ALLIED WORLD ASSURANCE CO HOLDINGS, AG – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Some of the statements in this Form 10-K include forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995 that involve inherent risks and uncertainties. These statements include in general forward-looking statements both with respect to us and the insurance industry. Statements that are not historical facts, including statements that use terms such as "anticipates," "believes," "expects," "intends," "plans," "projects," "seeks" and "will" and that relate to our plans and objectives for future operations, are forward-looking statements. In light of the risks and uncertainties inherent in all forward-looking statements, the inclusion of such statements in this Form 10-K should not be considered as a representation by us or any other person that our objectives or plans will be achieved. These statements are based on current plans, estimates and expectations. Actual results may differ materially from those projected in such forward-looking statements and therefore you should not place undue reliance on them. Important factors that could cause actual results to differ materially from those in such forward-looking statements are set forth in Item 1A. "Risk Factors" in this Form 10-K. We undertake no obligation to release publicly the results of any future revisions we make to the forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Overview Our Business We write a diversified portfolio of property and casualty insurance and reinsurance internationally through our subsidiaries and branches based inBermuda ,Europe ,Hong Kong ,Singapore andthe United States as well as our Lloyd's Syndicate 2232. We manage our business through three operating segments: U.S. insurance, international insurance and reinsurance. As ofDecember 31, 2012 , we had approximately$12.0 billion of total assets,$3.3 billion of total shareholders' equity and$4.1 billion of total capital, which includes shareholders' equity and senior notes. During the year endedDecember 31, 2012 , we continued to experience rate increases on property lines that had experienced significant loss activity in the prior year. We also continued to see rate improvement during the year on some of our casualty lines of business in certain jurisdictions. We believe that there are opportunities where certain products have attractive premium rates and that the expanded breadth of our operations allows us to target those classes of business. Given these trends, we continue to be selective in the insurance policies and reinsurance contracts we underwrite. Our consolidated gross premiums written increased by$389.8 million , or 20.1%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . Our net income increased by$218.5 million to$493.0 million compared to the year endedDecember 31, 2011 . The increase resulted from the improvement in underwriting results, as catastrophe losses were$112.6 million lower, combined with a$296.3 million increase in our realized investment gains as markets and economic conditions rebounded during the year, partially offset by the$101.7 million reduction in other income. Recent Developments
We reported a net loss of
The decrease in net income was due to the following:
• For the three months ended
pre-tax catastrophe-related losses from Superstorm Sandy (net of estimated
reinstatement premiums) compared to
catastrophe-related losses for the three months ended
related to the flooding in
2011 and from other catastrophes that occurred earlier in 2011, an increase
of$107.0 million .
• Net favorable reserve development related to prior years decreased $59.6
million to
$92.4 million for the same period in 2011. 63
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• The three months ended
fee income of
with Transatlantic. • Net realized investment gains decreased by$17.2 million .
• Income tax expense decreased by
described above.
During the three months endedDecember 31, 2012 , we completed four strategic investments through AWFS inCunningham Lindsey , MatlinPatterson,Aeolus Capital Management andCrescent Capital Group . Our goal with AWFS is to invest in strategic business opportunities that we believe will complement our core insurance and reinsurance operations and diversify our revenues. Financial Highlights Year Ended December 31, 2012 2011 2010 ($ in millions, except share, per share and percentage data) Gross premiums written $ 2,329.3 $ 1,939.5 $ 1,758.4 Net income 493.0 274.5 665.0 Operating income 202.7 183.7 397.8 Basic earnings per share: Net income $ 13.67 $ 7.21 $ 14.30 Operating income $ 5.62 $ 4.82 $ 8.56 Diluted earnings per share: Net income $ 13.30 $ 6.92 $ 13.32 Operating income $ 5.47 $ 4.63 $ 7.97 Weighted average common shares outstanding: Basic 36,057,145 38,093,351 46,491,279 Diluted 37,069,885 39,667,905 49,913,317 Basic book value per common share $ 95.59 $ 83.44 $ 80.75 Diluted book value per common share $ 92.59 $ 80.11 $ 74.29 Annualized return on average equity (ROAE), net income 15.3 % 8.9 % 21.9 % Annualized ROAE, operating income 6.3 % 6.0 % 13.1 %
Non-GAAP Financial Measures
In presenting the company's results, management has included and discussed certain non-GAAP financial measures, as such term is defined in Item 10(e) of Regulation S-K promulgated by theSEC . Management believes that these non-GAAP measures, which may be defined differently by other companies, better explain the Company's results of operations in a manner that allows for a more complete understanding of the underlying trends in the Company's business. However, these measures should not be viewed as a substitute for those determined in accordance with U.S. GAAP.
Operating income & operating income per share
Operating income is an internal performance measure used in the management of our operations and represents after-tax operational results excluding, as applicable, net realized investment gains or losses, net impairment charges recognized in earnings, net foreign exchange gain or loss and other non-recurring items. We exclude net realized investment gains or losses, net impairment charges recognized in earnings, net foreign exchange gain or loss and other non-recurring items from our calculation of operating income because these amounts are heavily influenced by and fluctuate in part according to the availability of market opportunities and other factors. We have excluded from our operating income the aggregate$101.7 million termination fee we 64
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received from Transatlantic in 2011 as this is a non-recurring item. In addition to presenting net income determined in accordance with U.S. GAAP, we believe that showing operating income enables investors, analysts, rating agencies and other users of our financial information to more easily analyze our results of operations and our underlying business performance. Operating income should not be viewed as a substitute for U.S. GAAP net income. The following is a reconciliation of operating income to its most closely related U.S. GAAP measure, net income. Year Ended December 31, 2012 2011 2010 ($ in millions, except per share data) Net income $ 493.0 $ 274.5 $ 665.0 Add after tax effect of: Net realized investment gains (291.1 ) (0.2 ) (267.7 ) Net impairment charges recognized in earnings - - 0.1 Other income - termination fee - (93.7 ) - Foreign exchange loss 0.8 3.1 0.4 Operating income $ 202.7 $ 183.7 $ 397.8 Basic per share data: Net income $ 13.67 $ 7.21 $ 14.30 Add after tax effect of: Net realized investment gains (8.07 ) (0.01 ) (5.75 ) Other income - termination fee - (2.46 ) - Foreign exchange loss 0.02 0.08 0.01 Operating income $ 5.62 $ 4.82 $ 8.56 Diluted per share data: Net income $ 13.30 $ 6.92 $ 13.32 Add after tax effect of: Net realized investment gains (7.85 ) (0.01 ) (5.36 ) Other income - termination fee - (2.36 ) - Foreign exchange loss 0.02 0.08 0.01 Operating income $ 5.47 $ 4.63 $ 7.97 65
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Diluted book value per share
We have included diluted book value per share because it takes into account the effect of dilutive securities; therefore, we believe it is an important measure of calculating shareholder returns. As of December 31, 2012 2011 2010 ($ in millions, except share and per share data) Price per share at period end $ 78.80 $ 62.93 $ 59.44 Total shareholders' equity $ 3,326.3 $ 3,149.0 $ 3,075.8 Basic common shares outstanding 34,797,781 37,742,131 38,089,226 Add: Unvested restricted share units 135,123 249,251 571,178 Performance based equity awards 485,973 889,939 1,440,017 Employee share purchase plan 10,750 11,053 10,576 Dilutive options/warrants outstanding 1,224,607 1,525,853 3,272,739 Weighted average exercise price per share $ 47.02 $ 45.72 $ 35.98 Deduct: Options bought back via treasury method (730,652 )
(1,108,615 ) (1,980,884 )
Common shares and common share equivalents outstanding 35,923,582 39,309,612 41,402,852 Basic book value per common share $ 95.59 $ 83.44 $ 80.75 Diluted book value per common share $ 92.59 $
80.11 $ 74.29
Annualized return on average equity
Annualized return on average shareholders' equity ("ROAE") is calculated using average shareholders' equity, excluding the average after tax unrealized gains or losses on investments. We present ROAE as a measure that is commonly recognized as a standard of performance by investors, analysts, rating agencies and other users of our financial information. Annualized operating return on average shareholders' equity is calculated using operating income and average shareholders' equity, excluding the average after tax unrealized gains or losses on investments. Year Ended December 31, 2012 2011 2010 ($ in millions) Opening shareholders' equity $ 3,149.0 $
3,075.8
Adjusted opening shareholders' equity $ 3,134.5 $ 3,018.7 $ 3,063.5 Closing shareholders' equity $ 3,326.3 $ 3,149.0 $ 3,075.8 Deduct: accumulated other comprehensive income -
(14.5 ) (57.1 )
Adjusted closing shareholders' equity $ 3,326.3 $ 3,134.5 $ 3,018.7 Average shareholders' equity $ 3,230.4 $ 3,076.6 $ 3,041.1 Net income available to shareholders $ 493.0 $ 274.5 $ 665.0 Annualized return on average shareholders' equity - net income available to shareholders 15.3 %
8.9 % 21.9 %
Operating income available to shareholders $ 202.7 $ 183.7 $ 397.8 Annualized return on average shareholders' equity - operating income available to shareholders 6.3 % 6.0 % 13.1 % 66
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Table of Contents Relevant Factors Revenues We derive our revenues primarily from premiums on our insurance policies and reinsurance contracts, net of any reinsurance or retrocessional coverage purchased. Insurance and reinsurance premiums are a function of the amounts and types of policies and contracts we write, as well as prevailing market prices. Our prices are determined before our ultimate costs, which may extend far into the future, are known. In addition, our revenues include income generated from our investment portfolio, consisting of net investment income and net realized investment gains or losses. Investment income is principally derived from interest and dividends earned on investments, partially offset by investment management and custodial expenses and fees paid to our custodian bank. Net realized investment gains or losses include gains or losses from the sale of investments, as well as the change in the fair value of investments that we mark-to-market through net income.
Expenses
Our expenses consist largely of net losses and loss expenses, acquisition costs and general and administrative expenses. Net losses and loss expenses incurred are comprised of three main components:
• losses paid, which are actual cash payments to insureds and reinsureds, net
of recoveries from reinsurers; • outstanding loss or case reserves, which represent management's best
estimate of the likely settlement amount for known claims, less the portion
that can be recovered from reinsurers; and • reserves for losses incurred but not reported, or "IBNR", which are
reserves (in addition to case reserves) established by us that we believe
are needed for the future settlement of claims. The portion recoverable
from reinsurers is deducted from the gross estimated loss.
General and administrative expenses include personnel expenses including stock-based compensation expense, rent expense, professional fees, information technology costs and other general operating expenses.
Ratios
Management measures results for each segment on the basis of the "loss and loss expense ratio," "acquisition cost ratio," "general and administrative expense ratio," "expense ratio" and the "combined ratio." Because we do not manage our assets by segment, investment income, interest expense and total assets are not allocated to individual reportable segments. General and administrative expenses are allocated to segments based on various factors, including staff count and each segment's proportional share of gross premiums written. Critical Accounting Policies It is important to understand our accounting policies in order to understand our financial position and results of operations. Our consolidated financial statements reflect determinations that are inherently subjective in nature and require management to make assumptions and best estimates to determine the reported values. If events or other factors cause actual results to differ materially from management's underlying assumptions or estimates, there could be a material adverse effect on our financial condition or results of operations. The following are the accounting estimates that, in management's judgment, are critical due to the judgments, assumptions and uncertainties underlying the application of those estimates and the potential for results to differ from management's assumptions. 67
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Reserve for Losses and Loss Expenses
Reserves for losses and loss expenses by segment as of
International U.S. Insurance Insurance Reinsurance Total December 31, December 31, December 31, December 31, 2012 2011 2012 2011 2012 2011 2012 2011 ($ in millions) Case reserves $ 508.8 $ 387.6 $ 550.5 $ 522.6 $ 479.8 $ 456.2 $ 1,539.1 $ 1,366.4 IBNR 1,389.5 1,274.8 1,716.1 1,726.4 1,000.8 857.5 4,106.4 3,858.7 Reserve for losses and loss expenses 1,898.3 1,662.4 2,266.6
2,249.0 1,480.6 1,313.7 5,645.5 5,225.1 Reinsurance recoverables
(517.3 ) (438.3 ) (620.6
) (564.3 ) (3.2 ) (0.3 ) (1,141.1 ) (1,002.9 )
Net reserve for losses and loss expenses $ 1,381.0 $ 1,224.1 $ 1,646.0 $ 1,684.7 $ 1,477.4 $ 1,313.4 $ 4,504.4 $ 4,222.2 The reserve for losses and loss expenses is comprised of two main elements: outstanding loss reserves, also known as case reserves, and reserves for IBNR. Outstanding loss reserves relate to known claims and represent management's best estimate of the likely loss settlement. IBNR reserves relate primarily to unreported events that, based on industry information, management's experience and actuarial evaluation, can reasonably be expected to have occurred and are reasonably likely to result in a loss to our company. IBNR reserves also relate to estimated development of reported events that based on industry information, management's experience and actuarial evaluation, can reasonably be expected to reach our attachment point and are reasonably likely to result in a loss to our company. We also include IBNR changes in the values of claims that have been reported to us but are not yet settled. Each claim is settled individually based upon its merits and it is not unusual for a claim to take years after being reported to settle, especially if legal action is involved. As a result, reserves for losses and loss expenses include significant estimates for IBNR reserves. The reserve for IBNR is estimated by management for each line of business based on various factors, including underwriters' expectations about loss experience, actuarial analysis, comparisons with the results of industry benchmarks and loss experience to date. The reserve for IBNR is calculated as the ultimate amount of losses and loss expenses less cumulative paid losses and loss expenses and case reserves. Our actuaries employ generally accepted actuarial methodologies to determine estimated ultimate loss reserves. While management believes that our case reserves and IBNR are sufficient to cover losses assumed by us, there can be no assurance that losses will not deviate from our reserves, possibly by material amounts. The methodology of estimating loss reserves is periodically reviewed to ensure that the assumptions made continue to be appropriate. To the extent actual reported losses exceed estimated losses, the carried estimate of the ultimate losses will be increased (i.e., unfavorable reserve development), and to the extent actual reported losses are less than estimated losses, the carried estimate of ultimate losses will be reduced (i.e., favorable reserve development). We record any changes in our loss reserve estimates and the related reinsurance recoverables in the periods in which they are determined. In certain lines of business, claims are generally reported and paid within a relatively short period of time ("shorter tail lines") during and following the policy coverage period. This generally enables us to determine with greater certainty our estimate of ultimate losses and loss expenses. The estimate of reserves for our shorter tail lines of business and products, including property, crop, aviation, marine, personal accident and workers compensation catastrophe relies primarily on traditional loss reserving methodologies, utilizing selected paid and reported loss development factors. Our casualty insurance and casualty reinsurance lines of business include general liability risks, healthcare and professional liability risks. Claims may be reported or settled several years after the coverage period has terminated for these lines of business ("longer tail lines"), which increases uncertainties of our reserve estimates in such lines. In addition, our attachment points for these longer tail lines are often relatively high, making reserving for these lines of business more difficult than shorter tail lines due to having to estimate whether the 68
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severity of the estimated losses will exceed our attachment point. We establish a case reserve when sufficient information is gathered to make a reasonable estimate of the liability, which often requires a significant amount of information and time. Due to the lengthy reporting pattern of these casualty lines, reliance is placed on industry benchmarks supplemented by our own experience. For expected loss ratio selections, we are giving increasing consideration to our existing experience supplemented with analysis of loss trends, rate changes and experience of peer companies. Our reinsurance treaties are reviewed individually, based upon individual characteristics and loss experience emergence. Loss reserves on assumed reinsurance have unique features that make them more difficult to estimate than direct insurance. We establish loss reserves upon receipt of advice from a cedent that a reserve is merited. Our claims staff may establish additional loss reserves where, in their judgment, the amount reported by a cedent is potentially inadequate. The following are the most significant features that make estimating loss reserves on assumed reinsurance difficult:
• Reinsurers have to rely upon the cedents and reinsurance intermediaries to
report losses in a timely fashion. • Reinsurers must rely upon cedents to price the underlying business appropriately. • Reinsurers have less predictable loss emergence patterns than direct
insurers, particularly when writing excess-of-loss reinsurance.
For excess-of-loss reinsurance, cedents generally are required to report losses that either exceed 50% of the retention, have a reasonable probability of exceeding the retention or meet serious injury reporting criteria. All reinsurance claims that are reserved are reviewed at least every six months. For quota share reinsurance treaties, cedents are required to give a periodic statement of account, generally monthly or quarterly. These periodic statements typically include information regarding written premiums, earned premiums, unearned premiums, ceding commissions, brokerage amounts, applicable taxes, paid losses and outstanding losses. They can be submitted 60 to 90 days after the close of the reporting period. Some quota share reinsurance treaties have specific language regarding earlier notice of serious claims. Reinsurance generally has a greater time lag than direct insurance in the reporting of claims. The time lag is caused by the claim first being reported to the cedent, then the intermediary (such as a broker) and finally the reinsurer. This lag can be up to six months or longer in certain cases. There is also a time lag because the insurer may not be required to report claims to the reinsurer until certain reporting criteria are met. In some instances this could be several years while a claim is being litigated. We use reporting factors based on data from theReinsurance Association of America to adjust for time lags. We also use historical treaty-specific reporting factors when applicable. Loss and premium information are entered into our reinsurance system by our claims department and our accounting department on a timely basis. We record the individual case reserves sent to us by the cedents through the reinsurance intermediaries. Individual claims are reviewed by our reinsurance claims department and adjusted as deemed appropriate. The loss data received from the intermediaries is checked for reasonableness and for known events. Details of the loss listings are reviewed during routine claim audits. The expected loss ratios that we assign to each treaty are based upon analysis and modeling performed by a team of actuaries. The historical data reviewed by the team of pricing actuaries is considered in setting the reserves for each cedent. The historical data in the submissions is matched against our carried reserves for our historical treaty years. Loss reserves do not represent an exact calculation of liability. Rather, loss reserves are estimates of what we expect the ultimate resolution and administration of claims will cost. These estimates are based on actuarial and statistical projections and on our assessment of currently available data, as well as estimates of future trends in claims severity and frequency, judicial theories of liability and other factors. Loss reserve estimates are refined 69
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as experience develops and as claims are reported and resolved. In addition, the relatively long periods between when a loss occurs and when it may be reported to our claims department for our casualty insurance and casualty reinsurance lines of business increase the uncertainties of our reserve estimates in such lines. We utilize a variety of standard actuarial methods in our analysis. The selections from these various methods are based on the loss development characteristics of the specific line of business. For lines of business with long reporting periods such as casualty reinsurance, we may rely more on an expected loss ratio method (as described below) until losses begin to develop. For lines of business with short reporting periods such as property insurance, we may rely more on a paid loss development method (as described below) as losses are reported relatively quickly. The actuarial methods we utilize include: Paid Loss Development Method. We estimate ultimate losses by calculating past paid loss development factors and applying them to exposure periods with further expected paid loss development. The paid loss development method assumes that losses are paid at a consistent rate. The paid loss development method provides an objective test of reported loss projections because paid losses contain no reserve estimates. In some circumstances, paid losses for recent periods may be too varied for accurate predictions. For many coverages, especially casualty coverages, claim payments are made slowly and it may take years for claims to be fully reported and settled. These payments may be unreliable for determining future loss projections because of shifts in settlement patterns or because of large settlements in the early stages of development. Choosing an appropriate "tail factor" to determine the amount of payments from the latest development period to the ultimate development period may also require considerable judgment, especially for coverages that have long payment patterns. As we have limited payment history, we have had to supplement our paid loss development patterns with appropriate benchmarks. Reported Loss Development Method. We estimate ultimate losses by calculating past reported loss development factors and applying them to exposure periods with further expected reported loss development. Since reported losses include payments and case reserves, changes in both of these amounts are incorporated in this method. This approach provides a larger volume of data to estimate ultimate losses than the paid loss development method. Thus, reported loss patterns may be less varied than paid loss patterns, especially for coverages that have historically been paid out over a long period of time but for which claims are reported relatively early and have case loss reserve estimates established. This method assumes that reserves have been established using consistent practices over the historical period that is reviewed. Changes in claims handling procedures, large claims or significant numbers of claims of an unusual nature may cause results to be too varied for accurate forecasting. Also, choosing an appropriate "tail factor" to determine the change in reported loss from the latest development period to the ultimate development period may require considerable judgment. As we have limited reported history, we have had to supplement our reported loss development patterns with appropriate benchmarks. Expected Loss Ratio Method. To estimate ultimate losses under the expected loss ratio method, we multiply earned premiums by an expected loss ratio. The expected loss ratio is selected utilizing industry data, historical company data and professional judgment. This method is particularly useful for new lines of business where there are no historical losses or where past loss experience is not credible. Bornhuetter-Ferguson Paid Loss Method. The Bornhuetter-Ferguson paid loss method is a combination of the paid loss development method and the expected loss ratio method. The amount of losses yet to be paid is based upon the expected loss ratios and the expected percentage of losses unpaid. These expected loss ratios are modified to the extent paid losses to date differ from what would have been expected to have been paid based upon the selected paid loss development pattern. This method avoids some of the distortions that could result from a large development factor being applied to a small base of paid losses to calculate ultimate losses. This method will react slowly if actual loss ratios develop differently because of major changes in rate levels, retentions or deductibles, the forms and conditions of reinsurance coverage, the types of risks covered or a variety of other changes. Bornhuetter-Ferguson Reported Loss Method. The Bornhuetter-Ferguson reported loss method is similar to the Bornhuetter-Ferguson paid loss method with the exception that it uses reported losses and reported loss development factors. 70
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During 2012, 2011 and 2010, we adjusted our reliance on actuarial methods utilized for certain casualty lines of business and loss years within our U.S. insurance and international insurance segments from using a blend of the Bornhuetter-Ferguson reported loss method and the expected loss ratio method to using only the Bornhuetter-Ferguson reported loss method. We also began adjusting our reliance on actuarial methods utilized for certain other casualty lines of business and loss years within all of our operating segments including the reinsurance segment, by placing greater reliance on the Bornhuetter-Ferguson reported loss method than on the expected loss ratio method. Placing greater reliance on more responsive actuarial methods for certain casualty lines of business and loss years within each of our operating segments is a natural progression as we mature as a company and gain sufficient historical experience of our own that allows us to further refine our estimate of the reserve for losses and loss expenses. We believe utilizing only the Bornhuetter-Ferguson reported loss method for older loss years will more accurately reflect the reported loss activity we have had thus far in our ultimate loss ratio selections, and will better reflect how the ultimate losses will develop over time. We will continue to utilize the expected loss ratio method for the most recent loss years until we have sufficient experience to utilize other acceptable actuarial methodologies.
We expect that the trend of placing greater reliance on more responsive actuarial methods, for example from the expected loss ratio method to the Bornhuetter-Ferguson reported loss method, to continue as both (1) our loss years mature and become more statistically reliable and (2) as we build databases of our internal loss development patterns. The expected loss ratio remains a key assumption as the Bornhuetter-Ferguson methods rely upon an expected loss ratio selection and a loss development pattern selection.
The key assumptions used to arrive at our best estimate of loss reserves are the expected loss ratios, rate of loss cost inflation, selection of benchmarks and reported and paid loss emergence patterns. Our reporting factors and expected loss ratios are based on a blend of our own experience and industry benchmarks for longer tailed business and primarily our own experience for shorter tail business. The benchmarks selected were those that we believe are most similar to our underwriting business. Our expected loss ratios for shorter tail lines change from year to year. As our losses from shorter tail lines of business are reported relatively quickly, we select our expected loss ratios for the most recent years based upon our actual loss ratios for our older years adjusted for rate changes, inflation, cost of reinsurance and average storm activity. For the shorter tail lines, we initially used benchmarks for reported and paid loss emergence patterns. As we mature as a company, we have begun supplementing those benchmark patterns with our actual patterns as appropriate. For the longer tail lines, we continue to use benchmark patterns, although we update the benchmark patterns as additional information is published regarding the benchmark data. For shorter tail lines, the primary assumption that changed during both 2012 as compared to 2011 and 2011 as compared to 2010 as it relates to prior year losses was actual paid and reported loss emergence patterns were generally less severe than estimated for each year due to lower frequency and severity of reported losses. As a result of this change, we recognized net favorable prior year reserve development in both 2012 and 2011. However, we did experience significant losses on certain of our shorter tail lines related to the current loss year.
During the years ended
We will continue to evaluate and monitor the development of these losses and the impact it has on our current and future assumptions. We believe recognition of the reserve changes in the period they were recorded was appropriate since a pattern of reported losses had not emerged and the loss years were previously too immature to deviate from the expected loss ratio method in prior periods. The selection of the expected loss ratios for the longer tail lines is our most significant assumption. Due to the lengthy reporting pattern of longer tail lines, we supplement our own experience with industry benchmarks of expected loss ratios and reporting patterns in addition to our own experience. For our longer tail lines, the primary assumption that changed during both 2012 as compared to 2011 and 2011 as compared to 2010 as it 71
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relates to prior year losses was using the Bornhuetter-Ferguson loss development method for certain casualty lines of business and loss years as discussed above. This method calculated a lower projected loss ratio based on loss emergence patterns to date. As a result of the change in the expected loss ratio, we recognized net favorable prior year reserve development in 2012, 2011 and 2010. We believe that recognition of the reserve changes in the period they were recorded was appropriate since a pattern of reported losses had not emerged and the loss years were previously too immature to deviate from the expected loss ratio method in prior periods. Our overall change in the loss reserve estimates related to prior years decreased as a percentage of total carried reserves during 2012. During 2012 we had a net decrease of$170.3 million , or 4.0%, on an opening carried reserve base of$4,222.2 million , net of reinsurance recoverable. During 2011 we had a net decrease of$253.5 million , or 6.4%, on an opening carried reserve base of$3,951.6 million , net of reinsurance recoverables. We believe that these changes are reasonable given the long-tail nature of our business. There is potential for significant variation in the development of loss reserves, particularly for the casualty lines of business due to their long tail nature and high attachment points. The maturing of our casualty insurance and reinsurance loss reserves have caused us to reduce what we believe is the reasonably possible variance in the expected loss ratios for older loss years. As ofDecember 31, 2012 and 2011, we believe the reasonably possible variances in our expected loss ratio in percentage points for our loss years are as follows: As of December 31, Loss Year 2012 2011 2004 0.0 % 2.0 % 2005 2.0 % 4.0 % 2006 4.0 % 6.0 % 2007 6.0 % 8.0 % 2008 8.0 % 10.0 % 2009 10.0 % 10.0 % 2010 10.0 % 10.0 % 2011 10.0 % 10.0 % 2012 10.0 % N/A The change in the reasonably possible variance for the 2005 through 2008 loss years in 2012 compared to 2011 is due to giving greater weight to the Bornhuetter-Ferguson loss development method for additional lines of business during 2011 and additional development of losses. The total reasonably possible variance of our expected loss ratio for all loss years for our casualty insurance and casualty reinsurance lines of business was six percentage points as ofDecember 31, 2012 . Because we expect a small volume of large claims, it is more difficult to estimate the ultimate loss ratios, so we believe the variance of our loss ratio selection could be relatively wide. If our final casualty insurance and reinsurance loss ratios vary by six percentage points from the expected loss ratios in aggregate, our required net reserves after reinsurance recoverable would increase or decrease by approximately$610.6 million . Excluding the impact of income taxes, this would result in either an increase or decrease to net income and total shareholders' equity of approximately$610.6 million . As ofDecember 31, 2012 , this represented approximately 18% of total shareholders' equity. In terms of liquidity, our contractual obligations for reserves for losses and loss expenses would also increase or decrease by approximately$610.6 million after reinsurance recoverable. If our obligations were to increase, we believe we currently have sufficient cash and investments to meet those obligations. 72
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The following tables provide our ranges of loss and loss expense reserve estimates by business segment as of
Reserve for Losses and Loss Expenses Gross of Reinsurance Recoverable Carried Low High Reserves Estimate Estimate ($ in millions) U.S. insurance $ 1,898.3 $ 1,450.8 $ 2,154.2
International insurance 2,266.6 1,736.6
2,559.2 Reinsurance 1,480.6 1,164.0 1,714.1 Consolidated(1) 5,645.5 4,472.2 6,306.6 Reserve for Losses and Loss Expenses Net of Reinsurance Recoverable Carried Low High Reserves Estimate Estimate ($ in millions) U.S. insurance $ 1,380.9 $ 1,062.7 $ 1,576.9
International insurance 1,646.1 1,247.1
1,865.5 Reinsurance 1,477.4 1,161.0 1,710.7 Consolidated(1) 4,504.4 3,574.0 5,049.9
(1) For statistical reasons, it is not appropriate to add together the ranges of
each business segment in an effort to determine the low and high range around
the consolidated loss reserves.
Our range for each business segment was determined by utilizing multiple actuarial loss reserving methods along with various assumptions of reporting patterns and expected loss ratios by loss year. The various outcomes of these techniques were combined to determine a reasonable range of required loss and loss expense reserves. While we believe our approach to determine the range of loss and loss expense is reasonable, there are no assurances that actual loss experience will be within the ranges of loss and loss expense noted above. Our selection of the actual carried reserves has typically been above the midpoint of the range. As ofDecember 31, 2012 , we were 4.5% above the midpoint of the consolidated net loss reserve range. We believe that we should be prudent in our reserving practices due to the lengthy reporting patterns and relatively large limits of net liability for any one risk of our direct excess casualty business and of our casualty reinsurance business. Thus, due to this uncertainty regarding estimates for reserve for losses and loss expenses, we have carried our consolidated reserve for losses and loss expenses, net of reinsurance recoverable, above the midpoint of the low and high estimates for the consolidated net losses and loss expenses. We believe that relying on the more prudent actuarial indications is appropriate for these lines of business.
Ceded Reinsurance
We cede insurance to reinsurers in order to limit our maximum loss, to protect against concentration of risk within our portfolio and to manage our exposure to catastrophic events. Because the ceding of insurance does not discharge us from our primary obligation to the insureds, we remain liable to the extent that our reinsurers do not meet their obligations under the reinsurance agreements. Therefore, we regularly evaluate the financial condition of our reinsurers and monitor concentration of credit risk. No material provision has been made for unrecoverable reinsurance as ofDecember 31, 2012 and 2011 as we believe that all reinsurance balances will be recovered. 73
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When we reinsure a portion of our exposures, we pay reinsurers a portion of premiums received on the reinsured policies. The following table illustrates our gross premiums written, ceded premiums written and net premiums written:
Year Ended December 31, 2012 2011 2010 ($ in millions)
Gross premiums written $ 2,329.3 $ 1,939.5 $
1,758.4
Premiums ceded (491.5 ) (405.7 )
(365.9 )
Net premiums written $ 1,837.8 $ 1,533.8 $
1,392.5
Ceded as a percentage of gross 21.1 % 20.9 % 20.8 %
The following table illustrates the effect of our reinsurance ceded strategies on our results of operations: Year Ended December 31, 2012 2011 2010 ($ in millions) Ceded premiums written $ 491.5 $ 405.8 $ 365.9 Ceded premiums earned $ 440.8 $ 366.3 $ 365.3 Losses and loss expenses ceded (252.6 ) (214.6 ) (165.8 ) Acquisition costs ceded (97.3 ) (92.6 ) (81.5 ) We had net cash outflows relating to ceded reinsurance activities (premiums paid less losses recovered and net ceding commissions received) of approximately$247.5 million ,$148.3 million and$128.5 million for the years endedDecember 31, 2012 , 2011 and 2010, respectively. The net cash outflows in all years are reflective of fewer losses that were recoverable under our reinsurance coverages. Our reinsurance treaties are generally purchased on an annual basis and are therefore subject to yearly renegotiation. The treaties typically specify ceding commissions, and include provisions for required reporting to the reinsurers, responsibility for taxes, arbitration of disputes and the posting of security for the reinsurance recoverable under certain circumstances, such as a downgrade in the reinsurer's financial strength rating. The amount of risk ceded by us to reinsurers is subject to maximum limits which vary by line of business and by type of coverage. We also purchase a limited amount of facultative reinsurance, which provides cover for specified policies, rather than for whole classes of business. The examples below illustrate the types of treaty reinsurance arrangements in force atDecember 31, 2012 : • General Property: We purchased both quota share reinsurance for our
general property business written in our U.S. insurance and international
insurance segments, as well as excess-of-loss cover providing protection
for specified classes of catastrophe. We have also purchased a limited
amount of facultative reinsurance, which provides cover for specified
general property policies.
•
our general casualty business since
percentage ceded varied by both location of writing office and by limits
reinsured, with a significantly larger cession being effective for policies
above
general casualty business written in our Asian branch offices. • Professional Liability: For professional liability policies, our
reinsurance varied by writing office and by policy type. Professional
liability policies written in our
quota-share reinsured with cession percentages dependent upon location.
Additionally, the professional liability policies written in the United
States were reinsured on an excess-of-loss basis.
• Healthcare: We purchased quota share and excess-of-loss reinsurance
protection for our healthcare line of business written by our
U.S. offices, respectively. As is the case with general casualty, our healthcare business originating inAsia is under an excess-of-loss reinsurance arrangement. 74
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The following table illustrates our reinsurance recoverable as ofDecember 31, 2012 and 2011: As of December 31, 2012 2011 ($ in millions) Ceded case reserves $ 234.2 $ 196.5 Ceded IBNR reserves 906.9 806.4 Reinsurance recoverable $ 1,141.1 $ 1,002.9 As noted above, we remain obligated for amounts ceded in the event our reinsurers do not meet their obligations. Accordingly, we have evaluated the reinsurers that are providing reinsurance protection to us and will continue to monitor their credit ratings and financial stability. We generally have the right to terminate our treaty reinsurance contracts at any time, upon prior written notice to the reinsurer, under specified circumstances, including the assignment to the reinsurer byA.M. Best of a financial strength rating of less than "A-." As ofDecember 31, 2012 , approximately 99% of ceded case reserves and ceded IBNR were recoverable from reinsurers who had anA.M. Best rating of "A-" or higher. The following table shows a breakdown of our reinsurance recoverables by credit rating as ofDecember 31, 2012 : As of December 31, 2012 Reinsurance Ceded Ceded Reinsurance Recoverable A.M Best Rating: OSLR IBNR Recoverable on Paid ($ in millions) A++ $ 38.0 $ 40.1 $ 78.1 $ - A+ 83.2 356.8 440.0 33.6 A 110.1 502.6 612.7 22.0 A- - 0.7 0.7 0.9 B++ 0.7 4.5 5.2 0.3 NR 2.2 2.2 4.4 0.1 Total $ 234.2 $ 906.9 $ 1,141.1 $ 56.9 We determine what portion of the losses will be recoverable under our reinsurance policies by reference to the terms of the reinsurance protection purchased. This determination is necessarily based on the underlying loss estimates and, accordingly, is subject to the same uncertainties as the estimate of case reserves and IBNR reserves.
The following table shows our reinsurance recoverables by operating segment as of
As of December 31, 2012 2011 ($ in millions) U.S. insurance $ 517.3 $ 438.3 International insurance 620.6 564.3 Reinsurance 3.2 0.3 Total $ 1,141.1 $ 1,002.9 Historically, our reinsurance recoverables related primarily to our property lines of business, which being short tail in nature, are not subject to the same variations as our casualty lines of business. However, during 2012 and 2011 we have increased the amount of reinsurance we utilize for our casualty lines of business in the U.S. insurance and international insurance segments; and as such, the reinsurance recoverables from our casualty lines of business have increased over the past several years. 75
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Our reinsurance recoverables are subject to the same uncertainties as the estimate of case reserves and IBNR reserves. The reasonably possible variance of our expected ceded loss ratio for all loss years for our casualty insurance and casualty reinsurance lines of business was eight percentage points as ofDecember 31, 2012 . If our final casualty insurance ceded loss ratios vary by eight percentage points from the expected loss ratios in aggregate, our required reinsurance recoverable would increase or decrease by approximately$152.2 million . Excluding the impact of income taxes, this would result in either an increase or decrease to net income and shareholders' equity of approximately$152.2 million . As ofDecember 31, 2012 , this amount represented approximately 5% of total shareholders' equity.
Premiums and Acquisition Costs
Premiums are recognized as written on the inception date of a policy. For certain types of business written by us, notably reinsurance, premium income may not be known at the contract inception date. In the case of quota share reinsurance assumed by us, the underwriter makes an estimate of premium income at inception as the premium income is typically derived as a percentage of the underlying policies written by the cedents. The underwriter's estimate is based on statistical data provided by reinsureds and the underwriter's judgment and experience. Such estimations are refined over the reporting period of each treaty as actual written premium information is reported by ceding companies and intermediaries. Management reviews estimated premiums at least quarterly and any adjustments are recorded in the period in which they become known. As ofDecember 31, 2012 , our changes in quota share premium estimates have been adjustments of 10%, 0% and (7)% for the 2011, 2010 and 2009 treaty years, respectively. For the 2012 treaty year, a 5% change in our premium estimate would cause gross premiums written in our reinsurance segment to increase or decrease by$13.8 million over the next three years. There would also be a related increase or decrease in loss and loss expenses and acquisition costs due to the increase or decrease in gross premiums written.
Total premiums estimated on quota share reinsurance contracts for the years ended
Other insurance and reinsurance policies can require that the premium be adjusted at the expiry of a policy to reflect the risk assumed by us. Premiums resulting from such adjustments are estimated and accrued based on available information.
Fair Value of Financial Instruments
In accordance with U.S. GAAP, we are required to recognize certain assets at their fair value in our consolidated balance sheets. This includes our fixed maturity investments and other invested assets. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There is a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon whether the inputs to the valuation of an asset or liability are observable or unobservable in the market at the measurement date, with quoted market prices being the highest level (Level 1) and unobservable inputs being the lowest level (Level 3). A fair value measurement will fall within the level of the hierarchy based on the input that is significant to determining such measurement. The three levels are defined as follows: • Level 1: Observable inputs to the valuation methodology that are quoted prices (unadjusted) for identical assets or liabilities in active markets.
• Level 2: Observable inputs to the valuation methodology other than
quoted market prices (unadjusted) for identical assets or
liabilities
in active markets. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical assets in markets that are not active and inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability.
• Level 3: Inputs to the valuation methodology which are unobservable
for the asset or liability. 76
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At each measurement date, we estimate the fair value of the financial instruments using various valuation techniques. We utilize, to the extent available, quoted market prices in active markets or observable market inputs in estimating the fair value of our financial instruments. When quoted market prices or observable market inputs are not available, we utilize valuation techniques that rely on unobservable inputs to estimate the fair value of financial instruments. The following describes the valuation techniques we used to determine the fair value of financial instruments held as ofDecember 31, 2012 and what level within the U.S. GAAP fair value hierarchy the valuation technique resides. U.S. government and U.S. government agencies: Comprised primarily of bonds issued by the U.S. Treasury, theFederal Home Loan Bank , the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association. The fair values of U.S. government securities are based on quoted market prices in active markets, and are included in the Level 1 fair value hierarchy. We believe the market for U.S. Treasury securities is an actively traded market given the high level of daily trading volume. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are included in the Level 2 fair value hierarchy.
Non-U.S. government and government agencies: Comprised of fixed income obligations of non-U.S. governmental entities. The fair values of these securities are based on prices obtained from international indices and are included in the Level 2 fair value hierarchy.
States, municipalities and political subdivisions: Comprised of fixed income obligations of U.S. domiciled state and municipality entities. The fair values of these securities are based on prices obtained from the new issue market, and are included in the Level 2 fair value hierarchy. Corporate debt: Comprised of bonds issued by corporations that are diversified across a wide range of issuers and industries. The fair values of corporate bonds that pay a floating rate coupon are priced using the spread above the London Interbank Offered Rate yield curve and the fair values of corporate bonds that are long term are priced using the spread above the risk-free yield curve. The spreads are sourced from broker-dealers, trade prices and the new issue market. As the significant inputs used to price corporate bonds are observable market inputs, the fair values of corporate bonds are included in the Level 2 fair value hierarchy. Mortgage-backed: Principally comprised of residential and commercial mortgages originated by both U.S. government agencies (such as the Federal National Mortgage Association) and non-U.S. government agency originators. The fair values of mortgage-backed securities originated by U.S. government agencies and non-U.S. government agencies are based on a pricing model that incorporates prepayment speeds and spreads to determine the appropriate average life of mortgage-backed securities. The spreads are sourced from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the mortgage-backed securities are observable market inputs, the fair values of these securities are included in the Level 2 fair value hierarchy, unless the significant inputs used to price the mortgage-backed securities are broker-dealer quotes and we are not able to determine if those quotes are based on observable market inputs, in which case the fair value is included in the Level 3 fair value hierarchy. Asset-backed: Principally comprised of bonds backed by pools of automobile loan receivables, home equity loans, credit card receivables and collateralized loan obligations originated by a variety of financial institutions. The fair values of asset-backed securities are priced using prepayment speed and spread inputs that are sourced from the new issue market or broker-dealer quotes. As the significant inputs used to price the asset-backed securities are observable market inputs, the fair values of these securities are included in the Level 2 fair value hierarchy, unless the significant inputs used to price the asset-backed securities are broker-dealer quotes and we are not able to determine if those quotes are based on observable market inputs, in which case the fair value is included in the Level 3 fair value hierarchy. 77
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Equity securities: Comprised of U.S. and foreign common and preferred stocks and mutual funds. Equities are generally included in the Level 1 fair value hierarchy as prices are obtained from market exchanges in active markets. Foreign mutual funds where the net asset value is not provided on a daily basis are included in the Level 3 fair value hierarchy. Other invested assets: Comprised of funds invested in a range of diversified strategies. In accordance with U.S. GAAP, the fair values of the funds are based on the net asset value of the funds as reported by the fund manager that the Company believes is an unobservable input, and as such, the fair values of those funds are included in the Level 3 fair value hierarchy. The Company does not measure its investments that are accounted for using the equity method of accounting at fair value.
Derivative instruments: The fair value of foreign exchange contracts and interest rate futures are priced from quoted market prices for similar exchange-traded derivatives and pricing valuation models that utilize independent market data inputs. The fair value of derivatives are included in the Level 2 fair value hierarchy.
Senior notes: The fair value of the senior notes is based on trades as reported inBloomberg . The fair value of the senior notes is included in the Level 2 fair value hierarchy.
The following table shows the pricing sources of our fixed maturity investments held as of
As of December 31, 2012 As of December 31, 2011 Fair Value Fair Value Percentage Hierarchy Percentage Hierarchy Fair Value of Total Level Fair Value of Total Level ($ in millions) ($ in millions)
Barclays indices $ 4,001.6 60.4 % 1 and 2 $ 4,044.1 62.2 % 1 and 2 Reuters pricing service 821.5 12.4 % 2 458.8 7.1 % 2 Interactive Data Pricing 622.6 9.4 % 2 996.5 15.3 % 2 Merrill Lynch indices 272.5 4.1 % 2 160.0 2.5 % 2 Broker-dealer quotes 230.1 3.5 % 3 343.9 5.3 % 3 International indices 122.4 1.8 % 2 115.4 1.8 % 2 Other sources 555.8 8.4 % 2 380.0 5.8 % 2 $ 6,626.5 100.0 % $ 6,498.7 100.0 % Barclays indices: We use Barclays indices to price our U.S. government, U.S. government agencies, corporate debt, agency and non-agency mortgage-backed and asset-backed securities. There are several observable inputs that the Barclays indices use in determining its prices which include among others, treasury yields, new issuance and secondary trades, information provided by broker-dealers, security cash flows and structures, sector and issuer level spreads, credit rating, underlying collateral and prepayment speeds. For U.S. government securities, traders that act as market makers are the primary source of pricing; as such, for U.S. government securities we believe the Barclays indices reflect quoted prices (unadjusted) for identical securities in active markets.
Interactive Data Pricing: We use Interactive Data Pricing to price our U.S. government agencies, municipalities, non-agency mortgage-backed and asset-backed securities. There are several observable inputs that Interactive Data Pricing uses in determining its prices which include among others, benchmark yields, reported trades and issuer spreads.
Reuters pricing service: We use the Reuters pricing service to price our U.S. government agencies, corporate debt, agency and non-agency mortgage-backed and asset-backed securities. There are several observable inputs that the Reuters pricing service uses in determining its prices which include among others, option-adjusted spreads, treasury yields, new issuance and secondary trades, sector and issuer level spreads, underlying collateral and prepayment speeds. 78
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Broker-dealer quotes: We also utilize broker-dealers to price our agency and non-agency mortgage-backed and asset-backed securities. The pricing sources includeJP Morgan Securities Inc. ,Bank of America Securities LLC ,Deutsche Bank Securities Inc. and other broker-dealers. When broker-dealer quotes are utilized it is primarily due to the fact that the particular broker-dealer was involved in the initial pricing of the security.
Merrill Lynch Index: We use the Merrill Lynch indices to price our non-U.S. government and government agencies securities, corporate debt, municipalities and asset-backed securities. There are several observable inputs that the Merrill Lynch indices use in determining its prices, which include reported trades and other sources.
Standard & Poor's Securities Evaluation: We use Standard & Poor's to price our U.S. government agencies, corporate debt, municipalities, mortgage-backed and asset-backed securities. There are several observable inputs that Standard & Poor's uses in determining its prices which include among others, benchmark yields, reported trades and issuer spreads. International indices: We use international indices, which include theFTSE , Deutsche Teleborse and the Scotia Index, to price our non-U.S. government and government agencies securities. The observable inputs used by international indices to determine its prices are based on new issuance and secondary trades and information provided by broker-dealers.
Other sources: We utilize other indices and pricing services to price various securities. These sources use observable inputs consistent with indices and pricing services discussed above.
We utilize independent pricing sources to obtain market quotations for securities that have quoted prices in active markets. In general, the independent pricing sources use observable market inputs, including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, non-binding broker-dealer quotes, reported trades and sector groupings to determine the fair value. For a majority of the portfolio, we obtained two or more prices per security as ofDecember 31, 2012 . When multiple prices are obtained, a price source hierarchy is utilized to determine which price source is the best estimate of the fair value of the security. The price source hierarchy emphasizes more weighting to significant observable inputs such as index pricing and less weighting towards non-binding broker quotes. In addition, to validate all prices obtained from these pricing sources including non-binding broker quotes, we also obtain prices from our investment portfolio managers and other sources (e.g., another pricing vendor), and compare the prices obtained from the independent pricing sources to those obtained from our investment portfolio managers and other sources. We investigate any material differences between the multiple sources and determine which price best reflects the fair value of the individual security. There were no material differences between the prices from the independent pricing sources and the prices obtained from our investment portfolio managers and other sources as ofDecember 31, 2012 . There have been no material changes to any of our valuation techniques from those used as ofDecember 31, 2011 . Based on all reasonably available information received, we believe the prices that were obtained from inactive markets were orderly transactions and therefore, reflected the current price a market participant would pay for the asset. Since fair valuing a financial instrument is an estimate of what a willing buyer would pay for our asset if we sold it, we will not know the ultimate value of our financial instruments until they are sold. We believe the valuation techniques utilized provide us with the best estimate of the price that would be received to sell our assets in an orderly transaction between participants at the measurement date. 79
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Goodwill and Other Intangible Asset Impairment Valuation
We classify intangible assets into three categories: (1) intangible assets with finite lives subject to amortization; (2) intangible assets with indefinite lives not subject to amortization and (3) goodwill. Intangible assets, other than goodwill, consist of renewal rights, internally generated software, non-compete covenants and insurance licenses held by subsidiaries domiciled inthe United States . The following is a summary of our goodwill and other intangible assets as ofDecember 31, 2012 and 2011: Carrying Value Year Finite or Estimated Useful As of December, 31, Source of Goodwill or Intangible Asset Acquired Indefinite Life 2012 2011 ($ in millions) Goodwill(1) 2008 Indefinite N/A $ 3.9 $ 3.9 Goodwill(2) 2008 Indefinite N/A 264.5 264.5 Total goodwill $ 268.4 $ 268.4 Insurance licenses(3) 2002 Indefinite N/A $ 3.9 $ 3.9 Insurance licenses(1) 2008 Indefinite N/A 12.0 12.0 Insurance licenses(2) 2008 Indefinite N/A 8.0 8.0 Distribution network(2) 2008 Finite 15 years 27.5 30.0 Total intangible assets $ 51.4 $ 53.9
(1) Related to the acquisition of
(2) Related to the acquisition of Darwin
(3) Related to the acquisition of
For intangible assets with finite lives, the value is amortized over their useful lives. We also test intangible assets with finite lives for impairment if conditions exist that indicate the carrying value may not be recoverable. Such factors include, but are not limited to: • A significant decrease in the market price of the intangible asset; • A significant adverse change in the extent or manner in which the intangible asset is being used or in its physical condition;
• A significant adverse change in legal factors or in the business climate
that could affect the value of the intangible asset, including an adverse
action or assessment by a regulator;
• An accumulation of costs significantly in excess of the amount originally
expected for the acquisition or construction of the intangible asset;
• A current-period operating or cash flow loss combined with a history of
operating or cash flow losses or a projection or forecast that demonstrates
continuing losses associated with the use of the intangible asset; and
• A current expectation that, more likely than not, the intangible asset will
be sold or otherwise disposed of significantly before the end of its previously estimated useful life. As a result of our evaluation, we determined that there was no impairment to the carrying value of our intangible assets with finite lives for the year endedDecember 31, 2012 . For indefinite lived intangible assets we do not amortize the intangible asset but test these intangible assets for impairment by comparing the fair value of the assets to their carrying values on an annual basis or more frequently if circumstances warrant. The factors we consider to determine if an impairment exists are similar to factors noted above. As a result of our evaluation, we determined that there was no impairment to the carrying value of our indefinite lived intangible assets for the year endedDecember 31, 2012 . 80
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Goodwill represents the excess of the cost of acquisitions over the fair value of net assets acquired and is not amortized. Goodwill is assigned at acquisition to the applicable reporting unit(s) based on the expected benefit to be received by the reporting unit(s) from the business combination. We determine the expected benefit based on several factors including the purpose of the business combination, the strategy of the company subsequent to the business combination and structure of the acquired company subsequent to the business combination. A reporting unit is a component of our business that has discrete financial information which is reviewed by management. In determining the reporting unit, we analyze the inputs, processes, outputs and overall operating performance of the reporting unit. We have determined that the goodwill arising from the acquisition of Darwin should be allocated to the U.S. insurance segment reporting unit as the assets employed and the liabilities relate to the U.S. insurance operations. All the insurance operations of Darwin are included into the U.S. insurance segment. For goodwill, we perform an impairment test annually, or more frequently if circumstances warrant. We may first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The results of the qualitative assessment will determine if an entity needs to proceed with the two-step goodwill impairment test. The first step of the goodwill impairment test is to compare the fair value of the reporting unit with its carrying value, including goodwill. If the carrying amount of the reporting unit exceeds its fair value then the second step of the goodwill impairment test is performed. In determining the fair value of the reporting units discounted cash flow models and market multiple models are utilized. The discounted cash flow models apply a discount to projected cash flows including a terminal value calculation. The market multiple models apply earnings and book value multiples of similar publicly-traded companies to the reporting unit's projected earnings or book value. We select the weighting of the models utilized to determine the fair value of the reporting units based on judgment, considering such factors as the reliability of the cash flow projections and the entities included in the market multiples. The second step of the goodwill impairment test compares the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill in order to determine the amount of impairment to be recognized. The implied fair value of goodwill is determined by deducting the fair value of a reporting unit's identifiable assets and liabilities from the fair value of the reporting unit as a whole. The excess of the carrying value of goodwill above the implied goodwill, if any, would be recognized as an impairment charge in "amortization and impairment of intangible assets" in the consolidated income statements.
During 2012, we elected to bypass the qualitative assessment and performed the first step of the goodwill impairment testing on the goodwill.
While we believe that the U.S. insurance segment reporting unit is not at risk of failing step one of the goodwill impairment test, the process of determining whether or not an asset, such as goodwill, is impaired or recoverable relies on projections of future cash flows, operating results and market conditions. Such projections are inherently uncertain and, accordingly, actual future cash flows may differ materially from projected cash flows. In evaluating the recoverability of goodwill, we perform a discounted cash flow analysis. The discounted cash value may be different from the fair value that would result from an actual transaction between a willing buyer and a willing seller. Such analyses are particularly sensitive to changes in discount rates and investment rates. Changes to these rates might result in material changes in the valuation and determination of the recoverability of goodwill. For example, an increase in the rate used to discount cash flows will decrease the discounted cash value. There is likely to be a similar, but not necessarily as large as, increase in the investment rate used to project the cash flows resulting from investment income earned on our investments. Accordingly, an increase in the investment rate would increase the discounted cash value. Based on our analysis, the point estimate fair value of the U.S. insurance segment reporting unit was in excess of its carrying value by approximately 30% as of theSeptember 30, 2012 measurement date. As a result, we concluded there was no implied goodwill impairment, and therefore, no step two goodwill impairment testing was required. 81
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Results of Operations
The following table sets forth our selected consolidated statement of operations data for each of the periods indicated.
Year Ended December 31, 2012 2011 2010 ($ in millions) Revenues Gross premiums written $ 2,329.3 $ 1,939.5 $ 1,758.4 Net premiums written $ 1,837.8 $ 1,533.8 $ 1,392.4 Net premiums earned $ 1,748.9 $ 1,457.0 $ 1,359.5 Net investment income 167.1 195.9 244.1 Net realized investment gains 306.4 10.1
285.6
Net impairment charges recognized in earnings - - (0.2 ) Other income - 101.7 0.9 $ 2,222.4 $ 1,764.7 $ 1,889.9 Expenses Net losses and loss expenses $ 1,139.3 $ 959.2 $ 707.9 Acquisition costs 205.7 167.3 159.5 General and administrative expenses 307.3 271.6
286.5
Amortization of intangible assets 2.5 3.0 3.5 Interest expense 55.4 55.0 40.2 Foreign exchange loss 0.8 3.1 0.4 $ 1,711.0 $ 1,459.2 $ 1,198.0 Income before income taxes 511.4 305.5 691.9 Income tax expense 18.4 31.0 26.9 Net income $ 493.0 $ 274.5 $ 665.0 Ratios Loss and loss expense ratio 65.1 % 65.8 % 52.1 % Acquisition cost ratio 11.8 % 11.5 % 11.7 % General and administrative expense ratio 17.6 % 18.6 % 21.1 % Expense ratio 29.4 % 30.1 % 32.8 % Combined ratio 94.5 % 95.9 % 84.9 % 82
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Comparison of Years Ended
Premiums
Gross premiums written increased by
• Gross premiums written in our U.S. insurance segment increased by $155.3
million, or 18.5%. The increase in gross premiums written was primarily due
to increased new business across most lines, growth from new products
introduced since 2010, and rate increases in all lines of business. This
growth was partially offset by non-recurring business, the non-renewal of
business that did not meet our underwriting requirements (which included
inadequate pricing and/or terms and conditions) and continued competition;
• Gross premiums written in our international insurance segment increased by
$44.7 million , or 8.4%, primarily as a result of increased premiums from new products and rate increases in select lines of business. This growth
was partially offset by non-recurring business, the non-renewal of business
that did not meet our underwriting requirements (which included inadequate
pricing and/or terms and conditions) and continued competition; and • Gross premiums written in our reinsurance segment increased by $189.8
million, or 33.3%. The increase in gross premiums written was primarily due
to new business, both from new products and new regions, as well as
increased participations on renewing business combined with rate increases
in select regions and lines of business. This growth was partially offset by the non-renewal of business that did not meet our underwriting requirements (which included inadequate pricing and/or terms and conditions) and continued competition.
The table below illustrates our gross premiums written by geographic location for each of the years indicated.
Year Ended December 31, Dollar Percentage 2012 2011 Change Change ($ in millions) United States $ 1,360.2 $ 1,080.1 $ 280.1 25.9 % Bermuda 611.4 565.8 45.6 8.1 % Europe 228.8 210.4 18.4 8.7 % Singapore 111.7 68.4 43.3 63.3 % Hong Kong 17.2 14.8 2.4 16.2 % $ 2,329.3 $ 1,939.5 $ 389.8 20.1 % Net premiums written increased by$304.0 million , or 19.8%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The increase in net premiums written was due to the increase in gross premiums written. The difference between gross and net premiums written is the cost to us of purchasing reinsurance coverage, including the cost of property catastrophe reinsurance coverage. We ceded 21.1% of gross premiums written for the year endedDecember 31, 2012 compared to 20.9% in 2011. Net premiums earned increased by$291.9 million , or 20.0%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 consistent with the higher net premiums written in 2012. 83
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We evaluate our business by segment, distinguishing between U.S. insurance, international insurance and reinsurance. The following table illustrates the mix of our business on both a gross premiums written and net premiums earned basis. Gross Premiums Written Net Premiums Earned Year Ended December 31, Year Ended December 31, 2012 2011 2012 2011 U.S. insurance 42.7 % 43.2 % 38.4 % 40.1 % International insurance 24.7 % 27.3 % 19.3 % 21.8 % Reinsurance 32.6 % 29.5 % 42.3 % 38.1 % Total 100.0 % 100.0 % 100.0 % 100.0 % Net Investment Income Net investment income decreased by$28.8 million , or 14.7%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The decrease was due to lower yields on our fixed maturity investments as well as an increased allocation to other invested assets, which contribute to our total return but carry little or no current yield. As ofDecember 31, 2012 , we held 8.9% of our total investments and cash equivalents in other invested assets compared to 6.7% as ofDecember 31, 2011 . The book yield of the investment portfolio for the years endedDecember 31, 2012 and 2011 was 2.1% and 2.5%, respectively. The decrease in the book yield was due to the reinvestment of cash at lower rates and an increased allocation to lower risk asset classes combined with lower market yields. As ofDecember 31, 2012 , we held 21.2% of our total investments and cash equivalents in U.S. government or government agency securities, compared to 16.1% as ofDecember 31, 2011 . Cash and cash equivalents also increased to 9.8% of total investments and cash equivalents as compared to 8.8% as ofDecember 31, 2011 . Our average duration increased from 1.9 years as ofDecember 31, 2011 to 2.1 years as ofDecember 31, 2012 . Investment management expenses of$16.5 million and$14.2 million were incurred during the years endedDecember 31, 2012 and 2011, respectively. The increase in investment management expenses was primarily due to the increase in the size of our investment portfolio, as well as expenses from higher expense asset classes.
Realized Investment Gains
Net realized investment gains were comprised of the following:
Year EndedDecember 31, 2012 2011 ($ in millions)
Gross realized gains on sale of invested assets
Gross realized losses on sale of invested assets (51.7 ) (62.1 )
Net realized gains on sale of invested assets 131.9
92.8
Net realized and unrealized losses on derivatives (3.6 ) (70.1 )
Mark-to-market changes:
Debt securities, trading 106.3
(8.1 )
Other invested assets and equity securities 71.8
(4.5 )
Total mark-to-market changes 178.1
(12.6 )
Net realized investment gains $ 306.4 $
10.1
During the years endedDecember 31, 2012 and 2011, we did not recognize any net impairment charges. The total return of our investment portfolio was 5.5% and 2.0% for the years endedDecember 31, 2012 and 2011, respectively. 84
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The investment portfolio return for the year endedDecember 31, 2012 benefited from the favorable financial, economic and business environment during the year and the absence of significant market events. Equity markets performed well, with the S&P 500 up over 13% during the year. Fixed income securities also benefited from the U.S. Federal Reserve's continued quantitative easing, resulting in spreads tightening during the year. The investment portfolio return for the year endedDecember 31, 2011 was negatively impacted by the credit downgrade of the U.S. Treasury and related securities in earlyAugust 2011 and the economic and political turmoil surrounding European sovereign and bank credit risk. The combination of these and other events caused investors to seek safe havens in specific sovereign risks, such as the U.S.,Switzerland ,Germany andJapan , while selling riskier asset classes, such as equities, corporate bonds and mortgage bonds, and driving down prices. As a result U.S. and European risk-free interest rates decreased and credit spreads widened. Equity markets were relatively flat over the full year of 2011, despite volatility during the year.
Other Income
There was no other income for the year endedDecember 31, 2012 . The other income of$101.7 million for the year endedDecember 31, 2011 represented a termination fee from our previously announced merger agreement with Transatlantic.
Net Losses and Loss Expenses
Net losses and loss expenses increased by$180.1 million , or 18.8%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The loss and loss expense ratio decreased by 0.7 percentage points for the same period. The increase in net losses and loss expenses was due to the growth in net premiums earned and lower prior year net favorable reserve development. This was partially offset by lower property catastrophe losses in 2012 compared to 2011. During the year endedDecember 31, 2012 , we incurred$179.6 million of catastrophe-related losses, of which$175.7 million related to Superstorm Sandy and$3.9 million related to Hurricane Isaac. During the year endedDecember 31, 2011 , we incurred$292.2 million of catastrophe-related losses, of which$96.5 million related to the Tohoku earthquake and tsunami,$58.6 million related to theNew Zealand earthquake,$53.7 million related to the Midwestern U.S. storms,$43.0 million related to theThailand floods,$23.7 million related to Hurricane Irene and$16.7 million related to the Australian storms. Excluding the prior year reserve development, property catastrophe losses and the impact of the commutation, the loss and loss expense ratios would have been 64.5% and 62.9% for the years endedDecember 31, 2012 and 2011, respectively. The increase was primarily due to the$36.4 million in crop reinsurance losses for the year endedDecember 31, 2012 that increased the loss and loss expense ratio by 2.1 percentage points. Year Ended Year Ended Change in December 31, 2012 December 31, 2011 Dollar Percentage Amount % of NPE (1) Amount % of NPE (1)(2) Change Points ($ in millions) Non-catastrophe $ 1,130.0 64.5 % $ 909.0 62.9 % $ 221.0 1.6 Pts Property catastrophe 179.6 10.3 292.2 20.2 (112.6 ) (9.9 ) Current year 1,309.6 74.8 1,201.2 83.1 108.4 (8.3 ) Prior year (170.3 ) (9.7 ) (253.5 ) (17.5 ) 83.2 7.8 Impact of commutation (3) - - 11.5 0.2 (11.5 ) (0.2 ) Net losses and loss expenses $ 1,139.3 65.1 % $ 959.2 65.8 % $ 180.1 (0.7 )Pts
(1) "NPE" means net premiums earned.
(2) Current year and prior year losses as a % of NPE are calculated excluding the
effect of the commutation on net premiums earned. 85
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Table of Contents (3) Reflects the impact of the commutation of prior year contracts in the year
ended
expenses by
We recorded net favorable reserve development related to prior years of$170.3 million during the year endedDecember 31, 2012 compared to net favorable reserve development of$253.5 million for the year endedDecember 31, 2011 , as shown in the tables below.
(Favorable) and
For the Year Ended December 31, 2012 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Total ($ in millions) U.S. insurance $ (0.6 ) $ 0.5 $ (2.2 ) $
(5.4 ) $ (19.3 ) $ (28.6 ) $ (6.0 ) $ (3.0 )
5.2 (4.0 ) (6.3 ) (3.8 ) (54.4 ) (42.3 ) (21.7 ) (4.9 ) (6.9 ) 16.1 (123.0 ) Reinsurance (0.3 ) (0.1 ) (0.5 ) (2.0 ) (8.0 ) (19.9 ) (7.2 ) (0.0 ) 5.5 2.1 (30.4 ) $ 4.3 $ (3.6 ) $ (9.0 ) $ (11.2 ) $ (81.7 ) $ (90.8 ) $ (34.9 ) $ (7.9 ) $ 11.1 $ 53.4 $ (170.3 ) The net favorable reserve development is a result of actual loss emergence being lower than anticipated. The unfavorable reserve development in our U.S. insurance segment for the 2010 and 2011 loss years was primarily due to adverse development of$25.1 million on a program that commenced writing in 2008 and was terminated during 2011. We also experienced adverse development for the 2011 loss year for certain errors and omissions products. The unfavorable reserve development in our international insurance segment for the 2011 loss year was due to adverse development on an individual claim, estimated to reach our full limit of$20.0 million , net of reinsurance. (Favorable)
and
For the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) U.S. insurance $ (0.4 ) $ (2.9 ) $ (4.6 ) $
(20.5 )
0.8 4.1 (6.7 ) (33.3 ) (45.3 ) (40.5 ) (14.6 ) (10.1 ) 27.1 (118.5 ) Reinsurance (0.4 ) (2.5 ) (10.9 ) (35.6 ) (16.0 ) (20.7 ) (2.3 ) (10.8 ) (12.6 ) (111.8 ) $ - $ (1.3 ) $ (22.2 ) $ (89.4 ) $ (42.2 ) $ (68.8 ) $ (21.6 ) $ (28.1 ) $ 20.1 $ (253.5 ) The unfavorable reserve development of$19.1 million in our U.S. insurance segment for the 2006 loss year was primarily due to directors and officers claims within our professional liability line of business related to a class action suit filed against a number of private equity firms alleging collusion. The unfavorable reserve development in our international insurance segment for the 2010 loss year was primarily due to a casualty claim emanating from an oil field services risk.
The following table shows the components of net losses and loss expenses for the years ended
Year Ended December 31, Dollar 2012 2011 Change ($ in millions) Net losses paid $ 861.0 $ 684.8 $ 176.2
Net change in reported case reserves 131.0 213.3
(82.3 )
Net change in IBNR 147.3 61.1
86.2
Net losses and loss expenses $ 1,139.3 $ 959.2
$ 180.1 86
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The table below is a reconciliation of the beginning and ending reserves for losses and loss expenses. Losses incurred and paid are reflected net of reinsurance recoverables: Year EndedDecember 31, 2012 2011 ($ in millions)
Net reserves for losses and loss expenses,
Incurred related to:
Commutation of variable rated reinsurance contracts -
11.5
Current year non-catastrophe 1,130.0
909.0
Current year property catastrophe 179.6 292.2 Prior year (170.3 ) (253.5 ) Total incurred 1,139.3 959.2 Paid related to: Current year non-catastrophe 99.1
72.1
Current year property catastrophe 18.1 70.1 Prior year 743.8 542.6 Total paid 861.0 684.8 Foreign exchange revaluation 3.9
(3.8 )
Net reserve for losses and loss expenses,
Losses and loss expenses recoverable 1,141.1
1,002.9
Reserve for losses and loss expenses,
Acquisition Costs Acquisition costs increased by$38.4 million , or 23.0%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The increase in acquisition costs was primarily due to the increase in net premiums earned. Acquisition costs as a percentage of net premiums earned were 11.8% for the year endedDecember 31, 2012 compared to 11.5% for 2011. The increase is due to the growth in our reinsurance segment, which has a higher acquisition cost ratio.
General and Administrative Expenses
General and administrative expenses increased by$35.7 million , or 13.1%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The increase in general and administrative expenses was primarily due to increased salary and related costs as average headcount increased by 9.6% to support our continued growth, combined with increased stock compensation expense resulting from the 25.2% increase in our share price during the year and higher performance-based compensation expense as profitability exceeded target levels. Our general and administrative expense ratio was 17.6% for the year endedDecember 31, 2012 compared to 18.6% for the year endedDecember 31, 2011 . The decrease was due to the growth in net premiums earned being greater than the increase in expenses, primarily due to the growth in our reinsurance segment, which has a lower general and administrative expense ratio. The expense ratio is the sum of the acquisition cost ratio and the general and administrative expense ratio. Our expense ratio was 29.4% for the year endedDecember 31, 2012 compared to 30.1% for the year endedDecember 31, 2011 . 87
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Amortization of Intangible Assets
The amortization of intangible assets decreased by$0.5 million , or 16.7%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The decrease is due to certain intangible assets that were fully amortized during 2011.
Interest Expense
Interest expense increased by$0.4 million , or 0.7%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The increase was due to fees associated with the termination of our$400 million unsecured credit facility onJune 7, 2012 . Income Tax Expense Corporate income tax expense or benefit is generated through our operations inBermuda ,Europe ,Hong Kong ,Singapore andthe United States . Our income tax expense or benefit may fluctuate significantly from period to period depending on the geographic distribution of pre-tax net income or loss in any given period between different jurisdictions with different tax rates. The geographic distribution of pre-tax net income or loss can vary significantly between periods principally due to the geographic location of the business written, the mix of business and the profitability of such business; the geographic location of investment income; the geographic location of net losses and loss expenses incurred; and the amount of inter-company reinsurance utilized for rating agency purposes. Income tax expense decreased by$12.6 million for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The decrease is due to the lower income before income taxes inthe United States due to the losses from Superstorm Sandy and the drought inthe United States . In addition, the year endedDecember 31, 2011 Switzerland of approximately$90.6 million due to the merger termination fee income received.
Net Income
Net income for the year endedDecember 31, 2012 was$493.0 million compared to$274.5 million for the year endedDecember 31, 2011 . The$218.5 million increase was primarily the result of lower catastrophe losses of$112.6 million , combined with the$296.3 million increase in our realized investment gains as markets and economic conditions rebounded during the year.
Comparison of Years Ended
Premiums
Gross premiums written increased by
• Gross premiums written in our U.S. insurance segment increased by $109.3
million, or 15.0%. The increase in gross premiums written was primarily due
to increased new business, including from new products, for the year ended
was partially offset by the non-renewal of business that did not meet our
underwriting requirements (which included inadequate pricing and/or terms and conditions) and increased competition. 88
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• Gross premiums written in our international insurance segment increased by
and healthcare lines and new business including new products. This growth
was partially offset by the non-renewal of business that did not meet our
underwriting requirements (which included inadequate pricing and/or terms and conditions) and increased competition.
• Gross premiums written in our reinsurance segment increased by $46.3
million, or 8.8%. The increase in gross premiums written was primarily due
to increased new business, including gross premiums written by our new global marine and specialty division and the continued build-out of our
international platform, particularly in
offset by the non-renewal of business that did not meet our underwriting
requirements (which included inadequate pricing and/or terms and
conditions).
The table below illustrates our gross premiums written by geographic location for each of the years indicated.
Year Ended December 31, Dollar Percentage 2011 2010 Change Change ($ in millions) United States $ 1,080.1 $ 993.5 $ 86.6 8.7 % Bermuda 565.8 545.6 20.2 3.7 % Europe 210.4 193.0 17.4 9.0 % Singapore 68.4 17.0 51.4 302.4 % Hong Kong 14.8 9.3 5.5 59.1 % $ 1,939.5 $ 1,758.4 $ 181.1 10.3 % Net premiums written increased by$141.4 million , or 10.2%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The increase in net premiums written was primarily due to the increase in gross premiums written. During the year endedDecember 31, 2011 , premiums ceded were reduced by$12.4 million due to the commutation of certain variable-rated reinsurance contracts that have swing-rated provisions. A "swing-rated" reinsurance contract links the ultimate amount of ceded premium to the ultimate loss ratio on the reinsured business. It enables the cedent to retain a greater portion of premium if the ultimate loss ratio develops at a level below the initial loss threshold set by the reinsurers, but requires a higher amount of ceded premium if the ultimate loss ratio develops above the initial threshold. In commuting these swing-rated reinsurance contracts, we reduced certain premiums previously ceded and also reduced ceded IBNR by$11.5 million in accordance with the terms of the contracts. During the year endedDecember 31, 2010 , net premiums written included a$9.3 million reduction in premiums ceded for the commutation of certain variable-rated reinsurance contracts.
The difference between gross and net premiums written is the cost to us of purchasing reinsurance coverage, including the cost of property catastrophe reinsurance coverage. We ceded 20.9% of gross premiums written for the year ended
Net premiums earned increased by$97.5 million , or 7.2%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 as a result of higher net premiums earned for the U.S. insurance and reinsurance segments. This is driven by increased net premiums written in the current and prior periods, as well as the impact of the commutation of the swing-rated reinsurance contracts, which are fully earned. 89
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The following chart illustrates the mix of our business on both a gross premiums written and net premiums earned basis.
Gross Premiums Net Premiums Written Earned Year Ended December 31, Year Ended December 31, 2011 2010 2011 2010 U.S. insurance 43.3 % 41.5 % 40.1 % 38.1 % International insurance 27.3 % 28.7 % 21.8 % 24.9 % Reinsurance 29.4 % 29.8 % 38.1 % 37.0 % Total 100.0 % 100.0 % 100.0 % 100.0 % Net Investment Income Net investment income decreased by$48.2 million , or 19.7%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The decrease was due to lower yields on our fixed maturity investments as well as an increased allocation to equity securities and other invested assets which contribute to our total return but carry little or no current yield. We increased our equity and other invested assets by$385.3 million betweenDecember 31, 2011 andDecember 31, 2010 . The book yield of the investment portfolio for the years endedDecember 31, 2011 and 2010 was 2.5% and 3.3%, respectively. Investment management expenses of$14.2 million and$11.7 million were incurred during the years endedDecember 31, 2011 and 2010, respectively. The increase in investment management expenses was due to the increase in the size of our investment portfolio as well as expenses from higher expense asset classes (equities). As ofDecember 31, 2011 , approximately 92.6% of our fixed income investments consisted of investment grade securities. The average credit rating of our fixed income portfolio was AA - as rated by Standard & Poor's and Aa3 as rated by Moody's, with an average duration of approximately 1.9 years as ofDecember 31, 2011 . The average duration of the investment portfolio was 2.7 years as ofDecember 31, 2010 .
Net Realized Investment Gains and Net Impairment Charges Recognized in Earnings
Net realized investment gains were comprised of the following:
Year EndedDecember 31, 2011 2010 ($ in millions)
Gross realized gains on sale of invested assets
Gross realized losses on sale of invested assets (62.1 ) (26.6 )
Net realized gains on sale of invested assets 92.8 215.8
Net realized and unrealized losses on derivatives (70.1 ) (4.0 )
Mark-to-market changes:
Debt securities, trading (8.1 )
42.2
Other invested assets and equity securities (4.5 )
29.7
Total mark-to-market changes (12.6 )
71.9
Gain on sale of Program Administrator -
1.9
Net realized investment gains $ 10.1 $
285.6
During the year endedDecember 31, 2011 , we did not recognize any net impairment charges compared to$0.2 million in net impairment charges recognized in earnings during the year endedDecember 31, 2010 . InJuly 2010 , the Company sold its program administrator and wholesale brokerage operations for$2.4 million in cash. The total return of our investment portfolio was 2.0% and 6.1% for the years endedDecember 31, 2011 and 2010, respectively. 90
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Other Income
The other income of
The other income of$0.9 million for the year endedDecember 31, 2010 represents fee income from our program administrator operations and wholesale brokerage operations. We sold these operations during the year endedDecember 31, 2010 .
Net Losses and Loss Expenses
Net losses and loss expenses increased by$251.3 million , or 35.5%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The loss and loss expense ratio increased by 13.7 percentage points for the same period. The increase in net losses and loss expenses was due to lower prior year net favorable reserve development and higher property catastrophe losses in 2011 compared to 2010. During the year endedDecember 31, 2011 , we incurred$292.2 million of catastrophe-related losses, of which$96.5 million related to the Tohoku earthquake and tsunami,$58.6 million related to theNew Zealand earthquake,$53.7 million related to the Midwestern U.S. storms,$43.0 million related to theThailand floods,$23.7 million related to Hurricane Irene and$16.7 million related to the Australian storms. During the year endedDecember 31, 2010 , we incurred$98.4 million of catastrophe-related losses, of which$66.8 million was from the Chilean earthquake,$17.0 million</money> from the New Zealand earthquake and$14.6 million from the Australian floods. Excluding the prior year reserve development, property catastrophe losses and the impact of the commutations, the loss and loss expense ratios would have been 62.9% and 67.7% for the years endedDecember 31, 2011 and 2010, respectively. Year Ended Year Ended Change in December 31, 2011 December 31, 2010 Dollar Percentage Amount % of NPE(2) Amount % of NPE(2) Change Points ($ in millions) Non-catastrophe $ 909.0 62.9 % $ 913.9 67.7 % $ (4.9 ) (4.8 )Pts Property catastrophe 292.2 20.2 98.4 7.3 193.8 12.9 Current year 1,201.2 83.1 1,012.3 75.0 188.9 8.1 Prior year (253.5 ) (17.5 ) (313.3 ) (23.2 ) 59.8 5.7 Impact of commutation(1) 11.5 0.2 8.9 0.3 2.6 (0.1 ) Net losses and loss expenses $ 959.2 65.8 % $ 707.9 52.1 % $ 251.3 13.7Pts
(1) Reflects the impact of the commutation of prior year contracts in the years
ended
loss expenses by
earned by$12.4 million and$9.3 million , respectively.
(2) Current year and prior year losses as a % of NPE are calculated excluding the
effect of the commutation on net premiums earned. 91
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We recorded net favorable reserve development related to prior years of$253.5 million and$313.3 million during the years endedDecember 31, 2011 and 2010, respectively, as shown in the tables below. (Favorable)
and
For the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) U.S. insurance $ (0.4 ) $ (2.9 ) $ (4.6 ) $
(20.5 )
0.8 4.1 (6.7 ) (33.3 ) (45.3 ) (40.5 ) (14.6 ) (10.1 ) 27.1 (118.5 ) Reinsurance (0.4 ) (2.5 ) (10.9 ) (35.6 ) (16.0 ) (20.7 ) (2.3 ) (10.8 ) (12.6 ) (111.8 ) $ - $ (1.3 ) $ (22.2 ) $ (89.4 ) $ (42.2 ) $ (68.8 ) $ (21.6 ) $ (28.1 ) $ 20.1 $ (253.5 ) The net favorable reserve development is a result of actual loss emergence being lower than anticipated. The unfavorable reserve development in our U.S. insurance segment for the 2006 loss year was primarily due to directors and officers claims within our professional liability line of business related to a class action suit filed against a number of private equity firms alleging collusion. The unfavorable reserve development in our international insurance segment for the 2010 loss year was primarily due to a casualty claim emanating from an oil field service risk. (Favorable) and
For the Year Ended
2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) U.S. insurance $ (1.6 ) $ (3.2 ) $ (25.6 ) $ (26.2 ) $ (5.3 ) $ (1.7 ) $ (2.5 ) $ (2.4 ) $ (68.5 ) International insurance 6.8 (6.7 ) (21.6 ) (87.5 ) (36.7 ) (19.3 ) (23.1 ) 7.5 (180.6 ) Reinsurance (0.9 ) (1.0 ) (9.8 ) (33.0 ) (12.4 ) (3.8 ) 3.0 (6.3 ) (64.2 ) $ 4.3 $ (10.9 ) $ (57.0 ) $ (146.7 ) $ (54.4 ) $ (24.8 ) $ (22.6 ) $ (1.2 ) $ (313.3 )
The following table shows the components of net losses and loss expenses for the years ended
Year Ended December 31, Dollar 2011 2010 Change ($ in millions) Net losses paid $ 684.8 $ 596.7 $ 88.1 Net change in reported case reserves 213.3 76.2 137.1 Net change in IBNR 61.1 35.0 26.1 Net losses and loss expenses $ 959.2 $ 707.9 $ 251.3 The increase in net losses paid for the year endedDecember 31, 2011 was due to higher paid losses in our U.S. insurance and reinsurance segments as a result of continued growth in these segments, combined with higher current period property catastrophe paid losses. The increase in reported case reserves was primarily due to higher case reserves in each of our operating segments. The increase in IBNR was due to higher IBNR in our international insurance segment as a result of lower net favorable reserve development. 92
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The table below is a reconciliation of the beginning and ending reserves for losses and loss expenses. Losses incurred and paid are reflected net of reinsurance recoverables: Year EndedDecember 31, 2011 2010 ($ in millions)
Net reserves for losses and loss expenses,
Incurred related to:
Commutation of variable rated reinsurance contracts 11.5
8.9
Current year non-catastrophe 909.0
913.9
Current year property catastrophe 292.2 98.4 Prior year (253.5 ) (313.3 ) Total incurred 959.2 707.9 Paid related to: Current year non-catastrophe 72.1
61.0
Current year property catastrophe 70.1 37.6 Prior year 542.6 498.1 Total paid 684.8 596.7 Foreign exchange revaluation (3.8 )
(1.4 )
Net reserve for losses and loss expenses,
Losses and loss expenses recoverable 1,002.9
927.6
Reserve for losses and loss expenses,
Acquisition Costs Acquisition costs increased by$7.8 million , or 4.9%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The increase in acquisition costs was primarily due to the increase in net premiums earned in our U.S. insurance segment and reinsurance segment. Acquisition costs as a percentage of net premiums earned were 11.5% for the year endedDecember 31, 2011 compared to 11.7% in 2010.
General and Administrative Expenses
General and administrative expenses decreased by$14.9 million , or 5.2%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The decrease in general and administrative expenses was primarily due to the following:
• A decrease of
loss activity during the year endedDecember 31, 2011 . • A decrease of$7.0 million in stock related compensation due to a decrease
in overall awards granted during the year ended
addition to a one-time increase of
for our performance-based awards granted in 2009. • During the year endedDecember 31, 2010 we incurred a one-time 1% capital
stamp duty of
million from Allied World Bermuda to Allied World Switzerland.
Our general and administrative expense ratio was 18.6% for the year ended
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Our expense ratio was 30.1% for the year endedDecember 31, 2011 compared to 32.8% for the year endedDecember 31, 2010 primarily due to a decrease in the general and administrative expense ratio.
Amortization of Intangible Assets
The amortization of intangible assets decreased$0.5 million , or 14.3%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The decrease was due to the non-compete covenants related to the acquisition of Darwin being fully amortized during 2010. No impairments were recognized during the year endedDecember 31, 2011 .
Interest Expense
Interest expense increased$14.8 million , or 36.8%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 primarily as a result of additional interest expense on our 5.5% senior notes that were issued by Allied World Bermuda inNovember 2010 .
Income Tax Expense
Tax expense increased$4.1 million , or 15.2%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The increase in tax expense is primarily due to higher taxable income for our Swiss holding company of approximately$90.6 million partially offset by lower taxable income for our U.S. operations of approximately$12.9 million . In addition, 2010 included a$5.0 million loss for tax purposes on the sale of our program administrator and wholesale brokerage operation which caused a reduction in tax expense in 2010 of$1.7 million . Our consolidated effective tax rates for the years endedDecember 31, 2011</chron> and 2010 were 10.1% and 3.9%, respectively.
Net Income
Net income for the year endedDecember 31, 2011 was$274.5 million compared to$665.0 million for the year endedDecember 31, 2010 . The decrease was primarily the result of lower net realized investment gains, higher net loss and loss expenses, and lower net investment income. Net income for the year endedDecember 31, 2011 included a net foreign exchange loss of$3.1 million compared to$0.4 million for the year endedDecember 31, 2010 . Underwriting Results by Operating Segments
Our company is organized into three operating segments:
U.S. Insurance Segment. The U.S. insurance segment includes our direct specialty insurance operations inthe United States . This segment provides both direct property and specialty casualty insurance primarily to non-Fortune 1000 North American domiciled accounts. International Insurance Segment. The international insurance segment includes our direct insurance operations inBermuda ,Europe ,Singapore andHong Kong . This segment provides both direct property and casualty insurance primarily to Fortune 1000 North American domiciled accounts from ourBermuda office and non-North American domiciled accounts from our European,Singapore andHong Kong offices. Reinsurance Segment. Our reinsurance segment has operations inBermuda ,Europe ,Singapore andthe United States . This segment includes the reinsurance of property, general casualty, professional liability, specialty lines and property catastrophe coverages written by insurance companies. We presently write reinsurance on both a treaty and a facultative basis, targeting several niche reinsurance markets. 94
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U.S. Insurance Segment
The following table summarizes the underwriting results and associated ratios for the U.S. insurance segment for each of the years endedDecember 31, 2012 , 2011 and 2010. Year Ended December 31, 2012 2011 2010 ($ in millions) Revenues Gross premiums written $ 993.9 $ 838.6 $ 729.3 Net premiums written 743.4 639.2 551.1 Net premiums earned 671.6 584.3 518.4 Other income - - 0.9 Expenses
Net losses and loss expenses $ 465.2 $ 387.1
Acquisition costs 86.7 75.0
67.8
General and administrative expenses 141.7 124.4
128.5
Underwriting (loss) income (22.0 ) (2.2 )
25.5
Ratios
Loss and loss expense ratio 69.3 % 66.2 %
57.4 %
Acquisition cost ratio 12.9 % 12.8 %
13.1 %
General and administrative expense ratio 21.1 % 21.3 %
24.8 % Expense ratio 34.0 % 34.1 % 37.9 % Combined ratio 103.3 % 100.3 % 95.3 %
Comparison of Years Ended
Premiums. Gross premiums written increased by$155.3 million , or 18.5%, for the year endedDecember 31, 2012 compared to 2011. The increase in gross premiums written was primarily due to new business across most lines that added$320.7 million during the year, combined with premium rate increases in all lines of business. Growth from new products introduced in 2012, such as mergers and acquisitions and primary construction, contributed a further$7.6 million for the year. This growth was partially offset by the non-renewal of business that did not meet our underwriting requirements (which included inadequate pricing and/or terms and conditions) and continued competition.
The table below illustrates our gross premiums written by line of business for each of the periods indicated.
Year Ended December 31, Dollar Percentage 2012 2011 Change Change ($ in millions) General casualty $ 269.6 $ 205.3 $ 64.3 31.3 % Professional liability 260.8 235.4 25.4 10.8 % Healthcare 207.3 201.7 5.6 2.8 % Programs 105.3 87.1 18.2 20.9 % General property 94.3 78.5 15.8 20.1 % Other(1) 56.6 30.6 26.0 85.0 % $ 993.9 $ 838.6 $ 155.3 18.5 %
(1) Includes our inland marine, environmental and mergers and acquisitions lines
of business 95
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Net premiums written increased by$104.2 million , or 16.3%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The increase in net premiums written was primarily due to higher gross premiums written, partially offset by the impact of the commutation of prior year contracts in 2011. The year endedDecember 31, 2011 included a$12.4 million reduction in premiums ceded due to the commutation of certain variable-rated reinsurance contracts that had swing-rated provisions. We ceded 25.2% of gross premiums written for the year endedDecember 31, 2012 compared to 23.8% for 2011. The increase in the cession percentage was due to the impact of the commutation on the prior year, which decreased the 2011 cession percentage by 1.5 percentage points. Net premiums earned increased by$87.3 million , or 14.9%, for the year endedDecember 31, 2012 compared to 2011. The increase was primarily due to the growth of our U.S. insurance operations during 2012 and 2011, partially offset by the$12.4 million impact of the commutation of prior year contracts in 2011, which was fully earned. Net losses and loss expenses. Net losses and loss expenses increased by$78.1 million , or 20.2%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The loss and loss expense ratio increased by 3.1 percentage points for the same period. The increase in net losses and loss expenses was primarily due to growth in net premiums earned, increased property catastrophe losses and lower favorable prior year reserve development in 2012 compared to 2011. This was partially offset by the$11.5 million impact of the commutation of prior year contracts in 2011. During the year endedDecember 31, 2012 , we incurred$23.0 million of catastrophe-related losses, of which$21.0 million related to Superstorm Sandy and$2.0 million related to Hurricane Isaac. During the year endedDecember 31, 2011 , we incurred$8.3 million of catastrophe-related losses, of which$3.8 million related to the Midwestern U.S. storms and$4.5 million related to Hurricane Irene. Excluding the prior year reserve development, property catastrophe losses and the impact of the commutation, the loss and loss expense ratios would have been 68.4% and 68.3% for the years endedDecember 31, 2012 and 2011, respectively. Year Ended Year Ended Change in December 31, 2012 December 31, 2011 Dollar Percentage Amount % of NPE Amount % of NPE(2) Change Points ($ in millions) Non-catastrophe $ 459.1 68.4 % $ 390.5 68.3 % $ 68.6 0.1 Pts Property catastrophe 23.0 3.4 8.3 1.5 14.7 1.9 Current year 482.1 71.8 398.8 69.8 83.3 2.0 Prior year (16.9 ) (2.5 ) (23.2 ) (4.1 ) 6.3 1.6 Impact of commutation(1) - - 11.5 0.5 (11.5 ) (0.5 ) Net losses and loss expenses $ 465.2 69.3 % $ 387.1 66.2 % $ 78.1 3.1 Pts
(1) Reflects the impact of the commutation of prior year contracts in the year
ended
expenses by
(2) Current year and prior year losses as a % of NPE are calculated excluding the
effect of the commutation on net premiums earned. 96
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Overall, our U.S. insurance segment recorded net favorable reserve development of$16.9 million during the year endedDecember 31, 2012 compared to net favorable reserve development of$23.2 million for the year endedDecember 31, 2011 , as shown in the tables below. (Favorable)
and
For the Year Ended December 31, 2012 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Total ($ in millions) General casualty $ (0.1 ) $ (0.7 ) $ (0.2 ) $ (1.2 ) $ (12.3 ) $ (3.3 ) $ (3.4 ) $ (0.6 ) $ (0.1 ) $ - $ (21.9 ) Professional liability (0.5 ) (0.5 ) (2.0 ) (0.9 ) (1.0 ) (20.5 ) (3.8 ) (5.1 ) (4.7 ) 24.7 (14.3 ) Healthcare - 1.7 (1.0 ) (3.1 ) (5.1 ) (4.6 ) (0.1 ) (2.2 ) 2.3 - (12.1 ) Other - - - - - - - - - 1.7 1.7 General property - - 1.0 (0.2 ) (0.1 ) (0.2 ) 1.3 1.0 1.1 1.0 4.9 Programs - - - - (0.8 ) - - 3.9 13.9 7.8 24.8 $ (0.6 ) $ 0.5 $ (2.2 ) $ (5.4 ) $ (19.3 ) $ (28.6 ) $ (6.0 ) $ (3.0 ) $ 12.5 $ 35.2 $ (16.9 ) The unfavorable reserve development for the 2010 and 2011 loss years was primarily due to adverse development of$25.1 million on a program that commenced writing in 2008 and was terminated during 2011. This was partially offset by favorable development on our active programs. We also experienced adverse development for the 2011 loss year for certain professional liability products. (Favorable) and
For
the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) General casualty $ - $ (0.9 ) $ (1.5 ) $ (17.4 ) $ (2.9 ) $ 2.5 $ (1.9 ) $ (0.9 ) $ 0.5 $ (22.5 ) Professional liability - (0.2 ) (0.3 ) (2.5 ) 23.4 (7.0 ) (0.8 ) (6.4 ) 7.1 13.3 Healthcare (0.4 ) (1.8 ) (2.7 ) - (1.4 ) 0.1 (0.9 ) 0.3 (2.6 ) (9.4 ) Other - - - - - - - - - - General property - - (0.1 ) (0.4 ) 0.1 (1.1 ) (0.3 ) (1.0 ) (1.2 ) (4.0 ) Programs - - - (0.2 ) (0.1 ) (2.1 ) (0.8 ) 0.8 1.8 (0.6 ) $ (0.4 ) $ (2.9 ) $ (4.6 ) $ (20.5 ) $ 19.1 $ (7.6 ) $ (4.7 ) $ (7.2 ) $ 5.6 $ (23.2 ) The unfavorable reserve development of$23.4 million for the 2006 loss year was primarily due to directors and officers claims within our professional liability line of business related to a class action suit filed against a number of private equity firms alleging collusion. Acquisition costs. Acquisition costs increased by$11.7 million , or 15.6%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The increase was primarily caused by increased net premiums earned. The acquisition cost ratio increased to 12.9% for the year endedDecember 31, 2012 from 12.8% for 2011. General and administrative expenses. General and administrative expenses increased by$17.3 million , or 13.9%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 , due to the continued growth of our U.S. insurance operations. The increase in general and administrative expenses was primarily due to increased salary and related costs as average headcount increased to support our continued growth, combined with increased stock compensation expense resulting from the 25.2% increase in our share price during the year and an increase in performance-based compensation expense as results have exceeded target levels. The general and administrative expense ratio decreased to 21.1% for the year endedDecember 31, 2012 from 21.3% in 2011, as a result of our increased net premiums earned. 97
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Comparison of Years Ended
Premiums. Gross premiums written increased by$109.3 million , or 15.0%, for the year endedDecember 31, 2011 compared to 2010. The increase in gross premiums written was primarily due to new business from existing products,$55.1 million in premiums from new products, specifically in our general casualty, environmental and inland marine lines of business and rate increases in our general property and general casualty lines of business. This growth was partially offset by the non-renewal of business that did not meet our underwriting requirements (which included inadequate pricing and/or terms and conditions), rate reductions in our other lines of business and increased competition.
The table below illustrates our gross premiums written by line of business for each of the periods indicated.
Year Ended December 31, Dollar Percentage 2011 2010 Change Change ($ in millions) Professional liability $ 235.4 $ 211.1 $ 24.3 11.5 % General casualty 205.3 145.7 59.6 40.9 % Healthcare 201.7 179.8 21.9 12.2 % Programs 87.1 105.6 (18.5 ) (17.5 %) General property 78.5 73.7 4.8 6.5 % Other(1) 30.6 13.4 17.2 128.4 % $ 838.6 $ 729.3 $ 109.3 15.0 %
(1) Includes our inland marine, environmental and mergers and acquisitions lines
of business
Net premiums written increased by$88.1 million , or 16.0%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The increase in net premiums written was primarily due to higher gross premiums written and the commutation of certain variable-rated reinsurance contracts that have swing-rated provisions, which reduced premiums ceded by$12.4 million . In commuting these swing-rated reinsurance contracts, we reduced certain premiums previously ceded and also reduced ceded losses by$11.5 million in accordance with the terms of the contracts. The net impact of the commutation was a net gain of$0.9 million . For the year endedDecember 31, 2010 , the commutation of certain variable-rated reinsurance contracts reduced premiums ceded by$9.3 million . Overall, we ceded 23.8% of gross premiums written for the year endedDecember 31, 2011 compared to 24.4% for the year endedDecember 31, 2010 . The decrease in the cession percentage was primarily due to the reduction of premiums ceded related to the commutation of the swing-rated reinsurance contracts. Excluding the impact of the commutation, we ceded 25.3% and 25.7% of gross premiums written during the years endedDecember 31, 2011 and 2010, respectively. Net premiums earned increased$65.9 million , or 12.7%, resulting from the growth of our U.S. insurance operations during 2010 and 2011. Additionally, the commutation of swing-rated reinsurance contracts during the year endedDecember 31, 2011 added$12.4 million to net premiums earned compared to$9.3 million during the year endedDecember 31, 2010 . Net losses and loss expenses. Net losses and loss expenses increased by$89.6 million , or 30.1%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The loss and loss expense ratio increased 8.8 percentage points for the same period. The increase in net losses and loss expenses was primarily due to the growth in net premiums earned, increased property catastrophe losses and lower prior year net favorable reserve development.
During the year ended
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Excluding the prior year reserve development, property catastrophe losses and the impact of the commutations, the loss and loss expense ratios would have been 68.3% and 70.1% for the years endedDecember 31 , 2011and 2010, respectively. The year endedDecember 31, 2010 included a$12.0 million net loss on aConnecticut power plant explosion which increased the loss and loss expense ratio by 2.4 percentage points. Year Ended Year Ended Change in December 31, 2011 December 31, 2010 Dollar Percentage Amount % of NPE(2) Amount % of NPE(2) Change Points ($ in millions) Non-catastrophe $ 390.5 68.3 % $ 357.1 70.1 % $ 33.4 (1.8 )Pts Property catastrophe 8.3 1.5 - - 8.3 1.5 Current year 398.8 69.8 357.1 70.1 41.7 (0.3 ) Prior year (23.2 ) (4.1 ) (68.5 ) (13.5 ) 45.3 9.4 Impact of commutation(1) 11.5 0.5 8.9 0.8 2.6 (0.3 ) Net losses and loss expenses $ 387.1 66.2 % $ 297.5 57.4 % $ 89.6 8.8 Pts
(1) Reflects the impact of the commutation of prior year contracts in the years
ended
loss expenses by
earned by$12.4 million and$9.3 million , respectively.
(2) Current year and prior year losses as a % of NPE are calculated excluding the
effect of the commutation on net premiums earned.
Overall, our U.S. insurance segment recorded net favorable reserve development of$23.2 million during the year endedDecember 31, 2011 compared to net favorable reserve development of$68.5 million for the year endedDecember 31, 2010 as shown in the tables below. (Favorable) and
For
the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) General casualty $ - $ (0.9 ) $ (1.5 ) $ (17.4 ) $ (2.9 ) $ 2.5 $ (1.9 ) $ (0.9 ) $ 0.5 $ (22.5 ) Professional liability - (0.2 ) (0.3 ) (2.5 ) 23.4 (7.0 ) (0.8 ) (6.4 ) 7.1 13.3 Healthcare (0.4 ) (1.8 ) (2.7 ) - (1.4 ) 0.1 (0.9 ) 0.3 (2.6 ) (9.4 ) General property - - (0.1 ) (0.4 ) 0.1 (1.1 ) (0.3 ) (1.0 ) (1.2 ) (4.0 ) Programs - - - (0.2 ) (0.1 ) (2.1 ) (0.8 ) 0.8 1.8 (0.6 ) $ (0.4 ) $ (2.9 ) $ (4.6 ) $ (20.5 ) $ 19.1 $ (7.6 ) $ (4.7 ) $ (7.2 ) $ 5.6 $ (23.2 ) The unfavorable reserve development of$23.4 million for the 2006 loss year was primarily due to directors and officers claims within our professional liability line of business related to a class action suit filed against a number of private equity firms alleging collusion. (Favorable) and
For
the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 Total ($ in millions) General casualty $ (1.4 ) $ (1.4 ) $ (2.6 ) $
(6.6 ) $ (1.4 ) $ (1.7 ) $ (1.5 ) $ (3.2 ) $ (19.8 ) Professional liability
- (0.2 ) (0.3 ) (1.8 ) (0.2 ) 0.9 (2.3 ) (3.7 ) (7.6 ) Healthcare (0.2 ) (1.6 ) (21.9 ) (7.3 ) - (0.6 ) 3.2 - (28.4 ) General property - - (0.8 ) (10.5 ) (3.6 ) (1.8 ) (1.9 ) 5.6 (13.0 ) Programs - - - (0.1 ) (0.1 ) 1.6 - (1.1 ) 0.3 $ (1.6 ) $ (3.2 ) $ (25.6 ) $ (26.3 ) $ (5.3 ) $ (1.6 ) $ (2.5 ) $ (2.4 ) $ (68.5 ) 99
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Acquisition costs. Acquisition costs increased by$7.2 million , or 10.6%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The increase was primarily caused by increased net premiums earned. The acquisition cost ratio decreased slightly to 12.8% for the year endedDecember 31, 2011 from 13.1% in 2010. General and administrative expenses. General and administrative expenses decreased by$4.1 million , or 3.2%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The decrease in general and administrative expenses was primarily due to a decrease in performance based incentive compensation expenses. The decrease in the general and administrative expense ratio from 24.8% for the year endedDecember 31, 2010 to 21.3% in 2011 was primarily caused by increased net premiums earned and the decrease in expenses as discussed above.
International Insurance Segment
The following table summarizes the underwriting results and associated ratios for the international insurance segment for the years endedDecember 31, 2012 , 2011 and 2010. Year Ended December 31, 2012 2011 2010 ($ in millions) Revenues Gross premiums written $ 575.1 $ 530.4 $ 504.9 Net premiums written 346.3 325.1 319.1 Net premiums earned 336.8 317.0 338.8 Expenses
Net losses and loss expenses $ 163.1 $ 206.6
Acquisition costs (0.5 ) (2.8 )
(0.5 )
General and administrative expenses 91.9 84.3
94.2
Underwriting income 82.3 28.9
84.9
Ratios
Loss and loss expense ratio 48.4 % 65.2 %
47.3 %
Acquisition cost ratio (0.1 %) (0.9 %)
(0.1 %)
General and administrative expense ratio 27.3 % 26.6 %
27.8 % Expense ratio 27.2 % 25.7 % 27.7 % Combined ratio 75.6 % 90.9 % 75.0 %
Comparison of Years Ended
Premiums. Gross premiums written increased by$44.7 million , or 8.4%, for the year endedDecember 31, 2012 compared to 2011. The increase was primarily a result of new business, including$19.8 million from trade credit as a result of expansion into new regions, combined with rate increases in select lines of business. Professional liability increased$17.6 million , primarily due to new business, including$7.9 million from new product initiatives, and strong premium retention. However, this increase was partially offset by the non-renewal of business that did not meet our underwriting requirements (which included inadequate pricing and/or terms and conditions), continued competition and a reduction in limits deployed for the international general property line of business. 100
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The table below illustrates our gross premiums written by line of business for each of the periods indicated.
Year Ended December 31, Dollar Percentage 2012 2011 Change Change ($ in millions) Professional liability $ 182.0 $ 164.4 $ 17.6 10.7 % General property 157.2 159.4 (2.2 ) (1.4 %) General casualty 131.6 127.2 4.4 3.5 % Healthcare 73.2 68.1 5.1 7.5 % Other(1) 31.1 11.3 19.8 175.2 % $ 575.1 $ 530.4 $ 44.7 8.4 %
(1) Includes our trade credit line of business
Net premiums written increased by$21.2 million , or 6.5%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . We ceded to reinsurers 39.8% of gross premiums written for the year endedDecember 31, 2012 compared to 38.7% for the year endedDecember 31, 2011 .
Net premiums earned increased by
Net losses and loss expenses. Net losses and loss expenses decreased by$43.5 million , or 21.1%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The loss and loss expense ratio decreased by 16.8 percentage points for the same period. The decrease in net losses and loss expenses was primarily due to significantly lower catastrophe losses in 2012 compared to 2011, combined with higher net favorable prior year reserve development in 2012 compared to 2011. During the year endedDecember 31, 2012 , we incurred$75.6 million of catastrophe-related losses, of which$73.7 million related to Superstorm Sandy and$1.9 million related to Hurricane Isaac. During the year endedDecember 31, 2011 , we incurred$107.6 million of catastrophe-related losses, of which$45.0 million related to the Tohoku earthquake and tsunami,$17.7 million related to the storms in the Midwestern United States,$12.7 million related to theNew Zealand earthquake,$22.8 million related to theThailand floods,$8.0 million related to Hurricane Irene and$1.4 million related to the Australian storms. Excluding the prior year reserve development and property catastrophe losses, the loss and loss expense ratios would have been 62.5% and 68.7% for the years endedDecember 31, 2012 and 2011, respectively. The decrease was due to lower attritional property losses in 2012 compared to 2011. Year Ended Year Ended Change in December 31, 2012 December 31, 2011 Dollar Percentage Amount % of NPE Amount % of NPE Change Points ($ in millions) Non-catastrophe $ 210.5 62.5 % $ 217.5 68.7 % $ (7.0 ) (6.2 )Pts Property catastrophe 75.6 22.4 107.6 33.9 (32.0 ) (11.5 ) Current year 286.1 84.9 325.1 102.6 (39.0 ) (17.7 ) Prior year (123.0 ) (36.5 ) (118.5 ) (37.4 ) (4.5 ) 0.9 Net losses and loss expenses $ 163.1 48.4 % $ 206.6 65.2 % $ (43.5 ) (16.8 )Pts 101
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Overall, our international insurance segment recorded net favorable reserve development of
(Favorable) and
For the Year Ended December 31, 2012 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Total ($ in millions)
Professional liability $ (0.4 ) $ (0.3 ) $ (3.0 ) $ (6.1 ) $ (34.6 ) $ (10.4 ) $ 2.9 $ - $ - $ - $ (51.9 ) General casualty 5.7 (2.8 ) (3.1 ) 6.6 (18.5 ) (23.2 ) (10.6 ) (4.7 ) 1.8 20.0 (28.8 ) Healthcare (0.1 ) (0.9 ) (0.9 ) (2.5 ) (2.1 ) (9.4 ) (10.3 ) 2.6 - - (23.6 ) General property - - 0.7 (1.8 ) 0.8 0.7 (3.7 ) (2.8 ) (8.7 ) (3.9 ) (18.7 ) $ 5.2 $ (4.0 ) $ (6.3 ) $ (3.8 ) $ (54.4 ) $ (42.3 ) $ (21.7 ) $ (4.9 ) $ (6.9 ) $ 16.1 $ (123.0 ) The net favorable reserve development for loss years 2003 to 2010 is a result of actual loss emergence being lower than anticipated. The unfavorable reserve development in our general casualty line for loss year 2011 was due to adverse development on an individual claim, estimated to reach our full limit of$20.0 million , net of reinsurance. (Favorable)
and
For the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) Professional liability $ 2.0 $ 8.5 $ (6.1 ) $ (12.6 ) $ (18.9 ) $ (14.8 ) $ 21.6 $ - $ - $ (20.3 ) General casualty (1.0 ) (4.2 ) 2.8 (16.0 ) (16.0 ) (14.1 ) (7.3 ) 7.2 22.5 (26.1 ) Healthcare (0.2 ) (0.1 ) (1.8 ) (2.0 ) (9.7 ) (10.5 ) - 0.2 - (24.1 ) General property - (0.1 ) (1.6 ) (2.7 ) (0.7 ) (1.1 ) (28.9 ) (17.5 ) 4.6 (48.0 ) $ 0.8 $ 4.1 $ (6.7 ) $ (33.3 ) $ (45.3 ) $ (40.5 ) $ (14.6 ) $ (10.1 ) $ 27.1 $ (118.5 )
The unfavorable reserve development for the 2010 loss year was primarily due to a casualty claim emanating from an oil field services risk.
Acquisition costs. Acquisition costs increased by$2.3 million , or 82.1%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The negative cost represents ceding commissions received on ceded premiums in excess of the brokerage fees and commissions paid on gross premiums written. The acquisition cost ratio was negative 0.1% for the year endedDecember 31, 2012 and negative 0.9% for the year endedDecember 31, 2011 . The increase was due to growth in lines of business with higher acquisition costs, such as trade credit. General and administrative expenses. General and administrative expenses increased by$7.6 million , or 9.0%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The increase in general and administrative expenses was primarily due to increased salary and related costs incurred as we continue to expand internationally, combined with higher incentive compensation due to increased profitability and the higher stock price. The general and administrative expense ratios for the years endedDecember 31, 2012 and 2011 were 27.3% and 26.6%, respectively. The increase was primarily due to increased incentive compensation as profitability improved. 102
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Comparison of Years Ended
Premiums. Gross premiums written increased by$25.5 million , or 5.1%, for the year endedDecember 31, 2011 compared to 2010. The increase in gross premiums written was primarily a result of new business, including$12.5 million from new products, specifically related to our trade credit line of business and small to mid-sized enterprise insurance products. In addition, we increased premiums in our healthcare line of business and experienced rate increases within our general property line of business. This growth was partially offset by the continued trend of the non-renewal of business that did not meet our underwriting requirements (which included inadequate pricing and/or terms and conditions) including the non-renewal of one general property policy that was previously written during the year endedDecember 31, 2010 for$5.1 million and the non-renewal of several policies totaling$15.7 million in our general casualty line of business.
The table below illustrates our gross premiums written by line of business for each of the periods indicated.
Year Ended December 31, Dollar Percentage 2011 2010 Change Change ($ in millions) Professional liability $ 164.4 $ 160.7 $ 3.7 2.3 % General property 159.4 150.7 8.7 5.8 % General casualty 127.2 132.3 (5.1 ) (3.9 %) Healthcare 68.1 59.3 8.8 14.8 % Other(1) 11.3 1.9 9.4 n/m $ 530.4 $ 504.9 $ 25.5 5.1 %
(1) Includes our trade credit line of business
Net premiums written increased$6.0 million , or 1.9%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . Net premiums written increased at a lower percentage than gross premiums written due to an increase in ceded premiums written on our professional lines treaty as well as the establishment of a trade credit treaty. We ceded to reinsurers 38.7% of gross premiums written for the year endedDecember 31, 2011 compared to 36.8% for the year endedDecember 31, 2010 . The increase is primarily due to increased cessions on our general casualty and professional liability lines of business.
Net premiums earned decreased
Net losses and loss expenses. Net losses and loss expenses increased by$46.4 million , or 29.0%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The loss and loss expense ratio increased by 17.9 percentage points for the same period. The increase in net losses and loss expenses was primarily due to higher loss activity in the current period and lower net favorable reserve development recognized. During the year endedDecember 31, 2011 , we incurred$107.6 million of catastrophe-related losses, of which$45.0 million related to the Tohoku earthquake and tsunami,$17.7 million related to the storms in the MidwesternUnited States ,$12.7 million related to theNew Zealand earthquake,$22.8 million related to theThailand floods,$8.0 million related to Hurricane Irene and$1.4 million related to the Australian storms. 103
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Excluding the prior year reserve development and property catastrophe losses, the loss and loss expense ratios would have been 68.7% and 81.7% for the years endedDecember 31, 2011 and 2010, respectively. Year Ended Year Ended Change in December 31, 2011 December 31, 2010 Dollar Percentage Amount % of NPE Amount % of NPE Change Points ($ in millions) Non-catastrophe $ 217.5 68.7 % $ 276.7 81.7 % $ (59.2 ) (13.0 )Pts Property catastrophe 107.6 33.9 64.1 18.9 43.5 15.0 Current year 325.1 102.6 340.8 100.6 (15.7 ) 2.0 Prior year (118.5 ) (37.4 ) (180.6 ) (53.3 ) 62.1 15.9 Net losses and loss expenses $ 206.6 65.2 % $ 160.2 47.3 % $ 46.4 17.9 Pts
Overall, our international insurance segment recorded net favorable reserve development of
(Favorable)
and
For the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) Professional liability $ 2.0 $ 8.5 $ (6.1 ) $ (12.6 ) $ (18.9 ) $ (14.8 ) $ 21.6 $ - $ - $ (20.3 ) General casualty (1.0 ) (4.2 ) 2.8 (16.0 ) (16.0 ) (14.1 ) (7.3 ) 7.2 22.5 (26.1 ) Healthcare (0.2 ) (0.1 ) (1.8 ) (2.0 ) (9.7 ) (10.5 ) - 0.2 - (24.1 ) General property - (0.1 ) (1.6 ) (2.7 ) (0.7 ) (1.1 ) (28.9 ) (17.5 ) 4.6 (48.0 ) $ 0.8 $ 4.1 $ (6.7 ) $ (33.3 ) $ (45.3 ) $ (40.5 ) $ (14.6 ) $ (10.1 ) $ 27.1 $ (118.5 ) The unfavorable reserve development in our professional liability segment for the 2008 loss year related primarily to a greater reliance on the Bornhuetter-Ferguson reported loss method than on the expected loss ratio method. The unfavorable reserve development for the 2010 loss year was primarily due to a casualty claim emanating from an oil field service risk. (Favorable) and
For
the Year Ended
2002 2003 2004
2005 2006 2007 2008 2009 Total
($ in millions) Professional liability $ 2.0 $ (2.8 ) $ (4.1 ) $ (41.8 ) $ (0.2 ) $ - $ - $ - $ (46.9 ) General casualty 5.1 (2.3 ) (15.3 ) (29.8 ) (7.6 ) (6.5 ) 11.3 7.8 (37.3 ) Healthcare (0.3 ) (1.5 ) (2.2 ) (9.9 ) (22.5 ) - - - (36.4 ) General property - (0.1 ) - (6.0 ) (6.4 ) (12.8 ) (34.4 ) (0.3 ) (60.0 ) $ 6.8 $ (6.7 ) $ (21.6 ) $ (87.5 ) $ (36.7 ) $ (19.3 ) $ (23.1 ) $ 7.5 $ (180.6 ) Acquisition costs. Acquisition costs decreased$2.3 million for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The negative cost represents ceding commissions received on ceded premiums in excess of the brokerage fees and commissions paid on gross premiums written. The acquisition cost ratio decreased from negative 0.1% for the year endedDecember 31, 2010 to negative 0.9% for the year endedDecember 31, 2011 . General and administrative expenses. General and administrative expenses decreased$9.9 million , or 10.5%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The decrease in general and administrative expenses was primarily due to a decrease in incentive-based compensation due to higher loss activity as well as a decrease in staffing and related salaries and benefits. The year endedDecember 31, 2010 included one-time expenses in professional fees related to the establishment of Syndicate 104
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2232 and our efforts to effect our redomestication toSwitzerland . These decreases were offset by an increase in fees for a full year of operating our Lloyd's Syndicate 2232 of$4.4 million in 2011 versus six months of operation in 2010. The general and administrative expense ratios for the years endedDecember 31, 2011 and 2010 were 26.6% and 27.8%, respectively, due to lower general and administrative expenses.
Reinsurance Segment
The following table summarizes the underwriting results and associated ratios for the reinsurance segment for the years endedDecember 31, 2012 , 2011 and 2010. Year Ended December 31, 2012 2011 2010 ($ in millions) Revenues Gross premiums written $ 760.3 $ 570.5 $ 524.2 Net premiums written 748.1 569.5 522.3 Net premiums earned 740.5 555.7 502.3 Expenses
Net losses and loss expenses $ 511.0 $ 365.5
Acquisition costs 119.5 95.1
92.1
General and administrative expenses 73.7 62.9
63.8
Underwriting income 36.3 32.2
96.2
Ratios
Loss and loss expense ratio 69.0 % 65.8 %
49.8 %
Acquisition cost ratio 16.1 % 17.1 %
18.3 %
General and administrative expense ratio 10.0 % 11.3 %
12.7 % Expense ratio 26.1 % 28.4 % 31.0 % Combined ratio 95.1 % 94.2 % 80.8 %
Comparison of Years Ended
Premiums. Gross premiums written increased by$189.8 million , or 33.3%, for the year endedDecember 31, 2012 compared to 2011. The increase in gross premiums written was primarily due to new business, from both new products and new regions, as well as increased participations on renewing business combined with rate increases. Within our specialty unit, crop reinsurance premiums increased by$48.1 million while marine contributed a further$21.7 million . Gross premiums written in our property reinsurance business also increased by$87.7 million . Gross premiums written in our North American property reinsurance grew$42.0 million as a result of new business and increased participations and our continued expansion intoAsia Latin America contributed a further$41.0 million . Casualty premiums increased$19.9 million , primarily due to the renewal of a$13.5 million expiring two year contract. This was partially offset by the non-renewal of business that did not meet our underwriting requirements (which included inadequate pricing and/or terms and conditions) and continued competition.
The table below illustrates our gross premiums written by underwriter geographic location for our reinsurance operations.
Year Ended December 31, Dollar Percentage 2012 2011 Change Change ($ in millions) United States $ 366.3 $ 241.6 $ 124.7 51.6 % Bermuda 210.1 204.7 5.4 2.6 % Singapore 106.5 66.6 39.9 59.9 % Europe 77.4 57.6 19.8 34.4 % $ 760.3 $ 570.5 $ 189.8 33.3 % 105
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The table below illustrates our gross premiums written by line of business for each of the periods indicated.
Year Ended December 31, Dollar Percentage 2012 2011 Change Change ($ in millions) Property $ 354.6 $ 266.9 $ 87.7 32.9 % Casualty 254.3 234.4 19.9 8.5 % Specialty 151.4 69.2 82.2 118.8 % $ 760.3 $ 570.5 $ 189.8 33.3 %
Net premiums written increased by
Net premiums earned increased by$184.8 million , or 33.3%, as a result of the increase in net premiums written during the years endedDecember 31, 2012 and 2011. Premiums related to our reinsurance business earn at a slower rate than those related to our direct insurance business. Direct insurance premiums typically earn ratably over the term of a policy. Reinsurance premiums under a quota share reinsurance contract are typically earned over the same period as the underlying policies, or risks, covered by the contract. As a result, the earning pattern of a quota share reinsurance contract may extend up to 24 months, reflecting the inception dates of the underlying policies. Property catastrophe premiums and premiums for other treaties written on a losses occurring basis generally earn ratably over the term of the reinsurance contract. Net losses and loss expenses. Net losses and loss expenses increased by$145.5 million , or 39.8%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The loss and loss expense ratio increased by 3.2 percentage points for the same period. The increase in net losses and loss expenses was due to growth in net premiums earned, lower prior year net favorable reserve development for the year endedDecember 31, 2012 compared to 2011 and$36.4 million of crop reinsurance-related losses recorded in 2012. This was partially offset by the lower property catastrophe losses in 2012 compared to 2011. During the year endedDecember 31, 2012 , we incurred$81.0 million of catastrophe-related losses for Superstorm Sandy. During the year endedDecember 31, 2011 , we incurred$176.3 million , of which$51.5 million related to the Tohoku earthquake and tsunami,$45.9 million from theNew Zealand earthquake,$32.2 million related to the Midwestern U.S. storms,$20.2 million related to theThailand floods,$11.2 million related to Hurricane Irene and$15.3 million related to the Australian storms. Excluding the prior year reserve development and property catastrophe losses, the loss and loss expense ratios would have been 62.2% and 54.2% for the years endedDecember 31, 2012 and 2011, respectively. The increase was primarily due to the$36.4 million in crop reinsurance losses and$15.3 million in other U.S. weather related losses for the year endedDecember 31, 2012 that increased the loss and loss expense ratio by 7.0 percentage points. Year Ended Year Ended Change in December 31, 2012 December 31, 2011 Dollar Percentage Amount % of NPE Amount % of NPE Change Points ($ in millions) Non-catastrophe $ 460.4 62.2 % $ 301.0 54.2 % $ 159.4 8.0Pts Property catastrophe 81.0 10.9 176.3 31.7 (95.3 ) (20.8 ) Current year 541.4 73.1 477.3 85.9 64.1 (12.8 ) Prior year (30.4 ) (4.1 ) (111.8 ) (20.1 ) 81.4 16.0 Net losses and loss expenses $ 511.0 69.0 % $ 365.5 65.8 % $ 145.5 3.2 Pts 106
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Overall, our reinsurance segment recorded net favorable reserve development of$30.4 million during the year endedDecember 31, 2012 compared to net favorable reserve development of$111.8 million for the year endedDecember 31, 2011 , as shown in the tables below. (Favorable) and Unfavorable Loss
For the Year
Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Total ($ in millions) Specialty $ (0.2 ) $ (0.4 ) $ (3.4 ) $ (5.5 ) $ (2.7 ) $ (4.8 ) $ (1.9 ) $ 0.3 $ 1.6 $ (3.5 ) $ (20.5 ) Property - (0.1 ) (0.7 ) 1.5 - (2.5 ) (1.8 ) (0.4 ) (2.3 ) (3.8 ) (10.1 ) Casualty (0.1 ) 0.4 3.6 2.0 (5.3 ) (12.6 ) (3.5 ) 0.1 6.2 9.4 0.2 $ (0.3 ) $ (0.1 ) $ (0.5 ) $ (2.0 ) $ (8.0 ) $ (19.9 ) $ (7.2 ) $ - $ 5.5 $ 2.1 $ (30.4 ) (Favorable) and Unfavorable Loss
For the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) Specialty $ - $ (0.1 ) $ (2.8 ) $ (1.9 ) $ - $ (0.9 ) $ (0.2 ) $ (5.7 ) $ (4.0 ) $ (15.6 ) Property (0.2 ) (0.9 ) (1.1 ) (2.7 ) (1.2 ) (4.2 ) (0.3 ) (4.8 ) (11.3 ) (26.7 ) Casualty (0.2 ) (1.5 ) (7.0 ) (31.0 ) (14.8 ) (15.6 ) (1.8 ) (0.3 ) 2.7 (69.5 ) $ (0.4 ) $ (2.5 ) $ (10.9 ) $ (35.6 ) $ (16.0 ) $ (20.7 ) $ (2.3 ) $ (10.8 ) $ (12.6 ) $ (111.8 ) Acquisition costs. Acquisition costs increased by$24.4 million , or 25.7%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 primarily due to the increase in net premiums earned. The acquisition cost ratio was 16.1% for the year endedDecember 31, 2012 , compared to 17.1% for the year endedDecember 31, 2011 , primarily due to the change in mix of business. General and administrative expenses. General and administrative expenses increased by$10.8 million , or 17.2%, for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 . The increase was due to higher salary and related costs due to higher headcount to support our growing operations, combined with higher incentive compensation due to increased profitability and our higher stock price. The general and administrative expense ratios for the years endedDecember 31, 2012 and 2011 were 10.0% and 11.3%, respectively, reflecting the higher growth in net premiums earned relative to expenses in 2012.
Comparison of Years Ended
Premiums. Gross premiums written increased by$46.3 million , or 8.8%, for the year endedDecember 31, 2011 compared to 2010. The increase in gross premiums written was primarily due to increased writings in our international reinsurance lines of business with the continuing build out of ourLondon andSingapore offices, including business written through Syndicate 2232, as well as$25.4 million of new business from our new global marine and specialty division. This growth was partially offset by the non-renewal of business that did not meet our underwriting requirements (which included inadequate pricing and/or terms and conditions). In addition, the increase in gross premiums written was partially offset by a two year treaty we wrote in our general casualty reinsurance line of business for$31.4 million in the year endedDecember 31, 2010 . 107
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The table below illustrates our gross premiums written by underwriter geographic location for our reinsurance operations.
Year Ended December 31, Dollar Percentage 2011 2010 Change Change ($ in millions) United States $ 241.6 $ 264.2 $ (22.6 ) (8.6 %) Bermuda 204.7 210.1 (5.4 ) (2.6 %) Singapore 66.6 16.6 50.0 301.2 % Europe 57.6 33.3 24.3 73.0 % $ 570.5 $ 524.2 $ 46.3 8.8 %
The table below illustrates our gross premiums written by line of business for each of the periods indicated.
Year Ended December 31, Dollar Percentage 2011 2010 Change Change ($ in millions) Property $ 266.9 $ 181.0 $ 85.9 47.5 % Casualty 234.4 301.3 (66.9 ) (22.2 %) Specialty 69.2 41.9 27.3 65.2 % $ 570.5 $ 524.2 $ 46.3 8.8 %
Net premiums written increased by
Net losses and loss expenses. Net losses and loss expenses increased by$115.3 million , or 46.1%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The loss and loss expense ratio increased by 16.0 percentage points for the same period. The increase in net losses and loss expenses was due to growth in net premiums earned and increased property catastrophe losses, partially offset by higher favorable net prior year reserve development in 2011 compared to 2010. During the year endedDecember 31, 2011 , we incurred$176.3 million of catastrophe-related losses, of which 51.5 million related to the Tohoku earthquake and tsunami,$45.9 million from theNew Zealand earthquake,$32.2 million related to the Midwestern U.S. storms,$20.2 million related to theThailand floods,$11.2 million related to Hurricane Irene and$15.3 million related to the Australian storms. During the year endedDecember 31, 2010 , we incurred$34.3 million of catastrophe-related losses from a number of earthquakes and other weather related events. Excluding the prior year reserve development and property catastrophe losses, the loss and loss expense ratios would have been 54.2% and 55.8% for the years endedDecember 31, 2011 and 2010, respectively. Year Ended Year Ended Change in December 31, 2011 December 31, 2010 Dollar Percentage Amount % of NPE Amount % of NPE Change Points ($ in millions) Non-catastrophe $ 301.0 54.2 % $ 280.1 55.8 % $ 20.9 (1.6 ) Pts Property catastrophe 176.3 31.7 34.3 6.8 142.0 24.9 Current year 477.3 85.9 314.4 62.6 162.9 23.3 Prior year (111.8 ) (20.1 ) (64.2 ) (12.8 ) (47.6 ) (7.3 ) Net losses and loss expenses $ 365.5 65.8 % $ 250.2 49.8 % $ 115.3 16.0 Pts 108
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Overall, our reinsurance segment recorded net favorable reserve development of$111.8 million and$64.2 million during the years endedDecember 31, 2011 and 2010, respectively, as shown in the tables below. (Favorable) and Unfavorable Loss
For the Year Ended
2002 2003 2004 2005 2006 2007 2008 2009 2010 Total ($ in millions) Specialty $ - $ (0.1 ) $ (2.8 ) $ (1.9 ) $ - $ (0.9 ) $ (0.2 ) $ (5.7 ) $ (4.0 ) $ (15.6 ) Property (0.2 ) (0.9 ) (1.1 ) (2.7 ) (1.2 ) (4.2 ) (0.3 ) (4.8 ) (11.3 ) (26.7 ) Casualty (0.2 ) (1.5 ) (7.0 ) (31.0 ) (14.8 ) (15.6 ) (1.8 ) (0.3 ) 2.7 (69.5 ) $ (0.4 ) $ (2.5 ) $ (10.9 ) $ (35.6 ) $ (16.0 ) $ (20.7 ) $ (2.3 ) $ (10.8 ) $ (12.6 ) $ (111.8 ) (Favorable) and Unfavorable Loss Reserve Development by Loss Year For the Year Ended December 31, 2010 2002 2003 2004 2005 2006 2007 2008 2009 Total ($ in millions) Specialty $ - $ (0.4 ) $ (1.1 ) $ (0.5 ) $ - $ (1.2 ) $ (2.6 ) $ - $ (5.8 ) Property (0.3 ) (0.7 ) (1.0 ) (3.6 ) (0.7 ) (3.5 ) 0.8 (7.7 ) (16.7 ) Casualty (0.5 ) (7.8 ) (28.9 ) (11.7 ) 0.9 4.9 1.4 (41.7 ) $ (0.8 ) $ (1.1 ) $ (9.9 ) $ (33.0 ) $ (12.4 ) $ (3.8 ) $ 3.1 $ (6.3 ) $ (64.2 ) Acquisition costs. Acquisition costs increased by$3.0 million , or 3.3%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The increase was primarily a result of higher net premiums earned partially offset by a decrease in profit commissions due to loss activity. The acquisition cost ratio was 17.1% for the year endedDecember 31, 2011 , slightly lower than the 18.3% for the year endedDecember 31, 2010 . The decrease in the acquisition cost ratio is due to more business written on an excess-of-loss basis, which typically carries a lower acquisition cost ratio than quota share business. General and administrative expenses. General and administrative expenses decreased$0.9 million , or 1.4%, for the year endedDecember 31, 2011 compared to the year endedDecember 31, 2010 . The decrease in general and administrative expenses was primarily due to a decrease in performance based incentive compensation expenses partially offset by additional professional fees related to the operation of the Lloyd's Syndicate which was operational for only six months in the prior year. The general and administrative expense ratios for the years endedDecember 31, 2011 and 2010 were 11.3% and 12.7%, respectively, due to lower general and administrative expenses and higher net premiums earned. Liquidity and Capital Resources Liquidity Liquidity is a measure of our ability to access sufficient cash flows to meet the short-term and long-term cash requirements of our business operations. The Company believes that its cash flows from operations and investments will provide sufficient liquidity for the foreseeable future. Holdings is a holding company and transacts no business of its own. Cash flows to Holdings may comprise dividends, advances and loans from its subsidiary companies. Holdings is therefore reliant on receiving dividends and other permitted distributions from its subsidiaries to make dividend payments on its common shares. Our operating subsidiaries depend upon cash inflows from premium receipts, net of commissions, investment income and proceeds from sales and redemptions of investments. Cash outflows for our operating subsidiaries are in the form of claims payments, reinsurance premium payments, purchase of investments, operating expenses and income tax payments as well as dividend payments to the holding company.
Historically, our operating subsidiaries have generated sufficient cash flows to meet all of their obligations. Because of the inherent volatility of our business, the seasonality in the timing of payments by insureds and
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cedents, the irregular timing of loss payments, and the impact of a change in interest rates and credit spreads on the investment income as well as seasonality in coupon payment dates for fixed income securities, cash flows from operating activities may vary between periods. In the unlikely event that paid losses exceed operating cash flows in any given period, we would use our cash balances available, liquidate a portion of our investment portfolio or borrow under our revolving loan facility (see "Credit Facility" below) in order to meet our short-term liquidity needs. Our total investments and cash totaled$8.8 billion as ofDecember 31, 2012 , the main components of which were investment grade fixed income securities and cash and cash equivalents. As ofDecember 31, 2012 , we held$681.9 million of cash and cash equivalents and$573.9 million of fixed income securities with a maturity of less than one year to meet short-term liquidity needs. Our remaining fixed income securities, equity securities and other invested assets are available to meet our long-term liquidity needs.
As of
Dividend RestrictionsAllied World Assurance Company, AG is subject to Swiss financial and regulatory restrictions limiting its ability to declare and pay dividends. In addition, the jurisdictions in which our operating subsidiaries are licensed to write business also impose regulations requiring companies to maintain or meet various defined statutory ratios, including solvency and liquidity requirements. Some jurisdictions also place restrictions on the declaration and payment of dividends and other distributions. The payment of dividends from Holdings'Bermuda domiciled operating subsidiary is, under certain circumstances, limited underBermuda law, which requires ourBermuda operating subsidiary to maintain certain measures of solvency and liquidity. Holdings' U.S. domiciled operating subsidiaries are subject to significant regulatory restrictions limiting their ability to declare and pay dividends. In particular, payments of dividends byAllied World Assurance Company (U.S.) Inc. ,Allied World National Assurance Company ,Allied World Insurance Company ,Darwin National Assurance Company ,Darwin Select Insurance Company and Vantapro Specialty Insurance Company are subject to restrictions on statutory surplus pursuant to the respective states in which these insurance companies are domiciled. Each state requires prior regulatory approval of any payment of extraordinary dividends. Allied World Assurance Company (Europe ) Limited andAllied World Assurance Company (Reinsurance) Limited are subject to regulatory restrictions limiting their ability to declare and pay any dividends without the consent of theCentral Bank of Ireland . We also have branch operations inCanada ,Hong Kong , Labuan andSingapore , which have regulatory restrictions limiting the ability to declare and pay dividends. We also have insurance subsidiaries that are the parent company for other insurance subsidiaries, which means that dividends and other distributions will be subject to multiple layers of regulations in order to dividend funds to Holdings. The inability of the subsidiaries of Holdings to pay dividends and other permitted distributions could have a material adverse effect on Holdings' cash requirements and our ability to make principal, interest and dividend payments on the senior notes and common shares. Cash Flows Year Ended December 31, 2012 2011 2010 ($ in millions)
Cash flows provided by operating activities
451.3 Cash flows used in investing activities (259.7 ) (509.1 ) 500.0 Cash flows used in financing activities (321.2 ) (162.1 ) (486.1 ) Effect of exchange rate changes on foreign currency cash (0.6 ) 0.1 (0.4 ) Net increase (decrease) in cash and cash equivalents 47.9 (123.0 ) 464.8 Cash and cash equivalents, beginning of year 634.0 757.0 292.2 Cash and cash equivalents, end of year $ 681.9 $ 634.0 $ 757.0 110
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The primary sources of cash inflows from operating activities are premiums received, loss payments from reinsurers and investment income. The primary sources of cash outflows from operating activities are ceded premiums paid to reinsurers, claims paid, commissions paid, operating expenses, interest expense and income taxes. The primary factor in our ability to generate positive operating cash flow is underwriting profitability. We have generated positive operating cash flow for more than 10 consecutive years. The$81.3 million increase in cash flows from operations was due to the higher premiums collected, net of reinsurance, as net premiums written increased by$304.0 million . This was partially offset by the$176.2 million increase in net paid losses as a result of the growth in operations, the settlement of 2011 catastrophe losses and the maturation of our inforce business. In our casualty lines of business, claims may be reported and settled several years after the coverage period has terminated. As a result, we expect that we will generate significant operating cash flow as we accumulate casualty loss reserves on our balance sheet. In our property lines of business, claims are generally reported and paid within a relatively short period of time and we expect volatility in our operating cash flows as losses are incurred. Our net paid losses may increase in the short-term due to the recent natural catastrophe activity. We expect increases in the amount of expected loss payments in future periods with a resulting decrease in operating cash flow; however, we do not expect loss payments to exceed the premiums generated. Actual premiums written and collected and losses and loss expenses paid in any period could vary materially from our expectations and could have a significant and adverse effect on operating cash flow.
Cash flows used in investing activities consist primarily of payments for investments acquired, proceeds on the sale of investments and changes in restricted cash. Cash flows used in investing activities decreased
Cash flows used in financing activities consist primarily of capital raising activities, which include the issuance of common shares or debt, the repurchase of our shares, the payment of dividends and the repayment of debt. The$159.1 million increase in cash flows used in financing activities was due to the$177.2 million increase in share repurchases. No shares were repurchased in the nine months endedSeptember 30, 2011 because of the merger negotiations with Transatlantic. This was partially offset by the$53.6 million in founder warrants repurchased inFebruary 2011 . The increase in cash flows used in financing activities was also due to the$39.2 million increase in dividends paid for the year endedDecember 31, 2012 compared to 2011. Under Swiss Law, we were not able to pay our quarterly dividend until two months after our annual general meeting, resulting in fewer dividend payments in 2011.
Investments
Our funds are primarily invested in liquid, high-grade fixed income securities. As ofDecember 31, 2012 and 2011, 89.2% and 92.6%, respectively, of our fixed income portfolio consisted of investment grade securities. The maturity distribution of our fixed income portfolio (on a fair value basis) as ofDecember 31, 2012 and 2011 was as follows: As of December 31, 2012 2011 ($ in millions) Due in one year or less $ 573.9 $ 661.6 Due after one year through five years 2,835.9 2,686.1 Due after five years through ten years 774.4 725.5 Due after ten years 73.0 94.2 Mortgage-backed 1,958.4 1,818.1 Asset-backed 410.9 513.2 Total $ 6,626.5 $ 6,498.7 111
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We have investments in other invested assets, comprising interests in hedge funds and private equity funds, the market value of which was$783.5 million as ofDecember 31, 2012 . Some of these funds have redemption notice requirements. For each of our funds, liquidity is allowed after certain defined periods based on the terms of each fund. See Note 3(c) "Investments - Other Invested Assets" to our consolidated financial statements for additional details on our other invested assets. We do not believe that inflation has had a material effect on our consolidated results of operations. The potential exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The effects of inflation are considered implicitly in pricing. Loss reserves are established to recognize likely loss settlements at the date payment is made. Those reserves inherently recognize the effects of inflation. The actual effects of inflation on our results cannot be accurately known, however, until claims are ultimately resolved. Pledged AssetsAllied World Assurance Company, Ltd uses trust accounts primarily to meet security requirements for inter-company and certain reinsurance transactions. We also have cash and cash equivalents and investments on deposit with various state or government insurance departments or pledged in favor of ceding companies in order to comply with reinsurance contract provisions and relevant insurance regulations. In addition,Allied World Assurance Company, Ltd currently has access to up to$1.45 billion in letters of credit under two letter of credit facilities, a$1 billion uncommitted facility withCitibank Europe plc and a$450 million committed Amended Secured Credit Facility. These facilities are used to provide security to reinsureds and are collateralized by us, at least to the extent of letters of credit outstanding at any given time. Security arrangements with ceding insurers may subject our assets to security interests or require that a portion of our assets be pledged to, or otherwise held by, third parties. Both of our letter of credit facilities are fully collateralized by assets held in custodial accounts at the Bank of New York Mellon held for the benefit of the banks. Although the investment income derived from our assets while held in trust accrues to our benefit, the investment of these assets is governed by the terms of the letter of credit facilities or the investment regulations of the state or territory of domicile of the ceding insurer, which may be more restrictive than the investment regulations otherwise applicable to us. The restrictions may result in lower investment yields on these assets, which may adversely affect our profitability.
As of
In addition, as ofDecember 31, 2012 and 2011, a further$1,225.2 million and$1,044.2 million , respectively, of cash and cash equivalents and investments were pledged as collateral for our credit facilities. We do not currently anticipate that the restrictions on liquidity resulting from restrictions on the payment of dividends by our subsidiary companies or from assets committed in trust accounts or to collateralize the letter of credit facilities will have a material impact on our ability to carry out our normal business activities, including interest and dividend payments, respectively, on our senior notes (described below) and common shares.
Financial Strength Ratings
Financial strength ratings represent the opinions of rating agencies on our capacity to meet our obligations. In the event of a significant downgrade in ratings, our ability to write business and to access the capital markets could be impacted. For additional information on our financial strength ratings refer to "Our Financial Strength Ratings" in Item 1 "Business". 112
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Capital Resources
The table below sets forth the capital structure of the Company as of
As of December 31, 2012 2011 ($ in millions) Senior notes $ 798.2 $ 798.0 Shareholders' equity 3,326.3 3,149.0 Total capitalization $ 4,124.5 $ 3,947.0 Debt to total capitalization 19.4 % 20.2 % OnSeptember 10, 2012 , we filed a shelf registration statement on Form S-3 with theU.S. Securities and Exchange Commission in which we may offer from time to time common shares of Allied World Switzerland, senior or subordinated debt securities of Allied World Bermuda, guarantees of debt securities of Allied World Bermuda, warrants to purchase common shares of Allied World Switzerland, warrants to purchase debt securities of Allied World Bermuda units which may consist of any combination of the securities listed above. The registration statement is intended to provide us with additional flexibility to access capital markets for general corporate purposes, subject to market conditions and our capital needs. Share Repurchases InMay 2012 , we established a new$500 million share repurchase program. Under the terms of this new share repurchase program, common shares repurchased shall be designated for cancellation and shall be cancelled upon prior shareholder approval. During the year endedDecember 31, 2012 , our share repurchases were as follows: Year Ended December 31, 2012 Common shares repurchased 3,655,959 Total cost of shares repurchased $ 263,942 Average price per share $ 72.20 Shares repurchased by the Company and not designated for cancellation are classified as "Treasury shares, at cost" on the consolidated balance sheets. The Company will issue shares out of treasury principally related to the Company's employee benefit plans. Shares repurchased and designated for cancellation are constructively retired and recorded as a share cancellation.
Long-Term Debt
InJuly 2006 , Allied World Bermuda issued$500 million aggregate principal amount of 7.50% senior notes dueAugust 1, 2016 , with interest payableAugust 1 andFebruary 1 each year. Allied World Bermuda can redeem the senior notes prior to maturity, subject to payment of a "make-whole" premium; however,Allied World Bermuda currently has no intention of redeeming the notes. InNovember 2010 , Allied World Bermuda issued$300 million aggregate principal amount of 5.50% senior notes dueNovember 1, 2020 , with interest payableMay 15 andNovember 15 each year, commencingMay 15, 2011 . Allied World Bermuda can redeem the senior notes prior to maturity, subject to payment of a "make-whole" premium; however, Allied World Bermuda currently has no intention of redeeming the notes.
The senior notes issued in 2006 and 2010 have been unconditionally and irrevocably guaranteed for the payment of the principal and interest by Holdings.
Credit Facility
In the normal course of our operations, we enter into agreements with financial institutions to obtain secured and unsecured credit facilities.
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OnJune 7, 2012 , Allied World Bermuda amended its existing secured credit facility. The amended$450 million four-year secured credit facility (the "Amended Secured Credit Facility") is with a syndication of lenders and is primarily for the issuance of standby letters of credit to support obligations in connection with the insurance and reinsurance business ofAllied World Bermuda and its subsidiaries. A portion of the facility may also be used for revolving loans for general corporate and working capital purposes, up to a maximum of$150 million . Allied World Bermuda may request that existing lenders under the Amended Secured Credit Facility make additional commitments from time to time, up to$150 million , subject to approval by the lenders. The Amended Secured Credit Facility contains representations, warranties and covenants customary for similar bank loan facilities, including certain covenants that, among other things, require us to maintain a certain leverage ratio and financial strength rating. We are in compliance with all covenants under the Amended Secured Credit Facility as ofDecember 31, 2012 .
On
As ofDecember 31, 2012 , we also have access to a$1 billion uncommitted letter of credit facility withCitibank Europe plc . This facility was increased from$900 million as ofDecember 31, 2011 . The letters of credit issued under the credit facility withCitibank Europe plc are deemed to be automatically extended without amendment for twelve months from the expiry date, or any future expiration date unless at least 30 days prior to any expiration dateCitibank Europe plc notifies us that they elect not to consider the letters of credit renewed for any such additional period. As ofDecember 31, 2012 , we had a combined unused letters of credit capacity of$433.6 million from theAmended Secured Credit Facility andCitibank Europe plc. We believe that this remaining capacity is sufficient to meet our future letter of credit needs.
Aggregate Contractual Obligations
The following table shows our aggregate contractual obligations by time period remaining until due date as of
Payment Due by Period Less Than More Than Total 1 Year 1-3 Years 3-5 Years 5 Years ($ in millions) Contractual Obligations Senior notes (including interest) $ 1,119.5 $ 54.0 $ 108.0 $ 608.0 $ 349.5 Operating lease obligations 65.9 11.2 19.2 15.4 20.1 Investment commitments outstanding 266.4 1.1 - 35.6 229.7 Real estate purchase commitment 42.0 5.5 36.5 - - Reinsurance collateral 700.0 300.0 400.0 - - Gross reserve for losses and loss expenses(1) 5,645.5 1,206.6 1,572.4 869.8 1,996.7 Total $ 7,839.3 $ 1,578.4 $ 2,136.1 $ 1,528.8 $ 2,596.0
(1) Our unpaid losses and loss expenses represent our best estimate of the cost
to settle the ultimate liabilities based on information available as of
commitments. The timing and amounts of actual loss payments related to these
reserves might vary significantly from our current estimate of the expected
timing and amounts of loss payments based on many factors, including large
individual losses as well as general market conditions.
The investment commitments outstanding represent unfunded commitments related to our other invested assets.
The amounts included for reserve for losses and loss expenses reflect the estimated timing of expected loss payments on known claims and anticipated future claims as ofDecember 31, 2012 and do not take reinsurance recoverables into account. Both the amount and timing of cash flows are uncertain and do not have contractual 114
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payout terms. For a discussion of these uncertainties, refer to "- Critical Accounting Policies - Reserve for Losses and Loss Expenses." Due to the inherent uncertainty in the process of estimating the timing of these payments, there is a risk that the amounts paid in any period will differ significantly from those disclosed. Total estimated obligations will be funded by existing cash and investments. Off-Balance Sheet Arrangements
As of
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LPL FINANCIAL HOLDINGS INC. – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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