We were formed by Haverford, a company controlled and capitalized by Mark Byrne, the Executive Chairman of our Board of Directors, and David Brown, our Chief Executive Officer, and we commenced operations in December 2005. On March 30, 2007, the Company’s common shares began trading on the New York Stock Exchange.
We measure our financial success through long term growth in diluted book value per share plus accumulated dividends measured over intervals of three years, which we believe is the most appropriate measure of the performance of the Company, a measure that focuses on the return provided to the Company’s common shareholders. Diluted book value per share is obtained by dividing shareholders’ equity by the number of common shares and common share equivalents outstanding including all potentially dilutive securities such as the warrant, performance share units and restricted share units.
Bornheutter-Ferguson Reported Loss Method. The Bornheutter-Ferguson reported loss method is similar to the Bornheutter-Ferguson paid loss method with the exception that it uses reported losses and reported loss development factors. The Company uses this method for lines of business and contracts where there are limited historical paid and reported losses.
In some cases, we obtain a minimum of two quotes directly from broker-dealers who actively trade in the corresponding markets when prices are unavailable from independent pricing services. This may also be the case if the pricing from these pricing services is not reflective of current market levels. At December 31, 2009, approximately 0.1% of our fixed maturities were priced using non-binding broker quotes, for which the lowest broker quotes were used for the valuation. Generally, broker-dealers value securities through their trading desks based on observable market inputs. Their pricing methodologies include mapping securities based on trade data, bids or offers, observed spreads and performance on newly issued securities. They may also establish pricing through observing secondary trading of similar securities. All broker quotes are reviewed by the investment managers to determine if they reflect the fair value of the securities by comparing them to both internal models and the valuation of comparable securities. The evaluation of whether or not actual transactions in the current financial markets represent distressed sales requires significant management judgment. We do not believe quotes received from broker-dealers reflect distressed transactions that would warrant an adjustment to fair value. At December 31, 2009, we have not adjusted any pricing provided by broker-dealers based on the review performed by our investment managers.
At December 31, 2009, the fair value of the derivative instruments classified as Level 3 under the Fair Value Measurements and Disclosures Topic of the FASB ASC was $(1.6) million. Refer to Note 9 “Derivatives” in Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for a breakdown of the fair value measurements.
Short-tail specialty and casualty reinsurance is comprised of reinsurance programs such as aviation, energy, accident and health, workers compensation, catastrophe, satellite and marine. Most short-tail specialty and casualty reinsurance is written with loss limitation provisions.
During the years ended December 31, 2009 and 2008, we recorded $3.4 million and $4.3 million of gross reinstatement premiums, respectively, which were primarily attributable to aviation, energy, and marine losses.
The underwriting results of a reinsurance company are often measured by reference to its loss ratio and expense ratios. The loss ratio is calculated by dividing loss and loss adjustment expenses (including estimates for IBNR losses) by net premiums earned. The two components of the expense ratio may be expressed as separate ratios; the acquisition cost ratio and the general and administrative expense ratio. The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned. The general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned. The combined ratio is the sum of these three ratios.
movement in outstanding loss or case reserves, which represent the change in management’s best estimate of the likely settlement amount for reported claims, less the portion that can be recovered from reinsurers; and
Loss and loss adjustment expenses for the year ended December 31, 2008 were $377.2 million, or 58.8% of net premiums earned, ($370.7 million, or 58.8% of net premiums earned, excluding the impact of acquisitions made in 2008) compared to $191.3 million, or 41.2% of net premiums earned, for the year ended December 31, 2007. The increase in the loss ratio was primarily due to more severe catastrophic events during 2008 than during 2007. Significant loss events for 2008 included Hurricane Ike ($158.4 million), Hurricane Gustav ($14.5 million), Chinese winter storms ($18.2 million) and the U.S. Memorial Day weekend storms ($11.1 million). During the year ended December 31, 2008, we also revisited our loss estimates for previous loss events. During 2007, the significant loss events included the European Windstorm Kyrill ($32.4 million), United Kingdom floods ($38.0 million), and New South Wales (Australia) floods ($18.5 million), three satellite losses during 2007 ($13.8 million), and the Sydney (Australia) hailstorm in December 2007 ($11.4 million).
The clear observation from the January renewals was that the capacity limitations of a year ago following the 2008 financial crisis had disappeared with there were signs of excess capacity in nearly all lines with many programs over subscribed and very few programs struggling to achieve full placement. However, in general the reinsurance market was disciplined with modest rate easing across the board. Many clients continued to dilute their exposures to the big professional insurers despite their renewed appetite for market share and we achieved gains in a number of areas as a result of this combined with our continued support from brokers and core clients. We expect the international catastrophe market to continue to soften in 2010 in the absence of any significant loss activity.
Net realized and unrealized gains (losses) on our investment portfolio amounted to a $39.7 million gain for the year ended December 31, 2009, compared to a $272.2 million loss for the year ended December 31, 2008. These amounts comprise net realized and unrealized gains and losses on our fixed maturities, equities, other investments and on our investment portfolio of derivatives which includes US equity, global equity, global bond, commodity and real estate futures, TBA securities, interest rate swaps and total return swaps. The increase during the year ended December 31, 2009 compared to the same period in 2008, was primarily due to our allocation to equities and commodities in 2008 being negatively impacted by the global financial crisis.
Interest expense was $12.1 million for the year ended December 31, 2009, compared to $18.3 million for the year ended December 31, 2008. For the year ended December 31, 2009, compared to the same period in 2008, the decrease of $6.2 million in interest expense is primarily related to the decrease in short term interest rates from period to period and the repurchase of $11.25 million of principal amount of the Company’s outstanding $100.0 million Notes during the second quarter of 2008.
The Company has entered into certain foreign currency forward contracts that are designated as hedges in order to hedge its net investments in foreign subsidiaries. The accounting for the gains and losses associated with changes in fair value of the designated hedge instruments were recorded in other comprehensive income as part of the cumulative translation adjustment, to the extent that it is effective as a hedge. The Company designated foreign currency forwards with notional contractual value of $337.7 million as hedging instruments, which had a fair value of $(5.7) million as of December 31, 2008. During the year ended December 31, 2008, the Company recorded $17.0 million of realized and unrealized losses directly into comprehensive income as part of the cumulative translation adjustment for the effective portion of the hedge. All other derivatives are not designated as hedges, and accordingly, the realized and unrealized gains and losses arising during the year are included in “Net realized gains and losses -investments” and “Net realized gains and losses -other” in the consolidated financial statements.
Generally, positive cash flows from our operating and financing activities are invested in the Company’s investment portfolio. For further discussion of our investment activities, including our strategy and current durations, refer to “Business” and also Note 6 “Investments” to our Consolidated Financial Statements included in Item 8 of this report.
The Company has reviewed its Level 3 investments, and the valuation methods are as follows: The fair value of the investment funds, being private equity funds, is determined by the investment fund managers using the net asset value provided by the general partners of the funds on a quarterly basis. These valuations are then adjusted by the investment fund managers for cash flows since the most recent valuation. The valuation methodology used for the investment funds is consistent with the methodology that is generally employed in the investment industry. Additionally, there are two mortgage-backed securities and one asset backed security that were classified as Level 3 due to the limited availability of the pricing sources which may be indicative of a less active market. Their fair value is determined using broker quotes.
As part of management’s 2009 analysis, it was determined that a foreign subsidiary which began operations in 2006 would be subject to local taxation. This subsidiary had approximately $5.1 million of net operating loss carryforwards. The Company has established a full valuation allowance on the deferred tax assets relating to these loss carryforwards. The addition of these deferred tax assets and additional valuation allowance had no impact on the 2008 or 2009 provision for income taxes.
At December 31, 2009, the projected pension obligation was $5.9 million, the accumulated pension obligation was $5.5 million, and the fair value of plan assets was $4.4 million. At December 31, 2008, the projected pension obligation was $5.6 million, the accumulated pension obligation was $5.3 million, and the fair value of plan assets was $4.4 million.
Interest expense includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period from the issuance of the Deferrable Interest Debentures to the earliest date that they may be called by the Company. For the years ended December 31, 2009, 2008 and 2007, the Company incurred interest expense of $11.1 million, $18.3 million and $18.7 million, respectively, on the Deferrable Interest Debentures. Also, at December 31, 2009, 2008 and 2007, the Company had $0.8 million, $1.4 million and $1.9 million, respectively, of interest payable included in other liabilities.
A summary of the activity under the PSU Plan as at December 31, 2009, 2008 and 2007 and changes during the years ended December 31, 2009, 2008 and 2007, is as follows:
At December 31, 2009, the Company’s consolidated results include the results of Island Heritage from July 1, 2007 onwards. The portions of Island Heritage’s net income and shareholders’ equity attributable to the minority shareholders for the years ended December 31, 2009, 2008 and 2007 are recorded in the consolidated financial statements of the Company as noncontrolling interest. In relation to Island Heritage, the Company recorded income (loss) attributable to noncontrolling interest of $1.7 million, $(0.6) million and $2.2 million for the years ended December 31, 2009, 2008 and 2007, respectively, and $18.4 million and $16.5 million, respectively, was included in noncontrolling interest on the consolidated balance sheets as at December 31, 2009 and 2008.
Short-tail Specialty and Casualty Reinsurance. The Company also provides short-tail specialty and casualty reinsurance for risks such as aviation, energy, accident and health, satellite, marine and workers’ compensation catastrophe. Most short-tail specialty and casualty reinsurance is written with loss limitation provisions.
The FASB ASC Topic on Financial Instruments requires disclosure of fair value information of financial instruments. For financial instruments where quoted market prices are not available, the fair value of these financial instruments is estimated by discounting future cash flows or by using similar recent transactions. Because considerable judgment is used, these estimates are not necessarily indicative of amounts that could be realized in a current market exchange. The Company does not carry its long term debt at fair value on its consolidated balance sheets. As at December 31, 2009, the Company estimated the fair value of its long term debt to be approximately $135.1 million and as at December 31, 2008, the Company estimated the fair value of its long term debt to be approximately $97.5 million.