Excess Casualty: The vast majority of this class consists of domestic treaties, including pro rata and excess-of-loss contracts of general liability business. Excess casualty is dominated by umbrella business, some of which have very high attachment points. This business is generally very long tailed and characterized by relatively low frequency and high severity type losses. Therefore, expected loss ratio methods, such as the incurred B-F method, are heavily relied upon for most years due to the lack of mature reported experience available. The ELRs utilized for the most recent years are based on the projected ultimate loss ratios of prior years adjusted for rate level changes, estimated loss cost trends and other quantifiable changes, as well as actuarial pricing indications.
Medical Malpractice: Healthcare professional, which is the most significant component of TRH’s medical malpractice line of business, is reviewed separately for treaty and facultative contracts. Pro rata contracts are reviewed separately from excess-of-loss contracts. There is significant volume in all categories. This class is also quite long tailed due to the excess-of-loss nature of most of the contracts. Due to the lack of mature reported experience, B-F methods are generally utilized for the most recent five underwriting years with some weight given to the loss development methods for earlier years. Because almost all of these accounts are actuarially priced, the indications from these reviews are critical to the selection of the ELRs.
TRH measures at fair value on a recurring basis financial instruments included principally in its available for sale securities portfolios, securities lending invested collateral (which includes asset-backed and non-asset-backed fixed maturities) and certain short-term investments and cash equivalents. The fair value of a financial instrument is the amount that would be received to sell an asset in an orderly transaction between willing, able and knowledgeable market participants at the measurement date.
Realized net capital (losses) gains generally result from 1) investment dispositions, which reflect TRH’s investment and tax planning strategies to maximize after-tax income; 2) write-downs of securities that, in the opinion of management, had experienced a decline in fair value for which TRH could not reasonably assert that the recovery period would be temporary; and 3) foreign currency transaction gains (losses).
The increase in the loss ratio for consolidated TRH in 2008 compared to 2007 reflects an increased current accident year loss ratio excluding catastrophe losses and increased net catastrophe costs, partially offset by lower net loss reserve development. The improvement in the loss ratio for consolidated TRH in 2007 compared to 2006 reflects improvement from domestic operations partially offset by deterioration from international operations. The loss ratio for consolidated TRH in 2007 benefited from lower net adverse loss reserve development, partially offset by increased net catastrophe costs. In the aggregate, catastrophe costs and net loss reserve development added 4.4%, 3.4% and 5.0% to the consolidated TRH combined ratio in 2008, 2007 and 2006, respectively.
Prior to the fourth quarter of 2008, the transfers of securities in exchange for collateral under the Securities Lending Program were accounted for as secured borrowings. Securities lending invested collateral was shown on the balance sheet at fair value. A liability was recorded in an amount equal to the collateral received, reflecting TRH’s obligation to return the collateral when the loaned securities were returned. As a result of conditions affecting the financial and credit markets, in the fourth quarter of 2008, counterparties were successful in negotiating significantly reduced collateral levels (i.e., collateral received as a percentage of the fair value of the security loaned). Due to the lower collateral levels, during the fourth quarter of 2008, many of such loaned securities were accounted for as sales at the time of transfer and as purchases when the securities were subsequently returned. In the fourth quarter of 2008, TRH terminated its participation in the Securities Lending Program.
At December 31, 2008, gross loss reserves totaled $8.12 billion, an increase of $198.2 million, or 2.5% over 2007. The increase in gross loss reserves was mitigated by the impact of changes in foreign currency exchange rates since the end of 2007.
The components of gross loss reserves as of December 31, 2008 and 2007 by major class of business, split between reported (“case”) amounts and IBNR amounts is presented below:
Such modeled after-tax net catastrophe costs arising out of events with a 1.0% or 0.4% probability of exceeding the amounts shown in the table above from the costliest of the modeled events, would represent 12.0% (Europe, Wind) and 16.1% (California, Earthquake), respectively, of TRH’s stockholders’ equity at December 31, 2008. If multiple severe catastrophic events occur in any one year, the potential economic cost to the company could be materially higher than any one of the amounts shown above.
