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The following is a discussion and analysis of our results of operations for the
years ended December 31, 2012, 2011 and 2010 and our financial condition at
December 31, 2012 and 2011. This should be read in conjunction with the
Consolidated Financial Statements and related notes included in Item 8 of this
report. Tabular dollars are in thousands, except per share amounts. Amounts in
tables may not reconcile due to rounding differences.
Page
2012 Financial Highlights 42
Executive Summary 43
Underwriting Results - Group 48
Results by Segment: Years ended December 31, 2012, 2011 and 2010 56
i) Insurance Segment 56
ii) Reinsurance Segment 59
Other Expenses (Revenues), Net 62
Net Investment Income and Net Realized Investment Gains/Losses 63
Cash and Investments 67
Liquidity and Capital Resources 77
Critical Accounting Estimates 83
i) Reserves for Losses and Loss Expenses 84
ii) Reinsurance Recoverable 94
iii) Premiums 95
iv) Fair Value Measurements 97
v) Other-Than-Temporary Impairments 99
Recent Accounting Pronouncements 101
Off-Balance Sheet and Special Purpose Entity Arrangements 101
Non-GAAP Financial Measures 101
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2012 FINANCIAL HIGHLIGHTS
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2012 Consolidated Results of Operations
• Net income available to common shareholders of $495 million, or $4.05 per
share basic and $4.00 per diluted share
• Operating income of $422 million, or $3.41 per diluted share(1)
• Gross premiums written of $4.1 billion
• Net premiums written of $3.3 billion
• Net premiums earned of $3.4 billion
• Net favorable prior year reserve development of $245 million
• Significant catastrophe and weather-related losses included:
• Pre-tax net losses (net of related reinstatement premiums) of $331
million in relation to Storm Sandy
• Aggregate pre-tax net losses (net of related reinstatement premiums) of
$105 million for other notable events of 2012 (including the impact of
severe drought conditions on U.S. crops, Hurricane Isaac and first and
second quarter U.S. weather events)
• Net financial impact of Storm Sandy of $301 million, after consideration of
reinstatement premiums, ceding commissions and the associated income tax
benefit
• No material change in our aggregate estimate for losses related to 2011 and
2010 calendar year natural catastrophe and weather-related events
• Underwriting income of $263 million and combined ratio of 96.2%
• Net investment income of $381 million
• Net realized investment gains of $127 million
• Senior leadership transition in the second quarter resulted in separation
payments and accelerated and incremental share-based compensation expenses
totaling $34 million
2012 Consolidated Financial Condition
• Total cash and investments of $14.4 billion; fixed maturities, cash and
short-term securities comprise 90% of total cash and investments and have an
average credit rating of AA-
• Total assets of $18.9 billion
• Reserve for losses and loss expenses of $9.1 billion and reinsurance
recoverable of $1.9 billion
• Total debt of $995 million and a debt to total capital ratio of 14.7%
• Repurchased 9.4 million common shares for total cost of $318 million;
remaining authorization under the repurchase program approved by our Board
of Directors of $634 million at February 21, 2013
• Common shareholders' equity of $5.3 billion; diluted book value per common
share of $42.97
(1) Operating income (loss) is a non-GAAP financial measure as defined in SEC
Regulation G. See 'Non-GAAP Financial Measures' for reconciliation to nearest
GAAP financial measure (net income available to common shareholders).
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EXECUTIVE SUMMARY
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Business Overview
We are a Bermuda-based global provider of specialty lines insurance and treaty
reinsurance products with operations in Bermuda, the United States, Europe,
Singapore, Canada, Australia and Latin America. Our underwriting operations are
organized around our two global underwriting platforms, AXIS Insurance and AXIS
Reinsurance.
Our mission is to provide our clients and distribution partners with a broad
range of risk transfer products and services and meaningful capacity, backed by
significant financial strength. We manage our portfolio holistically, aiming to
construct the optimum consolidated portfolio of funded and unfunded risks,
consistent with our risk appetite and development of our franchise. We nurture
an ethical, entrepreneurial and disciplined culture that promotes outstanding
client service, intelligent risk taking and the achievement of superior
risk-adjusted returns for our shareholders. We believe that the achievement of
our objectives will position us as a leading global, diversified specialty
insurance and reinsurance company, as measured by quality, sustainability and
profitability. Our execution on this mission in 2012 included:
• the continuing growth of our new accident & health line, focused on specialty
accident and health products; and
• the focus on lines of business with attractive rates, generating premium
growth in our insurance segment.
In addition, we effectively lowered the weighted average annual dividend rate on
our preferred equity capital base by 42 basis points, to 6.953%, at a book value
cost of $7 million. This was achieved via the issuance of $400 million of 6.875%
Series C shares, in conjunction with the redemption of $150 million of our 7.25%
Series A preferred shares and the repurchase of $247 million of our 7.50% Series
B preferred shares via tender offer.
Results of Operations
Year ended December 31, 2012 % Change 2011 % Change 2010
Underwriting income (loss):
Insurance $ 65,477 87% $ 35,034 (83%) $ 210,039
Reinsurance 197,660 nm (362,260 ) nm 199,164
Net investment income 380,957 5% 362,430 (11%) 406,892
Net realized investment gains 127,469 5% 121,439 (38%) 195,098
Other expenses, net (224,322 ) 103% (110,338 ) (29%) (154,470 )
Net income 547,241 nm 46,305 (95%) 856,723
Preferred share dividends (38,228 ) 4% (36,875 ) -% (36,875 )
Loss on repurchase of preferred (14,009 ) -% - -% -
shares
Net income available to common $ 495,004 nm $ 9,430 (99%) $ 819,848
shareholders
Operating income (loss) $ 421,523 nm $ (153,912 ) nm $ 611,342
nm - not meaningful
Underwriting Results
2012 versus 2011: The $590 million improvement in our underwriting result during
2012 was largely due to a reduction in the frequency and severity of natural
catastrophe and weather-related losses. During 2011, we recognized aggregate
pre-tax net losses (net of related reinstatement premiums) of $931 million for
numerous catastrophe and weather events, including: the February Christchurch,
New Zealand earthquake ("New Zealand II"), the Japanese earthquake and tsunami,
the series of severe U.S. storms and tornadoes in April/May, first quarter
Australian weather events (January floods and Cyclone Yasi), the Thai floods,
the June Christchurch aftershock ("New Zealand III"), the Danish floods,
Hurricane Irene and Tropical Storm Lee; these events impacted our reinsurance
segment to a greater extent. Comparatively, in 2012, we recognized pre-tax net
losses (net of related reinstatement premiums) of $331 million for Storm Sandy
and an aggregate $105 million for the impact
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of severe drought conditions on U.S. crops, Hurricane Isaac and first and second
quarter U.S. weather events. Growth in net premiums earned in our insurance
segment and improvements in the current accident year loss ratios exclusive of
the catastrophe and weather-related losses for both segments further contributed
to the improvement in 2012; this was partially offset by a $13 million reduction
in net favorable prior year reserve development and growth in general and
administrative expenses.
Our insurance segment's underwriting income for 2011 included aggregate pre-tax
net losses (inclusive of premiums to reinstate reinsurance protection) of $157
million related to the 2011 events noted above. Comparatively, underwriting
income for 2012 included pre-tax net losses (inclusive of related premiums to
reinstate reinsurance protection) of $178 million for Storm Sandy and an
aggregate $44 million for Hurricane Isaac and first and second quarter 2012 U.S.
weather events. Despite increased catastrophe and weather-related losses in
2012, underwriting income for the segment improved due to growth in net premiums
earned (driven by the expansion of our business over the past year), an
improvement in the current accident year loss ratio exclusive of catastrophe and
weather activity and a $19 million increase in net favorable prior year reserve
development. This was partially offset by commensurate growth in acquisition
costs and general and administrative expenses.
The $560 million improvement in the reinsurance segment's underwriting result
was primarily attributable to the significantly lower level of natural
catastrophe and weather-related losses; the majority of our 2011 natural
catastrophe and weather-related losses emanated from our reinsurance segment and
drove the underwriting loss for that year. The segment's underwriting loss for
2011 included aggregate pre-tax net losses (net of related reinstatement
premiums) of $774 million for the events noted above, with the most significant
amounts being for New Zealand II, the Japanese earthquake and tsunami and the
first quarter Australian weather events. Comparatively, in 2012, we recognized
pre-tax net losses (net of related reinstatement premiums) of $153 million for
Storm Sandy and an aggregate $60 million for the impact of severe drought
conditions on U.S. crops, Hurricane Isaac and first and second quarter 2012 U.S.
weather events. An improvement in the current accident year loss ratio,
exclusive of these catastrophe and weather-related losses, further contributed
to the improvement in 2012. Partially offsetting these improvements was a $32
million reduction in net favorable prior year reserve development, a reduction
in net premiums earned and increases in acquisition costs and general and
administrative expenses.
2011 versus 2010: The significantly high frequency and severity of natural
catastrophe activity in 2011, described above, was the primary driver of the
deterioration in underwriting results in that year. However, natural catastrophe
activity also impacted underwriting results for 2010. In comparison to the $931
million for 2011 noted above, during 2010 we recognized aggregate pre-tax net
losses (net of related reinstatement premiums) of $248 million for the September
New Zealand earthquake ("New Zealand I") and the Chilean earthquake, with
substantially all of this emanating from our reinsurance segment. Further
contributing to the reduction in underwriting income was a $56 million decrease
in net favorable prior year reserve development.
Our insurance segment's 2011 underwriting income included $157 million in
pre-tax net losses (inclusive of related premiums to reinstate reinsurance
protection) related to the events of 2011 noted above, while catastrophe losses
in 2010 were insignificant. A $15 million reduction in net favorable prior year
reserve development and an increase in acquisition costs also contributed to the
reduction in underwriting income; reductions in ceded reinsurance costs and
increases in gross premiums written contributed to higher net premiums earned
and partially offset these reductions.
Our reinsurance segment's 2011 underwriting loss included aggregate pre-tax net
losses (net of related reinstatement premiums) of $774 million for the events of
2011 noted above. Substantially all of our natural catastrophe-related pre-tax
net losses in 2010 emanated from the reinsurance segment. A $40 million
reduction in net favorable prior period reserve development also contributed to
the variance in the underwriting result between periods.
Net Investment Income
The variability in our net investment income for 2010 through 2012 was largely
attributable to our alternative investment portfolio ("other investments").
Income from this portfolio increased by $56 million in 2012, driven by improved
performance for our hedge funds (reflective of global equity market performance)
and credit funds (driven by pricing improvement in underlying bank loans).
Comparatively, income from these investments decreased $33 million in 2011,
reflective of the underperformance of both global equities and bank loans during
in that year.
Excluding income from our other investments, net investment income decreased by
$12 million and $37 million, respectively, in 2011 and 2012. These decreases
were primarily attributable our fixed maturity portfolio, where lower
reinvestment yields drove reductions in income despite higher investment
balances.
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Net Realized Investment Gains
During each period presented, we realized net investment gains largely due to
the sale of fixed maturities. Other-than-temporary impairment ("OTTI") charges
were $24 million, $16 million and $18 million in 2012, 2011 and 2010,
respectively.
Other (Expenses) Revenues, Net
Appreciation in the Sterling and euro against the U.S. dollar drove foreign
exchange losses of $30 million in 2012, related to the remeasurement of our
foreign-denominated net insurance-related liabilities. In 2011 and 2010,
depreciation in these currencies resulted in foreign exchange gains of $45
million and $16 million, respectively. Excluding these foreign exchange-related
amounts, other expenses were $170 million, $155 million and $195 million,
respectively in 2010, 2011 and 2012.
The $15 million decrease in 2011 was driven by a $23 million reduction in income
tax expense, as taxable income declined due to the significant catastrophe
activity previously noted. This was partially offset by an increase in interest
expense following our March 2010 senior note issuance.
A $53 million increase in corporate expenses drove the increase in other
expenses in 2012. Separation payments and accelerated and incremental
share-based compensation costs related to our second quarter 2012 senior
leadership transition totaled $34 million and were the primary driver of this
increase. Partially offsetting the increase in corporate expenses was a $12
million reduction in tax expense, as the impact of Storm Sandy led to minimal
taxable income in the U.S. for 2012.
Loss on Repurchase of Preferred Shares
In conjunction with the effective reduction of the dividend rate on our
preferred equity base previously discussed, we repurchased $150 million of our
7.25% Series A preferred shares and $247 million of our 7.50% Series B preferred
shares during the first half of 2012. While the Series A shares were redeemed at
liquidation value, we paid a $7 million premium to repurchase the Series B
shares in advance of the first eligible redemption date. This premium, combined
with the recognition of the proportionate share of issue costs for both series
as an expense, resulted in a $14 million loss. As the issue costs for these
shares were recognized in shareholders' equity in the period the shares were
originally issued, the only impact on book value related to the $7 million
premium on the Series B repurchase. Refer to Item 8, Note 13 to the Consolidated
Financial Statements for further details.
Outlook
Management expects gross premiums written to increase across both of our
segments in 2013. The primary insurance market continues to see favorable
pricing momentum. We see ongoing improvement across most classes and
geographies within our insurance segment and will pursue opportunities to expand
our reach in areas where we believe returns are most attractive.
We believe that the global reinsurance market is generally at equilibrium with
acceptable levels of profitability. There is some pressure in lines that have
shown strong profitability and have attracted new capacity in recent years.
On
the other hand, there is some upside pressure on pricing for loss-affected
property treaties and lines with recent major loss activity, including
Sandy-affected treaties, agriculture and marine, and Management expects that
these areas will contribute to growth in reinsurance premiums.
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Financial Measures
We believe that the following financial indicators are important in evaluating
our performance and measuring the overall growth in value generated for our
common shareholders:
Year ended and at December 31, 2012 2011 2010
ROACE(1) 9.7 % 0.2 % 16.2 %
Operating ROACE(2) 8.2 % (3.1 %) 12.1 %
Diluted book value per common share(3) $ 42.97$ 38.08$ 39.37
Cash dividends declared per common share 0.97 0.93 0.86
Value creation(4) $ 5.86 $ (0.36 ) $ 6.58
(1) Return on average common equity ("ROACE") is calculated by dividing net
income available to common shareholders for the period by the average
shareholders' equity determined by using the common shareholders' equity
balances at the beginning and end of the period.
(2) Operating ROACE is calculated by dividing operating income (loss) for the
period by the average common shareholders' equity determined by using the
common shareholders' equity balances at the beginning and end of the period.
Operating ROACE is a non-GAAP financial measure, as defined in SEC Regulation
G. See 'Non-GAAP Financial Measures' for additional information and a
reconciliation to the nearest GAAP financial measure (ROACE).
(3) Diluted book value per common share represents total common shareholders'
equity divided by the number of common shares and diluted common share
equivalents outstanding, determined using the treasury stock method.
(4) Value creation represents the change in diluted book value per common share
and dividends declared during the period.
Return on equity
Our objective is to generate superior returns on capital that appropriately
reward our common shareholders for the risks we assume and to grow revenue only
when we expect the returns will meet or exceed our requirements. We recognize
that the nature of underwriting cycles and the frequency or severity of large
loss events in any one year may make it difficult to achieve a profitability
target in any specific period and, therefore, established a ROACE target of 15%
over the full underwriting cycle. Our average annual ROACE since inception is
approximately 14%, tracking closely to our long-term goal.
2012 versus 2011: The improvement in our underwriting result, driven by the
lower level of catastrophe and weather-related losses previously discussed, was
the primary contributor to the improved operating ROACE; the increase in net
investment income also contributed. These favorable variances were partially
offset by the increase in corporate expenses previously discussed.
In addition to the items noted above for operating ROACE, ROACE is also impacted
by net realized investment gains, foreign exchange losses (gains) and the loss
on repurchase of preferred shares. The magnitude of our net realized investment
gains resulted in these amounts contributing favorably, in aggregate, to our
results for both periods; thus ROACE exceeded operating ROACE.
2011 versus 2010: Our underwriting loss, driven by catastrophe and
weather-related losses, was the primary driver of the negative operating ROACE
for 2011; reductions in net favorable prior year reserve development and net
investment income also contributed to a lower return when compared to 2010.
Our combined net realized investment gains and foreign exchange gains for 2011
were sufficient for us to recognize net income for the period; as such, our
ROACE for the year was marginally positive. Net realized investment gains and
foreign exchange gains in 2010 also contributed to a higher ROACE, in comparison
to operating ROACE.
Diluted book value per common share
We consider diluted book value per common share to be an appropriate measure of
our returns to common shareholders, as we believe growth in our book value on a
diluted basis will ultimately translate into appreciation of our stock price.
The previously described impact of catastrophe and weather-related losses on our
2011 net income available to common shareholders was the primary driver of the
3% reduction in our diluted book value per common share for the 2011 fiscal
year. During 2012, our diluted book value per common share appreciated by 13%,
driven by $495 million in net income available
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to common shareholders, an overall improvement in valuations for our
available-for-sale securities and, to a lesser extent, the execution of common
share repurchases at a discount to book value.
Cash dividends per common share
We believe in returning excess capital to our shareholders by way of dividends
(as well as share repurchases) and, accordingly, our dividend policy is an
integral part of the value we create for our shareholders. Our cumulatively
strong earnings have permitted our Board of Directors to approve nine successive
annual increases in quarterly common share dividends.
Value creation
Taken together, we believe that growth in diluted book value per common share
and common share dividends declared represent the total value created for our
common shareholders. Despite the impact of catastrophe events, our net income
combined with valuation improvements on our available-for-sale securities and
common share repurchases executed at a discount to book value led to an
increases in diluted book value per common share during 2010 and 2012; dividends
declared provided additional value for our shareholders. The global frequency
and severity of catastrophe activity in 2011 drove a small reduction in
shareholder value for that year.
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UNDERWRITING RESULTS - GROUP
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The following table provides our group underwriting results for the periods
indicated. Underwriting income (loss) is a pre-tax measure of underwriting
profitability that takes into account net premiums earned and other insurance
related income as revenues and net losses and loss expenses, acquisition costs
and underwriting-related general and administrative costs as expenses.
Year ended December 31, 2012 % Change
2011 % Change 2010
Revenues:
Gross premiums written $ 4,139,643 1% $ 4,096,153 9% $ 3,750,536
Net premiums written 3,337,456 (2%) 3,419,434 9% 3,147,540
Net premiums earned 3,415,463 3% 3,314,961 12% 2,947,410
Other insurance related income 2,676 2,396 2,073
Expenses:
Current year net losses and loss (2,340,868 ) (2,932,513 ) (1,990,187 )
expenses
Prior year reserve development 244,840 257,461 313,055
Acquisition costs (627,653 ) (587,469 ) (488,712 )
Underwriting-related general and (431,321 ) (382,062 ) (374,436 )
administrative expenses(1)
Underwriting income (loss)(2) $ 263,137 nm $ (327,226 ) nm $ 409,203
General and administrative $ 560,981 $ 459,151 $ 449,885
expenses(1)
Income before income taxes(2) $ 550,528 $ 61,538 $ 895,403
nm - not meaningful
(1) Underwriting-related general and administrative expenses is a non-GAAP
measure as defined in SEC Regulation G. Our total general and administrative
expenses also included $129,660, $77,089 and $75,449 of corporate expenses
for 2012, 2011 and 2010, respectively; refer to 'Other Expenses (Revenues),
Net' for additional information related to these corporate expenses. Also,
refer to 'Non-GAAP Financial Measures' for further information.
(2) Group (or consolidated) underwriting income (loss) is a non-GAAP financial
measure as defined in SEC Regulation G. Refer to Item 8, Note 3 to the
Consolidated Financial Statements, for a reconciliation of consolidated
underwriting income (loss) to the nearest GAAP financial measures (income
before income taxes) for the periods indicated above. Also, refer to
'Non-GAAP Financial Measures' for additional information related to the
presentation of consolidated underwriting income (loss).
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UNDERWRITING REVENUES
Premiums Written:
Gross and net premiums written, by segment, were as follows:
Gross Premiums Written
Year ended December 31, 2012 % Change 2011 % Change 2010
Insurance $ 2,309,481 9% $ 2,121,829 11% $ 1,916,116
Reinsurance 1,830,162 (7%) 1,974,324 8% 1,834,420
Total $ 4,139,643 1% $ 4,096,153 9% $ 3,750,536
% ceded
Insurance 34 % 3 pts 31 % 1 pts 30 %
Reinsurance 1 % - pts 1 % - pts 1 %
Total 19 % 2 pts 17 % 1 pts 16 %
Net Premiums Written
2012 % Change 2011 % Change 2010
Insurance $ 1,522,245 4% $ 1,466,134 10% $ 1,332,220
Reinsurance 1,815,211 (7%) 1,953,300 8% 1,815,320
Total $ 3,337,456 (2%) $ 3,419,434 9% $ 3,147,540
2012 versus 2011: Gross premiums written growth was driven by a $188 million
increase in our insurance segment, attributable to a number of lines of
business, with the most significant increases emanating from professional lines,
liability and accident & health. Growth in professional lines was driven by
geographic expansion (including our European operations) and newer initiatives,
with an improving rate environment also contributing. Select new business
opportunities, primarily in our U.S. excess and surplus lines umbrella business,
drove the increase in liability business; rate increases also contributed.
Finally, our recently established accident & health line continued to generate
new business.
Partially offsetting this growth was a reduction in gross premiums written in
our reinsurance segment, primarily related to the repositioning of our
catastrophe reinsurance portfolio throughout 2012. We reduced catastrophe
exposure in certain zones, including the Northeast and Mid-Atlantic regions of
the U.S.; this was partially offset by exposure increases in other areas, where
we believe risk and return characteristics are more attractive. Property
business also contributed to the overall reduction in gross premiums written for
the reinsurance segment, with the drivers being reduced purchasing by certain of
our clients and our evaluation of risk/return characteristics. In addition, our
trade credit and bond reinsurance premiums also decreased, as we managed our
European exposure base in light of current economic conditions and changes in
contract terms.
The three point increase in the ceded premium ratio for our insurance segment
was driven by changes in our reinsurance purchasing, primarily higher cession
rates on our professional lines quota share reinsurance program on renewal
during the second quarter. Business mix changes, driven by growth in our
liability business, also contributed.
2011 versus 2010: Our new accident & health line was the primary driver of the
11% increase in gross premiums written in our insurance segment. Geographic
expansion and new business initiatives also contributed to the increase. Gross
premiums written growth for our reinsurance segment was primarily driven by
proportional motor reinsurance business, with the primary contributing factors
being increases on renewal and new business. Gross premiums written for trade
credit and bond reinsurance business also increased.
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Net Premiums Earned:
Net premiums earned by segment were as follows:
% Change
Year ended 2012 2011 2010 11 to 12 10 to 11
December 31,
Insurance $ 1,558,058 46 % $ 1,429,687 43 % $ 1,206,493 41 % 9 % 18 %
Reinsurance 1,857,405 54 % 1,885,274 57 % 1,740,917 59 % (1 %) 8 %
Total $ 3,415,463 100 % $ 3,314,961 100 % $ 2,947,410 100 % 3 % 12 %
Changes in net premiums earned reflect period to period changes in net premiums
written and business mix, together with normal variability in premium earning
patterns.
2012 versus 2011: Growth in net premiums earned for our insurance segment was
primarily driven by recent growth in gross premiums written in our accident &
health line; net premiums earned also increased due to growth in our
professional lines business in recent quarters, though this was tempered by the
previously mentioned increase in quota share cessions. The reduction in
catastrophe gross premiums written during 2012, described above, was the primary
driver of the decline in net premiums earned for our reinsurance segment.
2011 versus 2010: Eleven percent growth in gross premiums written and changes in
our reinsurance purchasing effected during the second quarter of 2010 drove the
18% growth in net premiums earned for our insurance segment. The 8% increase in
our reinsurance segment is consistent with gross premiums written growth.
UNDERWRITING EXPENSES
The following table provides a breakdown of our combined ratio:
% Point % Point
Year ended December 31, 2012 Change 2011 Change 2010
Current accident year loss 68.5 % (20.0 ) 88.5 % 21.0 67.5 %
ratio
Prior year reserve development (7.1 %) 0.7 (7.8 %) 2.8 (10.6 %)
Acquisition cost ratio 18.4 % 0.7 17.7 % 1.1 16.6 %
General and administrative 16.4 % 2.5 13.9 % (1.3 ) 15.2 %
expense ratio(1)
Combined ratio 96.2 % (16.1 ) 112.3 % 23.6 88.7 %
(1) The general and administration expense ratio includes corporate expenses not
allocated to underwriting segments of 3.8%, 2.4% and 2.5% for 2012, 2011 and
2010, respectively. These costs are further discussed in the 'Other Expenses
(Revenues), Net' section.
Current Accident Year Loss Ratio:
2012 versus 2011: A lower level of natural catastrophe and weather-related
losses in 2012 was the primary driver of the 20.0 point reduction in our current
accident year loss ratio, though the ratios for both years were significantly
impacted by natural catastrophe events.
The most significant catastrophe event of 2012 was Storm Sandy, which made
landfall as a post-tropical cyclone with hurricane-force winds near Atlantic
City, New Jersey on October 29th. Storm Sandy impacted numerous U.S. states,
with particularly severe wind, flooding and storm surge damage in New Jersey and
New York. We recognized estimated pre-tax net losses (net of related
reinstatement premiums) of $331 million in relation to this event, with
approximately half of this amount recognized in each of our insurance and
reinsurance segments. In addition, during 2012 we recognized pre-tax net losses
of $37 million in relation to the impact of severe drought conditions on U.S.
crops and an aggregate $68 million (net of related reinstatement premiums) for
first and second quarter U.S. weather events and Hurricane Isaac. While the
crop-related losses were exclusive to our reinsurance segment, the other events
impacted both of our segments.
Comparatively, numerous notable natural catastrophe and significant weather
events impacted our results in 2011, namely: New Zealand II, the Japanese
earthquake and tsunami, the series of severe U.S. storms and tornadoes in April
and May, first quarter Australian weather events, the Thai floods, New Zealand
III, the Danish floods, Hurricane Irene and Tropical Storm Lee. In aggregate, we
recognized pre-tax net losses (net of related reinstatement premiums) of of $931
million in relation to
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these events during 2011. Of this amount, $774 million and $157 million,
respectively, emanated from our reinsurance and insurance segments.
Exclusive of the impact of the catastrophe and weather-related losses noted
above, the current accident year loss ratio for each of our segments improved in
2012:
• Reduced exposure and loss experience related to aggregate property
reinsurance of regional insurance companies in the U.S. drove an
improvement in our reinsurance segment, though this was partially offset
by a higher ratio for our trade credit and bond reinsurance business and
business mix changes; and
• A lower level of loss activity in our property and marine lines of
business and a reduction in the ratio for our credit and political risk
business (given a notable improvement in loss experience during the year)
were the primary drivers of the improvement in our insurance segment.
2011 versus 2010: The level of natural catastrophe and weather-related losses
was also the primary driver of the variance in the current accident year loss
ratios for these years. In comparison to the 2011 catastrophe and
weather-related losses noted above, we recognized pre-tax net losses (net of
related reinstatement premiums) of $138 million for New Zealand I and $110
million for the February earthquake in Chile during 2010. In addition, there
were a number of other weather-related loss events during 2010, including
Australian and U.S. storms and European Windstorm Xynthia in the first quarter
and further Australian storms and flooding and U.S. storms in the fourth
quarter. The 2010 events principally impacted our reinsurance segment.
Exclusive of the impact of the catastrophe and weather-related losses noted
above, the current accident year loss ratio increased in each of our segments
during 2011:
• Rate reductions, changes in business mix and an increased level of
property and marine loss activity contributed to an increase in our
insurance segment; and
• Business mix changes and rate reductions contributed to an increase in our
reinsurance segment, though partially offset by a reduction in the ratio
for our trade credit and bond reinsurance business, as global economic
conditions improved.
For further discussion on current accident year loss ratios, refer to the
insurance and reinsurance segment discussions below.
Estimates for Significant Catastrophe Events
Our estimated net losses in relation to the catastrophe events described above
were derived from ground-up assessments of our in-force contracts and treaties
providing coverage in the affected regions. These assessments take into account
the latest information available from clients, brokers and loss adjusters. In
addition, we consider industry insured loss estimates, market share analyses and
catastrophe modeling analyses, when appropriate. Our estimates remain subject to
change as additional loss data becomes available.
We continue to monitor paid and incurred loss development for catastrophe events
of prior years and update our estimates of ultimate losses accordingly. While
there was no material change in our aggregate estimate for the events of 2011
and 2010 during 2012, updated information received during the year resulted in
revisions to our estimated ultimate losses for each of the three New Zealand
earthquakes; our estimate for the 2010 accident year event (New Zealand I)
decreased and our combined estimate for the 2011 accident year events (New
Zealand II/III) increased.
The frequency and/or severity of natural catastrophe activity in each of 2010
through 2012 was high and our December 31, 2012 net reserve for losses and loss
expenses continues to include estimated amounts for numerous natural catastrophe
events that occurred during this period. We caution that the magnitude and/or
complexity of losses arising from certain of these events, in particular Storm
Sandy, the Japanese earthquake and tsunami, the three New Zealand earthquakes
and the Thai floods, inherently increases the level of uncertainty and,
therefore, the level of management judgment involved in arriving at our
estimated net reserves for losses and loss expenses. As a result, our actual
losses for these events may ultimately differ materially from our current
estimates.
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Prior Year Reserve Development:
Our favorable prior year reserve development was the net result of several
underlying developments on prior accident years, identified during our quarterly
reserve review process. The following table provides a breakdown of net prior
year reserve development by segment:
Year ended December 31, 2012 2011 2010
Insurance $ 122,209 $ 103,014 $ 118,336
Reinsurance 122,631 154,447 194,719
Total $ 244,840 $ 257,461 $ 313,055
Overview
The majority of the net favorable prior year reserve development related to
short-tail lines of business, with our professional lines business also
contributing notably.
The underlying exposures in the property, marine and aviation reserving classes
within our insurance segment and the property reserving class within our
reinsurance segment largely relate to short-tail business. Development from
these classes contributed $186 million, $178 million and $181 million of the
total net favorable prior year reserve development in 2012, 2011 and 2010,
respectively, and primarily reflected the recognition of better than expected
loss emergence.
Our professional lines insurance and reinsurance business contributed further
net favorable prior year reserve development of $54 million, $105 million and
$117 million, respectively in 2012, 2011 and 2010. This prior year reserve
development was driven by increased weight being given to experience-based
actuarial methods in selecting our ultimate loss estimates for accident years
2009 and prior. As our loss experience has generally been better than expected,
this resulted in the recognition of favorable prior year reserve development.
Given the significance of the global financial crisis, we expect that loss
development patterns for the 2007 through 2009 accident years may ultimately
differ from other years; as a result, we are exercising a greater degree of
caution in recognizing potential favorable loss emergence for these years.
Refer to the 'Critical Accounting Estimate - Reserve for Losses and Loss
Expenses' section for further details. We caution that conditions and trends
that impacted the development of our reserve for losses and loss expenses in the
past may not recur in the future.
The following sections provide further details on prior year reserve development
by segment, reserving class and accident year.
Insurance Segment:
Year ended December 31, 2012 2011 2010
Property and other $ 63,919 $ 55,779 $ 51,740
Marine 37,322 21,910 23,338
Aviation 5,017 9,842 11,995
Credit and political risk (143 ) (13,764 ) (18,414 )
Professional lines 19,458 49,868 56,993
Liability (3,364 ) (20,621 ) (7,316 )
Total $ 122,209 $ 103,014 $ 118,336
In 2012, we recognized $122 million of net favorable prior year reserve
development, the principal components of which were:
• $64 million of net favorable prior year reserve development on our property
and other business, the majority of which related to the 2009 through 2011
accident years ($42 million) and the 2008 accident year ($17 million).
While development was primarily driven by better than expected loss
emergence, $7 million of the 2008 accident year amount was due to the final
settlement of two Hurricane Ike claims.
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• $37 million of net favorable prior year reserve development on marine
business, spanning a number of accident years and largely related to better
than expected loss emergence. The majority of this, $21 million, related to
offshore energy business.
• $19 million of net favorable prior year reserve development on professional
lines business, primarily related to the 2006 through 2008 accident years
and for the reasons discussed in the overview.
During the fourth quarter of 2012, we began to give weight to actuarial methods
that incorporate our own favorable historical claims experience for our oldest
accident year liability business. Refer to the 'Critical Accounting Estimate -
Reserve for Losses and Loss Expenses' section for further details.
In 2011, we recognized $103 million of net favorable prior year reserve
development, the principal components of which were:
• $56 million of net favorable prior year reserve development on our property
and other business, the majority of which related to the 2010 ($27
million), 2009 ($9 million) and 2008 ($10 million) accident years. While
the 2010 and 2009 amounts primarily related to better than expected loss
emergence, the 2008 amount largely related to updated information from our
client with respect to one large loss event.
• $22 million of net favorable prior year reserve development on marine
business, spanning a number of accident years and related to better than
expected loss emergence. The majority of this, $21 million, related to
offshore energy business.
• $10 million of net favorable prior year reserve development on aviation
business, spanning a number of accident years and driven by better than
expected loss emergence.
• $14 million of net adverse prior year reserve development on credit and
political risk business, primarily driven by $21 million in adverse development on the 2009 accident year as we reduced our recovery estimates
based on the latest available information. Partially offsetting this amount
was $8 million in net favorable development on the 2007 and 2008 accident
years.
• $50 million of net favorable prior year reserve development on professional
lines business. We recognized a total of $60 million of net favorable
development for 2004 through 2007 accident years, largely due to the
reasons discussed in the overview. This amount included $19 million
reallocated from the 2007 accident year to the 2008 accident year,
recognized after consideration of our claims history and other available
information and data for accident years impacted by the global financial
crisis; in the aggregate, our estimate for global financial crisis remained
unchanged. Partially offsetting this was the recognition of $8 million of
net adverse development on the 2010 accident year.
• $21 million of net adverse prior year reserve development on liability
business, primarily emanating from the 2010 accident year and related to
the receipt of two notable claims.
In 2010, we recognized $118 million of net favorable prior year reserve
development, the principal components of which were:
• $52 million of net favorable prior year reserve development on our property
and other business, the majority of which emanated from the 2005 through
2009 accident years and related to better than expected loss emergence.
• $23 million of net favorable prior year reserve development on marine
business, largely related to the 2007 through 2009 accident years and
driven by better than expected loss emergence. The majority of this, $20
million, related to offshore energy business.
• $12 million of net favorable prior year reserve development on aviation
business, spanning several accident years and largely related to better
than expected loss emergence.
• $18 million of net adverse prior year reserve development on credit and
political risk business. This balance consisted of net adverse development
of $54 million on the 2009 accident year, as we finalized settlements for
certain loss events and reduced our recovery estimates for the latest
available information. Partially offsetting this amount was $36 million in
net favorable prior year reserve development on the 2006 through 2008
accident years, in recognition of better than anticipated loss emergence on
our CEND and credit business.
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• $57 million of net favorable prior year reserve development on professional
lines business, primarily generated from the 2004 through 2006 accident
years, for the reasons discussed in the overview.
• $7 million of net adverse development on liability business, primarily
related to the 2007 through 2009 accident years and reflecting earlier than
expected loss emergence on our U.S. excess and surplus lines umbrella
business for those accident years during 2010.
Reinsurance Segment:
Year ended December 31, 2012 2011 2010
Property and other $ 79,802 $ 90,437 $ 93,534
Credit and bond 12,254 39,806 37,793
Professional lines 34,291 55,628 60,067
Motor (4,328 ) (31,802 ) 1,225
Liability 612 378 2,100
Total $ 122,631 $ 154,447 $ 194,719
In 2012, we recognized $123 million of net favorable prior year reserve
development, the principal components of which were:
• $80 million of net favorable prior year reserve development on property and
other business, consisting largely of:
• $63 million of net favorable prior year reserve development on
catastrophe and property business. Net favorable development was
evident across all accident years, with the exception of 2011, and was
largely due to better than expected loss emergence. We recognized net adverse development of $18 million on the 2011 accident year, driven by
the revision in our estimates for New Zealand II/III as noted under
'Estimates for Significant Catastrophe Events' above.
• $16 million of net favorable prior year reserve development on crop
business, largely related to the 2011 accident year and due to better
than expected loss emergence. Of this amount, $6 million related to
updated information for one particular claim; the remainder was due to
better than expected loss emergence.
• $12 million of net favorable prior year reserve development on trade credit
and bond reinsurance business, primarily related to the 2010 and 2011
accident years, in recognition of better than expected loss emergence and
updated information from our cedants.
• $34 million of net favorable prior year reserve development on professional
lines reinsurance business, primarily related to the 2007, and to a lesser
extent 2006, accident years for the reasons discussed in the overview.
Aggregate net prior year reserve development for our liability reserving class
was insignificant during 2012; however, there were underlying favorable and
adverse movements by accident year, driven by an underwriting to accident year
reallocation for claims associated with a particular group of treaties.
In 2011, we recognized $154 million of net favorable prior year reserve
development, the principal components of which were:
• $90 million of net favorable prior year reserve development on property and
other business largely consisting of:
• $71 million of net favorable prior year reserve development on
catastrophe and property business. This development primarily related
to the 2007 through 2009 accident years and reflected better than
expected loss emergence.
• $11 million of net favorable prior year reserve development on crop
business, largely related to the 2010 accident year and due to better
than expected loss emergence.
• $8 million in net favorable prior year reserve development on
engineering business, primarily related to the 2007 through 2009
accident years and due to better than expected loss emergence.
• $40 million of net favorable prior year reserve development on trade credit
and bond reinsurance business, largely related to the 2009 and 2010
accident years, in recognition of better than expected loss emergence and
updated information from our cedants.
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• $56 million of net favorable prior year reserve development on professional
lines reinsurance business, primarily related to the 2005 through 2007
accident years for the reasons discussed in the overview.
• $32 million of net adverse prior year reserve development on motor
reinsurance business, primarily related to 2008 through 2010 accident year
non-proportional business and due to changes in assumptions relating to settlement practices in the U.K. motor market (namely, Periodic Payment
Orders, or "PPOs").
In 2010, we recognized $195 million of net favorable prior year reserve
development, the principal components of which were:
• $94 million of net favorable prior year reserve development on property and
other business largely consisting of:
• $75 million of net favorable prior year reserve development on property
and catastrophe business, largely consisting of net favorable
development on the 2009 ($39 million), 2007 ($14 million) and 2005 ($28
million) accident years and partially offset by net adverse development
of $17 million on the 2008 accident year. Development on the 2009 and
2007 accident years was driven by better than expected loss emergence,
while development on the 2005 accident year was driven by a favorable
court judgment associated with one claim and a reduction in our reserve
for another claim following the receipt of updated information. The net
adverse development on the 2008 accident year largely related to
updated information with respect to Hurricane Ike losses.
• $21 million of net favorable prior year reserve development on crop reserves, principally related to the 2009 accident year and largely
resulting from the reduction in reserves for Canadian crop losses
following updated information from the cedant.
• $38 million of net favorable prior year reserve development on trade credit
and bond reinsurance lines of business, largely related to the 2009
accident year and, to a lesser extent the 2007 and 2008 accident years, in
recognition of better than expected loss emergence and updated information
from our cedants.
• $60 million of net favorable prior year reserve development on professional
lines reinsurance business, primarily on the 2006 accident year and, to a
lesser extent the 2007, 2005 and 2004 accident years, for the reasons
discussed in the overview.
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RESULTS BY SEGMENT
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INSURANCE SEGMENT
Results from our insurance segment were as follows:
Year ended December 31, 2012 % Change 2011 % Change 2010
Revenues:
Gross premiums written $ 2,309,481 9% $ 2,121,829 11% $ 1,916,116
Net premiums written 1,522,245 4% 1,466,134 10% 1,332,220
Net premiums earned 1,558,058 9% 1,429,687 18% 1,206,493
Other insurance related 2,676 2,396 2,073
income
Expenses:
Current year net losses and (1,075,773 ) (1,022,333 ) (688,205 )
loss expenses
Prior year reserve 122,209 103,014 118,336
development
Acquisition costs (226,859 ) (199,583 ) (152,223 )
General and administrative (314,834 ) (278,147 ) (276,435 )
expenses
Underwriting income $ 65,477 87% $ 35,034 (83%) $ 210,039
% Point % Point
Change Change
Ratios:
Current year loss ratio 69.0 % (2.5) 71.5 % 14.5 57.0 %
Prior year reserve (7.8 %) (0.6) (7.2 %) 2.6 (9.8 %)
development
Acquisition cost ratio 14.6 % 0.6 14.0 % 1.4 12.6 %
General and administrative 20.2 % 0.8 19.4 % (3.6) 23.0 %
ratio
Combined ratio 96.0 % (1.7) 97.7 % 14.9 82.8 %
Gross Premiums Written:
The following table provides gross premiums written by line of business:
% Change
Year ended December 31, 2012 2011 2010 11 to 12 10 to 11
Property $ 651,188 27 % $ 635,278 30 % $ 600,806 31 % 3 % 6 %
Marine 252,434 11 % 240,481 11 % 224,814 12 % 5 % 7 %
Terrorism 37,186 2 % 34,313 2 % 37,246 2 % 8 % (8 %)
Aviation 65,143 3 % 70,792 3 % 75,794 4 % (8 %) (7 %)
Credit and political risk 39,405 2 % 35,734 2 % 30,669 2 % 10 % 17 %
Professional lines 836,634 36 % 764,205 36 % 712,053 37 % 9 % 7 %
Liability 266,696 12 % 213,256 10 % 228,247 12 % 25 % (7 %)
Accident & health 160,795 7 % 127,770 6 % 6,487 - % 26 % nm
Total $ 2,309,481 100 % $ 2,121,829 100 % $ 1,916,116 100 % 9 % 11 %
nm - not meaningful
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2012 versus 2011: Growth in gross premiums written was evident in the majority
of our lines of business, with professional lines, liability and accident &
health contributing most significantly. Geographic expansion (including our
European operations) and newer initiatives were the primary drivers of the
growth in professional lines; an improving rate environment also contributed.
Liability growth was attributable to select new business opportunities and, to a
lesser extent, rate increases in our U.S. excess and surplus lines umbrella
business. Our recently established accident & health line continued to generate
new business. Property premiums were also up, as growth driven by rate increases
and new business opportunities more than offset a reduction due to the
non-renewal of certain catastrophe-exposed business written through MGAs.
2011 versus 2010: Our accident & health line, launched in 2010, led the 11%
growth in gross premiums written. A large portion of this growth was due to
accident & health reinsurance business assumed.
Excluding accident & health, gross premiums written growth was 4% and was
largely attributable to geographic expansion and certain newer business lines,
including renewable energy and design professionals & environmental liability.
Geographic expansion (including our Australian and Canadian operations)
contributed to the increases in property and professional lines, with the design
professionals & environmental liability initiative also contributing to growth
in professional lines. Our renewable energy business relates to both onshore and
offshore exposures, with growth thus pertaining to the property and marine
lines, respectively.
Premiums Ceded:
2012 versus 2011: Premiums ceded in 2012 were $787 million, or 34%, of gross
premiums written, compared to $656 million, or 31%, in 2011. The increase in the
ceded premium ratio was largely due to changes in our reinsurance purchasing,
most notably a higher cession rate on our professional lines quota share
reinsurance program on renewal during the second quarter. Business mix changes
also contributed to the increase, most notably in relation to the growth in our
liability business, for which we purchase significant reinsurance.
2011 versus 2010: Our ceded premium ratios for 2011 and 2010 were comparable at
31% and 30% of gross premiums written, respectively.
Net Premiums Earned:
The following table provides net premiums earned by line of business:
% Change
Year ended December 31, 2012 2011 2010 11 to 12 10 to 11
Property $ 408,943 26 % $ 385,291 27 % $ 337,525 28 % 6 % 14 %
Marine 171,165 11 % 152,123 11 % 145,356 12 % 13 % 5 %
Terrorism 38,605 2 % 35,213 2 % 32,486 3 % 10 % 8 %
Aviation 60,363 4 % 70,681 5 % 66,636 6 % (15 %) 6 %
Credit and political risk 87,103 6 % 97,680 7 % 89,773 7 % (11 %) 9 %
Professional lines 563,500 36 % 536,238 38 % 444,663 37 % 5 % 21 %
Liability 86,873 6 % 89,555 6 % 87,481 7 % (3 %) 2 %
Accident & health 141,506 9 % 62,906 4 % 2,573 - % 125 % nm
Total $ 1,558,058 100 % $ 1,429,687 100 % $ 1,206,493 100 % 9 % 18 %
nm - not meaningful
2012 versus 2011: Growth in our accident & health line, commensurate with gross
premiums written growth since the launch of this product offering, accounted for
61% of the overall growth in net premiums earned. Growth in professional lines
business in recent quarters, arising from geographic expansion (including our
European, Australian and Canadian operations) and targeted initiatives, also
contributed to the increases; however, the impact of this growth was tempered in
the second half of 2012 by the aforementioned increase in quota share cessions.
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2011 versus 2010: The 18% growth in net premiums earned was primarily reflective
of the 11% growth in gross premiums written discussed above. Further
contributing were reinsurance purchasing changes effected during the second
quarter of 2010.
Loss Ratio:
The table below shows the components of our loss ratio:
% Point % Point
Year ended December 31, 2012 Change 2011 Change 2010
Current accident year 69.0 % (2.5 ) 71.5 % 14.5 57.0 %
Prior year reserve development (7.8 %) (0.6 ) (7.2 %) 2.6 (9.8 %)
Loss ratio 61.2 % (3.1 ) 64.3 % 17.1 47.2 %
Current Accident Year Loss Ratio
2012 versus 2011:
Natural catastrophe and weather-related losses impacted the current accident
year loss ratios for both periods.
During 2012, we recognized estimated pre-tax net losses (inclusive of related
premiums to reinstate our reinsurance protection) of $178 million for Storm
Sandy. In addition, we recognized aggregate pre-tax net losses of $44 million
for Hurricane Isaac and first and second quarter 2012 U.S. weather events.
Comparatively, during 2011, we recognized estimated pre-tax net losses
(inclusive of related premiums to reinstate our reinsurance protection) for the
following natural catastrophe and weather related events:
• $40 million in relation to the series of severe U.S. storms in April and May;
• $32 million in relation to the Thai floods;
• $29 million in relation to the Japanese earthquake and tsunami;
• $20 million in relation to New Zealand II; and
• an aggregate $35 million in relation to Hurricane Irene and Tropical
Storm Lee.
Exclusive of these catastrophe and weather-related losses, our 2012 current
accident year loss ratio improved relative to 2011 primarily due to:
• a lower level of loss activity in our property and marine lines of business;
and
• a reduction in the ratio for our credit & political risk line of business
(loss experience on this business was notably less in 2012, driving a 22
percentage point reduction in the ratio from 60% to 38%).
2011 versus 2010:
Natural catastrophe and weather-related losses were the primary driver of the
14.5 point increase. While the 2011 current accident year loss ratio was
impacted by the events noted above, catastrophe-related pre-tax net losses were
insignificant in 2010. Exclusive of these items, rate reductions, changes in
business mix and a higher level of loss activity in our property and marine
lines of business also contributed to a higher ratio in 2011.
Refer to the 'Prior Year Reserve Development' section for further details.
Acquisition Cost Ratio: Growth in accident & health gross premiums written
introduced some upward movement in the acquisition cost ratio for the segment
starting in 2011; excluding this business, the 2012 and 2011 acquisition cost
ratios were 13.0% and 13.2%, respectively.
General and Administrative Expense Ratio: General and administrative expenses
increased in 2012, driven by performance-based compensation expenses and staff
increases. From a general and administrative expense ratio perspective,
commensurate growth in net premiums earned muted the impact on the 2012 ratio.
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REINSURANCE SEGMENT
Results from our reinsurance segment were as follows:
Year ended December 31, 2012 % Change 2011 % Change 2010
Revenues:
Gross premiums written $ 1,830,162 (7%) $ 1,974,324 8% $ 1,834,420
Net premiums written 1,815,211 (7%) 1,953,300 8% 1,815,320
Net premiums earned 1,857,405 (1%) 1,885,274 8% 1,740,917
Expenses:
Current year net losses and (1,265,095 ) (1,910,180 ) (1,301,982 )
loss expenses
Prior year reserve 122,631 154,447 194,719
development
Acquisition costs (400,794 ) (387,886 ) (336,489 )
General and administrative (116,487 ) (103,915 ) (98,001 )
expenses
Underwriting income (loss) $ 197,660 nm $ (362,260 ) nm $ 199,164
% Point % Point
Change Change
Ratios:
Current year loss ratio 68.1 % (33.2) 101.3 % 26.5 74.8 %
Prior year reserve (6.6 %) 1.6 (8.2 %) 3.0 (11.2 %)
development
Acquisition cost ratio 21.6 % 1.0 20.6 % 1.3 19.3 %
General and administrative 6.3 % 0.8 5.5 % (0.2) 5.7 %
ratio
Combined ratio 89.4 % (29.8) 119.2 % 30.6 88.6 %
nm - not meaningful
Gross Premiums Written:
The following table provides gross premiums written by line of business for the
periods indicated:
% Change
Year ended December 31, 2012 2011 2010 11 to 12 10 to 11
Catastrophe $ 368,314 21 % $ 471,822 24 % $ 453,059 25 % (22 %) 4 %
Property 315,758 17 % 359,987 18 % 354,528 19 % (12 %) 2 %
Professional lines 301,863 16 % 281,394 14 %
288,236 16 % 7 % (2 %)
Credit and bond 264,572 14 % 299,923 15 % 254,130 14 % (12 %) 18 %
Motor 235,648 13 % 238,365 12 % 148,683 8 % (1 %) 60 %
Liability 242,817 13 % 229,728 12 % 238,062 13 % 6 % (4 %)
Engineering 70,597 4 % 65,219 3 % 68,215 4 % 8 % (4 %)
Other 30,593 2 % 27,886 2 % 29,507 1 % 10 % (5 %)
Total $ 1,830,162 100 % $ 1,974,324 100 % $ 1,834,420 100 % (7 %) 8 %
2012 versus 2011: Gross premiums written decreased by $144 million, primarily
driven by the $104 million reduction in catastrophe business. We repositioned
our catastrophe portfolio throughout 2012, reducing exposure in certain zones
(including the Northeast and Mid-Atlantic regions of the U.S.); this was
partially offset by exposure increases in other areas, including Florida and
Japan, where we believe risk and return characteristics are more attractive. The
decline in property premiums was driven by reductions in reinsurance purchasing
by certain of our clients, as well as our evaluation of risk/return
characteristics. Our trade credit and bond reinsurance premiums also decreased,
driven by management of our
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European exposure base in light of current economic conditions and changes in
contract terms. While motor premiums were down slightly for the year, there was
an underlying shift in business mix; we reduced our participation in
uncapitalized U.K. excess of loss business in light of recent settlement trends,
which was partially offset by an increase in proportional business.
2011 versus 2010: The 8% growth in gross premiums written was primarily driven
by our motor reinsurance line of business, driven by a higher volume of European
proportional business; both increases on renewal and new business contributed.
Gross premiums written for our trade credit and bond reinsurance business also
increased, with both premium adjustments on prior year treaties and an increase
in Latin American surety business contributing.
Refer to the 'Critical Accounting Estimates - Premiums' section for a further
discussion of related estimates.
Net Premiums Earned:
The following table provides net premiums earned by line of business:
% Change
Year ended December 31, 2012 2011 2010 11 to 12 10 to 11
Catastrophe $ 375,088 19 % $ 456,858 24 % $ 454,954 26 % (18 %) - %
Property 351,470 19 % 356,022 19 % 323,201 19 % (1 %) 10 %
Professional lines 297,726 16 % 281,025 15 % 285,224 16 % 6 % (1 %)
Credit and bond 277,185 15 % 263,912 14 % 217,809 13 % 5 % 21 %
Motor 237,006 13 % 202,830 11 % 127,404 7 % 17 % 59 %
Liability 220,874 12 % 230,872 12 % 232,014 13 % (4 %) - %
Engineering 68,402 4 % 65,727 4 % 71,229 4 % 4 % (8 %)
Other 29,654 2 % 28,028 1 % 29,082 2 % 6 % (4 %)
Total $ 1,857,405 100 % $ 1,885,274 100 % $ 1,740,917 100 % (1 %) 8 %
2012 versus 2011: The reduction in catastrophe business written during 2012,
described above, drove the decrease in net premiums earned. Partially offsetting
this was an increase for motor reinsurance, driven by the recent increases in
proportional writings previously noted.
2011 versus 2010: Growth was primarily driven by the increased motor and trade
credit and bond writings during 2011, outlined above.
Loss Ratio:
The table below shows the components of our loss ratio:
% Point % Point
Year ended December 31, 2012 Change 2011 Change 2010
Current accident year 68.1 % (33.2 ) 101.3 % 26.5 74.8 %
Prior year reserve development (6.6 %) 1.6 (8.2 %) 3.0
(11.2 %)
Loss ratio 61.5 % (31.6 ) 93.1 % 29.5 63.6 %
Current Accident Year Loss Ratio
2012 versus 2011:
While natural catastrophe and weather-related losses contributed to the current
accident year loss ratios for both periods, the impact was less significant in
2012.
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During 2012, we recognized estimated pre-tax net losses (net of related
reinstatement premiums) of $153 million for Storm Sandy. In addition, we
recognized aggregate pre-tax net losses (net of related reinstatement premiums)
of $60 million for the impact of severe drought conditions on U.S. crops,
Hurricane Isaac and first and second quarter 2012 U.S. weather events.
Comparatively, during 2011, we recognized estimated pre-tax net losses (net of
related reinstatement premiums) for the following natural catastrophe and
weather-related events:
• $370 million in relation to New Zealand II;
• $192 million in relation to the Japanese earthquake and tsunami;
• $74 million in relation to the first quarter Australian weather events;
• $44 million in relation to the series of U.S. storms and tornadoes in
April and May;
• $32 million in relation to the Thai floods; and
• an aggregate $63 million in relation to New Zealand III, the Danish
floods and Hurricane Irene.
Exclusive of these catastrophe and weather-related losses, our 2012 current
accident year loss ratio improved relative to 2011 largely due to reduced
exposure and loss experience related to aggregate property reinsurance of
regional insurance companies in the U.S. This was partially offset by a higher
ratio for our trade credit and bond reinsurance business (up 12 percentage
points to 62% in 2012, reflecting uncertainty around the economic environment in
Europe) and business mix changes (including growth in motor reinsurance).
2011 versus 2010:
Natural catastrophe and weather-related losses were the primary driver of the
increase in the 2011 current accident year loss ratio, in comparison to 2010.
While the 2011 current accident year loss ratio was impacted by the events noted
above, during 2010 we recognized pre-tax net losses (net of related
reinstatement premiums) of $136 million for New Zealand I and $110 million for
the Chilean earthquake. In addition, there were a number of other
weather-related loss events of note in 2010, including Australian and U.S.
storms and European Windstorm Xynthia in the first quarter and further
Australian storms and flooding and U.S. storms in the fourth quarter.
Changes in business mix and rate reductions also contributed to the increase in
2011; however, these increases were partially offset by a reduction in our
current accident year loss ratio for trade credit and bond business, as updated
information from our cedants suggested loss activity would continue to decrease
from levels experienced during the global financial crisis. Our current accident
year loss ratio for this business was 50% in 2011, compared to 61% in 2010.
Refer to the 'Prior Year Reserve Development' section for further details.
Acquisition Cost Ratio: The increases in the reinsurance segment's acquisition
cost ratios were driven by changes in business mix.
General and Administrative Expense Ratio: General and administrative expense
increased in 2012, driven by performance-based compensation expenses and
staffing increases.
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OTHER EXPENSES (REVENUES), NET
--------------------------------------------------------------------------------
The following table provides a breakdown of our other expenses (revenues), net:
Year ended December 31, 2012 % Change 2011 % Change 2010
Corporate expenses $ 129,660 68% $ 77,089 2% $ 75,449
Foreign exchange losses (gains) 29,512 nm (44,582 ) 187% (15,535 )
Interest expense and financing costs 61,863 (1%) 62,598 12% 55,876
Income tax expense 3,287 (78%) 15,233 (61%) 38,680
Total $ 224,322 103% $ 110,338 (29%) $ 154,470
nm - not meaningful
Corporate Expenses: Our corporate expenses include holding company costs
necessary to support our worldwide insurance and reinsurance operations and
costs associated with operating as a publicly-traded company. As a percentage of
net premiums earned, corporate expenses were 3.8%, 2.4% and 2.5% for 2012, 2011
and 2010, respectively. The increase in corporate expenses during 2012 was
reflective of costs associated with our second quarter 2012 senior leadership
transition; these costs included accelerated and incremental share-based
compensation expenses of $20 million and separation payments of $14 million.
Excluding these senior leadership transition amounts, corporate expenses were
2.8% of net premiums earned for 2012.
Foreign Exchange Losses (Gains): Some of our business is written in currencies
other than the U.S. dollar. Movements in the rates of exchange for the euro and
Sterling against the U.S. dollar were the primary drivers of the amounts in each
period presented. Appreciation in these currencies against the U.S. dollar
resulted in foreign exchange losses on the remeasurement of our net
insurance-related liabilities during 2012, whereas depreciation had the opposite
effect in 2011 and 2010.
Interest Expense and Financing Costs: Interest expense primarily relates to
interest due on our senior notes. The increase in 2011 noted above was driven by
our issuance of senior notes on March 23, 2010. See Item 8, Note 10(a) to the
Consolidated Financial Statements for further details.
Income Tax Expense: Income tax expense primarily results from income generated
by our foreign operations in the United States and Europe. Our effective tax
rate, which is calculated as income tax expense divided by income before tax,
was 0.6%, 24.8% and 4.3% in 2012, 2011 and 2010, respectively. This effective
rate can vary between periods depending on the distribution of net income (loss)
amongst tax jurisdictions, as well as other factors.
A significant portion of our losses and loss expenses for Storm Sandy related to
insurance risks written by our U.S. subsidiaries, driving a low effective tax
rate for 2012. Comparatively, a large proportion of the 2011 catastrophe and
weather-related losses previously described arose from reinsurance risks written
in Bermuda; these losses reduced income before tax without a corresponding tax
benefit. Our U.S. and European operations generated taxable income in 2011, thus
resulting in a notably higher effective tax rate for the year in comparison to
2010.
Further increasing income tax expense for 2011 was the establishment of a $13
million valuation allowance related to 2011 operating loss tax-carryforwards
generated from branch operations in Singapore and Australia. Partially
offsetting these increases was a further $10 million reduction in income tax
expense due to the elimination of the remaining valuation allowance associated
with our U.S. capital loss carryforwards. During 2011, we concluded an allowance
was no longer required, as there were sufficient net unrealized gains that could
be realized in order to generate capital gains in the remaining carryforward
period.
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NET INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS/LOSSES
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Net Investment Income
The following table provides a breakdown of income earned from our cash and
investment portfolio by major asset class:
Year ended December 31, 2012 % Change 2011 % Change 2010
Fixed maturities $ 304,400 (10 %) $ 337,616 (4 %) $ 352,357
Other investments 87,660 175 % 31,856 (51 %) 64,765
Equities 11,904 6 % 11,186 286 % 2,900
Cash and cash equivalents 4,528 (21 %) 5,697 (2 %) 5,836
Short-term investments 596 (63 %) 1,592 10 % 1,441
Gross investment income 409,088 5 % 387,947 (9 %) 427,299
Investment expense (28,131 ) 10 % (25,517 ) 25 % (20,407 )
Net investment income $ 380,957 5 % $ 362,430 (11 %) $ 406,892
Pre-tax yield:(1)
Fixed maturities 2.7 % 3.2 % 3.6 %
(1) Pre-tax yield is annualized and calculated as net investment income divided
by the average month-end amortized cost balances for the periods indicated.
Fixed Maturities:
2012 versus 2011: The 10% reduction in investment income from fixed maturities
reflected lower reinvestment yields throughout much of 2012 due to downward
shifts in U.S. and European risk-free yield curves. Spread tightening, primarily
on investment-grade and high yield corporate debt, also contributed to lower
reinvestment yields. These declines were partially offset by growth of 6% on our
average fixed maturities balances during 2012 as additional investments in fixed
maturities were funded primarily by reinvestment of net investment income.
2011 versus 2010: The 4% reduction in investment income from fixed maturities
reflected lower reinvestment yields primarily due to a downward shift in U.S.
and European risk-free yield curves. The reduction was partially offset by
widening credit spreads and growth of 7% on our average fixed maturities
balances during 2011 as additional cash provided by operations was allocated
partially to fixed maturities.
Other Investments:
Other investments include hedge funds, fund of hedge funds, credit funds and CLO
equity tranched securities ("CLO Equities"). These investments are recorded at
fair value, with the change in fair value reported in net investment income.
Consequently, the pre-tax return on other investments may vary materially period
over period, particularly during volatile credit and equity markets.
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The following table provides a breakdown of net investment income (loss) from
other investments:
Year ended December 31, 2012 2011 2010
Hedge funds $ 29,673 $ (7,329 ) $ 8,799
Fund of hedge funds 15,279 (1,561 ) 16,864
Credit funds 11,599 (4,125 ) 14,474
CLO - equity tranched securities 31,109 44,871
21,970
Short duration high yield fund - -
2,658
Total net investment income from other investments $ 87,660$ 31,856
$ 64,765
Pre-tax return on other investments(1) 11.1 % 5.3
% 12.1 %
(1) The pre-tax return on other investments is calculated by dividing total
income from other investments by the average month-end fair value balances
held for the periods indicated.
2012 versus 2011: The improvement in the pre-tax return on our other investments
portfolio was primarily driven by the strong rally in global equity markets and
its impact on our hedge funds and funds of hedge funds. Performance of our
credit funds also improved in 2012 due to modest improvements in the pricing of
the underlying bank loans. Although CLO Equities provided less income in 2012,
their continued strong performance is still a significant positive contributor
to current year performance. The increase in fair value of our CLO Equities was
driven primarily by lower than anticipated default rates and higher than
anticipated recovery rates for the underlying collateral. Refer to the 'Critical
Accounting Estimates - Fair Value Measurements' for further details on the fair
value measurement.
2011 versus 2010: The lower pre-tax return on other investments in 2011 was
primarily due to modest negative returns from our investments in hedge and
credit funds, compared to positive returns provided by these holdings in 2010.
The negative returns of these funds were reflective of the underperformance of
both global equities and bank loans during 2011. Partially offsetting the
decline in the pre-tax return was the increase in the fair value for our
investment in CLO Equities which was driven primarily by higher cash
distributions than previously expected.
Investment Expenses:
2012 versus 2011: The increase was primarily due to increased third party
investment manager fees relating to higher investment balances created by
improved valuations and additional allocations to emerging market debt, short
duration high yield debt and common stocks, which have higher management fees
than core fixed income.
2011 versus 2010: The increase was due to asset class changes. Additionally,
third party investment manager fees increased due to higher investment balances
as a result of improved valuations and additional allocations.
Net Realized Investment Gains/Losses
Our fixed maturities and equities are classified as available for sale and
reported at fair value. The effect of market movements on our available for sale
investment portfolio impacts net income (through net realized investment
gains/losses) only when securities are sold, hedged, or impaired. Additionally,
changes in the fair value of investment derivatives, mainly foreign exchange
forward contracts, are recorded in net realized investment gains/losses.
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The following table provides a breakdown of net realized investment gains:
Year ended December 31, 2012 2011
2010
On sale of investments:
Fixed maturities and short-term investments $ 140,238$ 134,804
$ 200,048
Equities 12,881 2,468 10,800
153,119 137,272 210,848
OTTI charges recognized in earnings (24,234 ) (15,861 ) (17,932 )
Change in fair value of investment derivatives (9,170 ) 4,431
(3,641 )
Fair value hedges 7,754 (4,403 )
5,823
Net realized investment gains $ 127,469 $ 121,439 $ 195,098
On sale of investments:
Generally, sales of individual securities occur when there are changes in the
relative value, credit quality, or duration of a particular issuer. We may also
sell to rebalance our investment portfolio in order to change exposure to
particular sectors or asset classes.
2012 versus 2011: Improvements in global equity markets throughout 2012 also
enabled us to realize gains on our equity holdings during 2012. The primary
sources of the net realized gains on fixed maturities in 2012 were
investment-grade corporate debt, agency MBS and non-U.S. governments compared to
the primary sources of investment-grade corporate debt, agency MBS and U.S.
government and agencies in 2011.
2011 versus 2010: The decrease in net realized gains was largely due to
significant gains realized in 2010 as a result of significant credit spread
tightening. In 2011, we realized net gains primarily on fixed maturities as a
result of the lower U.S. and European risk-free rates. The primary sources of
the net realized gains on fixed maturities in 2011 were investment-grade
corporate debt, U.S. government and agency securities and agency MBS which is
consistent with the sources of the 2010 net realized gains.
OTTI charges:
Refer to the 'Critical Accounting Estimates - OTTI' section for details on our
impairment review process.
The following table provides a summary of the OTTI recognized in earnings by
asset class:
Year ended December 31, 2012 2011 2010
Fixed maturities:
Non-U.S. government $ 3,281 $ - $ -
Corporate debt 1,821 1,954 3,156
CMBS - - 413
Non-Agency RMBS 2,016 717 4,715
ABS 795 61 1,126
Municipals - 483 19
7,913 3,215 9,429
Equities:
Common stocks 7,318 12,646 8,503
Exchange traded funds 9,003 - -
16,321 12,646 8,503
Total OTTI recognized in earnings $ 24,234 $ 15,861 $ 17,932
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The level of OTTI losses increased in 2012 compared to 2011 and 2010 due mainly
to losses recorded on equity exchange traded funds ("ETFs") where we no longer
have the intent to hold the securities until full recovery of cost as it is
likely that these investments will be reallocated to other asset classes.
Change in Fair Value of Investment Derivatives:
From time to time, we may economically hedge the foreign exchange exposure of
non-U.S. denominated securities by entering into foreign exchange contracts.
During 2012, our economic hedges related to Canadian dollar, Sterling, euro and
Australian dollar denominated securities. The net realized and unrealized loss
for the year was primarily driven by our exposure to the euro, which gained 2%
against the U.S. dollar during the year. These hedges did not qualify for fair
value hedge accounting and accordingly, the corresponding net unrealized gains
on the economically hedged securities are recorded as part of accumulated other
comprehensive income in shareholders' equity.
Fair Value Hedges:
We entered into foreign exchange forward contracts to hedge the foreign currency
exposure of certain available for sale fixed maturity portfolios denominated in
euros. The hedges were designated and qualified as fair value hedges, resulting
in the net impact of the hedges recognized in net realized investment gains
(losses). During 2012, we sold all available for sale fixed maturities in the
portfolios that qualified for hedge accounting and settled all of the associated
foreign exchange forward contracts.
Foreign denominated assets and liabilities will continue to be substantially
matched, in order to minimize any foreign exchange impact on book value.
Total Return
Our investment strategy is to take a long-term view by actively managing our
investment portfolio to maximize total return within certain guidelines and
constraints. In assessing returns under this approach, we include net investment
income, net realized investment gains and losses and the change in unrealized
gains and losses generated by our investment portfolio. The following table
provides a breakdown of the total return on cash and investments, inclusive of
foreign exchange impact, for the periods indicated:
Year ended December 31, 2012 2011 2010
Net investment income $ 380,957 $ 362,430 $ 406,892
Net realized investments gains 127,469 121,439 195,098
Change in net unrealized gains/losses, net 250,212 (34,320 ) 74,175
of currency hedges
Total $ 758,638 $ 449,549 $ 676,165
Average cash and investments(1) $ 14,098,888 $ 13,309,143
$ 12,285,244
Total return on average cash and 5.4 % 3.4 % 5.5 %
investments, pre-tax(2)
(1) The average cash and investments balance is calculated by taking the average
of the month-end fair value balances held for the periods indicated.
(2) Excluding the impact of foreign currencies due to matching with foreign
denominated insurance liabilities, the total return would be 4.9% for 2012
(2011: 3.7%, 2010: 5.3%).
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CASH AND INVESTMENTS
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The table below provides a breakdown of our cash and investments:
December 31, 2012 December 31, 2011
Amortized Cost Amortized Cost
or Cost Fair Value or Cost Fair Value
Fixed maturities $ 11,605,672 $ 11,928,049 $ 10,821,338 $ 10,940,100
Equities 608,306 666,548 699,566 677,560
Other investments 730,101 843,437 650,955 699,320
Short-term investments 108,860 108,860 149,909 149,909
Total investments $ 13,052,939 $ 13,546,894 $ 12,321,768 $ 12,466,889
Cash and cash equivalents(1) $ 850,550 $ 850,550 $ 1,082,838 $ 1,082,838
(1) Includes restricted cash and cash equivalents of $91 million and $101 million
for 2012 and 2011, respectively.
Overview
The cost of our total investments increased by $731 million from December 31,
2011, primarily due to investing a portion of our operating cash flows generated
in 2012, investing cash on hand and reinvesting net investment income and
proceeds from sales in 2012. In addition to these cash contributions,
significant contributors to the increase in the fair value of our total
investments from December 31, 2011 include improved valuations for our fixed
maturities and equities and, to a lesser degree, movements in foreign exchange
rates, mainly the euro strengthening against the U.S. dollar. The strong rally
in global equity markets during 2012 combined with new and incremental hedge
fund investments contributed to the increase in fair value of our other
investments.
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The following provides a further analysis on our investment portfolio.
Fixed Maturities
The following provides a breakdown of our investment in fixed maturities:
December 31, 2012 December 31, 2011
Fair Value % of Total Fair Value % of Total
Fixed maturities:
U.S. government and agency $ 1,422,885 13 % $ 1,148,267 10 %
Non-U.S. government 1,104,576 9 % 1,212,451 11 %
Corporate debt 3,876,382 32 % 3,609,591 33 %
Agency RMBS 2,659,908 22 % 2,636,634 24 %
CMBS 840,084 7 % 312,691 3 %
Non-Agency RMBS 95,199 1 % 165,713 2 %
ABS 643,206 5 % 632,042 6 %
Municipals(1) 1,285,809 11 % 1,222,711 11 %
Total $ 11,928,049 100 % $ 10,940,100 100 %
Credit ratings:
U.S. government and agency $ 1,422,885 13 % $ 1,148,267 10 %
AAA(2) 4,791,455 39 % 4,783,578 44 %
AA 1,175,205 10 % 1,345,583 12 %
A 2,215,326 19 % 1,949,612 18 %
BBB 1,473,388 12 % 1,181,156 11 %
Below BBB(3) 849,790 7 % 531,904 5 %
Total $ 11,928,049 100 % $ 10,940,100 100 %
(1) Includes bonds issued by states, municipalities, and political subdivisions.
(2) Includes U.S. government-sponsored agency RMBS and CMBS.
(3) Non-investment grade and non-rated securities.
At December 31, 2012, fixed maturities had a weighted average credit rating of
AA- (2011: AA-) with a book yield of 2.6% (2011: 2.9%) and an average duration
of 3.0 years (2011: 2.8 years). When incorporating short-term investments and
cash and cash equivalents into this calculation (bringing the total to $12.9
billion), the average rating would be AA- (2011: AA-) and the average duration
would be 2.8 years (2011: 2.5 years).
Our methodology for assigning credit ratings to our fixed maturities is in line
with the methodology used for the Barclay's U.S. Aggregate Bond index. This
methodology uses the middle of Standard & Poor's (S&P), Moody's and Fitch
ratings. When ratings from only two of these agencies are available, the lower
rating is used. When a rating from only one agency is available, it is used.
Previously, we used S&P's ratings; in the absence of a rating from S&P, we used
the lower of the ratings established by Moody's and Fitch.
To calculate the weighted average credit rating for fixed maturities, we assign
points to each rating with 29 points for the highest rating (AAA) and 2 points
for the lowest rating (D) and then calculate the weighted average based on the
fair values of the individual securities. Securities that are not rated by S&P,
Moody's or Fitch are excluded from the weighted average calculation. At
December 31, 2012, the fair value of fixed maturities not rated was $7 million
(2011: $2 million).
As part of our ongoing risk management process, in addition to managing our
credit risk exposure within our fixed maturity portfolio we also monitor the
aggregation of country risk exposure on a group-wide basis (refer to Item 1
'Risk and Capital Management' for further details). Country risk exposure is the
risk that events within a country, such as currency crises, regulatory changes
and other political events, will adversely affect the ability of obligors within
the country to honor their obligations to us. For foreign corporate debt
securities and structured securities, we measure the country risk exposure based
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on the country of the obligor's domicile. For debt securities issued by a
foreign subsidiary with an implicit or explicit parental guarantee, the country
of risk would be that of the parent.
In light of global concerns over the creditworthiness of certain countries
within the eurozone, we have actively managed our exposure to sovereign debt
issued by these countries. During 2012, we sold all remaining sovereign debt
holdings in France, Spain and Belgium. Our current non-U.S. government holdings
include exposure to only three countries within the eurozone - Germany,
Netherlands and Austria, all of which are rated AAA. At December 31, 2012, we
held no sovereign debt issued by the peripheral European countries of Greece,
Ireland, Italy, Portugal and Spain.
The following table provides a breakdown of the fair value of our eurozone
exposure within our fixed maturity portfolio:
Non-U.S. Non-Agency
Government Corporate RMBS ABS Total % of Total
At December 31, 2012
Eurozone countries:
Germany $ 107,291 $ 105,712 $ - $ 11,585 $ 224,588 42 %
Netherlands 23,988 62,170 1,866 22,497 110,521 20 %
Supranationals(1) 79,534 - - - 79,534 15 %
France - 40,693 - 8,567 49,260 9 %
Luxembourg - 30,352 - - 30,352 6 %
Belgium - 24,950 - - 24,950 5 %
Ireland - 7,989 - - 7,989 1 %
Spain - 7,627 - - 7,627 1 %
Austria 6,108 - - - 6,108 1 %
Italy - - - - - - %
Total eurozone $ 216,921 $ 279,493 $ 1,866 $ 42,649 $ 540,929 100 %
At December 31, 2011
Eurozone countries:
Germany $ 247,741 $ 133,990 $ - $ 23,990 $ 405,721 42 %
France 119,820 78,241 - - 198,061 20 %
Netherlands 63,264 23,208 7,247 23,505 117,224 12 %
Spain 80,010 21,563 - - 101,573 10 %
Supranationals(1) 58,350 - - - 58,350 6 %
Belgium 48,560 5,537 - - 54,097 6 %
Luxembourg - 19,836 - - 19,836 2 %
Austria 16,266 - - - 16,266 2 %
Italy - 3,977 - - 3,977 - %
Ireland - 390 - - 390 - %
Total eurozone $ 634,011 $ 286,742 $ 7,247 $ 47,495 $ 975,495 100 %
(1) Includes supranationals only within the eurozone.
We also have an indirect eurozone exposure through our investment of $104
million in non-U.S. bond mutual funds.
The following is an analysis of our fixed maturity portfolio by major asset
classes.
U.S. Government and Agency:
The increase was mainly due to an allocation to Treasury Inflation-Protected
Securities ("TIPS") which are expected to reduce the impact of rising rates on
the portfolio caused by higher than expected inflation.
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Non-U.S. Government:
Our holdings in non-U.S. government securities consisted of fixed income
obligations of non-U.S. sovereigns, including government agencies, local
governments and supranationals. The table below summarizes our aggregate fixed
maturity exposures to governments in the eurozone and other non-U.S. government
concentrations by fair value at December 31, 2012 and 2011:
December 31, 2012 December 31, 2011
Weighted Weighted
Average Average
Country Fair Value % of Total Credit Rating Fair Value % of Total Credit Rating
Eurozone countries:
Germany $ 107,291 10 % AAA $ 247,741 20 % AAA
Supranationals(1) 79,534 7 % AAA 58,350 5 % AAA
Netherlands 23,988 2 % AAA 63,264 5 % AAA
Austria 6,108 1 % AAA 16,266 1 % AAA
France - - % - 119,820 10 % AAA
Spain - - % - 80,010 7 % AA-
Belgium - - % - 48,560 4 % AA
Total eurozone $ 216,921 20 % AAA $ 634,011 52 % AA+
Other
concentrations:
United Kingdom $ 201,658 18 % AAA $ 245,098 20 % AAA
Australia 193,259 17 % AAA 108,923 9 % AAA
Canada 132,938 12 % AA+ 129,583 11 % AAA
Russian Federation 58,218 5 % BBB 23,203 2 % BBB
Brazil 49,987 5 % BBB 5,613 - % BBB
Other 251,595 23 % A 66,020 6 % AA-
Total other $ 887,655 80 % AA- $ 578,440 48 % AA+
concentrations
Total non-U.S. $ 1,104,576 100 % AA $ 1,212,451 100 % AA+
government
(1) Includes supranationals only within the eurozone.
During 2012, we decreased our allocation in non-U.S. government debt securities
as we actively reduced our exposure to eurozone sovereign debt. The primary
driver of the growth in "other concentrations" is the $133 million funding of a
portfolio of emerging market debt securities. At December 31, 2012, this
portfolio had a weighted average credit rating of BBB+, a duration of 3.9 years
and a yield-to-worst of 5.2%. The top four country exposures are Mexico, Russia,
South Africa and Brazil. The securities in this portfolio are held in local
currency and not currently hedged back to U.S. dollars.
At December 31, 2012, our non-U.S. sovereign debt portfolio had net unrealized
gains of $28 million (2011: $29 million net unrealized losses) which included
gross unrealized foreign exchange losses of $3 million (2011: $50 million),
mainly on euro-denominated securities.
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Corporate Debt:
The composition of our corporate debt securities by sector was as follows:
December 31, 2012 December 31, 2011
Weighted Weighted
Average Average
Fair Value % of Total Credit Rating Fair Value % of Total Credit Rating
Financial institutions:
U.S. banking $ 986,723 25 % A- $ 698,864 19 % A
Corporate/commercial 247,633 6 % BBB+ 206,404 6 % A-
finance
Insurance 208,149 5 % A 64,973 2 % A-
Foreign banking 31,924 1 % A- 31,814 1 % A+
Consumer finance 25,522 1 % BBB- 60,541 2 % A
Investment brokerage 10,110 - % BB+ 23,814 1 % A-
Total financial 1,510,061 38 % A- 1,086,410 31 % A
institutions
Communications 470,013 12 % BBB- 446,932 12 % BBB
Consumer cyclical 414,058 11 % BBB- 245,834 7 % BBB-
Consumer non-cyclicals 355,117 9 % BBB- 446,478 12 % BBB+
Industrials 335,017 9 % BB+ 341,936 9 % BBB
Utilities 287,693 7 % BBB 400,687 7 % BBB+
Energy 207,881 6 % BBB- 214,564 11 % BBB+
Non-U.S. government 94,987 2 % AAA 224,803 6 % AA-
guaranteed
Other 201,555 6 % BBB- 201,947 5 % BBB+
Total $ 3,876,382 100 % BBB $ 3,609,591 100 % BBB+
Credit quality summary:
Investment grade $ 3,094,744 80 % A- $ 3,148,337 87 % A-
Non-investment grade 781,638 20 % B+ 461,254 13 % B+
Total $ 3,876,382 100 % BBB $ 3,609,591 100 % BBB+
The increase in corporate debt holdings during 2012 was mainly due to the
increase in our allocation to short duration high yield corporate debt
securities. At December 31, 2012, our short duration high yield portfolio had a
fair value of $793 million (2011: $499 million), a weighted-average credit
rating of B+ (2011: BB-) and duration of 1.7 years (2011: 1.3 years). The
primary sector exposures for this high yield portfolio are consumer cyclical,
communications, industrials, consumer non-cyclicals and energy. These five
sectors comprise 75% (2011: 76%) of the total fair value of this portfolio.
During 2012, we added to our U.S. banking holdings as, despite the significant
rally in investment-grade corporates, spreads in this sector remained attractive
relative to historical averages. At December 31, 2012 and 2011, all of our
holdings in this sector are investment-grade. Our holdings of non-U.S.
government guaranteed corporates declined during 2012 due to the lack of new
supply to replace securities that matured during the year.
At December 31, 2012, our corporate debt portfolio, including short duration
high yield securities, had a weighted average credit rating of BBB (2011: BBB+)
and a duration of 2.9 years (2011: 3.1 years). The decline in the weighted
average credit rating for the portfolio in 2012 was largely due to the increase
in our allocation to short duration high yield corporate debt securities.
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Mortgage-Backed Securities:
The following table provides a breakdown of the fair value of our RMBS and CMBS
portfolios by credit rating:
December 31, 2012 December 31, 2011
RMBS CMBS RMBS CMBS
Government agency $ 2,659,908 $ - $ 2,636,634 $ -
AAA 27,266 603,001 92,851 260,443
AA 5,631 150,508 5,398 40,776
A 6,687 65,520 5,155 11,472
BBB 7,638 21,055 8,517 -
Below BBB(1) 47,977 - 53,792 -
Total $ 2,755,107 $ 840,084 $ 2,802,347 $ 312,691
(1) Non-investment grade securities
Residential MBS:
Our RMBS portfolio consists primarily of AAA-rated U.S. agency issues and is
supported by loans that are diversified across geographical areas. Due to a
change in prepayment speed assumptions, the duration of our agency MBS holdings
expanded from 1.8 years at December 31, 2011 to 2.6 years at December 31, 2012.
During 2012, our holdings of non-agency RMBS declined mainly due to paydowns. At
December 31, 2012, the average duration and weighted average life was 0.3 years
(2011: 0.1 years) and 3.5 years (2011: 5.8 years), respectively, for non-agency
RMBS.
Commercial MBS:
We increased our allocation to commercial MBS in 2012, primarily due to
attractive valuations relative to other structured products. Our non-agency CMBS
portfolio continues to be rated highly, with approximately 90% rated AA or
better (2011: 96%). Additionally, the weighted average estimated subordination
percentage for the portfolio was 30% at December 31, 2012 (2011: 25%), which
represents the current weighted average estimated percentage of the capital
structure subordinated to the investment holding that is available to absorb
losses before the security incurs the first dollar loss of principal. At
December 31, 2012, the average duration and weighted average life was 2.8 years
(2011: 2.9 years) and 3.1 years (2011: 4.2 years), respectively.
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Asset-Backed Securities:
The following table provides a breakdown of the fair value of our ABS by
underlying collateral and credit rating:
Asset-backed securities
AAA AA A BBB Below BBB(3) Total
At December 31, 2012
Auto $ 157,932 $ 5,221 $ 30,743 $ 28,402 $ - $ 222,298
Student loan 152,653 6,862 - - - 159,515
Credit card 52,984 - - - - 52,984
CLO - debt tranches - 17,222 8,853 14,749
11,750 52,574
Other 137,650 4,237 5,487 4,860 3,601 155,835
Total $ 501,219 $ 33,542 $ 45,083 $ 48,011 $ 15,351 $ 643,206
% of total 78 % 5 % 7 % 8 % 2 % 100 %
At December 31, 2011
Auto $ 265,652 $ - $ - $ - $ - $ 265,652
Student loan 152,100 7,893 - - - 159,993
Credit card 91,461 - - - - 91,461
CLO - debt tranches - - 24,775 13,101 9,643 47,519
Other 65,392 371 160 227 1,267 67,417
Total $ 574,605 $ 8,264 $ 24,935 $ 13,328 $ 10,910 $ 632,042
% of total 91 % 1 % 4 % 2 % 2 % 100 %
The average duration and weighted average life of our ABS portfolio at
December 31, 2012 was 0.9 years (2011: 0.7 years) and 3.6 years (2011: 3.1
years), respectively.
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Municipals:
Our holdings in municipal debt are primarily held within the taxable portfolios
of our U.S. subsidiaries and include debt issuance from states, municipalities
and political subdivisions. The following table provides a breakdown of the fair
value of our municipal debt portfolio by state and between Revenue and General
Obligation ("G.O.") bonds:
Gross Gross Weighted
% of Total Unrealized Unrealized Average
G.O. Revenue Total Fair Value Gains Losses Credit Rating
At December 31, 2012
New York $ 46,597 $ 163,859 $ 210,456 16 % $ 10,644 $ (301 ) AA
California 65,477 139,239 204,716 16 % 11,929 (250 ) A+
Texas 37,576 86,795 124,371 10 % 5,584 (8 ) AA
Florida 7,797 70,000 77,797 6 % 4,444 - AA-
Illinois 19,572 55,116 74,688 6 % 3,267 (33 ) A+
Other 154,958 438,823 593,781 46 % 22,902 (133 ) AA
$ 331,977 $ 953,832 $ 1,285,809 100 % $ 58,770 $ (725 ) AA-
At December 31, 2011
New York $ 47,856 $ 153,068 $ 200,924 16 % $ 9,020 $ (6 ) AA
California 66,113 132,870 198,983 16 % 9,874 (162 ) A+
Texas 46,446 91,235 137,681 11 % 5,355 (5 ) AA
Florida 10,344 57,825 68,169 6 % 3,297 - AA-
Washington 27,515 30,177 57,692 5 % 2,184 (9 ) AA
Other 117,217 442,045 559,262 46 % 22,708 (1,498 ) AA-
$ 315,491 $ 907,220 $ 1,222,711 100 % $ 52,438 $ (1,680 ) AA-
During 2012, we continued to add municipal debt securities primarily to our
taxable U.S. portfolios due to the attractive relative value of this asset
class.
G.O. bonds are backed by the full faith and credit of the authority that issued
the debt and are secured by the taxing powers of those authorities. Revenue
bonds are backed by the revenue stream generated by the services provided by the
issuer (e.g. sewer, water or utility projects). As issuers of revenue bonds do
not have the ability to draw from tax revenues or levy taxes to fund
obligations, revenue bonds may carry a greater risk of default than G.O. bonds.
At December 31, 2012, the top three revenue streams related to transportation
(22%), school (12%) and power (11%) (2011: transportation (20%), power (15%) and
school (14%)).
Additionally, certain of our holdings in municipal debt are insured by financial
guarantee companies. At December 31, 2012, we held insurance enhanced municipal
bonds in the amount of $202 million (2011: $231 million), with a weighted
average credit rating of AA- (2011: AA-). In the event the financial guarantors
are unable to make good on their guarantee on a defaulted security, we would
then be exposed to the credit loss. Excluding the insurance benefit from the
financial guarantee companies, the weighted average credit quality of our
insured bond holdings would be AA- (2011: AA-). At December 31, 2012, our
largest exposures to financial guarantors were Assured Guaranty Corp. for $90
million (2011: $92 million), National Public Finance Guarantee Corporation for
$58 million (2011: $63 million) and Ambac Financial Group, Inc. for $31 million
(2011: $38 million). We had no direct investments in these companies at
December 31, 2012 and 2011.
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Gross Unrealized Losses:
At December 31, 2012, the gross unrealized losses on our fixed maturities
portfolio were $18 million (2011: $125 million).
The following table provides information on the severity of the unrealized loss
position as a percentage of amortized cost for all investment grade fixed
maturities in an unrealized loss position and includes any impact of foreign
exchange:
December 31, 2012 December 31, 2011
% of % of
Gross Total Gross Gross Total Gross
Severity of Unrealized Unrealized Unrealized Unrealized
Unrealized Loss Fair Value Losses Losses Fair Value Losses Losses
0-10% $ 1,547,790 $ (13,192 ) 92 % $ 2,461,280 $ (78,634 ) 74 %
10-20% 9,533 (1,171 ) 8 % 174,001 (24,829 ) 23 %
20-30% - - - % 9,853 (3,110 ) 3 %
30-40% - - - % - - - %
40-50% - - - % - - - %
> 50% - - - % - - - %
Total $ 1,557,323 $ (14,363 ) 100 % $ 2,645,134 $ (106,573 ) 100 %
The improvement in investment-grade pricing is primarily due to significant
credit spread tightening. Lower risk-free rates on European issues also had a
meaningful impact on the reduction in total gross unrealized losses compared to
2011.
The following table provides information on the severity of the unrealized loss
position as a percentage of amortized cost for all non-investment grade fixed
maturities in an unrealized loss position at December 31, 2012 and 2011:
December 31, 2012 December 31, 2011
% of % of
Gross Total Gross Gross Total Gross
Severity of Fair Unrealized Unrealized
Fair Unrealized Unrealized
Unrealized Loss Value Losses Losses Value Losses Losses
0-10% $ 143,396 $ (3,223 ) 79 % $ 170,244 $ (4,965 ) 27 %
10-20% 4,302 (714 ) 17 % 29,538 (4,733 ) 26 %
20-30% 583 (185 ) 4 % 17,647 (6,532 ) 36 %
30-40% - - - % 4,172 (2,081 ) 11 %
40-50% - - - % - - - %
> 50% - - - % - - - %
Total $ 148,281 $ (4,122 ) 100 % $ 221,601 $ (18,311 ) 100 %
Despite significantly increasing our allocation to high yield corporate debt
during 2012, both the amount and severity of gross unrealized losses on our
non-investment grade fixed maturities declined, primarily due to significant
tightening of high yield credit spreads.
Equities
During 2012, we decreased our allocation to global equities, mainly due to sales
of exchange traded funds ("ETFs") which were originally introduced to our
portfolio in 2011 to provide highly liquid and cost efficient exposure to the
global equity markets. The proceeds from these sales were reinvested in high
yield corporate debt and hedge funds.
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At December 31, 2012, our equities portfolio had net unrealized gains of $58
million (2011: $22 million net unrealized losses) of which most relate to our
managed portfolios. The $80 million change in net unrealized gains/losses was
caused primarily by the strong rally in the equity markets during 2012.
Other Investments
The composition of our other investment portfolio is summarized as follows:
December 31, 2012 December 31, 2011
Hedge funds
Long/short equity funds $ 302,680 36 % $ 214,498 31 %
Multi-strategy funds 244,075 29 % 230,750 33 %
Event-driven funds 149,670 17 % 99,061 14 %
Total hedge funds 696,425 82 % 544,309 78 %
Credit funds
Leveraged bank loan funds 62,768 8 % 69,132 10 %
Event-driven funds 21,809 3 % 19,319 3 %
Total credit funds 84,577 11 % 88,451 13 %
Total hedge and credit funds 781,002 93 % 632,760 91 %
CLO - Equities 62,435 7 % 66,560 9 %
Total other investments $ 843,437 100 % $ 699,320 100 %
The $148 million increase in the fair value of our total hedge and credit funds
in 2012 was driven by $92 million of net subscriptions as well as $56 million of
increased valuations during the year as our hedge and credit funds tracked the
rally in the global equity and credit markets. Certain of these funds may be
subject to restrictions on redemptions which may limit our ability to liquidate
these investments in the short term. Refer to Item 8, Note 5(b) of our
Consolidated Financial Statements for further details.
The $4 million decrease in the fair value of the CLO - Equities since
December 31, 2011, was due to $31 million of improved valuations, offset by $35
million in cash distributions received during 2012.
Restricted Investments
In order to support our obligations in regulatory jurisdictions where we operate
as a non-admitted carrier, we provide collateral in the form of assets held in
trust and, to a lesser extent, letters of credit. Refer to Item 8, Note 10(b) to
our Consolidated Financial Statements for further information on our collateral
requirements upon issuance of certain letters of credit. The fair value of our
restricted investments primarily relates to these items, as noted in the table
below. Our restricted investments primarily consist of high-quality fixed
maturity and short-term investment securities.
At December 31, 2012 2011
Collateral in Trust for inter-company agreements $ 2,134,931$ 1,921,586
Collateral for secured letter of credit facility 470,062 441,229
Collateral in Trust for third party agreements 245,539 238,395
Securities on deposit with regulatory authorities 59,456 49,543
Total restricted investments $ 2,909,988 $ 2,650,753
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LIQUIDITY AND CAPITAL RESOURCES
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LIQUIDITY
Liquidity is a measure of a company's ability to generate cash flows sufficient
to meet the short-term and long-term cash requirements of its business
operations. We manage our liquidity at both the holding company and operating
subsidiary level.
Holding Company
As a holding company, AXIS Capital has no operations of its own and its assets
consist primarily of investments in its subsidiaries. Accordingly, AXIS
Capital's future cash flows depend on the availability of dividends or other
statutorily permissible distributions, such as returns of capital, from its
subsidiaries. The ability to pay such dividends and/or distributions is limited
by the applicable laws and regulations of the various countries and states in
which AXIS Capital's subsidiaries operate (refer to Item 8, Note 18, to the
Consolidated Financial Statements for further information), as well as the need
to maintain capital levels to adequately support (re)insurance operations and to
preserve financial strength ratings issued by independent rating agencies.
During 2012, AXIS Capital received $525 million (2011: $385 million; 2010: $698
million) of distributions from its subsidiaries. AXIS Capital's primary uses of
funds are dividend payments to both common and preferred shareholders, share
repurchases, interest and principal payments on debt, capital investments in
subsidiaries and payment of corporate operating expenses. We believe the
dividend/distribution capacity of AXIS Capital's subsidiaries, which was over $1
billion at December 31, 2012, will provide AXIS Capital with sufficient
liquidity for the foreseeable future.
Operating Subsidiaries
AXIS Capital's operating subsidiaries primarily derive cash from the net inflow
of premiums less claim payments related to underwriting activities and from net
investment income. Historically, these cash receipts have been sufficient to
fund the operating expenses of these subsidiaries, as well as to fund dividend
payments to AXIS Capital. The subsidiaries' remaining cash flows are generally
reinvested in our investment portfolio, although they have also been used to
fund common share repurchases in recent periods.
The (re)insurance business of our operating subsidiaries inherently provides
liquidity, as premiums are received in advance (sometimes substantially in
advance) of the time claims are paid. However, the amount of cash required to
fund claim payments can fluctuate significantly from period to period, due to
the low frequency/high severity nature of certain types business we write.
The following table summarizes our consolidated cash flows from operating,
investing and financing activities in the last three years:
Total cash provided by (used in)(1) 2012 2011 2010
Operating activities $ 1,120,617 $ 1,190,142 $ 1,187,777
Investing activities (862,381 ) (832,718 ) (687,790 )
Financing activities (481,811 ) (302,480 ) (351,661 )
Effect of exchange rate changes on cash 1,543
(2,610 ) (7,425 )
Increase (decrease) in cash and cash equivalents $ (222,032 ) $ 52,334$ 140,901
(1) See Consolidated Statements of Cash Flows included in Item 8, 'Financial
Statements and Supplementary Data', of this report for additional
information.
• While our 2011 cash flows from operating activities were comparable to 2010,
there were certain notable underlying movements; net premium-related cash
receipts increased but were partially offset by an increase in net paid
losses. Premium receipts increased due to growth in gross premiums written,
as well as changes in reinsurance purchasing effected in the second quarter
of 2010. The high frequency and severity of natural catastrophe and
weather-related events in 2010 and 2011 drove an increase in net paid losses,
though this was partially offset by a continued reduction in payments related
to lines of business impacted by the global financial crisis. The slight
reduction in operating cash flows in 2012 was driven by an increase in net
paid losses, as we continued to pay claims related to 2010 and 2011
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events. Partially offsetting this was an increase in net premium receipts,
driven by growth in gross premiums written; this growth was partially muted in
the second half of 2012 due to the previously discussed changes in reinsurance
purchasing in the second quarter.
• During 2011, we increased our allocation to global equities and hedge funds,
driving combined net purchases of equities and other investments of $0.5
billion. Our remaining cash outflows for 2011, and the majority for 2012 and
2010, largely related to the net purchase of fixed maturities (2012: $0.9
billion, 2011: $0.3 billion, 2010: $0.6 billion). Fixed income purchases for
2012 included the previously discussed increased allocations to TIPS, short
duration high yield corporate debt and CMBS, a portion of which was funded
from cash on hand at the end of 2011. Refer to the 'Cash and Investments'
section for further details.
• Dividends paid to common and preferred shareholders are the primary source of
recurring cash flows used in financial activities and totaled $159 million in
2012 (2011: $243 million, 2010: $145 million); this amount was higher for
2011 relative to the preceding and succeeding years largely due to the
payment of deferred dividends to certain warrant holders upon exercise (refer
to Item 8, Note 13 to our Consolidated Financial Statements). Financing cash
outflows also included common share repurchases totaling $318 million, $66
million and $710 million, respectively in 2012, 2011 and 2010. We note that
market share repurchases are completely discretionary (see 'Capital Resources
- Share Repurchases' below). During 2012, financing cash flows also included
a net $11 million outflow related to the three preferred share transactions
discussed under 'Capital Resources - Preferred Shares' below. During 2010,
cash outflows were partially offset by the $495 million net proceeds received
from our senior notes issuance (discussed in Item 8, Note 10(a) of our
Consolidated Financial Statements).
Our diversified underwriting portfolio has demonstrated an ability to withstand
catastrophic losses. Since 2003, with the only exception being 2009, our annual
cash flows from operations were in excess of $1 billion; operating cash flows of
$850 billion for 2009 were adversely impacted by claims arising amidst the
global financial crisis and a non-recurring payment of $200 million to settle
our insurance derivative contract. These positive cash flows were generated
notwithstanding the impacts of the global financial crisis and the recognition
of significant natural catastrophe-related losses during the period: our net
losses and loss expenses included $266 million for Hurricanes Charley, Frances,
Ivan and Jeanne in 2004; $1,019 million for Hurricanes Katrina, Rita and Wilma
in 2005; $408 million for Hurricanes Gustav and Ike in 2008; $256 million for
the Chilean earthquake and New Zealand I in 2010; $944 million for numerous
natural catastrophe and weather events in 2011; and $331 million for Storm Sandy
in 2012. There remains significant uncertainty associated with our estimates of
net losses for certain of these events (see 'Underwriting Results - Group -
Underwriting Expenses' for further details), as well as the timing of the
associated cash outflows.
Should claim payment obligations accelerate beyond our ability to fund payments
from operating cash flows, we would utilize our cash and cash equivalent
balances and/or liquidate a portion of our investment portfolio. Our investment
portfolio is heavily weighted towards conservative, high quality and highly
liquid securities. We expect that, if necessary, approximately $13.4 billion of
cash and invested assets at December 31, 2012 could be available in one to three
business days under normal market conditions; of this amount, $2.9 billion
relates to restricted assets, which primarily support our obligations in
regulatory jurisdictions where we operate as a non-admitted carrier (see Item 8,
Note 5(e) to the Consolidated Financial Statements for further details). For
context, our largest 1-in-250 year return period, single occurrence, single-zone
modeled probable maximum loss (Southeast U.S. Hurricane) is approximately $1
billion, net of reinsurance; our claim payments pertaining to such an event
would be paid out over a period spanning many months. Our internal risk
tolerance framework aims to limit both the loss of capital due to a single
event, and the loss of capital that would occur from multiple but perhaps
smaller events, in any year. Refer to the 'Risk and Capital Management' section
of Item 1 for further information.
Our net paid losses may continue to increase in the short-term, due to the
recent significant level of natural catastrophe activity. However, we continue
to expect that cash flows generated from our operations, combined with the
liquidity provided by our investment portfolio, will be sufficient to cover our
required cash outflows and other contractual commitments through the foreseeable
future. Refer to the 'Contractual Obligations and Commitments' section below for
further information about the anticipated amounts and timing of our contractual
obligations and commitments.
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CAPITAL RESOURCES
In addition to common equity, we have utilized other external sources of
financing, including debt, preferred shares and letters of credit to support our
business operations. We believe that we hold sufficient capital to allow us to
take advantage of market opportunities and to maintain our financial strength
ratings, as well as to comply with various local statutory regulations. We
monitor our capital adequacy on a regular basis and will seek to adjust our
capital base (up or down) according to the needs of our business (see 'Risk and
Capital Management' in Item 1).
The following table summarizes our consolidated capital position for the periods
indicated:
At December 31, 2012 2011
Long-term debt $ 995,245 $ 994,664
Preferred shares 502,843 500,000
Common equity 5,276,918 4,944,079
Shareholders' equity 5,779,761 5,444,079
Total capital $ 6,775,006 $ 6,438,743
Ratio of debt to total capital 14.7 %
15.4 %
Ratio of debt and preferred equity to total capital 22.1 %
23.2 %
We finance our operations with a combination of debt and equity capital. Our
debt to total capital and debt and preferred equity to total capital ratios
provide an indication of our capital structure, along with some insight into our
financial strength. A company with higher ratios in comparison to industry
average may show weak financial strength because the cost of its debts may
adversely affect results of operations and/or increase its default risk. We
believe that our financial flexibility remains strong.
Long-term Debt: Long-term debt represents the senior notes we issued during 2004
and 2010, which mature in 2014 and 2020, respectively. For further information,
refer to Item 8, Note 10(a) of the Consolidated Financial Statements.
Preferred Shares:
During 2005, we issued $250 million of 7.25% Series A and $250 million of 7.50%
Series B non-cumulative preferred shares.
During March 2012, we issued 16 million newly designated 6.875% Series C
preferred shares with a liquidation preference of $25.00 per share for gross
proceeds of $400 million. Dividends on the Series C preferred shares are
non-cumulative; to the extent declared, dividends will accumulate, with respect
to each dividend period, in an amount per share equal to 6.875% of the
liquidation preference per annum. We may redeem the shares on or after April 15,
2017 at a redemption price of $25.00 per share.
Concurrent with the closing of the Series C preferred share issuance, we
redeemed six million of our previously outstanding Series A preferred shares at
the $25.00 per share redemption price, for a total redemption of $150 million.
Following this redemption, four million Series A preferred shares, representing
$100 million in aggregate liquidation preference, remain outstanding.
During April 2012, we closed a cash tender offer for any and all of our
outstanding Series B preferred shares at a price of $102.81 per share. As a
result, we repurchased 2,471,570 Series B Preferred shares, for $254 million. At
December 31, 2012, 28,430 Series B preferred shares, representing $3 million in
aggregate liquidation preference, remain outstanding. We may redeem these shares
on or after December 1, 2015, at a redemption price of $100.00 per share.
On a combined basis, these three transactions resulted in a $7 million decrease
in book value and a 42 basis point reduction in the weighted average annual
dividend rate on our preferred equity.
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Common Equity: Underlying movements in the value of our common equity over the
past two years are outlined in the following table:
Year ended December 31, 2012 2011
Common equity - opening $ 4,944,079 $ 5,124,970
Net income 547,241 46,305
Change in unrealized appreciation on available for 232,232
(45,706 )
sale investments, net of tax
Share repurchases (317,687 ) (65,885 )
Common share dividends(1) (152,607 ) (121,646 )
Preferred share dividends (38,228 ) (36,875 )
Share-based compensation 67,912 39,134
Premium on repurchase of Series B preferred shares (6,916 )
-
Series C preferred share issue costs (included in (6,456 ) -
additional paid-in capital)
Other 7,348 3,782
Common equity - closing $ 5,276,918 $ 4,944,079
(1) Common share dividends were historically recognized as a reduction of
retained earnings when paid. During the fourth quarter of 2012, we recognized
a $31 million adjustment in order to recognize dividends when declared. See
Item 8, Note 13(c) of the Consolidated Financial Statements for further
details.
Credit and Letter of Credit Facilities
We routinely enter into agreements with financial institutions to obtain secured
and unsecured credit facilities. These facilities are primarily used for the
issuance of letters of credit, in the normal course of operations, to certain
(re)insurance operations that purchase reinsurance protection from us. These
letters of credit allow those operations to take credit, under local insurance
regulations, for reinsurance obtained in jurisdictions where AXIS Capital's
subsidiaries are not licensed or otherwise admitted as an insurer. The value of
our letters of credit outstanding is driven by, amongst other factors, loss
development on existing reserves, the payment patterns of such reserves, the
expansion of our business and the loss experience of such business. A portion of
these facilities may also be used for liquidity purposes.
Each of our existing facilities is described further below; refer to Item 8,
Note 10(b) to our Consolidated Financial Statements for additional information.
Secured Letter of Credit Facility
We maintain a secured $750 million letter of credit facility (the "LOC
Facility"). This facility is subject to certain covenants, including the
requirement to maintain sufficient collateral to cover all of our obligations
under the facility. Such obligations include contingent reimbursement
obligations for outstanding letters of credit and fees payable to the lender. In
the event of default, the lender may exercise certain remedies, including the
exercise of control over pledged collateral and the termination of the
availability of the facility to any or all of the participating operating
subsidiaries.
Credit Facility
We also have a revolving $500 million credit facility (the "Credit Facility"),
which provides us with combined borrowing and letter of credit issuance capacity
up to the aggregate amount of the facility. At our request, and subject to
certain conditions, the aggregate commitment of this facility may be increased
by up to $250 million. Interest on loans issued under this facility is payable
based on underlying market rates at the time of loan issuance. While any loans
are unsecured, we have the option to issue letters of credit on a secured basis
in order to reduce associated fees. This facility is subject to certain
non-financial covenants that we believe are customary for facilities of this
type, including limitations on fundamental changes, the incurrence of additional
indebtedness and liens and certain transactions with affiliates and investments,
as defined in the facility documents.
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Compliance with certain financial covenants that we believe are customary for
(re)insurance companies in credit facilities of this type is also required.
These covenants include:
(i) Maintenance of a minimum consolidated net worth, with the minimum being
equal to the sum of $3.689 billion plus 25% of consolidated net income (if
positive) for each semi-annual fiscal period ending on or after
December 31, 2010 plus 25% of the net cash proceeds received by AXIS
Capital from the issuance of its capital stock during each such semi-annual
fiscal period. For the purposes of this covenant, consolidated net worth
excludes unrealized appreciation (depreciation) on our available for sale
investments.
(ii) Maintenance of a maximum debt to total capital ratio of 0.35 to 1. For the
purposes of this covenant, unrealized appreciation (depreciation) on our
available for sale investments is excluded from total capital.
(iii) Maintenance of an A.M. Best Company, Inc. ("A.M. Best") financial strength
rating of at least B++ for each of AXIS Capital's material
insurance/reinsurance subsidiaries that are party to the Credit Facility.
At December 31, 2012, this facility required a minimum consolidated net worth of
$4.038 billion and our actual consolidated net worth, as calculated under the
provisions of the Credit Facility, was $5.431 billion. We had a consolidated
debt to total capital ratio, calculated in accordance with the Credit Facility
provisions, of 0.15 to 1 and each of our material insurance/reinsurance
subsidiaries party to the agreement had an A.M. Best financial strength rating
of A.
In the event of default, including a breach of the covenants outlined above, the
lenders may exercise certain remedies including the termination of the facility,
the declaration of all principal and interest amounts related to facility loans
to be immediately due and the requirement that any outstanding letters of credit
that we opted to obtain on an unsecured basis be collateralized.
Additionally, the facility allows for an adjustment to the level of pricing
should AXIS Capital experience a change in its senior unsecured debt ratings.
Available Capacity
At December 31, 2012, we had $423 million of letters of credit outstanding under
the LOC Facility. There were no letters of credit or borrowings outstanding
under the Credit Facility. Thus, remaining available capacity under these two
facilities was $827 million, not taking into consideration the $250 million
potential increase in the amount available under the Credit Facility. We were in
compliance with all covenants of both facilities at December 31, 2012. We are
currently evaluating alternatives in advance of the scheduled expirations of the
LOC Facility and the Credit Facility and believe that we will be able to
continue to meet the collateral requirements of our clients and adequately
preserve our liquidity.
Share Repurchases
As part of our capital management strategy, our Board of Directors authorizes
common share repurchase programs. On December 17, 2012, our Board of Directors
authorized a new $750 million share common share repurchase plan, which replaced
the existing plan set to expire at the end of 2012. At February 21, 2013, the
remaining authorization under the program was $634 million (refer to Item 5
'Market for Registrant's Common Equity, Related Stockholder Matters and Issue
Purchases of Equity Securities' and Item 8, Note 20 to the Consolidated
Financial Statements for additional information). As noted above, repurchases
under this program are entirely discretionary; the timing and amount of the
additional repurchase transactions will depend on a variety of factors
including, but not limited to, global (re)insurance and financial market
conditions and opportunities, capital management and regulatory considerations.
Shelf Registrations
On March 18, 2010, we filed an unallocated universal shelf registration
statement with the SEC, which became effective upon filing. Pursuant to the
shelf registration, we may issue an unlimited amount of equity, debt, trust
preferred securities, warrants, purchase contracts or a combination of those
securities. Our intent and ability to issue securities pursuant to this
registration statement will depend on market conditions at the time of any
proposed offering. We expect to renew this filing prior to its expiration.
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Financial Strength Ratings
Our principal (re)insurance operating subsidiaries are assigned financial
strength ratings from internationally recognized rating agencies, including
Standard & Poor's, A.M. Best and Moody's Investors Service. These ratings are
publicly announced and are available directly from the agencies, as well as on
our website.
Such financial strength ratings represent the opinions of the rating agencies on
the overall financial strength of a company and its capacity to meet the
obligations of its (re)insurance contracts. Independent ratings are one of the
important factors that establish our competitive position in (re)insurance
markets. The rating agencies consider many factors in determining the financial
strength rating of an insurance company, including the relative level of
statutory surplus necessary to support the business operations of the company.
These ratings are based upon factors considered by the rating agencies to be
relevant to policyholders, agents and intermediaries and are not directed toward
the protection of investors. Such ratings are not recommendations to buy, sell
or hold securities.
The following are the most recent financial strength ratings from
internationally recognized agencies in relation to our principal (re)insurance
operating subsidiaries:
Agency's description Agency's rating
Rating agency of rating Rating definition
Ranking of rating
Standard & Poor's An "opinion about the A+ (Stable) "Strong financial The 'A' grouping is the
financial security security third highest out of
characteristics of an characteristics" nine major rating
insurance categories. The first
organization, with seven major rating
respect to its categories may be
ability to pay under modified by the addition
its insurance of a plus or minus sign
policies and to show relative
contracts, in standing within the
accordance with their major rating categories.
terms".
A.M. Best An "opinion of an A (Positive) "Excellent The 'A' grouping is the
insurer's financial ability tomeet third highest ratings
strength and ability ongoing insurance category out of fifteen.
to meet its ongoing obligations" Ratings outlooks
insurance policy and ('Positive', 'Negative'
contract and 'Stable') are
obligations". assigned to indicate a
rating's potential
direction over an
intermediate term,
generally defined as 12
- 36 months.
Moody's Investors "Opinions of the A2 (Stable) "Upper-medium The 'A' grouping is the
Service ability of insurance grade andsubject third highest out of
companies to pay to low credit nine rating categories.
punctually senior risk" Each of the second
policyholder claims through seventh
and obligations." categories are
subdivided into three
subcategories, as
indicated by an appended
numerical modifier of
'1', '2' and '3'. The
'1' modifier indicates
that the obligation
ranks in the higher end
of the rating category,
the '2' modifier
indicates a mid-category
ranking and the '3'
modifier indicates a
ranking in the lower end
of the rating category.
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CONTRACTUAL OBLIGATIONS AND COMMITMENTS
The following table provides a breakdown of our contractual obligations and
commitments at December 31, 2012 by period due:
Payment Due By Period
Less than 1 More than
Contractual Obligations and Commitments Total year 1-3 years 3-5 years 5 years
Operating activities
Estimated gross loss and loss expense $ 9,058,731 $ 2,626,119 $ 2,894,122 $ 1,420,002 $ 2,118,488
payments(1)
Operating lease obligations(2) 186,741 26,904 54,225 38,793 66,819
Reinsurance purchase commitments(3) 53,751 53,751 - - -
Investing activities
Unfunded investment commitments(4) 40,000 40,000 - - -
Financing activities
Senior notes (including interest 1,277,813 58,125 587,500 58,750 573,438
payments)(5)
Total $ 10,617,036 $ 2,804,899 $ 3,535,847 $ 1,517,545 $ 2,758,745
(1) We are obligated to pay claims for specified loss events covered by the
(re)insurance contracts we write. Such loss payments represent our most
significant future payment obligation. In contrast to our other contractual
obligations, our cash payments are not determinable from the terms specified
within the underlying contracts. The total amount in the table above reflects
our best estimate of our reserve for losses and loss expenses. However, the
actual amounts and timing may differ materially; refer to the 'Critical
Accounting Estimates - Reserve for Losses and Loss Expenses' for further
information. We have not taken into account corresponding reinsurance
recoverable amounts that would be due to us. Given the limited loss
development pattern information specific to our experience, we have generally
estimated the timing of payment by applying industry benchmark payout
patterns to each underlying reserving class.
(2) We lease office space under operating leases which expire at various dates.
We renew and enter into new leases in the ordinary course of business, as
required.
(3) We purchase reinsurance protection for our insurance lines of business. The
minimum premiums are contractually due in advance on a quarterly basis.
(4) We have unfunded investment commitments related to our investments in hedge
and credit funds, which are callable by our investment managers. We have
assumed that such investments will be called in the next year but such
funding may occur over a longer period of time, due to market conditions and
other factors. For further details, refer to Item 8, Note 5(b) to the
Consolidated Financial Statements.
(5) For further details on the terms of our senior unsecured debt, refer to
Item 8, Note 10(a) to the Consolidated Financial Statements.
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CRITICAL ACCOUNTING ESTIMATES
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Our Consolidated Financial Statements include certain amounts that are
inherently uncertain and judgmental in nature. As a result, we are required to
make assumptions and best estimates in order to determine the reported values.
We consider an accounting estimate to be critical if: (1) it requires that
significant assumptions be made in order to deal with uncertainties and
(2) changes in the estimate could have a material impact on our results of
operations, financial condition or liquidity.
We believe that the material items requiring such subjective and complex
estimates are our:
• reserves for losses and loss expenses;
• reinsurance recoverable balances;
• premiums;
• fair value measurements for our financial assets and liabilities; and
• assessments of other-than-temporary impairments.
Nevertheless, other significant accounting policies are important to
understanding our Consolidated Financial Statements. See Item 8, Note 2
'Significant Accounting Policies' to the Consolidated Financial Statements for
further information.
We believe that the amounts included in our Consolidated Financial Statements
reflect our best judgment. However, factors such as those described in Item 1A
'Risk Factors' could cause actual events or results to differ materially from
our underlying assumptions and estimates; this could lead to a material adverse
impact on our results of operations, financial condition and/or liquidity.
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RESERVE FOR LOSSES AND LOSS EXPENSES
Overview
We believe the most significant accounting judgment we make is the estimate of
our reserve for losses and loss expenses ("loss reserves"). Our loss reserves
represent management's estimate of the unpaid portion of our ultimate liability
for losses and loss expenses ("ultimate losses") for (re)insured events that
have occurred at or before the balance sheet date. Our loss reserves reflect
both claims that have been reported to us ("case reserves") and claims that have
been incurred but not yet reported to us ("IBNR"). Our loss reserves represent
our best estimate of what the ultimate settlement and administration of claims
will cost, based on our assessment of facts and circumstances known at that
particular point in time.
Loss reserves are not an exact calculation of liability but instead are complex
estimates. The process of estimating loss reserves involves a number of
variables (see 'Selection of Reported Reserves (Management's Best Estimate)' )
below for further details). We review our estimate of loss reserves each
reporting period and consider all significant facts and circumstances then
known. As additional experience and other data become available and/or laws and
legal interpretations change, we may adjust our previous estimates of loss
reserves; these adjustments are recognized in the period they are determined
and, therefore, can impact that period's underwriting results either favorably
(when reserves established in prior years prove to be redundant) or adversely
(when reserves established in prior years prove to be deficient).
Case Reserves
With respect to our insurance operations, we are generally notified of insured
losses by our insureds and/or their brokers. Based on this information, our
claims personnel estimate our ultimate losses arising from the claim, including
the cost of administering the claims settlement process. These estimates reflect
the judgment of our claims personnel based on general reserving practices, the
experience and knowledge of such personnel regarding the nature of the specific
claim and, where appropriate, the advice of legal counsel, loss adjusters and
other relevant consultants.
For our reinsurance business, case reserves for reported claims are generally
established based on reports received from ceding companies and/or their
brokers. For excess of loss contracts, we are typically notified of insured
losses on specific contracts and record a case reserve for the estimated
ultimate liability arising from the claim. With respect to contracts written on
a proportional basis, we typically receive aggregated claims information and
record a case reserve based on that information. However, our proportional
reinsurance contracts typically require that losses in excess of pre-defined
amounts be separately notified so that we can adequately evaluate them. Our
claims department evaluates each specific loss notification we receive and
records additional case reserves when a ceding company's reserve for a claim is
not considered adequate.
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 practices to ensure that 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.
IBNR
The estimation of IBNR is necessary due to the time lags between when a loss
event occurs and when it is actually reported to us, referred to as the
reporting lag. Reporting lags may arise from a number of factors, including but
not limited to the nature of the loss, the use of intermediaries and
complexities in the claims adjusting process. By definition, we do not have
specific information on IBNR so it must be estimated. IBNR is calculated by
deducting incurred losses (i.e. paid losses and case reserves) from management's
best estimate of ultimate losses. In contrast to case reserves, which are
established at the contract level, IBNR reserves are generally estimated at an
aggregate level and cannot be identified as reserves for a particular loss event
or contract. Refer to the 'Reserving For Significant Catastrophic Events'
section below for additional information on reserving for such events.
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Reserving Process
Sources of Information
Our quarterly reserving process begins with the collection and analysis of paid
and incurred claim data for each of our segments. The segmental data is
disaggregated by reserving class and further disaggregated by accident year
(i.e. the year in which the loss event occurred). We use underwriting year
information (i.e. the year in which the contract incepted) to analyze some of
our proportional reinsurance business and subsequently allocate reserves to the
respective accident years. Our reserving classes are selected to ensure that the
underlying contracts have homogeneous loss development characteristics, while
remaining large enough to make the estimation of trends credible. We review our
reserving classes on a regular basis and adjust them over time as our business
evolves. This data, in addition to industry benchmarks, serves as a key input to
many of the methods employed by our actuaries. The relative weights assigned to
our own historical loss data versus industry data vary according to the length
of the development profile for the reserving class being evaluated. At present,
we generally give more weight to our own experience (and, correspondingly, less
weight to industry data) for reserving classes with short and medium claim
tails; the converse is true for reserving classes with longer claim tails. (See
'Claim Tail Analysis' below for more detailed information by claim tail class.)
Actuarial Analysis
Multiple actuarial methods are available to estimate ultimate losses. Each
method has its own assumptions and its own advantages and disadvantages, with no
single estimation method being better than the others in all situations and no
one set of assumption variables being meaningful for all reserving classes. The
relative strengths and weaknesses of the particular estimation methods when
applied to a particular group of claims can also change over time.
The following is a brief description of the reserve estimation methods commonly
employed by our actuaries and a discussion of their particular strengths and
weaknesses:
• Expected Loss Ratio Method ("ELR"): This method estimates ultimate losses for
an accident year by applying an expected loss ratio to the earned premium for
that accident year. Generally, expected loss ratios are based on one or more
of (a) an analysis of historical loss experience to date, (b) pricing
information and (c) industry data, adjusted as appropriate, to reflect
changes in rates and terms and conditions. This method is insensitive to actual incurred losses for the accident year in question and is, therefore,
often useful in the early stages of development when very few losses have
been incurred. Conversely, the lack of sensitivity to incurred/paid losses
for the accident year in question means that this method is usually
inappropriate in later stages of an accident year's development.
• Loss Development Method (also referred to as the Chain Ladder Method or Link
Ratio Method): This method assumes that the losses incurred/paid for each
accident year at a particular development stage follow a relatively similar
pattern. It assumes that on average, every accident year will display the
same percentage of ultimate losses incurred/paid at the same point in time
after the inception of the accident year. The percentages incurred/paid are
established for each development stage (e.g. 12 months, 24 months, etc.)
after examining historical averages from historical loss development data
and/or external industry benchmark information. Ultimate losses are then
estimated by multiplying the actual incurred/paid losses by the reciprocal of
the established incurred/paid percentage. The strengths of this method are
that it reacts to loss emergence/payments and that it makes full use of
historical claim emergence/payment experience. However, this method has
weaknesses when the underlying assumption of stable loss development/payment
patterns is not valid. This could be the consequence of changes in business
mix, claim inflation trends or claim reporting practices and/or the presence
of large claims, amongst 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 for
an accident year.
• Bornhuetter-Ferguson Method ("BF"): This method can be seen as a combination
of the ELR and Loss Development Methods, under which the Loss Development
Method is given progressively more weight as an accident year matures. The
main advantage of the BF Method is that it provides a more stable estimate of
ultimate losses than the Loss Development Method at earlier stages of
development, while remaining more sensitive to emerging loss development than
the ELR Method. In addition, the BF Method allows for the incorporation of
external market information through the use of expected loss ratios, whereas
the Loss Development Method does not incorporate such information.
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As part of our quarterly loss reserve review process, our actuaries employ the
estimation method(s) that they believe will produce the most reliable estimate
of ultimate losses, at that particular evaluation date, for each reserving class
and accident year combination. Often, this is a blend (i.e. weighted average) of
the results of two or more appropriate actuarial methods. These ultimate loss
estimates are generally utilized to evaluate the adequacy of our ultimate loss
estimates for previous accident years, as established in the prior reporting
period. For the initial estimate of the current accident year, the available
claim data is typically insufficient to produce a reliable estimate of ultimate
losses. As a result, our initial estimate for an accident year is generally
based on the ELR Method. The initial ELR for each reserving class is established
collaboratively by our actuaries, underwriters and management at the start of
the accident year as part of the planning process, taking into consideration
prior accident years' experience and industry benchmarks, adjusted after
considering factors such as exposure trends, rate differences, changes in
contract terms and conditions, business mix changes and other known differences
between the current accident year and prior accident years. The initial expected
loss ratios for a given accident year may be modified over time if the
underlying assumptions, such as loss development or premium rate changes, differ
from the original assumptions.
Reserving for Credit and Political Risk Business
Our credit and political risk insurance business consists primarily of credit
insurance and confiscation, expropriation, nationalization and deprivation
coverages ("CEND"). Claims for this business tend to be characterized by their
severity risk, as opposed to their frequency risk. Therefore, claim payment and
reporting patterns are anticipated to be volatile. Under the notification
provisions of our credit insurance, we anticipate being advised of an insured
event within a relatively short time period. As a result, we generally estimate
ultimate losses based on a contract-by-contract analysis which considers the
contracts' terms, the facts and circumstances of underlying loss events and
qualitative input from claims managers.
An important and distinguishing feature of many of these contracts, though, is
our contractual right, subsequent to payment of a claim to our insured, to be
subrogated to, or otherwise have an interest in, the insured's rights of
recovery under an insured loan or facility agreement. These estimated recoveries
are recorded as an offset to our credit and political risk loss reserves. The
lag between the date of a claim payment and our ultimate recovery from the
corresponding security can result in negative case reserves at a point in time
(as was the case at December 31, 2012 and 2011). The nature of the underlying
collateral is specific to each transaction and we also estimate the value of
this collateral on a contract-by-contract basis. This valuation process is
inherently subjective and involves the application of management's judgment
because active markets for the collateral often do not exist. Our estimates of
value are based on numerous inputs, including information provided by our
insureds, as well as third party sources including rating agencies, asset
valuation specialists and other publicly available information. We also assess
any post-event circumstances, including restructurings, liquidations and
possession of asset proposals/agreements.
In some instances, upon becoming aware of a loss event related to our credit and
political risk business, we negotiate a final settlement of all of our policy
liabilities for a fixed amount. In most circumstances, this occurs when the
insured moves to realize the benefit of the collateral that underlies the
insured loan or facility and presents us with a net settlement proposal that
represents a full and final payment by us under the terms of the policy. In
consideration for this payment, we secure a cancellation of the policy, or a
release of all claims, and waive our right to pursue a recovery of these
settlement payments against the security that may have been available to us
under the insured loan or facility agreement. In certain circumstances,
cancellation by way of net settlement or full payment can result in an
adjustment of the net premium to be received and earned on the policy.
Reserving For Significant Catastrophic Events
We cannot estimate losses from widespread catastrophic events, such as
hurricanes and earthquakes, using the traditional actuarial methods described
above. Rather, loss reserves for such events are estimated by management after a
catastrophe occurs by completing an in-depth analysis of individual contracts
which may potentially be impacted by the catastrophic event. This in-depth
analysis may rely on several sources of information, including: (1) estimates of
the size of insured industry losses from the catastrophic event and our
corresponding market share; (2) a review of our portfolio of contracts performed
to identify those contracts which may be exposed to the catastrophic event;
(3) a review of modeled loss estimates based on information previously reported
by customers and brokers, including exposure data obtained during the
underwriting process; (4) discussions of the impact of the event with our
customers and brokers and (5) catastrophe bulletins published by various
independent statistical reporting agencies. We generally use a blend of these
information sources to arrive at our aggregate estimate of the ultimate losses
arising from the catastrophic event. In subsequent reporting periods, we review
changes in paid and incurred losses in relation to each significant catastrophe
and adjust our estimates of ultimate
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losses for each event if there are developments that are different from our
previous expectations; such adjustments are recorded in the period in which they
are identified.
There are additional risks affecting our ability to accurately estimate ultimate
losses for catastrophic events. For example, the estimation of loss reserves
related to hurricanes and earthquakes can be affected by factors including, but
not limited to: the inability to access portions of impacted areas,
infrastructure disruptions, the complexity of factors contributing to losses,
legal and regulatory uncertainties, complexities involved in estimating business
interruption losses and additional living expenses, the impact of demand surge,
fraud and the limited nature of information available. For hurricanes,
additional complex coverage factors may include determining whether damage was
caused by flooding versus wind, evaluating general liability and pollution
exposures, and mold damage. The timing of a catastrophe, for example near the
end of a reporting period, can also affect the level of information available to
us to estimate reserves for that reporting period.
Our results of operations for each of 2012, 2011 and 2010 were significantly
impacted by natural catastrophe activity. See Item 7 'Underwriting Results -
Group, Underwriting Expenses' for a discussion of these events and the remaining
associated uncertainties.
Key Actuarial Assumptions
The use of the above actuarial methods requires us to make certain explicit
assumptions, the most significant of which are: (1) expected loss ratios and
(2) loss development patterns.
We began operations in late 2001. In our earlier years, we placed significant
reliance on industry benchmarks in establishing our expected loss ratios. Over
time, we have placed more reliance on our historical loss experience in
establishing these ratios where we believe the weight of our own actual
experience has become sufficiently credible for consideration. The weight given
to our experience differs for each of our three claim tail classes and is
discussed further in the 'Claim Tail Analysis' section below. In establishing
expected loss ratios for our insurance segment, we give consideration to a
number of other factors, including exposure trends, rate adequacy on new and
renewal business, ceded reinsurance costs, changes in claims emergence and our
underwriters' view of terms and conditions in the market environment. For our
reinsurance segment, expected loss ratios are based on a contract-by-contract
review, which considers information provided by clients together with estimates
provided by our underwriters and actuaries about the impact of changes in
pricing, terms and conditions and coverage. We also consider the market
experience of an independent actuarial firm, as appropriate.
Similarly, we also placed significant reliance on industry benchmarks in
selecting our loss development patterns in earlier years. Over time, we have
given varying degrees of weight to our own historical loss experience, as
further discussed in the 'Claim Tail Analysis' section.
Selection of Reported Reserves (Management's Best Estimate)
Our quarterly reserving process involves the collaboration of our underwriting,
claims, actuarial, legal and finance departments, includes various segmental
committee meetings and culminates with the approval of a single point best
estimate by our Group Reserving Committee, which comprises senior management. In
selecting this best estimate, management considers actuarial estimates and
applies informed judgment regarding qualitative factors that may not be fully
captured in these actuarial estimates. Such factors include, but are not limited
to: the timing of the emergence of claims, volume and complexity of claims,
social and judicial trends, potential severity of individual claims and the
extent of internal historical loss data versus industry information. While these
qualitative factors are considered in arriving at the point estimate, no
specific provisions for qualitative factors are established.
The quarterly evaluation process also includes consultation with an independent
actuarial firm. The work performed by the actuarial firm is an important part of
the reserving process. We compare our recorded loss reserves to those estimated
by the actuarial firm to determine whether our single point best estimate is
reasonable. On an annual basis, the independent actuarial firm provides an
actuarial opinion on the reasonableness of our loss reserves for each of our
operating subsidiaries; such actuarial opinions are required to meet various
insurance regulatory requirements. The actuarial firm discusses its conclusions
with management and presents its findings to our Board of Directors.
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Claim Tail Analysis
The following table shows our total loss reserves for each of our reportable
segments, segregated between case reserves and IBNR and by significant reserving
class. This table is presented on a gross basis and, therefore, does not include
the benefit of reinsurance recoveries.
2012 2011
At December 31, Case Reserves IBNR Total Case Reserves IBNR Total
Insurance segment:
Property and other $ 551,831 $ 297,389 $ 849,220 $ 435,887 $ 304,098 $ 739,985
Marine 218,523 174,780 393,303 176,111 195,422 371,533
Aviation 18,511 40,775 59,286 25,972 39,952 65,924
Credit and political risk (82,006 ) 84,811 2,805 (110,961 ) 90,143 (20,818 )
Professional lines 489,662 1,641,635 2,131,297 446,155 1,451,820 1,897,975
Liability 190,464 866,178 1,056,642 217,052 810,090 1,027,142
Total Insurance 1,386,985 3,105,568 4,492,553 1,190,216 2,891,525 4,081,741
Reinsurance segment:
Property and other 917,614 449,056 1,366,670 1,026,134 506,855 1,532,989
Credit and bond 104,537 173,259 277,796 81,357 145,694 227,051
Professional lines 280,386 802,605 1,082,991 239,986 763,693 1,003,679
Motor 386,528 407,610 794,138 313,518 323,871 637,389
Liability 196,632 847,951 1,044,583 168,161 774,035 942,196
Total Reinsurance 1,885,697 2,680,481 4,566,178 1,829,156 2,514,148 4,343,304
Total $ 3,272,682 $ 5,786,049 $ 9,058,731 $ 3,019,372 $ 5,405,673 $ 8,425,045
The overall increase in our gross loss reserves during 2012 was driven by the
impact of Storm Sandy, growth in our business and the continued accumulation of
reserves for longer-tailed lines.
In order to capture the key dynamics of our loss reserve development and
potential volatility, our reserving classes should be considered according to
their potential expected length of loss emergence and settlement, generally
referred to as the "tail". We consider our business to consist of three claim
tail classes: short-tail, medium-tail and long-tail. Below is a discussion of
the specifics of our loss reserve process as they apply to each claim tail
class, as well as commentary on the factors contributing to our historical loss
reserve development for each class. Favorable development on prior accident year
reserves indicates that our current estimates are lower than our previous
estimates, while adverse development indicates that our current estimates are
higher than our previous estimates.
Short-Tail Business
Our short-tail business generally includes exposures for which losses are
usually known and paid within a relatively short period of time after the
underlying loss event has occurred. Our short-tail business primarily relates to
property coverages and includes the majority of our property, terrorism and
marine business and certain aviation business within our insurance segment,
together with the property, catastrophe and crop business within our reinsurance
segment.
The key actuarial assumptions for our short-tail business in our early accident
years were primarily developed with reference to industry benchmarks for both
expected loss ratios and loss development patterns. As our own historical loss
experience amassed, it gained credibility and became relevant for consideration
in establishing these key actuarial assumptions. As a result, we gradually
increased the weighting assigned to our own historical experience in selecting
the expected loss ratios and loss development patterns utilized to establish our
estimates of ultimate losses for an accident year.
Due to the relatively short reporting and settlement patterns for our short-tail
business, we generally place more weight upon experience-based methods and other
qualitative considerations in establishing reserves for our most recent accident
years. Our estimates for more mature accident years are generally based on
actuarial methods that are more responsive to actual
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experience, such as the Loss Development Method. As our experience developed
more favorably than our initial expectations, we recognized favorable prior year
development on short-tail business in recent years. See 'Underwriting Results -
Group - Prior Year Reserve Development' for a discussion of the net favorable
reserve development recognized when re-estimating our ultimate losses for
short-tail business during the past three years.
Although our estimates of ultimate losses for our short-tail business are
inherently less uncertain than for our medium and long-tail business,
significant judgment is still required. For example, because much of our excess
insurance and excess of loss reinsurance business has high attachment points, it
is often difficult to estimate whether claims will exceed those attachment
points. Also, the inherent uncertainties relating to catastrophe events
previously discussed, together with our typically large line sizes, further add
to the complexity of estimating our potential exposure. In addition, we use MGAs
and other producers for certain business within our insurance segment; this can
delay the reporting of loss information to us. We expect that the majority of
development for an accident year will be recognized in the subsequent one to
three years.
Medium-Tail Business
Our medium-tail business primarily consists of professional lines (re)insurance
and trade credit and bond reinsurance business. Certain other classes of
business, including aviation hull and offshore energy insurance and engineering
reinsurance, are also considered to have a medium-tail. Claim reporting and
settlement periods on these classes are generally longer than those of our
short-tail reserving classes. We also consider our credit and political risk
insurance business to have a medium tail, due to the complex nature of claims
and the potential additional time that may be required to realize our
subrogation assets.
For our earliest accident years, our initial key actuarial expected loss ratio
and loss development assumptions were established utilizing industry benchmarks.
Due to the longer claim tail, the length of time required to develop our own
credible loss history for use in the reserving process is greater for our
medium-tail business than for our short-tail business. As a result, the number
of accident years where we relied heavily on industry benchmarks to establish
our key actuarial assumptions is greater for our medium-tail business. Our
reserving approach for medium-tail business is tailored by line of business,
with our significant lines being specifically addressed below.
Professional Lines (Re)insurance
For our professional lines business, claim payment and reporting patterns are
typically medium to long-tail in nature. The underlying business is
predominantly written on a claims-made basis, with the majority of reinsurance
treaties being written on a risks attaching basis. With respect to our key
actuarial assumptions, we are progressively giving more weight to our own
experience when establishing our expected loss ratios; our assumed loss
development patterns continue to be based primarily on industry benchmarks.
Loss reporting patterns for professional lines business tend to be volatile,
causing instability in actuarial indications based on incurred loss data until
an accident year matures for a number of years. Consequently, our initial loss
reserves for an accident year are generally based upon an ELR method and the
consideration of relevant qualitative factors. As accident years mature, we
increasingly give more weight to methods that reflect our actual experience
until our selections are based almost exclusively on experience-based methods.
We evaluate the appropriateness of the transition to experience-based methods at
the reserving class level, commencing this transition when we believe that our
incurred loss development is sufficient to produce meaningful actuarial
indications. The rate at which we transition fully to sole reliance on
experience-based methods can vary by reserving class and by accident year,
depending on our assessment of the stability and relevance of such indications.
Our transition from the ELR method to experience-based methods began during
2008, when we commenced gradual transition for the 2004 and prior accident
years. As our loss history continued to develop, the transition was expanded to
include additional accident years. At the end of 2012, the transition had begun
for the 2009 and prior accident years for certain underlying reserve classes. As
our actual loss experience has generally been more favorable than initial
expectations, this transition led to the recognition of net favorable prior year
reserve development in recent years; see 'Underwriting Results - Group - Prior
Year Development' for a discussion of the development recognized during the last
three years.
We believe that there continues to be relatively high uncertainty around
ultimate losses for the 2007 through 2009 accident years, resulting from the
global financial crisis. This is attributable to both a higher than average
volume of reported claims for these years and a higher proportion of open
claims, relative to earlier accident years at the same stage of development.
Given the significance of the global financial crisis, we believe that
development patterns for the 2007 through 2009 accident
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years may ultimately differ from other years. In light of this, we separately
evaluate the latest available claims information for each reserving class
impacted by this 'event' when establishing loss reserves, in addition to
considering actuarial indications. Given our expectation of longer development
patterns for these accident years, we are exercising a greater degree of caution
in recognizing potential favorable loss emergence.
Trade Credit and Bond Reinsurance
For our trade credit and bond reinsurance business, our initial and most recent
accident year loss reserves are generally based on the ELR method, with
consideration given to qualitative factors. Given that there is a more stable
reporting pattern for trade credit business, we generally commence the
transition to experience-based methods sooner than for bond business.
Credit and Political Risk Insurance
Refer to the previous discussions of this business under 'Reserving Process -
Actuarial Analysis' and 'Reserving Process - Reserving for Credit and Political
Risk Business' above for a discussion of specific loss reserve issues related to
this business. When considering prior accident year reserve development for this
line of business, it is important to note that the multi-year nature of the
credit business distorts loss ratios when a single accident year is considered
in isolation. In recent years, the average term of these contracts has been four
to five years. The premiums we receive are generally earned evenly over the
contract term, thus spanning multiple accident years. In contrast, losses
incurred on these contracts, which can be characterized as low in frequency and
high in severity, are reflected in a single accident year.
As previously described, the estimation of the value of our recoveries on credit
and political risk business requires significant management judgment. At
December 31, 2012, our total estimated recoveries on credit insurance business
were $106 million, of which $82 million related to contracts where we had
already paid losses and $24 million related to contracts where case reserves
were recognized. Comparatively, at December 31, 2011, our estimated recoveries
were $158 million, with $109 million and $49 million, respectively, relating to
paid losses and case reserves. The reduction in 2012 largely reflected the
reduction in recovery estimates for two claims based on updated information and
the settlement of one claim.
Long-Tail Business
In contrast to our short and medium-tail business, the claim tail for our
long-tail business is expected to be notably longer, as claims are often
reported and ultimately paid or settled years, or even decades, after the
related loss events occur. Our long-tail business primarily relates to liability
business written in our insurance and reinsurance segments, as well as our motor
reinsurance business.
As a general rule, our estimates of accident year ultimate losses for our
long-tail business are notably more uncertain than those for our short and
medium-tail business. Factors that contribute additional uncertainty to
estimates for our long-tail business include, but are not limited to:
• The more significant weight given to industry benchmarks in forming our key
actuarial assumptions;
• The potential volatility of actuarial estimates, given the number of years of
development it takes to produce a meaningful incurred loss as a percentage of
ultimate losses;
• Inherent uncertainties about loss trends, claims inflation (e.g. medical,
judicial, social) and general economic conditions; and
• The possibility of future litigation, legislative or judicial change that may
impact future loss experience relative to the prior industry loss experience
relied upon in reserve estimation.
To date, our key actuarial assumptions for our long-tail business have been
derived almost exclusively from industry benchmarks, rather than our own
historical experience. Given our relatively short operating history in
comparison to the development tail for this business, we do not believe that our
own historical loss development for our long-tail business has amassed an
appropriate volume to serve as a credible input into the key actuarial
assumptions previously outlined. While we utilize industry benchmarks that we
believe reflect the nature and coverage of our business, our actual loss
experience may differ from the benchmarks based on industry averages.
Due to the length of the development tail for this business, our reserve
estimates for all accident years are predominantly based on the ELR method and
the consideration of qualitative factors. As part of our quarterly reserving
process, we monitor actual paid and incurred loss emergence relative to expected
loss emergence based on industry-benchmark loss development patterns. The
drivers of any unfavorable loss emergence are investigated and, as a result,
have led to an immediate
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recognition of adverse development in some instances. Prior to the fourth
quarter of 2012 (see additional details below), we did not recognize any
favorable loss emergence. As a result, during each of the past three years, we
recognized net adverse development for our liability insurance business in light
of unfavorable loss emergence for certain reserving class and accident year
combinations.
In addition, during 2011, we recognized net adverse development on our motor
reinsurance business, mainly as a result of a change in our assumptions
surrounding U.K. settlement practices. Specifically, we increased our
assumptions relating to the frequency and cost of claims that are expected to
settle using Periodic Payment Orders ("PPOs"), which are annuities designed to
cover items such as the ongoing cost of care and loss of earnings for injured
claimants. We do not discount our loss reserves in order to adjust for the time
value of money associated with such annuity awards.
See 'Underwriting Results Group - Prior Year Reserve Development' for further
details on the recognition of adverse development for our long-tail business
during the last three years.
Commencing with our fourth quarter 2012 reserving process, we began to give
weight to actuarial methods that reflect our actual experience for liability
business as we believe that our oldest accident years are now at a stage of
expected development where such methods will produce meaningful actuarial
indications. As a result, we commenced a transition from the ELR method to the
BF method for the oldest accident years for certain reserving classes within our
insurance liability line of business and recognized corresponding net favorable
prior year reserve development totaling $6 million for the 2003, and to a lesser
extent the 2002, accident years during the quarter. We will continue to analyze
our incurred loss emergence relative to expected emergence for all of our
long-tail reserving classes and expect to commence transition to
experience-based methods for those accident years where we believe the stage of
expected development will produce meaningful actuarial indications.
Sensitivity Analysis
While we believe that our loss reserves at December 31, 2012 are adequate, new
information, events or circumstances may result in ultimate losses that are
materially greater or less than provided for in our loss reserves. As previously
noted, there are many factors that may cause our reserves to increase or
decrease, particularly those related to catastrophe losses and long-tail lines
of business.
Our expected loss ratios are a key assumption in our estimate of ultimate losses
for business at an early stage of development. All else remaining equal, a
higher expected loss ratio would result in a higher ultimate loss estimate, and
vice versa. Our assumed loss development patterns are another significant
assumption in estimating our loss reserves. All else remaining equal,
accelerating a loss reporting pattern (i.e. shortening the claim tail) would
result in lower ultimate losses, as the estimated proportion of losses already
incurred would be higher. The uncertainty in the timing of the emergence of
claims (i.e. the length of the development pattern) is generally greater for a
company like ours with a limited operating history which, therefore, must rely
on industry benchmarks to a certain extent when establishing loss reserve
estimates.
The following tables show the effect on our estimate of gross loss reserves of
reasonably likely changes in the two key assumptions used to estimate our gross
loss reserves at December 31, 2012.
The results show the cumulative increase (decrease) in our loss reserves across
all accident years. For example, if our assumed loss development pattern for our
property and other insurance business was three months shorter with no
accompanying change in our ELR assumption, our loss reserves may decrease by
approximately $22 million. Each of the impacts set forth in the tables is
estimated individually, without consideration for any correlation among key
assumptions or among reserving classes. Therefore, it would be inappropriate to
take each of the amounts and add them together in an attempt to estimate total
volatility. While we believe the variations in the expected loss ratios and loss
development patterns presented could be reasonably expected, our own historical
data regarding variability is generally limited and actual variations may be
greater or less than these amounts. It is also important to note that the
variations are not meant to be a "best-case" or "worst-case" series of scenarios
and, therefore, it is possible that future variations in our loss reserves may
be more or less than the amounts presented. While we believe that these are
reasonably likely scenarios, we do not believe this sensitivity analysis should
be considered an actual reserve range.
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INSURANCE
Development Pattern Expected Loss Ratio
Property and Other 5% lower Unchanged 5% higher
3 months shorter $ (43,974 ) $ (21,986 ) $ 3
Unchanged (23,088 ) - 23,088
3 months longer 13,032 38,021 63,010
Marine 5% lower Unchanged 5% higher
3 months shorter $ (25,502 ) $ (17,612 ) $ (9,722 )
Unchanged (8,771 ) - 8,771
3 months longer 14,628 24,630 34,632
Aviation 5% lower Unchanged 5% higher
3 months shorter $ (5,086 ) $ (3,239 ) $ (1,391 )
Unchanged (2,009 ) - 2,009
3 months longer 2,230 4,462 6,695
Credit and Political Risk 10% lower Unchanged 10% higher
3 months shorter $ (14,418 ) $ - $ 14,418
Unchanged (14,418 ) - 14,418
3 months longer (14,418 ) - 14,418
Professional Lines 10% lower Unchanged 10% higher
6 months shorter $ (258,715 ) $ (50,543 ) $ 158,666
Unchanged (211,132 ) - 217,687
6 months longer (127,922 ) 85,010 302,168
Liability 10% lower Unchanged 10% higher
6 months shorter $ (123,444 ) $ (18,031 ) $ 87,382
Unchanged (107,216 ) - 107,216
6 months longer (86,693 ) 22,803 132,300
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REINSURANCE
Development Pattern Expected Loss Ratio
Property and Other 5% lower Unchanged 5% higher
3 months shorter $ (96,027 ) $ (31,218 ) $ 33,591
Unchanged (66,370 ) - 66,370
3 months longer (28,444 ) 39,923 108,289
Credit and Bond 10% lower Unchanged 10% higher
6 months shorter $ (61,495 ) $ (18,606 ) $ 24,283
Unchanged (43,895 ) - 43,895
6 months longer (17,584 ) 30,184 77,951
Professional Lines 10% lower Unchanged 10% higher
6 months shorter $ (107,362 ) $ (22,297 ) $ 62,768
Unchanged (89,898 ) - 89,898
6 months longer (66,142 ) 29,579 125,300
Motor 10% lower Unchanged 10% higher
6 months shorter $ (98,128 ) $ (2,010 ) $ 94,108
Unchanged (96,178 ) - 96,178
6 months longer (93,360 ) 2,904 99,168
Liability 10% lower Unchanged 10% higher
6 months shorter $ (131,961 ) $ (3,106 ) $ 125,749
Unchanged (129,166 ) - 129,166
6 months longer (126,220 ) 3,273 132,766
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REINSURANCE RECOVERABLE
In the normal course of business, we purchase reinsurance to protect our
business from losses due to exposure aggregation and to limit ultimate losses
from catastrophic events. The purchase of reinsurance does not discharge our
liabilities under contracts written by us. Consequently, an exposure exists with
respect to reinsurance recoverable to the extent that any of our reinsurers are
unwilling or unable to pay our claims.
The following table shows the composition of our reinsurance recoverable on
unpaid losses for each of our reportable segments, segregated between those
related to case reserves and those related to IBNR and by significant line of
business:
2012 2011
Case Case
At December 31, Reserves IBNR Total Reserves IBNR Total
Insurance segment:
Property and other $ 146,478 $ 77,535 $ 224,013 $ 135,836 $ 96,207 $ 232,043
Marine 116,806 49,535 166,341 84,935 66,740 151,675
Aviation 243 861 1,104 740 1,211 1,951
Credit and political risk - - - - - -
Professional lines 197,308 534,332 731,640 200,380 485,908 686,288
Liability 100,708 537,231 637,939 119,200 489,855 609,055
Total Insurance 561,543 1,199,494 1,761,037 541,091 1,139,921 1,681,012
Reinsurance segment:
Property and other - - - - - -
Credit and bond - - - - - -
Professional lines - 329 329 - 433 433
Motor - - - - - -
Liability - 64,251 64,251 - 55,378 55,378
Total Reinsurance - 64,580 64,580 - 55,811 55,811
Total $ 561,543 $ 1,264,074 $ 1,825,617 $ 541,091 $ 1,195,732 $ 1,736,823
Reinsurance recoverable on unpaid losses as a percentage of gross loss reserves
was comparable, at 20% and 21% for December 31, 2012 and 2011, respectively. At
December 31, 2012 and 2011, respectively, 98.8% and 98.6% of our gross
reinsurance recoverable (i.e. excluding the provision for uncollectible amounts)
were collectible from reinsurers rated A- or better by A.M. Best. For an
analysis of the credit risk associated with our reinsurance recoverable balances
at December 31, 2012, refer to Item 8, Note 11 to the Consolidated Financial
Statements.
The recognition of reinsurance recoverable on unpaid losses and loss expenses
requires two key estimates. The first estimate is the amount of loss reserves to
be ceded to our reinsurers. This amount consists of two elements, those related
to our gross case reserves and those related to our gross IBNR. Reinsurance
recoveries related to our gross case reserves are estimated on a case-by-case
basis by applying the terms of any applicable reinsurance coverage to our
individual case reserve estimates. Our estimate of ceded IBNR is generally
developed as part of our loss reserving process and, consequently, its
estimation is subject to similar risks and uncertainties as the estimation of
gross IBNR. Estimates of amounts to be ceded under non-proportional reinsurance
contracts also take into account pricing information for those contracts and
require greater judgment than estimates for proportional contracts.
The second estimate is the amount of reinsurance recoverable on unpaid and paid
losses that we will ultimately be unable to recover from reinsurers. The
majority of our reinsurance recoverable on unpaid losses will not be due for
collection until some point in the future. As a result, the amount we ultimately
collect may differ from our estimate due to the ability and willingness of
reinsurers to pay our claims, which may be negatively impacted by factors such
as insolvency, contractual disputes over contract language or coverage and/or
other reasons. Additionally, over the period of time before the amounts become
due to us, economic conditions and/or operational performance of a particular
reinsurer may deteriorate and this
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could also affect the willingness and ability of a reinsurer to meet their
contractual obligations to us. Accordingly, we review our reinsurance
recoverable on a quarterly basis and estimate and record an offsetting provision
for uncollectible amounts. Any changes in this provision are reflected in net
income. We are selective in choosing our reinsurers, placing reinsurance
principally with reinsurers with a strong financial condition and industry
ratings.
We apply case-specific provisions against certain recoveries that we deem
unlikely to be collected in full. In addition, we use a default analysis to
estimate our provision for uncollectible amounts on the remainder of the
balance. The principal components of the default analysis are reinsurance
recoverable by reinsurer and default factors applied to estimate uncollectible
amounts based on our reinsurers' credit ratings. The default factors are based
on a model developed by a major rating agency. The provision recorded against
reinsurance recoverable was $16 million and $18 million at December 31, 2012 and
2011, respectively. We have not written off any significant reinsurance
recoverable balances in the last three years. At December 31, 2012, the use of
different assumptions within our approach could have a material effect on our
provision for uncollectible reinsurance recoverable. To the extent the
creditworthiness of our reinsurers was to deteriorate due to an adverse event
affecting the reinsurance industry, such as a large number of major
catastrophes, actual uncollectible amounts could be significantly greater than
our provision. Given the various considerations used to estimate our
uncollectible provision, we cannot precisely quantify the effect a specific
industry event may have on our provision.
PREMIUMS
Our revenues are primarily generated from gross premiums written originating
from our underwriting operations. The basis for our recognized gross premiums
written varies by contract type.
Insurance Segment
For the majority of our insurance business, we receive a fixed premium which is
identified in the policy and recorded as unearned premium on the inception date
of the contract. This premium will be adjusted only if the underlying insured
values ultimately differ. Accordingly, we actively monitor underlying insured
values and record adjustment premiums in the period in which amounts are
reasonably determinable. Gross premiums written on a fixed premium basis
accounted for approximately 93%, 92% and 97% of the segment's total for the
years ended December 31, 2012, 2011 and 2010, respectively. A portion of this
business is written through MGAs, third parties granted authority to bind risks
on our behalf in accordance with our underwriting guidelines. For this business,
we record premiums based on monthly statements received from the MGAs. Due to
inherent reporting delays, we generally record premiums written via MGAs one
month in arrears. In the event that a significant individual statement is not
received, we record our best estimate based upon our historical experience.
A limited portion of our insurance business is written on a line slip or
proportional basis, under which we assume a fixed percentage of the premiums and
losses on a particular risk or group of risks along with numerous other
unrelated insurers. Although premiums on this business are not contractually
stated, we recognize gross premiums written based on an estimate provided by the
client via the broker. For further details on the estimation process, see the
discussion provided for the reinsurance segment below. We review these estimates
on a quarterly basis and record significant adjustments in premium estimates
when identified. Gross premiums written on a line slip/proportional basis
comprised 7%, 8% and 3% of the segment's total for the years ended December 31,
2012, 2011 and 2010, respectively, and therefore the associated impact of these
estimates on our pre-tax net income was immaterial. The proportionate increase
in 2012 and 2011, when compared to 2010, was driven by growth in our accident &
health line, a large portion of which related to proportional reinsurance
business.
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, including assumptions relating to prepayments/refinancings.
Furthermore, certain contracts within this line of business meet the U.S. GAAP
definition of a financial guarantee insurance contract. Premiums for such
contracts are recognized as 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. Due to the scope exemption for insurance contracts
that are similar to financial guarantee insurance contracts, the determination
of whether certain of our credit and political risk contracts fall within the
scope of the U.S. GAAP definition for financial guarantee contracts requires
significant management judgment. For the years ended December 31, 2012 and 2011,
our total premiums from financial guarantee insurance contracts were immaterial
in the context of total gross premiums written for the segment. At December 31,
2012, the average duration of the outstanding unearned premiums written for our
credit and political line of business was 4.0 years (2011: 4.4 years).
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Reinsurance Segment
We provide excess of loss and proportional coverage to cedants (i.e. insurance
companies). In most cases, cedants 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.
Our excess of loss reinsurance contracts with cedants generally include
provisions for a deposit or minimum premium payable to us. The minimum/deposit
premium is generally adjusted at the end of the contract period to reflect
changes in the underlying risks in force during the contract period.
Minimum/deposit premiums generally cover the majority of premiums due under
excess of loss contracts, with the adjustable portion typically comprising an
insignificant portion of the total premium paid to us. Therefore, the
deposit/minimum premiums are generally considered to be the best estimate of the
excess of loss reinsurance written premiums at inception. We record adjustments
to the deposit/minimum premiums in the period during which they become
determinable. Excess of loss contracts accounted for 47%, 53% and 55% of our
reinsurance segment's total gross premiums written for the years ended
December 31, 2012, 2011 and 2010, respectively. The decrease during 2012 was
primarily driven by the repositioning of our catastrophe portfolio throughout
the year.
Many of our excess of loss contracts also include provisions that require an
automatic reinstatement of coverage in the event of a loss. In a year of large
loss events, reinstatement premiums will be higher than in a year in which there
are no such events. Reinstatement premiums are recognized when a triggering loss
event occurs and losses are recorded by us. While the reinstatement premium
amount is defined by contract terms, our recognition of reinstatement premiums
is dependent on our estimate of losses and loss expenses, which reflect
management's best judgment as described above in 'Critical Accounting Estimates
- Reserves for Losses and Loss Expenses'.
For business written under proportional contracts, our initial recognition of
gross premiums written is based on estimates of premiums written provided by the
cedant (via a broker) at contract inception. We may exercise judgment to modify
the initial premium estimates provided by the cedants based on our prior
experience with the cedant. We review these premium estimates on a quarterly
basis and evaluate their reasonability in light of actual premiums reported to
date by cedants, communications between us and the cedants/brokers and our view
of changes in the marketplace and the cedants' competitive positions therein.
Factors contributing to changes from the initial premium estimates may include:
• changes in renewal rates or rates of new business accepted by cedants (such
changes could result from changes in the relevant insurance market that could
affect more than one of our cedants or could be a consequence of changes in
the marketing strategy or risk appetite of an individual cedant);
• changes in underlying exposure values; and/or
• changes in rates being charged by cedants.
As a result of this review process, any adjustments to estimates are recognized
in gross premiums written during the period they are determined. Such changes in
premium estimates could be material to gross premiums written and the resulting
adjustments may directly and significantly impact net premiums earned favorably
or unfavorably in the period they are determined because the adjustment may be
substantially or fully earned. Gross premiums written for proportional
contracts, including amounts related to the adjustment of premium estimates
established in prior years, accounted for 53%, 47% and 45% of our reinsurance
segment's gross premiums written for the years ended December 31, 2012, 2011 and
2010, respectively.
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We made estimates on proportional treaties incepting during the year as follows:
Year ended December 31, 2012 2011 2010
Catastrophe $ 2,264 $ 4,595 $ 5,187
Property 169,214 200,823 206,269
Professional lines 199,732 165,297 168,897
Credit and bond 232,998 254,548 226,858
Motor 158,230 128,164 64,893
Liability 116,208 111,454 121,004
Engineering 55,846 60,576 54,505
Other 10,918 8,405 8,617
Total estimated premiums $ 945,410 $ 933,862 $ 856,230
Gross premiums written (reinsurance segment) 1,830,162 1,974,324
1,834,420
As a % of total gross premiums written 52 % 47 %
47 %
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 2012 proportional
reinsurance gross premiums written estimate would be 5% in either direction.
Such a change would result in a variance in our gross premiums written of
approximately $47 million and an immaterial impact on our pre-tax net income.
However, larger variations, both positive and negative, are possible.
Earning Basis
Our premiums are earned over the period during which we are exposed to the
underlying risk. Changes in circumstance subsequent to contract inception can
impact the earning period. For example, when our exposure limit for a contract
is reached, we fully earn any associated unearned premium. This can have a
significant impact on net premiums earned, particularly for multi-year contracts
such as those in our credit and political risk line of business.
Our fixed premium insurance and excess of loss reinsurance contracts are
generally written on a "losses occurring" or "claims made" basis over the term
of the contract. Accordingly, we earn the premium evenly over the contract term,
which is generally 12 months.
Line slip and proportional (re)insurance contracts are generally written on a
"risks attaching" basis, covering claims that relate to the underlying policies
written during the terms of such contracts. As the underlying business incepts
throughout the contract term (typically one year) and typically has a one-year
coverage period, we generally earn these premiums evenly over a 24-month period.
FAIR VALUE MEASUREMENTS
Our estimates of fair value for financial assets and financial liabilities are
based on the framework established in U.S. GAAP. This framework is based on the
inputs used in valuation and gives the highest priority to unadjusted quoted
prices in active markets and the lowest priority to unobservable inputs that
reflect our significant market assumptions. The three levels of the hierarchy
are as follows:
• Level 1 - Valuations based on unadjusted quoted prices in active markets for
identical assets or liabilities that we have the ability to access.
Valuation adjustments and block discounts are not applied to Level 1
instruments.
• Level 2 - Valuations based on quoted prices in active markets for similar
assets or liabilities, quoted prices for identical assets or liabilities in
inactive markets, or for which significant inputs are observable (e.g.
interest rates, yield curves, prepayment speeds, default rates, loss
severities, etc.) or can be corroborated by observable market data.
• Level 3 - Valuations based on inputs that are unobservable and significant
to the overall fair value measurement. The unobservable inputs reflect our
own assumptions about assumptions that market participants might use.
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Refer to Item 8, Note 6 of the Consolidated Financial Statements for further
details on the valuation techniques and assumptions used in estimating the fair
value of our financial instruments.
Our estimated fair value of a financial instrument may differ from the amount
that could be realized if the security was sold in an immediate sale, e.g., a
forced transaction. Additionally, the valuation of fixed maturities is more
subjective when markets are less liquid due to the lack of market based inputs,
as was the case during the global financial market crisis in late 2008 and early
2009. This may lead us to change the selection of our valuation technique (from
market to income approach) or may cause us to use multiple valuation techniques
to estimate the fair value of a financial instrument. This circumstance may
require significant management judgment and could cause an instrument to be
reclassified between levels of the fair value hierarchy.
Fixed Maturities and Equities
Since 2009, significant liquidity has returned to the financial markets,
resulting in an increase in observable market prices for our financial
instruments. At December 31, 2012, the fair value for 96% (2011: 95%) of our
total fixed maturities and equities was based on prices provided by globally
recognized independent pricing services where we have a current and detailed
understanding of how their prices were derived. The remaining securities were
priced by either non-binding broker quotes or internal valuation models.
Generally, we obtain quotes directly from broker-dealers who are active in the
corresponding markets when prices are unavailable from independent pricing
services. This may also be the case if the pricing from pricing services is not
reflective of current market levels, as detected by our pricing control
tolerance procedures. 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.
At December 31, 2012 and 2011, we have not adjusted any pricing provided by
independent pricing services (see 'Management Pricing Validation' below).
Additionally, our total Level 3 fixed maturities and equities amounted to $71
million (2011: $51 million), less than 1% of total fixed maturities and
equities. Refer to Item 8, Note 6 to our Consolidated Financial Statements for
further information.
Management Pricing Validation
While we obtain pricing from pricing services and/or broker-dealers, management
is ultimately responsible for determining the fair value measurements for all
securities. To ensure fair value measurement is applied consistently and in
accordance with U.S. GAAP, we periodically update our understanding of the
pricing methodologies used by the pricing services and broker-dealers.
We also challenge any prices we believe may not be representative of fair value
under current market conditions. Our review process includes, but is not limited
to: (i) initial and ongoing evaluation of the pricing methodologies and
valuation models used by outside parties to calculate fair value;
(ii) quantitative analysis; (iii) a review of multiple quotes obtained in the
pricing process and the range of resulting fair values for each security, if
available, and (iv) randomly selecting purchased or sold securities and
comparing the executed prices to the fair value estimates provided by the
independent pricing sources and broker-dealers.
Other Investments
Hedge Funds and Credit Funds
We measure the fair value for hedge and credit funds by obtaining the net asset
value (NAV) as advised by our external fund manager or third party
administrator. For any funds for which we did not receive a December 31, 2012
net asset value, we have recorded an estimate of the change in fair value for
the latest period based on return estimates obtained from the fund managers.
Accordingly, we do not have a reporting lag in our fair value measurements for
these funds. Historically, our estimated NAVs have not significantly diverged
from the subsequent final audited NAVs. Where we have the ability to liquidate
our holdings at the reported NAV in the near term, these hedge and credit funds
are classified as Level 2 within the fair value hierarchy while the remaining
funds are classified as Level 3.
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CLO - Equity Securities
We have also invested in CLO Equities, also known as "cash flow CLOs" in the
industry. In 2012, the CLO - Equity market continues to be mostly inactive with
only a small number of transactions being observed in the market and even fewer
still involving deals we hold. Accordingly, we continue to rely on the use of
our internal discounted cash flow model (income approach) to estimate the fair
value of CLO - Equities. At December 31, 2012, the estimated fair value for CLO
- Equities was $62 million (2011: $67 million), based on the following
significant inputs used in our valuation model.
At December 31, 2012 2011
Default rates 4.0% - 5.0% 4.0% - 5.0%
Loss severity rate 53.5% 53.5%
Collateral spreads 2.6% - 4.2% 2.6% - 4.2%
Estimated maturity dates 1.8 - 5.7 years 1.9 - 6.1 years
Of these significant inputs, the default and loss severity rates are the most
judgmental unobservable market inputs to which the valuation of CLO - Equities
is most sensitive.
