For the quarterly period ended September 30, 2008
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

        OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

OR

¨        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

        OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 001-31721

AXIS CAPITAL HOLDINGS LIMITED

(Exact name of registrant as specified in its charter)

BERMUDA

(State or other jurisdiction of incorporation or organization)

98-0395986

(I.R.S. Employer Identification No.)

92 Pitts Bay Road, Pembroke, Bermuda HM 08

(Address of principal executive offices and zip code)

(441) 496-2600

(Registrant’s telephone number, including area code)

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 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 the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  x  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

As of October 24, 2008 there were 141,453,047 Common Shares, $0.0125 par value per share, of the registrant outstanding.


Table of Contents

AXIS CAPITAL HOLDINGS LIMITED

INDEX TO FORM 10-Q

 

            Page  
     PART I     
   Financial Information    3
Item 1.    Consolidated Financial Statements    4
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    29
Item 3.    Quantitative and Qualitative Disclosures About Market Risk    57
Item 4.    Controls and Procedures    58
   PART II   
   Other Information    59
Item 1.    Legal Proceedings    59
Item 1A.    Risk Factors    59
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds    60
Item 6.    Exhibits    61
   Signatures    62


Table of Contents

 

 

PART  I FINANCIAL INFORMATION

 

 

Cautionary Statement Regarding Forward-looking Statements

This quarterly report contains forward-looking statements within the meaning of the U.S. federal securities laws. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the United States securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may,” “should,” “could,” “anticipate,” “estimate,” “expect,” “plan,” “believe,” “predict,” “potential” and “intend”. Forward-looking statements contained in this report may include information regarding our estimates of losses related to hurricanes and other catastrophes, including Hurricanes Ike and Gustav, measurements of potential losses in fair market values of our investment portfolio, our expectations regarding pricing and other market conditions, our growth prospects, the amount of our acquisition costs, the amount of our net losses and loss reserves, the projected amount of our capital expenditures, managing interest rate and foreign currency risks, and valuations of potential interest rate shifts and foreign currency rate changes. Forward-looking statements only reflect our expectations and are not guarantees of performance.

These statements involve risks, uncertainties and assumptions. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. We believe that these factors include, but are not limited to, the following:

 

   

the occurrence of natural and man-made disasters,

 

   

actual claims exceeding our loss reserves,

 

   

general economic, capital and credit market conditions,

 

   

the failure of any of the loss limitation methods we employ,

 

   

the effects of emerging claims and coverage issues,

 

   

the failure of our cedants to adequately evaluate risks,

 

   

the loss of one or more key executives,

 

   

a decline in our ratings with rating agencies,

 

   

loss of business provided to us by our major brokers,

 

   

changes in accounting policies or practices,

 

   

changes in governmental regulations,

 

   

increased competition,

 

   

changes in the political environment of certain countries in which we operate or underwrite business,

 

   

interest rate and/or currency value fluctuations, and

 

   

the other matters set forth under Item 1A, “Risk Factors” and Item 7, “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2007.

We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

 

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ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

       Page  

Consolidated Balance Sheets as at September 30, 2008 (Unaudited) and December 31, 2007

   5

Consolidated Statements of Operations for the three and nine months ended September 30, 2008 and 2007 (Unaudited)

   6

Consolidated Statements of Comprehensive Income for the three and nine months ended September  30, 2008 and 2007 (Unaudited)

   7

Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September  30, 2008 and 2007 (Unaudited)

   8

Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007 (Unaudited)

   9

Notes to the Consolidated Financial Statements (Unaudited)

   10

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED BALANCE SHEETS

SEPTEMBER 30, 2008 (UNAUDITED) AND DECEMBER 31, 2007

 

     2008     2007  
     (in thousands)  

Assets

    

Investments:

    

Fixed maturities, available for sale, at fair value
(amortized cost 2008: $8,911,721; 2007: $8,301,528)

   $ 8,449,620     $ 8,331,666  

Equity securities, available for sale, at fair value
(cost 2008: $165,579; 2007:$10,850)

     129,220       7,746  

Other investments, at fair value

     636,304       638,241  
                

Total investments

     9,215,144       8,977,653  

Cash and cash equivalents

     1,419,610       1,332,921  

Accrued interest receivable

     74,693       87,338  

Insurance and reinsurance premium balances receivable

     1,412,445       1,231,494  

Reinsurance recoverable balances

     1,410,554       1,280,295  

Reinsurance recoverable balances on paid losses

     62,617       76,598  

Deferred acquisition costs

     333,002       276,801  

Prepaid reinsurance premiums

     264,960       242,940  

Securities lending collateral

     731,661       865,256  

Net receivable for investments sold

     —         86,356  

Goodwill and intangible assets

     60,726       61,653  

Other assets

     190,042       156,004  
                

Total assets

   $  15,175,454     $  14,675,309  
                

Liabilities

    

Reserve for losses and loss expenses

   $ 6,406,204     $ 5,587,311  

Unearned premiums

     2,466,622       2,146,087  

Insurance and reinsurance balances payable

     223,963       244,988  

Securities lending payable

     730,412       863,906  

Senior notes

     499,342       499,261  

Other liabilities

     183,385       175,134  

Net payable for investments purchased

     64,336       —    
                

Total liabilities

     10,574,264       9,516,687  
                
Commitments and Contingencies     

Shareholders’ equity

    

Preferred shares - Series A and B

     500,000       500,000  

Common shares (2008: 137,991; 2007: 142,520)

     1,878       1,850  

Additional paid-in capital

     1,943,125       1,869,810  

Accumulated other comprehensive (loss) income

     (495,697 )     22,668  

Retained earnings

     3,097,487       2,968,900  

Treasury shares, at cost (2008: 12,451; 2007: 5,466)

     (445,603 )     (204,606 )
                

Total shareholders’ equity

     4,601,190       5,158,622  
                

Total liabilities and shareholders’ equity

   $ 15,175,454     $ 14,675,309  
                

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

 

     Three months ended     Nine months ended  
     2008     2007     2008     2007  
     (in thousands, except for per share amounts)  
Revenues         

Net premiums earned

   $ 689,970     $  685,845     $  2,028,895     $  2,065,090  

Net investment income

     50,583       118,908       273,249       357,873  

Net realized investment losses

     (89,079 )     (1,192 )     (51,842 )     (5,548 )

Other insurance related (loss) income

     (13,806 )     1,005       (19,073 )     3,638  
                                

Total revenues

     637,668       804,566       2,231,229       2,421,053  
                                
Expenses         

Net losses and loss expenses

     705,531       328,193       1,438,929       1,079,714  

Acquisition costs

     90,333       100,039       282,593       293,923  

General and administrative expenses

     86,722       79,813       248,425       210,993  

Foreign exchange gains

     (7,627 )     (7,202 )     (21,360 )     (16,477 )

Interest expense and financing costs

     7,941       13,929       23,789       43,241  
                                

Total expenses

     882,900       514,772       1,972,376       1,611,394  
                                
(Loss) income before income taxes      (245,232 )     289,794       258,853       809,659  

Income tax (recovery) expense

     (5,104 )     10,677       11,554       32,943  
                                
Net (loss) income      (240,128 )     279,117       247,299       776,716  

Preferred share dividends

     9,218       9,142       27,656       27,573  
                                
Net (loss) income available to common shareholders    $  (249,346 )   $ 269,975     $ 219,643     $ 749,143  
                                
Weighted average common shares and common share equivalents:         

Basic

     139,335       146,845       141,628       148,753  
                                

Diluted

     139,335       164,064       157,315       165,458  
                                
Earnings per common share:         

Basic

   $ (1.79 )   $ 1.84     $ 1.55     $ 5.04  
                                

Diluted

   $ (1.79 )   $ 1.65     $ 1.40     $ 4.53  
                                
Cash dividends declared per common share    $ 0.185     $ 0.165     $ 0.555     $ 0.495  
                                

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

 

     Three months ended     Nine months ended
     2008     2007     2008     2007
     (in thousands)

Net (loss) income

   $ (240,128 )   $  279,117     $ 247,299     $  776,716

Other comprehensive income, net of tax

        

Change in unrecognized prior service cost on the supplemental executive retirement plans (SERPs)

     562       562       1,687       1,687

Unrealized (losses) gains arising during the period

     (434,834 )     77,803       (573,831 )     10,109

Adjustment for re-classification of investment (gains) losses realized in net income

     89,296       (116 )     53,779       4,398
                              
Comprehensive (loss) income    $  (585,104 )   $ 357,366     $  (271,066 )   $ 792,910
                              

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

 

     2008     2007  
     (in thousands)  

Common shares (shares outstanding)

    

Balance at beginning of period

     142,520       149,982  

Shares issued

     2,456       729  

Shares repurchased for treasury

     (6,985 )     (2,226 )

Shares repurchased and cancelled

     —         (2,775 )
                
Balance at end of period      137,991       145,710  
                
Preferred shares - Series A and B     

Balance at beginning and end of period

   $ 500,000     $ 500,000  
                
Common shares (par value)     

Balance at beginning of period

     1,850       1,875  

Shares issued

     28       9  

Shares repurchased and cancelled

     —         (35 )
                
Balance at end of period      1,878       1,849  
                
Additional paid-in capital     

Balance at beginning of period

     1,869,810       1,929,406  

Shares issued

     2,623       1,294  

Shares repurchased and cancelled

     —         (103,436 )

Stock options exercised

     23,655       6,399  

Share-based compensation expense

     47,037       25,404  
                
Balance at end of period      1,943,125       1,859,067  
                
Accumulated other comprehensive income (loss)     

Balance at beginning of period

     22,668       (44,638 )

Unrealized depreciation on fixed maturities and equities

     (525,905 )     15,891  

Amortization of prior service cost on the SERPs

     1,687       1,687  

Change in deferred taxes

     5,853       (1,384 )
                
Balance at end of period      (495,697 )     (28,444 )
                
Retained earnings     

Balance at beginning of period

     2,968,900       2,026,004  

Net income

     247,299       776,716  

Series A and B preferred share dividends

     (27,656 )     (27,573 )

Common share dividends

     (91,056 )     (84,405 )
                
Balance at end of period      3,097,487       2,690,742  
                
Treasury shares, at cost     

Balance at beginning of period

     (204,606 )     —    

Shares repurchased for treasury

     (240,997 )     (79,622 )
                
Balance at end of period      (445,603 )     (79,622 )
                
Total shareholders’ equity    $  4,601,190     $  4,943,592  
                

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

 

     2008    2007
     (in thousands)

Cash flows from operating activities:

     

Net income

   $ 247,299     $ 776,716 

Adjustments to reconcile net income to net cash provided by operating activities:

     

Net realized investment losses

     51,842       5,548 

Net unrealized losses (gains) of other investments

     97,586       (14,300)

Amortization/accretion of fixed maturities

     10,516       (13,808)

Other amortization and depreciation

     8,263       17,566 

Share-based compensation expense

     47,037       25,404 

Changes in:

     

Accrued interest receivable

     12,645       710 

Reinsurance recoverable balances

     (116,278)      14,387 

Deferred acquisition costs

     (56,201)      (79,491)

Prepaid reinsurance premiums

     (22,020)      (4,206)

Reserve for loss and loss expenses

     818,893       516,266 

Unearned premiums

     320,535       417,783 

Insurance and reinsurance balances, net

     (201,976)      (298,116)

Other items

     10,115       (86,153)
             

Net cash provided by operating activities

     1,228,256       1,278,306 
             
Cash flows from investing activities:      

Purchases of fixed maturities

      (7,318,695)       (5,579,091)

Sales and maturities of fixed maturities

     6,842,657       4,310,846 

Purchases of equity securities

     (289,966)      -     

Sales of equity securities

     64,835       -     

Purchases of other investments

     (141,000)      (65,250)

Sales of other investments

     69,521       585,395 

Purchases of assets

     (8,640)      (38,261)
             

Net cash used in investing activities

     (781,288)      (786,361)
             

Cash flows from financing activities:

     

Repurchase of shares

     (240,997)      (183,093)

Dividends paid - common shares

     (80,653)      (83,806)

Dividends paid - preferred shares

     (27,656)      (27,573)

Proceeds from exercise of stock options

     23,655       6,399 

Proceeds from issuance of common shares

     2,651       1,303 

Repayment of repurchase agreement

     -           (400,000)
             

Net cash used in financing activities

     (323,000)      (686,770)
             

Effect of exchange rate changes on foreign currency cash

     (37,279)      36,389 
             

Decrease in cash and cash equivalents

     86,689       (158,436)

Cash and cash equivalents - beginning of period

     1,332,921       1,989,287 
             
Cash and cash equivalents - end of period    $  1,419,610     $  1,830,851 
             

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES

Basis of Presentation

Our consolidated balance sheet at September 30, 2008 and the consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for the periods ended September 30, 2008 and 2007 have not been audited. The balance sheet at December 31, 2007 is derived from the audited financial statements.

These statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) for interim financial information and with the Securities and Exchange Commission’s instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of our financial position and results of operations as at the end of and for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All significant inter-company accounts and transactions have been eliminated. In these notes, the terms “we,” “us,” “our,” or the “Company” refer to AXIS Capital Holdings Limited and its subsidiaries.

The following information is unaudited and should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2007. Certain reclassifications have been made to prior period amounts to conform to the current period presentation. Tabular dollars and share amounts are in thousands, except per share amounts.

Adoption of New Accounting Standards

The terms “FAS” and “FASB” used in these notes refer to Statements of Financial Accounting Standards issued by the United States Financial Accounting Standards Board.

(a) Fair Value Measurements

We adopted FAS 157, Fair Value Measurements (“FAS 157”), effective January 1, 2008. Under this standard, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants at the measurement date.

In determining fair value, we use various valuation approaches, including market and income approaches. FAS 157 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. The hierarchy is broken down into three levels based on the reliability of inputs as follows:

 

   

Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Valuation adjustments and block discounts are not applied to Level 1 instruments. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.

Examples of assets and liabilities utilizing Level 1 inputs include: exchange-traded equity securities and listed derivatives that are actively traded.

 

   

Level 2—Valuations based on quoted prices in active markets for similar assets or liabilities, quoted prices for identical assets or liabilities in inactive markets, or for which significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.

Examples of assets and liabilities utilizing Level 2 inputs include: exchange-traded equity securities and listed derivatives that are not actively traded; U.S. government and agency securities; non-U.S. government obligations; corporate and municipal bonds; mortgage-backed securities (“MBS”) and asset-backed securities (“ABS”); and over-the-counter (“OTC”) derivatives (e.g. foreign currency options and forward contracts).

 

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AXIS CAPITAL HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED)

 

Adoption of New Accounting Standards (Continued)

 

   

Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own assumptions about assumptions that market participants might use.

Examples of assets and liabilities utilizing Level 3 inputs include: insurance and reinsurance derivative contracts; hedge funds with partial transparency; and collateralized loan obligation (“CLO”)—equity tranche securities, credit funds and short duration high yield funds that are traded in less liquid markets.

The availability of observable inputs can vary from financial instrument to financial instrument and is affected by a wide variety of factors, including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment. Accordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. We use prices and inputs that are current as of the measurement date. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified between levels.

The adoption of FAS 157 did not result in any cumulative-effect adjustment to our beginning retained earnings at January 1, 2008. In February 2008, the FASB issued 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 statements on a recurring basis (at least annually). Accordingly, we have also adopted FSP FAS 157-2 effective January 1, 2008. FAS 157 will not be applied to our goodwill and other intangible assets measured annually for impairment testing purposes only. We will adopt FAS 157 for non-financial assets and non-financial liabilities on January 1, 2009. We do not anticipate this adoption will have a material impact on our results of operations, financial position or liquidity.

On October 10, 2008, the FASB issued Staff Position No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, which provided further clarification on fair value measurement for financial assets in inactive markets.

(b) Fair Value Option

FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”), became effective on January 1, 2008. Under this standard, an entity is permitted to irrevocably elect fair value on a contract-by-contract basis as the initial and subsequent measurement attribute for many financial instruments and certain other items including insurance contracts. We did not elect the fair value option for our available for sale investments and therefore future changes in unrealized gains and losses on these investments, net of tax, will continue to be reported through accumulated other comprehensive income (loss) in our shareholders’ equity. Accordingly, FAS 159 did not have an impact on our results of operations, financial position or liquidity.

 

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AXIS CAPITAL HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED)

 

Accounting Standards Not Yet Adopted

(a) Business Combinations and Non-controlling Interests

In December 2007, the FASB issued FAS No. 141(R), Business Combinations (“FAS 141(R)”) and FAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51 (“FAS 160”). FAS 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to provide additional disclosures on the nature and financial effect of the business combination. FAS 141(R) applies to all transactions or other events in which the acquirer obtains control of one or more businesses, even if control is not obtained by purchasing equity interests or net assets. FAS 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. Both FAS 141(R) and FAS 160 apply prospectively to business combinations for which the acquisition date is on or after December 15, 2008, except for the presentation and disclosure requirements of FAS 160 which will be applied retrospectively for all periods presented.

(b) Derivative Instruments and Hedging Activities

In March 2008, the FASB issued FAS No. 161, Disclosures about Derivative Instruments and Hedging Activitiesan amendment of FASB Statement No. 133 (“FAS 161”). This Statement expands the disclosure requirements of FAS 133 and requires the reporting entity to provide enhanced disclosures about the objectives and strategies for using derivative instruments, quantitative disclosures about fair values and amounts of gains and losses on derivative contracts, and credit-risk related contingent features in derivative agreements. FAS 161 will be effective for fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. As FAS 161 requires only additional disclosures concerning derivatives and hedging activities, its adoption will not affect our results of operations, financial position or liquidity.

(c) Financial Guarantee Insurance Contracts

In May 2008, the FASB issued FAS No. 163, Accounting for Financial Guarantee Insurance Contracts (“FAS 163”). This new standard clarifies how FAS No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities. It also requires expanded disclosures about financial guarantee insurance contracts. FAS 163 is effective for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for disclosures about the insurance enterprise’s risk-management activities, which are effective the first period (including interim periods) beginning after the date of issuance. Except for the required disclosures, earlier application is not permitted. We do not anticipate this adoption will have a material impact on our results of operations, financial position or liquidity.

(d) Credit Derivatives and Guarantee Disclosures

In September 2008, the FASB issued Staff Position No. FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161. This Staff Position amends FAS 133 to require a seller of credit derivatives, including credit derivatives embedded in hybrid instruments, to provide certain disclosures for each credit derivative (or group of similar credit derivatives) for each balance sheet presented. These disclosures must be provided even if the likelihood of having to make payments is remote. The Staff Position also clarifies that FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We do not anticipate the adoption of this Staff Position will have a material impact on our results of operations, financial position or liquidity.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

2. SEGMENT INFORMATION

 

Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Re and therefore we have determined that we have two reportable segments, insurance and reinsurance. Except for goodwill and intangible assets, we do not allocate our assets by segment as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.

Insurance

Our insurance segment offers specialty insurance products to a variety of niche markets on a global basis. The following are the lines of business in our insurance segment:

 

   

Property: provides physical damage and business interruption coverage primarily for industrial and commercial properties and physical damage, business interruption and liability coverage for onshore energy properties and operations. The book consists of both primary and excess risks, some of which are catastrophe-exposed.

 

   

Marine: provides coverage for hull, liability, cargo and specie and recreational marine risks. These risks include property damage or physical loss to ships, pollution damage caused by vessels on a sudden and accidental basis, protection for general cargo and the contents of armored cars, vaults, exhibitions and museums, and specific war related risks. This line of business also provides physical damage, business interruption and liability coverage for offshore energy property and operations.

 

   

Terrorism: provides coverage for physical damage and business interruption of an insured following an act of terrorism.

 

   

Aviation: includes hull and liability and specific war coverage for passenger and cargo airlines and privately owned aircraft as well as select aviation product liability coverage.

 

   

Political risk: provides protection against sovereign default or sovereign actions that result in the impairment of cross-border investments for banks and major corporations. This book also provides sovereign and corporate credit insurance, where lenders seek to mitigate the risk of non-payment from their borrowers.

 

   

Professional lines: includes coverage for directors’ and officers’ liability, errors and omissions liability, employment practices liability, media, cyber, technology and miscellaneous professional liability coverage.

 

   

Liability: primarily targets general liability and umbrella and excess liability in the U.S. excess and surplus lines markets. Target classes include mercantile, manufacturing and building/premises, with particular emphasis on commercial and consumer products, commercial construction and miscellaneous general liability.

 

   

Other: primarily includes employee medical coverage for self-insured, small and medium sized employers for losses in excess of a retention.

 

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2. SEGMENT INFORMATION (CONTINUED)

 

Reinsurance

Our reinsurance segment provides treaty and facultative property and casualty reinsurance to insurance companies on a worldwide basis. The following are the lines of business in our reinsurance segment:

 

   

Catastrophe: provides protection for most catastrophic losses that are covered in the underlying insurance policies written by our ceding company clients. The exposure in the underlying policies is principally property exposure but also covers other exposures including workers compensation, personal accident and life. The principal perils in this portfolio are hurricane and windstorm, earthquake, flood, tornado, hail and fire. In some instances, terrorism may be a covered peril or the only peril. We underwrite catastrophe reinsurance principally on an excess of loss basis, meaning that our exposure only arises when our customers’ claims exceed a certain retained amount.

 

   

Property: includes reinsurance written on both a pro rata and a per risk basis and covers underlying personal lines and commercial property exposures. Property pro rata treaty reinsurance covers a cedent’s aggregate losses from all events in the covered period on a proportional basis. Property per risk treaty reinsurance reinsures a portfolio of particular property risks of ceding companies on an excess of loss basis.

 

   

Professional Liability: covers directors’ and officers’ liability, employment practices liability, medical malpractice and miscellaneous errors and omissions insurance risks.

 

   

Credit and Bond: consists principally of reinsurance of trade credit insurance products and includes both proportional and excess-of loss structures. The underlying insurance indemnifies sellers of goods and services against a payment default by the buyer of those goods and services. Also included in this book is coverage for ceding insurers against losses arising from a broad array of surety bonds issued by bond insurers principally to satisfy regulatory demands in a variety of jurisdictions around the world, but predominantly in Europe.

 

   

Motor: provides coverage to insurers for motor liability losses arising out of any one occurrence. The occurrence can involve one or many claimants where the ceding insurer aggregates the claims from the occurrence.

 

   

Liability: provides coverage to insurers of standard casualty lines, including auto liability, general liability, personal and commercial umbrella and workers’ compensation.

 

   

Engineering: provides coverage for all types of civil construction risks and risks associated with erection, testing and commissioning of machinery and plants during the construction stage. This line of business also includes operational risks for machinery, plant and equipment, electronic equipment and business interruption. We write engineering business on a proportional and non-proportional treaty basis as well as on a facultative basis.

 

   

Other: includes aviation, marine, personal accident and crop reinsurance.

 

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2. SEGMENT INFORMATION (CONTINUED)

 

The following tables summarize the underwriting results of our operating segments for the periods indicated and the carrying values of goodwill and intangible assets as at September 30, 2008 and 2007:

 

      2008     2007       
Three months ended September 30,    Insurance     Reinsurance     Total     Insurance     Reinsurance     Total       

Gross premiums written

   $  402,672     $  322,611     $  725,283     $ 480,729     $ 274,495     $  755,224      

Net premiums written

     235,666       315,750       551,416       315,605       268,297       583,902      

Net premiums earned

     293,572       396,398       689,970       301,925       383,920       685,845      

Other insurance related (loss) income

     (13,751 )     (55 )     (13,806 )     610       395       1,005      

Net losses and loss expenses

     (230,577 )     (474,954 )     (705,531 )     (113,092 )     (215,101 )     (328,193 )    

Acquisition costs

     (21,964 )     (68,369 )     (90,333 )     (34,721 )     (65,318 )     (100,039 )    

General and administrative expenses

     (49,361 )     (17,366 )     (66,727 )     (43,262 )     (15,828 )     (59,090 )    
                                              

Underwriting (loss) income

   $ (22,081 )   $ (164,346 )     (186,427 )   $ 111,460     $ 88,068       199,528      
                                  

Corporate expenses

         (19,995 )         (20,723 )    

Net investment income

         50,583           118,908      

Net realized investment losses

         (89,079 )         (1,192 )    

Foreign exchange gains

         7,627           7,202      

Interest expense and financing costs

         (7,941 )         (13,929 )    
                              

(Loss) income before income taxes

       $  (245,232 )       $ 289,794      
                              
   

Net loss and loss expense ratio

     78.5%       119.8%       102.3%       37.5%       56.0%       47.9%      

Acquisition cost ratio

     7.5%       17.2%       13.1%       11.5%       17.0%       14.6%      

General and administrative expense ratio

     16.8%       4.4%       12.6%       14.3%       4.1%       11.6%      
                                                      

Combined ratio

     102.8%       141.4%       128.0%       63.3%       77.1%       74.1%      
                                                      
   
Goodwill and intangible assets    $ 60,726     $ -         $ 60,726     $ 61,967     $ -         $ 61,967      
                                                      
                                                      

 

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2. SEGMENT INFORMATION (CONTINUED)

 

      2008     2007       
Nine months ended September 30,    Insurance     Reinsurance     Total     Insurance     Reinsurance     Total       

Gross premiums written

   $  1,392,993     $  1,470,640     $  2,863,633     $  1,529,888     $  1,487,337     $  3,017,225      

Net premiums written

     872,909       1,454,498       2,327,407       1,004,536       1,474,066       2,478,602      

Net premiums earned

     890,558       1,138,337       2,028,895       915,102       1,149,988       2,065,090      

Other insurance related (loss) income

     (20,073 )     1,000       (19,073 )     1,737       1,901       3,638      

Net losses and loss expenses

     (549,723 )     (889,206 )     (1,438,929 )     (432,612 )     (647,102 )     (1,079,714 )    

Acquisition costs

     (84,798 )     (197,795 )     (282,593 )     (97,512 )     (196,411 )     (293,923 )    

General and administrative expenses

     (145,321 )     (51,813 )     (197,134 )     (117,952 )     (45,794 )     (163,746 )    
                                              

Underwriting income

   $ 90,643     $ 523       91,166     $ 268,763     $ 262,582       531,345      
                                  

Corporate expenses

         (51,291 )         (47,247 )    

Net investment income

         273,249           357,873      

Net realized investment losses

         (51,842 )         (5,548 )    

Foreign exchange gains

         21,360           16,477      

Interest expense and financing costs

         (23,789 )         (43,241 )    
                              

Income before income taxes

       $ 258,853         $ 809,659      
                              
   

Net loss and loss expense ratio

     61.7%       78.1%       70.9%       47.3%       56.3%       52.3%      

Acquisition cost ratio

     9.6%       17.4%       13.9%       10.7%       17.1%       14.2%      

General and administrative expense ratio

     16.3%       4.5%       12.2%       12.9%       4.0%       10.2%      
                                                      

Combined ratio

     87.6%       100.0%       97.0%       70.9%       77.4%       76.7%      
                                                      
   
Goodwill and intangible assets    $ 60,726     $ -         $ 60,726     $ 61,967     $ -         $ 61,967      
                                                      
                                                      

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

3. INVESTMENTS

 

a) Gross unrealized losses

The following tables summarize investment securities that are in a gross unrealized loss position for the period specified:

 

As at September 30, 2008    12 months or greater     Less than 12 months     Total  
      Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
 

Fixed maturities:

                 

U.S. government and agency

   $ -        $ -         $ 809,710    $ (8,493 )   $ 809,710    $ (8,493 )

Non-U.S. government

     -          -           208,715      (18,405 )     208,715      (18,405 )

Corporate

     176,091      (47,475 )     1,743,579      (240,249 )     1,919,670      (287,724 )

Mortgage-backed

     329,084      (31,618 )     2,175,576      (110,696 )     2,504,660      (142,314 )

Asset-backed

     44,460      (4,868 )     323,137      (22,379 )     367,597      (27,247 )

Municipals

     -          -           175,754      (6,208 )     175,754      (6,208 )
                                               

Total fixed maturities

   $ 549,635    $ (83,961 )   $  5,436,471    $ (406,430 )   $  5,986,106    $ (490,391 )
                                               
   

Equities:

                 

Common stock

   $ -        $ -         $ 89,979    $ (26,871 )   $ 89,979    $ (26,871 )

Non-redeemable preferred stock

     -          -           21,082      (10,313 )     21,082      (10,313 )
                                               

Total equities

   $ -        $ -         $ 111,061    $ (37,184 )   $ 111,061    $ (37,184 )
                                               
   
                                               

 

 

As at December 31, 2007    12 months or greater     Less than 12 months     Total  
      Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
 

Fixed maturities:

                 

U.S. government and agency

   $ 67,131    $ (169 )   $ 7,304    $ (18 )   $ 74,435    $ (187 )

Non-U.S. government

     -          -           87,214      (4,244 )     87,214      (4,244 )

Corporate

     188,901      (4,391 )     776,234      (56,296 )     965,135      (60,687 )

Mortgage-backed

     1,064,646      (13,100 )     241,920      (2,204 )     1,306,566      (15,304 )

Asset-backed

     68,959      (1,391 )     132,735      (6,754 )     201,694      (8,145 )

Municipals

     32,053      (150 )     50,782      (87 )     82,835      (237 )
                                               

Total fixed maturities

   $  1,421,690    $ (19,201 )   $  1,296,189    $ (69,603 )   $  2,717,879    $ (88,804 )
                                               
   

Equities:

                 

Common Stock

   $ -        $ -         $ 7,746    $ (3,104 )   $ 7,746    $ (3,104 )

Non-redeemable preferred stock

     -          -           -          -           -          -      
                                               

Total equities

   $ -        $ -         $ 7,746    $ (3,104 )   $ 7,746    $ (3,104 )
                                               
                                               

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

3. INVESTMENTS (CONTINUED)

 

Insurance enhanced bonds

At September 30, 2008, we held insurance enhanced bonds (mortgage-backed, asset-backed and municipal securities), in the amount of approximately $310 million, which represented approximately 3.4% of our total invested assets. If we exclude the insurance enhancement, the overall credit quality of our insured bond portfolio was an average rating of “Aa2” by Moody’s and “AA” by Standard & Poor’s. The financial guarantors of our $310 million of insurance enhanced bonds include Financial Security Assurance Inc. ($151 million), Ambac Financial Group, Inc. ($67 million), MBIA Insurance Corporation ($65 million), and Financial Guarantee Insurance Company ($18 million). We do not have any significant investments in companies which guarantee securities at September 30, 2008.

Other-than-temporary impairments (OTTI)

At September 30, 2008, 2,087 fixed maturities (2007: 1,440) were in an unrealized loss position with a fair value of $5,986 million (2007: $2,718 million) of which 414 securities (2007: 1,065) have been in continuous unrealized loss position for 12 months or greater and have a fair value of $550 million (2007: $1,422 million). For the three and nine months ended September 30, 2008, we incurred OTTI charges of $44 million (2007: negligible) and $60 million (2007: $2 million) relating primarily to Lehman Brothers corporate bonds. These charges are reported in net realized investment losses in the Consolidated Statements of Operations.

At September 2008, the remaining unrealized losses on fixed maturities were primarily due to widening of credit spreads relating to the market illiquidity, rather than any significant credit downgrades on these securities. Because we have the ability and intent to hold these securities until a recovery of fair value to amortized cost, we currently believe it is probable that we will collect all amounts due according to their respective contractual terms. Therefore we do not consider these fixed maturities to be other-than-temporarily impaired at September 30, 2008.

During the three and nine months ended September 30, 2008, we recorded an OTTI charge for one equity security in the amount of $5 million. The valuation for the remaining equity securities which are below cost is believed to be correlated with the volatility in the equity markets that existed at September 30, 2008. We do not consider these equities to be other-than-temporarily impaired at September 30, 2008, as we have the ability and intent to hold these securities for a reasonable period of time until a recovery of fair value to cost.

 

b) Equity Securities

The cost and fair value of our equity securities at September 30, 2008 and December 31, 2007 are as follows:

 

As at September 30, 2008    Cost    Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair
Value
 
              

Common stocks

   $  134,184    $  825    $ (26,871 )   $  108,138  

Non-redeemable preferred stocks

     31,395      -          (10,313 )     21,082  
                                

Total

   $ 165,579    $ 825    $ (37,184 )   $ 129,220  
                                
   
                                
          
As at December 31, 2007    Cost    Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair
Value
 
              

Common stocks

   $  10,850    $ -        $ (3,104 )   $  7,746  
   
                                

 

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3. INVESTMENTS (CONTINUED)

 

c) Other Investments

The table below provides a breakdown of our portfolio of other investments:

 

      September 30, 2008    December 31, 2007  
   

Hedge funds

   $ 284,613    45%    $ 277,757    44%   

Credit funds

     194,264    30%      194,241    30%  

CLO - equity tranches

     111,590    18%      120,596    19%  

Short duration high yield fund

     45,837    7%      45,647    7%  
                           

Total other investments

   $ 636,304    100%    $ 638,241    100%  
                           
                           

The increase in our hedge funds includes net subscriptions of $48 million, partially offset by an increase in unrealized losses during the year of $41 million. Net subscriptions in our credit funds during 2008 were $57 million, offset by unrealized losses of $57 million. Both unrealized losses were included in net investment income.

 

d) Net Investment Income

Net investment income was derived from the following sources:

 

      Three months ended
September 30,
    Nine months ended
September 30,
 
      2008     2007     2008     2007  

Fixed maturities

   $  108,277     $ 94,902     $  322,168     $  264,902  

Cash and cash equivalents

     11,713       25,280       37,138       71,512  

Other investments

     (66,395 )     1,856       (82,925 )     30,523  

Equity securities

     1,201       -           6,420       -      
                                  

Gross investment income

     54,796       122,038       282,801       366,937  

Investment expenses

     (4,213 )     (3,130 )     (9,552 )     (9,064 )
                                  

Net investment income

   $ 50,583     $ 118,908     $ 273,249     $ 357,873  
                                  
                                  

The following provides an analysis of gross realized gains/losses and the change in unrealized gains/losses on available for sale investments included within accumulated other comprehensive loss:

 

      Three months ended
September 30,
    Nine months ended
September 30,
 
      2008     2007     2008     2007  

Gross realized gains

   $ 35,710     $ 5,004     $ 110,645     $ 12,696  

Gross realized losses

     (126,664 )     (5,686 )     (164,012 )      (18,163 )
                                  

Net realized losses on fixed maturities

     (90,954 )     (682 )     (53,367 )     (5,467 )

Changes in fair values of investment derivatives

     1,875       (510 )     1,525       (81 )
                                  

Net realized investment losses

   $ (89,079 )   $ (1,192 )   $ (51,842 )   $ (5,548 )
                                  
   

Change in unrealized losses on available for sale investments

   $ (346,479 )   $ 79,044     $  (525,905 )   $ 15,891  
                                  
                                  

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

4. FAIR VALUE MEASUREMENTS

 

a) Fair Value Hierarchy

At September 30, 2008, we classified our financial instruments measured at fair value on a recurring basis in the following valuation hierarchy:

 

At September 30, 2008    Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  

Significant
Other Observable
Inputs

(Level 2)

  

Significant
Unobservable
Inputs

(Level 3)

   Total Fair
Value
 
               

Assets

             

Fixed maturities

   $ -        $ 8,449,620    $ -        $   8,449,620   

Equity securities

     129,220      -          -          129,220  

Other investments

     -          45,837      590,467      636,304  

Derivative assets(1)

     -          10,435      -          10,435  
                               

Total

   $ 129,220    $ 8,505,892    $ 590,467    $ 9,225,579  
                               
   

As a percentage of total assets

     0.9%      56.1%      3.9%      60.8%  
   

Liabilities

             

Derivative liabilities(2)

   $ -        $ -        $ 42,597    $ 42,597  
                               
   

As a percentage of total liabilities

           0.4%      0.4%  
                               

 

(1)

Included in other assets

(2)

Included in other liabilities

 

b) Level 3 Financial Instruments

The following table presents changes in Level 3 for our financial instruments measured at fair value on a recurring basis for the three and nine months ended September 30, 2008:

 

      Three months ended     Nine months ended  
September 30, 2008    Other
Investments
    Derivative
Liability
    Other
Investments
    Derivative
Liability
 
   

Balance at beginning of period

   $  677,689     $ 23,790     $  592,593     $ 16,346  

Change in net unrealized gains/losses

     (63,585 )     14,000       (93,038 )     21,444  

Net realized gains/losses

     (4,426 )     -            (4,737 )     -       

Net purchases, sales, and distributions

     (19,211 )     4,807       95,649       4,807  

Net transfers in (out of) of Level 3

     -            -            -            -       
                                  

Balance at end of period

   $ 590,467     $ 42,597     $ 590,467     $ 42,597  
                                  
   

Change in net unrealized (losses) relating to financial instruments held at reporting date

   $ (63,585 )(1)   $ (14,000 )(2)   $ (93,038 )(1)   $  (21,444 )(2)
                                  
                                  

 

(1)

Included in net investment income

(2)

Included in other insurance related (loss) income

 

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4. FAIR VALUE MEASUREMENTS (CONTINUED)

 

Other Investments

Hedge funds, credit funds and equity tranches of CLOs are included within Level 3. The fair value for hedge funds and credit funds are based on the most recently published net asset value as advised by the external fund manager or third party administrator. For these funds we do not have full access to the underlying investment holdings to enable us to corroborate the fair value measurement used by the fund managers. However, we regularly review performance directly with the fund managers and perform qualitative analysis to corroborate the reasonableness of the published net asset values.

Observable equity tranche CLO trades in the secondary markets are infrequent, particularly given the dislocation in the current credit markets. Accordingly, because we were unable to corroborate non-binding quotes from brokers with observable market data, we continued using our existing valuation model based on management’s assumptions of expected future cash flows and risk-adjusted discount rates which reflect current market factors including default, collateral spread, prepayment, and liquidity risks.

Derivative Liability

We classified our insurance derivative contract with longevity risk exposure within Level 3 as the inputs used in our valuation model include significant unobservable inputs. The most significant unobservable input used in this model is the margin that a market participant would require for insuring a $400 million note collateralized by a portfolio of life settlements comprising less than 200 insured individuals. We exercised significant judgment in determining a fair value for this derivative instrument. During the nine months ended September 30, 2008, we received $5 million in annual insurance premium which was reported as net purchases, sales, and distributions in the table above.

 

5. RESERVE FOR LOSSES AND LOSS EXPENSES

The following table shows a reconciliation of our beginning and ending gross unpaid losses and loss expenses for the periods indicated:

 

     
Nine months ended September 30,    2008     2007  

Gross unpaid losses and loss expenses at beginning of period

   $  5,587,311     $  5,015,113  

Less reinsurance recoverable balances at beginning of period

     (1,356,893     (1,359,154 )
                  

Net losses and loss expense reserves at beginning of period

     4,230,418       3,655,959  
                  
   

Net incurred losses related to:

      

Current year

     1,690,055       1,324,690  

Prior years

     (251,126     (244,976 )
                  
       1,438,929        1,079,714  
                  
   

Net paid losses related to:

      

Current year

     (176,793     (99,972 )

Prior years

     (482,469     (479,276 )
                  
       (659,262     (579,248 )
                  

Foreign exchange (gain) loss

     (77,052     30,187  
                  

Net losses and loss expense reserves at end of period

     4,933,033       4,186,612  

Reinsurance recoverable balances at end of period

     1,473,171       1,344,767  
                  

Gross unpaid losses and loss expenses at end of period

   $  6,406,204     $  5,531,379  
                  
                  

 

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5. RESERVE FOR LOSSES AND LOSS EXPENSES (CONTINUED)

 

Net losses and loss expenses incurred includes net favorable prior period reserve development of $251 million and $245 million for the nine months ended September 30, 2008 and 2007, respectively. Prior period development arises from changes to loss estimates recognized in the current year that relate to losses incurred in previous calendar years. The following table summarizes net favorable reserve development by segment:

 

       
Nine months ended September 30,      2008      2007        

Insurance

     $  142,294      $  143,148        

Reinsurance

       108,832        101,828       
                          

Total

     $ 251,126      $ 244,976       
                          
                          

Net favorable reserve development in the first nine months of 2008 and 2007 was predominately generated from our short tail insurance and reinsurance lines of business, and primarily reflected the occurrence of fewer late reported claims than we originally anticipated in our reserving process. The first nine months of 2008 also included favorable development of $65 million from the political risk line of business of our insurance segment, to recognize both the absence of reported losses on the sovereign and corporate credit products within the line and the lower likelihood of future reported losses emanating from our traditional political risk coverage from accident years 2004 and prior. We also refined the loss development profile for the sovereign and corporate credit portion of our book during the second quarter of 2008. Following an actuarial review, we began to use a more accelerated loss development profile.

Beginning in the third quarter of 2008, for our accident year 2003 and 2004 professional lines business, we began to incorporate the loss ratios implied by our claims experience to date with our initial expected loss ratios derived from industry benchmarks. We believe that for these more mature accident years for this claims-made line of business, our loss experience is sufficiently developed, and therefore more statistically reliable. This generated favorable reserve development of $29 million, of which $20 million was generated from our insurance segment and $9 million from our reinsurance segment.

Prior period development in the first nine months of 2008 included reserve strengthening with respect to our accident year 2007 professional lines IBNR reserves in connection with the heightened potential for losses arising from events related to the substantial deterioration of the sub-prime crisis. This generated adverse development of $33 million, of which $22 million was generated from our insurance segment and $11 million from our reinsurance segment.

 

6. DERIVATIVE INSTRUMENTS

We may enter into derivative instruments such as futures, options, interest rate swaps and foreign currency forward contracts as part of our overall foreign currency risk management strategy or to obtain exposure to a particular financial market and for yield enhancement. From time to time we may enter into insurance and reinsurance contracts that meet the definition of a derivative contract under FAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”).

All derivative instruments are measured at fair value (see Fair Value Measurements in Note 1) and recognized as either assets or liabilities in the Consolidated Balance Sheets. The recognition of gains or losses on derivative instruments in the Consolidated Statements of Operations depends on whether or not these have been designated and qualify for hedge accounting.

Derivative Instruments Designated as Hedging Instruments

We may designate a currency derivative as a hedge on the fair value of certain investment portfolios attributable to changes in foreign currency exchange rates. This is referred to as a fair value hedge. Changes in the fair value of a derivative that is designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk, are recorded in net realized investment gains (losses), including any hedge ineffectiveness.

 

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6. DERIVATIVE INSTRUMENTS (CONTINUED)

 

To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated changes in value of the hedged item. Further, the hedge relationship must be designated and formally documented at the inception, detailing the particular risk management objective and strategy for the hedge, including the item and risk that is being hedged, the derivative that is being used, and how effectiveness is being assessed. We formally measure the hedge effectiveness both at the inception and on an ongoing basis. We evaluate the effectiveness of our designated hedges on a retrospective and prospective basis using the period-to-period dollar offset method. Using this method, if the hedge correlation is within the range of 80% to 125%, we consider the hedge effective and apply hedge accounting.

During the three months ended September 30, 2008, we entered into foreign currency forward contracts to hedge the changes in the fair value of two available-for-sale (AFS) fixed maturity portfolios denominated in Euros. The hedges were designated and qualified as a fair value hedge. During this period, the hedge ineffectiveness between the foreign currency forward contracts and the hedged AFS portfolios was $1 million, which was included in net realized investment gains (losses). At September 30, 2008, the total outstanding notional amount of foreign currency forward contracts was $474 million.

Derivative Instruments not Designated as Hedging Instruments

For investment-related derivatives, we recognize the change in fair value on these derivatives in net realized investment gains (losses). We may use non-designated foreign currency derivatives to minimize the effect of fluctuating foreign currencies and to gain exposure to interest rate differentials between differing market rates in our investment portfolios.

For underwriting-related foreign currency derivatives, we recognize the change in fair value on these derivatives in foreign exchange gains (losses). We may use non-designated foreign currency derivatives to manage foreign currency exposures in our underwriting assets and liabilities.

For insurance and reinsurance contracts accounted for as derivatives under FAS 133, we recognize the change in fair value on these derivatives in other insurance related income (loss).

The following table provides a breakdown of total outstanding derivatives at September 30, 2008 and 2007, and the total unrealized and realized gains (losses) recorded in earnings for the three and nine months ended September 30, 2008 and 2007.

 

      September 30, 2008          September 30, 2007       
      Notional
Amounts
  Three months     Nine months          Notional
Amounts
   Three months     Nine months       
        Gains/ (Losses)          Gains/ (Losses)       

Investment-related:

                   

Currency forward contracts

   $  37,437      $  1,540     $  1,112       $  11,458      $  (212 )   $  307      

Mortgage derivatives

     29,592        336       413         53,671        (298 )     (388 )    
   

Underwriting-related:

                   

Catastrophe-related total return swap

   $  50,000      $ (345 )   $ (210 )     $ 50,000      $  (60 )   $  530      

Longevity risk derivative

     400,000        (14,000 )     (21,444 )       400,000        -           -          

Currency call options - short

     (63,414)       1,714       2,387         -            -           -          

Currency put options - long

     126,828        5,593       637         -            -           -          

Currency forward contracts

     -            -           -             -            -           (349 )    
                                             
       $ (5,162 )   $ (17,105 )        $ (570 )   $ 100      
                                             
                                                       

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

7. STOCK-BASED COMPENSATION

 

Stock Options

The following is a summary of stock options outstanding and exercisable at September 30, 2008, and related activity for the nine months ended:

 

     Number of Stock
Options
    Weighted Average
Exercise Price
  Weighted Average
Remaining
Contractual Term
 

Aggregate

Intrinsic
Value*

 

Outstanding - January 1, 2008

  4,810     $ 18.46      

Granted

  -           -          

Exercised

  (1,739 )     13.61      

Expired

  (3 )     27.94      
                   

Outstanding - September 30, 2008

  3,068     $ 21.20   4.73 years   $ 37,478   
                         
                         

* The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between our closing stock price on September 30, 2008, and the exercisable price, multiplied by the number of in-the-money-options) that would have been received by the stock option holders had all stock option holders exercised their stock options on September 30, 2008.

The total intrinsic value of stock options exercised during the first nine months of 2008 and 2007 was $35 million and $4 million, respectively, and we received proceeds of $24 million and $6 million, respectively. At December 31, 2007, there was no remaining unrecognized compensation cost related to stock options and accordingly we incurred no related compensation costs during 2008.

The following table summarizes information about our stock options outstanding and exercisable at September 30, 2008:

 

Range of Exercise Prices    Number of
Stock
Options
   Weighted
Average
Exercise
Price
   Weighted
Average
Remaining
Contractual
Term
 

$12.50 - $13.75

   890    $  12.57    3.26  

$13.76 - $15.00

   582      14.50    4.20  

$15.01 - $16.25

   29      16.25    4.75  

$16.26 - $25.65

   40      25.50    4.84  

$25.66 - $29.62

   1,527      28.77    5.79  
                    

Total

   3,068    $ 21.20    4.73   
                    
                    

 

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7. STOCK-BASED COMPENSATION (CONTINUED)

 

Restricted Stock

The following table provides a reconciliation of the beginning and ending balance of nonvested restricted stock for the nine months ended September 30, 2008:

 

      Number of Shares     Weighted Average
Grant Date Fair Value
 

Non-vested restricted stock - January 1, 2008

   3,312     $  31.44   

Granted

   2,743       37.25  

Vested

   (778 )     30.15  

Forfeited

   (100 )     34.03  
                

Non-vested restricted stock - September 30, 2008

   5,177     $ 34.66  
                
                

In May 2008, we granted 1,000,000 shares with a grant date fair value of $35.17 per share to our Chief Executive Officer (CEO) in connection with an amendment to his employment agreement. The grant made to our CEO will vest as follows: 500,000 shares on January 31, 2009; 166,667 shares on January 1, 2010; 166,667 shares on January 1, 2012; and 166,666 shares on January 1, 2013. We have elected the straight-line recognition method for awards subject to graded vesting based on a service condition.

For the three months ended September 30, 2008 and 2007, we incurred compensation costs of $18 million and $9 million, respectively, in respect of restricted stock, and recorded tax benefits thereon of $2 million and $2 million, respectively. For the nine months ended September 30, 2008 and 2007, we incurred compensation costs of $47 million and $25 million, respectively, in respect of restricted stock, and recorded tax benefits thereon of $6 million and $5 million, respectively. The compensation costs incurred in 2008 include $2 million for modified grants and an additional charge for the acceleration of restricted shares vesting for certain employees that have reached retirement eligibility under our 2007 Plan.

The total fair value of shares vested during the nine months ended September 30, 2008 and 2007 were $23 million and $13 million, respectively. At September 30, 2008 and December 31, 2007, there was $105 million and $47 million, respectively, of unrecognized compensation cost related to restricted stock awards, which is expected to be recognized over the weighted average period of 2.5 years.

During the first nine months ended September 30, 2008 and 2007, we also realized additional net tax benefits for certain vested restricted stocks and exercised stock options, which were $2 million. These excess tax benefits are included in our cash flows from financing activities in the Consolidated Statements of Cash Flows.

 

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8. EARNINGS PER COMMON SHARE

 

The following table sets forth the comparison of basic and diluted earnings per common share:

 

      Three months ended
September 30,
        Nine months ended
September 30,
    
      2008     2007         2008    2007     

Basic earnings per common share

                

Net (loss) income available to common shareholders

   $  (249,346 )   $  269,975      $  219,643    $  749,143    
                                    

Weighted average common shares outstanding

     139,335       146,845        141,628      148,753    
                                    

Basic earnings per common share

   $ (1.79 )   $ 1.84      $ 1.55    $ 5.04    
                                    
   

Diluted earnings per common share

                

Net (loss) income available to common shareholders

   $ (249,346 )   $ 269,975      $ 219,643    $ 749,143    
                                    

Weighted average common shares outstanding

     139,335       146,845        141,628      148,753    

Share equivalents:

                

Warrants

     -           13,124        12,600      12,937    

Restricted stock

     -           2,385        1,591      2,354    

Options

     -           1,710        1,496      1,414    
                                    

Weighted average common shares outstanding - diluted

     139,335       164,064        157,315      165,458    
                                    

Diluted earnings per common share

   $ (1.79 )   $ 1.65      $ 1.40    $ 4.53    
                                    
                                      

For the nine months ended September 30, 2008, there were 818,711 restricted shares that were excluded in the computation of diluted earnings per share because the effect would be anti-dilutive. Due to the net loss incurred in the three months ended September 30, 2008, all the shares equivalents were anti-dilutive. There were no such anti-dilutive restricted shares or options for the three or nine months ended September 30, 2007.

 

9. COMMITMENTS AND CONTINGENCIES

 

a) Legal Proceedings

Except as noted below, we are not a party to any material legal proceedings. From time to time, we are subject to routine legal proceedings, including arbitrations, arising in the ordinary course of business. These legal proceedings generally relate to claims asserted by or against us in the ordinary course of insurance or reinsurance operations. In our opinion, the eventual outcome of these legal proceedings is not expected to have a material adverse effect on our financial condition or results of operations.

In 2005, a putative class action lawsuit was filed against our U.S. insurance subsidiaries. In re Insurance Brokerage Antitrust Litigation was filed on August 15, 2005 in the United States District Court for the District of New Jersey and includes as defendants numerous insurance brokers and insurance companies. The lawsuit alleges antitrust and Racketeer Influenced and Corrupt Organizations Act (“RICO”) violations in connection with the payment of contingent commissions and manipulation of insurance bids and seeks damages in an unspecified amount. On October 3, 2006, the District Court granted, in part, motions to dismiss filed by the defendants, and ordered plaintiffs to file supplemental pleadings setting forth sufficient facts to allege their antitrust and RICO claims. After plaintiffs filed their supplemental pleadings, defendants renewed their motions to dismiss. On April 15, 2007, the District Court dismissed without prejudice plaintiffs’ complaint, as amended, and granted plaintiffs thirty (30) days to file another amended complaint and/or revised RICO Statement and Statements of Particularity. In May 2007, plaintiffs filed (i) a Second Consolidated Amended Commercial Class Action complaint, (ii) a Revised Particularized Statement Describing the Horizontal Conspiracies Alleged in the Second Consolidated Amended Commercial Class Action Complaint, and (iii) a Third Amended Commercial Insurance Plaintiffs’ RICO Case Statement Pursuant to Local Rule 16.1(B)(4). On June 21, 2007, the defendants filed renewed motions to dismiss. On September 28, 2007, the District Court dismissed with prejudice plaintiffs’ antitrust and RICO claims and declined to exercise supplemental jurisdiction over plaintiffs’ remaining state law claims. Plaintiffs have appealed this decision to the United States Court of Appeals for the Third Circuit, where their appeal is currently pending. We believe that the lawsuit is completely without merit and we continue to vigorously defend the filed action.

 

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9. COMMITMENTS AND CONTINGENCIES (CONTINUED)

 

b) Dividends for Common Shares and Preferred Shares

On September 19, 2008 the Board of Directors declared a dividend of $0.185 per common share to shareholders of record at September 30, 2008 and payable on October 15, 2008. The Board of Directors also declared a dividend of $0.453125 per Series A 7.25% Preferred Share and a dividend of $1.875 per Series B 7.5% Preferred Share. The Series A Preferred Share dividend is payable on October 15, 2008, to shareholders of record at the close of business on September 30, 2008 and the Series B Preferred Share dividend is payable on December 1, 2008, to shareholders of record at the close of business on November 14, 2008.

 

c) Reinsurance Purchase Commitment

During 2008, we purchased reinsurance coverage for our insurance lines of business. The minimum reinsurance premiums are contractually due on a quarterly basis in advance. Accordingly at September 30, 2008, we have an outstanding reinsurance purchase commitment of $94 million.

 

10. NET DEFERRED TAX ASSETS

Deferred income taxes reflect the tax impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. As of September 30, 2008, we recorded a net deferred tax asset of $89 million. This balance includes a reduction of $50 million for a valuation allowance which has been established against certain U.S. deferred tax assets attributable to realized and unrealized losses and capital loss carryforwards on investments. At this time, we believe it is necessary to establish a valuation allowance against the deferred tax assets due to insufficient positive evidence regarding the reversal of these losses. During the three months ended September 30, 2008, $25 million of the valuation allowance was recorded in the Consolidated Statements of Operations and $15 million recorded as a component of other comprehensive income in shareholders’ equity. For the nine months ended September 30, 2008, $25 million of the valuation allowance was recorded in the Consolidated Statements of Operations and $25 million recorded as a component of other comprehensive income in shareholders’ equity.

 

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11. SHAREHOLDERS’ EQUITY

 

For the three and nine months ended September 30, 2008, we made the following share repurchases, which were held in treasury:

 

      Three months ended September 30,    Nine months ended September 30,  
      2008    2007    2008    2007  

In the open market:

             

Total shares

     1,774      2,225      6,782      2,225   

Total cost

   $ 58,149    $ 79,590    $ 233,290    $ 79,590  
                               

Average price per share(2)

   $ 32.79    $ 35.77    $ 34.39    $ 35.77  
                               

From employees:(1)

             

Total shares

     2      -          203      87  

Total cost

   $ 54    $ -        $ 7,707    $ 2,922  
                               

Average price per share(2)

   $ 31.71    $ -        $ 38.01    $ 33.42  
                               

Total

             

Total shares

     1,776      2,225      6,985      2,312  

Total cost

   $ 58,203    $ 79,590    $ 240,997    $ 82,512  
                               

Average price per share(2)

   $ 32.77    $ 35.77    $ 34.50    $ 35.68  
                               
                               

 

(1)

To satisfy withholding tax liabilities upon the vesting of restricted stock awards and the exercise of stock options.

(2)

Calculated using whole figures.

On May 10, 2007, we repurchased from Trident II, L.P and affiliated entities, an aggregate of 2,700,000 shares of our common stock at $37.25 per share, for a total purchase price of $101 million. These shares were subsequently cancelled.

Additionally, during October 2008, we repurchased in the open market 1,791,121 shares at an average price of $27.91 per share, for a total cost of $50 million, which were held in treasury.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 

The following is a discussion and analysis of our financial condition and results of operations. This should be read in conjunction with the consolidated financial statements and related notes included in Item 1 of this report and also our Management’s Discussion and Analysis of Results of Operations and Financial Condition contained in our Annual Report on Form 10-K for the year ended December 31, 2007. Tabular dollars are in thousands, except per share amounts. Amounts in tables may not reconcile due to rounding differences.

 

 

FINANCIAL MEASURES

 

 

We believe the following financial indicators are important in evaluating our performance and measuring the overall growth in value generated for our common shareholders:

Return on average common equity (“ROACE”): ROACE represents the level of net income available to common shareholders generated from the average of the opening and closing common shareholders’ equity during the period. Our objective is to generate superior returns on capital that appropriately reward our common shareholders for the risks we assume and to grow revenue only when we deem the returns meet or exceed our requirements. ROACE for the three and nine months ended September 30, 2008 was (22.5%) and 6.7%, respectively, compared to 25.0% and 23.9% for the same periods in 2007. The reduction in our return over the quarter and year to date reflect the reductions in net income of $519 million and $529 million, respectively, as discussed below.

Diluted book value per common share: Diluted book value per common share represents total common shareholders’ equity divided by the number of common shares and diluted common share equivalents outstanding, using the treasury stock method. We consider diluted book value per common share an appropriate measure of our returns to common shareholders, as we believe growth in our book value on a diluted basis ultimately translates into growth of our stock price. Diluted book value per share decreased 9% from $28.79 at December 31, 2007 to $26.25 at September 30, 2008. Over the same period our common shareholders’ equity decreased $0.6 billion, or 12%, to $4.1 billion. These reductions were primarily due to an increase in net unrealized losses on our investment portfolio of $526 million, share repurchases of $241 million, and dividends to common and preferred shareholders of $119 million. This was partially offset by income in the first nine months of 2008 of $247 million.

Cash dividends per common share: Our dividend policy is an integral part of the value we create for our shareholders. Our quarterly cash dividend was $0.185 per common share in the first three quarters of 2008 compared to $0.165 in the first three quarters of 2007. Our Board of Directors reviews our dividend policy on a regular basis and in December 2007, they authorized a 12% increase in the quarterly dividend.

 

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RESULTS OF OPERATIONS OVERVIEW

 

 

The table below breaks out net income into three components; underwriting income, investment income and net realized gains/losses, and other revenues and expenses. Underwriting income on a segment basis is a measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenue and net losses and loss expenses, acquisition costs and underwriting related general and administrative costs as expenses. Underwriting income is the difference between these revenue and expense items. Because our investment portfolio is managed on a total return basis, we have reviewed investment income and net realized gains/losses together. Other revenues and expenses represent corporate expenses, foreign exchange gains/losses, interest expense and income tax expense.

 

      Three months ended September 30,           Nine months ended September 30,  
      2008     2007     Change           2008     2007     Change  

Underwriting (loss) income:

                 

Insurance

   $ (22,081 )   $  111,460     (120% )      $  90,643     $  268,763     (66% )  

Reinsurance

     (164,346 )     88,068     (287% )        523       262,582     (100% )

Investment income and net realized (losses)/ gains

     (38,496 )     117,716     (133% )        221,407       352,325     (37% )

Other revenues and expenses

     (15,205 )     (38,127 )   (60% )        (65,274 )     (106,954 )   (39% )
                                           

Net (loss) income

     (240,128 )     279,117     (186% )        247,299       776,716     (68% )

Preferred share dividends

     (9,218 )     (9,142 )   1%          (27,656 )     (27,573 )   -       
                                           

Net (loss) income available to common shareholders

   $ (249,346 )   $ 269,975     (192% )      $ 219,643     $ 749,143     (71% )
                                           
                                                   

Underwriting Results

Total underwriting income for the three and nine months ended September 30, 2008 decreased $386 million and $440 million, respectively, over the same periods in 2007. These reductions were driven by net losses incurred from Hurricanes Ike and Gustav in the current quarter of $386 million, net of related earned premiums. Almost three-quarters of these hurricane losses were incurred within our reinsurance segment. Our year-to-date underwriting result was also impacted by a higher frequency and severity of property risk losses within our insurance segment. The overall impact of net favorable reserve development in the three and nine months ended September 30, 2008 was largely comparable with the same periods in 2007.

For further discussion of our underwriting results, including segmental analysis, refer to ‘Underwriting Results’ sections below.

Investment Results

Total net investment income and net realized investment losses for the three and nine months ended September 30, 2008 decreased $156 million and $131 million, respectively, over the same periods in 2007. These reductions were driven by a combination of lower investment income on our other investment portfolio ($68 million in the quarter and $113 million year-to-date) coupled with higher realized investment losses ($88 million for the quarter and $46 million for the year to date). Our other investments were primarily impacted by unrealized losses on our credit and hedge funds, stemming from illiquidity in the financial markets. Our year to date investment results benefited from an increase in investment income from our fixed maturities, reflecting higher average investment balances.

For further discussion and analysis of our investment results, refer to ‘Investment Income’ section below.

 

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Other Revenues and Expenses

Our other revenues and expenses were as follows:

 

      Three months ended September 30,     Nine months ended September 30,  
      2008     Change   2007     2008     Change   2007  

Corporate expenses

   $ 19,995         (4%)   $ 20,723     $ 51,291         9%   $ 47,247  

Foreign exchange gains

     (7,627 )       6%     (7,202 )     (21,360 )     30%     (16,477 )

Interest expense

     7,941       (43%)     13,929       23,789     (45%)     43,241  

Income tax (recovery) expense

     (5,104 )   (148%)     10,677       11,554     (65%)     32,943  
                                      

Total

   $ 15,205       (60%)   $ 38,127     $ 65,274     (39%)   $ 106,954  
                                      
                                          

 

   

Corporate expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned corporate expenses were 2.9% and 2.5%, in the three and nine months ended September 30, 2008, respectively, compared to 3.0% and 2.3%, in the same periods of 2007.

 

   

Foreign exchange gains: Some of our business is written in currencies other than U.S. dollars. The foreign exchange gain in the third quarter of 2008 was primarily due to the remeasurement of our net liability balances denominated in Euro, following its significant depreciation against the U.S. dollar during this period.

 

   

Interest expense: Interest expense in the three and nine months ended September, 30 2007 included interest costs of $6 million and $19 million on a $400 million repurchase agreement we entered into in 2006 to finance a life settlements investment. We terminated the repurchase agreement in September 2007.

 

   

Income tax: Income tax is generated primarily through our foreign operations in the United States and Europe. Our effective tax rate may vary between periods depending on the distribution of net income or losses among our various taxable jurisdictions. Our effective tax rate, which we calculate as income tax expense or recovery divided by income or loss before income tax, was 2.0% and 4.5% for the three and nine months ended September 30, 2008, respectively, compared to 3.7% and 4.1% for the comparative periods of 2007. Significant to the current quarter was the establishment of a full valuation allowance against net deferred tax assets arising from U.S. realized capital losses and investment impairments arising during the quarter, due to insufficient positive evidence currently for recognition. Apart from these specific investment items, during the three months ended September 30, 2008, both the United States and Europe reported net losses before tax as a result of large loss activity. For the nine months ended September 30, 2008, the portion of total income generated by our U.S. subsidiaries was significantly lower than the comparable period of 2007, yet considering the impact of the valuation allowance, led to a similar effective tax rate when compared to the prior year.

 

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UNDERWRITING RESULTS – GROUP

 

 

The following table provides our group underwriting results followed by an overview of each line item:

 

      Three months ended September 30,     Nine months ended September 30,  
      2008     Percentage
Change
  2007     2008     Percentage
Change
  2007  

Revenues:

              

Gross premiums written

   $ 725,283         (4%)   $ 755,224     $ 2,863,633     (5%)   $ 3,017,225  

Net premiums written

     551,416         (6%)     583,902       2,327,407     (6%)     2,478,602  

Net premiums earned

     689,970         1%     685,845       2,028,895     (2%)     2,065,090  

Other insurance related (loss) income

     (13,806 )   nm     1,005       (19,073 )   nm     3,638  

Expenses:

              

Current year net losses and loss expenses

     (781,802 )     91%     (410,385 )     (1,690,055 )   28%     (1,324,690 )

Prior period reserve development

     76,271         (7%)     82,192       251,126       3%     244,976  

Acquisition costs

     (90,333 )     (10%)     (100,039 )     (282,593 )   (4%)     (293,923 )

General and administrative expenses

     (66,727 )     13%     (59,090 )     (197,134 )   20%     (163,746 )
                                      

Underwriting (loss) income (1)

   $ (186,427 )   (193%)   $ 199,528     $ 91,166     (83%)   $ 531,345  
                                      
   

Ratios:

     Point
Change
      Point
Change
   

Current year loss ratio

     113.3%     53.4%     59.9%       83.3%     19.1%     64.2%  

Prior period reserve development

     (11.0% )     1.0%     (12.0% )     (12.4% )   (0.5%)     (11.9% )

Acquisition cost ratio

     13.1%      (1.5%)     14.6%       13.9%     (0.3%)     14.2%  

General and administrative ratio (2)

     12.6%       1.0%     11.6%       12.2%     2.0%     10.2%  
                                          

Combined ratio

     128.0%     53.9%     74.1%       97.0%     20.3%     76.7%  
                                          
                                          

nm – not meaningful

(1) Refer to Item 1, Note 2 to the Consolidated Financial Statements, for a reconciliation of underwriting (loss)/income to net (loss)/income available to common shareholders for the periods indicated above.

(2) Our general and administration expense ratio includes corporate expenses not allocated to our underwriting segments of 2.9% and 2.5%, for the three and nine months ended September 30, 2008, respectively, and 3.0% and 2.3% for the three and nine months ended September 30, 2007, respectively. These costs are discussed further in “Other Revenue and Expenses”, above.

 

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UNDERWRITING REVENUES

Premiums Written: Gross and net premiums written, by segment, were as follows:

 

      Gross Premiums Written     
      Three months ended September 30,       Nine months ended September 30,     
      2008    Change    2007       2008    Change    2007     

Insurance

   $ 402,672    (16%)    $ 480,729     $ 1,392,993       (9%)    $ 1,529,888    

Reinsurance

     322,611     18%      274,495       1,470,640       (1%)      1,487,337    
                                        

Total

   $ 725,283      (4%)    $ 755,224     $ 2,863,633       (5%)    $ 3,017,225    
                                        
   

% ceded

                      

Insurance

     41.5%    7.2%      34.3%       37.3%    3.0%      34.3%    

Reinsurance

     2.1%    (0.2%)      2.3%       1.1%    0.2%      0.9%    

Total

     24.0%    1.3%      22.7%       18.7%    0.8%      17.9%    
   
      Net Premiums Written     
      Three months ended September 30,       Nine months ended September 30,     
      2008    Change    2007       2008    Change    2007     

Insurance

   $ 235,666     (25%)    $ 315,605     $ 872,909    (13%)    $ 1,004,536    

Reinsurance

     315,750     18%      268,297       1,454,498      (1%)      1,474,066    
                                        

Total

   $  551,416      (6%)    $  583,902     $  2,327,407      (6%)    $  2,478,602    
                                        
                                              

Gross premiums written this year have been impacted by increasing competition within the property and casualty markets. In the current quarter, gross premiums in our insurance segment were also impacted by a reduction in political risk premium. In comparison, gross premiums written in our reinsurance segment increased this quarter largely due to reinstatement premiums in connection with Hurricanes Ike and Gustav. The increase in our ceded premium ratios in 2008 reflect the purchase of additional quota share reinsurance coverage within our casualty and professional lines insurance business, together with the impact of business mix changes, particularly with respect to the quarter. Refer to the “underwriting results by segment”, for further discussion.

Premiums Earned: Net premiums earned by segment were as follows:

 

     Three months ended September 30,         Nine months ended September 30,
     2008     2007     Change         2008     2007     Change    

Insurance

  $ 293,572    43%     $ 301,925    44%     (3%)      $ 890,558    44%     $ 915,102    44%     (3%)    

Reinsurance

    396,398    57%       383,920    56%     3%        1,138,337    56%       1,149,988    56%     (1%)    
                                          

Total

  $  689,970    100%     $  685,845    100%     1%      $  2,028,895    100%     $  2,065,090    100%     (2%)    
                                          
                                                                  

Changes in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in premium earning patterns. The increase in net earned premium in the quarter was largely driven by additional earned premium in our reinsurance segment in connection with Hurricanes Ike and Gustav. Net premiums earned in both segments were otherwise down in the quarter and year-to-date, reflecting reductions in gross premiums written, as discussed above. Partially offsetting this, net premiums earned in our insurance segment this year benefited from growth of our political risk business in recent years, a line which typically provides multi-year coverage and therefore earns over a greater number of periods.

Other Insurance Related Income / Loss: During the three and nine months ended September 30, 2008, we recorded a reduction in value of $14 million and $21 million, respectively, relating to the change in fair value of our insurance derivative contract primarily attributable to longevity risk (refer to Item 1, Note 4(b) to the Consolidated Financial Statements).

 

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UNDERWRITING EXPENSES

Loss Ratio: The table below shows the components of our net loss and loss expense ratio (“loss ratio”):

 

      Three months ended September 30,           Nine months ended September 30,       
      2008     Change    2007          2008     Change    2007       

Current year

   113.3%     53.4%    59.9%        83.3%     19.1%    64.2%      

Prior period development

   (11.0% )   1.0%    (12.0% )      (12.4% )   (0.5%)    (11.9% )    
                                           

Loss ratio

   102.3%     54.4%    47.9%        70.9%     18.6%    52.3%      
                                           
                                             

Current Year - Quarter:

The 53.4 ratio point increase in our quarterly loss ratio was driven by an increase in catastrophe losses this quarter, largely emanating from net losses incurred on Hurricanes Ike and Hurricane Gustav of $407 million, or 59.0 ratio points. The third quarter of 2007 included net losses incurred on Hurricane Dean of $16 million, or 2.3 ratio points.

On September 1, Hurricane Gustav made landfall on the Louisiana Gulf coast as a category 2 hurricane. The hurricane and tropical storm force winds of Hurricane Gustav as well as spin-off tornadoes caused damage in our coverage areas of Louisiana, Mississippi and Alabama. The industry losses estimated by Risk Management Solutions, a risk modeling agency, currently stand at $2.5 billion to $4.5 billion, and include wind-related damages, flood-related damages and business interruption. Our estimate of net losses from Hurricane Gustav is $52 million, of which $30 million emanates from our insurance segment and $22 million from our reinsurance segment. Our estimate was derived from a combination of the output of industry models, market share analyses, a review of in-force contracts and preliminary loss information from our clients, brokers and loss adjusters.

On September 12, Hurricane Ike made landfall on Galveston Island in the State of Texas as a category 2 hurricane causing widespread flooding and wind damage throughout the Galveston and Houston areas. Prior to making landfall, Hurricane Ike moved through offshore energy production areas in the Gulf of Mexico. The industry losses estimated by Risk Management Solutions, a risk modeling agency, currently stand at $13 billion to $21 billion, and include wind-related damages, flood-related damages and business interruption. Our estimate of net losses from Hurricane Ike is $355 million, of which $85 million emanates from our insurance segment and $270 million from our reinsurance segment. The estimate for our reinsurance segment includes $195 million of losses relating to our exposure from the Texas Windstorm Insurance Association (“TWIA”) pool. TWIA is an association which provides Texas with wind and hail coverage when it is not available in the private insurance marketplace within prescribed coastal zones. Our exposure relates to a 13% share of each of the three $500 million layers, in excess of $600 million losses to the pool. TWIA currently estimate losses on Hurricane Ike at $2.7 billion. The balance of our loss estimates were derived from a combination of the output of industry models, market share analyses, a review of in-force contracts and preliminary loss information from our clients, brokers and loss adjusters.

Industry-wide insured losses and our own loss estimates for Hurricanes Gustav and Ike are subject to change as claims continue to be reported and adjusted. Actual losses may ultimately differ materially from current loss estimates.

Current Year – Year-to-date:

The 19.1 ratio point increase in our year-to date loss ratio was driven by an increase in catastrophe losses this year, largely emanating from net losses incurred on Hurricane Ike and Hurricane Gustav of 20.1 ratio points. In addition, we experienced a higher frequency and severity of property losses in our insurance segment this year.

Our initial expected loss ratios in 2008 were generally higher than those in 2007, reflecting the impact of pricing deterioration in many of our lines of business. Offsetting this, our initial loss ratios were favorably impacted by the incorporation of more of our own historical loss experience, rather than industry benchmarks, relative to the prior year.

 

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Prior Year Reserve Development:

Prior period development was the net favorable result of several underlying reserve developments, identified during our quarterly reserving process. The following table provides a break down of prior period development by segment:

 

      Three months ended September 30,         Nine months ended September 30,     
      2008    2007         2008    2007     

Insurance

   $ 41,608    $ 58,607      $ 142,294    $ 143,148    

Reinsurance

     34,663      23,585        108,832      101,828    
                                   

Total

   $  76,271    $  82,192      $  251,126    $  244,976    
                                   
                                     

Net favorable reserve development in the three and nine months ended September 30, 2008 and 2007 was predominately generated from our short tail insurance and reinsurance lines of business, and reflected the occurrence of fewer late reported claims than we originally anticipated in our reserving process. The three and nine months ended September 30, 2008 also included favorable development from the political risk line of business of our insurance segment of $5 million and $65 million, respectively.

The current quarter also included net adverse prior period reserve development of $5 million from our professional lines business in both our insurance and reinsurance segments, the significant items of which were as follows:

 

   

Favorable reserve development of $29 million on our 2003 and 2004 accident year reserves. Of this amount, $20 million was generated from our insurance segment and $9 million from our reinsurance segment. The favorable development was due to the fact that we began to incorporate more of our own claims experience into our loss ratios, with less weighting on our initial expected loss ratios derived from industry benchmarks. We believe that for these more mature accident years, for this claims-made line of business, our loss experience is sufficiently developed, and therefore more statistically reliable. As these older accident years mature further we expect to move from a blend of the Bornhuetter-Ferguson (“B-F”) and initial expected loss ratio (“IELR”) methods to using the B-F method only.

 

   

Adverse development of $33 million related to our accident year 2007 reserves. During the quarter, a number of large financial institutions incurred significant financial losses and, in some cases, bankruptcy precipitated by the continued deterioration in the U.S. sub-prime residential mortgage market and the ensuing dislocation in the credit markets. These market driven events triggered claims against directors and officers of these institutions as well as providers of professional services to these institutions. As part of our quarterly reserving process, we considered these market events during our analysis of our financial institutions insurance portfolio for potential loss movements, including our exposure to known notifications of potential loss, as well as analysis of accounts that may have exposure to the situation but have not yet provided notice of a claim. We also performed a similar review in our reinsurance segment, where potential exposure primarily exists within our financial institution classes. As a result, we strengthened our accident year 2007 IBNR reserves by $22 million in our insurance segment and by $11 million in our reinsurance segment.

Conditions and trends that affected the development of liabilities in the past may not necessarily occur in the future. Accordingly, it is inappropriate to anticipate future redundancies or deficiencies based on historical experience. Prior period reserve development is discussed in more detail in our segmental sections below.

Acquisition Cost ratio: The reduction in our acquisition cost ratio in the quarter was primarily due to adjustments on prior year sliding scale ceding commissions within the professional lines business of our insurance segment. These adjustments were triggered by prior year reserve releases on our accident year 2003 and 2004 loss reserves, as discussed above.

General and Administrative ratio: Our general and administrative ratio increased 1.0 ratio points in the quarter and by 2.0 ratio points over the year to date. The increase was due to a combination of lower net premiums earned, additional headcount and higher share-based compensation costs. The increase in share-based compensation costs was primarily driven by the renewed employment contract for our CEO and a higher grant date fair value on issued awards year over year (refer to Item 1, Note 7 to the Consolidated Financial Statements). This was partially set off by a reduction in accrued incentive-based compensation as compared to the prior year, which is based on our operating results.

 

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UNDERWRITING RESULTS – BY SEGMENT

 

 

INSURANCE SEGMENT

Results from our insurance segment were as follows:

 

      Three months ended September 30,    Nine months ended September 30,  
      2008    Percentage
Change
   2007    2008    Percentage
Change
   2007  

Revenues:

                   

Gross premiums written

   $ 402,672      (16%)    $ 480,729    $  1,392,993      (9%)    $  1,529,888   

Net premiums written

     235,666      (25%)      315,605      872,909    (13%)      1,004,536  

Net premiums earned

     293,572        (3%)      301,925      890,558      (3%)      915,102  

Other insurance related (loss) income

     (13,751)    nm      610      (20,073)    nm      1,737  

Expenses:

                   

Current year net losses and loss expenses

     (272,185)       59%       (171,699)      (692,017)     20%       (575,760)  

Prior period reserve development

     41,608      (29%)      58,607      142,294      (1%)      143,148  

Acquisition costs

     (21,964)      (37%)      (34,721)      (84,798)    (13%)      (97,512)  

General and administrative expenses

     (49,361)       14%       (43,262)      (145,321)    23%      (117,952)  
                                     

Underwriting (loss) income

   $ (22,081)    (120%)    $ 111,460    $ 90,643    (66%)    $ 268,763  
                                     
   

Ratios:

      Point
Change
         Point
Change
    

Current year loss ratio

     92.7%      35.8%       56.9%       77.7%      14.8%       62.9%   

Prior period reserve development

     (14.2%)       5.2%       (19.4%)      (16.0%)      (0.4%)      (15.6%)  

Acquisition cost ratio

     7.5%      (4.0%)      11.5%       9.6%       (1.1%)      10.7%   

General and administrative ratio

     16.8%        2.5%       14.3%       16.3%        3.4%       12.9%   
                                         

Combined ratio

     102.8%      39.5%       63.3%       87.6%      16.7%       70.9%   
                                         
                                         

nm – not meaningful

Gross Premiums Written: The following table provides gross premiums written by line of business:

 

      Three months ended September 30,    Nine months ended September 30,  
      2008     2007     Change    2008     2007     Change  

Property

   $  137,417    34%     $  147,033    31%      (7%)    $ 439,725    32%     $ 509,312     33%     (14% )  

Marine

     41,121    10%       49,971    10%     (18%)      170,609    12%       198,046     13%     (14% )

Terrorism

     7,112    2%       11,672    2%     (39%)      30,073    2%       41,541     3%     (28% )

Aviation

     11,735    3%       14,518    3%     (19%)      37,936    3%       41,599     3%     (9% )

Political risk

     24,817    6%       71,442    15%     (65%)      145,029    11%       157,139     10%     (8% )

Professional lines

     137,553    34%       123,824    26%      11%      420,929    30%       382,521     25%     10%  

Liability

     42,833    11%       53,158    11%     (19%)      145,162    10%       174,268     11%     (17% )

Other

     84    0%       9,111    2%     (99%)      3,530    0%       25,462     2%     (86% )
                                         

Total

   $ 402,672    100%     $ 480,729    100%     (16%)    $  1,392,993    100%     $  1,529,888     100%     (9% )
                                         
                                                                  

 

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The global property and casualty insurance markets continued to be highly competitive during 2008 with surplus capacity and price deterioration remaining prevalent. Gross premiums written declined in most of our lines of business in the quarter and year-to-date reflecting declining rates for new and renewal business, as well as the non-renewal of business that did not meet our underwriting requirements. Our political risk premium also decreased this quarter reflecting the reduction in available transactions associated with a slow down in private capital flows amidst the ongoing global financial crisis. We have also decided to reserve capacity for increased pricing which we expect will prevail when liquidity returns to the marketplace.

Partially offsetting these decreases, we experienced growth in our professional lines business this year. In the quarter, this was driven by new business arising from disruptions in the financial institutions sector together with some rate increases on renewal business. Year-to-date, this line also benefited from the additional renewal rights we acquired in conjunction with our purchase of the Media Pro business at the end of the second quarter of 2007.

Ceded Premiums: Premiums ceded in the third quarter of 2008 were $167 million, or 41.5% of gross premiums written, compared with $165 million, or 34.3%, in the comparative period of 2007. For the first nine months of 2008, premiums ceded were $520 million, or 37.3% of gross premiums written, compared with $525 million, or 34.3%, in the prior year period. The increase in our ceded premium ratios in the quarter and year-to-date primarily reflect the purchase of additional quota share coverage within our casualty and professional lines business this year. In addition, the increase was also due to changes in business mix, particularly in the current quarter, where we significantly reduced our political risk premium, a line where we do not purchase reinsurance cover for.

Net Premiums Earned: The following table provides net premiums earned by line of business:

 

      Three months ended September 30,     Nine months ended September 30,  
      2008     2007     Change     2008     2007     Change  

Property

   $ 83,841    29%     $ 81,075    27%     3%     $  247,589    28%     $ 241,426    26%     3%  

Marine

     33,480    11%       34,780    11%     (4% )     113,645    13%       118,258    13%     (4%

Terrorism

     10,407    3%       13,594    5%     (23% )     32,940    4%       47,641    5%     (31% )

Aviation

     16,945    6%       22,012    7%     (23% )     49,672    5%       69,189    8%     (28% )

Political risk

     41,784    14%       29,009    10%     44%       108,846    12%       84,203    9%     29%  

Professional lines

     83,851    29%       84,925    28%     (1% )     250,587    28%       248,975    27%     1%  

Liability

     21,517    7%       28,060    9%     (23% )     77,139    9%       79,982    9%     (4% )

Other

     1,747    1%       8,470    3%     (79% )     10,140    1%       25,428    3%     (60% )
                                        

Total

   $  293,572    100%     $  301,925    100%     (3% )   $ 890,558    100%     $  915,102    100%     (3% )
                                        
                                                                  

The 3% drop in net premiums earned in the quarter and year to date has been driven by the decrease in net premiums written this year, although the rate of reduction has been less accelerated. This is largely due to growth of our political risk line of business over the last several years, which typically provides multi-year coverage, and therefore earns over a greater number of periods. We expect total net premiums earned to continue to decrease into the foreseeable future, given the level of pricing deterioration continuing to impact many of our lines.

Insurance Losses

Loss Ratio: The table below shows the components of our loss ratio:

 

     Three months ended September 30,   Nine months ended September 30,  
     2008     Point
Change
    2007   2008     Point
Change
    2007  

Current year

  92.7 %   35.8 %   56.9%    77.7 %   14.8 %   62.9%    

Prior period reserve development

  (14.2 %)   5.2 %   (19.4%)   (16.0 %)   (0.4 %)   (15.6%)  
           

Loss ratio

  78.5 %   41.0 %   37.5%    61.7 %   14.4 %   47.3%   
           
                                   

 

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Current Year – Quarter

The 35.8 ratio point increase in our quarterly loss ratio was driven by an increase in catastrophe losses this quarter, largely emanating from net losses incurred on Hurricanes Ike and Gustav of $115 million, or 39.2 ratio points. Losses incurred from these hurricanes were primarily generated from our property and energy lines of business in connection with property damage and business interruption claims. The third quarter of 2007 included net losses incurred from Hurricane Dean of $11 million, or 3.5 ratio points.

Current Year – Year-to-Date

The 14.8 ratio point increase in our year-to date loss ratio was driven by an increase in catastrophe losses this year, largely emanating from losses incurred on Hurricanes Ike and Gustav of 12.9 ratio points. In addition, we experienced a higher frequency and severity of property losses in the first half of this year, including mining losses in Australia and several other worldwide property risk losses.

Our initial expected loss ratios in 2008 were generally higher than those in 2007, reflecting the impact of pricing deterioration in many of our lines of business, as discussed above. Offsetting this, our initial loss ratios were favorably impacted by the incorporation of more of our own historical loss experience, rather than industry benchmarks, relative to the prior year quarter.

Prior Period Reserve Development:

We experienced net favorable prior period reserve development of $42 million in the three months ended September 30, 2008 which included the following:

 

   

$14 million of favorable development from our accident year 2005 energy offshore line of business. This included the favorable settlement of a large hurricane related claim against our original case reserve estimate.

 

   

$10 million of favorable development from our aviation lines of business, predominately from accident year 2005. The favorable development was partially due to a reduction in our aerospace reserves following an assessment of our remaining exposures. In addition, claims experience on our other aviation lines has been better than expected, particularly on our pro-rata business.

 

   

$5 million of favorable development from the accident year 2006 sovereign and corporate credit portion of our political risk line of business. This was partially in recognition of lower than expected incurred loss activity on this accident year and also due to a change in development profile. Following an actuarial review earlier this year, we began to use a more accelerated development profile.

 

   

Net adverse development of $1 million from our professional lines business. This included adverse development of $22 million from our accident year 2007 IBNR reserves offset by favorable reserve development of $21 million from accident years 2004 and prior. Refer to discussion of prior period development in the group underwriting results section for further detail.

 

   

The balance of favorable reserve development in the quarter was predominately from our property lines of business, largely generated from our accident year 2007 (approximately $10 million) and 2006 accident year ($5 million) reserves. This was in recognition of limited late reporting of losses as well as minimal deterioration on previously reported claims on these lines.

For the nine months ended September 30, 2008, we experienced net favorable prior period reserve development of $142 million. This included $65 million of favorable development from our political risk line of business, with the balance predominately from our accident years 2006 and 2007 property, marine and aviation lines of business.

For the three and nine months ended September 30, 2007, we experienced net favorable prior period reserve development of $59 million and $143 million, respectively. For the quarter, favorable development was predominately generated from our accident year 2006 property lines of business and hurricane impacted lines from accident year 2005. For the first nine months of 2007, net favorable development was also predominately generated from our accident year 2006 property lines.

Insurance Outlook

The insurance markets generally remain highly competitive, with surplus capacity and consequent pricing pressure continuing to prevail in virtually all lines. Pricing continues to erode in property and energy business although the rate of decline has started to decelerate. The catastrophe events in the third quarter compounded with higher frequency and severity of property losses in the first half of the year should cause an improvement in pricing in most property and energy lines of business. Terrorism continues to be under significant pricing pressure, particularly on larger premium accounts, and we expect to further reduce our participation on this business in the fourth quarter. Although aviation pricing is stabilizing it has not reached a level at which we would consider significantly increasing our involvement but we continue to monitor the market-place for the right opportunities.

 

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In our liability business, we continue to witness increasing competitive pricing pressure within our surplus lines casualty business. In our professional lines business, there remain some pricing pressures, although we are witnessing some moderation in competition and improvement in pricing in the financial institutions classes. We believe our areas of focus in both our liability and professional lines business still contain good profit potential, but risk selection and overall execution strategy have become more critical.

The significant weakening of the world’s largest commercial insurer this quarter is expected to have a positive impact in market conditions across most of our lines of business, although it will take time for the dynamics of these changes to unfold.

REINSURANCE SEGMENT

Overview

Results in our reinsurance segment were as follows:

 

<
      Three months ended September 30,     Nine months ended September 30,  
      2008     Percentage
Change
    2007     2008     Percentage
Change
    2007  
Revenues:                                             

Gross premiums written

   $ 322,611     18%     $ 274,495     $  1,470,640     (1% )   $  1,487,337  

Net premiums written

     315,750     18%       268,297       1,454,498     (1% )     1,474,066  

Net premiums earned

     396,398     3%       383,920       1,138,337     (1% )     1,149,988  

Other insurance related (loss) income

     (55 )   (114% )     395       1,000     (47% )     1,901  
Expenses:               

Current year net losses and loss expenses

     (509,617 )   114%       (238,686 )     (998,038 )   33%       (748,930 )

Prior period reserve development

     34,663     47%       23,585       108,832     7%       101,828  

Acquisition costs

     (68,369 )   5%       (65,318 )     (197,795 )   1%       (196,411 )

General and administrative expenses

     (17,366 )   10%       (15,828 )     (51,813 )   13%       (45,794 )
                                      
Underwriting (loss) income    $  (164,346 )   (287% )   $ 88,068     $ 523     (100% )   $ 262,582  
                                      
   

Ratios:

     Point
Change
 
 
      Point
Change
 
 
   

Current year loss ratio

     128.5%     66.4%       62.1%       87.7%     22.5%       65.2%  

Prior period reserve development

     (8.7% )   (2.6% )     (6.1% )     (9.6% )   (0.7% )     (8.9% )

Acquisition cost ratio

     17.2%     0.2%       17.0%       17.4%     0.3%       17.1%  

General and administrative ratio

     4.4%     0.3%       4.1%