There is much uncertainty and imprecision in the compilation of these estimates at many stages in the process. Moreover, the makeup of TRH’s in-force business is constantly changing as new business is added and existing contracts terminate or expire, including contracts for reinsurance coverage purchased by TRH. In addition, these estimates take into account what TRH believes to be the most likely accumulation of territories and/or lines of business in a catastrophic natural peril event, but there can be no assurance that TRH has captured every possible scenario in its analysis. As a result of these factors, among others, there can be no assurance that TRH will not experience after-tax net catastrophe costs from individual events that exceed these estimates by a material amount. There also can be no assurance that TRH will not experience catastrophe events more frequently than the modeled probabilities would suggest. In any given year, catastrophe events could have a material adverse effect on TRH’s financial condition, results of operations, cash flows and liquidity.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS 157. TRH adopted SFAS 157 on January 1, 2008. In October 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”). For TRH, FSP FAS 157-3 was effective starting in the third quarter of 2008.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”).
I-Summary of Investments-Other than Investments in Related Parties As of December 31, 2008
II-Condensed Financial Information of Registrant As of December 31, 2008 and 2007 and For the Years Ended December 31, 2008, 2007 and 2006
(c) Investments: Fixed maturities are classified as held to maturity and carried at amortized cost if TRH has the positive intent and ability to hold each of these securities to maturity. When TRH does not have the positive intent to hold fixed maturities to maturity, such fixed maturities are classified as available for sale and carried at fair value. Premiums and discounts arising from the purchase of fixed maturities are treated as yield adjustments over their estimated lives, until maturity or call date, if applicable. Common stocks and non-redeemable preferred stocks are carried at fair value. See Note 3 for TRH’s methodology for determining the fair value of its investments.
Realized and unrealized gains and losses from investments in trading securities accounted for at fair value
Prior to the latter half of 2007, the collateral received was invested in segregated pooled accounts of the program manager containing floating rate bonds, including asset-backed securities, and interest-bearing cash equivalents. During the latter half of 2007, TRH’s interest in such pooled accounts was exchanged for separate portfolios containing floating rate bonds (i.e., fixed maturities), including asset-backed securities, and interest-bearing cash equivalents. These portfolios were maintained in segregated accounts for TRH by the program manager.
On January 1, 2007, TRH adopted FIN 48. At January 1, 2007, the total amount of TRH’s liability for unrecognized tax benefit, excluding interest and penalties, was $5.3 million. In 2007, TRH recognized this previously uncertain tax benefit. As a result, income tax expense for 2007 has been reduced by $5.3 million. At December 31, 2008, TRH has no liability for unrecognized tax benefits. TRH does not presently anticipate any material change in unrecognized tax benefits during the next twelve months.
The following table lists the tax years that remain subject to examination by major tax jurisdiction as of December 31, 2008:
TRH writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess liability business for such volatile classes as medical malpractice, D&O, E&O and general casualty. At the primary level, there are significant risk factors which contribute to the variability and unpredictability of the loss trend factors for this business, such as jury awards, social inflation, medical inflation, tort reforms and court interpretations of coverage. In addition, as a reinsurer, TRH is also highly dependent upon the claims reserving and reporting practices of its cedants, which vary greatly by size, specialization and country of origin and whose practices are subject to change without notice.
Net catastrophe costs represent TRH’s best estimate, including net changes from prior estimates, of the aggregate ultimate costs to be incurred relating to significant catastrophe events based upon information available at the time the estimate was made. These catastrophe cost estimates reflect significant judgment relating to many factors, including the ultimate resolution of certain legal and regulatory issues.
A summary of pre-tax net catastrophe costs by segment for 2008, 2007 and 2006 is presented below:
The charges made to operations for these plans for 2008, 2007 and 2006 were $6.4 million, $4.4 million and $5.2 million, respectively.
Expenses relating to stock-based compensation arrangements totaled $18.7 million, $14.8 million and $10.9 million in 2008, 2007 and 2006, respectively. Income tax benefits recognized related to stock-based compensation arrangements totaled $6.4 million, $4.9 million and $3.3 million in 2008, 2007 and 2006, respectively.
A weighted average dividend yield of 0.93% and 0.82% was used in 2008 and 2007, respectively, to value the options granted and was based on the dividend yield over the twelve month period prior to the grant date. The expected volatility was based on the historical volatility of TRH shares. The risk-free interest rate was based on the U.S. treasury yield curve in effect at the time of grant. The expected term was calculated based on historical data on employee exercise behavior.
One-third of the Service RSUs will vest on the anniversary of the date of the grant for each of the three years following the grant. The Company reserves the right to make payment for the Service RSUs in TRH shares or the cash equivalent of the fair value of such shares on the date of vesting.
Amounts recoverable from retrocessionnaires are recognized in a manner consistent with the claims liabilities associated with the retrocession and are presented on the balance sheet as reinsurance recoverable on paid and unpaid losses and LAE. Such balances at December 31, 2008 and 2007 are comprised as follows: