UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended September 30, 2008
OR
For the Transition Period from to
ACE LIMITED
(Incorporated in Switzerland)
Mainaustrasse 30
Zurich CH-8008, Switzerland
Telephone +41 (0)43 456 76 00
(Address of principal executive offices)
17 Woodbourne Avenue
Hamilton HM 08
Bermuda
Telephone 441-295-5200
(Former name, former address and former fiscal year if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES x NO ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
Non-accelerated filer
Smaller reporting company
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES ¨ NO x
The number of registrant’s Common Shares (CHF 33.44 par value) outstanding as of November 4, 2008, was 333,581,968.
INDEX TO FORM 10-Q
Part I. FINANCIAL INFORMATION
Item 1.
Financial Statements:
Consolidated Balance Sheets (Unaudited)September 30, 2008, and December 31, 2007
Consolidated Statements of Operations and Comprehensive Income (Unaudited)Three and Nine Months Ended September 30, 2008 and 2007
Consolidated Statements of Shareholders’ Equity (Unaudited)Nine Months Ended September 30, 2008 and 2007
Consolidated Statements of Cash Flows (Unaudited)Nine Months Ended September 30, 2008 and 2007
Notes to the Interim Consolidated Financial Statements (Unaudited)
Note 1.
General
Note 2.
Significant accounting policies
Note 3.
Acquisition
Note 4.
Fair value measurements
Note 5.
Investments
Note 6.
Assumed reinsurance programs involving minimum benefit guarantees under annuity contracts
Note 7.
Goodwill and other intangible assets
Note 8.
Debt
Note 9.
Commitments, contingencies, and guarantees
Note 10.
Preferred Shares
Note 11.
Shareholders’ equity
Note 12.
Share-based compensation
Note 13.
Segment information
Note 14.
Earnings per share
Note 15.
Information provided in connection with outstanding debt of subsidiaries
Note 16.
Subsequent events
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Item 4.
Controls and Procedures
Part II. OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Item 6.
Exhibits
2
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
ACE LIMITED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
Assets
Fixed maturities available for sale, at fair value (amortized cost – $34,609 and $32,994) (includes hybrid financial instruments of $257 and $282)
Fixed maturities held to maturity, at amortized cost (fair value – $2,852 and $3,015)
Equity securities, at fair value (cost – $1,336 and $1,618)
Short-term investments, at fair value and amortized cost
Other investments (cost – $1,327 and $880)
Total investments
Cash
Securities lending collateral
Accrued investment income
Insurance and reinsurance balances receivable
Reinsurance recoverable on losses and loss expenses
Reinsurance recoverable on future policy benefits
Deferred policy acquisition costs
Value of business acquired
Prepaid reinsurance premiums
Deferred tax assets
Investments in partially-owned insurance companies (cost—$786 and $686)
Income taxes receivable
Other assets
Total assets
Liabilities
Unpaid losses and loss expenses
Unearned premiums
Future policy benefits
Insurance and reinsurance balances payable
Deposit liabilities
Securities lending payable
Payable for securities purchased
Accounts payable, accrued expenses, and other liabilities
Income taxes payable
Short-term debt
Long-term debt
Trust preferred securities
Total liabilities
Commitments and contingencies
Preferred Shares ($1.00 par value, Nil and 2,300,000 shares authorized, issued, and outstanding)
Common Shares (CHF 33.44 and $0.041666667 par value, 500,000,000 shares authorized; 335,259,791 and 329,704,531 shares issued; 333,394,608 and 329,704,531 shares outstanding)
Common Shares in treasury (1,865,183 and nil shares)
Additional paid-in capital
Retained earnings
Deferred compensation obligation
Accumulated other comprehensive (loss) income
Common Shares issued to employee trust
Total shareholders’ equity
Total liabilities and shareholders’ equity
See accompanying notes to the interim consolidated financial statements
3
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
For the three and nine months ended September 30, 2008 and 2007
Revenues
Gross premiums written
Reinsurance premiums ceded
Net premiums written
Change in unearned premiums
Net premiums earned
Net investment income
Net realized gains (losses)
Total revenues
Expenses
Losses and loss expenses
Policy acquisition costs
Administrative expenses
Interest expense
Other (income) expense
Total expenses
Income before income tax
Income tax (benefit) expense
Net income
Other comprehensive (loss) income
Unrealized (depreciation) appreciation arising during the period
Reclassification adjustment for net realized (gains) losses included in net income
Change in:
Cumulative translation adjustments
Pension liability
Other comprehensive (loss) income, before income tax
Income tax benefit (expense) related to other comprehensive income items
Comprehensive (loss) income
Basic earnings per share
Diluted earnings per share
4
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
For the nine months ended September 30, 2008 and 2007
Balance – beginning of period
Preferred Shares redeemed
Balance – end of period
Common Shares
Exercise of stock options
Common Shares stock dividend
Dividends declared on Common Shares-par value reduction
Common Shares in treasury
Common Shares issued in treasury net of net shares redeemed under employee share-based compensation plans
Net shares redeemed under employee share-based compensation plans
Share-based compensation expense
Effect of partial adoption of FAS 157
Effect of adoption of FAS 159
Effect of adoption of FIN 48
Effect of adoption of FAS 155
Balance – beginning of period, adjusted for effect of adoption of new accounting principles
Dividends declared on Common Shares
Dividends declared on Preferred Shares
Balance – beginning and end of period
5
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (cont’d)
Net unrealized appreciation (depreciation) on investments
Change in period, net of income tax (expense) benefit of $317 and $10
Cumulative translation adjustment
Change in period, net of income tax (expense) benefit of $40 and $(35)
Pension liability adjustment
Change in period, net of income tax (expense) benefit of $(2) and $2
6
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities
Adjustments to reconcile net income to net cash flows from operating activities:
Net realized (gains) losses
Amortization of premium/discount on fixed maturities
Deferred income taxes
Income taxes payable/receivable
Other
Net cash flows from operating activities
Cash flows used for investing activities
Purchases of fixed maturities available for sale
Purchases of fixed maturities held to maturity
Purchases of equity securities
Sales of fixed maturities available for sale
Sales of equity securities
Maturities and redemptions of fixed maturities available for sale
Maturities and redemptions of fixed maturities held to maturity
Net proceeds from (payments made on) the settlement of investment derivatives
Acquisition of subsidiary (net of cash acquired of $19)
Net cash flows used for investing activities
Cash flows from (used for) financing activities
Dividends paid on Common Shares
Dividends paid on Preferred Shares
Net proceeds from (repayment of) short-term debt
Net proceeds from issuance of long-term debt
Redemption of Preferred Shares
Proceeds from exercise of options for Common Shares
Proceeds from Common Shares issued under ESPP
Net cash flows from (used for) financing activities
Effect of foreign currency rate changes on cash and cash equivalents
Net decrease in cash
Cash – beginning of period
Cash – end of period
7
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS
1. General
ACE Limited (ACE or the Company) is a holding company which, until July 18, 2008, was incorporated with limited liability under the Cayman Islands Companies Law. On March 19, 2008, the Company announced that its Board of Directors (the Board) approved a proposal to move the Company’s jurisdiction of incorporation from the Cayman Islands to Zurich, Switzerland (the Continuation). On July 10, 2008, and July 14, 2008, during ACE’s annual general meeting, the Company’s shareholders approved the Continuation and ACE became a Swiss company effective July 18, 2008.
On April 1, 2008, ACE acquired all outstanding shares of Combined Insurance Company of America (Combined Insurance) and certain of its subsidiaries from AON Corporation (AON) for $2.56 billion. Combined Insurance is a leading underwriter and distributor of specialty individual accident and supplemental health insurance products targeted to middle income consumers in the U.S., Europe, Canada, and Asia Pacific. ACE recorded the acquisition using the purchase method of accounting. The interim consolidated financial statements include the results of Combined Insurance from April 1, 2008. Based on ACE’s preliminary purchase price allocation, $936 million of goodwill and other intangible assets was generated as a result of the acquisition. Refer to Note 3.
The Company, through its various subsidiaries, provides a broad range of insurance and reinsurance products to insureds worldwide. ACE operates through the following business segments: Insurance – North American, Insurance – Overseas General, Global Reinsurance, and Life Insurance and Reinsurance. Refer to Note 13.
The interim unaudited consolidated financial statements, which include the accounts of the Company and its subsidiaries, have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and, in the opinion of management, reflect all adjustments (consisting of normally recurring accruals) necessary for a fair statement of the results and financial position for such periods. All significant intercompany accounts and transactions have been eliminated. Certain items in the prior year financial statements have been reclassified to conform to the current period presentation. The results of operations and cash flows for any interim period are not necessarily indicative of the results for the full year. These financial statements should be read in conjunction with the consolidated financial statements, and related notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
2. Significant accounting policies
New accounting pronouncements
Adopted in the nine months ended September 30, 2008
In September 2006, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard (FAS) No. 157, Fair Value Measurements (FAS 157). FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. FAS 157 focuses on how to measure fair value and establishes a three-level hierarchy for both measurement and disclosure purposes. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. Under FAS 157, fair value measurements are separately disclosed by level within the fair value hierarchy. FAS 157 does not expand the use of fair value measurement to any new circumstances. The Company adopted FAS 157, in part, as of January 1, 2008, and the cumulative effect of adoption resulted in a reduction to retained earnings of $4 million related to an increase in risk margins included in the valuation of certain guaranteed minimum income benefits (GMIB) contracts. For additional information regarding the partial adoption of FAS 157, refer to the following paragraph and Note 4.
In February 2008, the FASB issued FASB Staff Position (FSP) FAS 157-2, Effective Date of FASB Statement No. 157 (FSP FAS 157-2), which permits a one-year deferral of the application of FAS 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial
8
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
statements on a recurring basis (at least annually). FSP FAS 157-2 is effective in conjunction with FAS 157 for interim and annual financial statements issued after January 1, 2008. Accordingly, the provisions of FAS 157 have not been applied to Goodwill and other intangible assets held by the Company which are measured annually for impairment testing purposes only.
In October 2008, the FASB issued FSP FAS 157-3, Determining Fair Value of a Financial Asset in a Market That is Not Active (FSP FAS 157-3). FSP FAS 157-3 clarifies the application of FAS 157 in an inactive market and provides examples to illustrate key considerations in determining the fair value of a financial asset in an inactive market. FSP FAS 157-3 is effective for the Company for the three months ended September 30, 2008. The adoption of FSP FAS 157-3 did not have a material impact on the Company’s financial condition or results of operations.
Fair value option for financial assets and financial liabilities
In February 2007, the FASB issued FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (FAS 159). FAS 159 permits an entity to irrevocably elect fair value on a contract-by-contract basis as the initial and subsequent measurement attribute for many financial assets and liabilities and certain other items including insurance contracts. FAS 159 is effective for fiscal years beginning after November 15, 2007. Effective January 1, 2008, the Company elected the fair value option for certain of its available for sale equity securities. The Company elected the fair value option for these particular equity securities to simplify the accounting and oversight of this portfolio given the portfolio management strategy employed by the external investment manager. Since the equity securities were previously carried at fair value, the election did not have an effect on shareholders’ equity. However, the election resulted in an increase to retained earnings and a reduction to accumulated other comprehensive income of $6 million ($9 million pre-tax) as of January 1, 2008. Subsequent to this election, changes in fair value related to these equity securities were recognized in Net realized gains (losses) in the consolidated statement of operations. For additional information regarding the adoption of FAS 159, refer to Note 4.
Income tax benefits of dividends on share-based payment awards
In October 2006, the FASB issued Emerging Issues Task Force (EITF) Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (EITF 06-11). EITF 06-11 provides guidance on the treatment of realized income tax benefits arising from dividend payments to employees holding equity shares, non-vested equity share units, and outstanding equity share options. EITF 06-11 is applied prospectively to the income tax benefits of dividends on equity-classified employee share-based payment awards that are declared in fiscal years beginning after December 15, 2007. The adoption of EITF 06-11 did not have a material impact on the Company’s financial condition or results of operations.
The Hierarchy of Generally Accepted Accounting Principles
In May 2008, the FASB issued FAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (FAS 162). FAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. FAS 162 is effective September 28, 2008 (60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AICPA Professional Standards AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles). The adoption of FAS 162 did not have a material impact on the Company’s financial condition or results of operations.
9
To be adopted after September 30, 2008
Business combinations
In December 2007, the FASB issued FAS No. 141 (Revised), Business Combinations (FAS 141R). FAS 141R establishes standards that provide a definition of the “acquirer” and broaden the application of the acquisition method. FAS 141R also establishes how an acquirer recognizes and measures the assets, liabilities, and any noncontrolling interest in the “acquiree”; recognizes and measures goodwill or a gain from a bargain purchase; and requires disclosures that enable users to evaluate the nature and financial effects of the business combination. FAS 141R shall be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company does not expect the adoption of FAS 141R to have a material impact on the Company’s financial condition or results of operations.
Noncontrolling interests
In December 2007, the FASB issued FAS No. 160, Noncontrolling Interests in Consolidated Financial Statements – an Amendment of ARB No. 51 (FAS 160). FAS 160 establishes accounting and reporting standards that require that ownership interests in subsidiaries held by parties other than the parent be presented in the consolidated statement of shareholders’ equity separately from the parent’s equity; the consolidated net income attributable to the parent and noncontrolling interest be presented on the face of the consolidated statements of operations; changes in a parent’s ownership interest while the parent retains controlling financial interest in its subsidiary be accounted for consistently; and sufficient disclosure that identifies and distinguishes between the interests of the parent and noncontrolling owners. FAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company does not expect the adoption of FAS 160 to have a material impact on the Company’s financial condition or results of operations.
Disclosures about derivative instruments and hedging activities
In March 2008, the FASB issued FAS No. 161, Disclosures About Derivative Instruments and Hedging Activities (FAS 161). FAS 161 establishes reporting standards that require enhanced disclosures about how and why derivative instruments are used, how derivative instruments are accounted for under FAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and how derivative instruments affect an entity’s financial position, financial performance, and cash flows. FAS 161 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after November 15, 2008.
Determination of the Useful Life of Intangible Assets
In April 2008, the FASB issued FSP No. FAS 142-3,Determination of the Useful Life of Intangible Assets (FSP FAS 142-3). FSP FAS 142-3 amends the factors considered in developing assumptions used to determine the useful life of an intangible asset under FAS No. 142, Goodwill and Other Intangible Assets (FAS 142). The intent of FSP FAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under FAS 142 and the period of expected cash flows used to measure the fair value of the asset under FAS 141R and other applicable accounting literature. FSP FAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and must be applied prospectively to intangible assets acquired after the effective date. The Company does not expect the adoption of FSP FAS 142-3 to have a material impact on the Company’s financial condition or results of operations.
Financial Guarantee Insurance Contracts
In May 2008, the FASB issued FAS No. 163, Accounting for Financial Guarantee Insurance Contracts – An interpretation of FASB Statement No. 60 (FAS 163). FAS 163 requires that an insurance enterprise recognize a
10
claim liability prior to an event of default when there is evidence that credit deterioration has occurred in an insured financial obligation. It also clarifies how FAS No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities, and requires expanded disclosures about financial guarantee insurance contracts. FAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, except for some disclosures about the insurance enterprise’s risk management activities. FAS 163 requires that disclosures about the risk management activities of the insurance enterprise be effective for the first period beginning after issuance. Except for those disclosures, earlier application is not permitted.
Earnings Per Share
In June 2008, the FASB issued FSP EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (FSP EITF 03-6-1). FSP EITF 03-6-1 provides additional guidance in the calculation of earnings per share under FAS No. 128, Earnings Per Share, and requires unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) to be included in the computation of earnings per share pursuant to the two-class method. FSP EITF 03-6-1 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2008. The Company does not expect the adoption of FSP EITF 03-6-1 to have a material impact on the Company’s financial condition or results of operations.
3. Acquisition
On December 14, 2007, ACE entered into a stock purchase agreement with AON, pursuant to which ACE agreed to purchase all outstanding shares of capital stock of Combined Insurance and certain Combined Insurance subsidiaries. Combined Insurance is a leading underwriter and distributor of specialty individual accident and supplemental health insurance products targeted to middle income consumers in the U.S., Europe, Canada, and Asia Pacific. On April 1, 2008, ACE acquired all outstanding shares of Combined Insurance and certain of its subsidiaries from AON for $2.56 billion. This acquisition has diversified the Company’s A&H distribution capabilities by adding thousands of agents, while almost doubling the A&H franchise. ACE believes this will provide significant long-term growth opportunities.
ACE recorded the acquisition using the purchase method of accounting. The interim consolidated financial statements include the results of Combined Insurance from April 1, 2008. The most significant intangible asset is the value of business acquired (VOBA). VOBA represents the fair value of the future profits of the in-force long duration contracts and is amortized in relation to the profit emergence of the underlying contracts, in a manner similar to deferred acquisition costs, over a period of approximately thirty years. The VOBA calculation is based on many factors including mortality, morbidity, persistency, investment yields, expenses, and the discount rate with the discount rate being the most significant factor. The acquisition also generated $936 million of goodwill and other intangible assets (most, if not all, of which is expected to be deductible for income tax purposes) based on ACE’s preliminary purchase price allocation, which was apportioned to the Life Insurance and Reinsurance and Insurance – Overseas General segments in the amounts of $488 million and $448 million, respectively. The allocation of goodwill and other intangible assets to segments is preliminary and subject to change. Refer to Note 7. ACE financed the transaction through a combination of available cash ($811 million), reverse repurchase agreements ($1 billion), and new private and public long-term debt ($750 million). Refer to Note 8.
11
The following table summarizes ACE’s best estimate of fair value of the assets acquired and liabilities assumed from Combined Insurance at April 1, 2008. Upon the adoption of FAS 157, ACE elected to defer the fair value guidance applicable to valuing nonfinancial assets and nonfinancial liabilities that are not recognized or disclosed at fair value on a recurring basis. Accordingly, FAS 157 was not used to determine the fair values of the nonfinancial assets acquired and the nonfinancial liabilities assumed in this business combination. ACE expects to make further adjustments to its purchase price allocation during the quarter ending December 31, 2008, although ACE does not expect these changes to materially affect its financial position, results of operations, or cash flows.
Condensed Balance Sheet of Combined Insurance at April 1, 2008
(in millions of U.S. dollars)
Investments and cash
Value of business acquired (preliminary)
Goodwill and intangible assets (preliminary)
Other assets (preliminary)
Total assets (preliminary)
Liabilities and Shareholder’s Equity
Other liabilities (preliminary)
Total liabilities (preliminary)
Total shareholder’s equity (preliminary)
Total liabilities and shareholder’s equity (preliminary)
12
The following table presents pro forma information for the periods indicated assuming the acquisition of Combined Insurance occurred on January 1st of each of the respective periods. The pro forma financial information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the acquisition been consummated at the beginning of each period presented, nor is it necessarily indicative of future operating results. Significant assumptions used to determine pro forma operating results include amortization of VOBA and other intangible assets and recognition of interest expense associated with debt financing used to effect the acquisition.
Pro forma:
4. Fair value measurements
a) Fair value hierarchy
The Company partially adopted the provisions of FAS 157 on January 1, 2008, and the cumulative effect of adoption resulted in a reduction to retained earnings of $4 million related to an increase in risk margins included in the valuation of certain GMIB contracts. FAS 157 defines fair value as the price to sell an asset or transfer a liability in an orderly transaction between market participants and establishes a three-level valuation hierarchy in which inputs into valuation techniques used to measure fair value are classified. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. Inputs in Level 1 are unadjusted quoted prices for identical assets or liabilities in active markets. Level 2 includes inputs other than quoted prices included within Level 1 that are observable for assets or liabilities either directly or indirectly. Level 2 inputs include, among other items, quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, and inputs other than quoted prices that are observable for the asset or liability such as interest rates and yield curves. Level 3 inputs are unobservable and reflect management’s judgments about assumptions that market participants would use in pricing an asset or liability. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
The following is a description of the valuation measurements used for the Company’s financial instruments carried or disclosed at fair value, as well as the general classification of such financial instruments pursuant to the valuation hierarchy.
Fixed maturities
Fixed maturities with active markets such as U.S. Treasury and agency securities are classified within Level 1 as fair values are based on quoted market prices. For fixed maturities that trade in less active markets, including corporate and municipal securities, fair values are based on the output of “pricing matrix models”, the significant inputs into which include, but are not limited to, yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. These fixed maturities are classified within Level 2. Fixed maturities for which pricing is unobservable are classified within Level 3.
13
Equity securities
Equity securities with active markets are classified within Level 1 as fair values are based on quoted market prices. For nonpublic equity securities, fair values are based on market valuations and are classified within Level 2.
Short-term investments
Short-term investments, which comprise securities due to mature within one year of the date of purchase that are traded in active markets, are classified within Level 1 as fair values are based on quoted market prices. Securities such as commercial paper and discount notes are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their cost approximating par value.
Other investments
Fair values for other investments, principally other direct equity investments, investment funds, and limited partnerships, are based on the net asset value or financial statements and are included within Level 3. Equity securities and fixed maturities held in rabbi trusts maintained by the Company for deferred compensation plans, and included in Other investments, are classified within the valuation hierarchy on the same basis as the Company’s other equity securities and fixed maturities.
Investment derivative instruments
For actively traded investment derivative instruments, including futures, options, and exchange-traded forward contracts, the Company obtains quoted market prices to determine fair value. As such, these instruments are included within Level 1. Forward contracts that are not exchange-traded are priced using a pricing matrix model principally employing observable inputs and, as such, are classified within Level 2. The Company’s position in interest rate and credit default swaps is typically classified within Level 3.
Guaranteed minimum income benefits
The liability for GMIBs arises from the Company’s reinsurance programs covering living benefit guarantees whereby the Company assumes the risk of GMIBs associated with variable annuity contracts. The fair value of GMIB reinsurance is estimated using an internal valuation model which includes the use of management estimates and current market information. The fair value depends on a number of inputs, including changes in interest rates, changes in equity markets, changes in market volatility, changes in policyholder behavior, and changes in policyholder mortality. The model and related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information, such as market conditions and demographics of in-force annuities. Because of the significant use of unobservable inputs including policyholder behavior, GMIB reinsurance is classified within Level 3.
Other derivative instruments
The Company maintains positions in other derivative instruments including option contracts designed to limit exposure to a severe equity market decline, which would cause an increase in expected claims and, therefore, reserves for guaranteed minimum death benefits (GMDB) and GMIB reinsurance business. The fair value of the majority of the Company’s positions in other derivative instruments is based on significant observable inputs
14
including equity security and interest rate indices. Accordingly, these are classified within Level 2. The Company’s position in credit default swaps is typically included within Level 3.
The following table presents, by valuation hierarchy, the financial instruments carried or disclosed at fair value, and measured on a recurring basis, as of September 30, 2008.
Assets:
Fixed maturities available for sale
Fixed maturities held to maturity
Total assets at fair value
Liabilities:
Total liabilities at fair value
15
Level 3 financial instruments
The following tables provide a reconciliation of the beginning and ending balances of financial instruments carried or disclosed at fair value using significant unobservable inputs (Level 3) for the periods indicated.
Three Months Ended
September 30, 2008
Guaranteed minimum income benefits at fair value
Nine Months Ended
16
b) Fair value option
Effective January 1, 2008, the Company elected the fair value option for certain of its available for sale equity securities valued and carried at $161 million on the election date. The Company elected the fair value option for these particular equity securities to simplify the accounting and oversight of this portfolio given the portfolio management strategy employed by the external investment manager. The election resulted in an increase in retained earnings and a reduction to accumulated other comprehensive income of $6 million as of January 1, 2008. This adjustment reflects the net of tax unrealized gains ($9 million pre-tax) associated with this particular portfolio at January 1, 2008. Subsequent to this election, changes in fair value related to these equity securities were recognized in Net realized gains (losses). During the three months ended June 30, 2008, the Company sold the entire portfolio. Accordingly, the Company currently holds no assets for which the provisions of FAS 159 have been elected. For the three and six months ended June 30, 2008, the Company recognized net realized gains (losses) related to changes in fair value of these equity securities of $9 million and $(11) million, respectively, in the consolidated statements of operations. Throughout 2008 to the date of sale, all of these equity securities were classified within Level 1 in the fair value hierarchy.
5. Investments
a) Gross unrealized loss
As of September 30, 2008, there were 9,691 fixed maturities out of a total of 14,178 fixed maturities in an unrealized loss position. The largest single unrealized loss in the fixed maturities was $13 million. There were 612 equity securities out of a total of 964 equity securities in an unrealized loss position. The largest single unrealized loss in the equity securities was $6.6 million. Most of the fixed maturities in an unrealized loss position were investment grade securities for which fair value declined primarily due to widening credit spreads on corporate and structured credit investments. The unrealized loss also reflects higher non–U.S. interest rates.
The following tables summarize, for all securities in an unrealized loss position at September 30, 2008, and December 31, 2007 (including securities on loan), the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position.
U.S. Treasury and agency
Foreign
Corporate securities
Mortgage-backed securities
States, municipalities, and political subdivisions
Total fixed maturities
Total
17
Included in the “0 – 12 Months” and “Over 12 Months” aging categories at September 30, 2008, are fixed maturities held to maturity with combined fair values of $1.26 billion and $108 million, respectively. The associated gross unrealized losses included in the “0-12 Months” and “Over 12 Months” aging categories are $46 million and $17 million, respectively.
Included in the “0 – 12 Months” and “Over 12 Months” aging categories at December 31, 2007, are fixed maturities held to maturity with combined fair values of $361 million and $318 million, respectively. The associated gross unrealized losses included in the “0 – 12 Months” and “Over 12 Months” aging categories were $3 million and $4 million, respectively.
18
b) Net realized gains (losses) and other- than- temporary impairments
The following table shows, for the periods indicated, the Net realized gains (losses) and the losses included in Net realized gains (losses) as a result of conditions which caused the Company to conclude the decline in fair value of certain investments was “other-than-temporary”. The impairments for the nine months ended September 30, 2008, were primarily due to increased equity market volatility and fixed income securities in an unrealized loss position reflecting global interest rate conditions, including widening credit spreads on corporate and structured credit investments. For the three months ended September 30, 2008, approximately $150 million was related to ACE’s holdings in Lehman Brothers debt.
Fixed maturity other-than-temporary impairments
Equity securities other-than-temporary impairments
Other investments other-than-temporary impairments
Foreign currency gains (losses)
Futures, option contracts, and swaps
Fair value adjustments on insurance derivatives
6. Assumed reinsurance programs involving minimum benefit guarantees under annuity contracts
The presentation of income and expenses relating to GMDB and GMIB reinsurance for the periods indicated, is as follows:
GMDB
Life and annuity benefits expense
GMIB
Realized gains (losses)
Fair value components
Gain (loss) recognized in income
Net cash received (disbursed)
Net decrease (increase) in liability
At September 30, 2008, reported liabilities for GMDB and GMIB reinsurance were $214 million and $542 million, respectively, compared with $137 million and $225 million, respectively, at December 31, 2007. The
19
reported liability for GMIB reinsurance in 2008 and 2007 includes a fair value adjustment of $480 million and $157 million, respectively. Reported liabilities for both GMDB and GMIB reinsurance are determined using internal valuation models. Such valuations require considerable judgment and are subject to significant uncertainty. The valuation of these products is subject to fluctuations arising from, among other factors, changes in interest rates, changes in equity markets, changes in credit markets and, for GMIB reinsurance, changes in the allocation of the investments underlying annuitant’s account value and assumptions regarding future policyholder behavior. These models and the related assumptions are continually reviewed by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely information, such as market conditions and demographics of in-force annuities.
At September 30, 2008, the Company’s net amount at risk from its GMDB and GMIB reinsurance programs was $6.5 billion and $539 million, respectively, compared with $1.5 billion and $14 million, respectively, at December 31, 2007. For the GMDB programs, the net amount at risk is defined as the excess, if any, of the current guaranteed value over the current account value. For the GMIB programs, the net amount at risk is defined as the excess, if any, of the present value of the minimum guaranteed annuity payments over the present value of the annuity payments assumed (under the terms of the reinsurance contract) to be available to each policyholder.
7. Goodwill and other intangible assets
Prior to June 30, 2008, the Company included intangible assets other than goodwill in Other assets in the consolidated balance sheet. Effective June 30, 2008, the Company presents the aggregate balance of these intangible assets and goodwill in Goodwill and other intangible assets. ACE reclassified other intangible assets in the prior year financial statements to conform to the current period presentation.
As discussed in Note 3, the acquisition of Combined Insurance generated $936 million of goodwill and other intangible assets based on ACE’s preliminary purchase price allocation, which was apportioned to the Life Insurance and Reinsurance and Insurance – Overseas General segments in the amounts of $488 million and $448 million, respectively.
The following table details Goodwill and other intangible assets by reporting segment.
Insurance – North American
Insurance – Overseas General
Global Reinsurance
Life Insurance and Reinsurance
20
8. Debt
The following table outlines the Company’s debt as of September 30, 2008, and December 31, 2007.
Australia Holdings due 2008
ACE US Holdings senior notes due 2008
Reverse repurchase agreements
ACE INA subordinated notes due 2009
ACE European Holdings due 2010
ACE INA term loan due 2013
ACE INA senior notes due 2014
ACE INA senior notes due 2015
ACE INA senior notes due 2017
ACE INA senior notes due 2018
ACE INA debentures due 2029
ACE INA senior notes due 2036
ACE INA capital securities due 2030
a) Reverse repurchase agreements
The Company has executed reverse repurchase agreements with certain counterparties under which the Company agreed to sell securities and repurchase them at a future date for a predetermined price. During the three months ended March 31, 2008, the Company executed reverse repurchase agreements totaling $1 billion as part of the financing of the Combined Insurance acquisition. At September 30, 2008, these reverse repurchase agreements had been settled.
b) ACE INA notes and term loan
In February 2008, as part of the financing of the Combined Insurance acquisition, ACE INA issued $300 million of 5.8 percent senior notes due March 2018. These notes are redeemable at any time at ACE INA’s option subject to a “make-whole” premium plus 0.35 percent. The notes are also redeemable at par plus accrued and unpaid interest in the event of certain changes in tax law. These notes do not have the benefit of any sinking fund. These senior unsecured notes are guaranteed on a senior basis by the Company and they rank equally with all of the Company’s other senior obligations. They also contain customary limitations on lien provisions as well as customary events of default provisions which, if breached, could result in the accelerated maturity of such senior debt.
In April 2008, as part of the financing of the Combined Insurance acquisition, ACE INA entered into a $450 million floating interest rate syndicated term loan agreement due April 2013. The floating interest rate is based
21
on LIBOR plus 0.65 percent. Simultaneously, the Company entered into a $450 million swap transaction that has the economic effect of fixing the interest rate at 4.15 percent for the term of the loan. The swap counterparty is a highly-rated financial institution and the Company does not anticipate non-performance. The loan is unsecured and repayable on maturity and contains customary limitations on lien provisions as well as customary events of default provisions which, if breached, could result in the accelerated maturity of such debt. The obligation of the borrower under the loan agreement is guaranteed by ACE Limited.
In May 2008, ACE INA issued $450 million of 5.6 percent senior notes due May 2015. These notes are redeemable at any time at ACE INA’s option subject to a “make-whole” premium plus 0.35 percent. The notes are also redeemable at par plus accrued and unpaid interest in the event of certain changes in tax law. These senior unsecured notes are guaranteed on a senior basis by the Company and they rank equally with all of the Company’s other senior obligations. They also contain customary limitations on lien provisions as well as customary events of default provisions which, if breached, could result in the accelerated maturity of such senior debt. The proceeds from this debt offering, along with available cash, were used to redeem the Preferred Shares in June 2008. Refer to Note 10.
9. Commitments, contingencies, and guarantees
a) Other investments
The Company invests in limited partnerships with a carrying value of $831 million included in Other investments. In connection with these investments, the Company has commitments that may require funding of up to $968 million over the next several years.
b) Legal proceedings
(i) Claims and other litigation
The Company’s insurance subsidiaries are subject to claims litigation involving disputed interpretations of policy coverages and, in some jurisdictions, direct actions by allegedly-injured persons seeking damages from policyholders. These lawsuits, involving claims on policies issued by the Company’s subsidiaries which are typical to the insurance industry in general and in the normal course of business, are considered in the Company’s loss and loss expense reserves. In addition to claims litigation, the Company and its subsidiaries are subject to lawsuits and regulatory actions in the normal course of business that do not arise from, or directly relate to, claims on insurance policies. This category of business litigation typically involves, amongst other things, allegations of underwriting errors or misconduct, employment claims, regulatory activity, or disputes arising from business ventures. In the opinion of ACE’s management, ACE’s ultimate liability for these matters is not likely to have a material adverse effect on ACE’s consolidated financial condition, although it is possible that the effect could be material to ACE’s consolidated results of operations for an individual reporting period.
(ii) Subpoenas
Beginning in 2004, ACE and its subsidiaries and affiliates received numerous subpoenas, interrogatories, and civil investigative demands in connection with certain investigations of insurance industry practices. These inquiries have been issued by a number of attorneys general, state departments of insurance, and other authorities, including the New York Attorney General (NYAG), the Pennsylvania Department of Insurance, and the Securities and Exchange Commission (SEC). Such inquiries concern underwriting practices and non-traditional or loss mitigation insurance products. To the extent they are ongoing, ACE is cooperating and will continue to cooperate with such inquiries. ACE conducted its own investigation that encompassed the
22
subjects raised by the NYAG and the other state and federal regulatory authorities. The investigation was conducted by a team from the firm of Debevoise & Plimpton LLP headed by former United States Attorney Mary Jo White and operated under and at the direction of the Audit Committee of the Board of Directors. ACE’s internal investigations pertaining to underwriting practices and non-traditional or loss mitigation insurance products are complete.
In June 2008, in an action filed by the NYAG against another insurer, the New York Appellate Division, First Department, confirmed the legality of contingent commission agreements – one of the focal points of the NYAG’s investigation. “Contingent commission agreements between brokers and insurers are not illegal, and, in the absence of a special relationship between parties, defendants[s] had no duty to disclose the existence of the contingent commission agreement.” New York v. Liberty Mut. Ins. Co., 52 A.D. 3d 378, 379 (2008) (citingHersch v. DeWitt Stern Group, Inc., 43 A.D. 3d 644, 645 (2007).
(iii) Settlement agreements
On April 25, 2006, ACE reached a settlement with the Attorneys General of New York, Illinois, and Connecticut and the New York Insurance Department pursuant to which ACE received from these authorities an Assurance of Discontinuance (AOD). Under the AOD, these regulators agreed not to file certain litigation against ACE relating to their investigation of certain business practices, and ACE agreed to pay $80 million ($66 million after tax) without admitting any liability, and to adopt certain business reforms. Of the $80 million, $40 million was paid to the three settling Attorneys General as a penalty, and $40 million was distributed to eligible policyholders who executed a release of possible claims against ACE. A total of $80 million was recorded in administrative expenses in the quarter ended March 31, 2006.
On May 9, 2007, ACE and the Pennsylvania Insurance Department (Department) and the Pennsylvania Office of Attorney General (OAG) entered into a settlement agreement. This settlement agreement resolves the issues raised by the Department and the OAG arising from their investigation of ACE’s underwriting practices and contingent commission payments. As a result of this settlement agreement, ACE made a $9 million payment to the Department and agreed to comply with the business practice guidelines that ACE established in 2004 to assure ongoing antitrust compliance in its operations.
On October 24, 2007, ACE entered into a settlement agreement with the Attorneys General of Florida, Hawaii, Maryland, Massachusetts, Michigan, Oregon, Texas, West Virginia, the District of Columbia, and the Florida Department of Financial Services and Office of Insurance Regulation. The agreement resolves investigations of ACE’s underwriting practices and contingent commission payments. Under the agreement, ACE paid $4.5 million without admitting any liability, and agreed to keep in place certain business reforms already in effect.
(iv) Business practice-related litigation
ACE, ACE INA Holdings, Inc., and ACE USA, Inc., along with a number of other insurers and brokers, were named in a series of federal putative nationwide class actions brought by insurance policyholders. The Judicial Panel on Multidistrict Litigation (JPML) consolidated these cases in the District of New Jersey. On August 1, 2005, plaintiffs in the New Jersey consolidated proceedings filed two consolidated amended complaints – one concerning commercial insurance and the other concerning employee benefit plans. The employee benefit plans litigation against ACE has been dismissed.
In the commercial insurance complaint, the plaintiffs named ACE, ACE INA Holdings, Inc., ACE USA, Inc., ACE American Insurance Co., Illinois Union Insurance Co., and Indemnity Insurance Co. of North America.
23
They allege that certain brokers and insurers, including certain ACE entities, conspired to increase premiums and allocate customers through the use of “B” quotes and contingent commissions. In addition, the complaints allege that the broker defendants received additional income by improperly placing their clients’ business with insurers through related wholesale entities that acted as intermediaries between the broker and insurer. Plaintiffs also allege that broker defendants tied the purchase of primary insurance to the placement of such coverage with reinsurance carriers through the broker defendants’ reinsurance broker subsidiaries. The complaint asserts the following causes of action against ACE: Federal Racketeer Influenced and Corrupt Organizations Act (RICO), federal antitrust law, state antitrust law, aiding and abetting breach of fiduciary duty, and unjust enrichment.
In 2006 and 2007, the Court dismissed plaintiffs’ first two attempts to properly plead a case without prejudice and permitted plaintiffs one final opportunity to re-plead. The amended complaint, filed on May 22, 2007, purported to add several new ACE defendants: ACE Group Holdings, Inc., ACE US Holdings, Inc., Westchester Fire Insurance Company, INA Corporation, INA Financial Corporation, INA Holdings Corporation, ACE Property and Casualty Insurance Company, and Pacific Employers Insurance Company. Plaintiffs also added a new antitrust claim against Marsh, ACE, and other insurers based on the same allegations as the other claims but limited to excess casualty insurance. On June 21, 2007, defendants moved to dismiss the amended complaint and moved to strike the new parties that plaintiffs attempted to add to that complaint. The Court granted defendants’ motions and dismissed plaintiffs’ antitrust and RICO claims with prejudice on August 31, 2007, and September 28, 2007, respectively. The Court also declined to exercise supplemental jurisdiction over plaintiffs’ state law claims and dismissed those claims without prejudice. On October 10, 2007, plaintiffs filed a Notice of Appeal of the antitrust and RICO rulings to the United States Court of Appeals for the Third Circuit. The appeal is fully briefed. Oral argument is tentatively scheduled for April 20, 2009, but the Third Circuit has not yet decided whether oral argument will in fact be heard.
There are a number of federal actions brought by policyholders based on allegations similar to the allegations in the consolidated federal actions that were filed in, or transferred to, the United States District Court for the District of New Jersey for coordination. All proceedings in these actions are currently stayed.
New Cingular Wireless Headquarters LLC et al. v. Marsh & McLennan Companies, Inc. et al. (Case No. 06-5120; D.N.J.), was originally filed in the Northern District of Georgia on April 4, 2006. ACE Ltd., ACE American Ins. Co., ACE USA, Inc., ACE Bermuda Ins. Co. Ltd., Illinois Union Ins. Co., Pacific Employers Ins. Co., and Lloyd’s of London Syndicate 2488 AGM, along with a number of other insurers and brokers, are named.
Avery Dennison Corp. v. Marsh & McLennan Companies, Inc. et al. (Case No. 07-00757; D.N.J.) was filed on February 13, 2007. ACE, ACE INA Holdings, Inc., ACE USA, Inc., and ACE American Insurance Co., along with a number of other insurers and brokers, are named.
Henley Management Co., Inc. et al v. Marsh, Inc. et al. (Case No. 07-2389; D.N.J.) was filed on May 27, 2007. ACE USA, Inc., along with a number of other insurers and Marsh, are named.
Lincoln Adventures LLC et al. v. Those Certain Underwriters at Lloyd’s, London Members of Syndicates 0033 et al. (Case No. 07-60991; D.N.J.) was originally filed in the Southern District of Florida on July 13, 2007. Supreme Auto Transport LLC et al. v. Certain Underwriters of Lloyd’s of London, et al. (Case No. 07-6703; D.N.J.) was originally filed in the Southern District of New York on July 25, 2007. Lloyd’s of London Syndicate 2488 AGM, along with a number of other Lloyd’s of London Syndicates and various brokers, are named in both actions. The allegations in these putative class-action lawsuits are similar to the allegations in the consolidated federal actions identified above, although these lawsuits focus on alleged conduct within the London insurance market.
24
Sears, Roebuck & Co. et al. v. Marsh & McLennan Companies, Inc. et al. (Case No. 07-2535; D.N.J.) was originally filed in the Northern District of Georgia on October 12, 2007. ACE American Insurance Co., ACE Bermuda Insurance Ltd., and Westchester Surplus Lines Insurance Co., along with a number of other insurers and brokers, are named.
Three cases have been filed in state courts with allegations similar to those in the consolidated federal actions described above.
Van Emden Management Corporation v. Marsh & McLennan Companies, Inc., et al. (Case No. 05-0066A; Superior Court of Massachusetts), a class action in Massachusetts, was filed on January 13, 2005. Illinois Union Insurance Company, an ACE subsidiary, is named. The Van Emden case has been stayed pending resolution of the consolidated proceedings in the District of New Jersey or until further order of the Court.
Office Depot, Inc. v. Marsh & McLennan Companies, Inc. et al. (Case No. 502005CA004396; Circuit Court of the 15th Judicial Circuit in Palm Beach County Florida), a Florida state action, was filed on June 22, 2005. ACE American Insurance Co., an ACE subsidiary, is named. The trial court originally stayed this case, but the Florida Court of Appeals later remanded and the trial court declined to grant another stay. The court has denied motions to dismiss, and ACE American Ins. Co. has filed an answer. Discovery is ongoing.
State of Ohio, ex. rel. Marc E. Dann, Attorney General v. American Int’l Group, Inc. et al. (Case No. 07-633857; Court of Common Pleas in Cuyahoga County, Ohio) is an Ohio state action filed by the Ohio Attorney General on August 24, 2007. ACE INA Holdings, Inc., ACE American Insurance Co., ACE Property & Casualty Insurance Co., Insurance Company of North America, and Westchester Fire Insurance Co., along with a number of other insurance companies and Marsh, are named. Defendants filed motions to dismiss in November 2007. On July 2, 2008, the court denied all of the defendants’ motions. Discovery is ongoing.
ACE was named in four putative securities class action suits following the filing of a civil suit against Marsh by the NYAG on October 14, 2004. The suits were consolidated by the JPML in the Eastern District of Pennsylvania and the Court appointed Sheet Metal Workers’ National Pension Fund and Alaska Ironworkers Pension Trust as lead plaintiffs. Lead plaintiffs filed a consolidated amended complaint on September 30, 2005, naming ACE, Evan G. Greenberg, Brian Duperreault, and Philip V. Bancroft as defendants. Plaintiffs allege that ACE’s public statements and securities filings should have revealed that insurers, including certain ACE entities, and brokers allegedly conspired to increase premiums and allocate customers through the use of “B” quotes and contingent commissions and that ACE’s revenues and earnings were inflated by these practices. Plaintiffs assert claims solely under Section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act), Rule 10(b)-5 promulgated thereunder, and Section 20(a) of the Securities Act (control person liability). In 2005, ACE and the individual defendants filed a motion to dismiss. Oral argument is scheduled for November 10, 2008.
ACE is named as a defendant in a derivative suit filed in Delaware Chancery Court by shareholders of Marsh seeking to recover damages for Marsh and its subsidiary, Marsh, Inc., against officers and directors of Marsh, American International Group Inc. (AIG), former AIG chief executive officer Maurice R. Greenberg, and ACE. The suit alleges that the defendants breached their fiduciary duty to and thereby damaged Marsh and Marsh, Inc. by participating in a bid rigging scheme and obtaining “kickbacks” in the form of contingent commissions, and that ACE knowingly participated in the alleged scheme.
ACE, ACE USA, Inc., ACE INA Holdings, Inc., and Evan G. Greenberg, as a former officer and director of AIG and current officer and director of ACE, are named in one or both of two derivative cases brought by certain
25
shareholders of AIG. One of the derivative cases was filed in Delaware Chancery Court, and the other was filed in federal court in the Southern District of New York. The allegations against ACE concern the alleged bid rigging and contingent commission scheme as similarly alleged in the federal commercial insurance cases. Plaintiffs assert the following causes of action against ACE: breach of fiduciary duty, aiding and abetting breaches of fiduciary duties, unjust enrichment, conspiracy, and fraud. On April 14, 2008, the shareholder plaintiffs filed an amended complaint (their third pleading effort), which drops Evan Greenberg as a defendant. On June 13, 2008, ACE moved to dismiss the newly amended complaint. Briefing on ACE’s motion is complete and oral argument is tentatively scheduled for December 18, 2008. Discovery is currently stayed. The New York derivative action is stayed pending resolution of the Delaware derivative action.
In all of the lawsuits described above, plaintiffs seek compensatory and in some cases special damages without specifying an amount. As a result, ACE cannot at this time estimate its potential costs related to these legal matters and, accordingly, no liability for compensatory damages has been established in the consolidated financial statements.
ACE’s ultimate liability for these matters is not likely to have a material adverse effect on ACE’s consolidated financial condition, although it is possible that the effect could be material to ACE’s consolidated results of operations for an individual reporting period.
10. Preferred Shares
In 2003, the Company sold twenty million depositary shares in a public offering, each representing one-tenth of one of its 7.8 percent Cumulative Redeemable Preferred Shares, for $25 per depositary share. Underwriters exercised their over-allotment option which resulted in the issuance of an additional three million depositary shares.
The shares had an annual dividend rate of 7.8 percent with the first quarterly dividend paid on September 1, 2003. The shares were not convertible into or exchangeable for the Company’s Common Shares. The Company had the option to redeem these shares at any time after May 30, 2008, at a redemption value of $25 per depositary share or at any time under certain limited circumstances. On June 13, 2008, the Company redeemed all of the outstanding Preferred Shares for cash consideration of $575 million. Following the completion of the Preferred Share redemption, the New York Stock Exchange (NYSE) halted trading in and de-listed the shares from the NYSE.
11. Shareholders’ equity
In connection with the Continuation, the Company changed the currency in which the par value of Ordinary Shares is stated from U.S. dollars to Swiss francs and increased the par value of Ordinary Shares from $0.041666667 to CHF 33.74 (the New Par Value) through a conversion of all issued Ordinary Shares into “stock” and re-conversion of the stock into Ordinary Shares with a par value equal to the New Par Value (the Par Value Conversion). The Par Value Conversion was followed immediately by a stock dividend, to effectively return shareholders to the number of Ordinary Shares held before the Par Value Conversion. The stock dividend did not therefore have the affect of diluting earnings per share. Upon the effectiveness of the Continuation, the Company’s Ordinary Shares became Common Shares. All Common Shares are registered common shares under Swiss corporate law. Notwithstanding the change of the currency in which the par value of Common Shares is stated, the Company continues to use U.S. dollars as its reporting and functional currency for preparing the consolidated financial statements. For purposes of the consolidated financial statements, the increase in par value was accomplished by a corresponding reduction first to retained earnings and second to additional paid-in capital
26
to the extent that the increase in par value exhausted retained earnings at the date of the Continuation. Under Swiss corporate law, dividends, including distributions through a reduction in par value (par value distributions), must be declared by ACE in Swiss francs though dividend payments are made by the Company’s transfer agent in USD converted at the USD/CHF exchange rate shortly before the payment date. For the foreseeable future, the Company expects to pay dividends as a repayment of share capital in the form of a reduction in par value or qualified paid-in capital, which would not be subject to Swiss withholding tax. For the three months ended September 30, 2008 and 2007, dividends declared per Common Share amounted to CHF 0.30 ($0.26) and $0.27, respectively. The par value distribution in the three months ended September 30, 2008, is reflected as such through Common Shares in the consolidated statement of shareholders’ equity and had the effect of reducing par value per Common Share to CHF 33.44. Dividends declared for the nine months ended September 30, 2008, were $0.82 per Common Share including the par value distribution declared in the three months ended September 30, 2008. Dividends declared per Common Share amounted to $0.79 for the nine months ended September 30, 2007.
Under Swiss corporate law, the Company may not generally issue Common Shares below their par value. In the event there is a need to raise common equity at a time when the trading price of the Company’s Common Shares is below par value, the Company will need to obtain shareholder approval to decrease the par value of the Common Shares.
In July of 2008, prior to the Continuation, the Company issued and placed 2,000,000 Common Shares in treasury principally for issuance upon the exercise of employee stock options. At September 30, 2008, 1,865,183 Common Shares remain in treasury after net shares redeemed under employee share-based compensation plans.
12. Share-based compensation
During 2004, the Company established the ACE Limited 2004 Long-Term Incentive Plan (the 2004 LTIP). The Company’s 2004 LTIP provides for grants of both incentive and non-qualified stock options principally at an option price per share of 100 percent of the fair market value of the Company’s Common Shares on the date of grant. Stock options are generally granted with a 3-year vesting period and a 10-year term. The stock options vest in equal annual installments over the respective vesting period, which is also the requisite service period. On February 27, 2008, the Company granted 1,545,072 stock options with a weighted-average grant date fair value of $17.56. The fair value of the options issued is estimated on the date of grant using the Black-Scholes option pricing model.
The Company’s 2004 LTIP also provides for grants of restricted stock and restricted stock units. The Company generally grants restricted stock and restricted stock units with a 4-year vesting period, based on a graded vesting schedule. The restricted stock is granted at market close price on the day of grant. On February 27, 2008, the Company granted 1,632,711 restricted stock awards and 204,295 restricted stock units to officers of the Company and its subsidiaries with a grant date fair value of $60.28. Each restricted stock unit represents the Company’s obligation to deliver to the holder one share of Common Shares upon vesting.
13. Segment information
The Company operates through the following business segments: Insurance – North American, Insurance – Overseas General, Global Reinsurance, and Life Insurance and Reinsurance. These segments distribute their products through various forms of brokers, agencies, and direct marketing programs. Additionally, Insurance – North American has formed internet distribution channels for some of its products. Global Reinsurance, Insurance – North American, and Life Insurance and Reinsurance have established relationships with reinsurance intermediaries. Segment operating results for the three and nine months ended September 30, 2008, include the
27
results of Combined Insurance from April 1, 2008. Results from Combined Insurance’s North American operations are included in the Life Insurance and Reinsurance segment and the results from Combined Insurance’s international operations are included in the Insurance – Overseas General segment.
The Insurance – North American segment comprises the P&C operation in the U.S., Canada, and Bermuda. This segment includes the operations of ACE USA (including ACE Canada), ACE Westchester, ACE Bermuda, ACE Private Risk Services, and various run-off operations. ACE USA provides a broad array of P&C, A&H, and risk management products and services to a diverse group of commercial and non-commercial enterprises and consumers. ACE Westchester specializes in the wholesale distribution of excess, surplus, and specialty P&C products. ACE Bermuda provides commercial insurance products on an excess basis to a global client base, covering risks that are generally low in frequency and high in severity. ACE Private Risk Services provides personal lines coverages (homeowners, automobile) for high net worth clients. The run-off operations include Brandywine Holdings Corporation, Commercial Insurance Services, residual market workers’ compensation business, pools and syndicates not attributable to a single business group, and other exited lines of business. Run-off operations do not actively sell insurance products, but are responsible for the management of existing policies and related claims.
The Insurance – Overseas General segment consists of ACE International (excluding its life insurance business), the wholesale insurance operations of ACE Global Markets, and the international A&H and life insurance business of Combined Insurance. ACE International, our ACE INA network of indigenous retail insurance operations, maintains a presence in every major insurance market in the world and is organized geographically along product lines that provide dedicated underwriting focus to customers. ACE Global Markets, our London-based excess and surplus lines business that includes Lloyd’s Syndicate 2488 (2008 capacity of £330 million ($599 million)), offers an extensive product range through its unique parallel distribution of products via ACE European Group Limited (AEGL) and Lloyd’s Syndicate 2488. ACE provides funds at Lloyd’s to support underwriting by Syndicate 2488 which is managed by ACE Underwriting Agencies Limited. AEGL, our London-based, Financial Services Authority-U.K. regulated company, underwrites U.K. and Continental Europe insurance and reinsurance business. The reinsurance operation of ACE Global Markets is included in the Global Reinsurance segment. Combined Insurance distributes specialty individual accident and supplemental health and life insurance products targeted to middle income consumers in Europe and Asia Pacific. The Insurance – Overseas General segment has four regions of operations: the ACE European Group (which comprises ACE Europe and ACE Global Markets branded business), ACE Asia Pacific, ACE Far East, and ACE Latin America. Companies within the Insurance – Overseas General segment write a variety of insurance products including property, casualty, professional lines (Directors & Officers and Errors & Omissions), marine, energy, aviation, political risk, specialty personal lines, consumer lines products, A&H (principally accident and supplemental health), and life insurance products.
The Global Reinsurance segment represents ACE’s reinsurance operations comprising ACE Tempest Re Bermuda, ACE Tempest Re USA, ACE Tempest Re Europe, and ACE Tempest Re Canada. These divisions provide a broad range of property catastrophe, casualty, and property reinsurance coverages to a diverse array of primary P&C companies.
The Life Insurance and Reinsurance segment includes the operations of ACE Tempest Life Re (ACE Life Re), ACE International Life, and the domestic A&H and life business of Combined Insurance. ACE Life Re provides reinsurance coverage to other life insurance companies as well as marketing traditional life reinsurance products and services for the individual life business. ACE International Life provides traditional life insurance protection, investments, and savings products to individuals in several countries including China, Egypt, Thailand, the United Arab Emirates, Vietnam, and various Latin American countries. Combined Insurance distributes specialty
28
individual accident and supplemental health and life insurance products targeted to middle income consumers in the U.S. and Canada.
Corporate and Other (Corporate) includes ACE Limited, ACE Group Management and Holdings Ltd., ACE INA Holdings, Inc., and intercompany eliminations. In addition, Corporate includes the Company’s proportionate share of Assured Guaranty Ltd.’s earnings reflected in Other (income) expense. Included in Losses and loss expenses are losses incurred in connection with the commutation of ceded reinsurance contracts that resulted from a differential between the consideration received from reinsurers and the related reduction of reinsurance recoverable, principally related to the time value of money. Due to the Company’s initiatives to reduce reinsurance recoverable balances and thereby encourage such commutations, losses recognized in connection with the commutation of ceded reinsurance contracts are generally not considered when assessing segment performance and, accordingly, are directly allocated to Corporate. Additionally, the Company does not consider the development of loss reserves related to the September 11 tragedy in assessing segment performance as these loss reserves are managed by Corporate. As such, the effect of the related loss reserve development on net income is reported within Corporate.
For segment reporting purposes, certain items have been presented in a different manner than in the consolidated financial statements. The following tables summarize the operations by segment for the periods indicated.
Statement of Operations by Segment
For the Three Months Ended September 30, 2008
Underwriting (loss) income
Net investment income (loss)
Income tax expense (benefit)
Net (loss) income
29
For the Three Months Ended September 30, 2007
Underwriting income (loss)
Net income (loss)
For the Nine Months Ended September 30, 2008
30
For the Nine Months Ended September 30, 2007
Underwriting assets are reviewed in total by management for purposes of decision making. The Company does not allocate assets to its segments.
The following table shows the impact of the catastrophe losses by segment for the three months ended September 30, 2008.
Catastrophe Loss Charges - By Event
Gross loss
Net loss
Hurricane – Gustav
Hurricane – Ike
Other (1)
Reinstatement premiums (earned) expensed
Total before income tax
Income tax benefit
Total after income tax
(1)
Includes adjustments to catastrophe losses reported in the three months ended June 30, 2008, related to Midwest floods.
31
The following tables summarize the net premiums earned for each segment by product offering for the periods indicated.
Three Months Ended September 30, 2008
Three Months Ended September 30, 2007
Nine Months Ended September 30, 2008
Nine Months Ended September 30, 2007
32
14. Earnings per share
The following table sets forth the computation of basic and diluted earnings per share for the periods indicated.
Numerator:
Dividends on Preferred Shares
Net income available to holders of Common Shares
Denominator:
Denominator for basic earnings per share:
Weighted average shares outstanding
Denominator for diluted earnings per share:
Share-based compensation plans
Adjusted weighted average shares outstanding and assumed conversions
Basic earnings per share:
Diluted earnings per share:
Excluded from adjusted weighted average shares outstanding and assumed conversions is the impact of securities that would have been anti-dilutive during the respective periods. For the three months ended September 30, 2008 and 2007, the potential anti-dilutive share conversions were 892,049 and 255,163, respectively. For the nine months ended September 30, 2008 and 2007, the potential anti-dilutive share conversions were 545,331 and 268,501, respectively.
15. Information provided in connection with outstanding debt of subsidiaries
The following tables present condensed consolidating financial information at September 30, 2008, and December 31, 2007, and for the three and nine months ended September 30, 2008 and 2007, for ACE Limited (the Parent Guarantor) and its “Subsidiary Issuer”, ACE INA Holdings, Inc. The Subsidiary Issuer is an indirect 100 percent owned subsidiary of the Parent Guarantor. Investments in subsidiaries are accounted for by the Parent Guarantor under the equity method for purposes of the supplemental consolidating presentation. Earnings of subsidiaries are reflected in the Parent Guarantor’s investment accounts and earnings. The Parent Guarantor fully and unconditionally guarantees certain of the debt of the Subsidiary Issuer.
33
Condensed Consolidating Balance Sheet at September 30, 2008
Investments in subsidiaries
Due from (to) subsidiaries and affiliates, net
Other liabilities
Includes all other subsidiaries of ACE Limited and intercompany eliminations.
(2)
Includes ACE Limited parent company eliminations.
34
Condensed Consolidating Balance Sheet at December 31, 2007
35
Condensed Consolidating Statement of Operations
Equity in earnings of subsidiaries
Policy acquisition costs and administrative expenses
Income tax expense
36
37
Condensed Consolidating Statement of Cash Flows
Net cash flows from (used for) operating activities
Advances (to) from affiliates
Cash flows (used for) from financing activities
Net cash flows (used for) from financing activities
Net increase (decrease) in cash
38
Cash flows from (used for) investing activities
Advances from (to) affiliates
Net cash flows from (used for) investing activities
Repayment of short-term debt
39
16. Subsequent events
On October 1, 2008, the Company repaid the $250 million ACE US Holdings unsecured senior notes due October 2008 and executed reverse repurchase agreements, under which $250 million is payable in December 2008.
40
The following is a discussion of our results of operations, financial condition, and liquidity and capital resources as of and for the three and nine months ended September 30, 2008. Our results of operations and cash flows for any interim period are not necessarily indicative of our results for the full year. This discussion should be read in conjunction with our Consolidated Financial Statements and related notes, our Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2007 and “Risk Factors” set forth in Item 1A of Part II of this report as well as in Item 1A. of Part I of our 2007 Annual Report on Form 10-K and in Item 1A. of Part II of our quarterly reports on Form 10-Q for the quarters ended June 30, 2008, and March 31, 2008.
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. Any written or oral statements made by us or on our behalf may include forward-looking statements that reflect our current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks, uncertainties and other factors that could, should potential events occur, cause actual results to differ materially from such statements. These risks, uncertainties, and other factors (which are described in more detail elsewhere herein and in other documents we file with the Securities and Exchange Commission (SEC)) include but are not limited to:
developments in global financial markets, including changes in interest rates, stock markets and other financial markets, the cost and availability of financing, and foreign currency exchange rate fluctuations, which could affect our statement of operations, investment portfolio, and financing plans;
general economic and business conditions resulting from recent declines in the stock markets and tightening of credit;
losses arising out of natural or man-made catastrophes such as hurricanes, typhoons, earthquakes, floods, or terrorism which could be affected by:
the number of insureds and ceding companies affected,
the amount and timing of losses actually incurred and reported by insureds,
the impact of these losses on our reinsurers and the amount and timing of reinsurance recoverables actually received,
the cost of building materials and labor to reconstruct properties following a catastrophic event, and
complex coverage and regulatory issues such as whether losses occurred from storm surge or flooding and related lawsuits;
actions that rating agencies may take from time to time, such as changes in our claims-paying ability, financial strength or credit ratings or placing these ratings on credit watch negative or the equivalent;
global political conditions, the occurrence of any terrorist attacks, including any nuclear, radiological, biological, or chemical events, or the outbreak and effects of war, and possible business disruption or economic contraction that may result from such events;
the ability to collect reinsurance recoverables, credit developments of reinsurers, and any delays with respect thereto and changes in the cost, quality, or availability of reinsurance;
the occurrence of catastrophic events or other insured or reinsured events with a frequency or severity exceeding our estimates;
actual loss experience from insured or reinsured events and the timing of claim payments;
the uncertainties of the loss-reserving and claims-settlement processes, including the difficulties associated with assessing environmental damage and asbestos-related latent injuries, the impact of aggregate-policy-coverage limits, and the impact of bankruptcy protection sought by various asbestos producers and other related businesses and the timing of loss payments;
41
judicial decisions and rulings, new theories of liability, legal tactics, and settlement terms;
the effects of public company bankruptcies and/or accounting restatements, as well as disclosures by and investigations of public companies relating to possible accounting irregularities, and other corporate governance issues, including the effects of such events on:
the capital markets,
the markets for directors and officers and errors and omissions insurance, and
claims and litigation arising out of such disclosures or practices by other companies;
uncertainties relating to governmental, legislative and regulatory policies, developments, actions, investigations and treaties, which, among other things, could subject us to insurance regulation or taxation in additional jurisdictions or affect our current operations;
the actual amount of new and renewal business, market acceptance of our products, and risks associated with the introduction of new products and services and entering new markets, including regulatory constraints on exit strategies;
the competitive environment in which we operate, including trends in pricing or in policy terms and conditions, which may differ from our projections and changes in market conditions that could render our business strategies ineffective or obsolete;
Combined Insurance Company of America (Combined Insurance) and its subsidiaries, or any other acquisitions made by us, performing differently than expected or the failure to realize anticipated expense-related efficiencies from acquisitions;
risks associated with our re-domestication to Switzerland, including possible reduced flexibility with respect to certain aspects of capital management and the potential for additional regulatory burdens;
the potential impact from government-mandated insurance coverage for acts of terrorism;
the availability of borrowings and letters of credit under our credit facilities;
changes in the distribution or placement of risks due to increased consolidation of insurance and reinsurance brokers;
material differences between actual and expected assessments for guaranty funds and mandatory pooling arrangements;
the effects of investigations into market practices in the property and casualty (P&C) industry;
changing rates of inflation and other economic conditions, for example, recession;
the amount of dividends received from subsidiaries;
loss of the services of any of our executive officers without suitable replacements being recruited in a reasonable time frame;
the ability of our technology resources to perform as anticipated; and
management’s response to these factors and actual events (including, but not limited to, those described above).
The words “believe,” “anticipate,” “estimate,” “project,” “should,” “plan,” “expect,” “intend,” “hope,” “will likely result,” or “will continue,” and variations thereof and similar expressions, identify forward-looking statements. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. We undertake no obligation to publicly update or review any forward-looking statements, whether as a result of new information, future events or otherwise.
42
Overview
ACE Limited (“ACE”) and its direct and indirect subsidiaries (collectively, ACE, the Company, we, us or our) are a global insurance and reinsurance organization, servicing the insurance needs of commercial and individual customers in more than 140 countries and jurisdictions. Our product and geographic diversification differentiates us from the vast majority of our competitors and has been a source of stability during periods of industry volatility. Our long-term business strategy focuses on sustained growth in book value achieved through a combination of underwriting and investment income. By doing so, we provide value to our clients and shareholders through the utilization of our substantial capital base in the insurance and reinsurance markets.
Redomestication to Zurich, Switzerland
On July 10, 2008, and July 14, 2008, our shareholders approved the transfer of our domicile from the Cayman Islands to Zurich in Switzerland, our new jurisdiction of incorporation (the Continuation). As a result of the Continuation, we are deregistered in the Cayman Islands and are now subject to Swiss corporate law. We do not expect the re-domestication to have a material impact on the way we operate our business or on our financial condition or results of operations.
In connection with the Continuation, we changed the currency in which the par value of Ordinary Shares is stated from U.S. dollars to Swiss francs and increased the par value of Ordinary Shares from $0.041666667 to CHF 33.74. Upon the effectiveness of the Continuation, our Ordinary Shares became Common Shares. All Common Shares are registered common shares under Swiss corporate law. Notwithstanding the change of the currency in which the par value of Common Shares is stated, we continue to use U.S. dollars as our reporting and functional currency for preparing our Consolidated Financial Statements. For purposes of the Consolidated Financial Statements, the increase in par value was accomplished by a corresponding reduction first to retained earnings and second to additional paid-in capital to the extent that the increase in par value exhausted retained earnings at the date of the Continuation. On September 30, 2008, we reduced the par value by CHF 0.30 to CHF 33.44 in connection with the quarterly dividend declaration. For the foreseeable future, we expect to pay dividends as a repayment of share capital in the form of a reduction in par value or qualified paid-in capital, which would not be subject to Swiss withholding tax. Refer to “Liquidity and Capital Resources” below and Note 11 to our Consolidated Financial Statements for more information.
