(a) As of January 1, 2007, we adopted a new accounting pronouncement whereby substantially all of our investments are now carried at fair value with changes in fair value being reported as net realized and unrealized investment gains (losses) in our statement of operations. Prior to adoption, substantially all of our investments were carried at fair value with changes in fair value being reported as a separate component of our shareholders’ equity, with changes therein reported as a component of other comprehensive income (loss).
(c) During 2010 we incurred $135.9 million in net losses associated with earthquakes in Chile and New Zealand. During 2008 we incurred $177.1 million in net losses associated with Hurricanes Ike and Gustav. These catastrophic events significantly impacted our expenses in those years.
The following is a discussion and analysis of our results of operations for the years ended December 31, 2010, 2009 and 2008 and our financial condition as of December 31, 2010 and 2009. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes thereto included within this filing.
(1) Represents the value of MUSIC’s excess and surplus lines licenses and authorizations acquired in 2007.
(2) The Share Issuance Agreement was terminated in February 2009. Prior to its termination, the Share Issuance Agreement had the effect of substantially eliminating the economic dilution that would otherwise have resulted from the issuance of Common Shares. Therefore, we did not consider these Common Shares outstanding for the purposes of this computation. See Note 6 of the Notes to Consolidated Financial Statements.
(3) Computed as the change in fully converted tangible book value per share, inclusive of dividends declared.
We believe that our computations of our fully converted tangible book value per share and our change in fully converted tangible book value per share, inclusive of dividends declared, are non-GAAP measures which are important to our investors, analysts and other interested parties who benefit from having an objective and consistent basis for comparison with other companies within our industry.
Pricing in most insurance and reinsurance markets is cyclical in nature and 2010 proved to be a more difficult operating environment than in recent years, which has placed an increased emphasis on risk selection and capital management.
During 2009 we observed adequate to strong pricing levels in the majority of our business lines, ending broad price reductions experienced over the previous two years. During that time we and many of our peers experienced strong underwriting and investment returns due to a low level of catastrophe losses and a widespread rebound in the financial markets. These strong returns led to an increase in the amount of capital available in the reinsurance market, which in turn led to downward pricing pressure in 2010. Events that occurred during 2010, mainly earthquakes in both Chile and New Zealand and the Deepwater Horizon oil rig explosion and fire, did not reverse these trends. As a result, we expect it will become increasingly difficult to replicate the levels of success we achieved in 2009 and 2010 in an operating environment which is now marked by soft pricing conditions and low investment yields.
Our response to these conditions will be to focus on profitability and capital management during 2011, rather than on maintaining premium volume. For the first quarter of 2011, excluding the impact of any loss-generated reinstatement premiums, we expect to reduce our net written premium by approximately 20% compared to the first quarter of 2010. For the full year 2011, barring any significant changes in market conditions and excluding the impact of any reinstatement premiums, we expect the pattern of lower net written premiums to continue, although the rate of decrease for the full year 2011 is likely to be less than that of the first quarter.
Some of our classes of business will be scaled back to a lesser extent than others. Pricing for marine insurance, for example, has remained relatively strong. As a result, we do not currently anticipate a significant reduction in this class of business, which now represents the largest line written by Syndicate 5151. On the other hand, we currently expect a larger decrease in Montpelier Re’s property catastrophe business due to a combination of targeted exposure reductions, price erosion and the timing of some of our outward reinsurance purchases.
Overall, given the high opportunity cost of deploying capital in the current market and the lower expected returns now available, we have reduced our net catastrophe exposures significantly thus far in 2011. We intend to re-allocate the capital released by this reduction in exposure in two ways.
First, we intend to create and hold more free capital which will improve our operational and balance sheet flexibility. More specifically, we expect to accept less underwriting risk in the current pricing cycle in order to improve our ability to capitalize on future market dislocations and opportunities. Second, we expect to continue to utilize share repurchases as a means to deploy some of our free capital in a manner that is accretive to our fully converted tangible book value per share. These approaches will help us focus our activities on writing profitable business and aligning our capital with preferred underwriting opportunities.
As a predominantly short-tail property reinsurer, we have exposure to various natural catastrophes around the world. We manage our exposure to catastrophes using a combination of CATM, third-party vendor models, underwriting judgment, and our own reinsurance purchases.
For certain defined natural catastrophe region and peril combinations, we assess the probability and likely magnitude of losses using a combination of industry third-party vendor models, CATM and underwriting judgment. We attempt to model the projected net impact from a single event, taking into account contributions from our inward portfolio of property, aviation, workers’ compensation, engineering, marine, casualty, and personal accident insurance policies, reinsurance policies, and event-linked derivative securities offset by the net benefit of any reinsurance or derivative protections we purchase and the net benefit of reinstatement premiums. The table below details our estimated average net impact market share for selected natural catastrophe events of various industry loss magnitudes:
In addition to monitoring exposed contract limits and single event accumulation potential, we attempt to measure enterprise-wide risk using a simulated annual aggregate operating result approach. This approach estimates a net operating result over simulated annual return periods, including contributions from certain variables such as aggregate premiums, losses, expenses, and investment results. We view this approach as a supplement to our single event stress test as it allows for multiple losses from natural catastrophe and other sources and attempts to take into account certain risks from non-underwriting sources. Through our modeling we endeavor to take into account many risks that we face as an enterprise. By the very nature of the insurance and reinsurance business, and limitations associated with the use of models in general, our modeling does not cover every potential risk. Examples include emerging risks, changes in liability awards, pandemic illnesses, asteroid strikes, climate change, bioterrorism, scientific accidents, and various political and financial market catastrophes.
We currently operate through three reportable segments: Montpelier Bermuda, Montpelier Syndicate 5151 and MUSIC. Prior to its liquidation and dissolution in 2009, Blue Ocean constituted a fourth reportable segment. Each operating segment represents a separate underwriting platform through which we write insurance and reinsurance business. The activities of the Company, certain of its intermediate holding and service companies and intercompany eliminations relating to inter-segment reinsurance and support services, collectively referred to as “Corporate and Other”, are also presented herein.
Underwriting results for Montpelier Bermuda for the years ended December 31, 2010, 2009 and 2008 were as follows:
· Gross premiums written in 2010 within the Property and Specialty Individual Risk line of business decreased by $6.0 million, or 15%, over 2009, due mainly to non-renewals and pricing reductions.
Gross premiums written within our Montpelier Bermuda segment decreased by approximately 10% in 2009 as compared to 2008, as a result of the following:
In the normal course of its business, Montpelier Bermuda purchases reinsurance in order to manage its exposures. The amount and type of reinsurance that it purchases is dependent on a variety of factors, including the cost of a particular reinsurance cover and the nature of its gross premiums written during a particular period.
Net premiums written within our Montpelier Bermuda segment in 2010 decreased by approximately 4% as compared to 2009. Net premiums written during 2009 were consistent with those written in 2008. Various factors will continue to affect Montpelier Bermuda’s appetite and capacity to write and retain risk. These factors include the impact of changes in frequency and severity assumptions used in Montpelier Bermuda’s models and the corresponding pricing required to meet its return targets, evolving industry-wide capital requirements, increased competition, market conditions and other considerations. Also, the level of reinstatement premiums recognized in future periods is dependent upon the occurrence of losses.
The following tables summarize Montpelier Bermuda’s loss and LAE reserve activities for the years ended December 31, 2010, 2009 and 2008:
The following table presents Montpelier Bermuda’s net loss and LAE ratios for the years ended December 31, 2010, 2009 and 2008:
· $27.9 million associated with the September 2010 earthquake in New Zealand, and
During 2008 Montpelier Bermuda incurred catastrophic losses from European Windstorm Emma and Hurricanes Ike and Gustav, representing a combined net loss of $181.2 million. Additionally, Montpelier Bermuda incurred $49.2 million of net losses as a result of four individual risk losses within its Other Specialty line of business.
· Medical malpractice class of business, relating to several prior accident years ($8.0 million decrease),
· Other individual risk losses relating to prior several accident years ($7.4 million decrease),
· Net estimated ultimate losses and LAE associated with prior year catastrophe and individual risk events decreased by $35.2 million, which is broken down as follows (in millions):
· Net estimated ultimate losses and LAE associated with for prior year catastrophe events decreased by $54.9 million, which is broken down as follows (in millions):
· A reduction in losses reported to us during 2008 in connection with several individual risk claims, resulted in a decrease in estimated losses and LAE of $11.0 million,
· A reassessment of loss and LAE reserves in Montpelier Bermuda’s casualty class of business, primarily relating to medical malpractice policies, resulted in a decrease in estimated losses and LAE of $13.0 million,
Profit commissions, which are paid by assuming companies to ceding companies in the event of a favorable loss experience, change as Montpelier Bermuda’s estimates of loss and LAE fluctuate. Profit commissions (reversals) for Montpelier Bermuda totaled $1.0 million, $(3.8) million and $5.9 million for 2010, 2009 and 2008, respectively. The 2009 reversal reflects profit commission adjustments on a few large contracts. Excluding the impact of profit commissions, Montpelier Bermuda’s acquisition cost ratios were 13.3%, 13.6% and 14.6% for 2010, 2009 and 2008, respectively. Relatively few of Montpelier Bermuda’s assumed reinsurance contracts contain profit commission clauses, and the terms of these profit commissions are specific to the individual contracts and vary as a percentage of the contract results.
The following table summarizes Montpelier Bermuda’s general and administrative expenses during the years ended December 31, 2010, 2009 and 2008:
The decrease in Montpelier Bermuda’s incentive compensation expenses recognized during 2010 versus 2009 reflects the reduction in our consolidated underwriting income experienced from year to year.
Montpelier Syndicate 5151 wrote $231.3 million of gross premiums during 2010, which represents a 38% increase over the $167.3 million in gross premiums written during 2009. The increase was generated by Montpelier Syndicate 5151’s U.K.-based underwriters who wrote $185.0 million of gross premiums during 2010, as compared to $119.1 million during 2009. Montpelier Syndicate 5151’s U.S.-based underwriters wrote $46.3 million and $48.2 million of gross premiums during 2010 and 2009, respectively.
The largest drivers of the increase in 2010 gross premiums written related to the following classes of business:
· Marine premiums written increased by $31.5 million from 2009 to 2010, all of which is reflected in the Property and Specialty Individual Risk line of business.
Gross and net premiums written and ceded reinsurance premiums during the periods presented include amounts assumed and ceded as part of inter-segment excess-of loss reinsurance agreements. See “Corporate and Other” under this Item 7.
Reinstatement premiums written within Montpelier Syndicate 5151 during 2010 and 2009 were $6.7 million and $1.8 million, respectively. No reinstatement premiums were written during 2008. The significant increase in reinstatement premiums written during 2010 related primarily to the earthquake in Chile that occurred in February 2010.
In the normal course of its business, Montpelier Syndicate 5151 purchases reinsurance in order to manage its exposures. The amount and type of reinsurance that it purchases is dependent on a variety of factors, including the cost of a particular reinsurance cover and the nature of its gross premiums written during a particular period.
All of Montpelier Syndicate 5151’s reinsurance purchases to date have represented prospective cover; that is, Montpelier Syndicate 5151 purchases reinsurance as protection against the risk of future losses as opposed to covering losses that have already been incurred but have not been paid.
Various factors will continue to affect this segment’s appetite and capacity to write and retain risk. These include the impact of changes in frequency and severity assumptions used in Montpelier Syndicate 5151’s models and the corresponding pricing required to meet its return targets, evolving industry-wide capital requirements, increased competition, and other considerations.
Net premiums earned at Montpelier Syndicate 5151 during the years ended December 31, 2010, 2009 and 2008 were $175.0 million, $133.1 million and $63.6 million, respectively. Net premiums earned are a function of the timing of net premiums written.
We estimated Montpelier Syndicate 5151’s loss and LAE reserves using the methodology outlined in our “Summary of Critical Accounting Estimates” contained in Item 7 herein. We did not make any significant changes in the assumptions or methodology used in Montpelier Syndicate 5151’s reserving process during the year ended December 31, 2010.
The following table presents Montpelier Syndicate 5151’s net loss and LAE ratios for the years ended December 31, 2010, 2009 and 2008:
During 2008 Montpelier Syndicate 5151 incurred $46.7 million of current year net loss and LAE which related to several individual risk losses, as well as $6.8 million of losses relating specifically to Hurricanes Gustav and Ike.
The following table summarizes Montpelier Syndicate 5151’s underwriting expenses for the years ended December 31, 2010, 2009 and 2008:
Montpelier Syndicate 5151’s operating expenses consist mainly of: (i) salaries, employee benefits and premises costs associated with its underwriting and Coverholder operations located in the U.S., U.K. and Switzerland; (ii) intercompany allocations of information technology and risk modeling expenses; and (iii) fees from Lloyd’s.
Operating expenses have remained relatively stable during each of the years presented, with the year-to-year variation being largely attributable to fluctuations in Lloyd’s fees. In particular, during 2009 Montpelier Syndicate 5151 benefitted from a non-recurring $2.1 million Lloyd’s multi-year credit.
Incentive compensation expenses are recorded largely on the basis of Montpelier’s consolidated underwriting results achieved during the year.
The decrease in Montpelier Syndicate 5151’s incentive compensation expenses recognized during 2010 versus 2009 reflects the reduction in our consolidated underwriting income experienced from year to year.
Underwriting results for MUSIC were as follows for the years ended December 31, 2010, 2009 and 2008:
MUSIC’s gross premiums written, all of which relate to its Property and Specialty Individual Risk line of business, have been continually increasing since its inception in 2007. Ceded reinsurance premiums during 2010, 2009 and 2008 of $1.7 million, $0.6 million and zero, respectively, include amounts ceded to Montpelier Syndicate 5151 as part of an inter-segment excess-of-loss reinsurance agreement. See “Corporate and Other” under this Item 7.
Net premiums earned are a function of the timing of net premiums written.
The following tables summarize MUSIC’s loss and LAE reserve activities for the years ended December 31, 2010, 2009 and 2008:
We estimated MUSIC’s loss and LAE reserves using the methodology outlined in our “Summary of Critical Accounting Estimates” contained in Item 7 herein. We did not make any significant changes in the assumptions or methodology used in MUSIC’s reserving process during the year ended December 31, 2010.
The following table presents MUSIC’s net loss and LAE ratios for the years ended December 31, 2010, 2009 and 2008:
MUSIC incurred acquisition costs of $8.3 million, $3.4 million and $0.5 million for 2010, 2009 and 2008, respectively. The increases in MUSIC’s acquisition costs during these periods were largely consistent with the increases in MUSIC’s net earned premiums as evidenced by its consistent acquisition cost ratios during each of the years presented.
The decrease in MUSIC’s incentive compensation expenses recognized during 2010 versus 2009 reflects the reduction in our consolidated underwriting income experienced from year to year.
Underwriting results for Blue Ocean, which was liquidated and dissolved in 2009, for the year ended December 31, 2008, were as follows.
Blue Ocean was formed in order to capitalize on the attractive market conditions that existed in the property casualty retrocessional market following the 2005 hurricane season. While early pricing conditions for this segment were strong, increased competition and weaker demand experienced at the end of 2006 and throughout 2007 adversely impacted pricing.
Corporate and Other, which collectively represents the Company, certain intermediate holding and service companies and intercompany eliminations relating to inter-segment reinsurance and service charges, is not considered to be an operating segment of our business. The underwriting losses generated by Corporate and Other principally reflect general and administrative expenses in support of our various operating companies.
The gross premiums written and ceded reinsurance premiums presented within Corporate and Other represent the elimination of inter-segment excess-of-loss reinsurance arrangements between Montpelier Bermuda and Montpelier Syndicate 5151, and between Montpelier Syndicate 5151 and MUSIC. The premiums associated with these inter-segment arrangements during the years presented were as follows:
Operating expenses include salaries and benefits, information and technology systems costs, director fees, legal costs, corporate insurance, audit fees and fees associated with being a publicly traded company. The increase in operating expenses for 2010, as compared to 2009, was primarily attributable to a change in the manner in which Montpelier’s centrally-managed information technology costs are allocated. The decrease in operating expenses for 2009, as compared to 2008, was primarily attributable to: (i) a reduction in consulting services for information technology implementations; (ii) reduced legal expenses regarding corporate matters; (iii) lower audit fee allocations; and (iv) reduced insurance allocations.
The decrease in incentive compensation expenses recognized during 2010 versus 2009 reflects the reduction in our consolidated underwriting income experienced from year to year.
The increase in incentive compensation expenses recognized during 2009 versus 2008 reflects a significant increase in our consolidated underwriting income experienced from year to year.
Our investment income decreased in 2010 and 2009, as compared to 2008, mainly as a result of continual declines in short-term interest rates and reductions in dividend income earned on a smaller average portfolio of equity securities. In addition, we discontinued our securities lending program during the second quarter of 2008. Fees earned from our securities lending program during 2008 were recorded as additional investment income.
During 2009 we experienced $104.2 million of net realized and unrealized gains from our fixed maturity investments, $74.6 million in net realized and unrealized gains from our equity investments and $3.0 million in net realized and unrealized gains from our other investments. The fixed maturity gains and the majority of the other investment gains we experienced during 2009 were largely the result of a declining U.S. Treasury yield curve as well as tightening credit spreads between the yield on those securities versus that of U.S. Treasuries. Our equity portfolio also experienced net gains during 2009, benefitting from gains in the U.S. equity market as a whole.
During 2008 we experienced $82.4 million of net realized and unrealized losses from our fixed maturity investments and securities lending collateral, $103.5 million in net realized and unrealized losses from our equity investments and $59.0 million in net realized and unrealized losses from our other investments. The significant fixed maturity and other investment losses we experienced during 2008 were largely the result of credit concerns for corporate and asset-backed debt securities. Our equity portfolio also experienced significant losses during 2008, suffering from losses in the U.S.
equity market as a whole. The net realized investment losses recorded during 2008 principally resulted from a $17.5 million loss within our fixed maturity portfolio resulting from the bankruptcy of Lehman Brothers and $43.6 million in losses within our other investment portfolio attributable to two leveraged limited partnership funds which specialized in distressed loans.
The decrease in our Level 3 securities from December 31, 2009 to December 31, 2010, was the result of sales of bank loans within our portfolio of corporate debt securities, as well as increased pricing transparency associated with certain residential mortgage-backed and corporate fixed-maturity securities historically classified as Level 3, which resulted in a shift of such investments to Level 2. In addition, during 2010 our investment in Symetra was reclassified from Level 3 to Level 1 when its common shares began trading on the New York Stock Exchange.
The following table summarizes the components of our consolidated net foreign exchange gains (losses) for years ended December 31, 2010, 2009 and 2008:
Our net foreign exchange transaction gains (losses) on insurance and reinsurance balances represent realized gains and losses, primarily resulting from cash and premiums receivable by Montpelier Bermuda and Montpelier Syndicate 5151 in currencies other than the U.S. dollar. These transaction gains and losses do not include fluctuations associated with our loss and LAE, which we record as favorable or (unfavorable) loss reserve development.
From time to time we have entered into foreign currency exchange agreements in order to mitigate the financial effects of these foreign exchange rate fluctuations. See “Net Expense from Derivative Instruments” below.
In March 2008 we purchased the Hurricane Option, an option on hurricane seasonal futures traded on the Chicago Mercantile Exchange, in order to provide protection against our eastern U.S. hurricane exposure. Our maximum possible recovery under the Hurricane Option was $5.0 million and it expired without value in November 2008.
We recorded an expense of $1.0 million associated with the Hurricane Option during 2008.
In November 2010 we entered into ILW Swap II with a third-party in order to provide protection against our U.S. earthquake and Europe windstorm exposures through June 30, 2011. In return for a fixed-rate payment of $1.0 million, we receive a floating-rate payment which is triggered on the basis of losses incurred by the insurance industry as a whole. Our maximum recovery under ILW Swap II is $5.0 million.
In December 2005, we purchased fully-collateralized coverage for losses sustained from qualifying hurricane and earthquake loss events from a third-party that financed this coverage through the issuance of $90.0 million in catastrophe bonds to investors under two separate bond tranches, each of which matured in January 2009. Both tranches responded to parametric triggers, whereby payment amounts were determined on the basis of modeled losses incurred by a notional portfolio rather than by actual losses incurred by us. For that reason, this transaction was accounted for as a derivative, rather than as a reinsurance transaction, and was carried at fair value.
Through the date of maturity of the CAT Bond Protection, no industry loss event occurred which would have triggered a recovery by us under this coverage.
From time to time we, either directly or indirectly through our investment managers, enter into foreign currency exchange agreements which constitute obligations to buy or sell specified currencies at future dates at prices set at the inception of each contract. We enter into these agreements in connection with our underwriting and investing activities.
Our open Foreign Exchange Contracts at December 31, 2010 were denominated in British pounds, New Zealand dollars, European Union euros and Canadian dollars. Our open Foreign Exchange Contracts at December 31, 2009 were denominated in European Union euros and Canadian dollars.
We recorded income (expense) of $2.1 million, $(0.6) million and $(4.1) million associated with the Foreign Exchange Contracts during 2010, 2009 and 2008, respectively.
From time to time our investment managers enter into various interest rate derivative contracts whose values are based on the right to pay or receive a notional amount of money at a given interest rate. These instruments are used to either limit our exposure to fluctuations in specified interest rates or to address an anticipated change in interest rates.
From time to time we enter into various exchange-traded investment options and futures as part of our investing strategy. As of December 31, 2010 and 2009, we had open long option positions with a fair value of $2.2 million and $1.8 million, respectively.
In June 2006 we entered into the CAT Bond Facility under which we were entitled to receive contract payments from a third-party in return for assuming mark-to-market risk on a portfolio of securitized catastrophe risks. The difference between the notional capital amounts of the catastrophe bonds and their market value was marked to market over the terms of the bonds; the difference was settled on a monthly basis. These marked-to-market adjustments, in addition to any interest earned on the bonds, were included as a component of net income (expense) from derivative instruments.
In June 2008 the CAT Bond Facility was terminated and we purchased the underlying CAT Bonds from the counterparty at their fair value.
In August 2007 and April, 2010, we entered into ILW Contracts with third-parties under which qualifying loss payments are triggered exclusively by reference to the level of losses incurred by the insurance industry as a whole rather than by losses incurred by the insured. Each ILW Contract was designed to provide the insured with $15.0 million of protection resulting from industry losses of stated amounts. The first of these ILW Contracts covered losses from all natural perils within the U.S., and expired in August 2008 without any payment required by us. The second ILW Contract expires in March 2011, and covers losses incurred in several U.S. states resulting from earthquake damage. We received consideration of $4.0 million and $0.5 million for the first and second ILW Contract, respectively.
During 2010 we repurchased and retired $1.0 million in principal amount of our Senior Notes. The loss recognized on the transaction, representing the difference between the amount of consideration paid and the carrying value of the Senior Notes repurchased, was less than $0.1 million.
Our consolidated other revenue is comprised of: (i) services provided to third parties consisting of commissions earned by PUAL and advisory fees and royalties earned from providing catastrophe modeling services and technology to third parties; and (ii) interest on funds advanced to ceding companies to cover losses in accordance with contract terms. The following table summarizes our consolidated other revenue for the years ended December 31, 2010, 2009 and 2008:
The following table summarizes our consolidated interest and other financing expenses for the years ended December 31, 2010, 2009 and 2008:
Our interest and other financing expenses also decreased during 2009, as compared to 2008. The reduction in interest expense experienced in 2009 was due primarily to the repurchase of $21.0 million of our Senior Notes in 2009. The increase in letter of credit and trust fees experienced in 2009 related primarily to our Lloyd’s Standby Letter of Credit Facility, which was increased from £110.0 million to $230.0 million during 2009.
We are domiciled in Bermuda and have subsidiaries that are domiciled in several other countries, including the U.S., the U.K. and Switzerland. At the present time, no income taxes are levied in Bermuda and the Company and its Bermuda-domiciled subsidiaries have received an assurance from the Bermuda Minister of Finance exempting them from all Bermuda-imposed income, withholding and capital gains taxes until 2016. The Minister of Finance has recently indicated that this exemption will be extended to 2035 but the required legislation for this action has not yet been brought before the Bermuda legislature.
Excess of Fair Value of Acquired Net Assets Over Cost - Blue Ocean
In 2008 we had net income attributable to noncontrolling interests in Blue Ocean of $1.9 million. As a result of the Blue Ocean Transaction, no portion of our 2010 and 2009 net income was attributable to noncontrolling interests.
The primary sources of cash for our regulated operating subsidiaries are premium collections, investment income and sales and maturities of investments. The primary uses of cash for our operating subsidiaries are payments of losses and LAE, acquisition costs, operating expenses, investment purchases and dividends and distributions paid to the Company.
As of December 31, 2010, our sources of immediate and unencumbered liquidity consisted of: (i) $148.0 million of cash and cash equivalents; (ii) $191.5 million in highly liquid fixed maturity investments which currently trade at a very narrow bid/ask spread and whose proceeds are available upon one days’ notice; and (iii) $382.1 million of liquid fixed maturity investments which currently trade at a narrow bid-ask spread and whose proceeds are available upon three days’ notice. Further, we believe that we have significant sources of additional liquidity within our fixed maturity investment portfolio beyond these levels although the bid-ask spreads associated with such investment securities would be expected to be broader, perhaps significantly, from sales of those securities previously mentioned, particularly if a large individual investment holding were required to be liquidated in an expedient manner. We also believe that we have additional liquidity within our portfolio of equity securities.
During the years ended December 31, 2010, 2009 and 2008, we were able to meet all of our cash obligations. We anticipate that our current cash and cash equivalent balances, our capacity to raise additional cash through sales and maturities of investments and our projected future cash flows from operations will be sufficient to cover our cash obligations under most loss scenarios through the foreseeable future.
Our total capital decreased by $100.7 million during 2010 as a result of our recording comprehensive income of $208.7 million, recognizing $10.9 million of additional paid-in capital through the amortization and issuances of share based compensation, offset by reductions from repurchasing $1.0 million of our Senior Notes, declaring $25.5 million in dividends to our shareholders and repurchasing $293.8 million of Common Shares.
Our Senior Notes mature on August 15, 2013 and we currently intend to refinance this obligation prior to its maturity. Whereas we believe that current market conditions would permit such a refinancing on reasonable terms, future terms and conditions may prove to be unfavorable. In the event we are unable to refinance the Senior Notes prior to their maturity, we would expect to be in a position to repay that obligation with internal funds.
In the normal course of business, we maintain letter of credit facilities and provide letters of credit to third parties as a means of providing collateral and/or statutory credit to certain of our constituents. These letter of credit facilities were secured by collateral accounts containing cash and investments totaling $376.7 million and $835.8 million at December 31, 2010 and 2009, respectively. The following table outlines these facilities as of December 31, 2010:
Effective August 4, 2010, our Syndicated Facility: Tranche B, which had a capacity of $225.0 million, expired under its terms and was not renewed. As a result: (i) we can no longer issue letters of credit under the facility; (ii) all outstanding letters of credit drawn under the facility will continue for up to 360 days; and (iii) all outstanding letters of credit drawn under the facility will have to be renewed into an alternate facility upon expiry. This facility is subject to an annual commitment fee of 0.225% on drawn balances and, while active, was subject to an annual commitment fee of 0.075% on undrawn balances.
Our Syndicated 5-Year Facility (I) is subject to an annual commitment fee of 0.275% on drawn balances and 0.075% on undrawn balances. In June 2011 this facility, which has a capacity of $500.0 million, is scheduled to expire under its terms. We have not yet formally decided whether to renew this facility, replace this facility with a new letter of credit facility or allow it to expire. Whereas we believe that current market conditions would permit us to renew or replace this facility, the current indicative terms and conditions of such a facility would not be as favorable as those currently in effect and our future financing expenses would be adversely effected. In the event we are unable or unwilling to renew or replace this expiring facility, we would expect to be in a position to replace the expiring facility with spare capacity within the Reinsurance Trust.
Our Syndicated 5-Year Facility (II) is subject to an annual commitment fee of 0.225% on drawn balances and 0.08% on undrawn balances.
Effective September 30, 2010, we established the Reinsurance Trust as an alternative means of providing statutory credit to certain of our U.S. cedants. The initial minimum value of the Reinsurance Trust was set at $20.0 million plus the amount of our reinsurance liabilities to such cedants (which were $54.8 million at December 31, 2010). As of December 31, 2010, the fair value of all assets held in the Reinsurance Trust was $101.4 million.
Effective March 31, 2010, we entered into the Lloyd’s Capital Trust in order to meet our ongoing FAL requirements. As of December 31, 2010, the fair value of all assets held in the Lloyd’s Capital Trust was $249.5 million.
Our loss and LAE reserves do not have contractual maturity dates. The expected loss and LAE reserve obligations presented above are based on historical loss and LAE reserve payment patterns.
Our cash flows provided from operations totaled $317.7 million which resulted primarily from premiums received, net of acquisition costs, exceeding net paid losses of $189.3 million.
· we paid $7.8 million in net settlements of investment-related derivative instruments,
· we received $9.5 million from net settlements of investment-related derivative contracts,
Our cash flows provided from operations totaled $73.3 million which resulted primarily from premiums received, net of acquisition costs, exceeding net paid losses of $317.9 million.
· we paid $254.8 million for net purchases of equity securities and other investments,
· we had $193.4 million in net dispositions of securities lending collateral,
· we paid $1.0 million in connection with the termination of our securities lending program,
· we paid $75.0 million to retire Blue Ocean’s debt, paid $38.1 million in distributions and redemptions to Blue Ocean’s noncontrolling common shareholders and paid $21.0 million in dividends and redemptions to Blue Ocean’s noncontrolling preferred shareholders,
· we had a $193.4 million net reduction in securities lending payable.
Our loss and LAE relating to short-tail property risks are typically reported and settled more promptly than those relating to our long-tail risks, mainly our casualty risks. However, the timeliness of loss reporting can be affected by such factors as the nature of the event causing the loss, the location of the loss, whether the losses are from policies in force with primary insurers or with reinsurers and where we fall within the cedant’s overall reinsurance program.
Our loss and LAE reserves are comprised of case reserves (which are based on claims that have been reported to us) and IBNR reserves (which are based on losses that are believed to have occurred but for which claims have not yet been reported to us and may include a provision for expected future development on our case reserves).
Our IBNR reserves are determined using various actuarial methods as well as a combination of our own historical loss experience, historical insurance industry loss experience, estimates of pricing adequacy trends, and our professional judgment. In the case of our reinsurance business, our reserving process is highly dependent on the loss information we receive from ceding companies. The process we use to estimate our IBNR reserves involves projecting our estimated ultimate loss and LAE reserves and then subtracting paid claims and case reserves as notified by the ceding company, to arrive at our IBNR reserve.
Our reserving methodology does not lend itself well to a statistical calculation of a range of estimates surrounding the best point estimate of our loss and loss adjustment expense reserves. Due to the low frequency and high severity nature of our business, our reserving methodology principally involves arriving at a specific point estimate for the ultimate expected loss on a contract by contract basis, and our aggregate loss reserves are the sum of the individual reserves established. Our internal actuaries review our reserving assumptions and our methodologies on a quarterly basis. Our third quarter and year-end loss estimates are subject to a corroborative review by independent actuaries using generally accepted actuarial principles. The Audit Committee of our Board of Directors meets with our independent actuaries at least once annually and receives our internal reserve analyses each quarter and the independent actuaries’ summary reserve analysis annually.
While the approach we use in reserving for large events is applied with consistency, at any point in time the specific reserving assumptions may vary among contracts. The assumptions for a specific contract may depend upon the class of business, historical reporting patterns of the cedant, whether or not the cedant provides an IBNR estimate, how much of the loss has been paid, the number of underlying claims still open and other factors. For example, the expected loss development for a contract with 1% of claims still outstanding would likely be less than for a contract with 50% of claims still open.
For non-catastrophe losses, we often apply trend-based actuarial methodologies in setting reserves, including paid and incurred loss development, Bornheutter-Ferguson and frequency and severity techniques. We also utilize industry loss ratio and development pattern information in conjunction with our own experience. The weight given to a particular method will depend on many factors, including the homogeneity within the class of business, the volume of losses, the maturity of the accident year and the length of the expected development tail. For example, development methods rely on reported losses, while expected loss ratio methods are typically based on expectations in place prior to a notification of loss. Therefore, as an accident year matures, we may shift weight from an expected loss ratio method to an incurred development method.
Time lags are inherent in reporting to the primary insurer then to the broker and then to the reinsurer, especially in the case of excess-of-loss reinsurance contracts. Also, the combined characteristics of low claim frequency and high claim severity make the available data more volatile and less useful for predicting ultimate losses. In the case of proportional contracts, we rely on an analysis of a contract’s historical experience, industry information, and the professional judgment of underwriters in estimating reserves for these contracts. In addition, we utilize ultimate loss ratio forecasts when reported by cedants, which are normally subject to a quarterly or six month lag for proportional business. Because of the degree of reliance that we necessarily place on ceding companies for claims reporting, our reserve estimates are highly dependent on ceding companies’ management judgment. Furthermore, during the loss settlement period, which may last several years, additional facts regarding individual claims and trends often will become known, and current laws and case law may change, all of which can affect ultimate expected losses.
The following tables provide the details of our gross case reserves and IBNR, by line of business, at December 31, 2010 and 2009:
Provided we do not experience a significant loss late in the calendar year, the portion of our loss reserves at year-end represented by IBNR tends to be lower for large loss events than it does for loss events of lower severity. During 2010, a year with a high level of large losses as compared to 2009, our IBNR reserves decreased year-to-year relative to our total reserves.
We have determined that our best estimates for our gross loss and LAE reserves at December 31, 2010 and 2009 were $784.6 million and $680.8 million, respectively. Of these estimates, at December 31, 2010 and 2009, $108.0 million and $67.0 million related to our insurance business, respectively, and $676.6 million and $613.8 million related to our reinsurance business, respectively.
For pro-rata contracts and certain excess-of-loss contracts in which a deposit or minimum premium is not specified in the contract, we record an estimate of written premiums in the period in which the underlying insurance policies incept. The premium estimate is based on information provided by ceding companies at the inception of the contract. When the actual premium is reported by the ceding company, typically on a quarterly or six month lag, it may be significantly higher or lower than the estimate.
Excess-of-loss contracts often include contract terms that require an automatic reinstatement of coverage in the event of a loss. The associated reinstatement premium is normally calculated on the basis of (a) a fixed percentage (normally 100%) of the deposit or minimum premium and (b) the proportion of the original limit exhausted. In a year of large loss events, reinstatement premiums will be higher than in a year in which there are no such events. Reinstatement premiums are fully earned or expensed as applicable when a triggering loss event occurs and losses are recorded. We accrue reinstatement premiums on a basis consistent with our estimates of loss and LAE.
Reinsurance recoverable on paid losses represents amounts currently due from reinsurers. Reinsurance recoverable on unpaid losses represents amounts collectible from reinsurers once the losses are paid. The recognition of reinsurance recoverable requires two key judgments. The first judgment involves an estimate of the amount of gross IBNR to be ceded to reinsurers. Ceded IBNR is typically developed as part of our loss reserving process and consequently, the estimate is subject to similar risks and uncertainties as the estimate of gross IBNR. The second judgment relates to the amount of the reinsurance recoverable balance that ultimately will not be collected from reinsurers due to insolvency, contractual dispute, or other reasons.
As of December 31, 2010 and 2009, we recorded $12.9 million and $44.5 million in reinsurance recoverable on paid losses, respectively, and $62.4 million and $69.6 million in reinsurance recoverable on unpaid losses, respectively. We record provisions for uncollectible reinsurance recoverable when collection becomes unlikely due to the reinsurer’s inability to pay. Based on a review of the financial condition of the reinsurers and other factors, we have determined that a reserve for uncollectible reinsurance recoverable on paid and unpaid loss and LAE was not considered appropriate as of December 31, 2010 and 2009.
We are subject to litigation and arbitration proceedings in the normal course of our business. These proceedings often involve reinsurance contract disputes which are typical for the reinsurance industry. Expected or actual reductions in reinsurance recoveries due to contract disputes, as opposed to a reinsurer’s inability to pay, are not recorded as an uncollectible reinsurance recoverable. Rather, they are factored into the determination of our net loss and LAE reserves.
As of December 31, 2010, we had no ongoing material reinsurance contract disputes. We were involved in a dispute over two reinsurance contracts with MPCL that was concluded in June 2010. See Item 3, “Legal Proceedings.”
RSUs are phantom restricted shares which, depending on the individual award, vest in equal tranches over three, four or five-year periods, subject to the recipient maintaining a continuous relationship with us (either as an employee, a director or a consultant) through the applicable vesting date. Holders of RSUs are not entitled to voting rights but are entitled to receive payments equivalent to dividends and distributions declared on Common Shares.
For the Variable RSU award cycle from 2009 to 2012, the targeted performance metric was based on a 2009 ROE of 9.77%. At an achieved ROE of 9.77% (our target) we expected to grant approximately 650,000 Variable RSUs to participants, at an achieved ROE of 3.77% (our threshold) we expected to grant no Variable RSUs to participants and at an achieved ROE of 19.77% (our maximum) we expected to grant approximately 1,300,000 Variable RSUs to participants. Throughout the Initial RSU Period, our quarterly Variable RSU accrual for this cycle varied in response to actual year-to-date results achieved and ranged from as many as 1,260,327 RSUs (as recorded at December 31, 2009) to as few as 685,717 RSUs (as recorded at March 31, 2009). Based on our actual ROE achieved for 2009 of 19.11%, the final number of Variable RSUs granted for the 2009-2012 award cycle was determined to be 1,273,118 by the Compensation Committee in March 2010 and these awards have been converted to Fixed RSUs.
For the Variable RSU award cycle from 2010 to 2013, the targeted performance metric was based on a 2010 ROE of 9.69%. At an achieved ROE of 9.69% (our target) we expected to grant approximately 580,000 Variable RSUs to participants, at an achieved ROE of 3.69% (our threshold) we expected to grant no Variable RSUs to participants and at an achieved ROE of 19.69% (our maximum) we expected to grant approximately 1,160,000 Variable RSUs to participants. Throughout the Initial RSU Period, our quarterly Variable RSU accrual for this cycle varied in response to actual year-to-date results achieved and ranged from as many as 725,922 RSUs (as recorded at December 31, 2010) to as few as 408,084 RSUs (as recorded at June 30, 2010). Based on our estimated ROE achieved for 2010 of 11.94%, the preliminary number of Variable RSUs to be granted for the 2010-2013 award cycle was determined to be 725,922 at December 31, 2010. The actual ROE and final number of Variable RSUs to be granted and converted to Fixed RSUs will be determined by the Compensation Committee in March 2011.
For the years covered by this report, we assumed a 3% to 14.5% forfeiture rate depending on the nature and term of the individual award and past experience. Our forfeiture assumptions serve to reduce the unamortized grant date fair value of outstanding RSUs as well as our associated RSU expense. As RSUs are actually forfeited, the number of RSUs outstanding is reduced and the remaining unamortized grant date fair value is compared to assumed forfeitures levels. True-up adjustments are made as deemed necessary.
For the years ended December 31, 2010, 2009 and 2008, we recognized $13.5 million, $14.8 million and $8.3 million of RSU expense.
The unamortized grant date fair value, as of December 31, 2010, of our 911,658 Fixed RSUs outstanding was $5.6 million and the unamortized grant date fair value of our 725,922 Variable RSUs outstanding was $5.7 million.
The financial statements and supplementary data have been filed as a part of this Annual Report on Form 10-K as indicated in the Index to Consolidated Financial Statements and Financial Statement Schedules appearing on page 88 of this report.