Commercial Automobile - for third party claims, the methodology for establishing case reserves is virtually identical to that of general liability. First party automobile reserves are established based upon the cost of repair or actual cash value as appropriate under the circumstances, generally confirmed by an appraisal, and consistent with applicable state claims handling regulations.
In 2008, 2007 and 2006, the Company increased asbestos reserves by $25.2 million, $24.3 million and $22.7 million, respectively, (approximately 8%, 7% and 6%, respectively, of the preceding year-end reserves balances). The increases in each year were largely attributable to developments related to one policyholder, with whom the Company settled a lawsuit in the first quarter of 2008.
There is great uncertainty involved in estimating liabilities related to these exposures. First, the number of waste sites subject to cleanup is unknown. Currently, approximately 1,255 cleanup sites are included in the EPA’s National Priorities List. State authorities have identified many additional sites. Second, the liabilities of the policyholders themselves are difficult to estimate. At any given site, the allocation of remediation cost among the PRPs varies greatly depending upon a variety of factors. Third, different courts have been presented with liability and coverage issues regarding pollution claims and have reached inconsistent decisions on several issues. These uncertainties are unlikely to be resolved in the near future.
At December 31, 2008 and 2007, the fair value of the credit default swaps was $138.8 million and $234.1 million, respectively. Gains or losses arising from changes in the fair value of the credit default swaps are recorded in realized investment gains and losses in the consolidated statements of income. For the years ended December 31, 2008, 2007 and 2006, realized investment gains (losses) resulting from the net change in fair value of the credit default swaps was $283.5 million, $229.7 million and $(23.9) million, respectively.
Amounts recoverable from reinsurers are initially estimated in conjunction with the establishment of reserves for unpaid losses and LAE. These amounts may be adjusted as actual case reserves are recorded and reinsured claims are settled. The ceding of risk to reinsurers does not relieve the insurance companies of their primary obligation to policyholders as the direct insurer. Accordingly, the Company is exposed to the risk that any reinsurer may be unable, or unwilling, to meet the obligations assumed under its reinsurance agreements. Management attempts to mitigate this risk by obtaining collateral and by entering into reinsurance arrangements only with reinsurers that have credit ratings and statutory surplus above certain levels.
The Company is a national commercial property and casualty insurance company with a focused underwriting strategy, targeting specialty classes of business and underserved market opportunities. Operating through its home office and regional branch network, the Company writes a broad range of commercial coverage, including workers’ compensation, general liability, commercial automobile, property, commercial multi-peril, accident and health and other lines of business. The Company generally conducts business on a brokerage basis through more than 1,400 producers located throughout the United States.
For the year ended December 31, 2007, premiums earned increased by $102.1 million, or 9.4%, as compared to the year ended December 31, 2006. The increase in premiums earned relative to the decline in net premiums written in 2007 is primarily attributable to the Fairmont business which the Company assumed at the start of 2006 and which therefore contributed a lower portion to premiums earned in 2006 as compared to 2007.
In 2008, the Company recognized net adverse prior year loss development of $39.0 million (3.9 loss ratio points) prior to corporate aggregate reinsurance activity. Included in the adverse loss development is $84.3 million (8.4 loss ratio points) attributable to a loss on commutation of a reinsurance contract ($75.5 million after amortization of related deferred gain) and $25.5 million (2.6 loss ratio points) attributable to the settlement of an asbestos lawsuit. Excluding these one time charges, the Company recognized net favorable loss development of $89.7 million (9.0 loss ratio points) including $18.9 million of favorable development related to amortization of deferred gains on retroactive reinsurance. The favorable development was primarily in the workers’ compensation and general liability lines of business, reflecting favorable loss emergence in almost all accident years, partially offset by unfavorable ALAE emergence in general liability for both latent and non-latent exposures. Specifically, favorable development in the workers’ compensation line was principally attributable to favorable results in non-California medical reserves for older accident years and non-California indemnity reserves for more recent accident years.
Includes book value of assets pledged for derivatives and short-sale obligations of $4.4 million, $1,047.4 million and $540.9 million at December 31, 2008, 2007 and 2006, respectively.
The increase in net realized investment gains of $61.3 million, or 35.5%, in 2007 as compared to 2006 was primarily due to significant gains on the credit default swaps. During 2007, the Company recorded net gains of $229.7 million on the credit default swaps compared to net losses of $(23.9) million in 2006. Partially offsetting the increase in realized investment gains on the credit default swaps was a decline in the level of net gains achieved on the sale of fixed income and equity securities in 2007 as compared to 2006, which included a $106.6 million gain on the sale of Zenith common stock and a $45.0 million gain on the sale of a fixed income security.
The 2008 cash flow provided from operations of $100.9 million, includes $302.5 million of proceeds from the commutation of a reinsurance contract. Excluding the commutation, cash outflow from operations is $201.6 million, which is $195.7 million worse than prior year. The unfavorable variance from the prior year is primarily attributable to lower premium collections (as a result of the soft market and recent underwriting actions) and higher income tax payments which include payments in respect of realized investment gains, a component of investing activities. Income tax payments included in operating activities that are in respect of realized investment gains included in investing activities were $108.9 million, $23.6 million and $58.4 million in 2008, 2007 and 2006, respectively. The unfavorable variance in operating cash flows in 2007 from 2006 was primarily attributable to higher net paid losses and higher underwriting expenses in the face of declining premiums due to competitive market conditions. The increase in net paid losses was primarily due to additional losses associated with the Fairmont business, which was acquired in 2006, as well as higher net paid losses in the workers’ compensation and automobile lines of business. Expense growth reflected increased compensation and technology costs.
Investments in entities that are consolidated subsidiaries of Fairfax, but are less than 50% owned by the Company, as well as investments in certain partnerships, are carried under the equity method of accounting in accordance with Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” or at fair value in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”) which the Company adopted effective January 1, 2008. For all other investments, the Company determines if it exercises significant influence based upon its ownership of voting shares without consideration of the ownership interest of other Fairfax affiliates. Investments accounted for under the equity method of accounting are included as investments at equity on the consolidated balance sheets. The Company’s pro-rata share of earnings of equity method investees is recorded in the consolidated statements of income. Earnings of investment companies and similar equity method investees are reported in investment income and earnings of other equity method investees are reported as equity in earnings of investees, net of tax. The carrying value of investments at equity includes limited partnerships, and is based upon the Company’s share of net asset value of each investee, as determined by the general partner. Dividends from equity method investees reduce the carrying value of the investment. Investments that would have been subject to the equity method of accounting, but for which the Company has elected the fair value option under SFAS 159, are included in derivatives and other invested assets on the consolidated balance sheets, with changes in fair value recorded through earnings in the period in which they occur.
Company’s defined benefit postretirement plans pursuant to the provisions of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”). At December 31, 2008 and 2007, included in accumulated other comprehensive income were unrealized investment (losses) gains of $(10,836) and $11,640, net of tax, respectively, foreign currency translation (losses) gains of $(215) and $31,812, net of tax, respectively, and defined benefit postretirement plan gains of $3,596 and $1,027, net of tax, respectively.
SFAS No. 162. In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS 162”). SFAS 162 identifies the sources of accounting principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. SFAS 162 is effective 60 days following the SEC approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company currently adheres to the hierarchy of GAAP as presented in SFAS 162, and does not expect its adoption will have a material impact on its financial position or results of operations.
The Company has purchased credit default swaps, referenced to various issuers in the banking, mortgage and insurance sectors of the financial services industry. The credit default swaps serve as economic hedges against declines in the fair value of the Company’s financial assets. These credit default swaps were acquired by Fairfax and assigned to the Company to facilitate administration of counterparty credit risk and collateral maintenance. The credit default swaps are recorded at fair value with changes in fair value recorded as realized investment gains or losses in the period in which they occur. The Company obtains market-derived fair values for its credit default swaps from third-party providers, principally broker-dealers. In addition, the Company assesses the reasonableness of the fair values obtained from these providers by comparing the fair values to values produced using individual issuer credit default swap yield curves, by referencing them to movements in credit spreads and by comparing them to recent market transaction prices for similar credit default swaps where available. The fair values of credit default swaps are subject to significant volatility arising from the potential differences in the perceived risk of default of the underlying issuers, movements in credit spreads and the length of time to the contracts’ maturity. The fair value of the credit default swaps may vary materially either up or down in short periods, and their ultimate value may
respectively. The investment in Odyssey common stock was purchased in December 2008. The investments in Odyssey preferred stock and Advent were included in equity securities at December 31, 2007 at fair values of $7,347 and $15,996, respectively. Both Odyssey and Advent are affiliates of Fairfax.
On October 30, 2008, the Company purchased shares in Alliance Insurance Company, a publicly traded insurance company based in Dubai at a cost of $21,572.
SFAS 157 establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques. The fair value hierarchy is designed to indicate the relative reliability of fair value measurement. The highest priority is given to quoted prices in active markets and the lowest to unobservable data. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the hierarchy within which the fair value measurement falls is determined based on the lowest level significant input. The hierarchy is broken down into three levels based on the reliability of inputs as follows:
For the year ended December 31, 2008, losses and LAE is comprised of a loss on commutation of $4,123 offset by $8,778 of unamortized deferred income released on commutation as well as $10,172 of recurring deferred income amortization. For the years ended December 31, 2007 and 2006, losses and LAE is comprised of recurring amortization of deferred income only.
After May 1, 2012, the Company may redeem the 2017 Notes at its option, in whole or in part, upon not less than 30 nor more than 60 days’ notice, at the following redemption prices (expressed as percentages of the principal amount thereof) if redeemed during the twelve-month period commencing on May 1 of the year set forth below: