HCC INSURANCE HOLDINGS INC/DE/ – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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The following Management's Discussion and Analysis should be read in conjunction with the Selected Financial Data and the Consolidated Financial Statements and related Notes. Overview We are a specialty insurance group with offices inthe United States , theUnited Kingdom ,Spain andIreland , transacting business in approximately 180 countries. Our shares trade on theNew York Stock Exchange and closed at$39.97 onFebruary 15, 2013 , resulting in market capitalization of$4.0 billion . We underwrite and manage a variety of largely non-correlated specialty insurance products through five insurance underwriting segments and our Investing segment. Our insurance underwriting segments are U.S. Property & Casualty, Professional Liability, Accident & Health, U.S. Surety & Credit and International. We market our insurance products through a network of independent agents and brokers, through managing general agents owned by the company, and directly to consumers. In addition, we assume insurance written by other insurance companies. Our organization is focused on generating consistent, industry-leading combined ratios. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We rely on experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce risk. By focusing on underwriting profitability, we are able to accomplish our primary objectives of maximizing net earnings and growing book value per share.
Key facts about our consolidated group as of and for the year ended
• We had consolidated shareholders' equity of
value per share of$35.10 .
• We generated net earnings of
• We produced total revenue of
earned premium and 9% related to net investment income. • We recognized gross losses of$84.8 million and net losses, after
reinsurance and reinstatement premium, of
catastrophes, the largest being Superstorm Sandy, mainly in our International segment. • Our net loss ratio was 58.2% and our combined ratio was 83.6%. • We recorded net favorable loss development of$70.0 million . • Our debt to capital ratio was 14.2%.
• We purchased
current$300.0 million share buyback authorization. • We increased our regular quarterly cash dividend to$0.165 per share, marking the 16th consecutive year of increases in our dividend. We
declared dividends of
in 2012.
The following sections discuss our key operating results. The reason for any significant variations between 2011 and 2010 are the same as those discussed for variations between 2012 and 2011, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees. We adjusted certain prior period amounts to reflect our adoption of a new accounting standard in 2012 (see Note 1, "General Information and Significant Accounting and Reporting Policies - Accounting Guidance Adopted in 2012" to the Consolidated Financial Statements). We also adjusted all prior segment data to reflect our exit from two lines of business previously included in our Accident & Health segment (see Note 12, "Segments" to the Consolidated Financial Statements). 34
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Results of Operations
Our results and key metrics for the past three years were as follows:
2012 2011 2010 Net earnings $ 391,240 $ 255,243 $ 345,096
Earnings per diluted share $ 3.83 $ 2.30 $
2.99 Net loss ratio 58.2 % 65.8 % 59.4 % Expense ratio* 25.4 25.3 25.6 Combined ratio* 83.6 % 91.1 % 85.0 %
* 2011 and 2010 adjusted to reflect 2012 change in Exited Lines.
Our results include the impact of catastrophic events around the world, including these major events: 1) 2012 - Superstorm Sandy andUnited States storms, 2) 2011 -Japan earthquake and tsunami, Hurricane Irene,New Zealand earthquakes,United States tornados,Denmark storms andThailand floods and 3) 2010 -Chile earthquake. These losses primarily impacted our International and U.S. Property & Casualty segments. We reinsure a portion of our exposure to catastrophic events, although we incur some additional cost for reinstatement premium to continue our reinsurance coverage for future loss events. The following table summarizes our accident year catastrophe losses, as well as the impact on our net earnings and key metrics. 2012 2011 2010 Gross losses $ 84,751 $ 175,468 $ 44,042 Net losses $ 52,390 $ 103,907 $ 22,500 Reinstatement premium, net 401 14,008 (1,154 ) Total net catastrophe losses $ 52,791 $ 117,915
Impact of net catastrophe losses on:
Net earnings per diluted share $ (0.34 ) $ (0.70 ) $ (0.12 )
Net loss ratio (percentage points) 2.3 % 5.3 %
1.1 %
Combined ratio (percentage points) 2.4 % 5.4 %
1.1 %
We recognized net favorable loss development of$70.0 million in 2012, which included$21.4 million related to prior year catastrophes, compared to net adverse development of$10.1 million in 2011 and net favorable development of$22.7 million in 2010. See the "Segment Operations" section below for discussion of the impact of the catastrophe losses and the net loss development on each of our insurance underwriting segments.
Revenue
We generate our revenue from five primary sources:
• risk-bearing earned premium produced by our insurance underwriting segments,
• investment income earned on our consolidated investment portfolio by our
Investing segment, • fee and commission income received from third party insurers for premium produced for them by our underwriting agencies, 35
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• transaction-based revenues, primarily related to residual value and
mortgage reinsurance products in our U.S. Property & Casualty segment, and
• realized investment gains and losses related to our investment portfolio.
Total revenue increased$151.8 million in 2012, compared to 2011, primarily due to higher net earned premium, net investment income and net realized investment gains. Total revenue increased$71.8 million in 2011, compared to 2010, primarily due to higher net earned premium and net investment income, offset by lower other operating income and net realized investment gains. Gross written premium, net written premium and net earned premium are detailed below by segment. 2012 2011 2010 U.S. Property & Casualty $ 614,694 $ 540,436 $ 538,475 Professional Liability 539,383 562,503 596,291 Accident & Health 835,796 757,097 707,103 U.S. Surety & Credit 221,468 226,312 226,866 International 531,167 517,383 453,478 Exited Lines 41,565 45,395 56,695
Total gross written premium
2,578,908 U.S. Property & Casualty $ 383,938 $ 367,296 $ 328,821 Professional Liability 378,138 412,262 401,562 Accident & Health 835,008 756,539 706,747 U.S. Surety & Credit 195,904 208,859 209,373 International 419,155 391,819 324,344 Exited Lines 41,253 45,383 55,350 Total net written premium $ 2,253,396 $ 2,182,158 $ 2,026,197 U.S. Property & Casualty $ 354,050 $ 333,410 $ 339,513 Professional Liability 394,687 410,816 425,226 Accident & Health 831,827 758,270 705,408 U.S. Surety & Credit 207,955 210,535 199,908 International 412,853 368,748 316,186 Exited Lines 41,253 45,391 55,683 Total net earned premium $ 2,242,625 $ 2,127,170 $ 2,041,924 The 2012 and 2011 growth in premium from our insurance underwriting segments occurred primarily in: 1) the U.S. Property & Casualty segment, from new business lines started in 2011 and increased public risk, residual value and other premium; 2) the Accident & Health segment, from the growth of our medical stop-loss product and 3) the International segment, from new business and price increases in our energy and property treaty lines of business. See the "Segment Operations" section below for further discussion of the relationship and changes in premium revenue within each insurance segment. Net investment income, which is included in our Investing segment, increased 5% in 2012 and 4% in 2011 due to growth in our investment portfolio, partially offset by the effect of reduced yields. Our fixed maturity securities portfolio increased 7% in 2012 and 13% in 2011, from$5.2 billion atDecember 31, 2010 to$5.9 billion atDecember 31, 2011 and$6.3 billion atDecember 31, 2012 . In addition, we added publicly traded equity securities to our portfolio in 2012 and held$284.6 million atDecember 31, 2012 . The growth in investments resulted primarily from cash flow from operations and an increase of$105.6 million in the net unrealized gain on our available for sale securities during 2012. Our investment expense increased in 2012 due to growth in the portfolio and management expenses for the equity securities. 36
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Our other operating income primarily consists of fee and commission income related to third party agency and broker commissions and income from two financial instruments. In 2010, we terminated one of these contracts and recognized
Loss and Loss Adjustment Expense
We incur expenses for insurance claims paid or payable to policyholders, as well as the potential liability for incurred but not reported claims, and the expense to adjust and settle all claims (collectively referred to as loss and loss adjustment expense). Our net loss ratio is the percentage of our loss and loss adjustment expense divided by our net earned premium in each year. Loss development represents an increase or decrease in estimates of ultimate losses related to business written in prior accident years. Such increases or decreases are recorded as loss and loss adjustment expense in the current reporting year. Favorable development means the original ultimate loss estimate was higher than the current estimate. Adverse development means the current ultimate loss estimate is higher than the original estimate. Loss development occurs as we review our loss exposure with our actuaries, increasing or decreasing estimates of our ultimate losses as a result of such reviews and as losses are finally settled or claims exposure changes. The tables below detail our net loss and loss adjustment expense, the amount of net loss development included in our net loss and loss adjustment expense, and our net loss ratios on a consolidated basis and for our segments. 2012 2011 2010 U.S. Property & Casualty $ 209,286 $ 201,017 $ 191,108 Professional Liability 229,873 328,503 265,465 Accident & Health 601,076 552,292 506,994 U.S. Surety & Credit 38,535 52,206 52,940 International 189,410 233,879 143,412 Exited Lines 37,331 31,350 53,110
Net loss and loss adjustment expense
Net (favorable) adverse loss development U.S Property & Casualty $ 2,321 $ (3,145 ) $ (15,891 ) Professional Liability (25,897 ) 47,084 9,624 Accident & Health (10,511 ) (1,324 ) 1,374 U.S. Surety & Credit (25,377 ) (11,300 ) (7,181 ) International (10,084 ) (13,830 ) (22,277 ) Exited Lines (463 ) (7,338 ) 11,688 Total net (favorable) adverse loss development (70,011 ) 10,147 (22,663 ) Accident year catastrophe losses 52,390 103,907 22,500 All other net loss and loss adjustment expense 1,323,132 1,285,193 1,213,192
Net loss and loss adjustment expense
U.S. Property & Casualty 59.1 % 60.3 % 56.3 % Professional Liability 58.2 80.0 62.4 Accident & Health 72.3 72.8 71.9 U.S. Surety & Credit 18.5 24.8 26.5 International 45.9 63.4 45.4 Consolidated net loss ratio 58.2 % 65.8 % 59.4 % Consolidated accident year net loss ratio 61.5 % 65.3 % 60.4 % Loss and loss adjustment expense decreased 7% in 2012, compared to an increase of 15% in 2011. The 2012 decrease primarily related to: 1) net favorable loss development in 2012, compared to net adverse development in 2011, 2) lower 37
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accident year catastrophe losses in 2012 and 3) a slightly lower accident year loss ratio, excluding catastrophes, in 2012. The 2011 increase was driven by: 1) higher accident year catastrophe losses, primarily in the International segment and 2) an increase in reserves in 2011 to reflect a higher ultimate loss ratio for accident year 2011 for our diversified financial products (DFP) line of business in the Professional Liability segment. Our accident year net loss ratio was higher in 2011 due to the catastrophe losses and increased DFP reserves in that year. Excluding catastrophes, our accident year net loss ratio was 59.1% for 2012, 60.0% for 2011 and 59.4% for 2010. See the "Segment Operations" section below for additional discussion of the changes in our loss and loss adjustment expense, net development and net loss ratios for each segment. Our net paid loss ratio is the percentage of losses paid, net of reinsurance, divided by net earned premium for the year. The table below provides a reconciliation of our consolidated reserves for loss and loss adjustment expense payable, net of reinsurance ceded, the amount of our paid claims, and our net paid loss ratio. 2012 2011 2010 Net reserves for loss and loss adjustment expense payable at beginning of year $ 2,683,483 $ 2,537,772 $ 2,555,840 Net reserve additions from acquired businesses 14,705 6,261 8,110 Foreign currency adjustment 18,449 (6,108 ) (21,127 ) Net loss and loss adjustment expense 1,305,511 1,399,247 1,213,029 Net loss and loss adjustment expense payments (1,272,345 )
(1,253,689 ) (1,218,080 )
Net reserves for loss and loss adjustment expense payable at end of year $ 2,749,803 $
2,683,483
Net paid loss ratio 56.7 % 58.9 % 59.7 % The amount of claims paid fluctuates year-over-year due to our mix of business, the timing of claims settlement and catastrophic events. Our net paid loss ratio decreased slightly in both 2012 and 2011 due to offsetting changes in the amount of claims paid across our different lines of business, such that our net loss payments have increased at a slower rate than our net earned premium. We commuted certain loss reserves on large contracts included in our Exited Lines for$27.5 million in 2012 and$26.7 million in 2011. The commutations had no material effect on net earnings but increased our net paid loss ratios by 1.2 and 1.3 percentage points in 2012 and 2011, respectively.
Policy Acquisition Costs
Policy acquisition costs relate to direct costs we incur to issue insurance policies, including commissions, premium taxes and compensation of our underwriters. The percentage of policy acquisition costs to net earned premium was 12.5% in all three years. We record profit commissions due from reinsurers as an offset to policy acquisition costs, which impacted our policy acquisition cost percentages as follows: 2012 2011 2010 Profit commissions $ 10,227 $ 17,194 $ 1,594 Impact of profit commissions (percentage points) 0.5 % 0.8 % 0.1 %
After excluding profit commissions, the difference between years primarily relates to changes in the mix of business.
Other Operating Expense
Other operating expense increased 9% in 2012 and 2% in 2011. In 2012, 61% of our other operating expense related to compensation and benefits for our 1,870 employees, compared to 62% in 2011 and 61% in 2010. The 2012 increase in other operating expense was primarily due to increased compensation expense, including higher bonus expense directly related to higher pretax earnings in 2012, and the year-over-year fluctuation in foreign currency benefit/expense. The 2011 increase related to higher compensation and benefits and information technology expense. We recognized foreign currency expense of$6.2 million in 2012, compared to a benefit of$1.1 million in 2011 and expense of$1.6 million in 2010, primarily related to fluctuations in the British pound sterling. 38
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Other operating expense included$13.2 million ,$12.4 million and$13.6 million of stock-based compensation expense in 2012, 2011 and 2010, respectively. Stock-based compensation expense was lower in 2012 and 2011 due to the timing of vesting and forfeitures of awards. In 2012, we granted$11.2 million of restricted stock awards and units, with a weighted-average life of 3.2 years. AtDecember 31, 2012 , there was approximately$24.8 million of total unrecognized compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 3.0 years. In 2013, we expect to recognize$9.9 million of expense for all stock-based awards outstanding at year-end 2012.
Interest Expense
Interest expense on debt and short-term borrowings was$25.6 million ,$23.1 million and$21.3 million in 2012, 2011 and 2010, respectively. Our interest expense has increased due to a higher amount of outstanding borrowings on our$600.0 million Revolving Loan Facility, primarily to fund purchases of our common stock. Interest expense included$19.3 million per year for our Senior Notes. Income Tax Expense Our income taxes are due to U.S. Federal, state, local and foreign jurisdictions. Our effective income tax rate was 29.4% for 2012, compared to 28.1% for 2011 and 29.5% for 2010. The higher effective rates in 2012 and 2010 are due to the relationship of pretax income and tax-exempt investment income. Our pretax income was substantially higher in 2012 and 2010 than in 2011, whereas our tax-exempt investment income increased slightly each year. The lower effective rate in 2011 related to the increased benefit from tax-exempt investment income relative to a lower pretax income base.
Segment Operations
Each of our insurance segments bears risk for insurance coverage written within its portfolio of insurance products. Each segment generates income from premium written by our underwriting agencies, through third party agents and brokers, or on a direct basis. The insurance segments also write facultative or individual account reinsurance, as well as treaty reinsurance business. In some cases, we purchase reinsurance to limit the segments' net losses from both individual policy losses and multiple policy losses from catastrophic risks. Our segments maintain disciplined expense management and a streamlined management structure, which results in favorable expense ratios. A description of the type of products, distribution channels, risk exposure and other key facts about our five insurance underwriting segments is included in the "Segment and Geographic Information" section of Item 1, Business. The following provides operational information about our five insurance underwriting segments and our Investing segment.
U.S. Property & Casualty Segment
The following tables summarize the operations of the U.S. Property & Casualty segment. 2012 2011 2010 Net earned premium $ 354,050 $ 333,410 $ 339,513 Other revenue 18,865 23,951 31,201 Segment revenue 372,915 357,361 370,714
Loss and loss adjustment expense, net 209,286 201,017
191,108 Other expense 116,398 110,184 103,229 Segment expense 325,684 311,201 294,337 Segment pretax earnings $ 47,231 $ 46,160 $ 76,377 39
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Table of Contents 2012 2011 2010 Net loss ratio 59.1 % 60.3 % 56.3 % Expense ratio 31.2 30.8 27.8 Combined ratio 90.3 % 91.1 % 84.1 % Aviation $ 116,236 $ 113,341 $ 115,952 E&O 61,976 73,666 95,275 Public Risk 65,281 50,440 46,409 Other 110,557 95,963 81,877 Total net earned premium $ 354,050 $ 333,410 $ 339,513 Aviation 56.2 % 63.7 % 55.0 % E&O 70.9 70.8 79.2 Public Risk 94.1 79.8 61.8 Other 34.9 37.9 28.4 Total net loss ratio 59.1 % 60.3 % 56.3 % Aviation $ 144,621 $ 154,903 $ 162,539 E&O 60,639 68,846 81,567 Public Risk 85,857 73,168 64,802 Other 323,577 243,519 229,567 Total gross written premium $ 614,694 $ 540,436 $ 538,475 Aviation $ 112,712 $ 117,333 $ 110,539 E&O 58,066 67,606 81,443 Public Risk 69,081 58,096 46,844 Other 144,079 124,261 89,995
Total net written premium
Our U.S. Property & Casualty segment pretax earnings increased 2% in 2012 due to higher net earned premium and a lower net loss ratio. The segment's pretax earnings decreased 40% in 2011 primarily due to: 1) lower net earned premium, 2) a reduced amount of favorable development in 2011 compared to 2010, 3)$6.2 million of catastrophe losses in 2011, 4) higher operating expenses and 5) the effect of a$5.0 million gain in 2010 related to termination of a derivative contract. Net earned premium was higher in 2012 due to$14.3 million of additional premium from our new technical property, primary casualty and excess casualty underwriting teams, as well as increases in aviation, public risk, contingency, residual value and other premium. Premium grouped in Other includes numerous types of specialty insurance products, including the technical property, primary casualty and excess casualty lines of business. These new teams wrote$57.0 million of gross premium in 2012, compared to$16.7 million in 2011 and a minimal amount in 2010. In 2011 and again in 2012, we wrote less premium in some lines of business, particularly aviation and E&O, due to continued competition. Our public risk premium has grown primarily due to increased participation in one particular area of this business, as well as higher retention of the business beginning in 2011. Changes in the segment's net written premium relative to gross written premium are due to changes in timing and the amount of our reinsurance programs. The segment experienced accident year net catastrophe losses of$11.3 million in 2012, compared to$6.2 million in 2011, of which$7.0 million and$5.0 million , respectively, related to our public risk line of business. The segment had net adverse loss development of$2.3 million in 2012, compared to net favorable development of$3.1 million in 2011 and$15.9 million 40
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in 2010. In 2012, the segment experienced favorable development in aviation and various lines of business included in Other, which was more than offset by adverse development in the E&O and public risk lines of business. The 2011 net favorable development primarily related to offsetting favorable and adverse loss development for products grouped in Other. The 2010 net favorable loss development primarily related to an assumed quota share contract that is in runoff, as well as aviation, public risk, and smaller product lines included in Other. Aviation experienced higher 2011 accident year losses and E&O experienced higher 2010 accident year losses, as well as adverse loss development in 2010 related to the 2006 - 2009 underwriting years. The segment's expense ratio was higher in 2012 and 2011, primarily due to increasing compensation costs. In 2010, we terminated our interest in a derivative contract, which generated$8.0 million of other revenue and$3.0 million of other direct expenses in that year. The segment's remaining other revenue relates to fee and commission income earned by our agencies from third party insurance companies.
Professional Liability Segment
The following tables summarize the operations of the Professional Liability segment. 2012 2011 2010 Net earned premium $ 394,687 $ 410,816 $ 425,226 Other revenue 731 912 981 Segment revenue 395,418 411,728 426,207 Loss and loss adjustment expense, net 229,873 328,503 265,465 Other expense 66,721 59,036 74,524 Segment expense 296,594 387,539 339,989 Segment pretax earnings $ 98,824 $ 24,189 $ 86,218 Net loss ratio 58.2 % 80.0 % 62.4 % Expense ratio 16.9 14.3 17.5 Combined ratio 75.1 % 94.3 % 79.9 % U.S. D&O $ 332,661 $ 359,178 $ 377,868 International D&O 62,026 51,638 47,358 Total net earned premium $ 394,687 $ 410,816 $ 425,226 U.S. D&O 64.6 % 90.3 % 62.6 % International D&O 24.2 8.2 60.8 Total net loss ratio 58.2 % 80.0 % 62.4 % U.S. D&O $ 424,099 $ 453,669 $ 498,331 International D&O 115,284 108,834 97,960 Total gross written premium $ 539,383 $ 562,503 $ 596,291 U.S. D&O $ 311,576 $ 347,834 $ 362,255 International D&O 66,562 64,428 39,307 Total net written premium $ 378,138 $ 412,262 $ 401,562 41
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The Professional Liability segment pretax earnings increased$74.6 million in 2012, compared to 2011, due to an improved accident year loss ratio and changes in loss development. Segment earnings decreased in 2011, compared to 2010, due to lower net earned premium and net adverse loss development, partially offset by increased income related to profit commissions due from reinsurers. Gross written premium decreased 4% in 2012, primarily due to reduced writings in our DFP line of business (included in U.S. D&O) as we re-underwrote the DFP book of business in 2012. Gross written premium decreased 6% in 2011 because we wrote less D&O business inthe United States due to pricing competition. Net written premium fluctuated year-over-year due to a change in our reinsurance program in both years. The segment had net favorable loss development of$25.9 million in 2012, compared to net adverse development of$47.1 million in 2011 and$9.6 million in 2010. The 2012 development consisted of$9.0 million in U.S. D&O and$16.9 million in International D&O. The 2012 development related to lower than expected reported loss development in underwriting years 2003 - 2006, partially offset by higher expected losses in the 2008 underwriting year. The 2011 and 2010 development primarily related to our DFP line of business, which provides coverage for private equity partnerships, hedge funds, investment managers and similar groups. In 2011, DFP recorded$104.2 million of adverse development, as well as$37.3 million of additional losses related to our increase in the ultimate loss ratio for accident year 2011. These reserve changes resulted primarily from revised assumptions with regards to the frequency and severity of claims in the 2008 - 2011 accident years. Our U.S. D&O and International D&O lines of business had favorable development of$32.2 million and$24.9 million , respectively, in 2011, which partially offset the adverse development from DFP. The favorable D&O development related to lower than expected reported loss development in accident years 2002 - 2005. U.S. D&O's 2012 net loss ratio includes the impact of using DFP's higher ultimate loss ratio in 2012 for DFP's underwriting year 2011 premium that earned in 2012. The 2011 net loss ratio for U.S. D&O included the impact of DFP's adverse development, partially offset by the favorable development for the U.S. D&O line of business. International D&O's lower loss ratios in 2012 and 2011, compared to 2010, directly related to favorable development in those years. The fluctuations in the expense ratio primarily related to profit commissions of$5.1 million in 2012 and$13.5 million in 2011, recognized in conjunction with the favorable development in those years. The profit commissions, which offset the segment's other expense, reduced the 2012 and 2011 expense ratio by 1.3 and 3.3 percentage points, respectively. There were minimal profit commissions in 2010. 42
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Accident & Health Segment
The following tables summarize the operations of the Accident & Health segment. 2012 2011 2010 Net earned premium $ 831,827 $ 758,270 $ 705,408 Other revenue 4,918 4,684 3,872 Segment revenue 836,745 762,954 709,280 Loss and loss adjustment expense, net 601,076 552,292 506,994 Other expense 122,232 116,336 110,942 Segment expense 723,308 668,628 617,936 Segment pretax earnings $ 113,437 $ 94,326 $ 91,344 Net loss ratio 72.3 % 72.8 % 71.9 % Expense ratio 14.6 15.2 15.6 Combined ratio 86.9 % 88.0 % 87.5 % Medical Stop-loss $ 776,965 $ 703,619 $ 654,335 Other 54,862 54,651 51,073 Total net earned premium $ 831,827 $ 758,270 $ 705,408 Medical Stop-loss 73.7 % 74.5 % 73.6 % Other 52.1 51.8 49.4 Total net loss ratio 72.3 % 72.8 % 71.9 % Medical Stop-loss $ 777,351 $ 703,814 $ 654,335 Other 58,445 53,283 52,768 Total gross written premium $ 835,796 $ 757,097 $ 707,103 Medical Stop-loss $ 776,965 $ 703,619 $ 654,335 Other 58,043 52,920 52,412 Total net written premium $ 835,008 $ 756,539 $ 706,747 The Accident & Health segment pretax earnings increased 20% in 2012 and 3% in 2011. These increases directly related to higher net earned premium in our medical stop-loss product line and the impact of favorable loss development in 2012. Medical stop-loss premium increased in 2012 and 2011 due to growth in new business and rate increases on renewal business, which were in line with medical loss cost trends. The segment had favorable loss development of$10.5 million and$1.3 million in 2012 and 2011, respectively, compared to adverse development of$1.4 million in 2010. The 2012 development primarily related to favorable claims activity in the medical stop-loss product line for the 2011 underwriting year. The 2011 and 2010 information shown above has been adjusted to reflect our exit from two lines of business in 2012. See Note 12, "Segments" to the Consolidated Financial Statements. 43
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U.S. Surety & Credit Segment
The following tables summarize the operations of the U.S. Surety & Credit segment. 2012 2011 2010 Net earned premium $ 207,955 $ 210,535 $ 199,908 Other revenue 843 1,247 580 Segment revenue 208,798 211,782 200,488 Loss and loss adjustment expense, net 38,535 52,206 52,940 Other expense 113,619 113,932 109,685 Segment expense 152,154 166,138 162,625 Segment pretax earnings $ 56,644 $ 45,644 $ 37,863 Net loss ratio 18.5 % 24.8 % 26.5 % Expense ratio 54.4 53.8 54.7 Combined ratio 72.9 % 78.6 % 81.2 % Surety $ 158,711 $ 164,879 $ 160,373 Credit 49,244 45,656 39,535 Total net earned premium $ 207,955 $ 210,535 $ 199,908 Surety 16.6 % 20.6 % 22.8 % Credit 24.9 40.0 41.5 Total net loss ratio 18.5 % 24.8 % 26.5 % Surety $ 159,159 $ 169,237 $ 171,595 Credit 62,309 57,075 55,271 Total gross written premium $ 221,468 $ 226,312 $ 226,866 Surety $ 144,573 $ 158,116 $ 164,764 Credit 51,331 50,743 44,609 Total net written premium $ 195,904 $ 208,859 $ 209,373 Our U.S. Surety & Credit segment pretax earnings increased 24% in 2012, compared to 2011, due to a higher amount of favorable loss development in 2012, partially offset by a decrease in net earned premium. Segment earnings increased 21% in 2011, compared to 2010, primarily due to higher net earned premium. Gross written premium for our surety line of business decreased in 2012, primarily due to competition and economic conditions impacting the construction industry. This reduction was partially offset by growth in premium in our credit line of business. In 2011, increased pricing for commercial surety bonds written by a company we acquired in 2009 contributed to the growth in gross written premium. Our credit premium has grown due to improved market pricing following the 2008 world-wide credit market crisis. The segment had favorable loss development of$25.4 million in 2012, compared to$11.3 million in 2011 and$7.2 million in 2010. The 2012 development consisted of$18.0 million for surety and$7.4 million for credit. In all three years, the favorable development related to lower than expected reported loss development in both our surety and credit product lines. The expense ratio was slightly higher in 2012 due to a decrease in net earned premium, and lower in 2011 as growth in expenses was more than offset by higher net earned premium. 44
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International Segment
The following tables summarize the operations of the International segment.
2012 2011 2010 Net earned premium $ 412,853 $ 368,748 $ 316,186 Other revenue 5,005 5,309 7,344 Segment revenue 417,858 374,057 323,530 Loss and loss adjustment expense, net 189,410 233,879 143,412 Other expense 146,807 136,750 120,956 Segment expense 336,217 370,629 264,368 Segment pretax earnings $ 81,641 $ 3,428 $ 59,162 Net loss ratio 45.9 % 63.4 % 45.4 % Expense ratio 35.1 36.6 37.4 Combined ratio 81.0 % 100.0 % 82.8 % Energy $ 85,764 $ 66,512 $ 52,671 Property Treaty 100,565 90,912 47,594 Liability 76,484 81,339 81,887 Surety & Credit 71,378 73,832 69,264 Other 78,662 56,153 64,770 Total net earned premium $ 412,853 $ 368,748 $ 316,186 Energy 27.1 % 35.7 % 22.2 % Property Treaty 24.4 80.0 58.2 Liability 33.1 34.0 43.3 Surety & Credit 122.6 56.6 41.7 Other 36.6 121.0 61.3 Total net loss ratio 45.9 % 63.4 % 45.4 % Energy $ 136,070 $ 128,078 $ 106,902 Property Treaty 138,065 128,767 74,514 Liability 75,466 89,519 86,681 Surety & Credit 84,288 84,683 75,106 Other 97,278 86,336 110,275 Total gross written premium $ 531,167 $ 517,383 $ 453,478 Energy $ 88,834 $ 75,286 $ 53,063 Property Treaty 105,442 98,370 59,878 Liability 69,546 81,855 79,959 Surety & Credit 74,977 78,418 64,847 Other 80,356 57,890 66,597 Total net written premium $ 419,155 $ 391,819 $ 324,344 The International segment pretax earnings increased$78.2 million in 2012, compared to 2011, due to lower accident year net catastrophe losses and an increase in net earned premium in 2012. Segment earnings decreased$55.7 million in 2011, compared to 2010, due to higher accident year net catastrophe losses and a lower amount of net favorable loss development in 2011. 45
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Our International segment pretax earnings were impacted in all years by net catastrophe losses. The 2012 losses primarily related to Superstorm Sandy and impacted our property treaty, property (direct and facultative) and energy lines of business. In 2011, we experienced losses from catastrophes inJapan ,New Zealand ,Australia ,the United States andDenmark . The 2011 catastrophic events impacted our energy and property treaty lines of business, as well as our property and accident and health lines (both included in Other). The 2010 catastrophe losses occurred in our property treaty and property lines, primarily related to theChile earthquake. We reinsured a portion of our exposure to these catastrophic events and incurred net reinstatement premium for continued reinsurance coverage, which reduced 2011 net written and net earned premium. The following table summarizes the segment's accident year catastrophe losses, as well as the impact on key metrics: 2012 2011 2010 Gross losses $ 61,893 $ 168,100 $ 44,042 Net losses $ 41,063 $ 97,672 $ 22,500 Reinstatement premium, net 401 14,008 (1,154 ) Total net catastrophe losses $ 41,464 $ 111,680 $ 21,346 Impact of net catastrophe losses (in percentage points) on: Net loss ratio 10.0 % 27.8 % 7.0 % Expense ratio - 1.4 (0.1 ) Combined ratio 10.0 % 29.2 % 6.9 % The segment's increase in gross written, net written and net earned premium in 2012 was driven by higher writings in the energy, property treaty and property lines of business, related to the favorable pricing environment for these products. Net written and net earned premium also increased in 2012 due to lower reinstatement premium related to catastrophic events in 2012, compared to 2011. The increase in premium in 2011 principally related to our property treaty business, which we began to write in late 2009. In addition, in 2011, we wrote more energy business due to industry rate increases and expansion of our wind storm aggregates and retained a higher percentage of this business. Premium reported in Other decreased in 2011, primarily because we incurred$8.0 million of reinstatement premium related to the 2011 catastrophe losses and wrote less property business compared to 2010, which included short-tail business that was substantially reinsured. The segment had net favorable loss development of$10.1 million in 2012, compared to$13.8 million in 2011 and$22.3 million in 2010. The three years included$18.9 million ,$7.6 million and$11.6 million , respectively of favorable development related to prior years' catastrophe losses, primarily in our energy and property lines of business. The favorable catastrophe development in 2012 related to Hurricane Irene, theJapan earthquake and tsunami, and other 2011 events. The favorable catastrophe development in both 2011 and 2010 primarily related to the 2008 and 2005 hurricanes inthe United States . Our International segment had net adverse non-catastrophe development in 2012 and net favorable non-catastrophe development in 2011 and 2010. The non-catastrophe development in 2012 included favorable development on the 2010 and prior accident years for our energy and U. K. professional liability (included in Liability) lines of business and adverse development for our surety & credit line of business related to a specific class of Spanish surety bonds, the majority of which were written prior to 2006. The non-catastrophe development in 2011 included favorable development on the 2010 and prior accident years for ourU.K. professional liability and energy lines. Partially offsetting this was adverse development on our employers' liability and public liability lines for the 2010 accident year, as well as the specific class of Spanish surety bonds discussed above. The non-catastrophe favorable development for 2010 was for ourU.K. professional liability and energy lines, in both cases related to the 2004 - 2008 underwriting years. The segment's expense ratio decreased year-over-year due to growth in net earned premium. The 2011 expense ratio was negatively impacted by the reduction in net earned premium due to reinstatement premium related to catastrophe losses. 46
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Investing Segment
Our Investing segment includes our total investment portfolio, as well as all investment income, investment related expenses, realized investment gains and losses, and other-than-temporary impairment credit losses on investments. Our insurance segments generate the cash flow underlying these investments. We manage all investments and evaluate our investment results centrally and, thus, include them in a separate segment for reporting purposes. The following tables summarize the results and certain key metrics of our Investing segment. 2012 2011 2010 Fixed maturity securities $ 221,535 $ 212,022 $ 202,814 Equity securities 3,959 - - Short-term investments 620 537 900 Other investments and deposits 2,856 4,486 4,344 Net realized investment gain 31,148 3,653 12,104
Other-than-temporary impairment credit losses (1,028 ) (4,679 )
(425 ) Investment expenses (6,336 ) (4,774 ) (4,239 ) Segment pretax earnings $ 252,754 $
211,245
Fixed maturity securities: Average yield * 3.9 % 3.9 % 4.1 % Average tax equivalent yield * 4.7 % 4.8 % 5.0 % Weighted-average life 8.2 years 7.6 years 7.5 years Weighted-average duration 4.7 years 5.0 years 5.5 years Weighted-average rating AA AA AA+
* Excluding realized and unrealized gains and losses.
In 2012, we began investing in bank loans (classified as Corporate securities), which we expect will generate attractive yields and lower our overall duration without altering the weighted-average rating of the portfolio. We also began investing in global publicly traded equity securities. These investments in equity securities are focused on stable companies with a track record of above-market dividend yields. AtDecember 31, 2012 , our investments included$132.8 million of bank loans and$284.6 million of equity securities. The weighted-average duration of our fixed maturity securities portfolio dropped during the past three years, primarily due to the impact of lower market interest rates on our municipal securities with call options and structured securities with prepayment options. The decline in the weighted-average rating of our fixed maturity securities portfolio at year-end 2011 was a direct result of Standard & Poor's Corporation's downgrade of the U.S. government debt rating inAugust 2011 . 47
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The methodologies used to determine the fair value of our investments are described in Note 3, "Fair Value Measurements" in the Consolidated Financial Statements. This table summarizes our investments by type, substantially all of which are reported at fair value, atDecember 31, 2012 and 2011. December 31, 2012 December 31, 2011 Amount % Amount % Fixed maturity securities U.S. government and government agency securities $ 199,607 3 % $ 302,677 5 % Fixed income securities of states, municipalities and political subdivisions 1,065,811 15 1,085,341 18 Special purpose revenue bonds of states, municipalities and political subdivisions 2,200,331 32 1,863,888 31 Corporate securities 1,315,170 19 956,617 16 Residential mortgage-backed securities 664,887 10 1,100,086 18 Commercial mortgage-backed securities 524,289 8 256,124 4 Asset-backed securities 33,275 - 34,746 1 Foreign government securities 278,411 4 280,457 4 Equity securities 284,639 4 - - Short-term investments 363,053 5 133,917 2 Other investments 20,925 - 35,897 1 Total investments $ 6,950,398 100 % $ 6,049,750 100 % Our total investments increased$900.6 million in 2012, principally from: 1) operating cash flow, 2) consolidation of our Lloyd's of London Syndicate 4040 upon its merger into Syndicate 4141 as ofJanuary 1, 2012 and 3) a$105.6 million increase in the pretax net unrealized gain associated with our available for sale securities in 2012. AtDecember 31, 2012 , the net unrealized gain on our available for sale portfolio was$436.7 million , compared to$331.1 million atDecember 31, 2011 . We held$363.1 million of short-term investments atDecember 31, 2012 as certain long-term securities purchases were pending settlement at year-end. The average tax equivalent yield of our fixed maturity securities portfolio was 4.7%, 4.8% and 5.0% in 2012, 2011 and 2010, respectively. These yields reflect general declines in market interest rates over this period, partially offset by longer average duration of our new investments. Our general policy has been to hold our available for sale securities through periods of fluctuating interest rates. We sell securities and recognize realized gains and losses from these sales if we can reinvest the proceeds at a higher effective yield or if the security has credit-related issues. We recognized net realized investment gains of$31.1 million in 2012,$3.7 million in 2011 and$12.1 million in 2010. We realized other-than-temporary impairment credit losses through pretax earnings of$1.0 million in 2012,$4.7 million in 2011 and$0.4 million in 2010.
The ratings of our individual securities within our fixed maturity securities portfolio at
Fair value % AAA $ 884,506 14 % AA 3,739,618 60 A 1,204,142 19 BBB 323,181 5 BB and below 130,334 2 Total fixed maturity securities $ 6,281,781 100 % 48
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The table below indicates the contractual or expected maturity distribution of our fixed maturity securities atDecember 31, 2012 . In the table, we allocated the maturities of our mortgage-backed and asset-backed securities based on the expected future principal payments. The weighted-average life of our mortgage-backed and asset-backed securities is approximately 5.5 years based on expected future cash flows. Non-structured Mortgage-backed and securities at asset-backed securities amortized cost at amortized cost Total Amount % Amount % Amount % One year or less $ 300,842 6 % $ 17,290 2 % $ 318,132 6 % One year to five years 1,101,203 24 600,555 52 1,701,758 29 Five years to ten years 1,411,731 30 470,320 41 1,882,051 32 Ten years to fifteen years 936,809 20 60,109 5 996,918 17 More than fifteen years 957,573 20 - - 957,573 16
Total fixed maturity securities
AtDecember 31, 2012 , we held$2.2 billion of special purpose revenue bonds, as well as$1.1 billion of general obligation bonds, which are issued by states, municipalities and political subdivisions and collectively referred to, in the investment market, as municipal bonds. The overall rating of our municipal bonds was AA atDecember 31, 2012 . Within our municipal bond portfolio, we held$386.2 million of pre-refunded bonds, which are supported by U.S. government debt obligations. Our special purpose revenue bonds are secured by revenue sources specific to each security. AtDecember 31, 2012 , the percentages of our special purpose revenue bond portfolio supported by these major revenue sources were as follows: 1) education - 24%, 2) transportation - 21%, 3) water and sewer - 18% and 4) electric - 15%. Many of our special purpose revenue bonds are insured by mono-line insurance companies or supported by credit enhancement programs of various states and municipalities. We view bond insurance as credit enhancement and not credit substitution. We base our investment decision on the strength of the issuer. A credit review is performed on each issuer and on the sustainability of the revenue source before we acquire a special purpose revenue bond and periodically thereafter. The underlying average credit rating of our special purpose revenue bond issuers, excluding any bond insurance, was AA atDecember 31, 2012 . Although recent economic conditions inthe United States may reduce the sources of revenue to support certain of these securities, the majority are supported by revenue from essential sources, as indicated above, which we believe generate a stable source of revenue. AtDecember 31, 2012 , we held a commercial mortgage-backed securities portfolio with a fair value of$524.3 million , an average rating of AA+ and an average loan-to-value ratio of 67%. We owned no collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), and we are not counterparty to any credit default swap transactions. Some of our fixed maturity securities have call or prepayment options. In addition, mortgage-backed and certain asset-backed securities have prepayment, extension or other market-related credit risk. Calls and prepayments subject us to reinvestment risk should interest rates fall and issuers call their securities and we reinvest the proceeds at lower interest rates. Prepayment risk exists if cash flows from the repayment of principal occurs earlier than anticipated because of declining interest rates. Extension risk exists if cash flows from the repayment of principal occurs later than anticipated because of rising interest rates. Credit risk exists if mortgagees default on the underlying mortgages. Net investment income and/or cash flows from investments that have call or prepayment options and prepayment, extension or credit risk may differ from what was anticipated at the time of investment. We mitigate these risks by investing in investment grade securities with varied maturity dates so that only a portion of our portfolio will mature at any point in time. 49
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AtDecember 31, 2012 , we held corporate securities issued by foreign corporations with an aggregate fair value of$533.6 million . In addition, we held securities issued by foreign governments, agencies or supranational entities with an aggregate fair value of$278.4 million . The following table details our holdings of foreign debt atDecember 31, 2012 . Corporate debt Financial institutions Non-financial institutions Sovereign debt and agencies Cost or Cost or Cost or Total amortized Fair amortized Fair amortized Fair fair Country cost value cost value cost value value United Kingdom $ 60,268 $ 65,522 $ 94,323 $ 99,198 $ 24,570 $ 25,609 $ 190,329 Germany 12,132 12,507 22,488 23,676 96,860 102,636 138,819 The Netherlands 33,542 35,349 63,970 65,968 27,660 30,605 131,922 France 26,940 27,670 44,942 47,140 39,964 43,383 118,193 Canada 11,992 12,214 25,980 27,592 12,734 12,872 52,678 Supranational (1) - - - - 46,380 48,204 48,204 Switzerland 38,157 40,330 - - - - 40,330 Sweden 17,537 18,463 8,115 8,200 - - 26,663 Norway 5,456 5,556 7,496 8,103 - - 13,659 Australia - - 10,300 10,966 - - 10,966 Finland 2,577 2,507 - - 6,292 7,405 9,912 Belgium - - 6,869 7,358 - - 7,358 Other (2) 5,387 5,598 9,277 9,673 7,454 7,697 22,968 Total foreign debt $ 213,988 $ 225,716 $ 293,760 $ 307,874 $ 261,914 $ 278,411 $ 812,001
(1) Supranational represents investments in
Development,
$5.0 million . Corporate & Other Our Corporate & Other category includes operations not related to our segments, including unallocable corporate operating expenses, consolidated interest expense and foreign currency expense (benefit), and underwriting results of our Exited Lines of business.
The following table summarizes activity in the Corporate & Other category.
2012 2011 2010 Net earned premium $ 41,253 $ 45,391 $ 55,683 Other revenue 86 (513 ) 854 Total revenue 41,339 44,878 56,537 Loss and loss adjustment expense, net 37,331 31,350
53,110
Other expense - Exited Lines 7,713 9,080 11,263 Other expense - Corporate 61,083 53,027 48,191 Interest expense 25,132 22,494 20,592 Foreign currency expense (benefit) 6,184 (1,087 ) 16 Total expense 137,443 114,864 133,172 Pretax loss $ (96,104 ) $ (69,986 ) $ (76,635 )
The 2011 and 2010 amounts for net earned premium, loss and loss adjustment expense, and other expense - Exited Lines have been adjusted to reflect the addition of two product lines previously included in the Accident & Health segment. Net earned premium decreased year-over-year as we wrote less business related to our exited HMO and medical excess
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reinsurance products. Premium related to the other products included in Exited Lines was insignificant in all years. The majority of the loss and loss adjustment expense relates to the HMO and medical excess reinsurance products, which had higher losses in 2012 compared to 2011. The Exited Lines had net favorable loss development of$0.5 million and$7.3 million in 2012 and 2011, respectively, and adverse development of$11.7 million in 2010. The Exited Lines incur operating costs primarily for claims personnel and facilities. Our Corporate expenses not allocable to the segments increased$8.1 million in 2012, compared to 2011, principally due to higher employee compensation and benefit costs, including increased bonus expense due to higher profitability, and incremental expense related to our new technology systems. Corporate expenses not allocable to the segments increased$4.8 million in 2011, compared to 2010, due to higher information technology costs related to implementation of a company-wide financial reporting system and higher salary and employee benefit costs. Our interest expense increased year-over-year due to a higher amount of outstanding borrowings on our$600 million Revolving Loan Facility. The impact of foreign currency fluctuated period-over-period primarily due to the strengthening of the British pound sterling relative to the U.S. dollar in 2012. We hold available for sale securities denominated in non-functional currencies to economically hedge the currency exchange risk on our loss reserves denominated in non-functional currencies. The foreign currency benefit or expense related to loss reserves is recorded through the income statement, while the foreign currency benefit or expense related to available for sale securities is recorded through other comprehensive income within shareholders' equity. This mismatch may cause fluctuations in our reported foreign currency benefit or expense in future periods.
Liquidity and Capital Management
We believe we have sufficient sources of liquidity at a reasonable cost to pay claims and meet our other contractual obligations and liabilities as they become due in the short-term and long-term. Our current sources of liquidity include: 1) significant operating cash flow, 2) a$7.0 billion investment portfolio that is available for sale, 3) our revolving loan and standby letter of credit facilities, 4) the availability of dividends from our subsidiaries and 5) a$1.0 billion shelf registration, which are discussed below.
We receive substantial cash from premiums, reinsurance recoverables, surety collateral, outward commutations, proceeds from sales and redemptions of investments, and investment income. Our principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, return of surety collateral, inward commutations, purchases of investments, debt service, policy acquisition costs, operating expenses, taxes, dividends and common stock purchases. Cash provided by operating activities can fluctuate due to timing differences in the collection of premium receivables, reinsurance recoverables and surety collateral; the payment of losses, premium payables and return of surety collateral; and the completion of commutations. 51
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We generated cash from operations of$661.1 million in 2012,$421.3 million in 2011 and$415.2 million in 2010. The components of our net operating cash flows are summarized in the following table. 2012 2011 2010 Net earnings $ 391,240 $ 255,243 $ 345,096 Change in premium, claims and other receivables, net of reinsurance, premium and claims payables and excluding restricted cash 2,498 (68,810 ) (16,655 ) Change in unearned premium, net 4,082 41,377 (3,607 ) Change in loss and loss adjustment expense payable, net of reinsurance recoverables 75,389 133,471 4,625 Change in accounts payable and accrued liabilities 100,091 17,538 31,032 (Gain) loss on investments (30,120 ) 1,026 (12,168 ) Other, net 117,967 41,431 66,877 Cash provided by operating activities $ 661,147 $
421,276
We generated$239.9 million more cash flow from operating activities in 2012 than in 2011. The increase was primarily from additional premium collections. In addition, certain collateral held by our surety businesses, for which we record a liability within accounts payable and accrued liabilities, provided a net$96.6 million of cash flow from operating activities in 2012 and$32.7 million in 2010, compared to a net reduction of$8.3 million in 2011. Our cash flow from operating activities was reduced$27.5 million in 2012 and$26.7 million in 2011 for payments we made to commute large contracts in our assumed accident and health reinsurance business reported in Exited Lines.
Investments
AtDecember 31, 2012 , we held a$7.0 billion investment portfolio, which included$363.1 million of liquid short-term investments. All of the portfolio is classified as available for sale. We expect to hold our fixed maturity securities until maturity, but we would be able to sell these securities, as well as our equity securities and other investments, to generate cash if needed. See the "Investing Segment" section above for additional information about our investment portfolio. The parent company held$494.4 million of cash and investments, which are available to cover the holding company's required cash disbursements in 2013.
Revolving Loan and Standby Letter of Credit Facilities
We maintain a$600.0 million Revolving Loan Facility (Facility), of which$305.1 million of available capacity remained atDecember 31, 2012 . During 2012 and 2011, we used the Facility to fund repurchases of our common stock. We expect to continue to use the Facility to opportunistically repurchase stock in 2013. We also have a$90.0 million Standby Letter of Credit Facility (Standby Facility) that is used to guarantee our performance in our Lloyd's ofLondon syndicate. The Facility expires in 2015, and the Standby Facility expires in 2016. See Note 7, "Notes Payable" to the Consolidated Financial Statements for additional information related to the Facilities and our long-term indebtedness.
Subsidiary Dividends
HCC's obligations include servicing outstanding debt and interest, paying dividends to shareholders, purchasing HCC's common stock, and paying corporate expenses. The principal assets of HCC are the shares of capital stock of its insurance company subsidiaries. A significant percentage of HCC's profit is earned in our insurance companies, which has generated available capital in these companies. As a result, HCC receives dividends paid by our insurance companies. HCC can utilize these dividends for any purpose, including paying down debt, paying dividends to shareholders, funding acquisitions, purchasing our common stock and paying operating expenses. In 2012, 2011 and 2010, our domestic and foreign insurance companies paid HCC dividends of$262.4 million ,$248.2 million and$285.7 million , respectively. The payment of dividends by our insurance companies is subject to regulatory 52
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restrictions and will depend on the surplus and future earnings of these subsidiaries. HCC's direct U.S. insurance company subsidiaries can pay an aggregate of
Share Purchases
OnAugust 23, 2012 , the Board authorized a new$300.0 million stock purchase plan (the Plan) and cancelled$98.0 million remaining under a previous authorization. Purchases under the Plan may be made in the open market or in privately negotiated transactions from time-to-time in compliance with applicable laws, rules and regulations, including Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Purchases under the Plan will be made subject to market and business conditions, the level of cash generated from our operations, cash required for acquisitions, our debt covenant compliance, and other relevant factors. The Plan does not obligate us to purchase any particular number of shares, has no expiration date, and may be suspended or discontinued at any time at the Board's discretion. During 2012, we purchased$178.7 million , or 5.6 million shares, at an average cost of$32.09 per share, of which$50.2 million , or 1.4 million shares, were purchased under the Plan. Since our repurchase program began in 2008, we have purchased$686.2 million , or 24.2 million shares at a weighted-average cost of$28.37 throughDecember 31, 2012 . AtFebruary 15, 2013 ,$235.1 million of repurchase authority remains under the Plan.
Shelf Registration
We have a "Universal Shelf" registration statement that expires inMarch 2015 . The Universal Shelf provides for the issuance of$1.0 billion of securities, which may be debt securities, equity securities, or a combination thereof. The Universal Shelf provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial markets.
Claims Payments
We maintain sufficient liquidity from our current cash, short-term investments and investment maturities, in combination with future operating cash flow, to pay anticipated policyholder claims on their expected payment dates. We manage the liquidity of our insurance companies such that each subsidiary's anticipated claims payments will be met by its own current operating cash flows, cash, short-term investments or investment maturities. Our insurance companies have sufficient resources to pay potential claims. Based on historical payment patterns and claims history, we project that our insurance companies will pay approximately$1.4 billion of claims in 2013. We also project that they will collect approximately$0.4 billion of reinsurance recoveries in 2013. In addition to expected cash flow from their 2013 operations, these companies have$6.4 billion of investments as ofDecember 31, 2012 that are available to fund claims payments, if needed. The average duration of claims in many of our lines of business is relatively short. However, we write D&O, E&O and casualty insurance, all of which have a longer claims duration than our other products. We consider these different claims payment patterns in determining the duration of our investment portfolio. The weighted-average duration of all claims was approximately 2.2 years in 2012 and 2.5 years in both 2011 and 2010. The weighted-average duration of our fixed maturity securities was 4.7 years, 5.0 years and 5.5 years in 2012, 2011 and 2010, respectively. The longer duration of our fixed maturity securities reflects the effects of the investment of our capital. 53
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Contractual Obligations
The following table summarizes our total contractual cash payment obligations by estimated payment date at
Estimated payment dates Total 2013 2014 - 2015 2016 - 2017 Thereafter Gross loss and loss adjustment expense payable (1): U.S. Property & Casualty $ 668,824 $ 291,325 $ 260,745 $ 79,352 $ 37,402 Professional Liability 1,754,824 442,474 685,423 391,440 235,487 Accident & Health 242,600 242,474 126 - - U.S. Surety & Credit 109,790 63,340 35,948 7,178 3,324 International 734,779 301,028 269,283 96,725 67,743 Exited Lines 257,033 108,064 62,784 31,570 54,615 Total gross loss and loss adjustment expense payable 3,767,850 1,448,705 1,314,309 606,265 398,571 Life and annuity policy benefits 58,641 1,724 3,296 3,103 50,518 6.30% Senior Notes (2) 432,300 18,900 37,800 37,800 337,800$600.0 million Revolving Loan Facility (3) 296,239 5,147 291,092 - - Operating leases 48,925 11,770 21,208 12,540 3,407 Earnout liability (4) 11,847 6,482 5,365 - - Indemnifications (5) 8,334 1,695 3,691 2,642 306 Purchase obligations (6) 6,189 3,405 2,784 - - Total obligations $ 4,630,325 $ 1,497,828 $ 1,679,545 $ 662,350 $ 790,602
In preparing the contractual obligations table, we made the following estimates and assumptions:
(1) The estimated loss and loss adjustment expense payments for future periods
assume that the percentage of ultimate losses paid from one period to the
next by line of business will be relatively consistent over time. Actual
payments will be influenced by many factors and could vary from the estimated
amounts.
(2) The 6.30% Senior Notes are due in 2019. We pay interest semi-annually on
May 15 andNovember 15 , which is included in the above table.
(3) The
above table, the outstanding borrowings of
2012 are shown in 2015 with the annual interest of 137.5 basis points on the
outstanding balance and the annual commitment fee of 20 basis points on the
unused balance shown in each applicable year.
(4) See Note 5, "Goodwill" to the Consolidated Financial Statements for
information related to our earnout liability.
(5) See Note 13, "Commitments and Contingencies - Indemnifications" to the
Consolidated Financial Statements for information related to our indemnifications.
(6) Purchase obligations primarily relate to agreements with vendors to purchase
maintenance and administrative services for our technology systems and to license software. 54
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Impact of Inflation
Our operations, like those of other property and casualty insurers, are susceptible to the effects of inflation because premiums are established before the ultimate amounts of loss and loss adjustment expense are known.
Although we consider the potential effects of inflation when setting premium rates, our premiums, for competitive reasons, may not fully offset the effects of inflation. However, because the majority of our products have a relatively short period of time between the occurrence of an insured event, reporting of the claim to us and the final settlement of the claim, or have claims that are not significantly impacted by inflation, the effects of inflation are minimized. A portion of our revenue is related to healthcare insurance and reinsurance products that are subject to the effects of the underlying inflation of healthcare costs. Such inflation in the costs of healthcare tends to generate increases in premiums for medical stop-loss coverage, resulting in greater revenue but also higher claims payments. Inflation also may have a negative impact on insurance and reinsurance operations by causing higher claims settlements than originally estimated, without an immediate increase in premiums to a level necessary to maintain profit margins. We do not specifically provide for inflation when setting underwriting terms and claims reserves, although we do consider market trends in our quarterly reserve reviews. Inflation can also affect interest rates. A significant increase in interest rates could increase our net investment income related to newly invested cash flow and could also have a material adverse effect on the fair value of our investments. In addition, the interest rate payable under our Revolving Loan Facility fluctuates with market interest rates. See Item 7A., Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk for additional disclosures about the impact of changes in market interest rates on our fixed maturity securities and Revolving Loan Facility.
Critical Accounting Policies
The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in
Reserves
The process of estimating our loss and loss adjustment expense is inherently uncertain and involves a considerable degree of judgment. Our recorded reserves represent management's best estimate of unpaid losses and loss adjustment expenses as of each quarter end. See the "Reserves for Insurance Claims" section of Item 1, Business for a description of the factors considered by management in making loss reserve estimates, as well as the change in such estimates over the past ten years. We utilize the actuarial point and range estimates prepared by our internal actuaries to monitor the adequacy and reasonableness of our recorded reserves. Each quarter end, management compares recorded reserves to the most recent actuarial point estimate. If the recorded reserves vary significantly from the actuarial point estimate, management determines the reasons for the variances and may adjust the reserves up or down to an amount that, in management's judgment, is adequate based on all of the facts and circumstances considered, including the actuarial point estimates. Historically, our consolidated net reserves have been above the total actuarial point estimate but within the actuarial range. 55
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The following table shows our recorded net reserves by segment, as well as the actuarial reserve point estimates, and the high and low ends of the actuarial reserve range as determined by our reserving actuaries, as ofDecember 31, 2012 . Recorded Actuarial Low end of High end of net reserves point estimate actuarial range actuarial range Total net reserves $ 2,749,803 $ 2,604,730 $ 2,423,186 $ 2,871,746 U.S. Property & Casualty $ 460,427 $ 462,210 $ 418,310 $ 526,652 Professional Liability 1,236,456 1,136,330 965,881 1,363,596 Accident & Health 242,507 242,664 218,605 267,958 U.S. Surety & Credit 97,163 86,250 78,036 98,777 International 503,836 474,921 450,525 548,917 Exited Lines 209,414 202,355 180,823 246,160 Total net reserves $ 2,749,803 The excess of the total recorded net reserves over the actuarial point estimate was 5.3% of recorded net reserves atDecember 31, 2012 , compared to 4.2% atDecember 31, 2011 . The percentage will vary each year, in total and by segment, depending upon current economic events, the nature of the underlying products and their potential volatility, severity of claims reported in the current year, historical development patterns and management's judgment about these factors. While standard actuarial techniques are utilized in making actuarial point estimates, these techniques require a high degree of judgment, and changing conditions can cause fluctuations in the reserve estimates. The actuarial point estimates represent our actuaries' estimate of the most likely amount that will ultimately be paid to settle the net reserves we have recorded at a particular point in time. While, from an actuarial standpoint, a point estimate is considered the most likely amount to be paid, there is inherent uncertainty in the point estimate, and it can be thought of as the expected value in a distribution of possible reserve estimates. The actuarial ranges represent our actuaries' estimate of a likely lowest amount and highest amount that will ultimately be paid to settle the net reserves. There is still a possibility of ultimately paying an amount below the range or above the range. The range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimates. The low end of the actuarial range and the high end of the actuarial range for our total net reserves will not equal the sum of the low and high ends of the actuarial ranges for our insurance segments due to the estimated effect of diversification across the products in each segment. Some of the products in our segments may be more effectively modeled by a statistical distribution that is skewed or non-symmetric, which causes the midpoint of the range to be above the actuarial point estimate or mean value of the range. Our actuarial assumptions, estimates and judgments can change based on new information and changes in conditions, and, if they change, it will affect the determination of the range amounts. 56
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The following table details the characteristics and key assumptions used in the determination of the actuarial point estimates and ranges for our major products in each segment. We considered all lines of business written by the insurance industry when determining the relative characteristics of claims duration, speed of claim reporting and reserve volatility. Other companies may classify their own insurance products in different segments or utilize different actuarial assumptions. Major actuarial assumptions used include historical loss payment and reporting patterns, estimates for rate changes by product line, trends impacting losses, and the effects of large losses. Speed of claim Reserve Line of business Products Underwriting Duration
reporting volatility
U.S. Property & Casualty Aviation Direct and subscription Medium Fast Medium E&O liability Direct Medium Moderate Medium Other liability Direct and assumed Medium Moderate Medium Property Direct and assumed Short Fast Low Casualty Direct Long Moderate High Professional D&O Medium Liability liability Direct and subscription to long
Moderate Medium to high
E&O liability Direct Medium
Moderate Medium
Accident & Medical Health stop-loss Direct Short Fast Low Other medical Direct Short Fast Low U.S. Surety & Credit Surety Direct Medium Fast Low Credit Direct Medium Fast Low International Energy Subscription Medium
Moderate Medium Property Subscription Short Fast Low Property treaty Assumed Short Fast Medium Surety & credit Direct Medium Fast Medium Marine Subscription Medium Moderate Medium Accident & Medium health Direct and assumed to long Moderate Medium to high E&O liability Direct Medium Moderate Medium Other liability Direct and assumed Medium Moderate Medium to high Exited Lines Accident & health Assumed Long Slow High Medical Medium malpractice Direct to long Moderate Medium to high Other medical Assumed Short Fast Medium Direct insurance is coverage that is originated by our insurance companies and brokers in return for premium. Assumed reinsurance is coverage written by another insurance company, for which we assume all or a portion of the risk in exchange for all or a portion of the premium. Assumed reinsurance represented 13% of our gross written premium in both 2012 and 2011, and 14% of our gross reserves ($519.8 million of$3.8 billion ) atDecember 31, 2012 compared to 16% atDecember 31, 2011 . Subscription business is direct insurance or assumed reinsurance where we only take a percentage of the total risk and premium and other insurers take their proportionate percentage of the remaining risk and premium. The property treaty reinsurance business written in our International segment covers catastrophic risks worldwide. Our internal staff underwrites the business, which is placed by major brokers. Given the nature and size of these large losses, the brokers report these claims to us quickly. We establish loss reserves ($85.8 million atDecember 31, 2012 ) for this assumed reinsurance using a combination of our internal models, external sources that independently model catastrophic losses, and estimates provided by our insureds. 57
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We assume facultative reinsurance business in our U.S. Property & Casualty, Professional Liability and International segments. This business includes reinsurance of a company's captive insurance program or business that must be written through another insurance company licensed to write insurance in a particular country or locality. We establish loss reserves ($221.1 million atDecember 31, 2012 ) for this assumed reinsurance using the same methods and assumptions we use to set reserves for comparable direct business. Disputes, if any, generally relate to claims or coverage issues with insureds and are administered in the normal course of business. We have reserves ($39.1 million atDecember 31, 2012 ) for assumed quota share surplus lines business, which we discontinued writing in 2008, in our U.S. Property & Casualty segment. Case reserves are reported directly to us by the cedant. We establish incurred but not reported (IBNR) reserves based on our estimates using the same methods and assumptions we would use to set reserves for comparable direct business. We have not had any disputes with the cedant. Our Exited Lines include reserves for run-off assumed accident and health reinsurance business ($147.5 million atDecember 31, 2012 ), which is primarily reinsurance that provides excess coverage for large losses related to workers' compensation policies. This business is slow to develop and may take more than twenty years to pay out. Losses in lower layers must develop first before our excess coverage attaches. This business is subject to late reporting of claims by cedants and state guaranty associations. To mitigate our exposure to unexpected losses reported by cedants, our claims personnel review reported losses to ensure they are reasonable and consistent with our expectations. In addition, our claims personnel periodically audit the cedants' operations to assess whether cedants are submitting timely and accurate claims reports to us. Disputes with cedants related to claims or coverage issues are negotiated to resolution or settled through arbitration. We have commuted a portion of these reserves over the past ten years to reduce our exposure to adverse development. Based on the higher risk of the underlying insurance product and the potential for late reported claims, management believes there may be greater volatility in loss development for this product than for our other product lines. We underwrite and administer the claims for medical excess products, which we moved to Exited Lines in 2012. This business, although very similar to our direct medical stop-loss business, is written as excess reinsurance of HMOs, hospitals and other insurance companies. We establish loss reserves ($24.7 million atDecember 31, 2012 ) using the same methods and assumptions we would use to set reserves for comparable direct business. Disputes, if any, are administered in the normal course of business. The case reserves for reported losses related to our direct business and certain assumed reinsurance are initially set by our claims personnel or independent claims adjusters we retain. The case reserves are subject to our review, with a goal of setting them at the ultimate expected loss amount as soon as possible when the information becomes available. Case reserves for reported losses related to other assumed reinsurance are recorded based on information supplied to us by the ceding company. Our claims personnel monitor these assumed reinsurance reserves on a current basis and audit ceding companies' claims to ascertain that claims are being recorded currently and that net reserves are being set at levels that properly reflect the liability related to the claims. We determine our IBNR reserves by subtracting case reserves from our total estimated loss reserves, which are based on the ultimate expected losses for each product. The level of IBNR reserves in relation to total reserves depends upon the characteristics of the specific products within each segment, particularly related to the speed with which losses are reported and outstanding claims are paid. Segments that contain products for which losses are reported moderately or slowly will have a higher percentage of IBNR reserves than segments with products that report and settle claims more quickly.
Based on our reserving techniques, estimation processes and past results, we believe that our net reserves are adequate.
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The following tables show the composition of our gross, ceded and net reserves by segment at
% net IBNR to net total December 31, 2012 Gross Ceded Net reserves Case reserves: U.S. Property & Casualty $ 324,064 $ 106,963 $ 217,101 Professional Liability 666,113 191,572 474,541 Accident & Health 184,693 58 184,635 U.S. Surety & Credit 25,226 5,247 19,979 International 377,483 132,416 245,067 Exited Lines 178,826 42,769 136,057 Total case reserves 1,756,405 479,025 1,277,380 IBNR reserves: U.S. Property & Casualty 344,760 101,434 243,326 53 % Professional Liability 1,088,711 326,796 761,915 62 Accident & Health 57,907 35 57,872 24 U.S. Surety & Credit 84,564 7,380 77,184 79 International 357,296 98,527 258,769 51 Exited Lines 78,207 4,850 73,357 35 Total IBNR reserves 2,011,445 539,022 1,472,423 54 % Total loss and loss adjustment expense payable $ 3,767,850 $ 1,018,047 $ 2,749,803 December 31, 2011 Case reserves: U.S. Property & Casualty $ 327,491 $ 115,052 $ 212,439 Professional Liability 657,343 196,067 461,276 Accident & Health 153,872 67 153,805 U.S. Surety & Credit 23,763 3,409 20,354 International 355,598 118,008 237,590 Exited Lines 228,767 45,157 183,610 Total case reserves 1,746,834 477,760 1,269,074 IBNR reserves: U.S. Property & Casualty 359,841 110,674 249,167 54 % Professional Liability 1,040,896 305,332 735,564 61 Accident & Health 45,726 49 45,677 23 U.S. Surety & Credit 84,212 9,153 75,059 79 International 288,247 60,856 227,391 49 Exited Lines 92,561 11,010 81,551 31 Total IBNR reserves 1,911,483 497,074 1,414,409 53 % Total loss and loss adjustment expense payable $ 3,658,317 $ 974,834 $ 2,683,483 59
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Reinsurance Recoverables
We retain underwriting risk in order to retain a greater proportion of expected underwriting profits. Annually, we analyze our threshold for risk in each line of business and on an overall consolidated basis, based on a number of factors, including market conditions, pricing, competition and the inherent risks associated with each business type, and then we structure our reinsurance programs. We generally purchase reinsurance to reduce our net liability on individual risks and to protect against catastrophe losses and volatility. We have chosen not to purchase any reinsurance on businesses where volatility or catastrophe risks are considered remote and limits are within our risk tolerance. We purchase reinsurance on a proportional basis to cover loss frequency, individual risk severity and catastrophe exposure. Some of the proportional reinsurance agreements may have maximum loss limits, most of which are at or greater than a 200% loss ratio. We also purchase reinsurance on an excess of loss basis to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type and amount of reinsurance we purchase varies year to year based on our risk assessment, our desired retention levels based on profitability and other considerations, and on the market availability of quality reinsurance at prices we consider acceptable. Our reinsurance programs renew throughout the year, and the price changes in recent years have not been material to our net underwriting results. Our reinsurance generally does not cover war or terrorism risks. In our proportional reinsurance programs, we generally receive a commission on the premium ceded to reinsurers. This compensates our insurance companies for the direct costs associated with production of the business, the servicing of the business during the term of the policies ceded, and the costs associated with placement of the related reinsurance. In addition, certain of our reinsurance treaties allow us to share in any net profits generated under such treaties with the reinsurers. Various reinsurance brokers arrange for the placement of this reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers. Our reinsurance recoverables represented 30% and 32% of our shareholders' equity atDecember 31, 2012 and 2011, respectively. A high percentage of our reinsurance recoverables relates to our D&O business, where it takes longer for claims reserves to result in paid claims. In order to reduce our exposure to reinsurance credit risk, we evaluate the financial condition of our reinsurers and place our reinsurance with a diverse group of companies and syndicates, which we believe to be financially sound. OurReinsurance Security Policy Committee carefully monitors the credit quality of our reinsurers when we place new and renewal reinsurance, as well as on an ongoing basis. The Committee uses objective criteria to select and retain our reinsurers, with standards including: 1) minimum surplus of$250 million , 2) minimum capacity of £100 million for Lloyd's syndicates, 3) a financial strength rating of "A-" or better fromA.M. Best Company, Inc. or Standard & Poor's Corporation, 4) an unqualified opinion on the reinsurer's financial statements from an independent audit, 5) approval from the reinsurance broker, if a party to the transaction and 6) a minimum of five years in business for non-U.S. reinsurers. The Committee approves exceptions to these criteria when warranted. We continuously monitor our financial exposure to the reinsurance market and take necessary actions in an attempt to mitigate our exposure to possible credit loss. We monitor reinsurance recoverables to ensure diversification of credit risk by reinsurer. We limit our liquidity exposure for uncollected recoverables by holding funds, letters of credit or other security, such that net balances due from reinsurers are significantly less than the gross balances shown in our consolidated balance sheets. We constantly monitor the collectability of our reinsurance recoverables and record a reserve for uncollectible reinsurance when we determine an amount is potentially uncollectible. Our evaluation is based on our periodic reviews of our disputed and aged recoverables, as well as our assessment of recoverables due from reinsurers known to be in financial difficulty. In some cases, we make estimates as to what portion of a recoverable may be uncollectible. Our estimates and judgment about the collectability of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required. 60
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We maintain a reserve for potential collectability issues, including disputed amounts and associated expenses. We review the level and adequacy of our reserve at each quarter-end based on recoverable balances that are past due or in dispute. The reserve was$1.5 million atDecember 31, 2012 , compared to$1.9 million atDecember 31, 2011 . While we believe the year-end reserve is adequate based on information currently available, market conditions may change or additional information might be obtained that may require us to change the reserve in the future. Deferred Taxes We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability, taking in consideration our history of earnings, expectations for future earnings, taxable income in carryback years and the expected timing of the reversals of existing temporary differences. When we believe it is more likely than not that a deferred tax asset will be not be realized, we establish a valuation allowance for that deferred tax asset. Although realization is not assured, we believe that, as ofDecember 31, 2012 , it is more likely than not that we will be able to realize the benefit of recorded deferred tax assets, with the exception of certain tax loss carryforwards for which valuation allowances have been provided. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions, which could result in a change in the valuation allowance required.
Valuation of Goodwill
Goodwill is impaired when the fair value of a reporting unit is less than its carrying amount. We assess our goodwill for impairment annually, or sooner if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. We conducted our annual goodwill impairment test as ofJune 30, 2012 , which is consistent with the timeframe for our annual assessment in prior years. In 2012, we elected to perform a qualitative assessment for each of our five reporting units to determine whether further impairment testing would be necessary. We considered general economic conditions, industry and market conditions, our financial performance, key events and circumstances that could affect fair value using the income and market approaches, and additional factors such as significant changes in reporting unit management and regulatory factors. Based on our assessment, we determined that is it more likely than not that the fair value of each of our five reporting units exceeded its carrying amount as ofJune 30, 2012 . In addition, we had no indicators of impairment atDecember 31, 2012 . In years where we assess goodwill for impairment by determining the fair value of each reporting unit, we consider three valuation approaches (market, income and cost) to determine the fair value of each reporting unit. We utilize the income and market valuation approaches and base our assumptions and inputs on market participant data, as well as our own data. For the income approach, we estimate the present value of each reporting unit's expected cash flows to determine the fair value. We utilize estimated future cash flows of the portfolio of products included in each reporting unit, as well as a risk-appropriate rate of return specific to each reporting unit. We utilize our budgets and projection of future operations based on historical and expected industry trends to estimate our future cash flows and their probability of occurring as projected. We also determine fair value of each reporting unit based on market participant data, and use those results to test the reasonableness and validity of the income approach results. We will conduct our next annual goodwill impairment test as ofJune 30, 2013 , unless other events occur that indicate there is an impairment in our goodwill prior to that date.
Accounting Guidance Adopted in 2012
See Note 1, "General Information and Significant Accounting and Reporting Policies - Accounting Guidance Adopted in 2012" to the Consolidated Financial Statements for a description of recently adopted accounting guidance related to policy acquisition costs and its retrospective impact on our prior year consolidated financial statements. 61
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