Actual default rates at November 30, 2012 for our CLO - Equities varied from
0.2% to 4.5% (November 30, 2011: 0.2% to 1.8%) on the remaining underlying
collateral. While, on average, these default rates are much lower than our
default rate assumptions noted above, we remain cautious on this favorable
development given the continuing global economic uncertainty. Due to the use of
significant unobservable inputs in our discounted cash flow model, we continue
to classify the CLO - Equities as Level 3.
OTHER-THAN-TEMPORARY IMPAIRMENTS ("OTTI")
Because our available-for-sale ("AFS") investment portfolio is the largest
component of our consolidated assets and a multiple of shareholders' equity,
OTTI could be material to our financial condition and operating results
particularly during periods of dislocation in the financial markets. During
2012, we recorded a total OTTI charge in earnings of $24 million (2011: $16
million; 2010: $18 million). Refer to the 'Net Investment Income and Net
Realized Investment Gains/Losses' section above for further details.
We review quarterly whether a decline in the fair values of AFS securities below
their amortized costs is other-than-temporarily impaired. The OTTI assessment is
inherently judgmental, especially where securities have experienced severe
declines in fair value in a short period. Our OTTI review process is based on
both quantitative and qualitative approach. We identify securities for review
based on credit quality, relative health of industry sector, yield analysis,
security performance and topical issues. For identified securities, we prepare a
fundamental analysis at the security level and consider the following factors:
• The length of time and extent to which the fair value has been less than the
amortized cost for fixed maturities or cost for equity securities.
• The financial condition, near-term and long-term prospects for the issuer of
the security, including the relevant industry conditions and trends, and
implications of rating agency actions and offering prices.
• The historical and implied volatility of the fair value.
• The collateral structure and credit support.
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The following provides further details regarding our OTTI recognition and
processes for AFS fixed maturities and equity securities.
Fixed Maturities
A security is "impaired" when the fair value is below its amortized cost. For an
impaired fixed maturity, we recognize an OTTI in earnings when we:
1) have the intent to sell the security,
2) more likely than not will be required to sell the security before its
anticipated recovery, or
3) do not anticipate to recover fully the amortized cost based on projected
cash flows to be collected (i.e. a credit loss exists).
For the first two criteria above, the OTTI charge is the entire difference
between the security's fair value and its amortized cost. However, if the
impairment arises due to an anticipated credit loss on the security (third
criterion above), we recognize only the credit loss component of the OTTI amount
in earnings with a corresponding adjustment to amortized cost (new cost basis).
The non-credit component (e.g. interest rates, market conditions, etc.) of the
OTTI amount is recognized in other comprehensive income in our shareholders'
equity.
From time to time, we may sell fixed maturities subsequent to the balance sheet
date that we did not intend to sell at the balance sheet date. Conversely, we
may not sell fixed maturities that we previously asserted that we intended to
sell at the balance sheet date. Such changes in intent may arise due to events
occurring subsequent to the balance sheet date. The types of events that may
result in a change in intent include, but are not limited to, significant
changes in the economic facts and circumstances related to the specific issuer,
changes in liquidity needs, or changes in tax laws or the regulatory
environment.
For impaired investment-grade securities (i.e. rated BBB or above) that we do
not intend to sell and it is more likely than not that we will not be required
to sell, we have established some parameters for identifying securities with
potential credit impairments. Our parameters focus primarily on the extent and
duration of the decline, including but not limited to:
• declines in value greater than 20% for nine consecutive months,
• declines in value greater than 10% for twelve consecutive months, and
• declines in value greater than 5% and rated less than BBB (i.e. downgraded to
non-investment grade since its original purchase).
For impaired securities held within our high yield portfolios (i.e. managed
under a mandate to invest exclusively in non-investment grade securities), we
have established separate parameters for our credit loss assessment. Due to the
additional volatility inherent in high yield securities relative to
investment-grade securities, we focus on the severity of the impairment and work
closely with our external high yield investment managers to identify securities
with significant potential credit impairments.
If a security meets one of the above criteria, we then perform a fundamental
analysis by considering the qualitative factors noted above. Our OTTI review
process for credit impairment excludes all fixed maturities guaranteed by the
U.S. government and its agencies because we anticipate these securities will not
be settled below amortized costs.
The credit loss component of OTTI recognized in earnings is calculated based on
the difference between the amortized cost of the security and the net present
value of its projected future cash flows discounted at the effective interest
rate implicit in the debt security prior to the impairment. The significant
inputs and the methodology used to estimate the credit losses are disclosed in
Item 8, Note 5(d) to the Consolidated Financial Statements.
Equities
We consider our ability and intent to hold an equity security in an unrealized
loss position for a reasonable period of time to allow for a full recovery. As
an equity security does not have a maturity date, the forecasted recovery for an
equity security is inherently more judgmental than for a fixed maturity
security.
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In light of the volatile global equity markets we have experienced in recent
years, we generally impair any equities for which we do not forecast a recovery
to cost within three years. Further, we generally impair an equity security if
its value has declined by more than 30% for nine consecutive months or by more
than 20% for twelve consecutive months. We have also established parameters for
identifying potential impaired equity securities for fundamental analysis based
on the severity, in either percentage or absolute dollar terms, of the
unrealized loss position.
From time to time, we may sell our AFS equities subsequent to the balance sheet
date that were considered temporarily impaired at the balance sheet date. This
may occur due to events occurring subsequent to the balance sheet date that
result in a change in our intent or ability to hold an equity security. Such
subsequent events that may result in a sale include significant deterioration in
the financial condition of the issuer, significant unforeseen changes in our
liquidity needs, or changes in tax laws or the regulatory environment.
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RECENT ACCOUNTING PRONOUNCEMENTS
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See Item 8, Note 2(m) to the Consolidated Financial Statements for a discussion
of recently issued accounting pronouncements that we have not yet adopted.
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OFF-BALANCE SHEET AND SPECIAL PURPOSE ENTITY ARRANGEMENTS
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At December 31, 2012, we have not entered into any off-balance sheet
arrangements, as defined by Item 303(a)(4) of Regulation S-K.
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NON-GAAP FINANCIAL MEASURES
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In this report, we present operating income (loss), consolidated underwriting
income (loss) and underwriting-related general and administrative expenses,
which are "non-GAAP financial measures" as defined in Regulation G.
Operating income (loss) represents after-tax operational results without
consideration of after-tax net realized investment gains (losses), foreign
exchange losses (gains) and losses on repurchase of preferred shares. We also
present diluted operating income (loss) per common share and operating return on
average common equity ("operating ROACE"), which are derived from the non-GAAP
operating income (loss) measure.
Consolidated underwriting income (loss) is a pre-tax measure of underwriting
profitability that takes into account net premiums earned and other insurance
related income as revenues and net losses and loss expenses, acquisition costs
and underwriting-related general and administrative costs as expenses.
Underwriting-related general and administrative expenses include those general
and administrative expenses that are incremental and/or directly attributable to
our individual underwriting operations. While these measures are presented in
Item 8, Note 3 to our Consolidated Financial Statements, they are considered
non-GAAP financial measures when presented elsewhere on a consolidated basis.
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Operating income (loss), diluted operating income (loss) per common share and
operating ROACE can be reconciled to the nearest GAAP financial measures as
follows:
Year ended December 31, 2012 2011 2010
Net income available to common shareholders $ 495,004 $ 9,430 $ 819,848
Net realized investment gains, net of (115,854 ) (119,736 ) (193,124 )
tax(1)
Foreign exchange losses (gains), net of 28,364 (43,606 ) (15,382 )
tax(2)
Loss on repurchase of preferred shares, net 14,009 - -
of tax(3)
Operating income (loss) $ 421,523 $ (153,912 ) $ 611,342
Earnings per common share - diluted $ 4.00 $ 0.07 $ 6.02
Net realized investment gains, net of tax (0.94 ) (0.93 ) (1.42 )
Foreign exchange losses (gains), net of tax 0.24 (0.34 ) (0.11 )
Loss on repurchase of preferred shares, net 0.11 - -
of tax
Adjustment for anti-dilutive securities(4) - (0.06 ) -
Operating income (loss) per common share - $ 3.41 $ (1.26 ) $ 4.49
diluted
Weighted average common shares and common
share equivalents - diluted, for net 123,654 128,122 136,199
income(5)
Weighted average common shares and common
share equivalents - diluted, for operating 123,654 122,499 136,199
income (loss)
Average common shareholders' equity $ 5,110,499 $ 5,034,525 $ 5,062,607
ROACE 9.7 % 0.2 % 16.2 %
Operating ROACE 8.2 % (3.1 %) 12.1 %
(1) Tax cost of $11,615, $1,703 and $1,974 for 2012, 2011 and 2010, respectively.
Tax impact is estimated by applying the statutory rates of applicable
jurisdictions, after consideration of other relevant factors including the
ability to utilize capital losses.
(2) Tax benefit (cost) of $1,148, ($976) and ($153) for 2012, 2011 and 2010,
respectively. Tax impact is estimated by applying the statutory rates of
applicable jurisdictions, after consideration of other relevant factors
including the tax status of specific foreign exchange transactions.
(3) Tax impact is nil.
(4) For operating loss per share purposes, we have excluded the impact of
otherwise anti-dilutive securities.
(5) Refer to Note 12 to the Consolidated Financial Statements for further details
on the dilution calculation.
A reconciliation of consolidated underwriting income (loss) to income before
income taxes (the nearest GAAP financial measure) can be found in Item 8, Note 3
to the Consolidated Financial Statements. Underwriting-related general and
administrative are reconciled to general and administrative expenses (the
nearest GAAP financial measure) within 'Underwriting Results - Group'.
We present our results of operations in the way we believe will be most
meaningful and useful to investors, analysts, rating agencies and others who use
our financial information to evaluate our performance. This includes the
presentation of "operating income (loss)" (in total and on a per share basis),
"annualized operating return on average common equity" (which is based on the
"operating income (loss)" measure) and "consolidated underwriting income
(loss)", which incorporates "underwriting-related general and administrative
expenses".
Operating Income (Loss)
Although the investment of premiums to generate income and realized investment
gains (or losses) is an integral part of our operations, the determination to
realize investment gains (or losses) is independent of the underwriting process
and is heavily influenced by the availability of market opportunities.
Furthermore, many users believe that the timing of the realization of investment
gains (or losses) is somewhat opportunistic for many companies.
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Foreign exchange losses (gains) in our Consolidated Statements of Operations are
primarily driven by the impact of foreign exchange rate movements on net
insurance related-liabilities. However, this movement is only one element of the
overall impact of foreign exchange rate fluctuations on our financial position.
In addition, we recognize unrealized foreign exchange losses (gains) on our
available-for-sale investments in other comprehensive income and foreign
exchange losses (gains) realized upon the sale of these investments in net
realized investments gain (losses). These unrealized and realized foreign
exchange rate movements generally offset a large portion of the foreign exchange
losses (gains) reported separately in earnings, thereby minimizing the impact of
foreign exchange rate movements on total shareholders' equity. As such, the
Statement of Operations foreign exchange losses (gains) in isolation are not a
fair representation of the performance of our business.
Losses on repurchase of preferred shares arise from capital transactions and,
therefore, are not reflective of underlying business performance.
In this regard, certain users of our financial statements evaluate earnings
excluding after-tax net realized investment gains (losses), foreign exchange
losses (gains) and losses on repurchase of preferred shares to understand the
profitability of recurring sources of income.
We believe that showing net income available to common shareholders exclusive of
net realized gains (losses), foreign exchange losses (gains) and losses on
repurchase of preferred shares reflects the underlying fundamentals of our
business. In addition, we believe that this presentation enables investors and
other users of our financial information to analyze performance in a manner
similar to how our management analyzes the underlying business performance. We
also believe this measure follows industry practice and, therefore, facilitates
comparison of our performance with our peer group. We believe that equity
analysts and certain rating agencies that follow us, and the insurance industry
as a whole, generally exclude these items from their analyses for the same
reasons.
Consolidated Underwriting Income (Loss)/Underwriting-Related General and
Administrative Expenses
Corporate expenses include holding company costs necessary to support our
worldwide (re)insurance operations and costs associated with operating as a
publicly-traded company. As these costs are not incremental and/or directly
attributable to our individual underwriting operations, we exclude them from
underwriting-related general and administrative expenses and, therefore,
consolidated underwriting income (loss). Interest expense and financing costs
primarily relate to interest payable on our senior notes and are excluded from
consolidated underwriting income (loss) for the same reason.
We evaluate our underwriting results separately from the performance of our
investment portfolio. As such, we believe it appropriate to exclude net
investment income and net realized investment gains (losses) from our
underwriting profitability measure.
As noted above, foreign exchange losses (gains) in our Consolidated Statement of
Operations primarily relate to our net insurance-related liabilities. However,
we manage our investment portfolio in such a way that unrealized and realized
foreign exchange rate gains (losses) on our investment portfolio generally
offset a large portion of the foreign exchange losses (gains) arising from our
underwriting portfolio. As a result, we believe that foreign exchange losses
(gains) are not a meaningful contributor to our underwriting performance and,
therefore, exclude them from consolidated underwriting income (loss).
We believe that presentation of underwriting-related general and administrative
expenses and consolidated underwriting income (loss) provides investors with an
enhanced understanding of our results of operations, by highlighting the
underlying pre-tax profitability of our underwriting activities.
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
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Market risk represents the potential for an economic loss due to adverse changes
in the fair value of financial instruments. Refer to 'Risk and Capital
Management' section under Item 1 for further details on how we manage market
risk relating to our financial instruments.
Our Balance Sheets include a substantial amount of assets whose fair values are
subject to market risks. Our fixed income and equity securities are classified
as available-for-sale and, as such, changes in fair value caused by changes in
interest rates, equity prices and foreign currency exchange rates will have an
immediate impact on our comprehensive income, shareholders' equity and book
value but may not have an immediate impact on consolidated net income. Changes
in these market risks will only impact our consolidated net income when, and if,
securities are sold or an OTTI charge is recorded. Further, we have alternative
investments including hedge funds, credit funds, and CLO - Equities at
December 31, 2012 and 2011. These investments are also exposed to market risks,
with the change in fair value reported immediately in earnings.
The following is a sensitivity analysis of our primary market risk exposures at
December 31, 2012 and 2011. Our policies to address these risks in 2012 were not
materially different from 2011. We do not currently anticipate significant
changes in our primary market risk exposures or in how those exposures are
managed in future reporting periods based upon what is known or expected to be
in effect in future reporting periods.
SENSITIVITY ANALYSIS
Interest Rate and Credit Spread Risk
Interest rate risk includes fluctuations in interest rates and credit spreads
that have a direct impact on the fair value of our fixed maturities. As interest
rates rise and credit spreads widen, the fair value of fixed maturities falls,
and the converse is also true.
We monitor our sensitivity to interest rate changes and credit spread changes by
revaluing our fixed maturities using a variety of different interest rates
(inclusive of credit spreads). We use duration and convexity at the security
level to estimate the change in fair value that would result from a change in
each security's yield. Duration measures the price sensitivity of an asset to
changes in yield rates. Convexity measures how the duration of the security
changes with interest rates. The duration and convexity analysis takes into
account changes in prepayment expectations for MBS and ABS securities. The
analysis is performed at the security level and aggregated up to the asset
category levels for reporting in the tables below.
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The following table presents the estimated pre-tax impact on the fair value of
our fixed maturities at December 31, 2012 and 2011 due to an instantaneous
increase in the U.S. yield curve of 100 basis points and an additional 100 basis
point credit spread widening for corporate debt, non-agency residential and
commercial MBS, ABS and municipal bond securities.
Potential Adverse Change in Fair Value
Increase in Widening of
interest rate credit spreads
by 100 by 100
Fair Value basis points basis points Total
At December 31, 2012
U.S. government and agency $ 1,422,885 $ (55,856 ) $ - $ (55,856 )
Non-U.S. government 1,104,576 (34,088 ) - (34,088 )
Agency MBS 2,659,908 (68,821 ) - (68,821 )
Securities exposed to credit spreads:
Corporate debt 3,876,382 (111,035 ) (116,763 ) (227,798 )
CMBS 840,084 (23,773 ) (24,037 ) (47,810 )
Non agency RMBS 95,199 (1,897 ) (2,959 ) (4,856 )
ABS 643,206 (5,525 ) (14,331 ) (19,856 )
Municipals 1,285,809 (54,567 ) (55,134 ) (109,701 )
$ 11,928,049 $ (355,562 ) $ (213,224 ) $ (568,786 )
At December 31, 2011
U.S. government and agency $ 1,148,267 $ (30,557 ) $ - $ (30,557 )
Non-U.S. government 1,212,451 (37,172 ) - (37,172 )
Agency MBS 2,636,634 (50,924 ) - (50,924 )
Securities exposed to credit spreads:
Corporate debt 3,609,591 (113,228 ) (123,567 ) (236,795 )
CMBS 312,691 (9,145 ) (9,227 ) (18,372 )
Non agency RMBS 165,713 (217 ) (3,659 ) (3,876 )
ABS 632,042 (4,411 ) (12,699 ) (17,110 )
Municipals 1,222,711 (57,416 ) (57,844 ) (115,260 )
$ 10,940,100 $ (303,070 ) $ (206,996 ) $ (510,066 )
U.S. government agencies have a limited range of spread widening, therefore, 100
basis points of spread widening for these securities is highly improbable in
normal market conditions. As previously noted, our non-U.S. government debt
obligations are highly-rated, with no remaining exposure to the European
peripheral countries. Accordingly, we believe the potential for future widening
of credit spreads would also be limited for these securities. Further, certain
of our holdings in non-agency RMBS and ABS have floating interest rates, which
mitigate our interest rate risk exposure.
The above sensitivity analysis reflects our view of changes that are reasonably
possible over a one-year period. Note this should not be construed as our
prediction of future market events, but rather an illustration of the impact of
such events.
As the performance of our investment in credit funds are driven by the valuation
of the underlying bank loans, these funds are also exposed to credit spreads
movement. At December 31, 2012, the impact of an instantaneous 15% decline in
the fair value of our investment in credit funds would be $13 million (2011: $13
million), on a pre-tax basis. Our investment in CLO - Equities is also exposed
to interest rate risk, but it would have an insignificant impact to its fair
value in the event the risk free yield curve increase by 100 basis points.
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Additionally, our investment in foreign bond mutual funds is exposed to interest
rate risk; however, this exposure is largely mitigated by the short duration of
the underlying securities.
Equity Price Risk
Our portfolio of equity securities, excluding the foreign bond mutual funds, has
exposure to equity price risk. This risk is defined as the potential loss in
fair value resulting from adverse changes in stock prices. Our global equity
portfolio is correlated with a blend of the S&P 500 and MSCI World indices and
changes in this blend of indices would approximate the impact on our portfolio.
The fair value of our equity securities at December 31, 2012 was $563 million
(2011: $561 million). At December 31, 2012, the impact of a 20% decline in the
overall market prices of our equity exposures would be $113 million (2011: $112
million), on a pre-tax basis.
Our investment in hedge funds has significant exposure to equity strategies with
net long positions. At December 31, 2012, the impact of an instantaneous 15%
decline in the fair value of our investment in hedge funds would be $104 million
(2011: $82 million), on a pre-tax basis.
Foreign Currency Risk
The table below provides a sensitivity analysis of our total net foreign
currency exposures.
AUD NZD CAD EUR GBP JPY Other Total
At December 31, 2012
Net managed assets
(liabilities), excluding
derivatives $ (51,247 ) $ (278,388 ) $ 78,242 $ (25,315 ) $ (21,525 ) $ (8,387 ) $ (15,020 ) $ (321,640 )
Foreign currency 25,961 245,801 (58,297 ) 39,588 - 15,329 - 268,382
derivatives, net
Net managed foreign (25,286 ) (32,587 ) 19,945 14,273 (21,525 ) 6,942 (15,020 ) (53,258 )
currency exposure
Other net foreign 5,454 - 211 22,257 15,199 14,224 201,062 258,407
currency exposure
Total net foreign $ (19,832 ) $ (32,587 ) $ 20,156 $ 36,530 $ (6,326 ) $ 21,166 $ 186,042 $ 205,149
currency exposure
Net foreign currency
exposure as a percentage
of total shareholders'
equity (0.3 %) (0.6 %) 0.3 % 0.6 % (0.1 %) 0.4 % 3.2 % 3.5 %
Pre-tax impact of net
foreign currency
exposure on
shareholders' equity
given a hypothetical 10%
rate movement(1) $ (1,983 ) $ (3,259 ) $ 2,016 $ 3,653 $ (633 ) $ 2,117 $ 18,604 $ 20,515
At December 31, 2011
Net managed assets
(liabilities), excluding
derivatives $ (108,549 ) $ (327,165 ) $ 53,336 $
552,421 $ (16,960 ) $ (73,888 ) $ (1,047 ) $ 78,148
Foreign currency 72,093 314,890 (39,348 )
(637,822 ) (62,036 ) 44,666 8,225 (299,332 )
derivatives, net
Net managed foreign (36,456 ) (12,275 ) 13,988 (85,401 ) (78,996 ) (29,222 ) 7,178 (221,184 )
currency exposure
Other net foreign (945 ) - 1,209
26,748 22,581 33,580 30,052 113,225
currency exposure
Total net foreign $ (37,401 ) $ (12,275 ) $ 15,197 $ (58,653 ) $ (56,415 ) $ 4,358$ 37,230 $ (107,959 )
currency exposure
Net foreign currency
exposure as a percentage
of total shareholders'
equity (0.7 %) (0.2 %) 0.3 % (1.1 %) (1.1 %) 0.1 % 0.7 % (2.0 %)
Pre-tax impact of net
foreign currency
exposure on
shareholders' equity
given a hypothetical 10%
rate movement(1) $ (3,740 ) $ (1,228 ) $ 1,520 $ (5,865 ) $ (5,642 ) $ 436 $ 3,723 $ (10,796 )
(1) Assumes 10% change in underlying currencies relative to the U.S. dollar.
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Net Managed Foreign Currency Exposure
Our net managed foreign currency exposure is subject to our internal risk
tolerance standards. For significant foreign currency exposures, defined as
those where our net asset/liability position exceeds the greater of 1% of our
shareholders' equity or $50 million, the value of assets denominated in those
currencies should fall within a range of 90 - 110% of liabilities denominated in
the same currency. In addition, our aggregate foreign currency exposure is
subject to the same tolerance range. We use derivative instruments to maintain
net managed foreign currency exposures within our risk tolerance levels.
During 2012, our euro-denominated net assets, excluding derivatives, and the
derivatives used to hedge these net assets decreased, as we actively reduced our
eurozone sovereign debt exposure. Refer to Item 7 'Cash and Investments - Fixed
Maturities - Non-U.S. Government' for further details.
Business written as part of the January 2013 renewal season is expected to
offset a large portion of the $53 million net short managed foreign currency
exposure at December 31, 2012. Remaining un-matched foreign currency exposure
will be economically hedged with foreign currency derivatives to ensure our net
exposure remains within our risk tolerances.
Other Net Foreign Currency Exposure
Other net foreign currency exposure includes those assets managed by specific
investment managers who have the discretion to hold foreign currency exposures
as part of their total return strategy. The funding of an emerging market debt
securities portfolio was the primary driver for the increase in other net
foreign currency exposures during 2012. Refer to Item 7 'Cash and Investments -
Fixed Maturities - Non-U.S. Government' for further details on this portfolio.
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