In our insurance segment, the lower level of catastrophe losses in 2009 was more than offset by the previously mentioned losses on our indemnity contract exposed to longevity risk and higher current accident year loss activity on the credit and political risk lines. In addition to the lower level of catastrophe losses in 2009, underwriting income in our reinsurance segment increased due to an additional $38 million of net favorable prior period reserve development; however, these factors were partially offset by increased current accident year loss activity on trade credit and bond reinsurance business in 2009.
2009 versus 2008: The $217 million increase in 2009 was primarily due to improved market conditions for our other investments, which was partially offset by lower reinvestment yields on our fixed maturities, cash and short-term investments.
2010 versus 2009: Our 2010 operating income was adversely impacted by the higher level of catastrophe activity relative to 2009, a reduction in the net favorable prior period development recognized and continued reinvestment yield reductions on our fixed maturities portfolio. However, this was partially offset by the comparative absence of charges related to our indemnity contract exposed to longevity risk following the cancellation of that contract in 2009. Our average common equity increased 13%, also contributing to the reduction in the return. The increase
The twelve percentage point reduction in the ceded premium ratio for our insurance segment primarily reflected changes in reinsurance purchasing; we increased the attachment points on our excess of loss property program and reduced the cession rate on our quota share professional lines program on renewal during the second quarter.
2009 versus 2008: The 15.8% pre-tax return on other investments in 2009 was primarily driven by the strong recovery in the equity and credit markets from the 2008 financial crisis as a result of the unprecedented global economic stimuli provided by various government bodies in late 2008. This strong performance was partially offset by a negative fair value adjustment to CLO Equities due to accelerated defaults and lower recoveries observed earlier during 2009 which led us to negatively adjust our projected default rate and recovery rate assumptions.
The fair value of our total investments increased by $902 million from December 31, 2009, primarily due to net contributions and improved valuation for our fixed maturities driven by the downward shift in the U.S. Treasury
At December 31, 2010, fixed maturities had a weighted average credit rating of AA- (2009: AA) with a book yield of 3.3% (2009: 3.9%) and an average duration of 3.2 years (2009: 3.1 years). When incorporating cash and cash equivalents into this calculation (bringing fixed maturities and cash to $11.5 billion), the average rating would be AA (2009: AA) and the average duration would be 2.9 years (2009: 2.8 years).
In deciding whether to provide treaty reinsurance, we carefully review and analyze a cedant’s underwriting and risk management practices to ensure appropriate underwriting, data capture and reporting procedures. We also undertake an extensive program of cedant audits, using outsourced legal and industry experience where necessary. This allows us to review cedants’ claims administration to ensure reserves are consistent with exposures, adequately established and properly reported in a timely manner and also allows us to verify that claims are appropriately handled.
other things. Furthermore, this method tends to produce volatile estimates of ultimate losses where there is volatility in the underlying incurred/paid patterns. In particular, where the expected percentage of incurred/paid losses is low, small deviations between actual and expected claims can lead to very volatile estimates of ultimate losses. As a result, this method is often unsuitable at early development stages of an accident year.
In our credit and political risk line of business, we write certain policies on a multi-year basis with premiums generally payable in installments. We record premiums at the inception of the policy based on our best estimate of total premiums to be received over the policy term and exclude premiums for the period during which the client has the ability to unilaterally commute or cancel coverage. Furthermore, certain contracts within this line of business are deemed financial guarantee insurance contracts. In accordance with the new accounting guidance issued for these contracts effective January 1, 2009, we record premiums based on the present value of the contractual premiums due or expected to be collected using a discount rate that reflects the risk-free rate at the inception of contract. The determination of the applicability of this new accounting guidance to certain credit and political risk contracts requires significant management judgment due to the interpretation of the scope exemption for insurance contracts that are similar to financial guarantee insurance contracts. For the years ended December 31, 2010 and 2009, our total premiums from financial guarantee insurance contracts were immaterial in the context of total gross premiums written for the segment. At December 31, 2010, the average duration of the outstanding unearned premiums written for our credit and political line of business was 4.6 years (2009: 4.7 years).
We provide excess of loss and proportional coverage to cedants. In most cases, cedants (i.e. insurance companies) seek protection from us for business that they have not yet written at the time they enter into agreements with us. As a result, cedants must estimate their underlying premiums when purchasing reinsurance coverage from us.
Since inception, our historical experience has shown that cumulative adjustments to our annual initial premium estimates on proportional reinsurance contracts have ranged from a negative revision of 3% to a favorable revision of 9%. Giving more weight to recent years where premium volume was comparable to current levels, we believe that a reasonably likely change in our 2010 proportional reinsurance gross premiums written estimate would be 5%. Such a change would result in a variance in our gross premiums written of approximately $43 million and an immaterial impact on our pre-tax net income. However, larger variations, both positive and negative, are possible.
The CLO - Equity market continues to be mostly inactive with only a small number of transactions being observed in the market and none of them involving deals we hold. Accordingly, we continue to rely on the use of our internal cash flow model to estimate the fair value of CLO - Equities. For our cash flow projections, we consider the minimum over-collateralization ratios (“OC ratios”) of each CLO that must be maintained in order to receive cash distributions from the CLOs. Generally, the OC ratio is calculated as: a) the remaining collateral adjusted for marked-to-market defaulted loans, net of estimated recoveries, and certain credit downgrades, divided by b) the total remaining debt obligations. Additionally, the following table presents a range of other significant inputs used in our valuation model.
This new guidance overrides the previous requirement to assert both the “intent and ability” to hold the security for a period of time sufficient to allow for a recovery in its fair value to its amortized cost for not impairing a fixed maturity in an unrealized loss position.
Tabular dollars and share amounts are in thousands, except per share amounts. All amounts are reported in U.S. dollars.
We record other investments at fair value (see Note 6 - Fair Value Measurements), with both changes in fair value and realized gains/ losses reported in net investment income.
If either the CEO or Chairman dies, is disabled or a change of control of the Company occurs, the remaining benefits under their respective SERP are payable by the Company in a lump sum. At December 31, 2010, the total lump sum contingently payable to our CEO and Chairman was $21 million and $3 million, respectively. During 2010, pension expense was negligible (2009: negligible and 2008: $3 million) and total benefits paid was $1 million (2009: $1 million and 2008: $nil) for the two SERPs. At December 31, 2010, the accrued SERPs obligations were $16 million (2009: $17 million and 2008: $16 million).
We have determined the fair value of all stock and unit grants using the closing price of our common shares on the New York Stock Exchange on the day of the grant.