12%, primarily from WM Life Re’s put option portfolio. The table below assumes that all other market variables are constant and does not reflect the inter-dependencies between individual variables.
In the unfavorable scenario, Japanese interest rates are decreased 70 bps, Japanese swap spreads are tightened by 25 bps, and foreign bond fund yields are increased 70 bps. Conversely, in the favorable scenario, Japanese interest rates are increased 70 bps, Japanese swap spreads are widened 25 bps and foreign bond fund yields are decreased 70 bps. Without taking into account the proforma effect of Japanese interest rate swaps that were unwound or offset in January of 2013, the favorable interest rate change scenario results in an increase of the net value of WM Life Re’s derivative assets and variable annuity guarantee liability of $10, while the unfavorable scenario results in a decrease of $1.
White Mountains’ sensitivities for market implied volatilities vary by term. For equity implied volatilities, White Mountains changes implied volatilities by 15%, 13%, 11%, 9%, 7% and 7% for each of the terms to maturity for years one through six, respectively. For foreign currency implied volatilities, White Mountains changes implied volatilities by 6%, 5.5%, 5%, 4.5%, 4% and 4% for each of the terms to maturity for years one through six, respectively.
To test the impact of multiple variables moving simultaneously, WM Life Re performs capital market “shock” testing. Prior to 2009, in performing this testing, WM Life Re had not incorporated basis risk and other hedge underperformance relative to expectations in its models; it had assumed that its hedges would behave as modeled. However, the financial market turmoil of late 2008 and early 2009 demonstrated that, in periods of severe financial market disruption, various aspects of WM Life Re's hedging program may underperform or over-perform. As a result, WM Life Re now also estimates the efficacy of its hedging program in its “shock” testing. Estimated hedge effectiveness is based on actual results during the recent stressed market environment encompassing the fourth quarter of 2008 and the first quarter of 2009. Hedge effectiveness assumptions also incorporate any subsequent changes to the hedging program that were not in place during this stress period. Although this period captures a historically volatile period that included large market movements over short time periods, hedges may be less effective than the current assumptions to the extent future market movements of the magnitude of these “shocks” occur more quickly than during this recent stress period.
WM Life Re applies shocks to the Japanese interest rates and foreign bond fund yields in opposite directions. In the down market scenario, Japanese interest rates are decreased 70 bps, Japanese interest rate swap spreads are tightened by 25 bps, and foreign bond fund yields are increased 70 bps. The “up market” scenario assumes opposite movements in the same variables. For other variables, the “down market” scenario assumes equity indices decrease 20%, foreign currencies depreciate by 15% against the Japanese yen and implied market volatility increases as described in footnote 3 to the table above. The “up market” scenario assumes opposite movements in the same variables. Through December 31, 2012, both the up and down scenarios produce an expected net loss due to the convexity of the liability value, coupled with the assumption that the shock scenarios happen instantaneously without adjustment of the hedging portfolio. The proforma 2012 sensitivity analysis up market scenario results in a positive $10 million due to the reduction in the liability from higher discount rates that is no longer offset by losses from the Japanese interest rate swaps that have been unwound. However, this also causes the proforma 2012 down market scenario to be $13 million worse than the down market scenario as of December 31, 2012.
In addition to derivative instruments, WM Life Re held cash, short-term and fixed maturity investments of $393.6 and $485.3 at December 31, 2012
In connection with White Mountains’ acquisition of OneBeacon in 2001, Aviva caused OneBeacon to purchase reinsurance contracts with two reinsurance companies rated “AA+” (Very Strong, the second highest of twenty-one financial strength ratings) by Standard & Poor’s and “A++” (Superior, the highest of sixteen financial strength ratings) by A.M. Best. One is a reinsurance cover with NICO which entitles OneBeacon to recover up to $2.5 billion in ultimate loss and LAE incurred related primarily to claims arising from business written by its predecessor prior to 1992 for asbestos claims and 1987 for environmental claims, respectively. As of December 31, 2012, OneBeacon has ceded estimated incurred losses of approximately $2.3 billion to NICO under the NICO Cover. The other contract is a reinsurance cover with GRC for up to $570 million of additional losses on all claims arising from accident years 2000 and prior. As of December 31, 2012, OneBeacon has ceded estimated incurred losses of $562 million to GRC under the GRC Cover. The NICO Cover and GRC Cover, which were contingent on and occurred contemporaneously with the acquisition of OneBeacon, were put in place in lieu of a seller guarantee of loss and LAE reserves and are therefore accounted for as a seller guarantee under GAAP in accordance with Emerging Issues Task Force Topic No. D 54. NICO and GRC are wholly-owned subsidiaries of Berkshire. All of these balances relate to the Runoff Business, the results of which are included in discontinued operations and the balances as of
December 31, 2012 of which have been included in assets or liabilities held for sale on the consolidated balance sheet.
In September 2011, the U.S. Federal Reserve Bank (the “Fed”) began “Operation Twist”, which decreased long-term interest rates on fixed maturity investments. Under Operation Twist, the Fed sold shorter-term U.S. treasury securities, which have maturities of generally 3 years or less, to fund the purchase of longer-term U.S. securities, with maturities between