The Combined Insurance Acquisition
On April 1, 2008, ACE acquired all of the outstanding shares of Combined Insurance and certain of its subsidiaries from AON Corporation for $2.56 billion. ACE financed the transaction through a combination of available cash, the use of reverse repurchase agreements, and new private and public long-term debt (refer to “Capital Resources” for more information). Combined Insurance, which was founded in 1919 and headquartered in Glenview, Illinois, is a leading underwriter and distributor of specialty individual accident and supplemental health insurance products targeted to middle income consumers in the U.S., Europe, Canada, and Asia Pacific. Combined Insurance serves more than four million policyholders worldwide. This acquisition has diversified our accident and health (A&H) distribution capabilities by adding thousands of agents, while almost doubling our A&H franchise. We believe this will provide significant long-term growth opportunities. Our A&H operations have represented an increasing portion of our business in recent years. Within our A&H operations (including Combined Insurance), our primary business is personal accident. We are not in the primary health care business. Our products include, but are not limited to, accidental death, accidental disability, supplemental medical, hospital indemnity, and income protection coverages. With respect to our supplemental medical and hospital indemnity products, we typically pay fixed amounts for claims and are, therefore, insulated from rising health care costs. ACE recorded the acquisition using the purchase method of accounting. The interim Consolidated Financial Statements include the results of Combined Insurance beginning April 1, 2008. The acquisition generated $936 million of goodwill and other intangible assets, based on ACE’s preliminary purchase price allocation. Results from Combined Insurance’s North American operations are included in ACE’s Life Insurance and Reinsurance segment and the results from Combined Insurance’s international operations are included in ACE’s Insurance – Overseas General segment. Refer to Note 3 to our Consolidated Financial Statements for more information.
43
Market Conditions
The property and casualty insurance industry began 2008 with excess underwriting capacity, as defined by availability of capital. Since then, natural catastrophes and financial market losses have destroyed a great deal of this excess capital. Additionally, downgrades and government ownership are impairing the ability of a number of companies to deploy their capital and operate in the same manner as they have in the past. Moreover, the cost of debt and equity capital has soared for all industries globally, including the insurance and reinsurance industry, and we believe this will be true for some time to come.
Refer to “Overview” in our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2007 (2007 Form 10-K).
Fair Value Measurements
We partially adopted the provisions of Financial Accounting Standard No. 157, Fair Value Measurements (FAS 157) on January 1, 2008. FAS 157 defines fair value as the price to sell an asset or transfer a liability in an orderly transaction between market participants and establishes a three-level valuation hierarchy in which inputs into valuation techniques used to measure fair value are classified. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. Inputs in Level 1 are unadjusted quoted prices for identical assets or liabilities in active markets. Level 2 includes inputs other than quoted prices included within Level 1 that are observable for assets or liabilities either directly or indirectly. Level 2 inputs include, among other items, quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, and inputs other than quoted prices that are observable for the asset or liability such as interest rates and yield curves. Level 3 inputs are unobservable and reflect our judgments about assumptions that market participants would use in pricing an asset or liability. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
While the Company obtains values for the majority of the investment securities it holds from one or more pricing services, it is ultimately management’s responsibility to determine whether the values obtained and recorded in the financial statements are representative of fair value. We periodically update our understanding of the methodologies used by our pricing services in order to validate that the prices obtained from those services are consistent with FAS 157 valuation principles. Based on our understanding of the methodologies used by our pricing services, all investments have been valued in accordance with FAS 157. We do not typically adjust prices obtained from pricing services.
Volatility and widening credit spreads during the quarter ended September 30, 2008, adversely affected the values of certain of our securities. However, we believe there was sufficient market activity to price securities under FAS 157 in a manner consistent with prior periods.
At September 30, 2008, our Level 3 assets represented approximately four percent of our assets that are measured at fair value and two percent of our total assets. Our Level 3 liabilities represented approximately 99 percent of our liabilities that are measured at fair value and less than one percent of our total liabilities at September 30, 2008. During the quarter ended September 30, 2008, we transferred $14 million out of Level 3. The following is a description of the valuation measurements used for our financial instruments (Levels 1, 2, and 3) carried or disclosed at fair value, as well as the general classification of such financial instruments pursuant to the valuation hierarchy.
Fixed maturities with active markets such as U.S. Treasury and agency securities are classified within Level 1 as fair values are based on quoted market prices. For fixed maturities that trade in less active markets, including corporate and municipal securities, fair values are based on the output of “pricing matrix models”, the significant inputs into which include, but are not limited to, yield curves, credit
44
risks and spreads, measures of volatility, and prepayment speeds. These fixed maturities are classified within Level 2. Our pricing incorporates back-testing of valuation techniques as a standard part of our process. Fixed maturities for which pricing is unobservable are classified within Level 3.
Short-term investments, which comprise securities due to mature within one year of the date of purchase, that are traded in active markets are classified within Level 1 as fair values are based on quoted market prices. Securities such as commercial paper and discount notes are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their cost approximating par value.
Fair values for other investments, principally other direct equity investments, investment funds, and limited partnerships, are based on the net asset value or financial statements and are included within Level 3. Equity securities and fixed maturities held in rabbi trusts maintained by ACE for deferred compensation plans, and included in Other investments, are classified within the valuation hierarchy on the same basis as our other equity securities and fixed maturities.
For actively traded investment derivative instruments, including futures, options, and exchange-traded forward contracts, we obtain quoted market prices to determine fair value. As such, these instruments are included within Level 1. Forward contracts that are not exchange-traded are priced using a pricing matrix model principally employing observable inputs and, as such, are classified within Level 2. Our position in interest rate and credit default swaps is typically classified within Level 3.
We maintain positions in other derivative instruments including option contracts designed to limit long-term exposure to a severe equity market decline or decrease in interest rates, which would cause an increase in expected claims and, therefore, reserves for guaranteed minimum death benefits (GMDB) and guaranteed minimum income benefits (GMIB) reinsurance business. The fair value of the majority of our positions in other derivative instruments is based on significant observable inputs including equity security and interest rate indices. Accordingly, these are classified within Level 2. Our position in credit default swaps is typically included within Level 3.
For GMIB reinsurance, we estimate fair value using an internal valuation model which includes the use of management estimates and current market information. The cumulative effect of partially adopting FAS 157 resulted in a reduction to retained earnings of $4 million related to an increase in risk margins included in the valuation of certain GMIB contracts. The fair value depends on a number of inputs, including changes in interest rates, changes in equity markets, changes in market volatility, changes in policyholder behavior, and changes in policyholder mortality. The model and related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information, such as market conditions and demographics of in-force annuities. The two most significant policyholder behavior assumptions include lapse rates and annuitization rates using the guaranteed benefit (GMIB annuitization rate). A lapse rate is the percentage of in-force policies surrendered in a given calendar year. All else equal, as lapse rates increase, ultimate claim payments will decrease. The GMIB annuitization rate is the percentage of policies for which the customer will elect to annuitize using the guaranteed benefit provided under the GMIB. All else equal, as GMIB annuitization rates increase, ultimate claim payments will increase, subject to treaty claim limits. Assumptions regarding lapse rates and GMIB annuitization rates differ by treaty but the underlying methodology to determine rates applied to each treaty is comparable. The assumptions regarding lapse and GMIB annuitization rates determined for each treaty are based on a dynamic calculation that uses several underlying factors. The effect of changes in key market factors on assumed lapse and annuitization rates reflect emerging trends where data is available from cedants. For treaties with limited experience, rates are established in line with industry estimates. We view our variable annuity reinsurance business as having a similar risk profile to that of catastrophe reinsurance, with the probability of a cumulative long-term economic net loss
45
relatively small. However, in the short-run, adverse changes in market factors will have an adverse impact on both life underwriting income and our net income, which may be material. Because of the significant use of unobservable inputs including policyholder behavior, GMIB reinsurance is classified within Level 3. Refer to “GMIB/GMDB Reinsurance”, below, and to the “Critical Accounting Estimates – Guaranteed minimum income benefits derivatives” and “Quantitative and Qualitative Disclosures about Market Risk – Reinsurance of GMIB and GMDB guarantees” in our 2007 Form 10-K.
Change in Assumption
As a part of the quarterly reserve review we made a change to the volatility assumption used to calculate the fair value of the GMIB liabilities. To be more in-line with market valuations of GMIB liabilities, we changed the volatility assumption to be consistent with using short-term market-consistent implied volatilities grading to long-term historical average volatilities over time. The impact of this change was a reduction in the fair value of the GMIB liabilities of approximately $64 million.
Note 4 to our Consolidated Financial Statements presents a break-down of our financial instruments carried or disclosed at fair value by valuation hierarchy as well as a roll-forward of Level 3 financial instruments for the three and nine months ended September 30, 2008.
GMIB/GMDB Reinsurance
Our net income is directly impacted by changes in the reserves calculated in connection with the reinsurance of variable annuity guarantees, primarily GMDB and GMIB. These reserves are calculated in accordance with AICPA Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Non-traditional Long-duration Contracts and for Separate Accounts (SOP 03-1). Changes in these reserves are reflected as future policy benefits, which is included in life underwriting income. In addition, our net income is directly impacted by the change in the fair value of the GMIB liability, which is classified as a derivative according to Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). The fair value liability established for a GMIB reinsurance contract represents the difference between the fair value of the contract and the SOP 03-1 reserves. Changes in the fair value of the GMIB liability, net of associated changes in the calculated SOP 03-1 reserves, are reflected as realized gains or losses.
During the three and nine months ended September 30, 2008, we recorded $189 million and $319 million of net realized losses, respectively, in connection with changes in reported liabilities on GMIB reinsurance carried at fair value. For the quarter ended September 30, 2008, the change was caused by unfavorable market conditions, including a decrease in long-term interest rates, and an increase in implied volatility for both equity markets and interest rates. The change for the nine months ended September 30, 2008, which resulted in net realized losses, was caused by adverse financial market conditions, primarily poor equity market performance.
The SOP 03-1 reserves and fair value liability calculations are directly affected by market factors, the most significant of which are equity levels, interest rate levels, and implied equity volatilities. The table below shows the sensitivity, as of September 30, 2008, of the SOP 03-1 reserves and fair value liability associated with the variable annuity guarantee reinsurance portfolio. Note that the change in the fair value liability includes offsetting changes in the fair value of specific derivative instruments held to partially offset the risk in the variable annuity guarantee reinsurance portfolio. These derivatives do not receive hedge accounting treatment.
Increase in SOP 03-1 reserves/ reduction in life underwriting income
Increase in fair value liability, net
Reduction in net income
46
The table above demonstrates, for example, that a 10 percent decrease in worldwide equities would reduce our life underwriting income by $36 million and cause a net realized loss of $99 million, for a total reduction in net income of $135 million. The sensitivity of the liabilities to market risks will change over time and these changes could be significant. Equivalent opposite changes to the above market factors would have similar but not identical positive impacts. Factors affecting the sensitivities include changes in account values and guaranteed values of the variable annuity policies reinsured, receipt of reinsurance premium and payment of reinsurance claims, policyholder deaths, lapses, annuitization withdrawals, and asset reallocation, the addition of new reinsurance treaties, changes in equity and interest rate levels and volatility, model changes and improvements, and the passage of time.
Capital
As of September 30, 2008, the capital required to support the variable annuity guaranty business is approximately $400 million. If the Standard & Poor’s (S&P) 500 Index were to drop to a level of 900, the additional capital required net of the increase in value of currently held hedge assets would be approximately $250 million. Excess capital currently existing within ACE Tempest Life Reinsurance Ltd. is more than sufficient to meet this demand.
Risk Management
ACE Tempest Life Re employs a multi-layered strategy to manage the financial market and policyholder behavior risks embedded in the reinsurance of variable annuity guarantees. Risk management begins with underwriting a prospective client and guarantee design, with particular focus on protecting ACE’s position from policyholder options that, because of anti-selective behavior, could adversely impact our obligation (e.g. guarantees that allow policyholders the option to select ratchet points throughout the year rather than contracts that provide for ratchets annually at policy anniversary).
The second layer of risk management is the structure of the reinsurance contracts. All variable annuity guarantee reinsurance contracts include some form of annual or aggregate claim limit(s). The exact limits vary by contract but some examples of typical contract provisions include:
The third layer of risk management is the hedging strategy which is focused on mitigating long-term economic losses at a portfolio level and is best described as semi-static. As of September 30, 2008 ACE Tempest Life Re owned financial market instruments as part of the hedging strategy worth $109.9 million, up from $81.6 million at June 30, 2008. The instruments are with counterparties rated AA- or better by Standard & Poor’s and are collateralized daily.
We also limit the aggregate amount of variable annuity reinsurance guarantee risk we are willing to assume – ACE Tempest Life Re has not quoted new or renewal variable annuity transactions in 2008 and the aggregate exposure is currently decreasing through policyholder decrements at a rate of 5%-10% annually.
Net Amount at Risk
The Net Amount at Risk (NAR) for variable annuity death benefit reinsurance is calculated as the excess of the guaranteed values over the account values of the policies we reinsure, assuming all policyholders die immediately, or at such time as maximizes the loss to ACE under our claim limits. At September 30, 2008, the NAR associated with our variable annuity death benefit reinsurance was $6.5 billion. Using our current mortality assumptions we expect approximately $110 million of claims and $106 million of premium over the next 12 months. At current market levels we would expect claims to increase marginally year-on-year due to the aging population and premium to remain relatively steady (ignoring decrements). Actual claims will vary with mortality experience.
47
The NAR for variable annuity living benefit reinsurance is calculated as the total claims payable if all policies reinsured had already reached the end of their “waiting periods” and all policyholders elected to utilize their available living benefits in the manner most disadvantageous to ACE, adjusting for our claim limits. Actual claims cannot occur for any reinsured policy until it has reached the end of its “waiting period”. The vast majority of policies we reinsure reach the end of their “waiting periods” in 2013 or later, as shown in the table below.
Year of first annuitization eligibility
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018+
At September 30, 2008, the NAR associated with our variable annuity living benefit reinsurance was $539 million. This can be interpreted in conjunction with the chart above to indicate that at current market levels living benefit claims for policies becoming eligible in a calendar year would be limited to approximately $539 million multiplied by the percentage of living benefit account values becoming eligible in that year. We expect approximately $2 million of claims and $137 million of premium over the next 12 months. At current market levels we would expect similar levels of claims and premium through 2012 (ignoring decrements).
To be clear, the NAR is solely the potential amount of total claims payments assuming mortality and policyholder behavior are the least favorable to the Company and does not reflect the benefits of future premiums, existing reserves, other policyholder decrements or the impact of discounting.
Collateral
In order for its US-domiciled clients to obtain statutory reserve credit ACE Tempest Life Re holds collateral on behalf of its clients in the form of qualified assets in trust or letters of credit, equal to their statutory ceded reserves. ACE Tempest Life Re maintains sufficient qualified assets to meet its funding requirements.
48
Mortgage-backed and Asset-backed Securities
Our mortgage-backed securities represent 32 percent of our fixed income portfolio at September 30, 2008 and are predominantly AAA rated. Our sub-prime portfolio represented less than one percent of our investment portfolio at September 30, 2008, and we hold no collateralized debt obligations or collateralized loan obligations. We provide no credit default protection. Additional details on the mortgage-backed and asset-backed components of our investment portfolio at September 30, 2008, are provided below:
Market Value
Residential mortgage-backed (RMBS)
GNMA
FNMA
FHLMC
Total agency RMBS
Non-agency RMBS
Total RMBS
Commercial mortgage-backed
Total mortgage-backed securities
Asset-backed securities
Sub-prime
Credit Cards
Autos
Total asset-backed securities
Amortized Cost
49
Consolidated Operating Results – Three and Nine Months Ended September 30, 2008 and 2007
As discussed previously, on April 1, 2008, we acquired all outstanding shares of Combined Insurance and certain of its subsidiaries. As such, consolidated operating results for the three and nine months ended September 30, 2008, include the results of the acquired Combined Insurance business from April 1, 2008.
Our net income was significantly impacted by net realized losses in the three and nine months ended September 30, 2008. These losses were primarily related to our fixed income and equity portfolios and are largely due to the widening credit spreads in our high quality corporate bond portfolio. Refer to “Net Realized and Unrealized Gains (Losses)” and “Investments”. In addition, we recorded $411 million and $500 million in net catastrophe-related pre-tax charges in the three and nine months ended September 30, 2008, respectively, compared with $21 million and $136 million in the prior year periods, respectively. For the three and nine months ended September 30, 2008, our catastrophe losses were primarily related to Hurricanes Gustav and Ike and floods in the U.S.
Net premiums written, which reflect the premiums we retain after purchasing reinsurance protection, increased 17 percent and 10 percent in the three and nine months ended September 30, 2008, compared with the prior year periods. Net premiums written were bolstered by the inclusion of the acquired Combined Insurance business which added $373 million and $777 million to our total net premiums written in the three and nine months ended September 30, 2008, respectively. Our international operations benefited from growth in A&H business and favorable foreign exchange impact due to the strengthening of several major currencies, particularly the euro, relative to the U.S. dollar. In addition, our recently acquired ACE Private Risk Services unit added $27 million and $174 million to our net premiums written in the three and nine months ended September 30, 2008, respectively. The nine months ended September 30, 2007, included $168 million in net premiums written and earned relating to a one-time large assumed loss portfolio transfer written in the first quarter of 2007. Overall, we have continued to experience very competitive conditions across most lines of business and regions of operation, offset by a favorable foreign exchange impact and growth in our international A&H business.
50
The following table provides a consolidated breakdown of net premiums earned by line of business for the periods indicated.
Property and all other
Casualty
Subtotal
Personal accident (A&H)
Life
Net premiums earned reflect the portion of net premiums written that were recorded as revenues for the period as the exposure period expires. Net premiums earned increased 15 percent and 8 percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. As discussed, the increase was primarily related to the inclusion of the acquired Combined Insurance business which added $379 million and $780 million to our total net premiums earned in the three and nine months ended September 30, 2008, respectively. ACE Private Risk Services added $31 million and $104 million to our net premiums earned in the three and nine months ended September 30, 2008, respectively. The nine months ended September 30, 2007, included $168 million in net premiums earned relating to a one-time large assumed loss portfolio transfer (included under casualty in the prior year periods). As noted above, our A&H business continues to report growth.
Net investment income increased six percent and nine percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. This increase was primarily due to the investment of positive operating cash flows which have resulted in a higher overall average invested asset base. Refer to “Net Investment Income” and “Investments”.
In evaluating our segments excluding Life Insurance and Reinsurance, we use the combined ratio, the loss and loss expense ratio, the policy acquisition cost ratio, and the administrative expense ratio. We calculate these ratios by dividing the respective expense amounts by net premiums earned. We do not calculate these ratios for the Life Insurance and Reinsurance segment as we do not use these measures to monitor or manage that segment. The combined ratio is determined by adding the loss and loss expense ratio, the policy acquisition cost ratio, and the administrative expense ratio. A combined ratio under 100 percent indicates underwriting income and a combined ratio exceeding 100 percent indicates underwriting losses.
The following table shows our consolidated loss and loss expense ratio, policy acquisition ratio, administrative expense ratio, and combined ratio for the periods indicated.
Loss and loss expense ratio
Policy acquisition cost ratio
Administrative expense ratio
Combined ratio
51
The following table shows the impact of catastrophe losses, prior period development, and other significant events on our loss and loss expense ratio for the periods indicated.
Loss and loss expense ratio, as reported
Catastrophe losses
Prior period development
Large assumed loss portfolio transfer
Loss and loss expense ratio, adjusted
The table below shows the impact of the catastrophe losses by segment for the quarter ended September 30, 2008.
Other(1)
Effective tax rate
Includes adjustments to catastrophe losses reported in the second quarter of 2008 related to Midwest floods.
Prior period development arises from changes to loss estimates recognized in the current year that relate to loss reserves first reported in previous calendar years and excludes the effect of losses from the development of earned premium from previous accident years. We experienced $277 million and $562 million of net favorable prior period development in the three and nine months ended September 30, 2008, respectively. This compares with net favorable prior period development of $70 million and $128 million in the three and nine months ended September 30, 2007, respectively. The prior period development was the net result of several underlying favorable and adverse movements. Refer to Prior Period Development.
Overall, the loss and loss expense ratio, adjusted, has increased over the prior year periods. This increase is partially offset by the favorable impact of the increasing mix of A&H business, which experiences lower loss ratios relative to P&C business. Additionally, the nine months ended September 30, 2007, was negatively impacted by the large assumed loss portfolio transfer which was written at a higher loss ratio compared with other types of business. This contract added approximately 0.7 percentage points to the prior period’s loss and loss expense ratio.
52
Our policy acquisition costs include commissions, premium taxes, underwriting, and other costs that vary with, and are primarily related to, the production of premium. Administrative expenses include all other operating costs. Our policy acquisition cost ratio increased significantly in the three and nine months ended September 30, 2008, compared with the prior year periods. The increase was primarily related to the growth in A&H business, including the recently acquired Combined Insurance business, which is predominantly A&H. A&H business typically requires higher commission rates than traditional P&C business. For the nine months ended September 30, 2008, the increase in policy acquisition costs also included the impact of higher acquisition costs on ACE Westchester’s crop/hail business, reflecting more profitable crop/hail results on final settlement. This generated a higher profit share commission which added approximately 0.4 percentage points to our policy acquisition cost ratio in the nine months ended September 30, 2008. Additionally, for the three and nine months ended September 30, 2008, we experienced higher costs due to the inclusion of the recently acquired ACE Private Risk Services unit which typically generates a higher acquisition cost ratio than our commercial P&C business. Our administrative expenses increased in the three and nine months ended September 30, 2008, compared with the prior year periods, primarily due to the inclusion of administrative expenses related to the recently acquired Combined Insurance and ACE Private Risk Services.
Our effective income tax rate, which we calculate as income tax expense divided by income before income tax, is dependent upon the mix of earnings from different jurisdictions with various tax rates. A change in the geographic mix of earnings would change the effective income tax rate. The three and nine months ended September 30, 2008, were adversely impacted by large realized losses on investments and derivatives, as well as catastrophe losses which were incurred primarily in higher-tax paying jurisdictions. Our effective tax rate on catastrophe losses was 26 percent in the three months ended September 30, 2008. We incurred an income tax benefit in the quarter ended September 30, 2008. Our effective tax rate was 19 percent in the nine months ended September 30, 2008. This compares with an effective tax rate of 17 percent and 18 percent in the three and nine months ended September 30, 2007, respectively.
Prior Period Development
The favorable prior period development of $277 million and $70 million during the quarters ended September 30, 2008 and 2007, respectively, was the net result of several underlying favorable and adverse movements. In the sections following the table below, significant prior period movements within each reporting segment by claim-tail attribute are discussed in more detail. Long-tail lines include lines such as workers’ compensation, general liability, and professional liability, while short-tail lines include lines such as most property lines, energy, personal accident, aviation, and marine. The following table summarizes prior period development, (favorable) and adverse, by segment and claim-tail attribute for the periods indicated.
2007
53
Insurance – North American**
Global Reinsurance***
Insurance – North American experienced $103 million of net favorable prior period development in the quarter ended September 30, 2008, compared with net adverse prior period development of $4 million in the prior year quarter. The net prior period development for the quarter ended September 30, 2008, was the net result of underlying adverse and favorable movements.
Net favorable development of $73 million on long-tail business including:
Net adverse development totaling less than $1 million in our national accounts portfolio but comprised of several underlying parts, two of which are described here. First, $21 million of adverse development relating to 2004 and prior accident years as a result of a reconciliation review of deductible recoveries processed against workers’ compensation claims on high deductible contracts, primarily those with aggregate limits. The change was driven by identification of contracts where deductible recoveries continued to be processed despite the presence of an aggregate limit on the insured’s exposure. Second, favorable development of $13 million relating to the 1999-2002 accident years primarily on a block of runoff programs comprising general liability, auto liability, and workers’ compensation product coverages. The favorable development was a result of lower than expected paid and case incurred development observed in the most recent reserve review which resulted in lower selected ultimate loss projections.
Adverse development of $29 million on our portfolio of Defense Base Acts workers’ compensation coverage (covers U.S. government employees overseas). We experienced higher than expected incurred loss development since the last reserve study concentrated in the 2006 and 2007 accident years. The majority of the development was related to increases in case reserves on known claims for these accident years, and recorded in the current quarter. These increases were judged to be more than claim acceleration and resulted in significant increases in the 2006 and 2007 accident year ultimate loss projections given the immaturity of the impacted accident years and long-tail nature of the portfolio.
Favorable development of $46 million on our medical risk business, primarily our hospital professional liability portfolio for the 2004 and 2005 accident years. Coverage is provided on a
54
claims-made basis and both paid and case incurred loss activity since our last review have been favorable relative to expected. As these accident periods have matured, we have gradually increased the weight applied to experience-based methods, including the Bornhuetter-Ferguson method, and placing less weight on our initial expected loss ratio method.
Favorable development of $51 million on our long-tail exposures in our Canadian P&C operations, principally arising in the 2005 accident year on excess casualty, umbrella, and directors and officers (D&O) product lines. Actual paid and case incurred loss activity has been lower than expected since our prior analysis. In addition, we have increased the weighting given to experience-based methods from the initial expected loss ratio method as these accident years mature.
Net favorable development of $30 million on short-tail business including:
Favorable development of $29 million on ACE USA’s property business primarily associated with the 2007 accident year and a portfolio of diverse global exposures written on an excess basis. Reported loss activity during the 2008 year, including the current quarter, has been lower than anticipated in our prior review.
Favorable development of $6 million in Canadian P&C operations short-tail lines concentrated in the 2006 and 2007 accident years, covering multiple product lines including property and auto physical damage. Reported loss activity on these product lines was lower than expected.
The net prior period development for the quarter ended September 30, 2007, was the net result of several underlying favorable and adverse movements.
Adverse development of $13 million on long-tail business driven by the following principal changes:
Adverse development on ACE USA long-tail lines due to a correction of a $21 million processing error on high deductible contracts made in 2006 relating to incurred but not reported (IBNR) reserves.
Adverse development of $20 million on ACE Bermuda long-tail professional lines mainly in report years 2001 and 2002 due to revised loss estimates for a number of existing claims that reflect the impact from potential litigation and arbitration following our reassessment of severity for several specific claims during the quarter ended September 30, 2007.
Favorable development of $24 million on ACE Bermuda’s long-tail reinsurance book of business mainly in the 2001 accident year as a result of a settlement notification received in the quarter ended September 30, 2007, that was favorable relative to held reserves.
Favorable development of $8 million on long-tail business in the 1997 accident year because of an adjustment for reserves on a large claim in ACE USA’s U.S. international portfolio.
Favorable development of $9 million on short-tail business driven by the following principal changes:
Adverse development on the 2005 accident year hurricanes in the amount of $34 million on ACE Westchester property ($10 million) and inland marine covers ($11 million) and Financial Services finite reinsurance ($13 million). The changes in estimate were driven by developments in the quarter ended September 30, 2007, on claims arising from a few excess policies that are expected to be settled soon for amounts in excess of our case reserves prompting an adjustment to our projection of ultimate losses during the quarter ended September 30, 2007. The claim handling associated with these hurricanes has involved complex and unique causation and coverage issues. These issues continued to be present at September 30, 2007, and may have a further material adverse impact on our financial results.
Favorable development of $21 million arising from ACE USA’s Global Underwriting Group property business, primarily for the 2004-2006 accident years. Approximately $12 million arose from closure of claims arising from 2004 hurricanes on a more favorable basis than the held
55
reserves. The remaining development was driven by better than expected case incurred development in the 2005 and 2006 accident years relative to our prior estimates which relied more heavily upon loss ratio expectations used in booking initial results.
Favorable development totaling $11 million on a number of short-tail (ACE Energy, ACE Westchester property, and ACE Westchester inland marine) portfolios, where claims emergence and development for the 2006 accident year had been favorable relative to our prior projections as assessed in the quarter ended September 30, 2007.
Insurance – Overseas General experienced $121 million of net favorable prior period development in the quarter ended September 30, 2008, compared with net favorable prior period development of $64 million in the prior year quarter. The net prior period development for the quarter ended September 30, 2008, was the net result of several underlying favorable and adverse movements.
Net favorable development of $69 million on long-tail business including:
Favorable development of $104 million from accident years 2004 and prior in ACE International’s financial lines and casualty (primary and excess) portfolios. The financial lines and primary casualty releases were mainly in accident years 2004 and prior. The excess casualty changes were primarily in accident years 2001 and prior. Actual paid and case incurred loss activity have been lower than expected since our prior analysis. In addition, we have increased the weighting given to experience-based methods from the initial expected loss ratio method as these accident periods mature.
Adverse development of $34 million primarily on accident year 2007 in ACE International financial lines and casualty portfolios following heavier than expected loss emergence. Actual major claim notices received in the current quarter caused loss estimates on U.K. excess casualty and Continental Europe financial lines to be increased. Loss projections for the Italian and French primary casualty portfolios increased following adverse attritional claim activity (i.e. excluding catastrophes and large losses) in Italy and a large loss in France.
Net favorable development of $52 million on short-tail business including:
Favorable development in ACE Global Markets aviation of $18 million, including a release on years-of-account 2000-2002 of $26 million following claim reporting experience that was better than expected and a detailed claims review of actual reported claims. In contrast, more recent years-of-account were strengthened by $8 million, primarily from adverse claim activity in the airport liability book.
Net favorable development of $15 million in ACE International property and A&H lines. This was principally comprised of $10 million of favorable development on accident years 2003-2007, predominantly from a runoff block of excess property business. The block is reviewed annually and favorable emergence on individual case estimates since the last review led to the release. The remaining $5 million favorable development arose on A&H business following favorable loss emergence.
Favorable development on ACE International Specialty of $5 million. This was mainly from the Continental Europe marine book primarily in accident years 2002-2007. This line indicated lower projections due to actual losses being less than expected losses in the quarter. Since this short-tail line predominantly relies on experience-based methods, estimates were reduced for the quarter ended September 30, 2008.
Favorable development of $20 million for the 2004 and 2005 hurricane losses in ACE Global Markets property portfolio following the completion in the current quarter of a detailed review by the claims department of each reported case.
56
Adverse development of $12 million in the quarter due to several major ACE Global Markets energy losses primarily for years-of-account 2006 and 2007. We were notified of one of these losses in the quarter ended September 30, 2008. The remainder of the increase arose on previously notified claims that were subject to a detailed claims review during the quarter ended September 30, 2008, which considered individual event circumstances and their associated coverages.
Favorable development in the ACE Global Markets marine book of $5 million primarily in years-of-account 2005 and 2006 as a result of greater credibility to projections based on reported claims.
The net prior period development for the quarter ended September 30, 2007, was the net result of several underlying favorable and adverse movements:
Favorable development of $31 million on long-tail business driven by the following principal changes:
Favorable development of $44 million primarily in the 2004 and prior accident years for ACE International long-tail casualty and financial lines. This favorable prior period development arose following our annual review of long-tail lines completed in the quarter ended September 30, 2007. The development was driven by a combination of favorable emergence versus expectations over the prior period ended September 30, 2007, and greater credibility being assigned to Bornhuetter-Ferguson projections versus expected loss ratio methods, a common reserve practice, as accident years mature.
Adverse development of $12 million in ACE Global Markets long-tail professional lines, primarily in years-of-account 1999-2003. This adverse prior period development was driven largely by reserve strengthening for one account and revised assumptions regarding reinsurance recoveries on two other accounts.
Favorable development of $33 million on short-tail business driven by the following principal changes:
Favorable development of $15 million on property and fire lines primarily in the 2005 and 2006 accident years in ACE International and years 2005 and prior in ACE Global Markets. The favorable development in the quarter ended September 30, 2007, was driven by lower than anticipated frequency and severity of late reported claim emergence during that quarter and favorable development and settlement of several previously reported large losses.
Favorable development of $14 million in A&H primarily in the 2005 and 2006 accident years in Europe. This favorable prior period development followed the completion of our quarterly reserve analysis and was driven by better than expected loss experience relative to prior reserving assumptions. The favorable experience arose in direct marketing A&H businesses across several countries with no particular underlying claim or loss emergence trend identifiable.
Favorable development of $11 million in marine, primarily in the 2005 and 2006 accident years in both ACE International and ACE Global Markets. This favorable prior period development was largely driven by case reserve reductions booked by the claims department during the quarter ended September 30, 2007, as new information on the claims became available.
Adverse development of $9 million in consumer lines, primarily in the 2000-2006 accident years in ACE International. This adverse development was largely driven by continuing deterioration of homeowner’s warranty business. The adverse development in the quarter ended September 30, 2007, was primarily driven by higher than anticipated development on several key claim metrics underlying the reserve estimate; number of reopened claims, loss adjustment expenses and frequency and severity of late reported claims.
57
Global Reinsurance experienced $53 million of net favorable prior period development in the quarter ended September 30, 2008, compared with $10 million of net favorable prior period development in the prior year quarter. The net prior period development for the quarter ended September 30, 2008, was the net result of several underlying favorable and adverse movements.
Net favorable development of $8 million on long-tail business across a number of lines and years including:
Favorable development of $8 million principally from treaty years 2003 and 2004 in ACE Tempest Re USA and ACE Tempest Re Europe across a number of portfolios (professional liability, D&O, casualty, and medical malpractice). The lower loss estimates arose from the combined impact of continued favorable paid and case incurred loss trends and increased weighting given to experience-based methods away from expectations as these treaty periods mature.
Net favorable development of $45 million on short-tail business across a number of lines and years including:
Favorable prior period development of $18 million on treaty years 2006 and prior in ACE Tempest Re US across several portfolios. The development arose principally on property and the credit & surety line following completion of reserve reviews in the current quarter. The property portfolio benefited from better than expected claim emergence, while the release in the credit & surety line followed a detailed review of claims and associated recoveries, together with favorable loss emergence.
Favorable prior period development of $15 million on treaty years 2006 and prior in ACE Tempest Re Europe across several portfolios, principally property, marine, and energy. This included a $9 million property release on U.S. and international property exposures and reflected lower than anticipated loss emergence.
Net favorable development of $12 million on accident years 2002-2006 in ACE Tempest Re Bermuda’s property catastrophe portfolio of claims from prior catastrophic events. The release followed a current review of each cedant’s coverage terms and reflected lower reported claim development than previously anticipated.
The largest adverse movement was $2 million for long-tail business in the 2002 treaty year due to worse than expected claims development for several quarters preceding the quarter ended September 30, 2007.
The largest favorable movements were related to short-tail lines totaling $12 million. These movements were due to an aggregation of favorable developments across several accident years (primarily 2004-2006) on a number of lines of business in Europe and Bermuda. The favorable development arose from less than expected claims emergence.
Segment Operating Results – Three and Nine Months Ended September 30, 2008 and 2007
The discussions that follow include tables, which show our segment operating results for the three and nine months ended September 30, 2008 and 2007.
We operate through the following business segments: Insurance – North American, Insurance – Overseas General, Global Reinsurance, and Life Insurance and Reinsurance. As discussed previously, we completed the acquisition of all of the outstanding shares of Combined Insurance and certain of its subsidiaries on April 1, 2008. As such, segment operating results for the three and nine months ended September 30, 2008, include the
58
results of the acquired Combined Insurance business. The Combined Insurance results are included in our Insurance – Overseas General segment or Life Insurance and Reinsurance segment according to the nature of the business written. Results from Combined Insurance’s North American operations are included in ACE’s Life Insurance and Reinsurance segment and the results from Combined Insurance’s international operations are included in ACE’s Insurance – Overseas General segment. For more information on each of our segments refer to “Segment Information”, under Item 1 of our 2007 Form 10-K.
The Insurance – North American segment comprises our operations in the U.S., Canada, and Bermuda. This segment includes the operations of ACE USA (including ACE Canada), ACE Westchester, ACE Bermuda, and various run-off operations, including Brandywine Holdings Corporation (Brandywine Holdings). In addition, beginning in the quarter ended March 31, 2008, Insurance – North American includes ACE Private Risk Services, our recently acquired underwriting unit that provides personal lines coverages (homeowners, automobile) for high net worth clients.
Net premiums written for the Insurance – North American segment increased one percent and decreased three percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. Net premiums written include our recently acquired ACE Private Risk Services unit which added $27 million and $174 million, respectively, to this segment’s net premiums written. Excluding ACE Private Risk Services, Insurance – North American’s net premiums written declined one percent and seven percent, in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. The decrease for the quarter ended September 30, 2008, was primarily due to declines in production at ACE USA, this segment’s U.S.–based retail division, as a result of competitive conditions, which produced less new and renewal business in most lines. In addition, Insurance – North American’s net premiums written for the quarter ended September 30, 2008, reflect reinstatement premiums of $16 million, primarily related to catastrophe losses. For the nine month period, the decrease was primarily due to a decrease in assumed loss portfolio business, as well as lower new and renewal business for ACE USA. With respect to the decrease in assumed loss portfolio business, the first quarter of 2007 included a large one-time assumed loss portfolio transfer, which produced approximately $168 million of net premiums written and earned.
59
ACE USA continued to experience competitive conditions across many of its units in the third quarter of 2008 which resulted in lower new and renewal business in its casualty risk units, specifically umbrella excess, construction and workers’ compensation business, and its property and specialty business including aerospace and marine as well as a decline in medical risk and run-off business. These decreases were partially offset by increased writings in professional liability, foreign casualty, and A&H lines of business, as well as favorable foreign exchange impact on business written by our Canadian operations. ACE Westchester, our U.S.–based wholesale operation, reported an increase in net premiums written for the three months ended September 30, 2008, reflecting increased crop business which benefited from higher commodity prices, partially offset by weakness in overall market conditions resulting in lower casualty writings. For the nine months ended September 30, 2008, net premiums written decreased due to declines in our casualty, inland marine, and property units and catastrophe-related reinstatement premiums, all of which more than offset growth in crop business. ACE Bermuda experienced declines in its excess liability and professional lines primarily due to our declining of business submitted to us with unfavorable rates relative to risk exposure.
The following two tables provide a line of business and entity/divisional breakdown of Insurance – North American’s net premiums earned for the periods indicated.
Line of Business
Entity/Business
ACE USA
ACE Westchester
ACE Bermuda
ACE Private Risk Services
ACE USA’s net premiums earned decreased four percent and nine percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. The decline in net premiums earned was primarily due to decreases in middle-market workers’ compensation business and large risk accounts, due to competitive conditions and declining of business not meeting our selective underwriting standards. These decreases were partially offset by growth in ACE USA’s professional liability, A&H, inland marine, and foreign casualty units. Additionally, as discussed above, the prior year first quarter included a non-renewable assumed loss portfolio transfer which generated $168 million in net premiums earned. ACE Westchester’s net premiums earned decreased seven percent in the nine months ended September 30, 2008, compared with the prior year period. For the three and nine months ended September 30, 2008, net premiums earned from ACE Westchester’s casualty and inland marine lines decreased due to lower production, and net premiums earned from crop business increased on the strength of higher commodity prices. ACE Bermuda’s net premiums earned decreased ten percent and nine percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods, primarily due to lower production. The three and nine months ended September 30, 2008, included net premiums earned from ACE Private Risk Services, which we formed in the first quarter of 2008. In addition, the decline in Insurance – North American’s net premiums earned for the quarter ended September 30, 2008, reflects reinstatement premiums of $16 million, primarily related to catastrophe losses.
60
The following table shows the impact of catastrophe losses, prior period development, and other significant events on this segment’s loss and loss expense ratio for the periods indicated.
Insurance – North American’s net catastrophe losses were $258 million and $295 million in the three and nine months ended September 30, 2008, respectively, compared with $nil and $16 million in the prior year periods. The catastrophe losses for the three and nine months ended September 30, 2008, were primarily related to Hurricanes Gustav and Ike. Insurance – North American experienced net favorable prior period development of $103 million and $249 million in the three and nine months ended September 30, 2008, respectively. This compares with net adverse prior period development of $4 million and $8 million in the three and nine months ended September 30, 2007, respectively. Refer to “Prior Period Development” for more information. For the nine months ended September 30, 2008, Insurance – North American’s loss and loss expense ratio was positively impacted by the final settlement of 2007 crop year results for ACE Westchester, which reduced the segment’s loss and loss expense ratio by approximately 2.4 percentage points. With respect to ACE Westchester’s heavily ceded crop/hail business, during the first quarter of each year, the previous crop year is settled based on actual experience. The settlement for the quarter ended March 31, 2008, reduced Insurance – North American’s losses and loss expenses by approximately $105 million and gave rise to $44 million in profit share commission. The nine months ended September 30, 2007, was negatively impacted by the large assumed loss portfolio transfer which was written at a higher loss ratio compared with other types of business. This contract added approximately one percentage point to the loss and loss expense ratio for the nine months ended September 30, 2007. After considering the impact of the 2007 loss portfolio transfer and the current period crop settlement, the loss and loss expense ratio, as adjusted, has increased from the prior year periods due primarily to competitive market conditions, increasing loss cost trends and changes in business mix.
Insurance – North American’s policy acquisition cost ratio increased in the three and nine months ended September 30, 2008, compared with the prior year periods. For the three and nine months ended September 30, 2008, the increase in the policy acquisition cost ratio relates primarily to the inclusion of the recently acquired ACE Private Risk Services unit which typically generates a higher acquisition cost ratio than our commercial P&C business. This increase in policy acquisition cost ratio was partially offset by improvements at ACE Bermuda, primarily due to increased ceding commissions. The increase was also related to higher acquisition costs on ACE Westchester’s crop/hail business, reflecting more profitable crop/hail results on the first quarter final settlement as well as increased crop/hail production. The first quarter settlement required a higher profit share commission which added approximately 1.1 percentage points to Insurance – North American’s policy acquisition cost ratio in the nine months ended September 30, 2008. The prior year periods benefited from lower premium taxes due to reassessment of obligations for premium-based assessments and guaranty funds. In addition, for the nine months ended September 30, 2007, the assumed loss portfolio transfer written in the prior year period as noted above, gave rise to low acquisition costs, which is typical for these transactions.
Insurance – North American’s administrative expense ratio increased in the three and nine months ended September 30, 2008, primarily due to the inclusion of the recently acquired ACE Private Risk Services unit (which generates higher administrative expense ratios than our commercial P&C business) and the decline in net premiums earned.
61
The Insurance – Overseas General segment consists of ACE International, which comprises our network of indigenous insurance operations, the wholesale insurance operations of ACE Global Markets, our London market underwriting unit including Lloyd’s Syndicate 2488 (2008 capacity of £330 million) and the international A&H and life business of Combined Insurance. This segment has four regions of operations: ACE European Group, which is comprised of ACE Europe and ACE Global Markets branded business, ACE Asia Pacific, ACE Far East, and ACE Latin America. Combined Insurance distributes specialty individual accident and supplemental health insurance products targeted to middle income consumers in Europe and Asia Pacific.
Underwriting income
Insurance – Overseas General’s net premiums written increased 24 percent and 20 percent in the three and nine months ended September 30, 2008, compared with the prior year periods. The increases were primarily related to our recent acquisition of Combined Insurance which added $128 million and $263 million of net premiums written for the three and nine months ended September 30, 2008, respectively and favorable foreign exchange impact at ACE International due to the strengthening of several major currencies, particularly the euro, relative to the U.S. dollar (refer to the table below for the impact of foreign exchange on net premiums written and earned). ACE International continues to report growth in its A&H business, particularly in Latin America (Mexico, Chile, and Colombia) and Asia Pacific (Thailand, Korea, and Australia). On the P&C side, ACE International reported growth in emerging markets in Europe and the Middle East, Asia Pacific, and Latin America, offset by declines in the U.K. ACE Global Markets reported lower production in most product lines, particularly property, aviation, financial lines, and political risks, primarily due to competitive conditions.
62
The following two tables provide a line of business and entity/divisional breakdown of Insurance – Overseas General’s net premiums earned for the periods indicated.
Entity/Division
ACE Europe
ACE Asia Pacific
ACE Far East
ACE Latin America
ACE International
ACE Global Markets
Combined Insurance International
Insurance – Overseas General’s net premiums earned increased 25 percent and 20 percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. The increases were primarily driven by the added premiums from Combined Insurance and by favorable foreign exchange impact. ACE International’s net premiums earned increased 19 percent and 17 percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. ACE International continues to benefit from growth in A&H business, particularly in ACE Asia Pacific and ACE Latin America. For several years, these regions have been successfully utilizing unique and innovative distribution channels to grow their A&H customer base. Our A&H business is mainly personal accident with some supplemental medical cover, typically paying fixed amounts for claims, and is therefore insulated from rising health care costs. Following decreased production over the last year, ACE Global Markets reported decreases in net premiums earned of six percent and four percent in the three and nine months ended September 30, 2008, compared with the prior year periods.
Insurance – Overseas General conducts business internationally and in most major foreign currencies. The following table summarizes the approximate effect of changes in foreign currency exchange rates on the growth of net premiums written and earned, excluding Combined Insurance, for the periods indicated.
Net premiums written:
Growth in original currency
Foreign exchange effect
Growth as reported in U.S. dollars
Net premiums earned:
63
The following table shows the impact of catastrophe losses and prior period development on this segment’s loss and loss expense ratio for the periods indicated.
Net catastrophe losses were $49 million and $89 million in the three and nine months ended September 30, 2008, respectively. This compares with net catastrophe losses of $8 million and $81 million in the three and nine months ended September 30, 2007. The catastrophe losses for the current quarter were primarily associated with Hurricane Ike. For the nine months ended September 30, 2008, catastrophe losses also included tornadoes in the U.S. and an earthquake in China. Insurance – Overseas General experienced net favorable prior period development of $121 million and $219 million in the three and nine months ended September 30, 2008, respectively, compared with net favorable prior period development of $64 million and $116 million, respectively, in the prior year periods. Refer to “Prior Period Development” for more information. Our loss and loss expense ratio will tend to decrease on a comparative basis as the proportion of A&H business to P&C business grows. We expect that this trend will continue in the future as we continue to grow our A&H franchise. A&H business typically generates a much lower loss and loss expense ratio (and a higher policy acquisition cost ratio) than traditional P&C business. The impact of both the growth in A&H business relative to P&C and the addition of Combined Insurance resulted in a 2.8 and 2.2 percentage point decrease in the adjusted loss ratios for the three and nine months ended September 30, 2008, respectively. After considering this impact, the adjusted loss ratios in the current periods are increasing over the comparable prior year periods due to deteriorating market conditions.
Insurance – Overseas General’s policy acquisition cost ratio increased in the three and nine months ended September 30, 2008, compared with the prior year periods, primarily due to the growth in A&H business and the impact of the recently acquired Combined Insurance business, which is predominantly A&H business. A&H business typically attracts higher commission rates than traditional P&C business. In addition, for the nine months ended September 30, 2008, changes to ACE International’s reinsurance structure in its financial lines resulted in reduced ceding commissions which had the effect of increasing policy acquisition costs. Insurance – Overseas General’s administrative expense ratio was relatively stable in the three and nine months ended September 30, 2008, compared with the prior year periods, primarily due to successful expense management. Administrative expenses increased primarily due to unfavorable foreign exchange impact and the inclusion of administrative expenses related to the recently acquired Combined Insurance business.
64
The Global Reinsurance segment represents ACE’s reinsurance operations, comprising ACE Tempest Re Bermuda, ACE Tempest Re USA, ACE Tempest Re Europe, and ACE Tempest Re Canada. Global Reinsurance markets its reinsurance products worldwide under the ACE Tempest Re brand name and provides a broad range of coverages to a diverse array of primary P&C companies.
Global Reinsurance’s net premiums written decreased 19 percent and 23 percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. For the three and nine months ended September 30, 2008, Global Reinsurance continued to experience intense competition across the majority of its regions of operations. This segment reported declines in production as a result of cancelled or non-renewed business. This was partially offset by inward reinstatement premiums of $13 million relating to Hurricanes Gustav and Ike.
65
The following two tables provide a line of business and entity/divisional breakdown of Global Reinsurance’s net premiums earned for the periods indicated.
Property catastrophe
ACE Tempest Re Bermuda
ACE Tempest Re USA
ACE Tempest Re Europe
ACE Tempest Re Canada
Global Reinsurance’s net premiums earned decreased 19 percent and 21 percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods, primarily due to lower production. ACE Tempest Re Bermuda reported a decline in net premiums earned due to non-renewed business, partially offset by inward reinstatement premiums due to Hurricanes Gustav and Ike. ACE Tempest Re USA and ACE Tempest Re Europe reported declines in net premiums earned, primarily due to competitive conditions throughout 2007 and 2008.
Global Reinsurance reported $104 million and $116 million of net catastrophe losses in the three and nine months ended September 30, 2008, respectively. This compares with net catastrophe losses of $13 million and $39 million in the three and nine months ended September 30, 2007, respectively. The catastrophe losses incurred during the quarter ended September 30, 2008, were primarily related to Hurricanes Gustav and Ike. Global Reinsurance experienced net favorable prior period development of $53 million and $94 million in the three and nine months ended September 30, 2008, respectively. This compares with net favorable prior period development of $10 million and $20 million in the three and nine months ended September 30, 2007, respectively. Refer to “Prior Period Development” for more detail. The increase in the adjusted loss ratio during the quarter ended September 30, 2008, in the table above was due to changes in business mix.
The policy acquisition cost ratio decreased during the quarter ended September 30, 2008, primarily due to the increase in inward reinstatement premiums at ACE Tempest Re Bermuda. We pay little or no commission on reinstatement premiums written and earned. The administrative expense ratio increased in the three and nine months ended September 30, 2008, due to the decrease in net premiums earned, partially offset by reduced staffing costs.
66
The Life Insurance and Reinsurance segment includes the operations of ACE Tempest Life Re (ACE Life Re), ACE International Life, and the domestic A&H and life business of Combined Insurance. Combined Insurance distributes specialty individual accident and supplemental health insurance products that are targeted to middle income consumers in the U.S. and Canada. We assess the performance of our life insurance and reinsurance business based on life underwriting income which includes net investment income.
Loss and loss expenses
Life underwriting income
The following table provides a line of business breakdown of Life Insurance and Reinsurance’s net premiums earned for the periods indicated.
Life insurance
Life reinsurance
Life underwriting income increased 93 percent and 53 percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. The increases are primarily related to the inclusion of the operating results of the acquired Combined Insurance business as of April 1, 2008, the date of the acquisition. Life underwriting income attributed to Combined Insurance was $53 million and $95 million in the three and nine months ended September 30, 2008, respectively. For the three and nine months ended September 30, 2008, ACE Life Re’s life underwriting income was $38 million and $123 million, respectively. This compares with ACE Life Re life underwriting income of $48 million and $143 million in the three and nine months ended September 30, 2007, respectively. The decrease in ACE Life Re’s life underwriting income for the current periods was due to increased benefit reserves primarily due to poor worldwide equity market performance. Benefit reserves reflect the expected value of future claims on earned premium exposures and fluctuate with movements in equity indices, interest rates and policyholder behavior. The net realized gains (losses) relate primarily to changes in reported liabilities on GMIB reinsurance reported at fair value. For the three and nine months ended September 30, 2008, we experienced significant net realized losses, which were caused by adverse
67
financial market conditions, primarily poor equity market performance. Refer to “Fair Value Measurements” for more information. ACE International life generated a modest life underwriting loss in the current periods as we continue to incur start-up costs in several countries as we develop the business.
Net Investment Income
Gross investment income
Investment expenses
Net investment income is influenced by a number of factors, including the amounts and timing of inward and outward cash flows, the level of interest rates, and changes in overall asset allocation. Net investment income includes accretion from the new cost basis of securities for which other than temporary impairments have been recorded. Net investment income increased 6 percent and 9 percent in the three and nine months ended September 30, 2008, respectively, compared with the prior year periods. The increase in net investment income is primarily due to several years of positive operating cash flows which have resulted in a higher overall average invested asset base. The investment portfolio’s average market yield on fixed maturities was 6.1 percent and 5.5 percent at September 30, 2008 and 2007, respectively. Included in Other investment income are changes in fair value of trading securities included within rabbi trusts maintained for compensation plans.
Net Realized and Unrealized Gains (Losses)
We take a long-term view with our investment strategy and our investment managers manage our investment portfolio to maximize total return within certain specific guidelines designed to minimize risk. The majority of our investment portfolio is available for sale and reported at fair value. Our held to maturity investment portfolio is reported at amortized cost.
The effect of market movements on our available for sale investment portfolio impacts net income (through net realized gains (losses)) when securities are sold or when “other-than-temporary” impairments are recorded on fixed income and equity securities. Additionally, net income is impacted through the reporting of changes in the fair value of derivatives, including financial futures, options, swaps, and GMIB reinsurance. Changes in unrealized appreciation and depreciation on available for sale securities, which result from the revaluation of securities held, are reported as a separate component of accumulated other comprehensive income in shareholders’ equity.
68
The following table presents our pre-tax net realized and unrealized gains (losses) for the periods indicated.
Fixed maturities and short-term investments
Derivatives:
Equity and fixed income derivatives
Fair value adjustment on insurance derivatives
Subtotal derivatives
Total gains (losses)
For a sensitivity discussion of the effect of changes in interest rates and equity indices on the fair value of derivatives and the resulting impact on our net income, refer to Item 7A. of our 2007 Form 10-K.
We have historically reviewed our investments for other-than-temporary impairment based on the following:
the amount of time a security has been in a loss position, the magnitude of the loss position, and whether the security is rated below an investment grade level;
the period in which cost is expected to be recovered, if at all, based on various criteria including economic conditions, credit loss experience, and other issuer-specific developments;
the Company’s ability and intent to hold the security to the expected recovery period; and
securities in an unrealized loss position for twelve consecutive months were generally impaired.
69
Given current market conditions, and in light of recent general guidance from the SEC and the FASB regarding the application of existing guidance during stressed market conditions, beginning in the third quarter of 2008 we have qualitatively evaluated our application of the parameters under which we consider a decline in value to be other-than-temporary. Similar to prior quarters, we evaluated investments in our portfolio where cost exceeded fair value and made certain judgments as to our ability to recover our cost. Our analysis in the third quarter of 2008 required the Company to consider carefully the duration and severity of decline and the root causes thereof. Specifically, we further evaluated during the quarter whether declines were related to temporary liquidity concerns and current market conditions, and therefore more likely to be temporary, or were instead related to specific credit events or issuer performance, and therefore more likely to be other-than-temporarily impaired. Using this refined evaluation process resulted in a lower dollar value of investments in an unrealized loss position being deemed other-than-temporarily impaired in comparison to our previous evaluation process. The Company believes the underlying credit quality of the portfolio supports the use of our modified approach. Refer to Note 5 a) to the Consolidated Financial Statements, which includes a table that summarizes all of our securities in an unrealized loss position at September 30, 2008.
When we determine that there is an other-than-temporary impairment, we record a write-down to estimated fair value, which reduces the cost basis. The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. For fixed maturity investments, the discount (or reduced premium) based on the new cost basis is accreted into net investment income, except for securities for which we believe we will not receive all principal and interest payments, and included in income in future periods based upon the amount and timing of expected future cash flows of the security.
Our net realized gains (losses) in the three and nine months ended September 30, 2008, included write-downs of $224 million and $623 million, respectively, as a result of conditions which caused us to conclude that the decline in fair value was “other-than-temporary”. For the three and nine months ended September 30, 2007, write-downs amounted to $18 million and $72 million, respectively. A breakdown of write-downs by security type is included in Note 5 b) to the Consolidated Financial Statements.
Fixed maturity other-than-temporary impairments in the third quarter and first nine months of 2008 were concentrated in the financial services sector of our corporate securities and were primarily driven by downgrades in credit, bankruptcy or other adverse financial conditions of the respective issuers. Other-than-temporary impairments of fixed maturities in the third quarter of 2008 included approximately $150 million related to the filing of a Chapter 11 bankruptcy petition by Lehman Brothers. Other-than-temporary impairments of equity securities in the third quarter and first nine months of 2008 of $28 million and $103 million, respectively, were primarily driven by overall declines in the equity markets.
Our net realized and unrealized loss in the three and nine months ended September 30, 2008 included approximately $1 billion and $1.8 billion, respectively, of decline in our investment grade fixed income portfolio and approximately $200 million and $300 million, respectively, on our high yield bond portfolio.
As of September 30, 2008, our U.S. investment portfolios included approximately $772 million of gross unrealized losses on fixed income investments. Our tax planning strategy related to these losses is based on our view that we will hold our fixed income investments until they recover their cost. As such, we have recognized a deferred tax asset of approximately $270 million relating to these unrealized losses. This strategy allows us to fully recognize the associated deferred tax asset as we do not believe these losses will ever be realized, and accordingly we did not record a valuation allowance against this deferred tax asset.
Securities Lending Transactions
We engage in a securities lending program, which involves lending investments to other institutions for short periods of time. ACE invests the collateral received in short-term funds of high credit quality with the objective of maintaining a stable principal balance. During the third quarter of 2008 certain investments in the money
70
market mutual funds purchased with the securities lending collateral declined in value resulting in a $45 million unrealized loss. The unrealized loss is attributable to fluctuations in market values of the underlying performing debt instruments held by the respective mutual funds, rather than default of a debt issuer. We concluded that the decline in value was temporary.
Other Income and Expense Items
Equity in net income of partially-owned companies
Minority interest expense
Federal excise tax
Other (income) expense is primarily comprised of our equity in net income of Assured Guaranty Ltd. (AGO), included in equity in net income of partially-owned companies. During 2008, AGO recorded mark-to-market realized gains (losses) in its credit derivatives portfolio, our portion of which was $(21) million and $49 million for the three and nine months ended September 30, 2008, respectively. These gains and losses were reported as net realized gains (losses) by AGO. Our relationship with AGO is limited to our equity investment, which had a carrying value of $443 million compared with a market value of $311 million at September 30, 2008. We regularly review our investment for other-than-temporary impairment and we have not recorded a loss on AGO. We conduct no financial guaranty business directly or with AGO and we retain no financial guaranty exposures with AGO. Other income and expense also includes certain federal excise taxes incurred as a result of capital management initiatives. These transactions are considered capital in nature and are excluded from underwriting results.
Our investment portfolio is invested primarily in fixed income securities with an average credit quality of AA, as rated by the independent investment rating service Standard and Poor’s (S&P). The portfolio is externally managed by independent, professional investment managers. The average duration of our fixed income securities, including the effect of options and swaps, was 3.8 years at September 30, 2008. We estimate that a 100 basis point (bps) increase in interest rates would reduce our book value by approximately $1.4 billion at September 30, 2008. For the nine months ended September 30, 2008, we experienced net unrealized losses of approximately $1.7 billion, primarily due to widening of credit spreads. We currently expect to hold these securities until they recover their cost. Our “Other investments” are principally comprised of direct investments, investment funds, and limited partnerships. Our exposure to sub-prime asset backed securities was $98 million at September 30, 2008, which represented less than one percent of our investment portfolio. We do not expect any material investment loss from our exposure to sub-prime mortgages. Our investment portfolio continues to be predominantly invested in investment grade fixed income securities and is broadly diversified across geographies, sectors and issuers. Our aggregate investment exposure to Lehman Brothers and American International Group is a small percentage of our investment portfolio. We hold no collateralized debt obligations or collateralized loan obligations in our investment portfolio. We provide no credit default protection. We have long-standing global credit limits for our entire portfolio across the organization. Exposures are aggregated, monitored, and actively managed by our Global Credit Committee, comprised of senior executives, including our Chief Financial Officer, our Chief Investment Officer and our Treasurer. We also have well established strict contractual investment rules requiring managers to maintain highly diversified exposures to individual issuers and closely monitor investment manager compliance with portfolio guidelines.
71
The following table shows the fair value and cost/amortized cost of our invested assets at September 30, 2008, and December 31, 2007.
The fair value of our total investments decreased $25 million during the nine months ended September 30, 2008. The decrease was primarily due to unrealized depreciation on investments, settlement of reverse repurchase agreements, and redemption of our Preferred Shares, offset by the investing of operating cash flows and the net addition of Combined Insurance’s investment portfolio. Other investments increased primarily due to additional funding of limited partnerships and investment funds.
The following tables show the market value of our fixed maturities and short-term investments at September 30, 2008, and December 31, 2007. The first table lists investments according to type and the second according to S&P credit rating.
Treasury
Agency
Corporate
Municipal
Non-U.S.
AAA
AA
A
BBB
BB
B
72
The table below summarizes the Company’s significant exposures (defined as bonds issued by financial institutions) to corporate bonds of financial issuers held within its investment portfolio, representing market value at September 30, 2008:
General Electric Co.
JP Morgan Chase & Co.
Bank of America Corp.
Citigroup Inc.
HSBC Holdings Plc
AT&T Inc.
Wells Fargo & Co.
Comcast Corp.
Time Warner Inc.
Royal Bank of Scotland Group Plc
Goldman Sachs Group Inc.
ConocoPhillips
Verizon Communication Inc.
Wachovia Corp.
Merrill Lynch & Co. Inc.
Credit Suisse Group
Morgan Stanley
Telecom Italia SpA
XTO Energy Inc.
Deutsche Telekom AG
Barclays Plc
Dominion Resources Inc.
BT Group Plc
HBOS Plc
Australia & New Zealand Banking
Reinsurance Recoverable on Ceded Reinsurance
The composition of our reinsurance recoverable on losses and loss expenses at September 30, 2008, and December 31, 2007, is as follows:
Reinsurance recoverable on unpaid losses and loss expenses
Provision for uncollectible reinsurance on unpaid losses and loss expenses
Reinsurance recoverable on unpaid losses and loss expenses, net of a provision for uncollectible reinsurance
Reinsurance recoverable on paid losses and loss expenses
Provision for uncollectible reinsurance on paid losses and loss expenses
Net reinsurance recoverable on losses and loss expenses
73
We evaluate the financial condition of our reinsurers and potential reinsurers on a regular basis and also monitor concentrations of credit risk with reinsurers. The provision for uncollectible reinsurance is required principally due to the failure of reinsurers to indemnify us, primarily because of disputes under reinsurance contracts and insolvencies. The decrease in reinsurance recoverable was due to a decrease in gross and ceded IBNR for catastrophe losses in the second quarter, the settlement of ACE Westchester’s heavily ceded crop/hail business in the first quarter of 2008 as the previous crop year was settled based on favorable actual experience, collections on active business, and collections on run-off business of approximately $450 million. The decrease is offset by approximately $451 of catastrophe losses ceded during the quarter ended September 30, 2008, primarily related to Hurricanes Gustav and Ike. The acquisition of Combined Insurance added $34 million to our reinsurance recoverable.
As an insurance and reinsurance company, we are required, by applicable laws and regulations, which prescribe the use of generally accepted accounting principles (GAAP), to establish loss and loss expense reserves for the estimated unpaid portion of the ultimate liability for losses and loss expenses under the terms of our policies and agreements with our insured and reinsured customers. The estimate of the liabilities includes provision for claims that have been reported but unpaid at the balance sheet date (case reserves) and for future obligations from claims that have been incurred but not reported (IBNR) at the balance sheet date (IBNR may also include a provision for additional development on reported claims in instances where the case reserve is viewed to be insufficient). The reserves provide for liabilities on the premium earned on policies as of the balance sheet date. The loss reserve also includes an estimate of expenses associated with processing and settling these unpaid claims (loss expenses). At September 30, 2008, our gross unpaid loss and loss expense reserves were $38.4 billion. The table below presents a roll-forward of our unpaid losses and loss expenses for the indicated periods.
Balance at December 31, 2007
Losses and loss expenses incurred
Losses and loss expenses paid
Other (including foreign exchange revaluation)
Balance at March 31, 2008
Losses and loss expenses acquired
Balance at June 30, 2008
Balance at September 30, 2008
During the first quarter of 2008, our gross and ceded loss and loss expenses incurred and paid were favorably impacted by the settlement of the crop/hail business resulting in a decrease in the gross reserve of approximately $273 million and the ceded reserves of approximately $215 million. Losses and loss expenses acquired are in connection with the acquisition of Combined Insurance. Net unpaid losses and loss expenses increased $276 million in the quarter ended September 30, 2008, primarily due to the catastrophe losses of $411 million offset by favorable prior period development.
74
The process of establishing loss reserves for property and casualty claims can be complex and is subject to considerable variability as it requires the use of informed estimates and judgments based on circumstances known at the date of accrual. The following table shows our total reserves segregated between case reserves (including loss expense reserves) and IBNR reserves at September 30, 2008, and December 31, 2007.
Case reserves
IBNR
Asbestos and Environmental (A&E) and Other Run-off Liabilities
Due to timing constraints associated with statutory reporting, this section is presented on a one quarter lag basis.
Included in our liabilities for losses and loss expenses are amounts for A&E. These A&E liabilities principally relate to claims arising from bodily-injury claims related to asbestos products and remediation costs associated with hazardous waste sites. The estimation of these liabilities is particularly sensitive to future changes in the legal, social, and economic environment. We have not assumed any such future changes in setting the value of our A&E reserves, which include provisions for both reported and IBNR claims.
Our exposure to A&E claims principally arises out of liabilities acquired when we purchased Westchester Specialty in 1998 and the P&C business of CIGNA in 1999, with the larger exposure contained within the liabilities acquired in the CIGNA transaction. In 1996, prior to our acquisition of the P&C business of CIGNA, the Pennsylvania Insurance Commissioner approved a plan to restructure INA Financial Corporation and its subsidiaries (the Restructuring) which included the division of Insurance Company of North America (INA) into two separate corporations: (1) an active insurance company that retained the INA name and continued to write P&C business and (2) an inactive run-off company, now called Century Indemnity Company (Century). As a result of the division, predominantly all A&E and certain other liabilities of INA were allocated to Century and extinguished, as a matter of Pennsylvania law, as liabilities of INA. As part of the Restructuring, most A&E liabilities of various U.S. affiliates of INA were reinsured to Century, and Century and certain other run-off companies having A&E and other liabilities were contributed to Brandywine Holdings. As part of the 1999 acquisition of the P&C business of CIGNA, we acquired Brandywine Holdings and its various subsidiaries. For more information refer to “Brandywine Run-Off Entities” below.
The table below presents a roll forward of our consolidated A&E loss reserves, allocated and unallocated loss expense reserves for A&E exposures, and the provision for uncollectible reinsurance for the period ended June 30, 2008.
Incurred activity
Payment activity
The balance at December 31, 2007, was reduced by $10 million to reflect reserve reclassification between Asbestos and Other.
75
The A&E net loss reserves including allocated and unallocated loss expense reserves and provision for uncollectible reinsurance at June 30, 2008, of $1.790 billion shown in the above table are comprised of $1.247 billion in reserves held by Brandywine run-off companies, $206 million of reserves held by Westchester Specialty, $163 million of reserves held by ACE Bermuda, $153 million of reserves held by Insurance – Overseas General, and $21 million of reserves held by active ACE USA companies.
The net figures in the above table reflect third-party reinsurance other than reinsurance provided by National Indemnity Company (NICO) under three aggregate excess of loss contracts described below (collectively, the NICO contracts). We exclude the NICO contracts as they cover non-A&E liabilities as well as A&E liabilities. The split of coverage provided under the NICO contracts for A&E liabilities as compared to non-A&E liabilities is entirely dependant on the timing of the payment of the related claims. Our ability to make an estimate of this split is not practicable. We believe, instead, that the A&E discussion is best provided excluding the NICO contracts, while separately discussing the NICO contracts in relation to the total subject business, both A&E and non-A&E, covered by those contracts. With certain exceptions, the NICO contracts provide coverage for our net A&E incurred losses and allocated loss expenses within the limits of coverage and above ACE’s retention levels. These exceptions include losses arising from certain operations of Insurance – Overseas General and participations by ACE Bermuda as a co-reinsurer or retrocessionaire in the NICO contracts.
Brandywine run-off-impact of NICO contracts on ACE’s run-off liabilities
As part of the acquisition of CIGNA’s P&C business, NICO provided $2.5 billion of reinsurance protection to Century on all Brandywine loss and allocated loss adjustment expense reserves and on the A&E reserves of various ACE INA insurance subsidiaries reinsured by Century (in each case, including uncollectible reinsurance). The benefits of this NICO contract (the “Brandywine NICO Agreement”) flow to the other Brandywine companies and to the ACE INA insurance subsidiaries through agreements between those companies and Century. The Brandywine NICO Agreement was exhausted on an incurred basis in the fourth quarter of 2002.
The following table presents a roll forward of net loss reserves, allocated and unallocated loss adjustment expense reserves, and provision for uncollectible reinsurance in respect of Brandywine operations only, including the impact of the Brandywine NICO Agreement. The table presents Brandywine incurred activity for the period ended June 30, 2008.
Other consists primarily of workers’ compensation, non-A&E general liability losses, and provision for uncollectible reinsurance on non-A&E business. The Other reserve balance at December 31, 2007, has been increased by $24 million to reflect final activity on the fourth quarter 2007 NICO bordereau.
The balance at December 31, 2007, has been increased by $33 million to reflect final activity on the fourth quarter 2007 NICO bordereau.
The Brandywine A&E incurred benefit and the Brandywine Other incurred loss were primarily related to changes in bad debt estimation as a result of our regular revaluation of reinsurer credit ratings and changes in recoverable balances.
76
Reserve reviews
During 2007, we conducted an internal review of our consolidated A&E liabilities as of June 30, 2007. As a result of the internal review, we concluded that our net loss reserves for the Brandywine operations, including A&E, were adequate and, therefore, no change to the carried reserve was required.
In 2006, a team of external actuaries performed an evaluation as to the adequacy of the reserves of Century. This external review was conducted in accordance with the Brandywine Restructuring Order, which requires that an external actuarial review of Century’s reserves be completed every two years. The results of the external review were addressed with the Pennsylvania Insurance Department and no changes to statutory-basis loss reserves were deemed necessary.
The internal and external actuarial reviews of our consolidated A&E liabilities are currently being performed and any necessary reserve actions will be recorded in the fourth quarter of 2008.
Our A&E reserves are not discounted, consistent with current trends and do not reflect any anticipated future changes in the legal, social, or economic environment, or any benefit from future legislative reforms.
Westchester Specialty – impact of NICO contracts on ACE’s run-off liabilities
As part of the acquisition of Westchester Specialty in 1998, NICO provided a 75 percent pro-rata share of $1 billion of reinsurance protection on losses and loss adjustment expenses incurred on or before December 31, 1996, in excess of a retention of $721 million (the 1998 NICO Agreement). NICO has also provided an 85 percent pro-rata share of $150 million of reinsurance protection on losses and allocated loss adjustment expenses incurred on or before December 31, 1992, in excess of a retention of $755 million (the 1992 NICO Agreement). At June 30, 2008, the remaining unused incurred limit under the 1998 NICO Agreement was $482 million, which is only available for losses and loss adjustment expenses. The 1992 NICO Agreement is exhausted on an incurred basis.
The following table presents a roll forward of net loss reserves, allocated and unallocated loss adjustment expense reserves, and provision for uncollectible reinsurance in respect of 1996 and prior Westchester Specialty operations that are the subject business of the NICO covers. The table presents incurred activity for the period ended June 30, 2008.
The balance at December 31, 2007, has been reduced by $10 million to reflect reserve classification between Asbestos and Other.
Other consists primarily of non-A&E general liability and products liability losses. Other reserves were increased by $10 million to reflect reserve reclassification between Asbestos and Other.
Reserving considerations
For asbestos, we face claims relating to policies issued to manufacturers, distributors, installers, and other parties in the chain of commerce for asbestos and products containing asbestos. Claims can be filed by individual claimants or groups of claimants with the potential for hundreds of individual claimants at one time. Claimants will generally allege damages across an extended time period which may coincide with multiple policies for a single insured.
77
Environmental claims present exposure for remediation and defense costs associated with the contamination of property as a result of pollution. It is common, especially for larger defendants, to be named as a potentially responsible party (PRP) at multiple sites.
Brandywine run-off entities
In addition to housing a significant portion of our A&E exposure, the Brandywine operations include run-off liabilities related to various insurance and reinsurance businesses. The following companies comprise ACE’s Brandywine operations: Century (a Pennsylvania insurer), Century Re (a Pennsylvania insurer), and Century International Reinsurance Company Ltd. (a Bermuda insurer (CIRC)). All of the Brandywine companies are direct or indirect subsidiaries of Brandywine Holdings.
The U.S.-based ACE INA companies assumed two contractual obligations in respect of the Brandywine operations in connection with the Restructuring: a dividend retention fund obligation and a surplus maintenance obligation in the form of an aggregate excess of loss reinsurance agreement. In accordance with the Brandywine restructuring order, INA Financial Corporation established and funded a dividend retention fund (the Dividend Retention Fund) consisting of $50 million plus investment earnings. The full balance of the Dividend Retention Fund was contributed to Century as of December 31, 2002. To the extent future dividends are paid by INA Holdings Corporation to its parent, INA Financial Corporation, and to the extent INA Financial Corporation then pays such dividends to INA Corporation, a portion of those dividends must be withheld to replenish the principal of the Dividend Retention Fund to $50 million within five years. In the six months ended June 30, 2008, and in the years ended December 31 2007 and 2006, no such dividends were paid and, therefore, no replenishment of the Dividend Retention Fund occurred. The Dividend Retention Fund may not be terminated without prior written approval from the Pennsylvania Insurance Commissioner to terminate the fund.
In addition, an ACE INA insurance subsidiary provided reinsurance coverage to Century in the amount of $800 million under an aggregate excess of loss reinsurance agreement (the Aggregate Excess of Loss Agreement) if the statutory capital and surplus of Century falls below $25 million or if Century lacks liquid assets with which to pay claims as they become due, after giving effect to the contribution of the balance, if any, of the Dividend Retention Fund. Coverage under the Aggregate Excess of Loss Agreement was triggered as of December 31, 2002, following contribution of the balance of the Dividend Retention Fund, because Century’s capital and surplus fell below $25 million at December 31, 2002.
Effective December 31, 2004, ACE INA Holdings contributed $100 million to Century in exchange for a surplus note. After giving effect to the contribution and issuance of the surplus note, the statutory surplus of Century at June 30, 2008, was $25 million and approximately $297 million in statutory-basis losses were ceded to the Aggregate Excess of Loss Agreement. Century reports the amount ceded under the Aggregate Excess of Loss Agreement in accordance with statutory accounting principles, which differ from GAAP by, among other things, allowing Century to discount its asbestos and environmental reserves. For GAAP reporting purposes, intercompany reinsurance recoverables related to the Aggregate Excess of Loss Agreement are eliminated upon consolidation. To estimate ACE’s remaining claim exposure under the Aggregate Excess of Loss Agreement on a GAAP basis, we adjust the statutory cession to exclude the discount embedded in statutory loss reserves and we adjust the statutory provision for uncollectible reinsurance to a GAAP basis amount. At June 30, 2008, approximately $570 million in GAAP basis losses were ceded under the Aggregate Excess of Loss Agreement, leaving a remaining limit of coverage under that agreement of approximately $230 million. At December 31, 2007, the remaining limit of coverage under the agreement was $228 million. While we believe ACE has no legal obligation to fund losses above the Aggregate Excess of Loss Agreement limit of coverage, ACE’s consolidated results would nevertheless continue to include any losses above the limit of coverage for so long as the Brandywine companies remain consolidated subsidiaries of ACE.
Uncertainties relating to ACE’s ultimate Brandywine exposure
In addition to the Dividend Retention Fund and Aggregate Excess of Loss Agreement commitments described above, certain ACE entities are primarily liable for asbestos, environmental, and other exposures that they have
78
reinsured to Century. Accordingly, if Century were to become insolvent and ACE were to lose control of Century, some or all of the recoverables due to these ACE companies from Century could become uncollectible, yet those ACE entities would continue to be responsible to pay claims to their insureds or reinsureds. Under such circumstances, ACE would recognize a loss in its consolidated statement of operations. As of June 30, 2008, the aggregate reinsurance balances ceded by the active ACE companies to Century were approximately $1.5 billion. At June 30, 2008, Century’s carried gross reserves (including reserves ceded by the active ACE companies to Century) were $3.2 billion. We believe the intercompany reinsurance recoverables, which relate to liabilities payable over many years (i.e., 25 years or more), are not impaired at this time. A substantial portion of the liabilities ceded to Century by its affiliates have in turn been ceded by Century to NICO and, as of June 30, 2008, approximately $1.5 billion of cover remains on a paid basis. Should Century’s loss reserves experience adverse development in the future and should Century be placed into rehabilitation or liquidation, the reinsurance recoverables due from Century to its affiliates would be payable only after the payment in full of certain expenses and liabilities, including administrative expenses and direct policy liabilities. Thus, the intercompany reinsurance recoverables would be at risk to the extent of the shortage of assets remaining to pay these recoverables. As of June 30, 2008, losses ceded by Century to the active ACE companies and other amounts owed to Century by the active ACE companies were approximately $621 million in the aggregate.
Catastrophe Management
We continue to closely monitor our catastrophe accumulation around the world and have significantly reduced our U.S. wind exposure since 2005. Our modeled annual aggregate 1 in 100 year return period U.S. hurricane probable maximum loss, net of reinsurance is approximately $1,081 million; i.e., according to the model there is a one percent chance that ACE’s losses incurred in any year from U.S. hurricanes could be in excess of $1,081 million (or seven percent of our total shareholders’ equity at September 30, 2008). We estimate that at such hypothetical loss levels, aggregate industry losses would be approximately $134 billion. If loss levels similar to the 2005 hurricanes were to recur, our net losses on an “as-if” basis would be approximately 30 percent lower. Our modeled single occurrence 1 in 100 return period California earthquake probable maximum loss, net of reinsurance is approximately $750 million; i.e., according to the model there is a one percent chance that ACE’s losses incurred in any single California earthquake event could be in excess of $750 million (or approximately five percent of our total shareholders’ equity at September 30, 2008). We estimate that at such hypothetical loss levels, the industry losses would be approximately $37 billion. ACE’s modeled losses reflect our in-force portfolio and reinsurance program as of July 1, 2008.
The modeling estimates of both ACE and industry loss levels are inherently uncertain owing to key assumptions. First, while the use of third-party catastrophe modeling packages to simulate potential hurricane and earthquake losses is prevalent within the insurance industry, the models are reliant upon significant meteorology, seismology, and engineering assumptions to estimate hurricane and earthquake losses. In particular, modeled hurricane and earthquake events are not always a representation of actual events and ensuing additional loss potential. Second, there is no universal standard in the preparation of insured data for use in the models and the running of the modeling software. Third, we are reliant upon third-party estimates of industry insured exposures and there is significant variation possible around the relationship between ACE’s loss and that of the industry following an event. Fourth, we assume that our reinsurance recoveries following an event are fully collectible. These loss estimates do not represent ACE’s potential maximum exposures and it is highly likely that ACE’s actual incurred losses would vary materially from the modeled estimates.
Crop Insurance
We are, and have been since the 1980s, one of the leading writers of crop insurance in the U.S. and conduct such business through Rain and Hail L.L.C., a managing general agency (MGA). We provide protection throughout the U.S. and are therefore, geographically diversified which reduces the risk of exposure to a single event or a heavy accumulation of losses in any one region.
Our crop insurance book comprises two components – multi-peril crop insurance (MPCI) and hail insurance.
79
The MPCI program is a partnership with the U.S. Department of Agriculture (USDA). The policies cover crop losses due to natural causes such as drought, excessive moisture, hail, wind, frost, insects, and disease. Generally, policies have deductibles ranging from 10 percent to 50 percent of the insured’s risk. The USDA’s Risk Management Agency (RMA) sets the policy terms and conditions, rates and forms, and is also responsible for setting compliance standards. As a participating company, we report all details of policies underwritten to the RMA and are party to a Standard Reinsurance Agreement (SRA), which sets out the relationship between private insurance companies and the federal government concerning the terms and conditions regarding the risks each will bear. In addition to the pro-rata and excess of loss reinsurance protections inherent in the SRA, we cede business on a quota-share basis to third-party reinsurers and further protect our net retained position through the purchase of stop-loss reinsurance in the private market place.
Our hail program is a private offering where we use industry data to develop our own rates and forms for the coverage offered. The policy primarily protects farmers against yield reduction caused by hail and/or fire, and related costs such as transit to storage. We offer various deductibles to allow the grower to partially self-insure for a reduced premium cost. We limit our hail exposures through the use of township liability limits, quota-share reinsurance cessions, and stop-loss reinsurance on our net retained hail business.
On the MPCI business, we recognize net premiums written as we receive acreage reports from the policyholders on the various crops throughout the U.S. The program has specific timeframes as to when producers must report acreage to us. These reports allow us to determine the actual premium associated with the liability that is being planted. Once the net premium written has been booked, the premium is then earned over the growing season for the crops. Given the major crops that are covered in the program, we typically see a substantial written premium impact in the second and third quarter and the earned premium is also more concentrated in the second and third quarters.
On the hail program, the premium is earned over the coverage period of the policy. Given the very short nature of the growing season, most hail business is typically written in the second and third quarters with the earned premium also more heavily occurring during this time frame. During the first quarter of each calendar year our MGA reports to us the results from the previous crop year. Typically, this results in an adjustment to the previously estimated losses and loss expenses and profit share commission which impacts our policy acquisition costs. For example, for the quarter ended March 31, 2008, the 2007 crop-year settlement reduced our losses and loss expenses by approximately $105 million and gave rise to $44 million in profit share commission resulting in a net benefit to income of approximately $61 million.
Liquidity
Global market and economic conditions have been severely disrupted. These conditions, including the possibility of a recession, may potentially affect (among other aspects of our business) the demand for and claims made under our products, the ability of customers, counterparties and others to establish or maintain their relationships with us, our ability to access and efficiently use internal and external capital resources, the risks we assume under reinsurance programs covering variable annuity guarantees, and our investment performance.
The payments of dividends or other statutorily permissible distributions from our operating companies are subject to the laws and regulations applicable to each jurisdiction, as well as the need to maintain capital levels adequate to support the insurance and reinsurance operations, including financial strength ratings issued by independent rating agencies. During the nine months ended September 30, 2008, we were able to meet all of our obligations, including the payment of dividends declared on our Common Shares (refer to “Effects of the Continuation on Dividends”) and Preferred Shares, with our net cash flows and dividends received. The Preferred Shares were redeemed during the second quarter of 2008 (refer to “Capital Resources”).
We anticipate that positive cash flows from operations (underwriting activities and investment income) should be sufficient to cover cash outflows under most loss scenarios through 2008. Should the need arise, we generally have access to the capital markets and other available credit facilities. At September 30, 2008, our available
80
credit lines totaled $2 billion and usage was $1 billion. Our access to funds under existing credit facilities is dependent on the ability of the banks that are parties to the facilities to meet their funding commitments. Generally, our existing credit facilities have remaining terms of over four years. However, we may be required to replace credit sources in a difficult market should one of our existing credit providers experience financial difficulty. There has also been recent consolidation in the industry, which could lead to increased reliance on and exposure to particular institutions. If we cannot obtain adequate capital or sources of credit on favorable terms, or at all, our business, operating results, and financial condition could be adversely affected. To date, we have not experienced any difficulty accessing any of our credit facilities. Refer to “Credit Facilities”.
We assess which subsidiaries to draw dividends from based on a number of factors. Considerations such as regulatory and legal restrictions as well as the subsidiary’s financial condition are paramount to the dividend decision. The legal restrictions on the payment of dividends from retained earnings by our Bermuda subsidiaries are currently satisfied by the share capital and additional paid-in capital of each of the Bermuda subsidiaries. During the nine months ended September 30, 2008, ACE Bermuda declared and paid dividends of $280 million ($168 million in the prior year period), and ACE Tempest Life Re declared and paid dividends of $915 million ($nil in the prior year period). A portion of the dividends received were used in connection with the acquisition of Combined Insurance. We expect that a majority of our cash inflows for the remainder of 2008 will be from our Bermuda subsidiaries.
The payment of any dividends from ACE Global Markets or its subsidiaries is subject to applicable U.K. insurance laws and regulations. In addition, the release of funds by Syndicate 2488 to subsidiaries of ACE Global Markets is subject to regulations promulgated by the Society of Lloyd’s. ACE INA’s U.S. insurance subsidiaries may pay dividends, without prior regulatory approval, subject to restrictions set out in state law of the subsidiary’s domicile (or, if applicable, “commercial domicile”). ACE INA’s international subsidiaries are also subject to insurance laws and regulations particular to the countries in which the subsidiaries operate. These laws and regulations sometimes include restrictions that limit the amount of dividends payable without prior approval of regulatory insurance authorities.
ACE Limited did not receive any dividends from ACE Global Markets or ACE INA during the nine months ended September 30, 2008 and 2007. The debt issued by ACE INA is serviced by statutorily permissible distributions by ACE INA’s insurance subsidiaries to ACE INA as well as other group resources.
Sources of liquidity include cash from operations, routine sales of investments, and financing arrangements. The following is a discussion of our cash flows for the nine months ended September 30, 2008 and 2007.
Our consolidated net cash flows from operating activities were $3.1 billion in the nine months ended September 30, 2008, compared with $3.9 billion for the prior year period. These amounts reflect net income for each period, adjusted for non-cash items and changes in working capital. Net income for the nine months ended September 30, 2008, was $1.2 billion compared with $2.0 billion in the prior year period. For the nine months ended September 30, 2008, significant adjustments included net realized gains (losses) of $989 million, unpaid losses and loss expenses of $1.2 billion and unearned premiums of $236 million. The unpaid losses and loss expenses were significantly impacted by the third quarter catastrophes and the first quarter settlement of the crop/hail business. These adjustments were partially offset by an increase in deferred policy acquisition costs and prepaid reinsurance premiums, which resulted in an adjustment to net cash flows from operating activities of $330 million.
Our consolidated net cash flows used for investing activities were $3.5 billion in the nine months ended September 30, 2008, compared with $3.7 billion for the prior year period. For the indicated periods, net investing activities were related primarily to net purchases and maturities on the fixed maturities portfolio and the acquisition of Combined Insurance of $2.56 billion.
Our consolidated net cash flows from financing activities were $383 million in the nine months ended September 30, 2008, compared with net cash flows used for financing of $223 million in the prior year period. Net cash flows from financing activities in the nine months ended September 30, 2008, include
81
$1.2 billion net proceeds from the issuance of long-term debt. These items were partially offset by $575 million of net cash flows used for financing activities relating to the redemption of our Preferred Shares (refer to “Capital Resources” for more information) and dividends on our Common and Preferred Shares.
In addition to cash from operations, routine sales of investments, and financing arrangements, we entered into agreements with a bank provider to implement two international multi-currency notional cash pooling programs in order to enhance cash management efficiency during periods of short-term timing mismatches between expected inflows and outflows of cash by currency. In each program, participating ACE entities establish deposit accounts in different currencies with the bank provider and each day the credit or debit balances in every account are notionally translated into a single currency (U.S. dollars) and then notionally pooled. The bank extends overdraft credit to any participating ACE entity as needed, provided that the overall notionally-pooled balance of all accounts in each pool at the end of each day is at least zero. Actual cash balances are not physically converted and are not co-mingled between legal entities. ACE entities may incur overdraft balances as a means to address short-term timing mismatches, and any overdraft balances incurred under this program by an ACE entity would be guaranteed by ACE Limited (up to $150 million in the aggregate). Our revolving credit facility allows for same day drawings to fund a net pool overdraft should participating ACE entities withdraw contributed funds from the pool.
We also utilize reverse repurchase agreements as a low-cost alternative for short-term funding needs. We utilized this funding source to fund part of the purchase of Combined Insurance.
Capital Resources
Capital resources consist of funds deployed or available to be deployed to support our business operations. The following table summarizes the components of our capital resources at September 30, 2008, and December 31, 2007.
Total debt
Common shareholders’ equity
Total capitalization
Ratio of debt to total capitalization
Ratio of debt plus trust preferred securities to total capitalization
We have executed reverse repurchase agreements with certain counterparties whereby we agreed to sell securities and repurchase them at a date in the future for a predetermined price. During the quarter ended March 31, 2008, we executed reverse repurchase agreements totaling $1 billion as part of the financing of the Combined Insurance acquisition. All such reverse repurchase agreements had been settled at September 30, 2008. In February 2008, ACE INA issued $300 million of 5.8 percent senior notes due March 2018 and, on April 1, 2008, we entered into a $450 million unsecured term loan repayable in April 2013. The proceeds of the above-referenced reverse repurchase agreements, the notes, and the term loan were applied to pay a portion of the purchase price of the acquisition of the outstanding capital stock of Combined Insurance.
82
On October 1, 2008, we repaid $250 million of ACE US Holdings’ unsecured senior notes due October 2008 (included in short-term debt in the above table). We raised funds for this repayment by executing reverse repurchase agreements, under which $250 million is payable in December 2008. We expect to execute short-term reverse repurchase agreements to raise funds for the December 2008 repayment. Also included in short-term debt, is an $83 million 7.8 percent note due in December 2008. We are in the process of obtaining unsecured financing that will be used to refinance the note when it matures.
On May 12, 2008, ACE INA issued $450 million of 5.6 percent senior notes, due May 2015. The net proceeds plus available cash were used to redeem all $575 million of the 7.8 percent Preferred Shares and related depository shares on June 13, 2008.
Total shareholders’ equity decreased $1.3 billion in the nine months ended September 30, 2008. The following table reports the significant movements in our shareholders’ equity for the nine months ended September 30, 2008.
Total shareholders’ equity, December 31, 2007
Dividends on Common Shares
Proceeds from exercise of options
Change in net unrealized appreciation (depreciation) on investments
Other movements, net
Total shareholders’ equity, September 30, 2008
As part of our capital management program, our Board of Directors has authorized the repurchase of any ACE issued debt or capital securities including Common Shares up to $250 million. At September 30, 2008, this authorization had not been utilized. We generally maintain shelf registration capacity at all times in order to allow capital market access for refinancing as well as for unforeseen capital needs. Consistent with this policy, in 2005, we filed an unlimited shelf registration which expires in December 2008. We expect to file a new shelf registration to replace the one that expires in December 2008.
On January 11, 2008, and April 14, 2008, we paid dividends of 27 cents per Ordinary Share to shareholders of record on December 31, 2007, and March 31, 2008, respectively. On July 11, 2008, we paid dividends of 29 cents per share to shareholders of record on June 30, 2008. On October 14, 2008, we paid dividends of 26 cents per share (CHF 0.30) to shareholders of record on September 30, 2008, through a distribution from the par value of Common Shares (refer to “Effects of the Continuation on Dividends”). We have paid dividends each quarter since we became a public company in 1993.
On March 1, 2008, and June 1, 2008, we paid a dividend of $4.875 per Preferred Share to shareholders of record on February 29, 2008, and May 31, 2008, respectively. The Preferred Shares were redeemed on June 13, 2008.
Effects of the Continuation on Dividends
Under Swiss law all dividends and distributions through a reduction in par value, must be approved in advance by our shareholders, though the determination of the record and payment dates may be delegated to our Board of Directors. Swiss law permits distributions to shareholders by way of par value reductions if (a) after the implementation of the par value reduction the reduced aggregate nominal value of the share capital and the
83
statutory reserves is covered by net assets, (b) they are approved by shareholders at a general meeting, (c) the auditor confirms to the general meeting in a written report that the claims of the creditors are fully covered despite the par value reduction, (d) creditors are informed by way of public notification in the Swiss Commercial Gazette that they can within two months ask for discharge of or the posting of security for their claims and (e) the par value reduction is registered in the Swiss commercial register.
We currently intend, subject to the discretion of our Board of Directors and the needs of our business, to propose at each annual general meeting, beginning with our annual general meeting in 2009, a reduction in par value that will be effected in four quarterly installments. The amount of a proposed par value reduction will be based on the Board of Directors’ determination of an appropriate U.S. dollar dividend for the succeeding year and will be converted into Swiss francs for purposes of obtaining shareholder approval based on the U.S. dollar/Swiss franc exchange rate shortly before the annual general meeting. At our 2008 annual general meeting, our shareholders approved payments of a dividend in the form of a par value reduction equal to CHF 0.90 per Common Share in the aggregate, (equivalent at the time to U.S. $0.87 per Common Share), to be paid in three equal quarterly installments of CHF 0.30 (each equivalent at the time to U.S. $0.29 per Common Share).
Dividends, including distributions through a reduction in par value, must be declared by ACE in Swiss francs. However, we have arranged it such that these distributions are paid to our shareholders in U.S. dollars at the U.S. dollar/Swiss franc exchange rate shortly before the payment date. As a result, under the current process, shareholders will be exposed to fluctuations in the U.S. dollar/Swiss franc exchange rate between the date a dividend amount is determined and the relevant dividend payment date. For example, on October 14, 2008, we paid a quarterly dividend (through a reduction in par value) of U.S. $0.26 per Common Share to shareholders of record as of September 30, 2008. The payment amount was based on the October 7, 2008, U.S. dollar/Swiss Franc exchange rate of 1.1399 applied to the quarterly par value reduction installment amount of CHF 0.30 referenced above.
When proposing a par value reduction, our Board of Directors may also, but is not required to, consider the difference between U.S. dollars actually received by shareholders in the prior year and the U.S. dollar amount on which the prior year’s par value reduction was based. Should we determine to pay dividends other than by a reduction in par value, under Swiss law, such dividends (other than through reductions in par value) may be paid out only if the corporation has sufficient distributable profits from previous business years, or if the reserves of the corporation are sufficient to allow distribution of a dividend. The board of directors of a Swiss corporation may propose that a dividend be paid, but cannot itself set the dividend. The Company auditors must confirm that the dividend proposal of the board of directors conforms with statutory law. Prior to the distribution of dividends, five percent of the annual profits must be allocated to the general reserve until the amount of general reserves has reached twenty percent of the paid-in nominal share capital. Our Swiss Articles of Association can provide for a higher general reserve or for the creation of further reserves setting forth their purpose and use. Once this level has been reached and maintained, the shareholders meeting may approve a distribution of each year’s profit within the framework of applicable legal requirements. Dividends paid from retained earnings are usually due and payable immediately after the shareholders’ resolution relating to the allocation of profits has been passed. Under Swiss law, the statute of limitations in respect of claims for dividend payments is five years. As noted above, for the foreseeable future, we expect to pay dividends as a repayment of share capital in the form of a reduction in par value or qualified paid-in capital, which would not be subject to Swiss withholding tax.
Effects of the Continuation on par value of Common Shares
In connection with the Continuation, we changed the currency in which the par value of Ordinary Shares is stated from U.S. dollars to Swiss francs and increased the par value of Ordinary Shares from $0.041666667 to CHF 33.74 (the New Par Value) through a conversion of all issued Ordinary Shares into “stock” and re-conversion of the stock into Ordinary Shares with a par value equal to the New Par Value (the Par Value Conversion). The Par Value Conversion was followed immediately by a stock dividend, to effectively return shareholders to the number of Ordinary Shares held before the Par Value Conversion. Upon the effectiveness of the Continuation,
84
our Ordinary Shares became Common Shares. For purposes of the Consolidated Financial Statements, the increase in par value was accomplished by a corresponding reduction first to retained earnings and second to additional paid-in capital to the extent that the increase in par value exhausted retained earnings at the date of the Continuation. On September 30, 2008, we reduced the par value by CHF 0.30 to CHF 33.44 in connection with the quarterly dividend declaration.
For more information, including covenant restrictions on our credit facilities, refer to “Liquidity and Capital Resources” included in our 2007 Form 10-K.
Credit Facilities
As our Bermuda subsidiaries are not admitted insurers and reinsurers in the U.S., the terms of certain U.S. insurance and reinsurance contracts require them to provide letters of credit (LOCs) to clients. In addition, ACE Global Markets is required to satisfy certain U.S. regulatory trust fund requirements which can be met by the issuance of LOCs. LOCs may also be used for general corporate purposes and for funds at Lloyd’s.
The following table shows our main credit facilities by credit line, usage, and expiry date at September 30, 2008.
Unsecured Liquidity Facilities
ACE Limited2
Unsecured Operational LOC Facilities
ACE Limited
Unsecured Capital Facilities
ACE Limited3
Certain facilities are guaranteed by operating subsidiaries and/or ACE Limited.
May also be used for LOCs.
(3)
Supports ACE Global Markets underwriting capacity for Lloyd’s Syndicate 2488.
The facilities in the table above require that we maintain certain covenants, all of which have been met at September 30, 2008. These covenants include (but are not limited to):
At September 30, 2008, (a) the minimum consolidated net worth requirement under the covenant described in (i) above was $11.97 billion and our actual consolidated net worth as calculated under that covenant was $16.5 billion and (b) our ratio of debt to total capitalization was 0.18 to 1.
Our failure to comply with the covenants under any credit facility would, subject to grace periods in the case of certain covenants, result in an event of default. This could require us to repay any outstanding borrowings or to cash collateralize LOCs under such facility. A failure by ACE Limited (or any of its subsidiaries) to pay an
85
obligation due for an amount exceeding $50 million would result in an event of default under all of the facilities described above.
ACE Limited and its subsidiaries are assigned debt and financial strength (insurance) ratings from internationally recognized rating agencies, including S&P, A.M. Best, Moody’s Investors Service, and Fitch. The ratings issued on our companies by these agencies are announced publicly and are available directly from the agencies. Our Internet site, www.acelimited.com, also contains some information about our ratings, which can be found under the Investor Information tab. Financial strength ratings reflect the rating agencies’ opinions of a company’s claims paying ability. Independent ratings are one of the important factors that establish our competitive position in the insurance markets. The rating agencies consider many factors in determining the financial strength rating of an insurance company, including the relative level of statutory surplus necessary to support the business operations of the company. These ratings are based upon factors relevant to policyholders, agents, and intermediaries and are not directed toward the protection of investors. Such ratings are not recommendations to buy, sell, or hold securities. Debt ratings apply to short-term and long-term debt as well as preferred stock. These ratings are assessments of the likelihood that we will make timely payments of principal, interest, and preferred stock dividends.
It is possible that, in the future, one or more of the rating agencies may reduce our existing ratings. If one or more of our ratings were downgraded, we could incur higher borrowing costs and our ability to access the capital markets could be impacted. In addition, our insurance and reinsurance operations could be adversely impacted by a downgrade in our financial strength ratings, including a possible reduction in demand for our products in certain markets. For example, the ACE Global Markets capital facility requires that collateral be posted if the S&P financial strength rating of ACE falls to BBB+ or lower. Similarly, we have private debt that would require us to post additional collateral if the S&P financial strength rating of ACE falls to BBB+ or lower. Also, we have insurance and reinsurance contracts which contain rating triggers. In the event the S&P financial strength rating of ACE falls to BBB+ or lower, we may be faced with the cancellation of premium or be required to post collateral on our underlying obligation associated with this premium.
Recent Accounting Pronouncements
Refer to Note 2 to the Consolidated Financial Statements, for a discussion of recent accounting pronouncements.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Refer to the Item 7A. included in our 2007 Form 10-K. There have been no material changes to this item since December 31, 2007.
Item 4. Controls and Procedures
As of the end of the period covered by this report, the Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15 under the Securities Exchange Act of 1934. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in allowing information required to be disclosed in reports filed under the Securities and Exchange Act of 1934 to be recorded, processed, summarized, and reported within time periods specified in the rules and forms of the SEC and accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
During the quarter ended September 30, 2008, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
86
Item 1. Legal Proceedings
Our insurance subsidiaries are subject to claims litigation involving disputed interpretations of policy coverages and, in some jurisdictions, direct actions by allegedly-injured persons seeking damages from policyholders. These lawsuits, involving claims on policies issued by our subsidiaries which are typical to the insurance industry in general and in the normal course of business, are considered in our loss and loss expense reserves. In addition to claims litigation, we and our subsidiaries are subject to lawsuits and regulatory actions in the normal course of business that do not arise from, or directly relate to, claims on insurance policies. This category of business litigation typically involves, amongst other things, allegations of underwriting errors or misconduct, employment claims, regulatory activity, or disputes arising from our business ventures.
While the outcomes of the business litigation involving us cannot be predicted with certainty at this point, we are disputing and will continue to dispute allegations against us that are without merit and believe that the ultimate outcomes of the matters in this category of business litigation will not have a material adverse effect on our financial condition, future operating results, or liquidity, although an adverse resolution of a number of these items could have a material adverse effect on our results of operations in a particular quarter or fiscal year.
Information on the insurance industry investigations and related matters is set forth in Note 9 b) to our Consolidated Financial Statements.
Item 1A. Risk Factors
The following supplements the factors that could have a material impact on our results of operations or financial condition as described under “Risk Factors” in Item 1A. of Part I of our 2007 Annual Report on Form 10-K and under “Risk Factors” in Item 1A. of Part II of our quarterly reports on Form 10-Q for the quarters ended June 30, 2008, and March 31, 2008.
A recession and other adverse consequences of the recent U.S. and global economic and financial industry downturns could harm our business, our liquidity and financial condition, and our stock price.
Global market and economic conditions have been severely disrupted. These conditions, including the possibility of a recession, may potentially affect (among other aspects of our business) the demand for and claims made under our products, the ability of customers, counterparties and others to establish or maintain their relationships with us, our ability to access and efficiently use internal and external capital resources, the risks we assume under reinsurance programs covering variable annuity guarantees, and our investment performance. Continued volatility in the U.S. and other securities markets may adversely affect our stock price.
The effects of emerging claim and coverage issues on our business are uncertain.
As industry practices and legislative, regulatory, judicial, social, financial and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the frequency and severity of claims. In some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued.
We may require additional capital or financing sources in the future, which may not be available or may be available only on unfavorable terms.
Our future capital and financing requirements 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, as well as our investment performance. We may need to raise additional funds through financings or access funds through
87
existing or new credit facilities. Any equity or debt financing, if available at all, may be on terms that are not favorable 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 Common Shares. Our access to funds under existing credit facilities is dependent on the ability of the banks that are parties to the facilities to meet their funding commitments. Those banks may not be able to meet their funding commitments if they experience shortages of capital and liquidity or if they experience excessive volumes of borrowing requests within a short period of time, and we might be forced to replace credit sources in a difficult market. There has also been recent consolidation in the industry, which could lead to increased reliance on and exposure to particular institutions. If we cannot obtain adequate capital or sources of credit on favorable terms, or at all, our business, operating results, and financial condition could be adversely affected. It is possible that, in the future, one or more of the rating agencies may reduce our existing ratings. If one or more of our ratings were downgraded, we could incur higher borrowing costs and our ability to access the capital markets could be impacted.
Our investment performance may affect our financial results and ability to conduct business.
Our funds are invested by professional investment management firms under the direction of our management team in accordance with investment guidelines approved by the Finance and Investment Committee of the Board of Directors. Although our investment guidelines stress diversification of risks and conservation of principal and liquidity, our investments are subject to market risks, as well as risks inherent in individual securities. The volatility of our loss claims may force us to liquidate securities, which may cause us to incur capital losses. Investment losses could significantly decrease our book value, thereby affecting our ability to conduct business. The recent unprecedented investment market volatility, precipitous stock market decline and increased credit spreads have resulted in significant realized and unrealized losses in our investment portfolio. Refer to “Fair Value Measurements”, “Net Realized and Unrealized Gains (Losses)”, and “Investments”, under Item 2 of Part 1 of this Form 10-Q.
Our investment portfolio has exposure to below investment-grade securities that have a higher degree of credit or default risk which could adversely affect our results of operations and financial condition.
Our fixed income portfolio is primarily invested in high quality, investment-grade securities. However, we invest a smaller portion of the portfolio in below investment-grade securities. These securities, which pay a higher rate of interest, also have a higher degree of credit or default risk. These securities may also be less liquid in times of economic weakness or market disruptions. While we have put in place procedures to monitor the credit risk and liquidity of our invested assets, it is possible that, in periods of economic weakness (such as recession), we may experience default losses in our portfolio. This may result in a reduction of net income and capital. Refer to “Fair Value Measurements”, “Net Realized and Unrealized Gains (Losses)”, and “Investments”, under Item 2 of Part 1 of this Form 10-Q.
Our net income may be volatile because certain products offered by our Life business expose us to reserve and fair value liability changes that are directly affected by market factors.
Under reinsurance programs covering variable annuity guarantees, we assume the risk of guaranteed minimum death benefits (GMDB) and GMIBs associated with variable annuity contracts. Our net income is directly impacted by changes in the reserves calculated in connection with the reinsurance of GMDB and GMIB liabilities. In addition, our net income is directly impacted by the change in the fair value of the GMIB liability. The reserve and fair value liability calculations are directly affected by market factors, the most significant of which are equity levels, interest rate levels, interest rate swap volatilities, and implied equity volatilities. ACE views our variable annuity reinsurance business as having a similar risk profile to that of catastrophe reinsurance, with the probability of a cumulative long-term economic net loss relatively small, even taking into account current market conditions. However, in the short-run, adverse changes in market factors will have an adverse impact on both life underwriting income and our net income, which may be material. Refer to “Fair Value Measurements”, “Net Realized and Unrealized Gains (Losses)”, and “Investments”, under Item 2 of Part 1 of this Form 10-Q.
88
Events may result in political, regulatory, and industry initiatives which could adversely affect our business.
Government intervention has occurred in the insurance and reinsurance markets in relation to terrorism coverage both in the U.S. and through industry initiatives in other countries. The Terrorism Risk Insurance Act (TRIA), which was enacted in 2002 to ensure the availability of insurance coverage for certain types of terrorist acts in the U.S., was extended in 2007 for seven years, through 2014. Refer to “Regulation – U.S. Operations” for more information in our 2007 Annual Report on Form 10-K.
Government intervention and the possibility of future interventions has created uncertainty in the insurance and reinsurance markets about the definition of terrorist acts and the extent to which future coverages will extend to terrorist acts. Government regulators are generally concerned with the protection of policyholders to the exclusion of other constituencies, including shareholders of insurers and reinsurers. While we cannot predict the exact nature, timing, or scope of possible governmental initiatives, such proposals could adversely affect our business by:
providing insurance and reinsurance capacity in markets and to consumers that we target;
requiring our participation in industry pools and guaranty associations;
expanding the scope of coverage under existing policies;
regulating the terms of insurance and reinsurance policies; or
disproportionately benefiting the companies of one country over those of another.
The insurance industry is also affected by political, judicial, and legal developments that may create new and expanded theories of liability. Such changes may result in delays or cancellations of products and services by insurers and reinsurers, which could adversely affect our business. In addition, the recent economic climate presents additional uncertainties and risks relating to increased regulation and the potential for increased involvement of the U.S. and other governments in the financial services industry.
Changes in U.S. federal income tax law could adversely affect an investment in our shares.
Legislation is periodically introduced in the U.S. Congress intended to eliminate some perceived tax advantages of companies (including insurance companies) that have legal domiciles outside the United States but have certain U.S. connections. For example, in the current Congress a bill was introduced in the House of Representatives that would effectively render cross border affiliate reinsurance by foreign-owned U.S. insurance/reinsurance companies impossible regardless of whether or not it is properly priced under the internationally accepted arms-length standard. Companion legislation has not yet been introduced in the Senate. If enacted, such a law could have an adverse impact on us or our shareholders. It is possible that other legislative proposals could emerge in the future that could have an adverse impact on us or our shareholders.
89
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
The following table provides information with respect to purchases by the Company of its Common Shares during the three months ended September 30, 2008.
Issuer’s Purchases of Equity Securities
Period
July 1 through July 31
August 1 through August 31
September 1 through September 30
Item 6. Exhibits
Refer to the Exhibit Index.
90
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
November 7, 2008
Chairman and Chief
Executive Officer
91
Exhibit
Number
Exhibit Description
92