Newswires
ARCH CAPITAL GROUP LTD. – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
| Edgar Online, Inc. |
The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in these statements and, therefore, undue reliance should not be placed on them. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed in this report, including the sections entitled "Cautionary Note Regarding Forward-Looking Statements," and "Risk Factors." This discussion and analysis should be read in conjunction with our audited consolidated financial statements and notes thereto presented under Item 8. Tabular amounts are in U.S. Dollars in thousands, except share amounts, unless otherwise noted. 77
--------------------------------------------------------------------------------
Table of Contents GENERAL OverviewArch Capital Group Ltd. ("ACGL" and, together with its subsidiaries, "we" or "us") is aBermuda public limited liability company with approximately$5.03 billion in capital atDecember 31, 2011 and, through operations inBermuda ,the United States ,Europe andCanada , writes insurance and reinsurance on a worldwide basis. While we are positioned to provide a full range of property and casualty insurance and reinsurance lines, we focus on writing specialty lines of insurance and reinsurance. It is our belief that our underwriting platform, our experienced management team and our strong capital base that is unencumbered by significant pre-2002 risks have enabled us to establish a strong presence in the insurance and reinsurance markets. The worldwide insurance and reinsurance industry is highly competitive and has traditionally been subject to an underwriting cycle in which a hard market (high premium rates, restrictive underwriting standards, as well as terms and conditions, and underwriting gains) is eventually followed by a soft market (low premium rates, relaxed underwriting standards, as well as broader terms and conditions, and underwriting losses). Insurance market conditions may affect, among other things, the demand for our products, our ability to increase premium rates, the terms and conditions of the insurance policies we write, changes in the products offered by us or changes in our business strategy. The financial results of the insurance and reinsurance industry are influenced by factors such as the frequency and/or severity of claims and losses, including natural disasters or other catastrophic events, variations in interest rates and financial markets, changes in the legal, regulatory and judicial environments, inflationary pressures and general economic conditions. These factors influence, among other things, the demand for insurance or reinsurance, the supply of which is generally related to the total capital of competitors in the market. Current Outlook The broad market environment continues to be competitive with most long-tail product lines having plenty of capacity available. From a rate standpoint, most lines of business moved into positive territory in the second half of 2011. However, even with this slight improvement in the rate environment, additional rate increases are needed in many lines in order for us to achieve adequate returns. In the property and property catastrophe areas, the environment improved with the best increases to date reflected in international, catastrophe exposed businesses. Such improvements were driven, in part, by the impact of higher than expected 2011 catastrophic activity. Our underwriting teams continue to execute a disciplined strategy by emphasizing small and medium-sized accounts over large accounts and by focusing more on short-tail business. Our objective is to achieve an average operating return on average equity of 15% or greater over the insurance cycle, which we believe to be an attractive return to our common shareholders given the risks we assume. We continue to look for opportunities to find acceptable books of business to underwrite without sacrificing underwriting discipline and continue to believe that the most attractive area from a pricing point of view remains catastrophe-exposed business. We expect that catastrophe-exposed business will continue to represent a significant proportion of our overall book, which could increase the volatility of our operating results. The current economic conditions could continue to have a material impact on the frequency and severity of claims and, therefore, could negatively impact our underwriting returns. In addition, volatility in the financial markets could continue to significantly affect our investment returns, reported results and shareholders' equity. We consider the potential impact of economic trends in the estimation process for establishing unpaid losses and loss adjustment expenses and in determining our investment strategies. 78
--------------------------------------------------------------------------------
Table of Contents
In addition, the impact of the continuing weakness of the U.S., European countries and other key economies, projected budget deficits for the U.S., European countries and other governments and the consequences associated with possible additional downgrades of securities of the U.S., European countries and other governments by credit rating agencies is inherently unpredictable and could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business, financial condition and results of operations and, in particular, this could have a material adverse effect on the value and liquidity of securities in our investment portfolio.
Natural Catastrophe Risk
We monitor our natural catastrophe risk globally for all perils and regions, in each case, where we believe there is significant exposure. Our models employ both proprietary and vendor-based systems and include cross-line correlations for property, marine, offshore energy, aviation, workers compensation and personal accident. Currently, we seek to limit our 1-in-250 year return period net probable maximum pre-tax loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders' equity. We reserve the right to change this threshold at any time. Based on in-force exposure estimated as ofJanuary 1, 2012 , our modeled peak zone catastrophe exposure (using the updated vendor-based system version) is a windstorm affecting theGulf of Mexico , with a net probable maximum pre-tax loss of$881 million , followed by windstorms affecting the Northeastern U.S. and Florida Tri-County with net probable maximum pre-tax losses of$842 million and$638 million , respectively. Our exposures to other perils, such as U.S. earthquake and international events, are less than the exposures arising from U.S. windstorms and hurricanes. As ofJanuary 1, 2012 , our modeled peak zone earthquake exposure (Los Angeles area earthquake) represented less than 50% of our peak zone catastrophe exposure, and our modeled peak zone international exposure (United Kingdom windstorm) is substantially less than both our peak zone windstorm and earthquake exposures. Net probable maximum pre-tax loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones. The loss estimates shown above do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer a net loss greater than 25% of our total shareholders' equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders' equity exposed to a single catastrophic event. In addition, actual losses may increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See "Risk Factors-Risk Relating to Our Industry" and "Management's Discussion and Analysis of Financial Condition and Results of Operations-Natural and Man-Made Catastrophic Events."
Financial Measures
Management uses the following three key financial indicators in evaluating our performance and measuring the overall growth in value generated for ACGL's common shareholders:
Book Value per Common Share
Book value per common share represents total common shareholders' equity divided by the number of common shares outstanding. Management uses growth in book value per common share as a 79
--------------------------------------------------------------------------------
Table of Contents
key measure of the value generated for our common shareholders each period and believes that book value per common share is the key driver of ACGL's common share price over time. Book value per common share is impacted by, among other factors, our underwriting results, investment returns and share repurchase activity, which has an accretive or dilutive impact on book value per common share depending on the purchase price.
Book value per common share was
After-Tax Operating Return on Average Common Equity
After-tax operating return on average common equity ("Operating ROAE") represents after-tax operating income available to common shareholders divided by the average of beginning and ending common shareholders' equity during the period. After-tax operating income available to common shareholders, a "non-GAAP measure" as defined in the SEC rules, represents net income available to common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. Management uses Operating ROAE as a key measure of the return generated to common shareholders and has set an objective to achieve an average Operating ROAE of 15% or greater over the insurance cycle, which it believes to be an attractive return to common shareholders given the risks we assume. See "Comment on Non-GAAP Financial Measures." Our Operating ROAE was 7.2% for 2011, compared to 12.0% for 2010 and 18.3% for 2009. The lower level of Operating ROAE for 2011 than in 2010 was primarily due to a higher amount of losses from catastrophic events and also reflected the impact of current insurance and reinsurance market conditions and the impact of lower interest yields on the investment portfolio. The lower level of Operating ROAE for 2010 compared to 2009 was also due to the impact of higher losses from catastrophic events, market conditions and lower interest yields.
Total Return on Investments
Total return on investments includes net investment income, equity in net income or loss of investment funds accounted for using the equity method, net realized gains and losses and the change in unrealized gains and losses generated by our investment portfolio. Total return is calculated on a pre-tax basis and before investment expenses and includes the effect of financial market conditions along with foreign currency fluctuations. Management uses total return on investments as a key measure of the return generated to common shareholders on the capital held in the business, and compares the return generated by our investment portfolio against a benchmark return index. The benchmark return index is a customized combination of indices intended to approximate a target portfolio by asset mix and average credit quality while also matching the approximate estimated duration and currency mix of our insurance and reinsurance liabilities. Although the estimated duration and average credit quality of this index will move as the duration and rating of its constituent securities change, generally we do not adjust the composition of the benchmark return index. The benchmark return index should not be interpreted as expressing a preference for or aversion to any particular sector or sector weight. The index is intended solely to provide, unlike many master indices that change based on the size of their constituent indices, a relatively stable basket of investable indices. 80
--------------------------------------------------------------------------------
Table of Contents
At
Weighting
Merrill Lynch Unsubordinated U.S. Treasuries/Agencies, 1-10 Years Index
30.875 % Merrill Lynch U.S. Corporates and All Yankees, 1-10 Years Index 20.875 % Merrill Lynch Mortgage Master Index 11.875 % Barclays Capital CMBS,AAA Index 10.000 % Merrill Lynch Municipals, 1-10 Years Index 7.125 % MSCI World Free Index 5.000 % Merrill Lynch U.S. Treasury Bills, 0-3 Months Index 4.750 % Merrill Lynch U.S. High Yield Master II Constrained Index 2.375 % Barclays Capital U.S. High-Yield Corporate Loan Index 2.375 % Merrill LynchU.K. Gilts, 1-10 Years Index 2.375 % Merrill Lynch EMU Direct Government 1-10 Years Index 2.375 % Total 100.000 % The following table summarizes the pre-tax total return (before investment expenses) of our investment portfolio compared to the benchmark return against which we measured our portfolio during the periods: Arch
Benchmark
Portfolio(1)
Return
Pre-tax total return (before investment expenses): Year ended December 31, 2011 3.81 % 4.80 % Year ended December 31, 2010 7.00 % 6.38 % Year ended December 31, 2009 11.28 % 9.71 %
--------------------------------------------------------------------------------
º (1) º Our investment expenses were approximately 0.22%, 0.19% and 0.20%, respectively, of average invested assets in 2011, 2010 and 2009. Total return for our investment portfolio underperformed that of the benchmark return index in 2011. The lower return was due, in part, to the impact of global economic and investment market conditions on our alternative assets and high yield corporate bonds, with risk aversion in the second half of 2011 impacting returns across our portfolio. Excluding foreign exchange, total return was 4.10% for 2011, compared to 7.26% for 2010 and 10.56% for 2009.
Comment on Non-GAAP Financial Measures
Throughout this filing, we present our operations in the way we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who use our financial information in evaluating the performance of our company. This presentation includes the use of after-tax operating income available to common shareholders, which is defined as net income available to common shareholders, excluding net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses, net of income taxes. The presentation of after-tax operating income available to common shareholders is a "non-GAAP financial measure" as defined in Regulation G. The reconciliation of such measure to net income available to common shareholders (the most directly comparable GAAP financial measure) in accordance with Regulation G is included under "Results of Operations" below. 81
--------------------------------------------------------------------------------
Table of Contents
We believe that net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses in any particular period are not indicative of the performance of, or trends in, our business. Although net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses are an integral part of our operations, the decision to realize investment gains or losses, the recognition of net impairment losses, the recognition of equity in net income or loss of investment funds accounted for using the equity method and the recognition of foreign exchange gains or losses are independent of the insurance underwriting process and result, in large part, from general economic and financial market conditions. Furthermore, certain users of our financial information believe that, for many companies, the timing of the realization of investment gains or losses is largely opportunistic. In addition, net impairment losses recognized in earnings on our investments represent other-than-temporary declines in expected recovery values on securities without actual realization. The use of the equity method on certain of our investments in certain funds that invest in fixed maturity securities is driven by the ownership structure of such funds (either limited partnerships or limited liability companies). In applying the equity method, these investments are initially recorded at cost and are subsequently adjusted based on our proportionate share of the net income or loss of the funds (which include changes in the fair value of the underlying securities in the funds). This method of accounting is different from the way we account for our other fixed maturity securities and the timing of the recognition of equity in net income or loss of investment funds accounted for using the equity method may differ from gains or losses in the future upon sale or maturity of such investments. Due to these reasons, we exclude net realized gains or losses, net impairment losses recognized in earnings, equity in net income or loss of investment funds accounted for using the equity method and net foreign exchange gains or losses from the calculation of after-tax operating income available to common shareholders. We believe that showing net income available to common shareholders exclusive of the items referred to above reflects the underlying fundamentals of our business since we evaluate the performance of and manage our underwriting to produce a profit. In addition to presenting net income available to common shareholders, we believe that this presentation enables investors and other users of our financial information to analyze our performance in a manner similar to how management analyzes performance. We also believe that this measure follows industry practice and, therefore, allows the users of financial information to compare our performance with our industry peer group. We believe that the equity analysts and certain rating agencies which follow us and the insurance industry as a whole generally exclude these items from their analyses for the same reasons. RESULTS OF OPERATIONS
The following table summarizes, on an after-tax basis, our consolidated financial data, including a reconciliation of after-tax operating income available to common shareholders to net income available to common shareholders:
Year EndedDecember 31, 2011 2010
2009
After-tax operating income available to common shareholders $ 303,577 $ 491,074 $ 651,805 Net realized gains, net of tax 108,306
247,054 137,428 Net impairment losses recognized in earnings, net of tax
(9,062 ) (11,321 ) (66,056 ) Equity in net income (loss) of investment funds accounted for using the equity method, net of tax (9,605 ) 61,400 167,819 Net foreign exchange gains (losses), net of tax 17,298
28,537 (39,895 )
Net income available to common shareholders $ 410,514 $ 816,744 $ 851,101 82
--------------------------------------------------------------------------------
Table of Contents
The lower level of after-tax operating income in 2011 than in 2010 was primarily due to a higher amount of losses from catastrophic events and also reflected the impact of current insurance and reinsurance market conditions and the impact of lower interest yields on the investment portfolio.
Segment Information
We classify our businesses into two underwriting segments-insurance and reinsurance-and corporate and other (non-underwriting). Accounting guidance regarding disclosures about segments of an enterprise and related information requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. For a description of our underwriting segments, refer to Note 3, "Segment Information," of the notes accompanying our consolidated financial statements. Management measures segment performance based on underwriting income or loss.
Insurance Segment
The following table sets forth our insurance segment's underwriting results: Year Ended December 31, Year Ended December 31, 2011 2010 % Change 2010 2009 % Change Gross premiums written $ 2,444,485 $ 2,402,202 1.8 $ 2,402,202 $ 2,512,127 (4.4 ) Net premiums written 1,721,279 1,658,963 3.8 1,658,963 1,704,284 (2.7 ) Net premiums earned 1,679,047 1,651,106 1.7 1,651,106 1,688,519 (2.2 ) Fee income 2,870 3,252 3,252 3,362 Losses and loss adjustment expenses (1,172,742 ) (1,117,564 ) (1,117,564 ) (1,139,415 ) Acquisition expenses, net (278,696 ) (263,201 ) (263,201 ) (238,261 ) Other operating expenses (306,801 ) (312,404 ) (312,404 )
(281,340 )
Underwriting
income (loss) $ (76,322 ) $ (38,811 ) n/m $ (38,811 ) $ 32,865 n/m % Point % Point Underwriting Ratios Change Change Loss ratio 69.8 % 67.7 % 2.1 67.7 % 67.5 % 0.2 Acquisition expense ratio(1) 16.4 % 15.7 % 0.7 15.7 % 13.9 % 1.8 Other operating expense ratio 18.3 % 18.9 % (0.6 ) 18.9 % 16.7 % 2.2 Combined ratio 104.5 % 102.3 % 2.2 102.3 % 98.1 % 4.2
--------------------------------------------------------------------------------
º (1)
º The acquisition expense ratio is adjusted to include certain fee income.
The components of the insurance segment's underwriting results are discussed below.
83
--------------------------------------------------------------------------------
Table of Contents Premiums Written. The following table sets forth our insurance segment's net premiums written by major line of business: Year Ended December 31, 2011 2010 2009 Amount % Amount % Amount % Property, energy, marine and aviation $ 335,589 20 $ 321,529 19 $ 353,761 21 Programs 297,985 17 273,076 17 274,735 16 Professional liability 237,860 14 268,176 16 258,187 15 Executive assurance 231,405 13 219,458 13 220,088 13 Construction 120,405 7 112,827 7 131,792 8 Casualty 114,235 7 107,962 7 103,546 6 Lenders products 86,694 5 92,921 6 75,357 4 National accounts 80,973 5 67,925 4 79,088 5 Travel and accident 71,940 4 71,237 4 68,617 4 Surety 42,475 2 34,149 2 43,353 3 Healthcare 35,652 2 37,508 2 42,350 2 Other(1) 66,066 4 52,195 3 53,410 3 Total $ 1,721,279 100 $ 1,658,963 100 $ 1,704,284 100
--------------------------------------------------------------------------------
º (1)
º Includes excess workers' compensation, employer's liability, alternative
markets and accident and health business.
2011 versus 2010: Increases in property and energy business as well as in program business, national accounts and executive assurance were partially offset by reductions in commercial aviation and professional liability lines of business. The increase in property premiums primarily resulted from new business and a higher retention rate on existing accounts in the insurance segment's U.S. operations and growth in the insurance segment's European operations in both global property and energy lines. The increase in national accounts resulted from new business while the increase in program business resulted from growth on existing programs. The reduction in commercial aviation business primarily resulted from a strategic decision to exit the business in early 2010 while the lower level of professional liability business was primarily due to market conditions. 2010 versus 2009: Decreases in commercial aviation, construction, national accounts and surety lines of business were partially offset by increases in lenders products. The reduction in commercial aviation business primarily resulted from a strategic decision to exit the business, while the lower level of construction and surety lines was due to market conditions. The higher level of lenders products business was generated through new business opportunities. 84
--------------------------------------------------------------------------------
Table of Contents Net Premiums Earned. The following table sets forth our insurance segment's net premiums earned by major line of business: Year Ended December 31, 2011 2010 2009 Amount % Amount % Amount % Property, energy, marine and aviation $ 322,510 19 $ 335,967 20 $ 338,430 20 Programs 287,598 17 272,406 17 275,586 16 Professional liability 252,037 15 264,603 16 255,117 15 Executive assurance 228,623 14 218,135 13 212,962 13 Construction 112,764 7 109,394 7 139,963 8 Casualty 111,654 7 109,613 7 121,146 7 National accounts 79,542 5 74,538 5 67,093 4 Lenders products 75,291 4 71,170 4 62,906 4 Travel and accident 69,945 4 66,791 4 66,127 4 Surety 41,119 2 37,967 2 49,219 3 Healthcare 35,906 2 39,722 2 43,947 3 Other(1) 62,058 4 50,800 3 56,023 3 Total $ 1,679,047 100 $ 1,651,106 100 $ 1,688,519 100
--------------------------------------------------------------------------------
º (1)
º Includes excess workers' compensation, employer's liability, alternative
<p> markets and accident and health business.
Net premiums earned by the insurance segment were 1.7% higher in 2011 than in 2010, reflecting changes in net premiums written over the previous five quarters. Net premiums earned by the insurance segment were 2.2% lower in 2010 than in 2009.
Losses and Loss Adjustment Expenses. The table below shows the components of the insurance segment's loss ratio:
Year Ended December 31, 2011 2010 2009 Current year 72.9 % 68.9 % 70.3 % Prior period reserve development (3.1 )% (1.2 )% (2.8 )% Loss ratio 69.8 % 67.7 % 67.5 % Current Year Loss Ratio. 2011 versus 2010: The insurance segment's current year loss ratio was 4.0 points higher in 2011 than in 2010. The 2011 loss ratio included 6.5 points of current year catastrophic event activity, compared to 1.9 points in the 2010. Specific 2011 catastrophic events included the severe flooding inThailand , the Japanese earthquake and Tsunami and various U.S. wind/rain events. 2010 versus 2009: The insurance segment's current year loss ratio was 1.4 points lower in 2010 than in 2009. The 2010 loss ratio benefited from a lower level of large, specific risk loss activity than in 2009. In addition, the 2010 loss ratio included 1.9 points for current year catastrophic event activity, while the 2009 loss ratio did not include any significant catastrophic event activity. Specific 2010 catastrophic events included the Chilean earthquake and the 2010 fourth quarterQueensland, Australia floods. 85
--------------------------------------------------------------------------------
Table of Contents PriorPeriod Reserve Development . 2011 prior period reserve development: The insurance segment's net favorable development of$52.1 million , or 3.1 points of net premiums earned, consisted of net favorable development of$75.7 million from short-tailed lines, partially offset by$23.6 million of net adverse development from medium-tailed and long-tailed lines. Favorable development in short-tailed lines reflected$67.2 million of favorable development in property reserves, including$18.1 million ,$19.3 million and$31.1 million , respectively, from the 2008 to 2010 accident years (i.e., the year in which a loss occurred), and$7.5 million of favorable development in surety business, including$2.7 million ,$4.2 million and$5.0 million from the 2004, 2008 and 2009 accident years, partially offset by$3.8 million of adverse development from the 2006 accident year. The reduction of loss estimates in 2011 for the insurance segment's short-tailed lines included an aggregate of$23.0 million of favorable development from the 2005, 2008 and 2010 named catastrophic events. In addition, adverse development in alternative markets business from the 2009 to 2010 accident years of$9.3 million , which was primarily related to experience on a single account, was partially offset by$8.0 million of favorable development from the 2004 to 2008 accident years. The adverse development on longer-tailed lines primarily resulted from$32.3 million of increases in casualty reserves which included$14.3 million of adverse development, primarily from the 2005 and 2007 accident years, onNew York residential contractors business based on the most recent actuarial analyses,$8.5 million of adverse development on a 2010 accident year energy casualty claim, and$9.5 million from other commercial claims. In addition, there was$9.8 million of adverse development in program business, including$2.8 million and$6.8 million from the 2003 and 2004 accident years on a small number of programs. Favorable development was indicated on healthcare business, with$13.8 million of releases from the 2004 to 2008 accident years resulting from a continuation of better than expected loss emergence, and on marine business, with$4.6 million of releases in the 2009 accident year. Development in professional lines (professional liability and executive assurance) was minimal in the aggregate, with adverse development of$3.0 million ,$10.4 million and$11.6 million in the 2006, 2008 and 2010 accident years substantially offset by favorable development of$8.2 million and$15.2 million from the 2007 and 2009 accident years. 2010 prior period reserve development: The insurance segment's net favorable development of$19.1 million , or 1.2 points, reflected reductions in property reserves from the 2005 to 2009 accident years of$5.3 million ,$6.8 million ,$7.9 million ,$23.4 million and$4.3 million , respectively, and reductions in healthcare and other lines of$11.4 million and$11.5 million , respectively, which were spread across a number of accident years. In addition, the insurance segment had reductions in professional liability reserves from the 2007 and 2008 accident years of$11.2 million and$7.9 million , respectively, partially offset by adverse development from the 2006 accident year of$8.4 million . The loss ratio for the year endedDecember 31, 2010 reflected adverse development in casualty reserves from the 2003 to 2005 accident years of$16.6 million ,$9.8 million and$11.0 million , respectively, which was primarily due to a small number of high severity claims in excess casualty and a high frequency of small claims in specialty casualty. Additionally, there was adverse development in program reserves from the 2003, 2005 and 2009 accident years of$7.6 million ,$6.7 million and$9.3 million , respectively, partially offset by reductions from the 2006 to 2008 accident years of$6.1 million ,$4.7 million and$4.2 million , respectively. In addition, the insurance segment had adverse development in executive assurance reserves from the 2008 and 2009 accident years of$14.1 million and$21.3 million , respectively, due to large specific risk loss activity relating to the credit crisis, partially offset by reductions from the 2003, 2004, 2006 and 2007 accident years of$2.0 million ,$2.6 million ,$3.4 million and$7.6 million , respectively. 86
--------------------------------------------------------------------------------
Table of Contents
2009 prior period reserve development: The insurance segment's net favorable development of$47.1 million , or 2.8 points, was primarily due to reductions in reserves in medium-tailed and short-tailed lines of business. Such amount included favorable development in professional liability reserves from the 2005 to 2007 accident years of$6.3 million ,$16.1 million and$8.6 million , respectively, and adverse development on the 2008 accident year of$9.4 million . In addition, favorable development on construction reserves from the 2005 and 2006 accident years contributed$10.6 million and$5.4 million , respectively, which resulted from lower than expected large loss activity. Favorable development in short-tailed lines primarily consisted of reductions in property reserves from the 2007 and 2008 accident years of$9.4 million and$11.1 million , respectively. Offsetting favorable development on medium-tailed and short-tailed lines of business were increases in executive assurance reserves for the 2007 and 2008 accident years of$14.8 million and$28.3 million , respectively, due to large specific risk loss activity relating to the credit crisis, partially offset by favorable development in the 2004 to 2006 accident years of$4.1 million ,$17.5 million and$3.6 million , respectively. Reductions in the 2004 to 2006 accident years relate to less large loss activity than expected in commercial D&O, a distinctive downward trend in security class action cases filed from 2004 through 2006, and to the claims-made nature of the coverage. The claims-made aspect eliminates the potential of new claims being reported for these years, and narrows the remaining liability to changes in reserve estimation for claims which have already been reported.
Underwriting Expenses.
2011 versus 2010: The insurance segment's underwriting expense ratio was 34.7% in 2011, compared to 34.6% in 2010. The acquisition expense ratio was 16.4% for 2011, compared to 15.7% for 2010. The acquisition expense ratio is influenced by, among other things, (1) the amount of ceding commissions received from reinsurers, (2) the amount of business written on a surplus lines (non-admitted) basis and (3) mix of business. In addition, the 2011 acquisition expense ratio included 0.5 points related to favorable reserve development in prior accident years on certain contracts with variable commission structures, compared to a 0.4 points in 2010, and also reflected changes in the form of reinsurance ceded and mix of business. The insurance segment's other operating expense ratio was 18.3% for 2011, compared to 18.9% for 2010. The 2010 operating expense ratio reflected 0.4 points related to an accrual for certain employee benefit costs recorded in 2010 that did not recur in 2011. 2010 versus 2009: The insurance segment's underwriting expense ratio was 34.6% in 2010, compared to 30.6% in 2009. The acquisition expense ratio was 15.7% for 2010, compared to 13.9% for 2009. The 2010 acquisition expense ratio included 0.4 points related to prior year reserve development, compared to a 0.2 points in 2009, included a higher level of premium assessments and other charges and reflected changes in the form of reinsurance ceded and mix of business. The insurance segment's other operating expense ratio was 18.9% for 2010, compared to 16.7% for 2009. The 2010 operating expense ratio reflected 0.4 points related to an accrual for certain employee benefit costs and also reflected expenses related to the expansion of the insurance segment's presence in executive assurance business. 87
--------------------------------------------------------------------------------
Table of Contents Reinsurance Segment The following table sets forth our reinsurance segment's underwriting results: Year Ended December 31, Year Ended December 31, 2011 2010 % Change 2010 2009 % Change Gross premiums written $ 998,520 $ 874,957 14.1 $ 874,957 $ 1,093,940 (20.0 ) Net premiums written 952,047 852,077 11.7 852,077 1,058,828 (19.5 ) Net premiums earned 952,768 901,377 5.7 901,377 1,154,226 (21.9 ) Fee income 559 2,113 2,113 100 Losses and loss adjustment expenses (554,811 ) (400,151 ) (400,151 ) (515,259 ) Acquisition expenses, net (184,241 ) (178,001 ) (178,001 ) (255,299 ) Other operating expenses (93,299 ) (91,523 ) (91,523 ) (80,567 ) Underwriting income $ 120,976 $ 233,815 (48.3 ) $ 233,815 $
303,201 (22.9 ) % Point % Point Underwriting Ratios Change Change Loss ratio 58.2 % 44.4 % 13.8 44.4 % 44.6 % (0.2 )
Acquisition expense ratio 19.3 % 19.7 % (0.4 ) 19.7 %
22.1 % (2.4 )
Other operating expense ratio 9.8 % 10.2 % (0.4 ) 10.2 %
7.0 % 3.2 Combined ratio 87.3 % 74.3 % 13.0 74.3 % 73.7 % 0.6
The components of the reinsurance segment's underwriting results are discussed below.
Premiums Written.
The following table sets forth our reinsurance segment's net premiums written by major line of business:
Year Ended December 31, 2011 2010 2009 Amount % Amount % Amount % Property catastrophe $ 246,793 26 $ 202,989 24 $ 237,445 23 Property excluding property catastrophe(1) 226,013 24 249,791 29 349,915 33 Other specialty 211,019 22 131,158 15 65,189 6 Casualty(2) 181,957 19 186,774 22 325,699 31 Marine and aviation 77,309 8 77,063 9 77,677 7 Other 8,956 1 4,302 1 2,903 - Total $ 952,047 100 $ 852,077 100 $ 1,058,828 100 Pro rata $ 416,321 44 $ 411,962 48 $ 586,212 55 Excess of loss 535,726 56 440,115 52 472,616 45 Total $ 952,047 100 $ 852,077 100 $ 1,058,828 100
--------------------------------------------------------------------------------
º (1) º Includes facultative business. º (2) º Includes professional liability, executive assurance and healthcare business.
2011 versus 2010: Increases in property catastrophe and other specialty lines were partially offset by a decrease in property other than property catastrophe and casualty business. The growth in
88
--------------------------------------------------------------------------------
Table of Contents
premiums written in the property catastrophe line in 2011 reflected share increases, new business following the 2011 catastrophic events and higher premiums on in force contracts due to market conditions. The higher level of other specialty business primarily resulted from a new opportunity inU.K. motor business written, and growth in accident and health and trade credit business. Premiums written in casualty and property other than property catastrophe lines were lower than in 2010, reflecting non-renewals and share reductions based on market conditions. 2010 versus 2009: Reductions in casualty and property other than property catastrophe business were partially offset by growth in the reinsurance segment's other specialty line. The decrease in casualty and property business in 2010 resulted from the impact of non-renewals of a number of contracts and contract participation decreases, reflecting the impact of current market conditions. The increase in other specialty business primarily resulted from new business written in accident and health and trade credit.
Net Premiums Earned.
The following table sets forth our reinsurance segment's net premiums earned by major line of business: Year Ended December 31, 2011 2010 2009 Amount % Amount % Amount % Property excluding property catastrophe(1) $ 243,702 25 $ 282,163 31 $ 373,088 32 Property catastrophe 238,748 25 215,148 24 236,073 20 Casualty(2) 196,370 21 231,338 26 344,938 30 Other specialty 189,093 20 95,611 11 106,698 10 Marine and aviation 77,819 8 72,886 8 90,441 8 Other 7,036 1 4,231 - 2,988 - Total $ 952,768 100 $ 901,377 100 $ 1,154,226 100 Pro rata $ 435,311 46 $ 449,532 50 $ 704,470 61 Excess of loss 517,457 54 451,845 50 449,756 39 Total $ 952,768 100 $ 901,377 100 $ 1,154,226 100
--------------------------------------------------------------------------------
º (1) º Includes facultative business. º (2) º Includes professional liability, executive assurance and healthcare business. Net premiums earned in 2011 were 5.7% higher than in 2010, reflecting changes in net premiums written over the previous five quarters, including the mix and type of business written. Net premiums earned in 2010 were 21.9% lower than in 2009.
Losses and Loss Adjustment Expenses. The table below shows the components of the reinsurance segment's loss ratio:
Year Ended December 31, 2011 2010 2009 Current year 82.6 % 58.6 % 56.9 % Prior period reserve development (24.4 )% (14.2 )% (12.3 )% Loss ratio 58.2 % 44.4 % 44.6 % 89
--------------------------------------------------------------------------------
Table of Contents Current Year Loss Ratio. 2011 versus 2010: The reinsurance segment's current year loss ratio was 24.0 points higher in 2011 than in 2010. The 2011 loss ratio included 31.0 points for current year catastrophic event activity, compared to 9.9 points in 2010. Specific 2011 catastrophic events included the severe flooding inThailand , the Japanese earthquake and Tsunami, theNew Zealand earthquake events and various U.S. wind/rain events. 2010 versus 2009: The reinsurance segment's current year loss ratio was 1.7 points higher in 2010 than in 2009. The 2010 loss ratio included 9.9 points for current year catastrophic event activity, compared to 2.0 points in 2009. Specific 2010 catastrophic events included the Chilean andNew Zealand earthquakes, the 2010 first quarter Australian hailstorm and flood event and the 2010 fourth quarterQueensland, Australia floods. In addition, 2010 benefited from a higher percentage of property (both treaty and facultative) and short-tail business than in 2009. Net premiums earned in property and other short-tailed lines were approximately 74% of the total for 2010, compared to 70% in 2009.
Prior
2011 prior period reserve development: The reinsurance segment's net favorable development of$232.9 million , or 24.4 points of net premiums earned, consisted of$118.5 million from short-tailed lines,$99.0 million from long-tailed lines and$15.4 million from medium-tailed lines. Favorable development in short-tailed lines included$97.6 million of favorable development from property catastrophe and property other than property catastrophe reserves. Such amount included reductions of$7.5 million ,$25.8 million and$59.8 million from the 2007, 2009 and 2010 underwriting years, respectively, and$4.5 million from all other underwriting years. In addition, favorable development on short-tailed lines included$20.8 million in other specialty business, including$3.7 million ,$2.2 million ,$6.2 million and$2.7 million , respectively, from the 2007 to 2010 underwriting years, respectively, and$6.0 million from prior underwriting years. The reduction of loss estimates for the reinsurance segment's short-tailed lines primarily resulted from a lower level of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2011. The reduction of loss estimates in 2011 for the reinsurance segment's short-tailed lines included an aggregate of$19.4 million of favorable development from the 2005, 2008 and 2010 named catastrophic events. Net favorable development of$99.0 million in long-tailed lines included reductions in casualty reserves from the 2002 to 2007 underwriting years of$14.1 million ,$16.6 million ,$30.9 million ,$24.7 million ,$11.3 million and$16.2 million , respectively, which primarily resulted from a lower level of reported and paid claims activity than previously anticipated on U.S. and international excess liability, professional liability and D&O lines. Such amounts were partially offset by adverse development of$2.2 million and$12.4 million from the 2008 and 2009 underwriting years, respectively, on long-tailed lines which primarily resulted from increases in loss selections due to the reinsurance segment's view of the current insurance environment. Favorable development on medium-tailed lines resulted from reductions in marine and aviation reserves of$2.3 million ,$2.2 million and$6.7 million , respectively, from the 2006 to 2008 underwriting years and$4.2 million from other underwriting years. The reinsurance segment's reserves for more mature underwriting years are now based more on actual loss activity and historical patterns than on the initial assumptions based on pricing indications. 2010 prior period reserve development: The reinsurance segment's net favorable development of$127.6 million , or 14.2 points, consisted of$84.2 million from short-tailed lines,$34.1 million from long-tailed lines and$9.3 million from medium-tailed lines. Favorable development in short-tailed lines included$61.0 million of favorable development from property catastrophe and property other than property catastrophe reserves. Such amount included reductions of$9.4 million ,$11.2 million and$28.6 million from the 2007, 2008 and 2009 underwriting years, respectively, and$11.8 million from prior underwriting years. In addition, favorable development in other specialty business included$4.7 million and$7.8 million from the 2008 and 2009 underwriting years, respectively, and$10.7 million 90
--------------------------------------------------------------------------------
Table of Contents
from prior underwriting years. The reduction of loss estimates for the reinsurance segment's short-tailed lines primarily resulted from a lower level of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2010. Net favorable development of$34.1 million in long-tailed lines included reductions in casualty reserves from the 2002 to 2006 underwriting years of$10.8 million ,$17.5 million ,$33.3 million ,$13.5 million and$5.8 million , respectively, which primarily resulted from a lower level of reported and paid claims activity than previously anticipated on U.S. and international excess liability, professional liability and D&O lines. Such amounts were partially offset by adverse development of$7.5 million ,$31.9 and$5.6 million from the 2007 to 2009 underwriting years, respectively, on long-tailed lines which primarily resulted from increases in loss selections due to the reinsurance segment's view of the insurance environment. Favorable development on medium-tailed lines resulted from reductions in marine and aviation reserves of$8.3 million from the 2007 underwriting year and$7.7 million from other underwriting years, partially offset by adverse development of$6.7 million from the 2008 underwriting year. 2009 prior period reserve development: The reinsurance segment's net favorable development of$142.1 million , or 12.3 points, consisted of$83.4 million from short-tailed lines and$78.7 million came from long-tailed lines, partially offset by$20.0 million of adverse development on medium-tailed lines. Favorable development in short-tailed lines included$58.5 million of favorable development from property catastrophe and other property lines. Such amount included reductions in 2005 to 2008 underwriting years of$8.1 million ,$5.6 million ,$21.0 million and$20.9 million , respectively. In addition, favorable development in short-tailed lines included$22.7 million from other specialty business, which included reductions of$9.7 million ,$4.3 million and$5.3 million from the 2004, 2005 and 2008 underwriting years. The reduction of loss estimates for the reinsurance segment's short-tailed lines primarily resulted from a lower level of reported and paid claims activity than previously anticipated which led to decreases in certain loss ratio selections during 2009. Net favorable development of$78.7 million in long-tailed lines included reductions in casualty reserves of$14.4 million ,$25.9 million ,$25.0 million and$32.3 million from the 2002 to 2005 underwriting years which primarily resulted from a lower level of reported and paid claims activity than previously anticipated on U.S. and international excess liability, professional liability and D&O lines. Such amounts were partially offset by adverse development of$25.0 million from the 2007 underwriting year, which primarily resulted from increases in loss selections due to the reinsurance segment's view of the insurance environment. Adverse development on medium-tailed lines resulted from increases on marine exposures in the 2007 and 2008 underwriting years of$7.2 million and$26.9 million , respectively, due in part to increases in Hurricane Ike estimates, partially offset by reductions in prior underwriting years. Underwriting Expenses. 2011 versus 2010: The underwriting expense ratio for the reinsurance segment was 29.1% in 2011, compared to 29.9% in 2010. The acquisition expense ratio for 2011 was 19.3%, compared to 19.7% for 2010. The comparison of the 2011 and 2010 acquisition expense ratios is influenced by, among other things, the mix and type of business written and earned and the level of ceding commission income. The operating expense ratio for 2011 of 9.8% was lower than the 2010 ratio primarily due to the higher level of net premiums earned. 2010 versus 2009: The underwriting expense ratio for the reinsurance segment was 29.9% in 2010, compared to 29.1% in 2009. The acquisition expense ratio for 2010 was 19.7%, compared to 22.1% for 2009. The comparison of the 2010 and 2009 acquisition expense ratios is influenced by, among other things, the mix and type of business written and earned and the level of ceding commission income. The operating expense ratio for 2010 of 10.2% was higher than the 2009 ratio primarily due to the lower level of net premiums earned and a higher contribution to net premiums earned from the reinsurance segment's property facultative operations which operate primarily on a direct basis and, accordingly, at a higher operating expense ratio. 91
--------------------------------------------------------------------------------
Table of Contents Net Investment Income The components of net investment income were derived from the following sources: Year Ended December 31, 2011 2010 2009 Fixed maturities $ 331,469 $ 378,682 $ 404,861 Equity securities 7,332 1,363 - Short-term investments 2,174 1,337 1,897 Other(1) 22,006 3,882 4,413 Gross investment income 362,981 385,264 411,171 Investment expenses (24,783 ) (20,386 ) (21,040 ) Net investment income $ 338,198 $ 364,878 $ 390,131
--------------------------------------------------------------------------------
º (1)
º Includes interest on term loan investments (included in "investments
accounted for using the fair value option"), dividends on investment funds
and other items.
The pre-tax investment income yield was 2.89% for 2011, compared to 3.34% for 2010 and 3.74% for 2009. The comparability of net investment income between the periods was influenced by our share repurchase program, as well as the decrease in the pre-tax investment income yield, due in part to the prevailing interest rate environment. The pre-tax investment income yields were calculated based on amortized cost. Yields on future investment income may vary based on financial market conditions, investment allocation decisions and other factors.
Equity in Net Income (Loss) of Investment Funds Accounted for Using the
Equity Method
We recorded$9.6 million of equity in net losses for 2011, compared to$61.4 million of equity in net income for 2010 and equity in net income of$167.8 million for 2009. Such amounts were primarily related to our investments in U.S. and Euro-denominated bank loan funds which use leverage to achieve a higher rate of return. While leverage presents opportunities for increasing the total return of such investments, it may increase losses as well. Accordingly, any event that adversely affects the value of the underlying securities held by such investments would be magnified to the extent leverage is used and our potential losses from such investments would be magnified. Losses in 2011 were primarily related to investments in two funds that employ leverage in their investment strategy, one of which that invests in a portfolio of loans and another public-private investment fund ("PPIF") that invests in high quality U.S. residential and commercial mortgages.
Net Realized Gains (Losses)
We recorded net realized gains of$110.6 million ,$252.8 million and$143.6 million , respectively, for 2011, 2010 and 2009. Currently, our portfolio is actively managed to maximize total return within certain guidelines. In assessing returns under this approach, we include net investment income, net realized gains and losses and the change in unrealized gains and losses generated by our investment portfolio. The effect of financial market movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced. See note 7, "Investment Information-Net Realized Gains (Losses)," of the notes accompanying our consolidated financial statements for additional information. Total return on our portfolio under management for 2011 was 3.81%, compared to 7.00% for 2010 and 11.28% for 2009. Excluding foreign exchange, total return was 4.10% for 2011, compared to 7.26% for 2010 and 10.56% for 2009. Total return is calculated on a pre-tax basis and before investment expenses. 92
--------------------------------------------------------------------------------
Table of Contents Net Impairment Losses Recognized in Earnings On a quarterly basis, we perform reviews of our available for sale investments to determine whether declines in fair value below the cost basis are considered other-than-temporary in accordance with applicable accounting guidance regarding the recognition and presentation of other-than-temporary impairments. The process of determining whether a security is other-than-temporarily impaired requires judgment and involves analyzing many factors. These factors include (i) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (ii) the time period in which there was a significant decline in value, (iii) the significance of the decline, and (iv) the analysis of specific credit events. We evaluate the unrealized losses of our equity securities by issuer and determine if we can forecast a reasonable period of time by which the fair value of the securities would increase and we would recover our cost. If we are unable to forecast a reasonable period of time in which to recover the cost of our equity securities, we record a net impairment loss in earnings equivalent to the entire unrealized loss. For 2011, we recorded$9.1 million of credit related impairments in earnings, compared to$11.3 million in 2010 and$66.1 million in 2009. The other-than-temporary impairments ("OTTI") recorded in 2011, 2010 and 2009 primarily resulted from reductions in estimated recovery values on certain mortgage-backed and asset-backed securities following the review of such securities. See note 7, "Investment Information-Other-Than-Temporary Impairments," of the notes accompanying our consolidated financial statements for additional information. Other Expenses Other expenses, which are included in our other operating expenses and part of corporate and other (non-underwriting), were$31.4 million for 2011, compared to$28.9 million for 2010 and$30.2 million for 2009. Such amounts primarily represent certain holding company costs necessary to support our worldwide insurance and reinsurance operations, share based compensation expense and costs associated with operating as a publicly traded company.
Net Foreign Exchange Gains or Losses
Net foreign exchange gains for 2011 of$17.4 million consisted of net unrealized gains of$23.5 million and net realized losses of$6.1 million , compared to net foreign exchange gains for 2010 of$28.1 million which consisted of net unrealized gains of$29.5 million and net realized losses of$1.4 million . Net foreign exchange losses for 2009 of$39.2 million consisted of net unrealized losses of$37.6 million and net realized losses of$1.6 million . Net unrealized foreign exchange gains or losses result from the effects of revaluing our net insurance liabilities required to be settled in foreign currencies at each balance sheet date. Historically, we have held investments in foreign currencies which are intended to mitigate our exposure to foreign currency fluctuations in our net insurance liabilities. However, changes in the value of such investments due to foreign currency rate movements are reflected as a direct increase or decrease to shareholders' equity and are not included in the consolidated statements of income. As a result of the current financial and economic environment as well as the potential for additional investment returns, we may not match a portion of our projected liabilities in foreign currencies with investments in the same currencies, which could increase our exposure to foreign currency fluctuations and increase the volatility in our shareholders' equity. Income Taxes ACGL changed its legal domicile fromthe United States toBermuda inNovember 2000 . Under currentBermuda law, we are not obligated to pay any taxes inBermuda based upon income or capital gains. We have received a written undertaking from the Minister of Finance inBermuda under the Exempted Undertakings Tax Protection Act of 1966 that in the event legislation is enacted inBermuda imposing tax computed on profits, income, gain or appreciation on any capital asset, or tax in the 93
--------------------------------------------------------------------------------
Table of Contents
nature of estate duty or inheritance tax, such tax will not be applicable to us or our operations until
ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. taxpayers. ACGL does not consider itself to be engaged in a trade or business within the U.S. and, consequently, does not expect to be subject to direct U.S. income taxation. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business withinthe United States , there can be no assurances that theU.S. Internal Revenue Service will not contend successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or business inthe United States . If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL's shareholders' equity and earnings could be materially adversely affected. ACGL has subsidiaries and branches that operate in various jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The significant jurisdictions in which ACGL's subsidiaries and branches are subject to tax includethe United States ,United Kingdom ,Canada ,Ireland ,Switzerland andDenmark . See "Risk Factors-Risks Relating to Taxation" and "Business-Tax Matters." The income tax provision on income before income taxes resulted in a benefit of 2.2% for 2011, compared to an expense of 0.9% for 2010 and 2.3% for 2009. Our effective tax rate fluctuates from year to year consistent with the relative mix of income or loss reported by jurisdiction and the varying tax rates in each jurisdiction. See note 12, "Income Taxes," of the notes accompanying our consolidated financial statements for a reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average statutory tax rate for 2011, 2010 and 2009.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RECENT ACCOUNTING PRONOUNCEMENTS
The preparation of consolidated financial statements in accordance with GAAP requires us to make many estimates and judgments that affect the reported amounts of assets, liabilities (including reserves), revenues and expenses, and related disclosures of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, allowance for doubtful accounts, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation. We base our estimates on historical experience, where possible, and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments for a relatively new insurance and reinsurance company, like our company, are even more difficult to make than those made in a mature company since relatively limited historical information has been reported to us throughDecember 31, 2011 . Actual results will differ from these estimates and such differences may be material. We believe that the following critical accounting policies affect significant estimates used in the preparation of our consolidated financial statements.
Reserves for Losses and Loss Adjustment Expenses
We are required by applicable insurance laws and regulations and GAAP to establish reserves for losses and loss adjustment expenses ("Loss Reserves") that arise from the business we underwrite. Loss Reserves for our insurance and reinsurance operations are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured events which have occurred at or before the balance sheet date. Loss Reserves do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial. 94
--------------------------------------------------------------------------------
Table of Contents
AtDecember 31, 2011 and 2010, our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows: December 31, 2011 2010 Insurance: Case reserves $ 1,311,740 $ 1,251,896 IBNR reserves 2,783,091 2,590,529 Total net reserves $ 4,094,831 $ 3,842,425 Reinsurance: Case reserves $ 721,032 $ 747,545 Additional case reserves 178,640 93,110 IBNR reserves 1,643,660 1,712,173 Total net reserves $ 2,543,332 $ 2,552,828 Total: Case reserves $ 2,032,772 $ 1,999,441 Additional case reserves 178,640 93,110 IBNR reserves 4,426,751 4,302,702 Total net reserves $ 6,638,163 $ 6,395,253 Insurance Operations Loss Reserves for our insurance operations are comprised of (1) estimated amounts for claims reported ("case reserves") and (2) incurred but not reported ("IBNR") losses. For our insurance operations, generally, claims personnel determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices, the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. Our insurance operations also contract with a number of outside third party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of such administrators is reviewed and monitored by our claims personnel. Loss Reserves are also established to provide for loss adjustment expenses and represent the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made. IBNR reserves are established to provide for incurred claims which have not yet been reported at the balance sheet date as well as to adjust for any projected variance in case reserving. Actuaries estimate ultimate losses and loss adjustment expenses using various generally accepted actuarial methods applied to known losses and other relevant information. Like case reserves, IBNR reserves are adjusted as additional information becomes known or payments are made. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain. Ultimate losses and loss adjustment expenses are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can reasonably be expected to persist into the future. In forecasting ultimate losses and loss adjustment expenses with respect to any line of business, past experience with respect to that line of business is the primary resource, developed through both industry and company experience, but cannot be relied upon in isolation. Uncertainties in estimating ultimate losses and loss adjustment expenses are magnified by the time lag between when a claim actually occurs and when it is reported and settled. This time lag is sometimes referred to as the 95
--------------------------------------------------------------------------------
Table of Contents
"claim-tail". The claim-tail for most property coverages is typically short (usually several months up to a few years). The claim-tail for certain professional liability, executive assurance and healthcare coverages, which are generally written on a claims-made basis, is typically longer than property coverages but shorter than casualty lines. The claim-tail for liability/casualty coverages, such as general liability, products liability, multiple peril coverage, and workers' compensation, may be especially long as claims are often reported and ultimately paid or settled years, or even decades, after the related loss events occur. During the long claims reporting and settlement period, additional facts regarding coverages written in prior accident years, as well as about actual claims and trends, may become known and, as a result, our insurance operations may adjust their reserves. If management determines that an adjustment is appropriate, the adjustment is recorded in the accounting period in which such determination is made in accordance with GAAP. Accordingly, should Loss Reserves need to be increased or decreased in the future from amounts currently established, future results of operations would be negatively or positively impacted, respectively. In determining ultimate losses and loss adjustment expenses, the cost to indemnify claimants, provide needed legal defense and other services for insureds and administer the investigation and adjustment of claims are considered. These claim costs are influenced by many factors that change over time, such as expanded coverage definitions as a result of new court decisions, inflation in costs to repair or replace damaged property, inflation in the cost of medical services and legislated changes in statutory benefits, as well as by the particular, unique facts that pertain to each claim. As a result, the rate at which claims arose in the past and the costs to settle them may not always be representative of what will occur in the future. The factors influencing changes in claim costs are often difficult to isolate or quantify and developments in paid and incurred losses from historical trends are frequently subject to multiple and conflicting interpretations. Changes in coverage terms or claims handling practices may also cause future experience and/or development patterns to vary from the past. A key objective of actuaries in developing estimates of ultimate losses and loss adjustment expenses, and resulting IBNR reserves, is to identify aberrations and systemic changes occurring within historical experience and accurately adjust for them so that the future can be projected reliably. Because of the factors previously discussed, this process requires the substantial use of informed judgment and is inherently uncertain.
At
December 31, 2011 2010 Casualty $ 655,017 $ 656,446 Professional liability 631,991 603,258 Executive assurance 636,692 598,527 Property, energy, marine and aviation 590,098 519,560 Programs 541,113 504,068 Construction 403,109 391,179 National accounts 169,906 132,064 Healthcare 139,825 145,343 Surety 70,680 79,264 Travel and accident 37,645 31,707 Lenders products 12,332 12,156 Other 206,423 168,853 Total net reserves $ 4,094,831 $ 3,842,425 96
--------------------------------------------------------------------------------
Table of Contents
The initial reserving method for our insurance operations to date has been, to a large extent, the expected loss method, which is commonly applied when limited loss experience exists. Our insurance operations employ a number of different reserving methods depending on the line of business, the availability of historical loss experience and the stability of that loss experience. Over time, such techniques have been given more weight in the reserving process due to the continuing maturation of their Loss Reserves and the increased availability and credibility of the historical experience. Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that relatively limited historical information has been reported to our insurance operations throughDecember 31, 2011 in some lines of business. See below for a discussion of the key assumptions in our insurance operations' reserving process. Although Loss Reserves are initially determined based on underwriting and pricing analyses, our insurance operations apply several generally accepted actuarial methods, as discussed below, on a quarterly basis to evaluate their Loss Reserves, in addition to the expected loss method, in particular for Loss Reserves from more mature accident years (the year in which a loss occurred). As noted below, beginning in 2005, our insurance operations began to give a relatively small amount of weight to their own experience following reviews of open claims on lines of business written on a claims-made basis for which they developed a reasonable level of credible data. Each quarter, as part of the reserving process, actuaries at our insurance operations reaffirm that the assumptions used in the reserving process continue to form a sound basis for the projection of liabilities. If actual loss activity differs substantially from expectations based on historical information, an adjustment to loss reserves may be supported. Estimated Loss Reserves for more mature accident years are now based more on historical loss activity and patterns than on the initial assumptions based on pricing indications. More recent accident years rely more heavily on internal pricing assumptions. Our insurance operations place more or less reliance on a particular actuarial method based on the facts and circumstances at the time the estimates of Loss Reserves are made. These methods generally fall into one of the following categories or are hybrids of one or more of the following categories: º • º Expected loss methods-these methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the
information derived by underwriters and actuaries during the initial
pricing of the business, supplemented by industry data available from organizations, such as statistical bureaus and consulting firms, where
appropriate. These ratios consider, among other things, rate increases
and changes in terms and conditions that have been observed in the
market. Expected loss methods are useful for estimating ultimate
losses and loss adjustment expenses in the early years of long-tailed
lines of business, when little or no paid or incurred loss information
is available, and is commonly applied when limited loss experience
exists for a company.
º •
º Historical incurred loss development methods-these methods assume that
the ratio of losses in one period to losses in an earlier period will
remain constant in the future. These methods use incurred losses
(i.e., the sum of cumulative historical loss payments plus outstanding
case reserves) over discrete periods of time to estimate future
losses. Historical incurred loss development methods may be preferable
to historical paid loss development methods because they explicitly
take into account open cases and the claims adjusters' evaluations of
the cost to settle all known claims. However, historical incurred loss
development methods necessarily assume that case reserving practices
are consistently applied over time. Therefore, when there have been
significant changes in how case reserves are established, using
incurred loss data to project ultimate losses may be less reliable</p>
than other methods. º • º Historical paid loss development methods-these methods, like
historical incurred loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant. These methods use historical loss payments over discrete periods of time to 97
--------------------------------------------------------------------------------
Table of Contents
estimate future losses and necessarily assume that factors that have
affected paid losses in the past, such as inflation or the effects of
litigation, will remain constant in the future. Because historical
paid loss development methods do not use incurred losses to estimate ultimate losses, they may be more reliable than the other methods that use incurred losses in situations where there are significant changes in how incurred losses are established by a company's claims adjusters. However, historical paid loss development methods are more leveraged (meaning that small changes in payments have a larger impact on estimates of ultimate losses) than actuarial methods that use incurred losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative incurred amounts.
In addition, and for similar reasons, historical paid loss development
methods are often slow to react to situations when new or different
factors arise than those that have affected paid losses in the past. º •
º Adjusted historical paid and incurred loss development methods-these
methods take traditional historical paid and incurred loss development
methods and adjust them for the estimated impact of changes from the past in factors such as inflation, the speed of claim payments or the adequacy of case reserves. Adjusted historical paid and incurred loss development methods are often more reliable methods of predicting ultimate losses in periods of significant change, provided the actuaries can develop methods to reasonably quantify the impact of
changes. As such, these methods utilize more judgment than historical
paid and incurred loss development methods.
º •
º Bornhuetter-Ferguson ("B-F") paid and incurred loss methods-these
methods utilize actual paid and incurred losses and expected patterns of paid and incurred losses, taking the initial expected ultimate losses into account to determine an estimate of expected ultimate losses. The B-F paid and incurred loss methods are useful when there are few reported claims and a relatively less stable pattern of reported losses. º • º Additional analyses-other methodologies are often used in the reserving process for specific types of claims or events, such as catastrophic or other specific major events. These include vendor catastrophe models, which are typically used in the estimation of Loss Reserves at the early stage of known catastrophic events before
information has been reported to an insurer or reinsurer, and analyses of specific industry events, such as large lawsuits or claims. In the initial reserving process for casualty business, primarily consisting of primary and excess exposures written on an occurrence basis, our insurance operations primarily rely on the expected loss method. The development of our insurance operations' casualty business may be unstable due to its long-tail nature and the occurrence of high severity events, as a portion of our insurance operations' casualty business is in high excess layers. As time passes, for a given accident year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. Our insurance operations make a number of key assumptions in reserving for casualty business, including that the pricing loss ratio is the best estimate of the ultimate loss ratio at the time the policy is entered into, that our insurance operations' loss development patterns, which are based on a combination of company and industry loss development patterns and adjusted to reflect differences in our insurance operations' mix of business, are reasonable and that our insurance operations' claims personnel and underwriters analyses of our exposure to major events are assumed to be our best estimate of our exposure to the known claims on those events. As noted earlier, due to the long claims reporting and settlement period for casualty business, additional facts regarding coverages written in prior accident years, as well as about actual claims and trends may become known and, as a result, our insurance operations may be required to adjust their casualty reserves. The expected loss ratios used in the initial reserving process for our insurance operations' casualty business for recent accident years have varied, in some cases significantly, from earlier accident years. As the credibility of historical experience for earlier accident years increases, the experience from these accident years will be given a greater weighting in the actuarial analysis to determine future 98
--------------------------------------------------------------------------------
Table of Contents
accident year expected loss ratios, adjusted for changes in pricing, loss trends, terms and conditions and reinsurance structure.
In the initial reserving process for property, energy, marine and aviation business, which are primarily short-tail exposures, our insurance operations rely on a combination of the reserving methods discussed above. For catastrophe-exposed business, our insurance operations' reserving process also includes the usage of catastrophe models for known events and a heavy reliance on analysis of individual catastrophic events and management judgment. The development of property losses can be unstable, especially for policies characterized by high severity, low frequency losses. As time passes, for a given accident year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. Our insurance operations make a number of key assumptions in their reserving process, including that historical paid and reported development patterns are stable, catastrophe models provide useful information about our exposure to catastrophic events that have occurred and our underwriters' judgment as to potential loss exposures can be relied on. The expected loss ratios used in the initial reserving process for our insurance operations' property business have varied over time due to changes in pricing, reinsurance structure, estimates of catastrophe losses, policy changes (such as attachment points, class and limits) and geographical distribution. As losses in property lines are reported relatively quickly, expected loss ratios are selected for the current accident year based upon actual attritional loss ratios for earlier accident years, adjusted for rate changes, inflation, changes in reinsurance programs and expected attritional losses based on modeling. Due to the short-tail nature of property business, reported loss experience emerges quickly and ultimate losses are known in a reasonably short period of time. In addition to the assumptions and development characteristics noted above for casualty and property business, our insurance operations authorize managing general agents, general agents and other producers to write program business on their behalf within prescribed underwriting authorities. This adds additional complexity to the reserving process. To monitor adherence to the underwriting guidelines given to such parties, our insurance operations periodically perform claims due diligence reviews. In the initial reserving process for program business, consisting of property and liability exposures which are primarily written on an occurrence basis, our insurance operations primarily rely on the expected loss method. As time passes, for a given accident year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. The expected loss ratios used in the initial reserving process for our insurance operations' program business have varied over time depending on the type of exposures written (casualty or property) and changes in pricing, loss trends, reinsurance structure and changes in the underlying business. In the initial reserving process for executive assurance, professional liability and healthcare business, primarily consisting of medium-tail exposures written on a claims-made basis, our insurance operations primarily rely on the expected loss method. As time passes, for a given accident year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. Beginning in 2005, our insurance operations began to give a relatively small amount of weight to their own experience following reviews of open claims, in particular for lines of business written on a claims-made basis for which they developed a reasonable level of credible data. Over the last few years, our insurance operations have increased their reliance on reviews of open claims. In general, the expected loss ratios established for executive assurance, professional liability and healthcare business for recent accident years vary, in some cases materially, from earlier accident years based on analysis of pricing, loss cost trends and changes in policy coverage. Since this business is primarily written on a claims-made basis and is subject to high severity, low frequency losses, a great deal of uncertainty exists in setting these initial reserves. In addition, only a limited number of years of historical experience is available for use in projecting 99
--------------------------------------------------------------------------------
Table of Contents
loss experience using standard actuarial methods. As the credibility of historical experience for earlier accident years increases, the experience from these accident years will be given a greater weighting in the actuarial analysis to determine future accident year expected loss ratios, adjusted for the occurrence or lack of large losses, changes in pricing, loss trends, terms and conditions and reinsurance structure. In the initial reserving process for construction and surety business, consisting of primary and excess casualty and contract surety coverages written on an occurrence and claims-made basis, our insurance operations primarily rely on a combination of the reserving methods discussed above. Such business is subject to the assumptions and development characteristics noted above for casualty business. As time passes, for a given accident year, additional weight has been given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. In general, the expected loss ratios used in the initial reserving process for our insurance operations' construction and surety business for recent accident years vary, in some cases materially, from earlier accident years. As the credibility of historical experience for earlier accident years has increased, the experience from these accident years has been given a greater weighting in the actuarial analysis to determine future accident year expected loss ratios, adjusted for anticipated changes in the regulatory environment, pricing, loss trends, terms and conditions and reinsurance structure.
Reinsurance Operations
Loss Reserves for our reinsurance operations are comprised of (1) case reserves for claims reported, (2) additional case reserves ("ACRs") and (3) IBNR reserves. Our reinsurance operations receive reports of claims notices from ceding companies and record case reserves based upon the amount of reserves recommended by the ceding company. Case reserves on known events may be supplemented by ACRs, which are often estimated by our reinsurance operations' claims personnel ahead of official notification from the ceding company, or when our reinsurance operations' judgment regarding the size or severity of the known event differs from the ceding company. In certain instances, our reinsurance operations establish ACRs even when the ceding company does not report any liability on a known event. In addition, specific claim information reported by ceding companies or obtained through claim audits can alert our reinsurance operations to emerging trends such as changing legal interpretations of coverage and liability, claims from unexpected sources or classes of business, and significant changes in the frequency or severity of individual claims. Such information is often used in the process of estimating IBNR reserves. The estimation of Loss Reserves for our reinsurance operations is subject to the same risk factors as the estimation of Loss Reserves for our insurance operations. In addition, the inherent uncertainties of estimating such reserves are even greater for reinsurers, due primarily to the following factors: (1) the claim-tail for reinsurers is generally longer because claims are first reported to the ceding company and then to the reinsurer through one or more intermediaries, (2) the reliance on premium estimates, where reports have not been received from the ceding company, in the reserving process, (3) the potential for writing a number of reinsurance contracts with different ceding companies with the same exposure to a single loss event, (4) the diversity of loss development patterns among different types of reinsurance contracts, (5) the necessary reliance on the ceding companies for information regarding reported claims and (6) the differing reserving practices among ceding companies. As with our insurance operations, the process of estimating Loss Reserves for our reinsurance operations involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain. As discussed above, such uncertainty is greater for reinsurers compared to insurers. As a result, our reinsurance operations obtain information from numerous sources to assist in the process. Pricing actuaries from our reinsurance operations devote considerable effort to understanding and analyzing a ceding company's operations and loss history during the underwriting of the business, using a combination of ceding company and industry statistics. Such statistics normally 100
--------------------------------------------------------------------------------
Table of Contents
include historical premium and loss data by class of business, individual claim information for larger claims, distributions of insurance limits provided, loss reporting and payment patterns, and rate change history. This analysis is used to project expected loss ratios for each treaty during the upcoming contract period. As mentioned above, there can be a considerable time lag from the time a claim is reported to a ceding company to the time it is reported to the reinsurer. The lag can be several years in some cases and may be attributed to a number of reasons, including the time it takes to investigate a claim, delays associated with the litigation process, the deterioration in a claimant's physical condition many years after an accident occurs, the case reserving approach of the ceding company, etc. In the reserving process, our reinsurance operations assume that such lags are predictable, on average, over time and therefore the lags are contemplated in the loss reporting patterns used in their actuarial methods. This means that our reinsurance operations must rely on estimates for a longer period of time than does an insurance company. Backlogs in the recording of assumed reinsurance can also complicate the accuracy of loss reserve estimation. As ofDecember 31, 2011 , there were no significant backlogs related to the processing of assumed reinsurance information at our reinsurance operations. Our reinsurance operations rely heavily on information reported by ceding companies, as discussed above. In order to determine the accuracy and completeness of such information, underwriters, actuaries, and claims personnel at our reinsurance operations often perform audits of ceding companies and regularly review information received from ceding companies for unusual or unexpected results. Material findings are usually discussed with the ceding companies. Our reinsurance operations sometimes encounter situations where they determine that a claim presentation from a ceding company is not in accordance with contract terms. In these situations, our reinsurance operations attempt to resolve the dispute with the ceding company. Most situations are resolved amicably and without the need for litigation or arbitration. However, in the infrequent situations where a resolution is not possible, our reinsurance operations will vigorously defend their position in such disputes.
At
December 31, 2011 2010 Casualty $ 1,600,887 $
1,748,888
Property excluding property catastrophe 336,425 295,425 Property catastrophe 237,804 160,237 Marine and aviation 166,294 194,925 Other specialty 153,455 106,241 Other 48,467 47,112 Total net reserves $ 2,543,332 $ 2,552,828 Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that relatively limited historical information has been reported to our reinsurance operations throughDecember 31, 2011 in some lines of business. See below for a discussion of the key assumptions in our reinsurance operations' reserving process. Although Loss Reserves are initially determined based on underwriting and pricing analysis, our reinsurance operations apply several generally accepted actuarial methods, as discussed above, on a quarterly basis to evaluate their Loss Reserves in addition to the expected loss method, in particular for Loss Reserves from more mature underwriting years (the year in which business is underwritten). Each quarter, as part of the reserving process, actuaries at our reinsurance operations reaffirm that the assumptions used in the reserving process continue to form a sound basis for projection of liabilities. If 101
--------------------------------------------------------------------------------
Table of Contents
actual loss activity differs substantially from expectations based on historical information, an adjustment to loss reserves may be supported. Estimated Loss Reserves for more mature underwriting years are now based more on actual loss activity and historical patterns than on the initial assumptions based on pricing indications. More recent underwriting years rely more heavily on internal pricing assumptions. Our reinsurance operations place more or less reliance on a particular actuarial method based on the facts and circumstances at the time the estimates of Loss Reserves are made. In the initial reserving process for medium-tail and long-tail lines, consisting of casualty, other specialty, marine and aviation and other exposures, our reinsurance operations primarily rely on the expected loss method. The development of medium-tail and long-tail business may be unstable, especially if there are high severity major events, with business written on an excess of loss basis typically having a longer tail than business written on a pro rata basis. As time passes, for a given underwriting year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. Our reinsurance operations make a number of key assumptions in reserving for medium-tail and long-tail lines, including that the pricing loss ratio is the best estimate of the ultimate loss ratio at the time the contract is entered into, historical paid and reported development patterns are stable and our reinsurance operations' claims personnel and underwriters analyses of our exposure to major events are assumed to be our best estimate of our exposure to the known claims on those events. The expected loss ratios used in our reinsurance operations' initial reserving process for medium-tail and long-tail contracts have varied over time due to changes in pricing, terms and conditions and reinsurance structure. As the credibility of historical experience for earlier underwriting years increases, the experience from these underwriting years will be used in the actuarial analysis to determine future underwriting year expected loss ratios, adjusted for changes in pricing, loss trends, terms and conditions and reinsurance structure. In the initial reserving process for short-tail lines, consisting of property excluding property catastrophe and property catastrophe exposures, our reinsurance operations rely on a combination of the reserving methods discussed above. For known catastrophic events, our reinsurance operations' reserving process also includes the usage of catastrophe models and a heavy reliance on analysis which includes ceding company inquiries and management judgment. The development of property losses may be unstable, especially where there is high catastrophic exposure, may be characterized by high severity, low frequency losses for excess and catastrophe-exposed business and may be highly correlated across contracts. As time passes, for a given underwriting year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. Our reinsurance operations make a number of key assumptions in reserving for short-tail lines, including that historical paid and reported development patterns are stable, catastrophe models provide useful information about our exposure to catastrophic events that have occurred and our underwriters' judgment and guidance received from ceding companies as to potential loss exposures may be relied on. The expected loss ratios used in the initial reserving process for our reinsurance operations' property exposures have varied over time due to changes in pricing, reinsurance structure, estimates of catastrophe losses, terms and conditions and geographical distribution. As losses in property lines are reported relatively quickly, expected loss ratios are selected for the current underwriting year incorporating the experience for earlier underwriting years, adjusted for rate changes, inflation, changes in reinsurance programs, expectations about present and future market conditions and expected attritional losses based on modeling. Due to the short-tail nature of property business, reported loss experience emerges quickly and ultimate losses are known in a reasonably short period of time. 102
--------------------------------------------------------------------------------
Table of Contents Potential Variability in Loss Reserves The tables below summarize the effect of reasonably likely scenarios on the key actuarial assumptions used to estimate our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, atDecember 31, 2011 by operating segment. The scenarios shown in the tables summarize the effect of (i) changes to the expected loss ratio selections used atDecember 31, 2011 , which represent loss ratio point increases or decreases to the expected loss ratios used, and (ii) changes to the loss development patterns used in our reserving process atDecember 31, 2011 , which represent claims reporting that is either slower or faster than the reporting patterns used. We believe that the illustrated sensitivities are indicative of the potential variability inherent in the estimation process of those parameters. The results show the impact of varying each key actuarial assumption using the chosen sensitivity on our IBNR reserves, on a net basis and across all accident years. Higher Slower Loss Lower Faster Loss Expected Development Expected Development INSURANCE SEGMENT Loss Ratios Patterns Loss Ratios Patterns Reserving lines selected assumptions: Property, energy, marine and aviation 5 points 3 months (5) points (3) months Third party occurrence business(1) 10 6 (10 ) (6 ) Third party claims-made business(2) 10 6 (10 ) (6 ) All other(3) 10 6 (10 ) (6 ) Increase (decrease) in Loss Reserves, net: Property, energy, marine and aviation $ 43,617 $ 50,779 $ (43,617 ) $ (27,994 ) Third party occurrence business(1) 143,451 98,463 (143,451 ) (88,921 ) Third party claims-made business(2) 129,751 160,477 (129,751 ) (106,921 ) All other(3) 97,415 73,516 (97,415 ) (54,872 )
--------------------------------------------------------------------------------
º (1)
º Third party occurrence business includes casualty, construction, national
accounts and excess workers' compensation business.
º (2)
º Third party claims-made business includes executive assurance, healthcare
and professional liability business. º (3) º All other includes programs, surety, travel and accident and other business. Higher Slower Loss Lower Faster Loss Expected Development Expected Development REINSURANCE SEGMENT Loss Ratios Patterns Loss Ratios Patterns Reserving lines selected assumptions: Casualty 10 points 6 months (10) points (6) months Property excluding property catastrophe 5 3 (5 ) (3 ) Marine and aviation 5 3 (5 ) (3 ) Property catastrophe 5 3 (5 ) (3 ) Other specialty 5 3 (5 ) (3 ) Other 5 3 (5 ) (3 ) Increase (decrease) in Loss Reserves, net: Casualty $ 135,447 $ 153,440 $ (135,447 ) $ (125,912 ) Property excluding property catastrophe 12,680 29,501 (12,680 ) (28,156 ) Marine and aviation 5,053 8,496 (5,053 ) (7,683 ) Property catastrophe 14,283 22,801 (14,283 ) (15,329 ) Other specialty 15,771 9,487 (15,771 ) (12,407 ) Other 2,856 1,162 (2,856 ) (1,180 ) 103
--------------------------------------------------------------------------------
Table of Contents
It is not necessarily appropriate to sum the total impact for a specific factor or the total impact for a specific business category as the business categories are not perfectly correlated. In addition, the potential variability shown in the tables above are reasonably likely scenarios of changes in our key assumptions atDecember 31, 2011 and are not meant to be a "best case" or "worst case" series of outcomes and, therefore, it is possible that future variations may be more or less than the amounts set forth above.
Simulation Results
In order to illustrate the potential volatility in our Loss Reserves, we used a Monte Carlo simulation approach to simulate a range of results based on various probabilities. Both the probabilities and related modeling are subject to inherent uncertainties. The simulation relies on a significant number of assumptions, such as the potential for multiple entities to react similarly to external events, and includes other statistical assumptions. AtDecember 31, 2011 , our recorded Loss Reserves by operating segment, net of unpaid losses and loss adjustment expenses recoverable, and the results of the simulation were as follows: December 31, 2011 Insurance Reinsurance Total Total net reserves $ 4,094,831 $ 2,543,332 $ 6,638,163 Simulation results: 90th percentile(1) $ 4,915,196 $ 3,265,061 $ 7,880,231 10th percentile(2) $ 3,339,544 $ 1,918,279 $ 5,500,892
--------------------------------------------------------------------------------
º (1)
º Simulation results indicate that a 90% probability exists that the net
reserves for losses and loss adjustment expenses will not exceed the indicated amount. º (2)
º Simulation results indicate that a 10% probability exists that the net
reserves for losses and loss adjustment expenses will be at or below the
indicated amount.
The simulation results shown for each segment do not add to the total simulation results, as the individual segment simulation results do not reflect the diversification effects across our segments. For informational purposes, based on the total simulation results, a change in our Loss Reserves to the amount indicated at the 90th percentile would result in a decrease in income before income taxes of approximately$1.24 billion , or$8.98 per diluted share, while a change in our Loss Reserves to the amount indicated at the 10th percentile would result in an increase in income before income taxes of approximately$1.14 billion , or$8.22 per diluted share. The simulation results noted above are informational only, and no assurance can be given that our ultimate losses will not be significantly different than the simulation results shown above, and such differences could directly and significantly impact earnings favorably or unfavorably in the period they are determined. We do not have significant exposure to pre-2002 liabilities, such as asbestos-related illnesses and other long-tail liabilities. It is difficult to provide meaningful trend information for certain liability/casualty coverages for which the claim-tail may be especially long, as claims are often reported and ultimately paid or settled years, or even decades, after the related loss events occur. Any estimates and assumptions made as part of the reserving process could prove to be inaccurate due to several factors, including the fact that relatively limited historical information has been reported to us throughDecember 31, 2011 .
Ceded Reinsurance
In the normal course of business, our insurance operations cede a portion of their premium on a quota share or excess of loss basis through treaty or facultative reinsurance agreements. Our reinsurance operations also obtain reinsurance whereby another reinsurer contractually agrees to
104
--------------------------------------------------------------------------------
Table of Contents
indemnify it for all or a portion of the reinsurance risks underwritten by our reinsurance operations. Such arrangements, where one reinsurer provides reinsurance to another reinsurer, are usually referred to as "retrocessional reinsurance" arrangements. In addition, our reinsurance subsidiaries participate in "common account" retrocessional arrangements for certain pro rata treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurers, such as our reinsurance operations, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the reinsurers' ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, our insurance or reinsurance operations would be liable for such defaulted amounts. The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Although we believe that our insurance and reinsurance operations have been successful in obtaining reinsurance and retrocessional protection, it is not certain that they will be able to continue to obtain adequate protection at cost effective levels. As a result of such market conditions and other factors, our insurance and reinsurance operations may not be able to successfully mitigate risk through reinsurance and retrocessional arrangements and may lead to increased volatility in our results of operations in future periods. See "Risk Factors-Risks Relating to Our Industry-The failure of any of the loss limitation methods we employ could have a material adverse effect on our financial condition or results of operations." Our insurance operations had in effect during 2011 a reinsurance program which provided coverage equal to a maximum of 84% of the first$250 million in excess of a$100 million retention per occurrence for certain property catastrophe-related losses occurring during 2011, compared to a maximum of 77% of the first$275 million in excess of a$75 million retention per occurrence during 2010 and a maximum of 80% of the first$275 million in excess of a$75 million retention per occurrence during 2009. In the 2012 first quarter, our insurance operations renewed its reinsurance program which provides coverage for certain property-catastrophe related losses occurring during 2012 equal to 27% of the first layer of$50 million in excess of a$100 million retention per occurrence and 100% of the next three layers which total$200 million in excess of$150 million . For purposes of managing risk, we reinsure a portion of our exposures, paying to reinsurers a part of the premiums received on the policies we write, and we may also use retrocessional protection. Ceded premiums written represented approximately 22% of gross premiums written for 2011, compared to 23% for 2010 and 2009. We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. If the financial condition of our reinsurers or retrocessionaires deteriorates, resulting in an impairment of their ability to make payments, we will provide for probable losses resulting from our inability to collect amounts due from such parties, as appropriate. We evaluate the credit worthiness of all the reinsurers to which we cede business. If our analysis indicates that there is significant uncertainty regarding the collectability of amounts due from reinsurers, managing general agents, brokers and other clients, we will record a provision for doubtful accounts. See "Risk Factors-Risks Relating to Our Company-We are exposed to credit risk in certain of our business operations" and "Financial Condition, Liquidity and Capital Resources-Financial Condition-Premiums Receivable and Reinsurance Recoverables" for further details.
Premium Revenues and Related Expenses
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products, usually 12 months. Premiums written include estimates in our insurance operations' programs, specialty lines, collateral protection business and for participation in involuntary pools. The amount of such insurance premium estimates, included in premiums receivable and other assets, was$71.4 million atDecember 31, 2011 , compared to$60.8 million at 2010. Such premium estimates are derived from multiple sources which include the historical experience of the underlying business, similar business and available industry information. 105
--------------------------------------------------------------------------------
Table of Contents
Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of in-force insurance policies.
Reinsurance premiums written include amounts reported by brokers and ceding companies, supplemented by our own estimates of premiums where reports have not been received. The determination of premium estimates requires a review of our experience with the ceding companies, familiarity with each market, the timing of the reported information, an analysis and understanding of the characteristics of each line of business, and management's judgment of the impact of various factors, including premium or loss trends, on the volume of business written and ceded to us. On an ongoing basis, our underwriters review the amounts reported by these third parties for reasonableness based on their experience and knowledge of the subject class of business, taking into account our historical experience with the brokers or ceding companies. In addition, reinsurance contracts under which we assume business generally contain specific provisions which allow us to perform audits of the ceding company to ensure compliance with the terms and conditions of the contract, including accurate and timely reporting of information. Based on a review of all available information, management establishes premium estimates where reports have not been received. Premium estimates are updated when new information is received and differences between such estimates and actual amounts are recorded in the period in which estimates are changed or the actual amounts are determined. Premiums written are recorded based on the type of contracts we write. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, premiums are recorded as written based on the terms of the contract. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term. Reinstatement premiums for our insurance and reinsurance operations are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums, if obligatory, are fully earned when recognized. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management's judgment, as described above in "-Reserves for Losses and Loss Adjustment Expenses."
The amount of reinsurance premium estimates included in premiums receivable and the amount of related acquisition expenses by type of business were as follows at
December 31, 2011 December 31, 2010 Gross Acquisition Net Gross Acquisition Net Amount Expenses Amount Amount Expenses Amount Casualty. $ 44,344 $ (6,522 ) $ 37,822 $ 59,796 $ (11,934 ) $ 47,862 Property excluding property catastrophe 23,826 (6,217 ) 17,609 47,552 (12,474 ) 35,078 Other specialty 35,860 (11,293 ) 24,567 40,761 (12,006 ) 28,755 Marine and aviation 26,785 (6,049 ) 20,736 27,354 (7,346 ) 20,008 Property catastrophe 914 (46 ) 868 1,527 (82 ) 1,445 Other 456 (25 ) 431 279 (15 ) 264 Total $ 132,185 $ (30,152 ) $ 102,033 $ 177,269 $ (43,857 ) $ 133,412 Premium estimates are reviewed by management at least quarterly. Such review includes a comparison of actual reported premiums to expected ultimate premiums along with a review of the 106
--------------------------------------------------------------------------------
Table of Contents
aging and collection of premium estimates. Based on management's review, the appropriateness of the premium estimates is evaluated, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to premium estimates could be material and such adjustments could directly and significantly impact earnings favorably or unfavorably in the period they are determined because the estimated premium may be fully or substantially earned. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Based on currently available information, management believes that the premium estimates included in premiums receivable will be collectible and, therefore, no provision for doubtful accounts has been recorded on the premium estimates atDecember 31, 2011 . Reinsurance premiums assumed, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Contracts and policies written on a "losses occurring" basis cover claims that may occur during the term of the contract or policy, which is typically 12 months. Accordingly, the premium is earned evenly over the term. Contracts which are written on a "risks attaching" basis cover claims which attach to the underlying insurance policies written during the terms of such contracts. Premiums earned on such contracts usually extend beyond the original term of the reinsurance contract, typically resulting in recognition of premiums earned over a 24-month period. Certain of our reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses, are recorded based upon the projected experience under such contracts. Retroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered by the underlying policies reinsured. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and, accordingly, we bifurcate the prospective and retrospective elements of these reinsurance contracts and account for each element separately. Underwriting income generated in connection with retroactive reinsurance contracts is deferred and amortized into income over the settlement period while losses are charged to income immediately. Subsequent changes in estimated or actual cash flows under such retroactive reinsurance contracts are accounted for by adjusting the previously deferred amount to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction, with a corresponding charge or credit to income. Acquisition expenses and other expenses that vary with, and are directly related to, the acquisition of business in our underwriting operations are deferred and amortized over the period in which the related premiums are earned. Acquisition expenses, net of ceding commissions received from reinsurers, consist primarily of commissions and premium taxes paid to obtain our business. Other operating expenses also include expenses that vary with, and are directly related to, the acquisition of business. Deferred acquisition costs, which are based on the related unearned premiums, are carried at their estimated realizable value and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income. A premium deficiency occurs if the sum of anticipated losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs and anticipated investment income exceed unearned premiums. A premium deficiency is recorded by charging any unamortized acquisition costs to expense to the extent required in order to eliminate the deficiency. If the premium deficiency exceeds unamortized acquisition costs then a liability is accrued for the excess deficiency. No significant premium deficiency charges were recorded by us during 2011, 2010 or 2009. 107
--------------------------------------------------------------------------------
Table of Contents
Fair Value Measurements
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority). We determine the existence of an active market based on our judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. We use quoted values and other data provided by nationally recognized independent pricing sources as inputs into our process for determining fair values of our fixed maturity investments. To validate the techniques or models used by pricing sources, our review process includes, but is not limited to: (i) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to their target benchmark, with significant differences identified and investigated); (ii) a review of the average number of prices obtained in the pricing process and the range of resulting fair values; (iii) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value including a review of deep dive reports on selected securities which indicated the use of observable inputs in the pricing process; (iv) comparing the fair value estimates to our knowledge of the current market; (v) a comparison of the pricing services' fair values to other pricing services' fair values for the same investments; and (vi) back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. AtDecember 31, 2011 , we obtained an average of 2.8 quotes or prices per investment, compared to 2.7 quotes or prices atDecember 31, 2010 . Where multiple quotes or prices were obtained, a price source hierarchy was maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used from a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, we will challenge any prices for a security or portfolio which are considered not to be representative of fair value. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of "matrix pricing" in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. In addition, pricing vendors use model processes, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage backed and asset backed securities. In certain circumstances, when fair values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above. Of the$11.97 billion of financial assets and liabilities measured at fair value atDecember 31, 2011 , approximately$1.19 billion , or 9.9%, were priced using non-binding broker-dealer quotes. 108
--------------------------------------------------------------------------------
Table of Contents
InApril 2009 , the FASB issued guidance regarding the determination of fair value when the volume and level of activity for the asset or liability have significantly decreased and the identification of transactions that are not orderly. This affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction, and clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active. Under this guidance, if an entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly, the entity shall place little, if any weight on that transaction price as an indicator of fair value. This guidance also expanded certain disclosure requirements. The adoption of this guidance did not have a material impact on our consolidated financial condition or results of operations.
We review our securities measured at fair value and discuss the proper classification of such investments with investment advisors and others. See note 8, "Fair Value," of the notes accompanying our consolidated financial statements for a summary of our financial assets and liabilities measured at fair value at
Other-Than-Temporary Impairments
On a quarterly basis, we perform reviews of our investments to determine whether declines in fair value below the cost basis are considered other-than-temporary in accordance with applicable accounting guidance regarding the recognition and presentation of OTTI. The process of determining whether a security is other-than-temporarily impaired requires judgment and involves analyzing many factors. These factors include (i) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (ii) the time period in which there was a significant decline in value, (iii) the significance of the decline, and (iv) the analysis of specific credit events. We evaluate the unrealized losses of our equity securities by issuer and determine if we can forecast a reasonable period of time by which the fair value of the securities would increase and we would recover our cost. If we are unable to forecast a reasonable period of time in which to recover the cost of our equity securities, we record a net impairment loss in earnings equivalent to the entire unrealized loss. In 2009, we adopted additional guidance that requires entities to separate an other-than-temporary impairment of a debt security into two components when there are credit related losses associated with the impaired debt security for which an entity asserts that it does not have the intent to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of its cost basis. The effect of adoption was an increase to the amortized cost basis of debt securities that were impaired prior to 2009, net of deferred tax, of$62.0 million . The cumulative effect adjustment had no effect on total shareholders' equity as it increased retained earnings and reduced accumulated other comprehensive income. In accordance with the additional guidance, the amount of the OTTI related to a credit loss is recognized in earnings, and the amount of the OTTI related to other factors (e.g., interest rates, market conditions, etc.) is recorded as a component of other comprehensive income (loss). The amount of the credit loss of an impaired debt security is the difference between the amortized cost and the greater of (i) the present value of expected future cash flows and (ii) the fair value of the security. In instances where no credit loss exists but it is more likely than not that we will have to sell the debt security prior to the anticipated recovery, the decline in fair value below amortized cost is recognized as an OTTI in earnings. In periods after the recognition of an OTTI on debt securities, we account for such securities as if they had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the OTTI recognized in earnings. For debt securities for which 109
--------------------------------------------------------------------------------
Table of Contents
OTTI were recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted or amortized into net investment income. During 2011, we recorded$9.1 million of net impairment losses recognized in earnings, compared to$11.3 million in 2010. See note 7, "Investment Information-Other-Than-Temporary Impairments," of the notes accompanying our consolidated financial statements for additional information.
Reclassifications
We have reclassified the presentation of certain prior year information to conform to the current presentation. Such reclassifications had no effect on our net income, shareholders' equity or cash flows.
Recent Accounting Pronouncements
See note 2(o), "Significant Accounting Policies-Recent Accounting Pronouncements," of the notes accompanying our consolidated financial statements.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Financial Condition
Investable Assets
The finance and investment committee of our board of directors establishes our investment policies and sets the parameters for creating guidelines for our investment managers. The finance and investment committee reviews the implementation of the investment strategy on a regular basis. Our current approach stresses preservation of capital, market liquidity and diversification of risk. While maintaining our emphasis on preservation of capital and liquidity, we expect our portfolio to become more diversified and, as a result, we may expand into areas which are not currently part of our investment strategy. Our Chief Investment Officer administers the investment portfolio, oversees our investment managers, formulates investment strategy in conjunction with our finance and investment committee and directly manages certain portions of our fixed income and equity portfolios. 110
--------------------------------------------------------------------------------
Table of Contents The following table summarizes our investable assets: December
31,
2011
2010
Fixed maturities available for sale, at fair value
147,779
124,969
Fixed maturities pledged under securities lending agreements, at fair value(2) 56,393 75,575 Total fixed maturities 9,579,776 9,158,403
Short-term investments available for sale, at fair value
904,219
915,841
Cash 351,699
362,740
Equity securities available for sale, at fair value 299,584
310,194
Equity securities, at fair value(1) 87,403
94,204
Other investments available for sale, at fair value 238,111
275,538
Other investments, at fair value(1) 131,721
-
TALF investments, at fair value(3) 387,702
402,449
Investments accounted for using the equity method(4) 380,507
508,334
Total cash and investments 12,360,722
12,027,703
Securities sold but not yet purchased(5) (27,178 ) (41,143 ) Securities transactions entered into but not settled at the balance sheet date (17,339 ) (144,047 ) Total investable assets $ 12,316,205 $ 11,842,513
--------------------------------------------------------------------------------
º (1)
º Represents securities which are carried at fair value under the fair value
option and reflected as "investments accounted for using the fair value
option" on our balance sheet. Changes in the carrying value of such securities are recorded in net realized gains or losses. º (2)
º This table excludes the collateral received and reinvested and includes the
fixed maturities and short-term investments pledged under securities lending agreements, at fair value. º (3)
º The Federal Reserve's Term Asset-Backed Securities Loan Facility ("TALF")
provides secured financing for certain asset-backed securities and legacy
commercial mortgage-backed securities. TALF financing is non-recourse to
us, is collateralized by the purchased securities and provides financing
for the purchase price of the securities, less a 'haircut' that varies based on the type of collateral. We can deliver the collateralized securities to the Federal Reserve in full defeasance of the loan. º (4)
º Changes in the carrying value of investment funds accounted for using the
equity method are recorded as "equity in net income (loss) of investments
funds accounted for using the equity method" rather than as an unrealized
gain or loss component of accumulated other comprehensive income.
º (5)
º Represents our obligation to deliver equity securities that we did not own
at the time of sale. Such amounts are included in "other liabilities" on
our balance sheet.
AtDecember 31, 2011 , our fixed income portfolio, which includes fixed maturity securities and short-term investments, had average credit quality ratings from S&P/Moody's of "AA/Aa1" and an average yield to maturity (imbedded book yield), before investment expenses, of 2.98%. AtDecember 31, 2010 , our fixed income portfolio had average credit quality ratings from S&P/Moody's of "AA+/Aa1" and an average yield to maturity (imbedded book yield), before investment expenses, of 3.52%. Our investment portfolio had an average effective duration of 2.99 years atDecember 31, 2011 , 111
--------------------------------------------------------------------------------
Table of Contents
compared to 2.83 years atDecember 31, 2010 . AtDecember 31, 2011 , approximately$7.9 billion , or 66%, of our total investments and cash was internally managed, compared to$7.48 billion , or 65%, atDecember 31, 2010 . The following table summarizes our fixed maturities by type: Estimated Gross Gross Cost or OTTI Fair Unrealized Unrealized Amortized Unrealized Value Gains Losses Cost Losses(2) AtDecember 31, 2011 Fixed maturities and fixed maturities pledged under securities lending agreements(1): Corporate bonds $ 2,719,052 $ 79,407 $ (29,922 ) $ 2,669,567 $ (1,138 ) Mortgage backed securities 1,592,762 27,633 (23,226 ) 1,588,355 (20,466 ) Municipal bonds 1,430,565 77,977 (886 ) 1,353,474 (105 ) Commercial mortgage backed securities 1,046,326 28,780 (2,904 ) 1,020,450 (3,259 ) U.S. government and government agencies 1,451,993 34,811 (3 ) 1,417,185 (207 ) Non-U.S. government securities 762,321 33,486 (17,684 ) 746,519 - Asset backed securities 576,757 14,649 (10,078 )
572,186 (3,876 )
Total $ 9,579,776 $ 296,743 $ (84,703 ) $ 9,367,736 $ (29,051 ) At December 31, 2010 Fixed maturities and fixed maturities pledged under securities lending agreements(1): Corporate bonds $ 2,839,344 $ 97,400 $ (18,343 ) $ 2,760,287 $ (18,047 ) Mortgage backed securities 1,806,813 18,801 (26,893 ) 1,814,905 (21,147 ) Municipal bonds 1,182,100 40,410 (6,958 ) 1,148,648 (125 ) Commercial mortgage backed securities 1,167,299 31,743 (6,028 ) 1,141,584 (3,481 ) U.S. government and government agencies 872,149 20,150 (5,696 ) 857,695 (207 ) Non-U.S. government securities 732,666 39,539 (11,894 ) 705,021 (72 ) Asset backed securities 558,032 20,672 (3,990 ) 541,350 (3,954 ) Total $ 9,158,403 $ 268,715 $ (79,802 ) $ 8,969,490 $ (47,033 )
--------------------------------------------------------------------------------
º (1)
º In our securities lending transactions, we receive collateral in excess of
the fair value of the fixed maturities and short-term investments pledged.
For purposes of this table, we have excluded the investment of collateral
received and reinvested and included the fixed maturities and short-term
investments pledged.
º (2)
º Represents the total other-than-temporary impairments ("OTTI") recognized
in accumulated other comprehensive income ("AOCI"). It does not include the
change in fair value subsequent to the impairment measurement date. At
a non-credit OTTI was recognized in AOCI was
net unrealized loss of
112
--------------------------------------------------------------------------------
Table of Contents
The following table provides the credit quality distribution of our fixed maturities and fixed maturities pledged under securities lending agreements (excluding TALF investments):
December 31, 2011 December 31, 2010 Estimated Estimated Rating(1) Fair Value Total Fair Value Total U.S. government and government agencies(2) $ 3,154,480 32.9 $ 2,712,187 29.6 AAA 3,229,161 33.7 3,819,570 41.7 AA 1,425,249 14.9 1,053,666 11.5 A 884,957 9.2 605,483 6.6 BBB 412,566 4.3 388,564 4.2 BB 140,029 1.5 133,673 1.5 B 165,003 1.7 242,479 2.6 Lower than B 114,672 1.2 109,596 1.2 Not rated 53,659 0.6 93,185 1.1 Total $ 9,579,776 100.0 9,158,403 100.0
--------------------------------------------------------------------------------
º (1)
º For individual fixed maturities, S&P ratings are used. In the absence of an
S&P rating, ratings from Moody's are used, followed by ratings from Fitch
Ratings.
º (2)
º Includes U.S. government-sponsored agency mortgage backed securities and
agency commercial mortgage backed securities.
The following table provides information on the severity of the unrealized loss position as a percentage of amortized cost for all fixed maturities and fixed maturities pledged under securities lending agreements which were in an unrealized loss position: December 31, 2011 December 31, 2010 % of % of Estimated Gross Total Gross Estimated Gross Total Gross Fair Unrealized Unrealized Fair Unrealized Unrealized Severity of Unrealized Loss Value Losses Losses Value Losses Losses 0 - 10% $ 1,692,722 $ (44,803 ) 52.9 $ 2,650,335 $ (58,941 ) 73.8 10 - 20% 144,523 (20,222 ) 23.9 79,419 (11,896 ) 14.9 20 - 30% 38,749 (11,709 ) 13.8 18,799 (5,721 ) 7.2 30 - 40% 14,596 (7,413 ) 8.8 1,372 (689 ) 0.9 40 - 50% 619 (445 ) 0.5 733 (660 ) 0.8 70 - 80% 29 (111 ) 0.1 466 (1,895 ) 2.4 Total $ 1,891,238 $ (84,703 ) 100.0 $ 2,751,124 $ (79,802 ) 100.0 113
--------------------------------------------------------------------------------
Table of Contents
The following table provides information on the severity of the unrealized loss position as a percentage of amortized cost for non-investment grade fixed maturities and fixed maturities pledged under securities lending agreements which were in an unrealized loss position: December 31, 2011 December 31, 2010 % of % of Estimated Gross Total Gross Estimated Gross Total Gross Fair Unrealized Unrealized Fair Unrealized Unrealized
Severity of Unrealized Loss Value Losses Losses Value Losses Losses 0 - 10% $ 143,782 $ (6,418 ) 7.6 $ 74,340 $ (2,845 ) 3.6 10 - 20% 33,926 (5,484 ) 6.5 36,900 (5,475 ) 6.9 20 - 30% 26,733 (8,042 ) 9.5 7,918 (2,619 ) 3.3 30 - 40% 13,558 (6,905 ) 8.2 1,054 (537 ) 0.7 40 - 50% 619 (445 ) 0.5 733 (659 ) 0.8 50 - 100% 29 (110 ) 0.1 466 (1,895 ) 2.4 Total $ 218,647 $ (27,404 ) 32.4 $ 121,411 $ (14,030 ) 17.7 AtDecember 31, 2011 , below-investment grade securities comprised approximately 5% of our fixed maturities and fixed maturities pledged under securities lending agreements, compared to approximately 6% atDecember 31, 2010 . In accordance with our investment strategy, we invest in high yield fixed income securities which are included in "Corporate bonds." Upon issuance, these securities are typically rated below investment grade (i.e., rating assigned by the major rating agencies of "BB" or less). In the table above, corporate bonds represented 46% of the total below investment grade securities at fair value, mortgage backed securities represented 46% of the total and 8% were in other classes atDecember 31, 2011 . AtDecember 31, 2010 , corporate bonds represented 26% of the total below investment grade securities at fair value, mortgage backed securities represented 69% of the total and 5% were in other classes. Unrealized losses include the impact of foreign exchange movements on certain securities denominated in foreign currencies and, as such, the amount of securities in an unrealized loss position fluctuates due to foreign currency movements. We determine estimated recovery values for our fixed maturities and fixed maturities pledged under securities lending agreements following a review of the business prospects, credit ratings, estimated loss given default factors and information received from asset managers and rating agencies for each security. For structured securities, we utilize underlying data, where available, for each security provided by asset managers and additional information from credit agencies in order to determine an expected recovery value for each security. The analysis provided by the asset managers includes expected cash flow projections under base case and stress case scenarios which modify expected default expectations and loss severities and slow down prepayment assumptions. In the tables above, securities atDecember 31, 2011 which were in an unrealized loss position of greater than 40% of amortized cost were primarily in asset backed and mortgage backed securities where the estimated fair value for the securities was lower than our expected recovery value. 114
--------------------------------------------------------------------------------
Table of Contents
The following table summarizes our top ten exposures to fixed income corporate issuers by fair value atDecember 31, 2011 , excluding guaranteed amounts: Estimated Fair Credit Value Rating(1) General Electric Co. $ 40,019 AA+/Aa2 Abbey National Treasury Svcs 29,669
AA-/A1
Total SA 29,514
AA-/Aa1
National Australia Bank Limited 29,324
AA-/Aa2
Royal Dutch Shell PLC 28,636
AA/Aa1
Verizon Communications Inc 26,017
A-/A3
JPMorgan Chase & Co. 25,848
A/Aa3
Berkshire Hathaway Inc 25,759
A/A2
Australia & New Zealand Banking Group Ltd 24,703
AA-/Aa3
Svenska Handelsbanken AB 21,130 AA-/Aa2 Total $ 280,619
--------------------------------------------------------------------------------
º (1)
º Ratings as assigned by S&P/Moody's.
Our portfolio includes investments, such as mortgage-backed securities, which are subject to prepayment risk. AtDecember 31, 2011 , our investments in mortgage-backed securities ("MBS"), excluding commercial mortgage-backed securities, amounted to approximately$1.59 billion , or 12.9% of total investable assets, compared to$1.81 billion , or 15.3%, atDecember 31, 2010 . As with other fixed income investments, the fair value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to changes in the prepayment rate on these investments. In periods of declining interest rates, mortgage prepayments generally increase and MBS are prepaid more quickly, requiring us to reinvest the proceeds at the then current market rates. Conversely, in periods of rising rates, mortgage prepayments generally fall, preventing us from taking full advantage of the higher level of rates. However, current economic conditions may curtail prepayment activity as refinancing becomes more difficult, thus limiting prepayments on MBS. Since 2007, the residential mortgage market in the U.S. has experienced a variety of difficulties. During this time, delinquencies and losses with respect to residential mortgage loans generally have increased and may continue to increase, particularly in the subprime sector. In addition, during this period, residential property values in many states have declined or remained stable, after extended periods during which those values appreciated. A continued decline or an extended flattening in those values may result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to second homes and investment properties, and with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater than the related property values. These developments may have a significant adverse effect on the prices of loans and securities, including those in our investment portfolio. The situation continues to have wide ranging consequences, including downward pressure on economic growth and the potential for increased insurance and reinsurance exposures, which could have an adverse impact on our results of operations, financial condition, business and operations. Our portfolio includes commercial mortgage backed securities ("CMBS"). AtDecember 31, 2011 , CMBS constituted approximately$1.05 billion , or 8.5% of total investable assets, compared to$1.17 billion , or 9.9%, atDecember 31, 2010 . The commercial real estate market has experienced price deterioration, which could lead to increased delinquencies and defaults on commercial real estate mortgages. 115
--------------------------------------------------------------------------------
Table of Contents
The following table provides information on our mortgage backed securities ("MBS") and CMBS at December 31, 2011 , excluding amounts guaranteed by the U.S. government and TALF investments: Fair Value Average % of % of Issuance Amortized Credit
Amortized Investable
Year Cost Quality Total Cost Assets Non-agency MBS: 2003 $ 2,475 AAA $ 2,401 97.0 % 0.0 % 2004 15,219 BBB 13,565 89.1 % 0.1 % 2005 49,966 B- 42,922 85.9 % 0.3 % 2006 30,522 CCC+ 24,349 79.8 % 0.2 % 2007 42,344 CCC 37,439 88.4 % 0.3 % 2008 7,372 CCC 6,765 91.8 % 0.1 % 2009 (6) 40,322 AAA 42,733 106.0 % 0.3 % 2010 (6) 32,554 AAA 31,407 96.5 % 0.3 % Total non-agency MBS $ 220,774 BBB- $ 201,581 91.3 % 1.6 % Non-agency CMBS: 1998 3,509 AAA 3,561 101.5 % 0.0 % 2002 35,186 AAA 35,322 100.4 % 0.3 % 2003 41,487 AAA 42,674 102.9 % 0.3 % 2004 29,297 AAA 29,279 99.9 % 0.2 % 2005 48,934 AAA 48,988 100.1 % 0.4 % 2006 5,576 A 5,517 98.9 % 0.0 % 2007 77,536 AA 82,577 106.5 % 0.7 % 2008 190 AA+ 185 97.4 % 0.0 % 2010 244,556 AAA 249,464 102.0 % 2.0 % 2011 230,611 AAA 237,453 103.0 % 1.9 % Total non-agency CMBS $ 716,882 AAA $ 735,020 102.5 % 6.0 % Non-Agency MBS Non-Agency Additional Statistics: Re-REMICs All Other
CMBS(1)
Weighted average loan age (months) 67 71 46 Weighted average life (months)(2) 23 65 37 Weighted average loan-to-value %(3) 70.2 % 68.2 % 66.3 % Total delinquencies(4) 17.9 % 23.6 % 4.2 % Current credit support %(5) 41.2 % 10.2 % 28.5 %
--------------------------------------------------------------------------------
º (1)
º Loans defeased with government/agency obligations represented approximately
3% of the collateral underlying our CMBS holdings.
º (2)
º The weighted average life for MBS is based on the interest rates in effect
atDecember 31, 2011 . The weighted average life for CMBS reflects the average life of the collateral underlying our CMBS holdings. º (3)
º The range of loan-to-values is 31% to 87% on MBS and 31% to 100% on CMBS.
º (4) º Total delinquencies includes 60 days and over. º (5)
º Current credit support % represents the % for a collateralized mortgage
obligation ("CMO") or CMBS class/tranche from other subordinate classes in
the same CMO or CMBS deal.
º (6)
º Primarily represents Re-REMICs issued in 2009 and 2010 with an average
credit quality of "AAA" from Fitch Ratings.
116
--------------------------------------------------------------------------------
Table of Contents
The following table provides information on our asset backed securities ("ABS"), excluding TALF investments, at
Fair Value Average % of % of Amortized Credit Amortized Investable Cost Quality Total Cost Assets Sector: Credit cards(1) $ 216,439 AAA $ 220,173 101.7 % 1.8 % Autos(2) 162,059 AAA 161,148 99.4 % 1.3 % U.K. securitized(3) 18,327 AAA 18,087 98.7 % 0.1 % Student loans(4) 22,471 AA+ 23,070 102.7 % 0.2 % Rate reduction bonds(5) 67,263 AAA 70,036 104.1 % 0.6 % Other 71,567 A+ 70,881 99.0 % 0.6 % 558,126 AA+ 563,395 100.9 % 4.6 % Home equity(6) $ 3,026 AAA $ 2,562 84.7 % 0.0 % 31 A 30 96.8 % 0.0 % 6,413 BBB to B 5,717 89.1 % 0.0 % 4,412 CCC to C 4,970 112.6 % 0.0 % 178 D 83 46.6 % 0.0 % 14,060 BB- 13,362 95.0 % 0.1 % Total ABS $ 572,186 AA+ $ 576,757 100.8 % 4.7 %
--------------------------------------------------------------------------------
The effective duration of the total ABS was 1.3 years at
º (1) º The weighted average credit support % on credit cards is 20.0%. º (2) º The weighted average credit support % on autos is 28.3%. º (3) º The weighted average credit support % onU.K. securitized is 18.5%. º (4) º The weighted average credit support % on student loans is 7.9%. º (5)
º The weighted average credit support % on rate reduction bonds is 9.0%.
º (6)
º The weighted average credit support % on home equity is 22.6%.
AtDecember 31, 2011 , our fixed income portfolio included$40.1 million par value in sub-prime securities with an estimated fair value of$15.4 million and an average credit quality of "BB+/Ba2" from S&P/ Moody's. AtDecember 31, 2010 , our fixed income portfolio included$47.1 million par value in sub-prime securities with an estimated fair value of$19.9 million and an average credit quality of "BBB/Baa3" from S&P/Moody's. Such amounts were primarily in the home equity sector of our asset backed securities, with the balance in other ABS, MBS and CMBS sectors. We define sub-prime mortgage-backed securities as investments in which the underlying loans primarily exhibit one or more of the following characteristics: low FICO scores, above-prime interest rates, high loan-to-value ratios or high debt-to-income ratios. In addition, the portfolio of collateral backing our securities lending program contains approximately$7.3 million estimated fair value of sub-prime securities with an average credit quality of "CCC/Caa2" from S&P/Moody's atDecember 31, 2011 , compared to approximately$13.2 million estimated fair value with an average credit quality of "B-/Caa2" from S&P/Moody's atDecember 31, 2010 .
At
117
--------------------------------------------------------------------------------
Table of Contents
or approximately 2.1% of our total investable assets. These securities had an average rating of "AA/Aa2" by S&P/Moody's with and without the insurance enhancement. This is due to the fact that, in cases where the claims paying ratings of the guarantors are below investment grade, those ratings have been withdrawn from the bonds by the relevant rating agencies, and the insured ratings have been equated to the underlying ratings. The ratings were obtained from the individual rating agencies and were assigned a numerical amount with 1 being the highest rating. The average ratings were calculated using the weighted average fair values of the individual bonds. Guarantors of our insurance enhanced municipal bonds, net of prerefunded bonds that are escrowed in U.S. government obligations, includedNational Public Finance Guarantee (f.k.a.MBIA Insurance Corporation ) ($99.8 million ), Assured Guaranty Ltd. ($82.6 million ), theTexas Permanent School Fund ($51.4 million ) and Financial Guaranty Insurance Company ($29.6 million ). We do not have a significant exposure to insurance enhanced asset-backed or mortgage-backed securities. We do not have any significant investments in companies which guarantee securities atDecember 31, 2011 .
The following table provides information on the fair value of our Eurozone investments at
Financial Other Covered Bank Equities and Sovereign(2) Corporates Corporates Bonds(3) Loans(4) Other(5) Total Country(1) Germany $ 170,512 $ 1,266 $ 4,294 $ 7,064 $ 18,334 $ 252 $ 201,722 Netherlands 10,177 32,966 45,440 30,180 5,742 19,940 144,445 France 3,040 3,415 29,683 69,610 4,870 8,836 119,454 Finland 83,772 232 - - - - 84,004 Supranational(6) 83,193 - - - - - 83,193 Spain 3,220 3,239 193 12,847 6,596 206 26,301 Luxembourg - - 19,573 - 2,104 (26 ) 21,651 Italy 6,725 - 7,121 3,726 2,293 (143 ) 19,722 Belgium 1,936 - - - - - 1,936 Ireland - 1,129 781 - - - 1,910 Portugal - - 614 - - - 614 Total $ 362,575 $ 42,247 $ 107,699 $ 123,427 $ 39,939 $ 29,065 $ 704,952
--------------------------------------------------------------------------------
º (1)
º The country allocations set forth in the table are based on various
assumptions made by us in assessing the country in which the underlying
credit risk resides, including a review of the jurisdiction of
organization, business operations and other factors. Based on such
analysis, we do not believe that we have any Eurozone fixed maturities from
Austria ,Cyprus ,Estonia ,Greece ,Malta ,Slovakia orSlovenia atDecember 31, 2011 . º (2) º Sovereign includes securities issued and/or guaranteed by Eurozone governments. º (3) º Securities issued by Eurozone banks where the security is backed by a separate group of loans. º (4) º Included in corporate bonds. º (5) º Includes long or (short) net equity positions and other. º (6)
º
and
AtDecember 31, 2011 , our equity portfolio consisted of$359.8 million of equity securities, compared to$363.3 million atDecember 31, 2010 . Such amounts are shown net of securities sold but not purchased. Our equity portfolio primarily consists of publicly traded common stocks in the natural resources, energy and consumer staples sectors. Certain of our equity managers use leverage to achieve 118
--------------------------------------------------------------------------------
Table of Contents
a higher rate of return on their assets under management. While leverage presents opportunities for increasing the total return of such investments, it may increase losses as well. Accordingly, any event that adversely affects the value of the underlying holdings would be magnified to the extent leverage is used and our potential losses would be magnified. The following table provides information on the severity of the unrealized loss position as a percentage of cost for all equity securities classified as available for sale which were in an unrealized loss position: December 31, 2011 December 31, 2010 % of % of Estimated Gross Total Gross Estimated Gross Total Gross Fair Unrealized Unrealized Fair Unrealized Unrealized
Severity of Unrealized Loss Value Losses Losses Value Losses Losses 0 - 10% $ 74,813 $ (3,651 ) 16.3 $ 65,892 $ (1,993 ) 58.2 10 - 20% 26,791 (4,457 ) 19.9 2,393 (824 ) 24.1 20 - 30% 21,457 (7,827 ) 35.0 39 (145 ) 4.2 30 - 40% 5,070 (2,645 ) 11.9 - - - 40 - 50% 2,345 (1,984 ) 8.9 - - - 50 - 70% 1,492 (1,780 ) 8.0 400 (462 ) 13.5 Total $ 131,968 $ (22,344 ) 100.0 $ 68,724 $ (3,424 ) 100.0 During 2011, falling global equity markets, commodity prices and natural resource stocks contributed to an increase in unrealized losses across many of our equity positions. On a quarterly basis, we evaluate the unrealized losses of our equity securities by issuer and forecast a reasonable period of time by which the fair value of the securities would increase and we would recover its cost basis. A substantial portion of the equity securities with unrealized losses were less than 30% under their cost basis atDecember 31, 2011 . We believe that a reasonable period of time exists to allow for recovery of the cost basis of our equity securities. Other investments totaled$369.8 million atDecember 31, 2011 , compared to$275.5 million atDecember 31, 2010 . Investment funds accounted for using the equity method (excluding our investment inAeolus LP ) totaled$345.3 million atDecember 31, 2011 , compared to$434.6 million atDecember 31, 2010 . Certain of our investments, primarily those included in "other investments" and "investments accounted for using the equity method" on our balance sheet, may use leverage to achieve a higher rate of return. While leverage presents opportunities for increasing the total return of such investments, it may increase losses as well. Accordingly, any event that adversely affects the value of the underlying securities held by such investments would be magnified to the extent leverage is used and our potential losses from such investments would be magnified. In addition, the structures used to generate leverage may lead to such investment funds being required to meet covenants based on market valuations and asset coverage. Market valuation declines in the funds could force the sale of investments into a depressed market, which may result in significant additional losses. Alternatively, the funds may attempt to deleverage by raising additional equity or potentially changing the terms of the established financing arrangements. We may choose to participate in the additional funding of such investments. Our investment strategy allows for the use of derivative instruments. We utilize various derivative instruments such as futures contracts to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. See note 9, "Derivative Instruments," of the notes accompanying our consolidated financial statements for additional disclosures concerning derivatives. 119
--------------------------------------------------------------------------------
Table of Contents
Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. See note 8, "Fair Value" of the notes accompanying our consolidated financial statements for a summary of our financial assets and liabilities measured at fair value atDecember 31, 2011 and 2010 by level.
Premiums Receivable and Reinsurance Recoverables
AtDecember 31, 2011 , 72.6% of premiums receivable of$501.6 million represented amounts not yet due, while amounts in excess of 90 days overdue were 4.8% of the total. AtDecember 31, 2010 , 77.9% of premiums receivable of$503.4 million represented amounts not yet due, while amounts in excess of 90 days overdue were 4.4% of the total. Approximately 2.3% of the$33.5 million of paid losses and loss adjustment expenses recoverable were in excess of 90 days overdue atDecember 31, 2011 , compared to 0.6% of the$60.8 million of paid losses and loss adjustment expenses recoverable atDecember 31, 2010 . AtDecember 31, 2011 and 2010, our reserves for doubtful accounts were approximately$14.2 million and$13.6 million , respectively. AtDecember 31, 2011 , approximately 90.1% of reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of$1.85 billion were due from carriers which had anA.M. Best rating of "A-" or better and the largest reinsurance recoverables from any one carrier was approximately 5.4% of our total shareholders' equity. AtDecember 31, 2010 , approximately 91.1% of reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of$1.76 billion were due from carriers which had anA.M. Best rating of "A-" or better and the largest reinsurance recoverables from any one carrier was approximately 5.5% of our total shareholders' equity. The following table details our reinsurance recoverables atDecember 31, 2011 :A.M. Best % of Total Rating(1)
Everest Reinsurance Company 13.6 % A+ Lloyd's syndicates(2) 8.3 % A Munich Reinsurance America, Inc. 7.0 % A+ Odyssey America Reinsurance Corporation(3) 6.1 % A Allied World Assurance Company Ltd. 5.6 % A Transatlantic Reinsurance Company 4.9 % A+ Partner Reinsurance Company of the U.S. 3.9 % A+ Hannover Rückversicherung AG 3.6 % A ACE Property & Casualty Insurance Company 3.0 % A+ Platinum Underwriters Reinsurance Inc. 2.7 % A Swiss Reinsurance America Corporation 2.7 % A Berkley Insurance Company 2.4 % A+ Alterra Reinsurance Ltd. 2.3 % A Munich Reinsurance Company 2.1 % A+ AXIS Reinsurance Company 1.9 % A XL Reinsurance America 1.9 % A Flatiron Re Ltd.(4) 1.8 % NR All other(5) 26.2 % Total 100.0 %
--------------------------------------------------------------------------------
º (1)
º The financial strength ratings are as of
by
such date. An explanation of
120
--------------------------------------------------------------------------------
Table of Contents
the ratings listed in the table follows: the rating of "A+" is designated
"Superior"; and the "A" and "A-" ratings are designated "Excellent."
Additionally,
"NR" category. Reasons for an "NR" rating being assigned by
include insufficient data, size or operating experience, companies which
are in run-off with no active business writings or are dormant, companies
which disagree with their rating and request that a rating not be published
or insurers that request not to be formally evaluated for the purposes of
assigning a rating opinion. º (2) º TheA.M. Best group rating of "A" (Excellent) has been applied to all Lloyd's syndicates. º (3) º A significant portion of amounts due fromOdyssey America Reinsurance Corporation is collateralized through reinsurance trusts. º (4)
º Flatiron is required to contribute funds into a trust for the benefit of
Arch Re Bermuda. The recoverable from Flatiron was fully collateralized
through such trust at
º (5)
º Such amount included 18.1% due from companies rated "A-" or better and 8.1%
from companies not rated. For items not rated, a substantial portion of
such amount is collateralized through reinsurance trusts or letters of credit. Reserves for Losses and Loss Adjustment Expenses We establish reserves for losses and loss adjustment expenses ("Loss Reserves") which represent estimates involving actuarial and statistical projections, at a given point in time, of our expectations of the ultimate settlement and administration costs of losses incurred. Estimating Loss Reserves is inherently difficult, which is exacerbated by the fact that we are a relatively new company with relatively limited historical experience upon which to base such estimates. We utilize actuarial models as well as available historical insurance industry loss ratio experience and loss development patterns to assist in the establishment of Loss Reserves. Actual losses and loss adjustment expenses paid will deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Reserves for Losses and Loss Adjustment Expenses" and "Business-Reserves" for further details.
Shareholders' Equity
Our shareholders' equity was$4.63 billion atDecember 31, 2011 , compared to$4.51 billion atDecember 31, 2010 . The increase in the year endedDecember 31, 2011 of$115.5 million was attributable to net income, partially offset by share repurchase activity. 121
--------------------------------------------------------------------------------
Table of Contents Book Value per Common Share
The following table presents the calculation of book value per common share at
December 31 , (U.S. dollars in thousands, except share data) 2011
2010
Calculation of book value per common share:
Total shareholders' equity $ 4,628,486 $
4,513,003
Less preferred shareholders' equity (325,000 )
(325,000 )
Common shareholders' equity $ 4,303,486 $
4,188,003
Common shares outstanding(1) 134,358,345
139,632,225
Book value per common share $ 32.03 $
29.99
--------------------------------------------------------------------------------
º (1)
º Excludes the effects of 8,706,441 and 12,251,568 stock options and 298,425
and 519,534 restricted stock units outstanding at
2010, respectively.
Liquidity and Capital Resources
ACGL is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, ACGL depends on its available cash resources, liquid investments and dividends or other distributions from its subsidiaries to make payments, including the payment of debt service obligations and operating expenses it may incur and any dividends or liquidation amounts with respect to the series A non-cumulative and series B non-cumulative preferred shares and common shares. ACGL's readily available cash, short-term investments and marketable securities, excluding amounts held by our regulated insurance and reinsurance subsidiaries, totaled$8.0 million atDecember 31, 2011 , compared to$14.4 million atDecember 31, 2010 . During 2011, ACGL received dividends of$341.5 million from Arch Re Bermuda which were primarily used to fund the share repurchase program described below. The ability of our regulated insurance and reinsurance subsidiaries to pay dividends or make distributions or other payments to us is dependent on their ability to meet applicable regulatory standards. UnderBermuda law,Arch Re Bermuda is required to maintain an enhanced capital requirement which must equal or exceed its minimum solvency margin (i.e., the amount by which the value of its general business assets must exceed its general business liabilities) equal to the greatest of (1)$100.0 million , (2) 50% of net premiums written (being gross premiums written less any premiums ceded by Arch Re Bermuda, butArch Re Bermuda may not deduct more than 25% of gross premiums when computing net premiums written) and (3) 15% of net discounted aggregated losses and loss expense provisions and other insurance reserves. Arch Re Bermuda is prohibited from declaring or paying any dividends during any financial year if it is not in compliance with its enhanced capital requirement, minimum solvency margin or minimum liquidity ratio. In addition, Arch Re Bermuda is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year's statutory balance sheet) unless it files, at least seven days before payment of such dividends, with theBermuda Monetary Authority ("BMA") an affidavit stating that it will continue to meet the required margins. In addition, Arch Re Bermuda is prohibited, without prior approval of the BMA, from reducing by 15% or more its total statutory capital, as set out in its previous year's statutory financial statements. Arch Re Bermuda is required to meet enhanced capital requirements and a target capital level (defined as 120% of the enhanced capital requirements) as calculated using a new risk based capital model called the Bermuda Solvency Capital Requirement ("BSCR") model. AtDecember 31, 2011 , as determined underBermuda law, Arch Re Bermuda had statutory capital of$2.28 billion ($2.26 billion atDecember 31, 2010 ) and statutory capital and surplus of$4.56 billion ($4.44 billion atDecember 31, 2010 ), which amounts were 122
--------------------------------------------------------------------------------
Table of Contents
in compliance with Arch Re Bermuda's capital requirement at such date. Such amounts include ownership interests in U.S. insurance and reinsurance subsidiaries. Accordingly, Arch Re Bermuda can pay approximately$1.14 billion to ACGL during 2012 without providing an affidavit to the BMA, as discussed above. In addition to meeting applicable regulatory standards, the ability of our insurance and reinsurance subsidiaries to pay dividends to intermediate parent companies owned by Arch Re Bermuda is also constrained by our dependence on the financial strength ratings of our insurance and reinsurance subsidiaries from independent rating agencies. The ratings from these agencies depend to a large extent on the capitalization levels of our insurance and reinsurance subsidiaries. We believe that ACGL has sufficient cash resources and available dividend capacity to service its indebtedness and other current outstanding obligations. Our insurance and reinsurance subsidiaries are required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support their operations. The assets on deposit are available to settle insurance and reinsurance liabilities to third parties. Our insurance and reinsurance subsidiaries maintain assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies and also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. AtDecember 31, 2011 and 2010, such amounts approximated$5.60 billion and$5.87 billion , respectively. Our non-U.S. operations account for a significant percentage of our net premiums written. In the current market environment, the business written in our non-U.S. operations has been more profitable than the business written in our U.S. operations, which has significantly increased the non-U.S. group's contribution to our overall pre-tax income. Additionally, a significant component of our pre-tax income is generated through our investment performance, especially in this competitive insurance and reinsurance market. We hold a substantial amount of our investable assets in our non-U.S. operations and, accordingly, a large portion of our investment income is produced in our non-U.S. operations. In addition, ACGL, through its subsidiaries, provides financial support to certain of its insurance subsidiaries and affiliates, through certain reinsurance arrangements beneficial to the ratings of such subsidiaries. Our U.S.-based insurance and reinsurance groups enter into separate reinsurance arrangements with Arch Re Bermuda covering individual lines of business. For the 2011 calendar year, the U.S. groups ceded business to Arch Re Bermuda at an aggregate net cession rate (i.e., net of third party reinsurance) of approximately 51%. Except as described in the above paragraph, or where express reinsurance, guarantee or other financial support contractual arrangements are in place, each of ACGL's subsidiaries or affiliates is solely responsible for its own liabilities and commitments (and no other ACGL subsidiary or affiliate is so responsible). Any reinsurance arrangements, guarantees or other financial support contractual arrangements that are in place are solely for the benefit of the ACGL subsidiary or affiliate involved and third parties (creditors or insureds of such entity) are not express beneficiaries of such arrangements. Our insurance and reinsurance operations provide liquidity in that premiums are received in advance, sometimes substantially in advance, of the time losses are paid. The period of time from the occurrence of a claim through the settlement of the liability may extend many years into the future. Sources of liquidity include cash flows from operations, financing arrangements or routine sales of investments. 123
--------------------------------------------------------------------------------
Table of Contents
As part of our investment strategy, we seek to establish a level of cash and highly liquid short-term and intermediate-term securities which, combined with expected cash flow, is believed by us to be adequate to meet our foreseeable payment obligations. However, due to the nature of our operations, cash flows are affected by claim payments that may comprise large payments on a limited number of claims and which can fluctuate from year to year. We believe that our liquid investments and cash flow will provide us with sufficient liquidity in order to meet our claim payment obligations. However, the timing and amounts of actual claim payments related to recorded Loss Reserves vary based on many factors, including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claim payments could differ materially from our estimated amounts. Certain lines of business written by us, such as excess casualty, have loss experience characterized as low frequency and high severity. The foregoing may result in significant variability in loss payment patterns. The impact of this variability can be exacerbated by the fact that the timing of the receipt of reinsurance recoverables owed to us may be slower than anticipated by us. Therefore, the irregular timing of claim payments can create significant variations in cash flows from operations between periods and may require us to utilize other sources of liquidity to make these payments, which may include the sale of investments or utilization of existing or new credit facilities or capital market transactions. If the source of liquidity is the sale of investments, we may be forced to sell such investments at a loss, which may be material. Our investments in certain securities, including certain fixed income and structured securities, investments in funds accounted for using the equity method, other investments and our investment in Gulf Re (joint venture) may be illiquid due to contractual provisions or investment market conditions. If we require significant amounts of cash on short notice in excess of anticipated cash requirements, then we may have difficulty selling these investments in a timely manner or may be forced to sell or terminate them at unfavorable values. Consolidated net cash provided by operating activities was$866.1 million for the year endedDecember 31, 2011 , compared to$802.1 million for the year endedDecember 31, 2010 . The increase in operating cash flows over the 2010 period was primarily due to higher premium collected, the timing of dividend receipts on other investments and the timing of certain expense payments. Cash flow from operating activities are provided by premiums collected, fee income, investment income and collected reinsurance recoverables, offset by losses and loss adjustment expense payments, reinsurance premiums paid, operating costs and current taxes paid. On a consolidated basis, our aggregate investable assets totaled$12.32 billion atDecember 31, 2011 , compared to$11.84 billion atDecember 31, 2010 . The primary goals of our asset liability management process are to satisfy the insurance liabilities, manage the interest rate risk embedded in those insurance liabilities and maintain sufficient liquidity to cover fluctuations in projected liability cash flows, including debt service obligations. Generally, the expected principal and interest payments produced by our fixed income portfolio adequately fund the estimated runoff of our insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the fair value of the fixed income portfolio exceeds the expected present value of the net insurance liabilities, as well as the positive cash flow from newly sold policies and the large amount of high quality liquid bonds, provide assurance of our ability to fund the payment of claims and to service our outstanding debt without having to sell securities at distressed prices or access credit facilities. Our unfunded investment commitments totaled approximately$274.7 million atDecember 31, 2011 . InAugust 2011 , S&P downgraded the U.S. credit rating from "AAA" to "AA+" with a negative outlook and warned it could lower the credit rating to "AA" within the next two years if it sees less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory. In addition, both Moody's and Fitch have announced the possibility of a downgrade to the U.S. credit rating. The impact of the continuing weakness of the U.S., European countries and other key economies, projected budget deficits for the 124
--------------------------------------------------------------------------------
Table of Contents
U.S., European countries and other governments and the consequences associated with possible additional downgrades of securities of the U.S., European countries and other governments by credit rating agencies is inherently unpredictable and could have a material adverse effect on financial markets and economic conditions in the U.S. and throughout the world. In turn, this could have a material adverse effect on our business, financial condition and results of operations and, in particular, this could have a material adverse effect on the value and liquidity of securities in our investment portfolio. Our investment portfolio as ofDecember 31, 2011 included$1.45 billion of obligations of the U.S. government and government agencies at fair value and$1.43 billion of municipal bonds at fair value. Please refer to Item 1A "Risk Factors" for a discussion of other risks relating to our business and investment portfolio. We expect that our liquidity needs, including our anticipated insurance obligations and operating and capital expenditure needs, for the next twelve months, at a minimum, will be met by funds generated from underwriting activities and investment income, as well as by our balance of cash, short-term investments, proceeds on the sale or maturity of our investments, and our credit facilities. We monitor our capital adequacy on a regular basis and will seek to adjust our capital base (up or down) according to the needs of our business. The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by several ratings agencies, at a level considered necessary by management to enable our key operating subsidiaries to compete; (2) sufficient capital to enable our underwriting subsidiaries to meet the capital adequacy tests performed by statutory agencies in the U.S. and other key markets; and (3) letters of credit and other forms of collateral that are necessary for our non-U.S. operating companies because they are "non-admitted" under U.S. state insurance regulations. As part of our capital management program, we may seek to raise additional capital or may seek to return capital to our shareholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our board of directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements and such other factors as our board of directors deems relevant. The board of directors of ACGL has authorized the investment in ACGL's common shares through a share repurchase program. Authorizations have consisted of a$1.0 billion authorization inFebruary 2007 , a$500.0 million authorization inMay 2008 , a$1.0 billion authorization inNovember 2009 and a$1.0 billion authorization inFebruary 2011 . Since the inception of the share repurchase program throughDecember 31, 2011 , ACGL has repurchased approximately 104.8 million common shares for an aggregate purchase price of$2.56 billion . AtDecember 31, 2011 , approximately$942.0 million of share repurchases were available under the program. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions throughDecember 2012 . The timing and amount of the repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations. We will continue to monitor our share price and, depending upon results of operations, market conditions and the development of the economy, as well as other factors, we will consider share repurchases on an opportunistic basis. To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. Given the recent severe disruptions in the public debt and equity markets, including among other things, widening of credit spreads, lack of liquidity and bankruptcies, we can provide no assurance that, 125
--------------------------------------------------------------------------------
Table of Contents
if needed, we would be able to obtain additional funds through financing on satisfactory terms or at all. Continued adverse developments in the financial markets, such as disruptions, uncertainty or volatility in the capital and credit markets, may result in realized and unrealized capital losses that could have a material adverse effect on our results of operations, financial position and our businesses, and may also limit our access to capital required to operate our business. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by ratings agencies to our operating subsidiaries, which could place those operating subsidiaries at a competitive disadvantage compared to higher-rated competitors; (2) reductions in the amount of business that our operating subsidiaries are able to write in order to meet capital adequacy-based tests enforced by statutory agencies; and (3) any resultant ratings downgrades could, among other things, affect our ability to write business and increase the cost of bank credit and letters of credit. In addition, under certain of the reinsurance agreements assumed by our reinsurance operations, upon the occurrence of a ratings downgrade or other specified triggering event with respect to our reinsurance operations, such as a reduction in surplus by specified amounts during specified periods, our ceding company clients may be provided with certain rights, including, among other things, the right to terminate the subject reinsurance agreement and/or to require that our reinsurance operations post additional collateral. In addition to common share capital, we depend on external sources of finance to support our underwriting activities, which can be in the form (or any combination) of debt securities, preference shares, common equity and bank credit facilities providing loans and/or letters of credit. As noted above, equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result, and, in any case, such securities may have rights, preferences and privileges that are senior to those of our outstanding securities. InAugust 2011 , we entered into a three-year agreement for a$300.0 million unsecured revolving loan and letter of credit facility and a$500.0 million secured letter of credit facility. Under the terms of the agreement, Arch Re U.S. and Arch Re Bermuda are limited to issuing an aggregate of$100.0 million of unsecured letters of credit as part of the unsecured revolving loan. In addition, we have access to letter of credit facilities for up to a total of$80.0 million , which are available on a limited basis and for limited purposes. Refer to note 14, "Commitments and Contingencies-Letter of Credit and Revolving Credit Facilities," of the notes accompanying our consolidated financial statements for a discussion of our available facilities, applicable covenants on such facilities and available capacity. During 2006, ACGL completed two public offerings of non-cumulative preferred shares. OnFebruary 1, 2006 ,$200.0 million principal amount of 8.0% series A preferred shares were issued and, onMay 24, 2006 ,$125.0 million principal amount of 7.875% series B preferred shares (together with the series A preferred shares, the "preferred shares") were issued. ACGL has the right to redeem all or a portion of the preferred shares at a redemption price of$25.00 per share. Dividends on the preferred shares are non-cumulative. Consequently, in the event dividends are not declared on the preferred shares for any dividend period, holders of preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accrue and will not be payable. Holders of preferred shares will be entitled to receive dividend payments only when, as and if declared by ACGL's board of directors or a duly authorized committee of ACGL's board of directors. Any such dividends will be payable from the date of original issue on a non-cumulative basis, quarterly in arrears. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 8.0% of the$25.00 liquidation preference per annum for the series A preferred shares and 7.875% of the$25.00 liquidation preference per annum for the series B preferred shares. AtDecember 31, 2011 , had declared an aggregate of$3.3 million of dividends to be paid to holders of the preferred shares. 126
--------------------------------------------------------------------------------
Table of Contents
InMarch 2009 ,ACGL andArch Capital Group (U.S.) Inc. filed a universal shelf registration statement with theSEC . This registration statement allows for the possible future offer and sale by us of various types of securities, including unsecured debt securities, preference shares, common shares, warrants, share purchase contracts and units and depositary shares. The shelf registration statement enables us to efficiently access the public debt and/or equity capital markets in order to meet our future capital needs. The shelf registration statement also allows selling shareholders to resell common shares that they own in one or more offerings from time to time. We will not receive any proceeds from any shares offered by the selling shareholders. This report is not an offer to sell or the solicitation of an offer to buy nor shall there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state. We purchased asset-backed and commercial mortgage-backed securities under the FRBNY's TALF program. As ofDecember 31, 2011 , we had$387.7 million of securities under TALF which are reflected as "TALF investments, at fair value" and$310.5 million of secured financing from the FRBNY which is reflected as "TALF borrowings, at fair value." As ofDecember 31, 2010 , we had$402.4 million of TALF investments, at fair value and$325.8 million of TALF borrowings, at fair value. Refer to note 14, "Commitments and Contingencies-TALF Program," and note 22, "Subsequent Events," of the notes accompanying our consolidated financial statements for further details on the TALF Program. AtDecember 31, 2011 , ACGL's capital of$5.03 billion consisted of$300.0 million of senior notes, representing 6.0% of the total,$100.0 million of revolving credit agreement borrowings due inAugust 2014 , representing 2.0% of the total,$325.0 million of preferred shares, representing 6.5% of the total, and common shareholders' equity of$4.30 billion , representing the balance. AtDecember 31, 2010 , ACGL's capital of$4.91 billion consisted of$300.0 million of senior notes, representing 6.1% of the total,$100.0 million of revolving credit agreement borrowings, representing 2.0% of the total,$325.0 million of preferred shares, representing 6.6% of the total, and common shareholders' equity of$4.19 billion , representing the balance. The increase in capital during 2011 was primarily attributable to net income, partially offset by share repurchase activity.
NATURAL AND MAN-MADE CATASTROPHIC EVENTS
We have large aggregate exposures to natural and man-made catastrophic events. Catastrophes can be caused by various events, including hurricanes, floods, windstorms, earthquakes, hailstorms, tornados, explosions, severe winter weather, fires, droughts and other natural disasters. Catastrophes can also cause losses in non-property business such as workers' compensation or general liability. In addition to the nature of property business, we believe that economic and geographic trends affecting insured property, including inflation, property value appreciation and geographic concentration, tend to generally increase the size of losses from catastrophic events over time. We have substantial exposure to unexpected, large losses resulting from future man-made catastrophic events, such as acts of war, acts of terrorism and political instability. These risks are inherently unpredictable. It is difficult to predict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate. It is not possible to completely eliminate our exposure to unforecasted or unpredictable events and, to the extent that losses from such risks occur, our financial condition and results of operations could be materially adversely affected. Therefore, claims for natural and man-made catastrophic events could expose us to large losses and cause substantial volatility in our results of operations, which could cause the value of our common shares to fluctuate widely. In certain instances, we specifically insure and reinsure risks resulting from terrorism. Even in cases where we attempt to exclude losses from terrorism and certain other similar risks from some coverages written by us, we may not be successful in doing so. Moreover, irrespective 127
--------------------------------------------------------------------------------
Table of Contents
of the clarity and inclusiveness of policy language, there can be no assurance that a court or arbitration panel will limit enforceability of policy language or otherwise issue a ruling adverse to us. We seek to limit our loss exposure by writing a number of our reinsurance contracts on an excess of loss basis, adhering to maximum limitations on reinsurance written in defined geographical zones, limiting program size for each client and prudent underwriting of each program written. In the case of proportional treaties, we may seek per occurrence limitations or loss ratio caps to limit the impact of losses from any one or series of events. In our insurance operations, we seek to limit our exposure through the purchase of reinsurance. We cannot be certain that any of these loss limitation methods will be effective. We also seek to limit our loss exposure by geographic diversification. Geographic zone limitations involve significant underwriting judgments, including the determination of the area of the zones and the inclusion of a particular policy within a particular zone's limits. There can be no assurance that various provisions of our policies, such as limitations or exclusions from coverage or choice of forum, will be enforceable in the manner we intend. Disputes relating to coverage and choice of legal forum may also arise. Underwriting is inherently a matter of judgment, involving important assumptions about matters that are inherently unpredictable and beyond our control, and for which historical experience and probability analysis may not provide sufficient guidance. One or more catastrophic or other events could result in claims that substantially exceed our expectations, which could have a material adverse effect on our financial condition or our results of operations, possibly to the extent of eliminating our shareholders' equity. For our natural catastrophe exposed business, we seek to limit the amount of exposure we will assume from any one insured or reinsured and the amount of the exposure to catastrophe losses from a single event in any geographic zone. We monitor our exposure to catastrophic events, including earthquake and wind and periodically reevaluate the estimated probable maximum pre-tax loss for such exposures. Our estimated probable maximum pre-tax loss is determined through the use of modeling techniques, but such estimate does not represent our total potential loss for such exposures. Our models employ both proprietary and vendor-based systems and include cross-line correlations for property, marine, offshore energy, aviation, workers compensation and personal accident. We seek to limit the probable maximum pre-tax loss to a specific level for severe catastrophic events. Currently, we seek to limit our 1-in-250 year return period net probable maximum loss from a severe catastrophic event in any geographic zone to approximately 25% of total shareholders' equity. We reserve the right to change this threshold at any time. Net probable maximum loss estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones. Our loss estimates do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer pre-tax losses greater than 25% of our total shareholders' equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders' equity exposed to a single catastrophic event. In addition, actual losses may increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. See "Risk Factors-Risk Relating to Our Industry." Depending on business opportunities and the mix of business that may comprise our insurance and reinsurance portfolio, we may seek to adjust our self-imposed limitations on probable maximum pre-tax loss for catastrophe exposed business. See "-Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Ceded Reinsurance" for a discussion of our catastrophe reinsurance programs. 128
--------------------------------------------------------------------------------
Table of Contents
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
Letter of Credit and Revolving Credit Facilities
As ofDecember 31, 2011 , we had a$300.0 million unsecured revolving loan and letter of credit facility and a$500.0 million secured letter of credit facility (the "Credit Agreement"). Under the terms of the agreement, Arch Re U.S. and Arch Re Bermuda are limited to issuing an aggregate of$100.0 million of unsecured letters of credit as part of the$300.0 million unsecured revolving loan. Borrowings of revolving loans may be made by ACGL at a variable rate based onLIBOR or an alternative base rate at our option. Secured letters of credit are available for issuance on behalf of our insurance and reinsurance subsidiaries. The Credit Agreement and related documents are structured such that each party that requests a letter of credit or borrowing does so only for itself and for only its own obligations. Issuance of letters of credit and borrowings under the Credit Agreement are subject to our compliance with certain covenants and conditions, including absence of a material adverse change. These covenants require, among other things, that we maintain a debt to total capital ratio of not greater than 0.35 to 1 and consolidated tangible net worth in excess of$3.09 billion plus 25% of future aggregate net income for each quarterly period (not including any future net losses) beginning afterJune 30, 2011 and 25% of future aggregate proceeds from the issuance of common or preferred equity and that our principal insurance and reinsurance subsidiaries maintain at least a "B++" rating fromA.M. Best . In addition, certain of our subsidiaries which are party to the Credit Agreement are required to maintain minimum shareholders' equity levels. We were in compliance with all covenants contained in the Credit Agreement atDecember 31, 2011 . The Credit Agreement expires onAugust 18, 2014 . We have access to other letter of credit facilities for up to a total of$80.0 million , which are available on a limited basis and for limited purposes (together with the secured portion of the Credit Agreement and these letter of credit facilities, the "LOC Facilities"). The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from our reinsurance subsidiaries inUnited States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations inthe United States , and to comply with requirements of Lloyd's ofLondon in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, certain letters of credit are secured by a portion of our investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which we were in compliance with atDecember 31, 2011 . At such date, we had approximately$515.7 million in outstanding letters of credit under the LOC Facilities, which were secured by investments with a fair value of$607.7 million , and had$100.0 million of borrowings outstanding under the Credit Agreement.
Senior Notes
InMay 2004 , ACGL completed a public offering of$300.0 million principal amount of 7.35% senior notes ("Senior Notes") dueMay 1, 2034 . The Senior Notes are ACGL's senior unsecured obligations and rank equally with all of its existing and future senior unsecured indebtedness. Interest payments on the Senior Notes are due onMay 1st andNovember 1st of each year. ACGL may redeem the Senior Notes at any time and from time to time, in whole or in part, at a "make-whole" redemption price. For 2011, 2010 and 2009, interest expense on the Senior Notes was$22.1 million . The fair value of the Senior Notes atDecember 31, 2011 and 2010 was$353.8 and$310.9 , respectively. 129
--------------------------------------------------------------------------------
Table of Contents
TALF Program
During the 2009 third quarter, we purchased asset-backed and commercial mortgage-backed securities under the FRBNY TALF program. TALF provides secured financing for asset-backed securities backed by certain types of consumer and small business loans and for legacy commercial mortgage-backed securities. TALF financing is non-recourse to us, except in certain limited instances, and is collateralized by the purchased securities and provides financing for the purchase price of the securities, less a 'haircut' that varies based on the type of collateral. We can deliver the collateralized securities to a special purpose vehicle created by the FRBNY in full defeasance of the borrowings. As ofDecember 31, 2011 , we had$387.7 million of securities under TALF, consisting of 19 individual TALF investments, which are reflected as "TALF investments, at fair value" and$310.5 million of secured financing from the FRBNY which is reflected as "TALF borrowings, at fair value." The maturity dates for the TALF borrowings range fromJuly 2012 toMarch 2015 , with interest rates that range from approximately 1.2% to 3.9% based on either variable or fixed interest rates depending on the related TALF investments. See note 22, "Subsequent Events," of the notes accompanying our consolidated financial statements.
Investment in Joint Venture
InMay 2008 , we provided$100.0 million of funding toGulf Reinsurance Limited ("Gulf Re"), a newly formed reinsurer based in theDubai International Financial Centre , pursuant to the joint venture agreement withGulf Investment Corporation GSC ("GIC"). Under the agreement, Arch Re Bermuda and GIC each own 50% of Gulf Re, which commenced underwriting activities inJune 2008 . Gulf Re targets the six member states of theGulf Cooperation Council ("GCC"), which includeBahrain ,Kuwait ,Oman ,Qatar ,Saudi Arabia and theUnited Arab Emirates . Gulf Re provides property and casualty reinsurance primarily in the member states of the GCC. The initial capital of the joint venture consisted of$200.0 million with an additional$200.0 million commitment to be funded equally by us and GIC depending on the joint venture's business needs we account for our investment in Gulf Re, shown as "Investment in joint venture," using the equity method and record our equity in the operating results of Gulf Re in "Other income (loss)" on a quarter lag basis. 130
--------------------------------------------------------------------------------
Table of Contents
Contractual Obligations
The following table provides an analysis of our contractual commitments atDecember 31, 2011 : Payment due by period Less than More than Total 1 year 1 - 3 years 4 - 5 years 5 years Debt obligations $ 400,000 $ - $ 100,000 $ - $ 300,000 Interest expense on long-term debt obligations 500,285 23,610 46,700 44,100 385,875 TALF borrowings 310,486 101,603 145,358 63,525 - Operating lease obligations 121,610 16,189 28,846 24,130 52,445 Purchase obligations 16,991 9,078 4,464 2,314 1,135 Reserve for losses and loss adjustment expenses, gross(1) 8,456,210 2,396,024 2,761,978 1,326,741 1,971,467 Deposit accounting liabilities(2) 29,139 2,125 3,101 1,186 22,727 Contractholder payables(3) 748,231 279,175 260,006 89,946 119,104 Securities lending collateral(4) 58,546 58,546 - - - Investment in Joint Venture(5) 100,000 - - - 100,000 Unfunded investment commitments(6) 274,693 274,693 - - - Total $ 11,016,191 $ 3,161,043 $ 3,350,453 $ 1,551,942 $ 2,952,753
--------------------------------------------------------------------------------
º (1)
º The estimated expected contractual commitments related to the reserves for
losses and loss adjustment expenses are presented on a gross basis. It
should be noted that until a claim has been presented to us, determined to
be valid, quantified and settled, there is no known obligation on an
individual transaction basis, and while estimable in the aggregate, the
timing and amount contain significant uncertainty. Approximately 66% of our
reserves for losses and loss adjustment expenses were incurred but not reported atDecember 31, 2011 . º (2) º The estimated expected contractual commitments related to deposit
accounting liabilities have been estimated using projected cash flows from
the underlying contracts. It should be noted that, due to the nature of
such liabilities, the timing and amount contain significant uncertainty.
º (3)
º Certain insurance policies written by our insurance operations feature
large deductibles, primarily in construction and national accounts lines.
Under such contracts, we are obligated to pay the claimant for the full
amount of the claim and are subsequently reimbursed by the policyholder for
the deductible amount. In the event we are unable to collect from the policyholder, we would record an increase to losses and loss adjustment
expenses related to such policy.
º (4)
º As part of our securities lending program, we loan certain fixed income
securities to third parties and receive collateral, primarily in the form
of cash. The collateral received is reinvested and is reflected as
"Investment of funds received under securities lending agreements, at fair
value" or "Securities purchased under agreements to resell using funds
received under securities lending agreements." Such collateral is due back
to the third parties at the close of the securities lending transaction.
º (5)
º We have committed an additional
depending on the joint venture's business needs. We do not anticipate that
additional funding will be required in the next five years.
º (6)
º Unfunded investment commitments are callable by our investment managers. We
have assumed that such investments will be funded in the next year but the
funding may occur over a longer period of time, due to market conditions and other factors. 131
--------------------------------------------------------------------------------
Table of Contents
OFF-BALANCE SHEET ARRANGEMENTS
We are not party to any transaction, agreement or other contractual arrangement to which an entity unconsolidated with us is a party that management believes is reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
MARKET SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
Our investment results are subject to a variety of risks, including risks related to changes in the business, financial condition or results of operations of the entities in which we invest, as well as changes in general economic conditions and overall market conditions. We are also exposed to potential loss from various market risks, including changes in equity prices, interest rates and foreign currency exchange rates. In accordance with theSEC's Financial Reporting Release No. 48, we performed a sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments as ofDecember 31, 2011 . Market risk represents the risk of changes in the fair value of a financial instrument and consists of several components, including liquidity, basis and price risks. The sensitivity analysis performed as ofDecember 31, 2011 presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which were held by us onDecember 31, 2011 and are sensitive to changes in interest rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future events of losses. The focus of theSEC's market risk rules is on price risk. For purposes of specific risk analysis, we employ sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments. The financial instruments included in the following sensitivity analysis consist of all of our investments and cash.
Investment Market Risk
Fixed Income Securities . We invest in interest rate sensitive securities, primarily debt securities. We consider the effect of interest rate movements on the market value of our fixed maturities, fixed maturities pledged under securities lending agreements, short-term investments and certain of our other investments which invest in fixed income securities and the corresponding change in unrealized appreciation. As interest rates rise, the market value of our interest rate sensitive securities falls, and the converse is also true. Based on historical observations, there is a low probability that all interest rate yield curves would shift in the same direction at the same time. Furthermore, in recent months interest rate movements in many credit sectors have exhibited a much lower correlation to changes in U.S. Treasury yields. Accordingly, the actual effect of interest rate movements may differ materially from the amounts set forth in the following tables. 132
--------------------------------------------------------------------------------
Table of Contents
The following table summarizes the effect that an immediate, parallel shift in the interest rate yield curve would have had on the portfolio atDecember 31, 2011 and 2010: Interest Rate Shift in Basis Points (U.S. dollars in millions) -100 -50 - 50 100 AtDecember 31, 2011 Total fair value $ 11,320.9 $ 11,215.5 $ 11,067.5 $ 10,905.6 $ 10,743.4 Change from base 2.29 % 1.34 % - (1.46 )% (2.93 )% Change in unrealized value $ 253.4 $ 148.0 $ - $ (161.9 ) $ (324.1 ) AtDecember 31, 2010 Total fair value $ 10,668.3 $ 10,542.6 $ 10,404.9 $ 10,249.0 $ 10,100.0 Change from base 2.53 % 1.32 % -
(1.50 )% (2.93 )% Change in unrealized value
In addition, we consider the effect of credit spread movements on the market value of our fixed maturities, fixed maturities pledged under securities lending agreements, short-term investments and certain of our other investments and investment funds accounted for using the equity method which invest in fixed income securities and the corresponding change in unrealized appreciation. As credit spreads widen, the fair value of our fixed income securities falls, and the converse is also true. The following table summarizes the effect that an immediate, parallel shift in credit spreads in a static interest rate environment would have had on the portfolio atDecember 31, 2011</chron> and 2010: Credit Spread Shift in Basis Points (U.S. dollars in millions) -100 -50 - 50 100 At December 31, 2011 Total fair value $ 11,297.6 $ 11,189.3 $ 11,067.5 $ 10,952.5 $ 10,836.4 Change from base 2.08 % 1.10 % - (1.04 )% (2.09 )% Change in unrealized value $ 230.1 $ 121.8 $ - $ (115.0 ) $ (231.1 ) AtDecember 31, 2010 Total fair value $ 10,608.2 $ 10,506.5 $ 10,404.9 $ 10,304.2 $ 10,204.4 Change from base 1.95 % 0.98 % - (0.97 )% (1.93 )% Change in unrealized value $ 203.3 $ 101.6 $ - $ (100.7 ) $ (200.5 )
Another method that attempts to measure portfolio risk is Value-at-Risk ("VaR"). VaR attempts to take into account a broad cross-section of risks facing a portfolio by utilizing relevant securities volatility data skewed towards the most recent months and quarters. VaR measures the amount of a portfolio at risk for outcomes 1.65 standard deviations from the mean based on normal market conditions over a one year time horizon and is expressed as a percentage of the portfolio's initial value. In other words, 95% of the time, should the risks taken into account in the VaR model perform per their historical tendencies, the portfolio's loss in any one year period is expected to be less than or equal to the calculated VaR, stated as a percentage of the measured portfolio's initial value. As of December 31, 2011 , our portfolio's VaR was estimated to be 3.23%, compared to an estimated 3.76% at December 31, 2010 . Equity Securities , Privately Held Securities and Other Investments. Our investment portfolio includes an allocation to equity securities, privately held securities and certain other investments. At December 31, 2011 and 2010, the fair value of our investments in equity securities, privately held securities (excluding our investment in Aeolus LP which is accounted for using the equity method) and certain other investments totaled $508.5 million and $587.1 million , respectively. These securities are exposed to price risk, which is the potential loss arising from decreases in fair value. An immediate 133
--------------------------------------------------------------------------------
Table of Contents
hypothetical 10% depreciation in the value of each position would reduce the fair value of such investments by approximately$50.8 million and$58.7 million atDecember 31, 2011 and 2010, respectively, and would have decreased book value per common share by approximately$0.38 and$0.42 , respectively. Investment-Related Derivatives. Derivative instruments may be used to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. The fair values of those derivatives are based on quoted market prices. See note 9, "Derivative Instruments," of the notes accompanying our consolidated financial Statements for additional disclosures concerning derivatives. AtDecember 31, 2011 , the notional value of the net long position of derivative instruments (excluding to-be-announced mortgage backed securities which are included in the fixed income securities analysis above and foreign currency forward contracts which are included in the foreign currency exchange risk analysis below) was$877.9 million , compared to$1.04 billion atDecember 31, 2010 . A 100 basis point depreciation of the underlying exposure to these derivative instruments atDecember 31, 2011 and 2010 would have resulted in a reduction in net income of approximately$8.8 million and$10.4 million , respectively, and would have decreased book value per common share by$0.07 and$0.07 , respectively.
For further discussion on investment activity, please refer to "-Financial Condition, Liquidity and Capital Resources-Financial Condition-Investable Assets."
Foreign Currency Exchange Risk
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Through our subsidiaries and branches located in various foreign countries, we conduct our insurance and reinsurance operations in a variety of local currencies other than the U.S. Dollar. We generally hold investments in foreign currencies which are intended to mitigate our exposure to foreign currency fluctuations in our net insurance liabilities. We may also utilize foreign currency forward contracts and currency options as part of our investment strategy. See Note 9, "Derivative Instruments," of the notes accompanying our consolidated financial statements for additional information. 134
--------------------------------------------------------------------------------
Table of Contents
The following table provides a summary of our net foreign currency exchange exposures, as well as foreign currency derivatives in place to manage these exposures, at
December 31 , (U.S. dollars in thousands, except per share data) 2011
2010
Assets, net of insurance liabilities, denominated in foreign currencies, excluding shareholders' equity and derivatives
108,575
Net foreign currency forward contracts outstanding(2) (16,569 )
(105,022 )
Net assets denominated in foreign currencies $ 374,327 $ 164,910 Pre-tax impact of a hypothetical 10% appreciation of the U.S. Dollar against foreign currencies: Shareholders' equity $ (37,433 ) $ (16,491 ) Book value per common share $ (0.28 ) $ (0.12 ) Pre-tax impact of a hypothetical 10% decline of the U.S. Dollar against foreign currencies: Shareholders' equity $ 37,433 $ 16,491 Book value per common share $ 0.28 $ 0.12
--------------------------------------------------------------------------------
º (1)
º Represents capital contributions held in the foreign currencies of our
operating units.
º (2)
º Notional value of the outstanding foreign currency forward contracts in
U.S. Dollars.
As a result of the current financial and economic environment as well as the potential for additional investment returns, we may not match a portion of our projected liabilities in foreign currencies with investments in the same currencies, which would increase our exposure to foreign currency fluctuations and increase the volatility in our results of operations. Historical observations indicate a low probability that all foreign currency exchange rates would shift against the U.S. Dollar in the same direction and at the same time and, accordingly, the actual effect of foreign currency rate movements may differ materially from the amounts set forth above. For further discussion on foreign exchange activity, please refer to "-Results of Operations."
Effects of Inflation
We do not believe that inflation has had a material effect on our consolidated results of operations, except insofar as inflation may affect our reserves for losses and loss adjustment expenses and interest rates. The potential exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The anticipated effects of inflation on us are considered in our catastrophe loss models. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Reference is made to the information appearing above under the subheading "Market Sensitive Instruments and Risk Management" under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operation," which information is hereby incorporated by reference.
135
--------------------------------------------------------------------------------
Table of Contents
| Wordcount: | 32242 |
PENNSYLVANIA REAL ESTATE INVESTMENT TRUST – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Advisor News
- What advisors think about pooled employer plans, alternative investments
- AI, stablecoins and private market expansion may reshape financial services by 2030
- Cheers to summer, and planning for what comes next
- Why seniors fear spending their own retirement wealth
- The McEwen Group Merges with Prairie Wealth Advisors to Form Billion Dollar RIA
More Advisor NewsAnnuity News
- AuguStar Retirement launches StarStream Variable Annuity
- Prismic Life Announces Completion of Oversubscribed Capital Raise
- Guaranteed income streams help preserve assets later in retirement
- MassMutual turns 175, Marking Generations of Delivering on its Commitments
- ALIRT Insurance Research: U.S. Life Insurance Industry In Transition
More Annuity NewsHealth/Employee Benefits News
- Providence to end most health insurance plans, forcing hundreds of thousands in Oregon to switch
- Flemington-Raritan Seeking Assistance From State Regarding Rising Health Insurance Costs
- Mandela Barnes proposes blocking use of AI to boost consumer prices
- NCOIL adopts Individual Coverage Health Reimbursement Arrangement Model Act
- All about AHCCCS: Navigating Arizona Medicaid’s changing landscape
More Health/Employee Benefits NewsLife Insurance News
- AI, stablecoins and private market expansion may reshape financial services by 2030
- Transgender plaintiffs win preliminary victories in three gender-affirming care lawsuits
- AM Best Upgrades Issuer Credit Rating of Southern Farm Bureau Life Insurance Company
- Industry Innovator Scores New High-Water Mark: Reliance Matrix Logs 8 Millionth Employee Benefit/Absence Claim
- $150M+ asset sale payout distributed to Greg Lindberg policyholders
More Life Insurance News