In establishing our initial reserves for a given accident year, due to the lack of available data for both open and closed claims for that accident year, we heavily rely on the loss assumptions that are used in our pricing models. Historically, and at present, we utilize loss ratios that are approximately 8 to 10 percentage points above the ratios incorporated within the pricing targets for that accident year. We believe this considers inherent risks associated with our rate development process and the historic volatility of professional liability losses (the industry has experienced accident year loss ratios as high as 163% and as low as 57% over the past 30 years) and produces a reasonable best estimate of the reserves required to cover actual ultimate unpaid losses. In the current environment this equates to an initial loss ratio of approximately 85% as compared to an average loss ratio of approximately 75% assumed in our pricing.
In general, management has assumed that severity trends would prove to be higher than actual results have indicated over the past several years. With the decline in the frequency of claims that both we and the industry have observed over the past five years, we had anticipated that the quality of claims would improve which would lead to higher average claim values and a higher severity trend. While the increase in severity has not been at the level we anticipated, management continues to believe that an increase in severity is a likely ultimate outcome of a lower frequency environment.
We record the majority of our investments at fair value as shown in the table below. The distribution of our investments based on GAAP fair value hierarchies (levels) is as follows:
(4) The timing of reinsurance recoveries varies from period to period and can depend upon the terms of the applicable reinsurance agreement, the nature of the underlying claim and the timing and amount of underlying loss payments.
Payments of $5.9 million made in 2011 for the 2008 and 2007 tax years as a result of Federal tax return audits conducted by the Internal Revenue Service. The payments reduced tax liabilities recognized prior to January 1, 2011 and did not increase or decrease 2011 tax expense. For additional information regarding the Internal Revenue Service audits, see Note 6 of the Notes to Consolidated Financial Statements.
We have no direct European sovereign debt exposure. We have indirect exposure through our investments in debt securities and through our reinsurance receivables. Issuers of our debt securities and our reinsurers may hold European sovereign debt or have counterparty exposure to European banks or European corporations. Entities that have significant European exposure may suffer credit downgrades due to European sovereign debt exposure or due to European creditor exposure, if they have significant business in the Euro-zone or Eurocurrency denominated business should either or both fail, or should a severe European recession arise.
These adverse severity trends then began to moderate, with that moderation becoming more pronounced in 2009, 2010 and 2011. We continue to be cautious in giving full recognition to newer indications that the pace of severity increase has slowed, but have given measured recognition of the improving trends in our reserve estimates, as discussed more fully under “Critical Accounting Estimates-Reserve for Losses and Loss Adjustment Expenses (reserve for losses or reserve).” We have recognized favorable development related to our previously established reserves primarily for accident years 2002 through 2008, giving stronger recognition to a lower severity trend as time elapses and the percentage of closed claims increases.
The following table identifies those reinsurers for which our recoverables for both paid and unpaid claims (net of amounts due to the reinsurer) and our prepaid balances are $10 million or more as of December 31, 2011:
Each of our debt instruments allows for repayment before maturity, at our option, on or after certain dates. For more information on our debt see Note 10 of the Notes to Consolidated Financial Statements.
(1) We continue to invest in tax credit partnerships (see Equity in Earnings (Loss) of Unconsolidated Subsidiaries). In 2011 we have recognized an expected tax benefit of approximately $5.7 million related to the credits to be transferred to us by the partnerships.
(1) All adjustments were calculated using the 35% federal statutory tax rate.