10-K 1 d301747d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

Form 10-K

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

For the fiscal year ended December 31, 2011

Commission file number 000-33047

 

 

ALTERRA CAPITAL HOLDINGS LIMITED

(Exact name of registrant as specified in its charter)

 

 

 

Bermuda   98-0584464

(State of or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

Alterra House

2 Front Street

Hamilton, HM 11

Bermuda

(441) 295-8800

(Address and telephone number, including area code, of registrant’s principal executive offices)

 

 

Securities Registered Pursuant to Section 12(b) of the Act:

Common Shares, Par Value $1.00 per share

Name of each exchange on which registered

The NASDAQ Stock Market LLC

Securities Registered Pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in any definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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 definition of “accelerated filer”, “large 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 Act.).    Yes  ¨    No  x

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2011 was $2,030,647,478, based on the closing price of the registrant’s common shares on June 30, 2011, the last business day of the registrant’s most recently completed second fiscal quarter. Solely for the purpose of this calculation and for no other purpose, the non-affiliates of the registrant are assumed to be all shareholders of the registrant other than (i) directors of the registrant, (ii) executive officers of the registrant who are identified as “named executive officers” pursuant to Item 11 of this Form 10-K, (iii) any shareholder that beneficially owns 10% or more of the registrant’s common shares and (iv) any shareholder that has one or more of its affiliates on the registrant’s board of directors. Such exclusion is not intended, nor shall it be deemed, to be an admission that such persons are affiliates of the registrant.

The number of shares of the registrant’s common shares outstanding as of February 21, 2012 was 100,939,218.

 

 

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the proxy statement for the registrant’s 2012 annual meeting of shareholders, to be filed subsequently with the Securities and Exchange Commission, or SEC, pursuant to Regulation 14A, are incorporated by reference in Part III of this Annual Report on Form 10-K.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

         Page  

PART I

     3   

ITEM 1.

  BUSINESS      3   

ITEM 1A.

  RISK FACTORS      17   

ITEM 1B.

  UNRESOLVED STAFF COMMENTS      31   

ITEM 2.

  PROPERTIES      32   

ITEM 3.

  LEGAL PROCEEDINGS      32   

ITEM 4.

  MINE SAFETY DISCLOSURES      32   

PART II

     33   

ITEM 5.

  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES      33   

ITEM 6.

  SELECTED FINANCIAL DATA      35   

ITEM 7.

  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS      36   

ITEM 7A.

  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK      80   

ITEM 8.

  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA      81   

ITEM 9.

  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE      81   

ITEM 9A.

  CONTROLS AND PROCEDURES      82   

ITEM 9B.

  OTHER INFORMATION      82   

PART III

     83   

ITEM 10.

  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT AND CORPORATE GOVERNANCE      83   

ITEM 11.

  EXECUTIVE COMPENSATION      83   

ITEM 12.

  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS      83   

ITEM 13.

  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE      83   

ITEM 14.

  PRINCIPAL ACCOUNTANT FEES AND SERVICES      83   

PART IV

     84   

ITEM 15.

  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES      84   

 

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PART I

 

ITEM 1. BUSINESS

Alterra Capital Holdings Limited, or Alterra, and, collectively with its wholly-owned subsidiaries, the Company, is a Bermuda-headquartered global enterprise dedicated to providing diversified specialty insurance and reinsurance products to corporations, public entities and property and casualty insurers. Alterra was formed on May 12, 2010 by the amalgamation, or the Amalgamation, of Alterra Holdings Limited, or Alterra Holdings, a direct wholly-owned subsidiary of Max Capital Group Ltd., or Max, and Harbor Point Limited, or Harbor Point.

Max was incorporated on July 8, 1999 under the laws of Bermuda. Harbor Point was formed on December, 15, 2005 through the acquisition of the continuing operations and certain assets of Chubb Re, Inc., the reinsurance business unit of The Chubb Corporation (“Chubb”). After the consummation of the Amalgamation, Max was renamed Alterra. The results of operations of the former Harbor Point companies are included in the consolidated results of operations for all periods from May 12, 2010.

Unless otherwise indicated or unless the context otherwise requires, all references in this Annual Report on Form 10-K to the “Company” “we,” “us,” “our” and similar expressions are references to Alterra and its consolidated subsidiaries.

Unless otherwise indicated or unless the context otherwise requires, all references in this Annual Report on Form 10-K to entity names are as set forth in the following table:

 

Reference

  

Entity’s legal name

Alterra    Alterra Capital Holdings Limited
Alterra Agency    Alterra Agency Limited
Alterra America    Alterra America Insurance Company
Alterra at Lloyd’s    Alterra at Lloyd’s Limited
Alterra Bermuda    Alterra Bermuda Limited (formed from the amalgamation of Alterra Insurance Limited and Alterra Re)
Alterra Capital UK    Alterra Capital UK Limited
Alterra E&S    Alterra Excess & Surplus Insurance Company
Alterra Finance    Alterra Finance LLC
Alterra Holdings    Alterra Holdings Limited (formed from the amalgamation of Harbor Point Limited and Alterra Holdings Limited)
Alterra Insurance    Alterra Insurance Limited
Alterra Europe    Alterra Europe plc
Alterra Insurance USA    Alterra Insurance USA Inc.
Alterra Managers    Alterra Managers Limited
Alterra Re    Harbor Point Re Limited
Alterra Re Europe    Alterra Reinsurance Europe plc
Alterra Re USA    Alterra Reinsurance USA Inc.
Alterra USA    Alterra USA Holdings Limited
New Point IV    New Point IV Limited
New Point Re IV    New Point Re IV Limited

Alterra Bermuda, Alterra Europe, Alterra E&S, Alterra America, Alterra Re USA and Alterra at Lloyd’s are the primary operating subsidiaries of Alterra. All other subsidiaries are either holding companies or companies providing services to the operating companies.

Certain terms and financial measures used below are in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. Certain terms and non-GAAP financial measures used in this Annual Report on Form 10-K are defined in the “Glossary of Selected Insurance Industry Terms and Non-GAAP Financial Measures” appearing on page 31 of this Annual Report on Form 10-K. We have included in this Annual Report on Form 10-K certain non-GAAP financial measures within the meaning of SEC Regulation G. These measures are commonly used by us and other companies within the insurance industry. We believe that these non-GAAP financial measures allow for a more complete understanding of the performance of our business. These measures should not be viewed as a substitute for those measures determined in accordance with U.S. GAAP.

 

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Safe Harbor Disclosure

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. We intend that the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 apply to these forward-looking statements. Forward-looking statements are not statements of historical fact but rather reflect our current expectations, estimates and predictions about future results and events.

These statements may use words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “predict,” “project” and similar expressions as they relate to us or our management. When we make forward-looking statements, we are basing them on management’s beliefs and assumptions using information currently available to us. These forward-looking statements are subject to risks, uncertainties and assumptions. Factors that could cause such forward-looking statements not to be realized are described in the Risk Factors section of this Annual Report on Form 10-K. Any forward-looking statements made in this Annual Report on Form 10-K are qualified by these cautionary statements, and there can be no assurance that the actual results or developments anticipated will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, our business or operations. We undertake no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.

Generally, our policy is to communicate events that we believe may have a material adverse impact on our operations or financial position, including property and casualty catastrophic events and material losses in our investment portfolio, in a timely manner through a public announcement. It is also our policy not to make public announcements regarding events that we believe have no material impact on our operations or financial position based on management’s current estimates and available information, other than through regularly scheduled calls, press releases or filings.

General Description

We are a Bermuda-headquartered global enterprise dedicated to providing diversified specialty insurance and reinsurance products to corporations, public entities and property and casualty insurers. As of December 31, 2011, we had $2,809.2 million in consolidated shareholders’ equity.

In Bermuda, we conduct our insurance and reinsurance operations through Alterra Bermuda, which is registered as a Class 4 insurer under the insurance laws of Bermuda. Alterra Bermuda is also registered as a Class C long term insurer under the insurance laws of Bermuda. Alterra Bermuda was formed by the amalgamation of Alterra Insurance and Alterra Re on September 1, 2010.

In Europe, we conduct our non-Lloyd’s operations primarily from Dublin, Ireland through Alterra Europe. Effective November 1, 2011, Alterra Europe and Alterra Re Europe merged with Alterra Europe as the surviving entity. Alterra Europe also operates a branch in London. Our Lloyd’s operations are conducted by Alterra at Lloyd’s. Alterra at Lloyd’s underwrites a diverse portfolio of specialty risks in Europe, the United States and Latin America through Lloyd’s Syndicates 1400, 2525 and 2526, which we collectively refer to as the Syndicates. Alterra at Lloyd’s operations are based primarily in London, England, with branches in Dublin, Ireland and Zurich, Switzerland. As of December 31, 2011, our proportionate share of Syndicates 1400, 2525 and 2526 was 100%, approximately 2% and approximately 22%, respectively.

In the United States, our U.S. reinsurance operations are conducted through Alterra Re USA, a Connecticut-domiciled reinsurance company. Our U.S. insurance operations are conducted through Alterra E&S, a Delaware-domiciled excess and surplus insurance company, and Alterra America, a Delaware-domiciled admitted insurance company. Through Alterra E&S and Alterra America, we write both admitted and non-admitted business throughout the United States and Puerto Rico.

In Latin America, we provide reinsurance to clients through Alterra at Lloyd’s in Rio de Janeiro, Brazil, using Lloyd’s admitted status, and through Alterra Europe using a representative office in Bogota, Colombia and a service company in Buenos Aires, Argentina. In January 2012, our application to incorporate a local reinsurance company in Brazil was approved. We believe this will complement our existing presence in Brazil, and will provide us with greater access to additional reinsurance opportunities.

We employ personnel and hold assets within our global service companies incorporated and located in Bermuda, Ireland, the United Kingdom and the United States, which we believe improves the efficiency of providing corporate services across the Company.

To manage our insurance and reinsurance liability exposure, make our investment decisions and assess our overall enterprise risk, we model our underwriting and investing activities on an integrated basis. Our integrated risk management approach, as well as terms and conditions of our products, provide flexibility in making decisions regarding investments. Our investments comprise three high grade fixed maturities securities portfolios (one held for trading, one held as available for sale and one held to maturity) and a diversified alternative asset portfolio. Our investment portfolios are designed to provide diversification and to generate positive returns while attempting to reduce the frequency and severity of credit losses. Based on fair values as of December 31, 2011, the allocation of invested assets was 96.4% in cash and fixed maturities and 3.6% in other investments, principally hedge funds.

 

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Business Segments

We monitor the performance of our underwriting operations in five segments: insurance, reinsurance, U.S. specialty, Alterra at Lloyd’s and life and annuity reinsurance. The table below sets forth gross premiums written by type of risk for the years ended December 31, 2011, 2010 and 2009.

 

            2011     2010     2009  
            Gross
Premiums
Written
     Percentage
of Total
Premiums
Written
    Gross
Premiums
Written (a)
     Percentage
of Total
Premiums
Written
    Gross
Premiums
Written
     Percentage
of Total
Premiums
Written
 
            (in thousands)            (in thousands)            (in thousands)         

Insurance:

                  

Aviation

     S       $ 32,376        1.7   $ 39,888        2.8   $ 69,834        5.1

Excess Liability

     L         116,606        6.1       113,573        8.1       133,340        9.7  

Professional Liability

     L         184,377        9.7       183,051        13.0       179,904        13.1  

Property

     S         76,922        4.0       63,100        4.5       64,262        4.7  
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Insurance

        410,281        21.5       399,612        28.3       447,340        32.5  

Reinsurance:

                  

Agriculture

     S         30,682        1.6       29,222        2.1       89,550        6.5  

Auto

     S         99,807        5.2       32,902        2.3       —           —     

Aviation

     S         15,991        0.8       31,292        2.2       34,715        2.5  

Credit/ Surety

     S         34,916        1.8       2,196        0.2       —           —     

General Casualty

     L         73,814        3.9       48,357        3.4       29,185        2.1  

Marine & Energy

     S         24,012        1.3       16,381        1.2       18,321        1.3  

Medical Malpractice

     L         37,345        2.0       51,391        3.6       67,483        4.9  

Other

     S         3,137        0.2       2,784        0.2       2,297        0.2  

Professional Liability

     L         159,542        8.4       110,427        7.8       71,531        5.2  

Property

     S         319,684        16.8       148,146        10.5       87,039        6.3  

Whole Account

     S/L         35,800        1.9       5,129        0.4       11,456        0.8  

Workers’ Compensation

     L         34,979        1.8       30,826        2.2       77,451        5.6  
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Reinsurance

        869,709        45.7       509,053        36.1       489,028        35.6  

U.S. Specialty:

                  

General Liabiity

     L         86,630        4.5       81,137        5.8       68,209        5.0  

Marine

     S         88,493        4.6       67,454        4.8       61,360        4.5  

Professional Liability

     L         17,673        0.9       6,602        0.5       576        —     

Property

     S         137,380        7.2       139,305        9.9       135,760        9.9  
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total U.S. Specialty

        330,176        17.3       294,498        20.9       265,905        19.3  

Alterra at Lloyd’s:

                  

Accident & Health

     S         37,093        1.9       30,921        2.2       22,602        1.6  

Aviation

     S         13,269        0.7       16,138        1.1       2,611        0.2  

Financial Institutions

     L         27,205        1.4       19,448        1.4       23,822        1.7  

International Casualty

     L         52,425        2.8       26,174        1.9       —           —     

Marine

     S         1,493        0.1       —           —          

Professional Liability

     L         20,696        1.1       19,591        1.4       19,889        1.4  

Property

     S         132,068        6.9       85,553        6.1       60,049        4.4  

Surety

     S         6,295        0.3       4,808        0.3       —           —     
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Alterra at Lloyd’s

        290,544        15.3       202,633        14.4       128,973        9.4  
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Property & Casualty

      $ 1,900,710        99.8   $ 1,405,796        99.7   $ 1,331,246        96.8
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Life & Annuity:

                  

Annuity

      $ 1,826        0.1 %   $ 1,135        0.1   $ —           —  

Life

        1,530        0.1       3,800        0.3       43,755        3.2  
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Life & Annuity

        3,356        0.2   $ 4,935        0.3   $ 43,755        3.2
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Property & Casualty, and Life & Annuity

      $ 1,904,066        100.0   $ 1,410,731        100.0   $ 1,375,001        100.0
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

S = Short tail lines

      $ 1,071,518        56.4   $ 712,655        50.7   $ 654,128        49.1

L = Long tail lines

        829,192        43.6       693,141        49.3       677,118        50.9  
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Property & Casualty

      $ 1,900,710        100.0   $ 1,405,796        100.0   $ 1,331,246        100.0
     

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Percentages may not add due to rounding.

                  

 

(a)    Gross premiums written by the former Harbor Point companies are included for the period from May 12 to December 31, 2010.

 

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Short-tail lines are those lines of business which generally have a short claims pay-out period. Long-tail lines are those which generally have a long claims pay-out period.

Additional information about our business segments is set forth in Item 7—Management’s Discussion and Analysis and Note 20 to our audited consolidated financial statements included herein.

For our property and casualty businesses, the majority of our clients are insurers, reinsurers and companies located in North America. The following table shows the percentage of property and casualty gross premiums written by location of client for each of the years ended December 31, 2011, 2010 and 2009:

Source of gross premiums written:

 

Property and Casualty

   2011     2010     2009  

North America

     73.8     75.6     78.5

Europe

     16.1       14.7       13.6  

Rest of the world

     10.1       9.7       7.9  
  

 

 

   

 

 

   

 

 

 
     100.0     100.0     100.0
  

 

 

   

 

 

   

 

 

 

In 2009, 100.0% of our life and annuity gross premiums written were from North American clients. In 2011 and 2010, our life and annuity gross premiums written were comprised solely of premium adjustments related to previous years’ contracts.

Description of Business

We write both quota share and excess of loss insurance and reinsurance. Quota share contracts require us to share the premiums as well as the losses and expenses in an agreed proportion with the ceding client. Excess of loss contracts require us to indemnify the ceding client against all or a specified portion of losses and expenses in excess of a specified dollar or percentage amount. In both types of contracts, we may provide a ceding commission to the client.

Effective January 1, 2011, we redefined two of our operating and reporting segments based on changes to our internal reporting structure. Insurance business underwritten by Alterra Insurance USA, which was previously reported within the U.S. specialty segment, has been reclassified to the insurance segment. Alterra Insurance USA is a managing general underwriter for Alterra E&S and Alterra America, as well as various third party insurance companies, and is our principal insurance underwriting platform for retail distribution in the United States. All segment disclosures for comparative periods in this Annual Report on Form 10-K have been restated to reflect this reclassification.

Insurance

Our insurance segment offers property and casualty excess of loss insurance from our offices in Bermuda, Dublin and the United States. We offer professional liability, excess liability, aviation (particularly airline, general aviation and aerospace) and property insurance products primarily to Fortune 1000 companies. Our professional liability products include errors and omissions insurance, employment practices liability insurance and directors and officers insurance. Our excess liability products include excess umbrella liability insurance, excess product liability insurance, excess medical malpractice insurance and excess product recall insurance. We underwrite our insurance products on an individual risk basis.

Reinsurance

Our reinsurance segment offers property and casualty reinsurance from our offices in Bermuda, the United States, Dublin, London, Bogota, Buenos Aires and Rio de Janeiro to insurance companies worldwide. Principal lines of business include agriculture, auto, aviation, credit/surety, general casualty, marine & energy, medical malpractice, professional liability, property, whole account and workers’ compensation.

We typically write our reinsurance products in the form of treaty reinsurance contracts, which are contractual arrangements that provide for automatic reinsuring of a type or category of risk underwritten by our clients. Generally, we participate on reinsurance treaties with a number of other reinsurers, each with an allocated portion of the treaty and whereby the terms and conditions of the treaty are substantially the same for each participating reinsurer. With treaty reinsurance contracts, we do not separately evaluate each of the individual risks assumed under the contracts and are largely dependent on the individual underwriting decisions made by the ceding client. Accordingly, we review and analyze the ceding client’s risk management and underwriting practices in deciding whether to provide treaty reinsurance and in pricing of treaty reinsurance contracts.

 

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Our reinsurance products may include features such as contractual provisions that require our client to share in a portion of losses resulting from its ceded risks, may require payment of additional premium amounts if we incur greater losses than those projected at the time of the execution of the contract, may require reinstatement premium to restore the coverage after there has been a loss occurrence or may provide for experience refunds if the losses we incur are less than those projected at the time the contract is executed.

U.S. Specialty

Our U.S. specialty segment offers property and casualty insurance coverage from offices in the United States primarily to small to medium sized companies. Principal lines of business include general liability, marine (inland marine and ocean marine), professional liability and property.

We operate in the excess and surplus lines market through Alterra E&S and in the admitted insurance market through Alterra America. Excess and surplus lines insurance is a segment of the U.S. insurance market that allows consumers to buy property and casualty insurance through non-admitted carriers. Risks placed in the excess and surplus lines insurance market are often insurance programs that cannot be filled in the conventional insurance markets due to a shortage of state-regulated insurance capacity or the complexity of the risk. This market has significant flexibility regarding insurance rate and form, enabling us to utilize our underwriting expertise to develop customized insurance solutions for our clients.

Alterra E&S is domiciled and licensed in Delaware and is authorized as an eligible surplus lines insurer in 49 other U.S. states along with the District of Columbia, Puerto Rico and the U.S. Virgin Islands. Alterra America is domiciled in Delaware and licensed to write business on an admitted basis in all 50 states and the District of Columbia.

Alterra at Lloyd’s

Our Alterra at Lloyd’s segment offers property and casualty quota share and excess of loss insurance and reinsurance from its offices in London, Dublin and Zurich, primarily to medium to large sized international clients. It also provides reinsurance to clients in Latin America, principally Brazil, using Lloyd’s admitted status.

This segment comprises our proportionate share of the underwriting results of the Syndicates. Effective January 1, 2011, the management of Syndicates 2525 and 2526 was transferred from Alterra at Lloyd’s to an unaffiliated third party. Alterra at Lloyd’s continues to act as the managing agent for Syndicate 1400.

Syndicate 1400 offers property insurance and reinsurance, aviation insurance (particularly airline, general aviation and aerospace), accident and health insurance and reinsurance, financial institutions insurance products, international casualty reinsurance, marine insurance and surety reinsurance. Syndicate 2525 offers employers’ and public liability insurance products. Syndicate 2526 specializes in professional liability and medical malpractice insurance products. We include our proportional share of the gross written premiums of Syndicates 2525 and 2526 in the professional liability line of business in the table above.

Life and Annuity Reinsurance

Prior to 2010, we wrote life and annuity reinsurance agreements with respect to individual and group disability, whole life, universal life, corporate owned life, term life, fixed annuities, annuities in payment and structured settlements. We did not write any variable annuity products. In 2010, we decided not to write any new life and annuity contracts for the foreseeable future. Historically, our life and annuity focus was on low underwriting risk business that generated an invested asset spread. In the current low return investment environment, however, we do not believe that strategy is attractive. We have chosen not to change our business model to assume more underwriting and asset risk in this area, especially with the many opportunities we have in our core property and casualty businesses.

Our life and annuity reinsurance products took the form of co-insurance transactions whereby the risks are reinsured on the same basis as the original policies. In a co-insurance transaction, we receive a percentage of the gross premium charged to the policyholder by the cedent, less an expense allowance that we grant to the cedent, as the primary insurer. By accepting the transfer of liabilities and the related assets from our cedents in these co-insurance transactions, we sought to enable these clients to achieve capital relief and improved returns on equity.

The life reinsurance risks that we wrote included mortality and investment risks and, to a lesser extent, early surrender and lapse risks. The annuity products that we wrote included longevity and investment risks. The disability products that we wrote included investment risk and, to a lesser extent, morbidity risk and longevity risk. Mortality risk measures the sensitivity of the insurance company’s liability to higher mortality rates than were assumed in setting the premium. Longevity risk measures the sensitivity of the insurance company’s liability to future mortality improvement being greater than expected. Morbidity risk measures the sensitivity of the insurance company’s liability for higher illness, sickness and disease rates than were assumed in setting the premium. Early surrender and lapse risks measure the sensitivity of the insurance company’s liability to early or changing policy surrender distributions.

 

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Underwriting and Risk Management

Our objective is to generate returns on capital that reward our shareholders for the risks that we assume. We believe that the estimated returns on the risks that we underwrite will meet or exceed our return requirements. In order to achieve our objective, we must accurately assess the potential losses associated with the risks that we underwrite, manage our investment portfolio risk appropriately and control our expenses throughout the organization.

Short tail business represented approximately 56.4% of our property and casualty premium volume for the year ended December 31, 2011. Our short tail catastrophe exposed business comprises mostly our property, agriculture, aviation and marine and energy products in both insurance and reinsurance, which are susceptible to large catastrophe events that may trigger losses to a number of our cedants. As a result, we believe our short tail catastrophe exposed business is our largest exposure in terms of potential adverse earnings impact from a single event or series of events. We seek to manage and monitor our exposure so that the estimated maximum impact of a catastrophic event in any geographic zone is less than 25% of our beginning of year shareholders’ equity for a modeled 1-in-250 year event. However, this self-imposed long term target can be adjusted if and when we believe that market pricing makes the risk/reward trade off attractive.

We seek to reduce the volatility arising out of the underlying risks we assume by including contractual features such as overall aggregate limits on liabilities, per event limits on liabilities and attachment points for liabilities. We utilize internally developed catastrophe models that are based upon the results of commercially available products provided by companies such as Risk Management Solutions, Inc. and AIR Worldwide Corporation. We seek to obtain further protection against volatility and aggregation risk through the purchase of reinsurance as described under “Retrocessional and Balance Sheet Protections.”

We manage the duration, volatility and currency of our asset mix in relation to our liabilities in an attempt to manage our overall risk. We believe that our portfolio of underwriting risks benefits from diversification, and we tailor our investment strategy accordingly.

We use a series of proprietary and non-proprietary actuarial and financial models to analyze the underlying risk characteristics of our liabilities and assets. We conduct both contract-by-contract modeling as well as portfolio aggregation modeling and then analyze these modeled results on an integrated basis in an effort to determine the aggregation of our underwriting risk and investment risk and the ultimate impact that adverse events might have on our financial results and shareholders’ equity.

We utilize dynamic financial analysis to examine the possible effects of future variables, such as the effect of inflation on the cost of losses, using multiple scenarios to predict the range of outcomes and prices of our products. In addition, we attempt to manage capital adequacy by incorporating value at risk and risk based capital analyses into our modeling. Through the use of dynamic financial analysis, we seek to measure the risk inherent in each underwriting transaction as well as our overall asset and liability risk, and the potential for adverse scenarios producing projected losses and potential adverse cash flow. Additionally, by employing a risk based capital analysis rather than using premium income as a measure of risk, we are able to obtain an estimate of the amount of capital to be allocated to each transaction and our overall asset and liability portfolio. We believe that our actuarial analysis of loss payment patterns enables us to generate meaningful projections of the total and interim cash flows of our overall liability portfolios and use these projections to determine the profile of liquidity and investment returns required of our investment portfolio. We believe that this integrated approach allows us to optimize the use of our capital by providing a dynamic measurement of risk and return to evaluate competing reinsurance, insurance and investment opportunities.

We recognize the importance of information technology and management of data in supporting our business platform growth. We continue to develop and enhance our existing technology platforms to assist in our underwriting, risk management, financial and regulatory reporting processes and procedures across all of our segments.

We perform due diligence as we believe appropriate on risks that we consider underwriting and perform regular monitoring and periodic due diligence on the transactions that we complete. When we believe appropriate, we complement our internal skills with reputable third party service providers, including actuaries, attorneys, claim adjusters and other professionals. These third parties perform on-site client due diligence on our behalf, assist us in modeling transactions and provide legal advice on contract documentation.

 

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Risk Management Framework

We believe that our risk management framework provides us with a disciplined process to profitably manage risks. We seek to embed risk management discipline across our business commencing when a submission is received and continuing throughout the life of the contract. Our risk management framework permeates all aspects of our operations and, in this way, serves as an effective business management tool.

We aim to generate a return on capital that rewards our shareholders for the risks that we assume. Net operating return on average shareholders’ equity, or net operating ROE, is our primary return metric. In determining risk appetite, we focus on the volatility of net operating ROE and how much we are “willing to lose” under various scenarios. We also define success measures and tolerance levels and assess potential trade-offs across risks, including underwriting, reserving, credit, investment, liquidity and operational risks.

Our risk management framework comprises various layers of oversight:

 

   

The Audit and Risk Management Committee of our Board of Directors oversees our risk assessment and risk management policies;

 

   

The Operating and Risk Management Committee, or ORMCO, is comprised of executive management and risk managers from across the Company. ORMCO meets at least quarterly to review our current risk positions relative to risk appetite and tolerances in the context of the prevailing business environment and opportunities. ORMCO also reviews and discusses proposed risk management policies and makes recommendations to the Audit and Risk Management Committee;

 

   

The group risk management team is primarily responsible for liaising with our business units and functions to ensure the ongoing effective operation of the risk management framework. This team works with the business units to identify, measure and report on company-wide risks. Our risk management team is responsible for the timely escalation to ORMCO of significant deviations from our established risk profile, as well as the potential emergence of previously unidentified key risks; and

 

   

The internal audit function independently reviews the effectiveness of the risk management framework.

Our proprietary internal capital model supports the ongoing monitoring and measurement of risks and the calculation of economic and regulatory capital. This internal capital model is currently being enhanced to meet additional regulatory standards, including those required in Bermuda and under the Solvency II Directive in Europe.

Retrocessional and Balance Sheet Protections

As part of our underwriting process, we reinsure or retrocede portions of certain risks for which we have accepted liability. In these transactions, we cede to another counterparty reinsurer or retrocessionaire all or part of the risk that we have assumed. Like many other insurance and reinsurance companies, we cede risks to reinsurers and retrocessionaires for one or more of the following reasons:

 

   

reduce net liability on individual risks;

 

   

protect against catastrophic losses;

 

   

manage volatility of underwriting income;

 

   

obtain additional underwriting capacity; and

 

   

enhance underwriting pricing margins.

When we reinsure risks, we utilize reinsurance arrangements, such as quota share reinsurance, excess of loss reinsurance and stop-loss reinsurance contracts that are available in the reinsurance and retrocessional markets. In quota share reinsurance arrangements, the reinsurer or retrocessionaire shares a proportional part of our premiums and losses associated with the risks being reinsured. Under the terms of excess of loss reinsurance and stop-loss reinsurance, the reinsurer or retrocessionaire agrees to cover losses in excess of the amount of risk that we have retained, subject to negotiated limits.

Our reinsurance strategy includes purchasing reinsurance to limit losses on a single risk or transaction and/or on a portfolio basis as the need arises. Generally, we utilize quota share reinsurance for our property and casualty business in order to allow us to provide increased capacity to our clients while still meeting our internally governed maximum net exposure thresholds. For our property and aviation business, we also purchase excess of loss reinsurance in order to reduce the volatility of our underwriting results and manage our aggregate exposures.

Our reinsurance and retrocessional arrangements do not legally discharge our liability with respect to obligations that we have insured or reinsured. We remain liable with respect to the liabilities that we cede if a counterparty is unable to meet its obligations assumed under a reinsurance or retrocessional agreement. Accordingly, we evaluate and monitor the financial strength of each of our counterparties. Some reinsurance and retrocessional agreements give us the right to receive additional collateral or to terminate the agreement in the event of deterioration in the financial strength of the counterparty.

 

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Loss and Benefit Reserves

We establish and carry as liabilities loss reserves that are estimated by actuaries and management’s reserving committee. These reserve amounts have been established to meet our estimated future obligations for losses and related expenses that have occurred relating to premiums we have earned. Future loss and benefit payments comprise the majority of our financial obligations. We use our own actuaries in our loss reserving process. In addition, we engage external independent actuaries to perform an annual review of our loss reserve estimates.

Loss and benefit reserves do not represent an exact calculation of our liabilities. The estimation of loss and benefit reserves is a complex process impacted by many internal and external factors. We apply the general assumption that past experience (both industry’s and our own) is a suitable guide to future experience after making allowance for current developments and likely future trends. The reserves presented represent our estimate of the expected cost of the ultimate settlement and administration of our claims. These estimates are based on a combination of quantitative techniques, subjective considerations and managerial judgment.

In estimating an initial reserve, our actuaries utilize the underwriting information received when a transaction is negotiated. When combined with our own historic claims experience, this data helps us to select the appropriate assumptions used to create an initial pricing and reserving model. Initial assumptions include estimates of future trends in claims severity and frequency, mortality, judicial theories of liability and other factors. We regularly evaluate and update our initial loss development and trending factor selections using both client specific and industry data. During the underwriting process, a client’s data is analyzed by our underwriting teams to ascertain its quality and credibility. This process may include an underwriting audit and claims audit of a client’s operations. We also examine the claim estimates made by the insured or ceding company to evaluate the trends assumed in the estimates. In cases where the data initially provided by the client is not sufficient, we utilize industry data collected from either third party sources or from our own historical submission database. This enhances the quality of the reserve model that is created.

On a quarterly basis, our reserving committee performs a detailed review of our contracts and of the actuarial methods utilized in arriving at reserve estimates and the related reinsurance recoverables. This review is performed in conjunction with our corporate actuarial group. The quarterly review utilizes the initial submission information updated by current premium, loss and claims data reported to us. Changes in reported loss information from our clients is the principal reason for changes to our loss reserve estimates. As part of this process, our actuaries check that the actuarial methods applied continue to be appropriate to allow us to form a sound basis for projection of future liabilities.

Marketing

Most of our business is placed through insurance and reinsurance brokers worldwide. We also place some insurance business through managing general agents. We believe that diversity in sourcing our business reduces the potential adverse effects arising from the termination of any one of our business relationships. We seek to develop and capitalize on relationships with insurance and reinsurance brokers, insurance and reinsurance companies, large global corporations and financial intermediaries to develop and underwrite business.

A significant volume of premium for the property and casualty insurance and reinsurance industry is produced through a small number of large insurance and reinsurance brokers. During the years ended December 31, 2011, 2010 and 2009, the top three independent brokers accounted for 24%, 18% and 12%; 22%, 14% and 13%; and 25%, 11% and 7%, respectively, of our property and casualty gross premiums written. We have relationships with multiple key personnel in these firms and seek to maintain strong working relationships with these firms in the future. See “Item 1A—Risk Factors—A limited number of insurance and reinsurance brokers account for a large portion of our revenues, and a loss of all or a substantial portion of this brokered business or the consolidation of these brokers could have a significant and negative effect on our business and results of operations.”

Potential credit risk associated with brokers and intermediaries is discussed in “Item 1A—Risk Factors—The involvement of brokers subjects us to their credit risk.”

Competition

The insurance and reinsurance industry is highly competitive. Competition in the types of business that we currently underwrite and intend to underwrite in the future is based principally on:

 

   

premium rates;

 

   

ability to obtain terms and conditions appropriate for the risk being assumed;

 

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the general reputation and perceived financial strength of the insurer or reinsurer;

 

   

relationships with insurance and reinsurance companies and insurance intermediaries;

 

   

ratings assigned by independent rating agencies;

 

   

speed of claims payment and quality of administrative services; and

 

   

experience in the particular line of insurance or reinsurance to be underwritten.

We compete directly with numerous insurance and reinsurance companies, captive insurance companies, subsidiaries or affiliates of established insurance companies or newly formed companies, reinsurance departments of primary insurance companies, government sponsored reinsurance pools and underwriting syndicates from countries throughout the world in each of our product lines. Many of these competitors are well established, have significant operating histories, underwriting expertise and extensive capital resources and have developed longstanding customer relationships. Our worldwide competitors include many larger companies with higher ratings and greater underwriting capacity than we have. See “Item 1A—Risk Factors—Competitors and/or consolidation in our industry may make it difficult for us to write business effectively and profitably.

Employees

As of December 31, 2011, we had 500 employees.

Overview of Investments

Our investment portfolio is managed by third-party investment managers. We seek to earn a risk-adjusted total return on our assets by engaging in an investment strategy that combines cash, fixed maturities and other investments and employs strategies intended to manage investment risk. We diversify our portfolio in an attempt to limit volatility and maintain adequate liquidity in our fixed maturities and other investments to fund operations and losses from unexpected events. We seek to manage our credit risk through industry and issuer diversification and interest rate risk by monitoring the duration and structure of the investment portfolio relative to the duration and structure of our liability portfolio.

The Finance and Investment Committee of our Board of Directors establishes our investment guidelines and selects our investment managers. The Finance and Investment Committee may waive or amend the provisions of our investment guidelines. The Finance and Investment Committee also regularly monitors the performance of our investment managers and periodically reviews and amends our investment guidelines in light of prevailing market conditions. Based on fair values as of December 31, 2011, the allocation of invested assets was 96.4% in cash and fixed maturities and 3.6% in other investments.

Fixed Maturities Investments

Our fixed maturities portfolio is managed by nine independent investment managers. Our fixed maturities investment portfolio guidelines emphasize high quality, liquid securities. A minimum weighted average credit quality rating of Aa3/AA-, or its equivalent, must be maintained for our fixed maturities investment portfolio as a whole. As of December 31, 2011, our fixed maturities investments had a dollar-weighted average credit rating of Aa2/AA, an average duration of approximately 4.7 years and an average book yield to maturity of 3.95%. Including cash and cash equivalents, the average duration was approximately 4.1 years as of December 31, 2011.

Approximately 82.5% of our invested assets by fair value as of December 31, 2011 were managed by six investment managers utilizing a core strategy. This strategy emphasizes high credit quality, diversification and preservation of principal. Under our investment guidelines, securities in the core portfolio, when purchased, must have a minimum credit rating of A3/A-, or its equivalent, from at least one internationally recognized statistical rating organization. However, a minimum weighted average credit rating of Aa2/AA, or its equivalent, must be maintained for the core portfolio as a whole. Our core portfolio investment guidelines also provide that we cannot leverage the fixed maturities investments.

Approximately 4.9% of our invested assets by fair value as of December 31, 2011 were managed by one investment manager utilizing a total return strategy. This strategy emphasizes high credit quality, diversification and preservation of principal. Under our investment guidelines, securities in this portfolio, when purchased, must have a minimum credit rating of Baa3/BBB-, or its equivalent, from at least one internationally recognized statistical rating organization. However, a minimum weighted average credit rating of A3/A-, or its equivalent, must be maintained for this portfolio as a whole. This strategy allows the use of derivatives for purposes of portfolio risk hedging and security replication. Derivatives approved for use are futures, options, interest rate swaps, swaptions, credit derivatives and non-deliverable foreign currency forwards. Derivatives in this portfolio may not be used to leverage the portfolio or increase exposure or risk beyond the restrictions stated in the investment guidelines. Derivatives in this portfolio are included within other investments on our consolidated balance sheet and are further discussed below.

 

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Approximately 3.0% of our invested assets by fair value as of December 31, 2011 were managed by three investment managers utilizing an opportunistic strategy. This strategy allows for the purchase of securities below investment-grade and securities trading at deep discounts. Each investment manager has separate and distinct investment guidelines which emphasize diversification and preservation of principal and which limit the manager to specific market opportunities. These opportunistic portfolios are required to maintain a minimum weighted average credit rating of B2/B. Investments in free-standing derivatives and other leverage instruments are prohibited in these portfolios.

For certain of our fixed income securities, we employ a strategy to hold the securities to maturity. These securities are principally of long duration and generally match the more predictable cash flow requirements of our long term liabilities.

Our cash and fixed maturities investments, excluding those which are being held to maturity, provide liquidity for day-to-day operations. We believe that we will be able to satisfy our foreseeable cash needs from our cash and available for sale fixed maturities investments, and we maintain significant cash and cash equivalent balances to reduce the likelihood that we will be required to sell fixed maturities investments before maturity.

Our fixed maturities investments are held by five different custodians. These custodians are all large financial institutions that are highly regulated. These institutions have controls over their investment processes that are certified annually.

Additional information about our fixed maturities investments can be found in Note 3 to our audited consolidated financial statements included herein.

Other Investments

Other investments comprise our investments in hedge funds, or the hedge fund portfolio, investments in structured deposits, various derivative instruments and equity method investments. Based on fair values as of December 31, 2011, other investments comprised approximately 3.6% of our total invested assets.

Hedge Funds

Our hedge fund portfolio is invested in accordance with our investment guidelines, which currently mandate, among other things, that:

 

   

at least five distinct hedge fund investment strategies must be employed at all times;

 

   

no more than 5.0% of the fair value of the hedge fund portfolio may be invested in any single underlying hedge fund;

 

   

no more than 10.0% of the fair value of the hedge fund portfolio may be allocated to any single hedge fund manager; and

 

   

monthly or quarterly liquidity must be available on 50.0% or more, by fair value, of the aggregate active hedge fund investments in our hedge fund portfolio.

As of December 31, 2011 and 2010, the distribution of the hedge fund portfolio by investment strategy was:

 

     As of December 31,  
     2011     2010  
     Fair
Value
     Allocation %     Fair
Value
     Allocation %  
In millions of U.S. Dollars                           

Distressed securities

   $  25.0         9.9   $ 35.8        12.2

Diversified arbitrage

     17.4         6.9       27.9         9.5  

Emerging markets

     4.9         2.0       13.0         4.4  

Event driven arbitrage

     21.1         8.5       30.2         10.2  

Fund of funds

     31.7         12.7       42.9         14.6  

Global macro

     49.0         19.6       49.7         16.9  

Long/short credit

     4.4         1.8       10.0         3.4  

Long/short equity

     94.8         37.9       82.1         27.9  

Opportunistic

     1.7         0.7       2.7         0.9  
  

 

 

    

 

 

   

 

 

    

 

 

 

Total hedge funds

   $  250.0         100.0   $ 294.3        100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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The following is a summary of the underlying strategies of funds in which we may invest:

Commodities Trading. Commodities trading advisors seek to make returns by trading futures, options and other securities in the over-the-counter market and on the regulated commodities exchanges.

Convertible Arbitrage. This strategy typically entails the simultaneous purchase of a convertible bond and a short sale of the underlying common stock, which results in an offsetting hedged position. The principal risk of this strategy is a decline in the price of the convertible bond due to interest rate movements or credit quality changes that are not offset by an increase in the value of the corresponding common stock short position.

Distressed Securities. Funds that pursue a distressed investing strategy purchase securities of companies experiencing financial distress.

Diversified Arbitrage. This strategy typically entails simultaneously pursuing a variety of market-neutral strategies such as convertible arbitrage and event-driven arbitrage. Managers are able to allocate resources opportunistically to the strategies that are perceived as offering the greatest potential for returns in any given environment.

Emerging Markets. Emerging market funds seek to generate returns by employing analysis of emerging market countries and investing in government and corporate securities of emerging market countries.

Event-Driven Arbitrage. This strategy typically entails the purchase of securities of a company involved in a significant corporate event. Funds may employ strategies such as merger arbitrage, capital structure arbitrage, reorganizations and investments in the debt and/or equity instruments of a company with a defined catalyst.

Fixed Income Arbitrage. Principal trading activities include making arbitrage trades based on aberrations in the yield curve, credit spreads or between sectors in the fixed maturities market, such as between mortgage backed securities and asset backed securities.

Fund of Funds. The fund of funds may invest across a variety of underlying hedge fund investment strategies.

Global Macro. This strategy typically participates in directional or relative value trading of bonds, stocks and currencies in an attempt to take advantage of perceived changes in macroeconomic conditions.

Long/Short Credit. This strategy seeks opportunities to invest primarily in high grade, high yield and distressed fixed maturities based on the identification of imbalance in valuation and capital allocation across credit ratings, industry sectors and geographic regions.

Long/Short Equities. This strategy deploys capital long and short, taking views across companies and sectors based on the perceived fundamentals of those securities. Returns are generated through superior stock selection based upon fundamental analysis.

Merger Arbitrage. This strategy typically entails the simultaneous purchase of common stock of a company being acquired or merged and a short sale of the common stock of the acquiring company.

Opportunistic. The strategy seeks to take advantage of temporarily dislocated securities by deploying capital across different asset classes based on the current opportunity set.

Structured Deposits, Derivatives and Equity Method Investments

We hold an index-linked structured deposit with a guaranteed minimum redemption amount of $24.3 million and a scheduled redemption date of December 18, 2013. We carry this instrument at fair value and it is presented within other investments on our consolidated balance sheet.

Our investment guidelines allow for the use of derivative instruments, including futures, options, interest rate swaps, swaptions, credit derivatives and non-deliverable foreign currency forwards. Derivatives may be used for purposes of portfolio risk hedging or security replication, to obtain risk neutral substitutes for physical securities, and to adjust the curve and/or duration positioning of the investment portfolio. Within our available for sale fixed maturities portfolio, we hold convertible bond securities. The equity call option component of these securities is bifurcated and presented within other investments on our consolidated balance sheet.

Equity method investments comprise our equity ownership in four private reinsurance entities. The largest of our equity method investments is New Point IV, a Bermuda domiciled company incorporated in 2011. In conjunction with our 34.8% shareholding in New Point IV, we entered into an underwriting services agreement with New Point Re IV, a wholly-owned subsidiary of New Point IV. New Point Re IV is a reinsurance company that offers fully-collateralized retrocessional reinsurance to the property reinsurance market. Our participation in this company enables us to earn fee income for underwriting services and to participate in the underwriting results while limiting our exposure to the amount of our investment.

 

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We may from time to time invest in catastrophe-linked securities, or catastrophe bonds. Catastrophe bonds are generally privately placed fixed income securities for which all or a portion of the repayment of the principal is linked to catastrophic events. We underwrite and model these securities using the same tools and techniques used to evaluate our traditional property catastrophe reinsurance business assumed. The maximum possible loss to us is limited to the value of our investment. During the year ended December 31, 2011, we disposed of all of our holdings in catastrophe bonds.

Additional information about our hedge fund portfolio and other investments can be found in “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Notes 3 and 4 to our audited consolidated financial statements included herein.

Ratings

Ratings are an important factor in establishing the competitive position of reinsurance and insurance companies and are important to our ability to market our products. We have a financial strength rating for our non-Lloyd’s reinsurance and insurance subsidiaries, as set forth in the table below, from each of A.M. Best Company, or A.M. Best, Fitch Inc., or Fitch, Moody’s Investor Services, Inc., or Moody’s, and Standard and Poor’s Ratings Services, or S&P. These ratings reflect each rating agency’s opinion of our financial strength, operating performance and ability to meet obligations. They are not evaluations directed toward the protection of investors in our securities. The Syndicates share the Lloyd’s market ratings.

As of December 31, 2011, we were rated as follows:

 

    

A.M. Best

  

Fitch

  

Moody’s

  

S&P

Financial strength rating for non-Lloyd’s insurance and reinsurance subsidiaries

   A (excellent)(1)(2)    A (strong)(1)    A3(3)    A (1)(2)

Outlook on financial strength rating

   Negative (1)(2)    Stable (1)    Stable (3)    Stable (1)(2)

Lloyd’s market financial strength rating applicable to the Syndicates

   A (excellent)    A+ (strong)    Not applicable    A+ (strong)

 

(1) Applicable to Alterra Bermuda, Alterra Europe, Alterra America and Alterra E&S.
(2) Applicable to Alterra Re USA.
(3) Applicable to Alterra Bermuda.

Administration

We provide most of our own management and administrative services. We manage and administer the claims activity associated with our insurance and reinsurance operations and utilize both internal resources and external experts to assist with the settlement of claims and establishment of reserves. Our underwriters, actuaries and financial staff assist our claims personnel in performing traditional claims tasks such as monitoring claims and reserving. In addition, when we write highly specialized business, we from time to time hire third-party claims specialists to assist in evaluating loss exposure and establishing reserving practices and claims-paying procedures.

In connection with the administration of the life and annuity benefit payments of our clients’ primary insureds that are covered on certain reinsurance transactions, we and our client may select an independent third-party claims administrator. We and our client then enter into a contract with the third-party administrator that will typically contain a provision requiring a significant amount of advance notice in order to terminate the contract. We are responsible for the loss and benefit payment expense charged by the third party administrator.

We outsource some administrative functions to third parties that can provide levels of expertise in a cost-efficient manner that we cannot provide internally. Outsourced functions include investment management services, investment accounting services, information systems development and tax preparation and advice.

Regulation

The principal jurisdictions of our operations are Bermuda, Ireland, the United Kingdom and the United States.

 

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Bermuda

The insurance and reinsurance industry in Bermuda is regulated by the Bermuda Monetary Authority, or the BMA. Alterra Bermuda is regulated by the BMA under the Insurance Act 1978 of Bermuda and its related regulations, which we refer to collectively as the Bermuda Insurance Act. The Bermuda Insurance Act imposes solvency and liquidity standards and auditing and reporting requirements on Alterra Bermuda and grants to the BMA powers to supervise, investigate and intervene in the affairs of Bermuda insurance and reinsurance companies. Alterra Bermuda is required to prepare and file annual financial statements in accordance with U.S. GAAP, annual statutory financial statements, an annual statutory financial return and an annual capital and solvency return, which comprises a statutory risk based capital model, a schedule of fixed income investments by rating categories, a schedule of net reserves for losses and loss expense provisions by line of business, a schedule of premiums written by line of business and a schedule of risk management.

Under the Bermuda Insurance Act, Alterra Bermuda’s property and casualty business is subject to enhanced capital requirements in addition to minimum solvency and liquidity requirements. The enhanced capital requirement is determined by reference to a statutory risk-based capital model that determines a control threshold for statutory capital and surplus. If a company fails to maintain or meet the control level, various degrees of regulatory action may be taken by the BMA. In addition, in an effort to achieve equivalency with European Union regulators under the Solvency II Directive, the BMA may, in respect of an insurance group, determine whether it is appropriate for it to be the group supervisor of that group. The BMA has determined that it will act as the group supervisor of the Company and has designated Alterra Bermuda as the designated insurer. The BMA has introduced rules that implement a group supervision regime and enhance the group capital and solvency framework. The Company is required to prepare and file annual group statutory financial statements, an annual group statutory financial return and an annual group capital and solvency return in addition to quarterly financial returns.

Alterra Bermuda is subject to the Insurance Code of Conduct, or the Insurance Code, which establishes duties and standards that must be complied with by all insurers registered under the Insurance Act. Non compliance with the Insurance Code could result in intervention by the BMA. The BMA also monitors each insurer’s compliance with the Insurance Code and may use it as a factor in calculating the applicable operational risk charge in accordance with that insurer’s risk-based capital model.

Pursuant to the Bermuda Insurance Act, any person who becomes a holder of at least 10%, 20%, 33% or 50% of our common shares must notify the BMA in writing within 45 days of becoming such a holder. The BMA has the power to object to a person holding 10% or more of our common shares if the BMA determines that the person is not a fit and proper person to be a controller of the registered insurer. In such a case, the BMA may require the holder to reduce their shareholding and may direct, among other things, that the voting rights attaching to their common shares shall not be exercisable.

In addition, our Bermuda domiciled entities are each required to comply with the provisions of the Companies Act 1981 of Bermuda, or the Bermuda Companies Act. The Bermuda Companies Act regulates, among other things, the payment of dividends and making of distributions from contributed surplus.

Ireland

The insurance and reinsurance industry in Ireland is regulated by the Central Bank of Ireland, or the CBI. Our Irish operating subsidiary, Alterra Europe, is subject to regulation by the CBI under a variety of Irish rules and regulations. Alterra Europe must comply with the Irish Insurance Acts 1909 to 2000, regulations promulgated thereunder, regulations relating to insurance business promulgated under the European Communities Act 1972, the Irish Central Bank Acts 1942 to 2010, as amended, regulations promulgated thereunder and directions and guidelines and codes of conduct issued by the CBI, which we refer to collectively as the Insurance Acts and Regulations.

Alterra Europe is required to maintain statutory reserves, particularly in respect of underwriting liabilities, and a solvency margin as provided for in the Insurance Acts and Regulations. Assets constituting statutory reserves must comply with admissibility, diversification, localization and currency matching rules. Statutory reserves must be actuarially certified annually.

Anyone acquiring or disposing of a direct or indirect holding in an Irish authorized insurance company that represents 10% or more of the capital or of the voting rights of such company or that makes it possible to exercise a significant influence over the management of such company, or anyone who proposes to decrease or increase that holding to specified levels, must first notify the CBI of their intention to do so. Any Irish authorized insurance company that becomes aware of any acquisitions or disposal of its capital involving the specified levels must also notify the CBI. The specified levels are 20%, 33% and 50% or such other level or ownership that results in the company becoming the acquirer’s subsidiary within the meaning of article 20 of the European Communities (Non-Life Insurance) Framework Regulations 1994. The CBI has three months from the date of submission of a notification within which to oppose the proposed transaction if the CBI is not satisfied as to the suitability of the acquirer in view of the necessity “to ensure prudent and sound management of the insurance undertaking concerned.” As a result of these restrictions, no person, corporation or entity is permitted to acquire control of Alterra, Alterra Europe or any intermediary company unless such person, corporation or entity has obtained the prior approval of the CBI.

 

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Alterra Europe will be required to comply with the Solvency II Directive when it is implemented. We currently believe that European Union member states will be required to enact Solvency II into national laws by January 1, 2013 and that it will apply to (re)insurers starting January 1, 2014. Solvency II takes a risk-based approach to the authorization and supervision of (re)insurers. It comprises three “pillars” dealing with quantitative requirements, including capital requirements, qualitative requirements, such as risk management and control systems, and supervisory reporting and disclosure requirements. During 2012 and 2013, the CBI will expect Alterra Europe to begin preparing for additional reporting requirements and generally to be able to demonstrate its preparedness for Solvency II.

United Kingdom and Lloyd’s

The financial services industry in the United Kingdom is regulated by the Financial Services Authority, or FSA. The FSA regulates insurers, insurance intermediaries and Lloyd’s. The FSA and Lloyd’s have common objectives in ensuring that the Lloyd’s market is appropriately regulated and, to minimize duplication, the FSA has arrangements with Lloyd’s for co-operation on supervision and enforcement.

The Lloyd’s market permits its members to underwrite insurance and reinsurance risks through Lloyd’s syndicates. Members of Lloyd’s may participate on a syndicate for one or more underwriting years by providing capital to support the syndicate’s underwriting activities. All syndicates are managed by managing agents that receive fees and profit commissions in respect of the underwriting and administrative services they provide to the syndicates.

We participate in the Lloyd’s market through the Syndicates. Alterra at Lloyd’s was the managing agent for each of the Syndicates until December 31, 2010. Effective January 1, 2011, management of Syndicates 2525 and 2526 was transferred to an unaffiliated third party, with Alterra at Lloyd’s continuing as the managing agent for Syndicate 1400. Alterra Corporate Capital 2 Limited and Alterra Corporate Capital 3 Limited, or the Alterra Corporate Capital Vehicles, are corporate members of Lloyd’s and participate in the underwriting years of the Syndicates for which they are a member. By entering into a membership agreement with Lloyd’s, the Alterra Corporate Capital Vehicles have undertaken to comply with all byelaws and regulations of Lloyd’s as well as the provisions of the Lloyd’s Acts and the Financial Services and Markets Act 2000. The Syndicates, as well as the Alterra Corporate Capital Vehicles, Alterra at Lloyd’s and their directors, are subject to the Lloyd’s regulatory regime.

Both the FSA and Lloyd’s have powers to remove their respective authorization to manage Lloyd’s syndicates. Lloyd’s approves annually the business plan of each of the Syndicates along with any subsequent material changes, and the amount of capital required to support those plans. Alterra at Lloyd’s, as the managing agent of Syndicate 1400, is required to carry out a capital assessment of Syndicate 1400 in order to determine whether any additional capital should be held by that Syndicate on account of any particular risks arising from its business or operational infrastructure. This assessment, known as an individual capital assessment, is reviewed and may be challenged by Lloyd’s.

During 2012, the United Kingdom intends to introduce legislation to create a new prudential regulation authority, the PRA, and a new financial conduct authority, the FCA, and transfer regulatory responsibility from the FSA to them. Responsibility for the prudential regulation of insurers will be transferred to the PRA. Responsibility for the regulation of the conduct of business of insurers will be transferred to the FCA. The United Kingdom intends for the PRA and the FCA to be fully operational by the beginning of 2013.

United States

Alterra Re USA is domiciled in Connecticut and is licensed or accredited to provide reinsurance in all 50 U.S. states and the District of Columbia. The principal insurance regulatory authority of Alterra Re USA is the Connecticut Department of Insurance. Alterra Re USA is also subject to regulation by all state insurance departments and under all applicable state insurance laws.

Alterra E&S is domiciled and licensed in Delaware as a property and casualty insurer. Alterra E&S does not hold an insurance certificate of authority in any other jurisdiction; however, Alterra E&S is listed or authorized as an eligible surplus lines insurer in 49 other U.S. states along with the District of Columbia, Puerto Rico and the U.S. Virgin Islands. The principal insurance regulatory authority of Alterra E&S is the Delaware Department of Insurance. Alterra E&S is also subject to regulation as an eligible surplus lines insurer by state insurance departments and under applicable state insurance laws in each jurisdiction in which it is listed or authorized.

Alterra America is domiciled in Delaware and is admitted as a licensed insurer in all 50 U.S. states and the District of Columbia. The principal insurance regulatory authority of Alterra America is the Delaware Department of Insurance. Alterra America is also subject to regulation by all state insurance departments and under all applicable state insurance laws.

Alterra Re USA, Alterra E&S and Alterra America are subject to the laws and regulations of their respective state of domicile, as well as any other state in the United States where they conduct business. In states where the companies are admitted, the companies must comply with all insurance laws and regulations, including rate and form requirements, maintenance of minimum levels of statutory capital, surplus, liquidity and solvency standards. They are also required to submit to periodic examinations of their

 

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respective financial condition, including risk-based capital standards based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners and adopted by the states. These laws and regulations also sometimes restrict payments of dividends, reductions of capital and/or the ability to make certain investments.

Alterra, an insurance holding company, is subject to regulation under the Delaware and Connecticut insurance holding company system laws, as well as those of additional U.S. states. These laws and applicable regulations require periodic disclosure concerning, among other things, ownership structure and prior notice and non-disapproval of certain affiliate transactions within the Alterra holding company system. Furthermore, no person, corporation or other entity is permitted to acquire control of Alterra, Alterra Re USA, Alterra E&S, Alterra America or any intermediary company unless such person, corporation or entity has obtained the prior approval of the Delaware and/or Connecticut Insurance Commissioner or obtained an applicable waiver or exemption. The insurance holding company system laws in each of Delaware and Connecticut broadly define a change of control, and create a presumption of control when any person, directly or indirectly, owns, controls, holds with the power to vote, or holds proxies representing 10% or more of the voting securities of an insurance company or any of its parent companies.

In July 2010, the Dodd Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, was enacted. Among other things, the Dodd-Frank Act authorizes the federal preemption of certain state insurance laws and streamlines the regulation of reinsurance and surplus lines insurance. Many provisions of the Dodd-Frank Act will become effective over time, and certain provisions of the Dodd-Frank Act require the implementation of regulations that have not yet been adopted.

Other Jurisdictions

As a global provider of specialty insurance and reinsurance, we must comply with various regulatory requirements in jurisdictions where we provide coverage or have activities in addition to the principal jurisdictions discussed above. For example, Alterra Europe and Alterra at Lloyd’s must comply with applicable Latin America regulatory requirements in connection with our Latin American reinsurance operations, and Alterra Europe must comply with applicable German, Swiss and United Kingdom regulatory requirements in connection with its activities in those countries.

In addition to the regulatory requirements imposed by the jurisdictions in which a reinsurer is licensed, a reinsurer’s business operations are affected by regulatory requirements governing credit for reinsurance in other jurisdictions in which its ceding companies are located. In general, a ceding company that obtains reinsurance from a reinsurer that is licensed, accredited or approved by the jurisdiction in which the ceding company files statutory financial statements is permitted to reflect in its statutory financial statements a credit in an aggregate amount equal to the liability for unearned premiums and loss reserves and loss expense reserves ceded to the reinsurer. Many jurisdictions also permit ceding companies to take credit on their statutory financial statements for reinsurance obtained from unlicensed or non-admitted reinsurers if certain prescribed security arrangements are made. Because Alterra Bermuda is not licensed, accredited or approved in any jurisdiction other than Bermuda, in certain instances our reinsurance customers require Alterra Bermuda to provide a letter of credit or enter into other security arrangements.

Available Information

Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports and the Proxy Statement for our Annual General Meeting of Shareholders are made available, free of charge, on our web site, http://www.alterracap.com, as soon as reasonably practicable after such reports have been filed with or furnished to the SEC. In addition, our Code of Business Conduct and Ethics is available on our web site.

 

ITEM 1A. RISK FACTORS

Any of the following risk factors could cause our actual results to differ materially from historical results or anticipated results. These risks and uncertainties are not the only ones we face, but represent the risks that we believe are material. However, there may be additional risks that we currently consider not to be material or of which we are not currently aware, and any of these risks could cause our actual results to differ materially from historical or anticipated results.

Risks Related to Our Business

Our losses and loss adjustment expenses and benefits may exceed our loss and benefit reserves, which could significantly increase our liabilities and reduce our net income and could have a significant and negative effect on our financial condition and results of operations.

Our success depends on our ability to assess accurately the risks associated with the business that we insure and reinsure. If we fail to assess these risks accurately, or if events or circumstances cause our estimates to be incorrect, we may not establish appropriate premium rates and our reserves may be inadequate to cover our losses and benefits. If our actual claims experience is less favorable than our underlying assumptions, we will be required to increase our liabilities, which will reduce our net income and could have a significant and negative effect on our financial condition and results of operations.

 

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Reserves are actuarial and statistical projections at a given point in time of what we ultimately expect to pay on claims and benefits, based on facts and circumstances then known, estimates of future trends in claim frequency and severity, mortality and other variable factors, such as inflation. Our actual losses and benefits may deviate, perhaps substantially, from the reserve estimates contained in our financial statements. The establishment of new reserves or the adjustment of reserves for reported claims could result in significant positive or negative changes to our financial condition or results of operations in any particular period.

Reinsurance reserves are subject to greater uncertainty than insurance reserves primarily because a reinsurer relies on the original underwriting decisions made by ceding companies. As a result, we are subject to the risk that our ceding companies may not have adequately evaluated the risks reinsured by us and the premiums ceded may not adequately compensate us for the risks we assume. In addition, reinsurance reserves may be less reliable than insurance reserves because there is generally a longer lapse of time from the occurrence of the event to the reporting of the loss or benefit to the reinsurer to the ultimate resolution or settlement of the loss.

The failure of any of the loss limitation methods we employ could have a significant and negative effect on our financial condition and results of operations.

We seek to mitigate our loss exposure through a variety of methods. We write many of our insurance and reinsurance contracts on an excess of loss basis. Excess of loss insurance and reinsurance indemnifies the insured against a specified amount of losses in excess of a specified amount. We also seek to limit our loss exposure by diversifying our business by class of business and type of peril and by using geographic zone limitations. Geographic zone limitations involve significant underwriting judgments, including the determination of the area of the zones and the inclusion of a particular policy within a particular zone’s limits. Many of our insurance and reinsurance contracts include loss limitation features that may not be enforceable in the manner that we intend, such as exclusions from coverage and choice of coverage provisions. In addition, many of our reinsurance contracts do not contain aggregate loss limits, which means that there is no contractual limit to the amount of losses that we may be required to pay pursuant to such reinsurance contracts. We purchase a substantial amount of reinsurance in order to reduce our loss exposure to various risks. We may be unable to collect all amounts due from our reinsurers under our reinsurance agreements. The failure of any our loss limitation methods could have a significant and negative effect on our financial condition and results of operations.

Our ability to write insurance and reinsurance is affected by cyclical trends and by global economic conditions and fluctuations in interest rates.

The property and casualty insurance and reinsurance industry has historically been affected by cyclical trends. Demand for property and casualty insurance and reinsurance is influenced significantly by underwriting results and prevailing general economic and market conditions, all of which affect insurance and reinsurance premium rates and the amount of risk that companies and insurers elect to retain. The supply of property and casualty insurance and reinsurance is directly related to the levels of surplus available to support assumed business that, in turn, may fluctuate in response to changes in rates of return on investments being realized in the insurance and reinsurance industry, the frequency and severity of losses and prevailing general economic and market conditions. The cyclical trends in the property and casualty insurance and reinsurance industries and the profitability of these industries can also be significantly affected by volatile and unpredictable developments, including what we believe to be a trend of courts to grant increasingly larger awards for certain types of damages, natural disasters, fluctuations in interest rates, changes in the investment environment that affect market prices of investments and inflationary pressures that may tend to affect the size of losses experienced by insureds and primary insurance companies. We cannot predict with accuracy whether market conditions will remain constant, improve or deteriorate. Adverse market conditions may lead to a significant reduction in property and casualty premium rates, less favorable policy terms and/or less premium volume.

A downgrade or withdrawal of any of our ratings may significantly and negatively affect our ability to implement our business strategy successfully.

Companies, insurers and reinsurance and insurance intermediaries use financial ratings as an important means of assessing the financial strength and quality of insurers and reinsurers. An unfavorable rating or the lack of a rating of its insurer or reinsurer may adversely affect the rating of a company purchasing insurance or reinsurance.

The ratings assigned by rating agencies to insurance and reinsurance companies are based upon factors relevant to policyholders and are not directed toward the protection of investors or a recommendation to buy, sell or hold securities. For the financial strength of each of our principal operating subsidiaries, please see “Item 1—Business – Our Ratings.” To date, none of our ratings issued by an independent rating agency has been downgraded. However, if an independent rating agency downgrades or withdraws any of our ratings, we could be severely limited or prevented from writing any new insurance and reinsurance contracts, some existing contracts may be terminated, we could incur higher borrowing costs and our ability to access the capital markets could be negatively impacted. A downgrade or withdrawal of any of our ratings by an independent rating agency would significantly and negatively affect our ability to implement our business strategy successfully.

 

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Our results of operations and financial condition could be adversely affected by the occurrence of catastrophes.

We have substantial exposure to unexpected losses resulting from natural and man-made catastrophes. Catastrophes can be caused by various unpredictable events, including hurricanes, earthquakes, hailstorms, severe winter weather, floods, fires, tornadoes, volcano eruptions, explosions, airplane crashes and other natural or man-made disasters, including acts of war, terrorism and political risk. The incidence and severity of catastrophes are inherently unpredictable, but the loss experience of property catastrophe insurers and reinsurers has been generally characterized as low frequency and high severity in nature. The catastrophe modeling tools that we use to help manage catastrophe exposures are based on assumptions and judgments that rely on historical trends, are subject to error and may produce estimates that are materially different from actual results. In addition, because accounting regulations do not permit insurers and reinsurers to reserve for catastrophic events until they occur, claims from catastrophic events could cause substantial volatility in our financial results for any fiscal quarter or year and could have a significant and negative effect on our results of operations and financial condition.

Many scientists believe that in recent years changing climate conditions have added to the unpredictability and frequency of natural disasters in some parts of the world and created additional uncertainty as to future trends and exposures. For example, in recent years, hurricane activity has affected areas further inland than previously experienced, which has expanded hurricane exposures for insurers and reinsurers. Changing climate conditions could cause catastrophe models to be less accurate, which could limit our ability to effectively manage catastrophe exposures.

Competitors and/or consolidation in our industry may make it difficult for us to write business effectively and profitably.

The insurance and reinsurance industry is highly competitive. Competition in the types of business that we currently underwrite and intend to underwrite in the future is based principally on:

 

   

premium rates;

 

   

ability to obtain terms and conditions appropriate with the risk being assumed;

 

   

the general reputation and perceived financial strength of the insurer or reinsurer;

 

   

relationships with insurance and reinsurance intermediaries;

 

   

ratings assigned by independent rating agencies;

 

   

speed of claims payment and quality of administrative activities; and

 

   

experience in the particular line of insurance or reinsurance to be written.

We compete directly with numerous independent insurance and reinsurance companies, captive insurance companies, subsidiaries or affiliates of established and newly formed insurance companies, reinsurance departments of primary insurance companies, government sponsored reinsurance pools and underwriting syndicates from countries throughout the world in our chosen product lines. Many of these competitors are well established, have significant operating histories, underwriting expertise and extensive capital resources and have developed longstanding customer relationships. Our worldwide competitors include many larger companies with higher ratings and greater underwriting capacity than we have.

Further, our ability to compete may be harmed if our competitors consolidate. Consolidated entities may try to use their enhanced market power to negotiate price reductions for our products and services. If competitive pressures reduce our prices, we would expect to write less business and net income would decrease. If our industry consolidates, competition for customers will become more intense and the importance of acquiring and properly servicing each customer will become greater. We could incur greater expenses relating to customer acquisition and retention, further reducing our operating margins. In addition, insurance companies that consolidate may be able to spread their risks across a consolidated, larger capital base so that they require less reinsurance. The number of companies offering retrocessional reinsurance may decline. Any of the foregoing could significantly and negatively affect our business and our results of operations.

The effect of emerging claim and coverage issues could have a material adverse effect on our business.

As industry practices and legal, judicial and social conditions change, unexpected issues related to claims and coverage may emerge. Various provisions of our contracts, such as limitations or exclusions from coverage or choice of forum, may be difficult to enforce. These issues may adversely affect our business by either extending coverage beyond the period that we intended or by increasing the number or size of claims. In some instances, these changes may not become apparent until many years after we issue insurance or reinsurance contracts affected by these changes. As a result, we may not be able to ascertain the full extent of our liabilities under our insurance or reinsurance contracts for many years following the issuance of our contracts. Emerging claims and coverage issues could have a material adverse effect on our business.

 

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A limited number of insurance and reinsurance brokers account for a large portion of our revenues, and a loss of all or a substantial portion of this brokered business or the consolidation of these brokers could have a significant and negative effect on our business and results of operations.

Most of our insurance and reinsurance business is placed through brokers worldwide. A significant volume of our premiums is produced through a limited number of insurance and reinsurance brokers. During the years ended December 31, 2011, 2010 and 2009, the top three independent producing brokers accounted for 24%, 18% and 12%; 22%, 14% and 13%; and 25%, 11% and 7%, respectively, of property and casualty gross premiums written. Insurance and reinsurance brokers may consolidate in the future, which could adversely affect our ability to access business and distribute our products. Loss of all or a substantial portion of the business provided through one or more of these brokers, or the consolidation of these brokers, could have a significant and negative effect on our business and results of operations.

The involvement of reinsurance brokers subjects us to their credit risk.

In accordance with industry practice, we frequently pay amounts owed on claims under our contracts to reinsurance brokers, and these brokers, in turn, pay these amounts over to the ceding insurers that have reinsured a portion of their liabilities with us. Although the law is unsettled and depends upon the facts and circumstances of any particular case, in some jurisdictions, if a broker fails to make such a payment, we might remain liable to the ceding insurer for the deficiency. Conversely, in certain jurisdictions, when the ceding insurer pays premiums for these policies to reinsurance brokers for payment to us, these premiums are considered to have been paid and the ceding insurer will no longer be liable to us for these premiums, whether or not we have actually received them. Consequently, consistent with the industry, we assume a degree of credit risk associated with brokers with whom we do business; however, due to the unsettled and fact-specific nature of the law, we are unable to quantify our exposure to this risk. To date, we have not experienced any material losses related to these credit risks.

Reinsurance and retrocessional reinsurance may not be available at all or on acceptable terms, which could adversely impact our ability to write new business or mitigate the effect of large or multiple losses.

We purchase reinsurance and retrocessional reinsurance in order to mitigate the effect of large and multiple losses. From time to time, market conditions have limited, and in some cases have prevented, insurers and reinsurers from obtaining the types and amounts of reinsurance and retrocessional reinsurance that they consider adequate for their business needs. Accordingly, we may be unable to obtain desired amounts of reinsurance or retrocessional reinsurance. In addition, even if we are able to obtain such reinsurance or retrocessional reinsurance, we may not be able to negotiate appropriate or acceptable terms or obtain reinsurance or retrocessional reinsurance from entities with satisfactory creditworthiness. If we fail to obtain reinsurance or retrocessional reinsurance at all or on acceptable terms, our capacity to underwrite new business may be limited. If we purchase reinsurance or retrocessional reinsurance but are unable to collect, we may have difficulty mitigating the effect of large or multiple losses which, in turn, could have a significant and negative effect on our business, results of operations and financial condition.

We could be adversely affected by the loss of one or more members of our senior management or other key personnel.

Our future success depends to a significant extent on the efforts of our senior management and other key personnel to implement our business strategy. We do not currently maintain key man life insurance with respect to any of our senior management.

Under Bermuda law, non-Bermudians, other than spouses of Bermudians and holders of permanent resident’s certificates or working resident’s certificates, may not engage in any gainful occupation in Bermuda without an appropriate governmental work permit. A work permit may be granted or renewed only upon showing that, after proper public advertisement, no Bermudian, spouse of a Bermudian, holder of a permanent resident’s certificate or holder of a working resident’s certificate meets the minimum standards reasonably required by the employer and has applied for the position. In addition, the Bermuda government limits the term of work permits to six years, subject to certain exemptions for key employees.

The loss of the services of one or more of the members of our senior management or other key personnel, including as a result of our inability to renew the Bermudian work permit of such individual, or our inability to hire and retain other senior management and other key personnel, could delay or prevent us from fully implementing our business strategy and, consequently, significantly and negatively affect our business.

The integration of new operations may expose us to operational risks.

Over the past several years, we have grown through acquisitions and by expanding our lines of business. Acquisitions involve numerous risks, including operational, strategic and financial risks, such as potential liabilities associated with the acquired business. We may experience difficulties in integrating an acquired company, which could adversely affect the acquired company’s performance or prevent us from realizing anticipated synergies, cost savings and operational efficiencies. Our existing businesses could also be negatively impacted by acquisitions. Expanding our lines of business, expanding our geographic reach and entering into joint ventures or partnerships also involve operational, strategic and financial risks, including retaining qualified management and implementing satisfactory budgetary, financial and operational controls. Our failure to manage successfully these risks may adversely affect our financial condition, results of operations or business or we may not realize any of the intended benefits.

 

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We may require additional capital and credit in the future, which may not be available to us on satisfactory terms or at all.

We need liquidity to pay our operating expenses, interest on our debt and dividends. To the extent that we experience significant losses from our operations or funds generated by our ongoing operations are insufficient to fund our operating expenses, we may need to raise additional capital. The worldwide financial markets have experienced significant volatility and disruption for the last few years, which may reduce our access to the equity and debt markets and make raising capital on satisfactory terms difficult or impossible. Our access to funds under our existing credit facilities is dependent on the ability of the banks that are parties to the facilities to meet their funding commitments. Those banks may fail or may not be able to meet their funding commitments if they experience shortages of capital and liquidity or if they experience excessive volumes of borrowing requests within a short period of time. The banking industry also has experienced significant consolidation in the past few years, which could lead to increased reliance on and exposure to particular institutions. Our inability to obtain adequate capital and credit could have a significant and negative effect on our business, results of operations and financial condition.

We could incur substantial losses and reduced liquidity if one of the financial institutions we use in our operations fails.

We maintain cash balances, including restricted cash held in premium trust accounts, significantly in excess of the U.S. Federal Deposit Insurance Corporation insurance limits at various U.S. depository institutions. We also maintain cash balances in foreign banks and institutions. If one or more of these financial institutions fails, our ability to access cash balances might be temporarily or permanently limited, which could have a significant and negative effect on our results of operations, financial condition and cash flows.

Currency fluctuations could result in exchange losses and our failure to effectively manage our multiple currency assets or liabilities could significantly and negatively affect our results of operations and financial condition.

A portion of our investments, insurance and reinsurance liabilities and insurance and reinsurance assets are denominated in currencies other than U.S. dollars. We purchase fixed maturities denominated in the currencies of the relevant insurance and reinsurance liabilities to manage our multiple currency exposures. We monitor those assets and liabilities to reduce our exposure to currency risk; however, mismatches in multiple currency assets and liabilities may give rise to currency losses that could significantly and negatively affect our results of operations and financial condition.

We publish our consolidated financial statements in U.S. dollars. As a result, fluctuations in exchange rates used to convert other currencies, particularly the Euro and British pound sterling, into U.S. dollars will impact our results of operations and financial condition from year to year.

Our failure to maintain sufficient letter of credit facilities or to increase our letter of credit capacity on commercially acceptable terms could significantly and negatively affect our ability to implement our business strategy.

Our principal reinsurance operations are conducted by our companies licensed and operated in Bermuda, Ireland, the United States and the United Kingdom. Many jurisdictions do not permit ceding companies to take statutory credit for reinsurance obtained from unlicensed or non-admitted reinsurers, such as Alterra Bermuda, Alterra Europe and Alterra Re USA, in their statutory financial statements unless appropriate security measures are implemented. Consequently, the majority of our reinsurance clients typically require us to obtain a letter of credit or provide other collateral through funds withheld or trust arrangements. When we obtain a letter of credit facility, we are required to provide collateral to secure our obligations under the facility.

As of December 31, 2011, we had two U.S. dollar denominated letter of credit facilities totaling $1,175.0 million with an additional $500.0 million available subject to certain conditions. As of December 31, 2011, we had $604.0 million in letters of credit outstanding under these facilities. We had a British pound sterling denominated letter of credit facility of GBP 30.0 million ($46.6 million) to support our London branch of Alterra Europe, of which GBP 16.8 million ($26.1 million) was utilized as of December 31, 2011. We also had a British pound sterling denominated letter of credit facility of GBP 60.0 million ($93.3 million) to support our Funds at Lloyd’s commitments, which was not utilized as of December 31, 2011. Our failure to maintain our letter of credit facilities or to increase our letter of credit capacity on commercially acceptable terms when necessary could significantly and negatively affect our ability to implement our business strategy.

Our results of operations may fluctuate significantly from period to period and may not be indicative of our long-term prospects.

Our results of operations may fluctuate significantly from period to period. These fluctuations result from a variety of factors, including the seasonality of the insurance and reinsurance business, the volume and mix of insurance and reinsurance products that we write, loss experience on our insurance and reinsurance contracts, the performance of our investment portfolio and our ability to assess and integrate our risk management strategy effectively. In particular, we seek to underwrite business and make investments to achieve long-term results. As a result, our short-term results of operations may not be indicative of our long-term prospects.

 

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We are a holding company that depends on the ability of our subsidiaries to pay dividends.

Alterra is a holding company and does not have any significant operations or assets other than its ownership of the shares of its subsidiaries. Dividends and other permitted distributions from our subsidiaries are our primary source of funds to meet ongoing cash requirements, including future debt service payments and other expenses, and to pay dividends to our shareholders. Some of our insurance and reinsurance subsidiaries are subject to significant regulatory restrictions that limit their ability to declare and pay dividends. In addition, certain of Alterra Bermuda’s credit facilities prohibit Alterra Bermuda from paying dividends at any time that Alterra’s shareholders’ equity or Alterra Bermuda’s shareholders’ equity is less than a specified amount, as well as in certain other circumstances. The inability of our insurance and reinsurance subsidiaries to pay dividends in an amount sufficient to enable us to meet our cash requirements at the holding company level could have an adverse effect on our operations and our ability meet our debt service obligations and to pay dividends to our shareholders.

The payment of dividends and making of distributions by Bermuda legal entities are limited under Bermuda law. Alterra Bermuda is prohibited from declaring or paying dividends if it is in breach of its enhanced capital requirement, solvency margin or minimum liquidity ratio or if the declaration or payment of such dividend would cause such a breach. Where an insurer fails to meet its solvency margin or minimum liquidity ratio on the last day of any financial year, it is prohibited from declaring or paying any dividends during the next financial year without the approval of the Bermuda Monetary Authority, or BMA. Further, Alterra Bermuda is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus unless it files with the BMA an affidavit stating that it will continue to meet its solvency margin or minimum liquidity ratio. Alterra Bermuda must obtain the BMA’s prior approval for a reduction by 15% or more of the total statutory capital as set forth in its previous year’s financial statements. In addition, as a long-term insurer, Alterra Bermuda may not declare or pay a dividend to any person other than a policyholder unless the value of the assets in its long-term business fund exceeds the liabilities of the insurer’s long-term business by the amount of the dividend and at least the prescribed minimum solvency margin.

Our failure to comply with covenants contained in our indentures or our credit facilities could trigger prepayment obligations, which could adversely affect our results of operations and financial condition.

We currently guarantee the senior notes issued by certain of our subsidiaries. The indentures governing those senior notes contain covenants that impose restrictions on us and certain of our subsidiaries with respect to, among other things, the incurrence of liens and the disposition of capital stock of these subsidiaries. In addition, each of our credit facilities requires us and/or certain of our subsidiaries to comply with certain covenants, including the maintenance of a minimum consolidated net tangible worth and restrictions on the payment of dividends. Our failure to comply with these covenants could result in an event of default under the indentures or credit facilities, which could result in us being required to repay the notes or any amounts outstanding under these facilities prior to maturity. These prepayment obligations could have an adverse effect on our results of operations and financial condition.

Risks Related to Our Investments

Changes in market interest rates and general economic conditions could have a significant and negative effect on our investment portfolio, investment income and results of operations.

Our operating results depend in part on the performance of our investment portfolio. Our investments are subject to market wide risks and fluctuations. Increasing market interest rates reduce the value of our fixed maturities, and we may realize a loss if we sell fixed maturities whose value has fallen below their acquisition cost. Declining market interest rates can have the effect of reducing our investment income, as we invest proceeds from positive cash flows from operations and reinvest proceeds from maturing and called investments in new investments that may yield less than our investment portfolio’s average rate of return. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. We attempt to mitigate interest rate risk by monitoring the duration and structure of our investment portfolio relative to the duration and structure of our liability portfolio; however, our estimates of the duration and structure of our liability portfolio may be inaccurate and we may be forced to liquidate investments prior to maturity at a loss in order to cover the liability. Any measures we take that are intended to manage the risks of operating in a changing interest rate environment may not effectively mitigate such interest rate sensitivity. Accordingly, changes in interest rates could have a significant and negative effect on our investment portfolio, financial condition and results of operations.

Disruptions in the public debt and equity markets, including widening of credit spreads, bankruptcies and government intervention in large financial institutions, could result in significant realized and unrealized losses in our investment portfolio. Depending on market conditions, we could incur additional realized and unrealized losses in future periods, which could have a significant and negative effect on our investment portfolio, results of operations and financial condition.

 

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Unexpected volatility or illiquidity associated with our fixed maturities investment portfolio could significantly and negatively affect our investment portfolio, results of operations and financial condition.

Our fixed maturities portfolio investment strategy requires a minimum weighted average credit quality rating of Aa3/AA-, or its equivalent, from at least one internationally recognized statistical rating organization. Market conditions and other factors beyond our control could cause the credit quality rating of our investments to deteriorate. Deterioration of credit ratings on our fixed maturities investments may result in the need to liquidate these securities in the financial markets. If we are required to liquidate these securities during a period of tightening credit in the financial markets, we may realize a significant loss. In addition, our fixed maturities portfolio includes below investment grade and unrated securities that have a greater risk of default than higher rated securities.

Our fixed maturities portfolio includes mortgage-backed and asset-backed securities and collateralized mortgage obligations. These types of securities have cash flows that are backed by the principal and interest payments of a group of underlying mortgages or other receivables. As a result of the increasing default rates of borrowers, there is a greater risk of default on mortgage-backed and asset-backed securities and collateralized mortgage obligations than historically existed, especially those that are non-investment grade. These factors make the estimate of fair value more uncertain. We obtain fair value estimates from multiple independent pricing sources to corroborate the fair value we record and in an effort to mitigate some of the uncertainty surrounding the fair value estimates. If we need to liquidate these securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated at December 31, 2011.

The financial crisis in Europe, including the threat of default on European sovereign debt, the devaluation of the Euro and the dissolution of the European Union, could adversely affect our results of operations, liquidity and financial condition.

A number of European Union member states, namely Greece, Ireland, Italy, Portugal and Spain, have recently undertaken financial restructuring efforts in order to avoid insolvency and default on their sovereign debt. The failure of these restructuring efforts could have an adverse effect on the portion of our investment portfolio held in sovereign debt issued by European Union members. Furthermore, the failure of the European Union member states to successfully resolve this crisis could result in the devaluation of the Euro. In addition to European sovereign debt, we have other assets in our investment portfolio that are Euro-denominated. As of December 31, 2011, $1,055.3 million (€814.4 million) of our invested assets were denominated in Euros. A devaluation of the Euro could lead to a significant decline in the value of these assets.

It is possible that this financial crisis may lead to the abandonment of the Euro by one or more members of the European Union or the dissolution of the European Union. The European Union member states have implemented a regulatory scheme that facilitates our ability to operate across Europe. The dissolution of the European Union and the absence of this regulatory scheme could negatively affect our ability to operate across Europe.

It is impossible to predict all of the consequences that the potential default by European Union member states on sovereign debt, the devaluation or abandonment of the Euro or the dissolution of the European Union may have on the global economy in general or more specifically on our business. Any or all of these events could have a material adverse effect on the results of our operations, liquidity and financial condition.

The determination of the impairments taken on our investments is subjective and could materially impact our financial position or results of operations.

The determination of the impairments taken on our investments varies by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects impairments in operations as such evaluations are revised. We cannot assure you that we have accurately assessed the level of impairments taken in our financial statements. Furthermore, additional impairments may need to be taken in the future, which could materially impact our financial position or results of operations. Historical trends may not be indicative of future impairments.

Our valuation of fixed maturity securities and hedge fund investments include methodologies, estimations and assumptions that are subject to differing interpretations and could result in changes to investment valuations that may materially adversely affect our results of operations or financial condition.

Fixed maturity and hedge fund investments, which are reported at fair value on the consolidated balance sheet, represent the majority of our total cash and invested assets. Fair value prices for all securities in the fixed maturities portfolio are independently provided by our investment custodians, investment accounting service provider and investment managers, which each utilize internationally recognized independent pricing services. We record the unadjusted price provided by our primary pricing source, which may be the investment custodian or the investment accounting service provider, after an internal validation process.

 

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Investments in hedge funds comprise a portfolio of limited partnerships and stock investments in trading entities, or funds, which invest in a wide range of financial products. The units of account that are fair valued are our interest in the funds and not the underlying holdings of such funds. As a result, the inputs we use to value our investment in each of the funds may differ from the inputs used to value the underlying holdings of such funds. These funds are stated at fair value, which ordinarily will be the most recently reported net asset value as advised by the fund manager or administrator, where the funds underlying holdings can be in various quoted and unquoted investments.

During periods of market disruption, including periods of significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain of our securities, such as mortgage backed securities, if trading becomes less frequent or market data becomes less observable. In addition, there may be certain asset classes that were in active markets with significant observable data that become illiquid due to changes in the financial environment. In such cases, more securities may require more subjectivity and management judgment. As a result, valuations may include inputs and assumptions that are less observable or require greater estimation as well as valuation methods that are more sophisticated or require greater estimation thereby resulting in values that may be less than the value at which the investments may be ultimately sold. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within our consolidated financial statements and the period-to-period changes in value could vary significantly. Decreases in value may have a significant and negative effect on our investment portfolio, financial condition and results of operations.

Unexpected volatility or illiquidity associated with our hedge fund investment portfolio could significantly and negatively affect our ability to conduct business.

As of December 31, 2011, we had reduced our allocation to hedge fund investments to approximately 3.2% of total invested assets, although our investment guidelines permit us to invest up to 15% of our investment portfolio in alternative investments, including hedge funds. We invest in various hedge funds, which follow investment strategies that involve investing in a broad range of investments, some of which may be volatile. The risks associated with our hedge fund investment portfolio may be substantially greater than the risks associated with fixed maturities investments. Further, because many of the hedge funds in which we invest impose limitations on the timing of withdrawals, or may suspend withdrawals for a period of time, we may be unable to withdraw our investment from a particular hedge fund on a timely basis. Unexpected volatility or illiquidity associated with our hedge fund investment portfolio could significantly and negatively affect our ability to conduct business.

The failure of our investment managers to perform their services effectively could significantly and negatively affect our ability to conduct business.

We have entered into investment management agreements with a number of managers to manage our aggregate fixed maturities portfolio. Additionally, each underlying hedge fund manager for our hedge fund investment portfolio has discretionary authority over the portion of our underlying hedge fund investment portfolio that it manages. As a result, the aggregate performance of our investment portfolio depends to a significant extent on the ability of our investment managers, and the investment managers of each underlying hedge fund, to select and manage appropriate investments. The failure of these investment managers to perform their services in a manner consistent with our expectations and investment objectives could significantly and negatively affect our ability to conduct our business.

Risks Related to Regulation of Our Company

The regulatory systems under which we operate, and potential changes thereto, could have a significant and negative effect on our business.

Our insurance and reinsurance subsidiaries operate in numerous countries around the world as well as in all 50 U.S. states. The insurance and reinsurance industry is generally heavily regulated, and our operations in each of these jurisdictions are subject to varying degrees of regulation and supervision. The laws and regulations of the jurisdictions in which our insurance and reinsurance subsidiaries are domiciled require these companies to maintain minimum levels of statutory capital, surplus and liquidity, meet solvency standards, submit to periodic examinations of their financial condition and restrict payments of dividends and reductions of capital. Our insurance and reinsurance subsidiaries also are subject to laws and regulations that may restrict the ability of these companies to write insurance and reinsurance policies, make certain investments and distribute funds.

In recent years, the insurance regulatory environment has become subject to increased scrutiny in many jurisdictions. In July 2010, the U.S. government passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), one of the most sweeping financial reforms in decades. The legislation is expected to affect virtually every segment of the financial services industry, including the insurance and reinsurance industry in the United States. Among other things, the Dodd-Frank Act created the Federal Insurance Office to be located within the U.S. Treasury department, with the authority to monitor nearly all aspects of the insurance industry and change the regulatory framework for non-admitted insurance and reinsurance. In April 2009, the European Union parliament adopted the Solvency II Directive, which enhances the capital and solvency framework applicable to insurance and

 

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reinsurance companies. When this regulation becomes effective, we expect that it will substantially increase the level of regulation on our European operations, including Alterra Europe and Alterra at Lloyd’s. In an effort to achieve equivalency with the Solvency II Directive, the BMA has recently enacted regulations that will enhance the capital and solvency framework to ensure that insurers maintain adequate capital and liquidity levels proportionate to the insurer’s risk profile and require additional financial and other disclosure. We expect that this regulation will substantially increase the level of regulation on Alterra Bermuda. The BMA also is enacting a group solvency framework that could enhance the required capital and solvency of the Company as a whole. In addition, the National Association of Insurance Commissioners, or NAIC, which is the organization of insurance regulators from the 50 U.S. states, the District of Columbia and the four U.S. territories, as well as state insurance regulators regularly reexamine existing laws and regulations.

The cost of compliance with existing laws and regulations is expensive, and the costs of compliance with any new legal requirements could have a significant and negative effect on our business. We may not be able to comply fully with, or obtain desired exemptions from, new laws and regulations that govern the conduct of our business. Failure to comply with, or to obtain desired authorizations and/or exemptions under, any applicable laws could result in restrictions on our ability to do business or undertake activities that are regulated in one or more of the jurisdictions in which we operate and could subject us to fines and other sanctions. In addition, changes in the laws or regulations to which our insurance and reinsurance subsidiaries are subject, or in the interpretations thereof by enforcement or regulatory agencies, could have a material adverse effect on our business.

Certain of our subsidiaries are subject to minimum capital and surplus requirements, and our failure to meet these requirements could subject us to regulatory action.

All of our insurance and reinsurance subsidiaries are subject to minimum capital and surplus requirements. In the United States, our insurance and reinsurance operating companies are subject to risk-based capital standards and other minimum capital and surplus requirements imposed by state laws. The risk-based capital standards, or RBC standards, are based upon the Risk-Based Capital Model Act adopted by the NAIC. Alterra Bermuda is subject to risk-based capital standards and other minimum capital and surplus requirements imposed by the BMA. Alterra Europe is required to maintain statutory reserves, particularly in respect of underwriting liabilities, and a solvency margin as provided for under Irish law.

Alterra at Lloyd’s underwriting activities are regulated by the FSA as well as being subject to the Lloyd’s “franchise.” Lloyd’s approves annually the business plan of each of the Syndicates along with any subsequent material changes, and the amount of capital required to support those plans. The FSA requires that the managing agent of the Syndicates carry out a capital assessment of the Syndicates in order to determine whether any additional capital should be held by the Syndicates on account of any particular risks arising from its business or operational infrastructure. Additionally, Lloyd’s insurance and reinsurance business is subject to local regulation. Regulators in the United States require Lloyd’s to maintain certain minimum deposits in trust funds as protection for policyholders in the United States. The FSA requires Lloyd’s to satisfy an annual solvency test and to maintain solvency on a continuous basis. The solvency position of each member, and of Lloyd’s as a whole, is monitored on a regular basis.

Any failure to meet applicable requirements or minimum statutory capital requirements could subject us to further examination or corrective action by regulators, including limitations on our writing additional business or engaging in finance activities, supervision or liquidation. Further, any changes in existing risk based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we might be unable to do.

Political, regulatory and industry initiatives could adversely affect our business.

The insurance and reinsurance regulatory framework is subject to substantial scrutiny by governmental authorities worldwide. Regulators are generally concerned with the protection of policyholders to the exclusion of other constituencies, including shareholders. Increasingly, governmental authorities seem to be interested in the potential systemic risks posed by the insurance and reinsurance industry as a whole. We cannot predict the exact nature, timing or scope of possible governmental initiatives; however, we believe it is likely there will be increased regulatory intervention in our industry in the future and these initiatives could adversely affect our business. For example, we could be adversely affected by proposals that:

 

   

provide insurance and reinsurance capacity in markets and to consumers that we target;

 

   

require our participation in industry pools and guaranty associations;

 

   

increasingly mandate the terms of insurance and reinsurance policies;

 

   

establish a new federal insurance regulator or financial industry systemic risk regulator;

 

   

revise tax laws, including a potential change to U.S. tax laws to disallow or limit the current tax deductions for reinsurance premiums paid by our U.S. subsidiaries to our Bermuda subsidiary for reinsurance it provides to our U.S. subsidiaries; or

 

   

disproportionately benefit the companies of one country over those of another.

 

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Changes in current accounting practices and future pronouncements may materially impact our reported financial results.

Unanticipated developments in accounting practices may require us to incur considerable additional expenses to comply with such developments, particularly if we are required to prepare information relating to prior periods for comparative purposes or to apply the new requirements retroactively. The impact of changes in current accounting practices and future pronouncements cannot be predicted but may affect the calculation of net income, shareholders’ equity and other relevant financial statement line items. In particular, recent guidance and ongoing projects put in place by standard setters globally have indicated a possible move away from the current insurance accounting models toward more “fair value” based models, which could introduce significant volatility in the earnings of insurance industry participants. Furthermore, rules relating to certain accounting practices in the insurance and reinsurance industry are currently being reviewed by applicable regulatory bodies and any changes required by that review could have a material effect on the reported operating results and financial condition of the industry or particular market participants.

Risks Related to Our Common Shares

Our common shares are subject to limitations on transfer and voting rights and rights of repurchase.

Under our bye-laws, our board of directors is authorized to decline to register any transfer of our common shares if they determine that such transfer would result in adverse tax, regulatory or legal consequences to us or any shareholder or if such transfer would result in any U.S. shareholder owning, directly or indirectly, 9.5% or more of our common shares. In addition, under our bye-laws, if our board of directors determines that ownership of any of our common shares may result in adverse tax, regulatory or legal consequences to us or any shareholder or if such ownership would result in any U.S. shareholder owning, directly or indirectly, 9.5% or more of our common shares, we may repurchase the common shares. We are authorized to request information from any holder or prospective acquirer of our common shares as necessary to effect registration of any such transaction and may decline to register any such transaction if complete and accurate information is not received as requested.

In addition, our bye-laws generally provide that any U.S. shareholder owning, directly or by attribution, 9.5% or more of our common shares will have the voting rights attached to such common shares reduced such that the common shares will constitute less than 9.5% of the voting power of all of our common shares. Because of the attribution provisions of the Internal Revenue Code, this requirement may have the effect of reducing the voting rights of a shareholder whether or not that shareholder directly holds of record 9.5% or more of our common shares. Furthermore, our board of directors has the authority to request from any shareholder certain information for the purpose of determining whether that shareholder’s voting rights are to be reduced. Failure to respond to such a notice, or submitting incomplete or inaccurate information, gives the board of directors discretion to disregard all votes attached to such shareholder’s common shares.

U.S. persons who own our common shares may have more difficulty in protecting their interests than U.S. persons who are shareholders of a U.S. corporation.

The rights of shareholders under Bermuda law are not as extensive as the rights of shareholders under legislation or judicial precedent in many U.S. jurisdictions. Class actions and derivative actions are generally not available to shareholders under the laws of Bermuda. However, the Bermuda courts ordinarily would be expected to follow English case law precedent, which would permit a shareholder to commence an action in the name of a company to remedy a wrong done to a company where the act complained of is alleged to be beyond the corporate power of a company, is illegal or would result in the violation of our memorandum of association or bye-laws. Furthermore, consideration would be given by the court to acts that are alleged to constitute a fraud against the minority shareholders or where an act requires the approval of a greater percentage of our shareholders than actually approved it. The winning party in such an action generally would be able to recover a portion of attorneys’ fees incurred in connection with such action. Our bye-laws provide that shareholders waive all claims or rights of action that they might have, individually or in the right of the Company, against any director or officer for any act or failure to act in the performance of such director’s or officer’s duties, except with respect to any fraud or dishonesty of such director or officer. Class actions and derivative actions generally are available to stockholders under Delaware law for, among other things, breach of fiduciary duty, corporate waste and actions not taken in accordance with applicable law. In such actions, the court has discretion to permit the winning party to recover attorneys’ fees incurred in connection with such action.

Anti-takeover provisions contained in our bye-laws could impede an attempt to replace or remove our management or delay or prevent the sale of our Company, which could diminish the value of our common shares.

Our bye-laws contain provisions that could delay or prevent changes in our management or a change of control that a shareholder might consider favorable. For example, they may prevent a shareholder from receiving the benefit from any premium over the market price of our common shares offered by a bidder in a potential takeover. Even in the absence of a takeover attempt, these provisions may adversely affect the prevailing market price of our common shares if they are viewed as discouraging takeover attempts in the future. For example, provisions in our bye-laws that could delay or prevent a change in management or change in control include:

 

   

the board is permitted to issue preferred shares and to fix the price, rights, preferences, privileges and restrictions of the preferred shares without any further vote or action by our shareholders;

 

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shareholders have limited ability to remove directors;

 

   

in order to nominate directors at shareholder meetings, shareholders must own a minimum percentage of our common shares, provide advance notice and furnish certain information with respect to the nominee and any other information as may be reasonably required by the Company;

 

   

the total voting power of any U.S. shareholder owning 9.5% or more of our common shares is automatically reduced to less than 9.5% of the total voting power of our capital stock;

 

   

if the board determines that the ownership of our common shares by any person may result in adverse tax, regulatory or legal consequences to us, our subsidiaries or any shareholder, then the board may, in its discretion and on behalf of the Company, purchase or assign the right to purchase all or a part of the common shares held by such person at fair market value (as defined in our bye-laws); and

 

   

the board, in its absolute discretion, may decline to register a transfer of common shares if it has reason to believe that the effect of the transfer would be to increase the total number of common shares owned by any person to 9.5% or higher, that the transfer may expose us, any subsidiary or any shareholder to adverse tax or regulatory treatment or that the registration of the transfer under any federal or state securities law or under the laws of any other jurisdiction is required and the registration has not yet been effected.

Applicable insurance laws may make it difficult to effect a change of control of our company.

Before a person can acquire control of a U.S. insurance company, prior written approval must be obtained from the insurance commissioner of the state where the domestic insurer is domiciled. Prior to granting approval of an application to acquire control of a domestic insurer, the state insurance commissioner will consider such factors as the financial strength of the acquirer, the integrity and management of the acquiror’s board of directors and executive officers, the acquirer’s plans for the future operations of the domestic insurers and any anti-competitive results that many arise from the consummation of the acquisition of control. Because a person acquiring 10% or more of our common shares would indirectly control the same percentage of the stock of our U.S. subsidiaries, the insurance change of control laws of Connecticut and Delaware would likely apply to such a transaction. Under the Delaware and Connecticut insurance holding company system laws, acquiring 10% or more of the voting stock of an insurance company or any of its parent companies is presumptively considered a change of control, although such presumption may be rebutted. Accordingly, any person who acquires, directly or indirectly, 10% or more of the voting securities of Alterra without the prior approval of the Delaware and/or Connecticut Insurance Commissioner, will be in violation of these laws and may be subject to injunctive action requiring the disposition or seizure of those securities by the applicable state insurance commissioner. In addition, many U.S. state insurance laws require prior notification of state insurance departments of a change in control of a non-domiciliary insurance company doing business in that state. While these pre-notification statutes do not authorize the state insurance departments to disapprove a change of control, they authorize regulatory action in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change in control of Alterra may require prior notification in those U.S. states that have adopted pre-acquisition notification laws.

Anyone acquiring or disposing of a direct or indirect holding in an Irish authorized insurance company that represents 10% or more of the capital or of the voting rights of such company or that makes it possible to exercise a significant influence over the management of such company, or anyone who proposed to decrease or increase that holding to specified levels, must first notify the Irish regulatory authority of their intention to do so. Any Irish authorized insurance company that becomes aware of any acquisitions or disposal of its capital involving the specified levels must also notify the Irish regulatory authority. The specified levels are 20%, 33% and 50% or such other level or ownership that results in the company becoming the acquirer’s subsidiary. The Irish regulatory authority has three months from the date of submission of a notification within which to oppose the proposed transaction if the Irish regulatory authority is not satisfied as to the suitability of the acquirer in view of the necessity “to ensure prudent and sound management of the insurance undertaking concerned.”

Any person who becomes a holder of at least 10%, 20%, 33% or 50% of a Bermuda insurance company must notify the BMA in writing within 45 days of becoming such a holder. The BMA has the power to object to a person holding 10% or more of a Bermuda insurance company if it determines that the person is not fit and proper. In such a case, the BMA may require the holder to reduce their shareholding and may direct, among other things, that holder may not exercise their voting rights in the company.

These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of the Company, including transactions that some or all of our shareholders might consider to be desirable.

 

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Investors may have difficulty effecting service of process on us or enforcing judgments against us in the United States.

We are incorporated pursuant to the laws of Bermuda and our business is based in Bermuda. In addition, certain of our directors and officers reside outside the United States, and a significant portion of our assets and the assets of such persons are located in jurisdictions outside the United States. Accordingly, we have been advised that there is doubt as to whether:

 

   

a holder of our common shares would be able to enforce, in the courts of Bermuda, judgments of U.S. courts based upon the civil liability provisions of the U.S. federal securities laws;

 

   

a holder of our common shares would be able to bring an original action in the Bermuda courts to enforce liabilities against us or our directors and officers who reside outside the United States, based solely upon U.S. federal securities laws.

We have also been advised that there is no treaty in effect between the United States and Bermuda providing for the enforcement of judgments of U.S. courts and there are grounds upon which Bermuda courts may not enforce judgments of U.S. courts. Furthermore, certain remedies available under U.S. federal and state laws, including U.S. federal securities laws, may not be available under Bermuda law. Because judgments of U.S. courts are not automatically enforceable in Bermuda, it may be difficult for shareholders to recover against us based upon such judgments.

Certain of our shareholders and directors may have conflicts of interest.

Certain of our shareholders and directors hold positions, engage in commercial activities and enter into transactions or agreements with us or in competition with us, which may give rise to conflicts of interest. Certain of our directors have sponsored, and may in the future sponsor, other entities engaged in or intending to engage in insurance and reinsurance underwriting, some of which compete or may in the future compete with us. They have also entered into or may in the future enter into agreements with companies that compete or may in the future compete with us. We do not have any agreement or understanding with any of these parties regarding the resolution of potential conflicts of interest. We may not be in a position to influence any party’s decision to engage in activities that would give rise to a conflict of interest.

Future issuances of common shares may cause the market price of our common shares to decline.

As of December 31, 2011, we had 102,101,950 common shares outstanding. In addition, 13,692,293 common shares are issuable under currently outstanding stock options and warrants granted to employees and certain of our founders. In the future, we may also issue our securities in connection with investments or acquisitions. The issuance of substantial amounts of our common shares could cause dilution to our shareholders and could adversely affect the price of our common shares.

Risks Related to Taxation

Alterra and its non-U.S. subsidiaries may be subject to U.S. federal income taxation.

If Alterra or any of our non-U.S. subsidiaries were treated as engaged in a trade or business in the United States, that entity could be subject to U.S. income and branch profits tax on all or a portion of the income that is effectively connected with such trade or business. We intend to operate in a manner such that neither Alterra nor any of our non-U.S. subsidiaries (with certain limited exceptions) will be treated as being engaged in a trade or business in the United States. Accordingly, we do not believe that Alterra or any of such non-U.S. subsidiaries are or will be subject to U.S. federal income taxation on net income. However, this determination is essentially factual in nature, and there are no definitive standards provided by the Internal Revenue Code, regulations or court decisions as to what activities constitute being engaged in a trade or business within the United States. Accordingly, there can be no assurance that the U.S. Internal Revenue Service, or IRS, would not find that Alterra or any of such non-U.S. subsidiaries is engaged in a trade or business in the United States. Any such income or branch profits tax could materially adversely affect our results of operations.

Even if Alterra and such non-U.S. subsidiaries are not treated as being engaged in a trade or business in the United States, we may be subject to U.S. federal income tax on certain fixed or determinable annual or periodical gains, profits and income (such as dividends and certain interest on investments) derived from sources within the United States. In addition, we are subject to a U.S. excise tax that is imposed on reinsurance and insurance premiums received with respect to risks or insureds located in the United States.

We might experience a material adverse effect on our results of operations if companies in our group that are incorporated outside a relevant jurisdiction are determined to be carrying on a trade or business there.

Although we operate globally, we intend to operate in such a manner that (other than in limited exceptions) our companies will not be considered resident for tax purposes or be deemed to have a permanent establishment in jurisdictions other than those of their formation. Nevertheless, tax rules and interpretations are uncertain and the operations of these companies often involve activities in

 

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higher tax jurisdictions. As a result, the taxing authorities in those jurisdictions may assert that the activities of one or more of these companies creates a sufficient nexus in that jurisdiction to subject the company to income and other taxes in that jurisdiction. Accordingly, we could incur substantial unexpected tax liabilities that could have a material adverse effect on our results of operations.

Shareholders who are U.S. persons may recognize income for U.S. federal income tax purposes on our undistributed earnings.

Shareholders who are U.S. persons may recognize income for U.S. federal income tax purposes on our undistributed earnings if we are treated as a passive foreign investment company or a controlled foreign corporation or if we have generated more than a permissible amount of related person insurance income. In addition, gain on the disposition of our common shares may be treated as dividend income.

Passive Foreign Investment Company. In order to avoid significant potential adverse U.S. federal income tax consequences for any U.S. person who owns our common shares, we must not constitute a passive foreign investment company in any year in which such U.S. person is a shareholder. Those consequences could include increasing the tax liability of the investor, accelerating the imposition of the tax and causing a loss of the basis step-up on the death of the investor. In general, a non-U.S. corporation is a passive foreign investment company for a taxable year if 75% or more of its income constitutes passive income or 50% or more of its assets produce passive income. Passive income generally includes interest, dividends and other investment income. However, passive income does not include income derived in the active conduct of an insurance business by a company that is predominantly engaged in an insurance business. This exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive income, except to the extent such income is attributable to financial reserves in excess of the reasonable needs of the insurance business. Currently, we do not believe that we maintain financial reserves in excess of the reasonable needs of our insurance business. If, because of a change in the business plan or for any other reason, we maintain excess financial reserves, we may be characterized as a passive foreign investment company. Although Alterra’s insurance and reinsurance subsidiaries, which we refer to as the Insurance Subsidiaries, expect to engage predominantly in insurance activities that involve significant risk transfer and do not expect to have financial reserves in excess of the reasonable needs of their insurance businesses, we could nonetheless be deemed to be a passive foreign investment company. We may be characterized as a passive foreign investment company if any Insurance Subsidiary engages in certain non-traditional insurance activities that do not involve sufficient transfer of risk or if any company maintains financial reserves in excess of the reasonable needs of its respective insurance business. In addition, there may be other circumstances that may cause us not to satisfy the exception for insurance companies. For example, the IRS may disagree with our interpretation of the current scope of the active insurance company exception and successfully challenge our position that we qualify for the exception. In addition, the IRS may issue regulatory or other guidance that applies on either a prospective or retroactive basis under which we may fail to qualify for the active insurance company exception. While we do not believe that we are or will be a passive foreign investment company, we cannot assure shareholders that the IRS or a court will concur that we are not a passive foreign investment company with respect to any given year. If we were treated as a passive foreign investment company, the availability of the mark to market election is uncertain for shareholders who are U.S. persons. This election may under certain circumstances mitigate the negative tax consequences of an investment in a passive foreign investment company.

Controlled Foreign Corporation. Each U.S. person who, directly, indirectly, or through attribution rules, owns 10% or more of our common shares should consider the possible application of the controlled foreign corporation rules. Each U.S. 10% shareholder of a controlled foreign corporation on the last day of the controlled foreign corporation’s taxable year generally must include in its gross income for U.S. federal income tax purposes its pro-rata share of the controlled foreign corporation’s subpart F income, even if the subpart F income has not been distributed. In general, a non-U.S. insurance company is treated as a controlled foreign corporation only if such U.S. 10% shareholders collectively own more than 25% of the total combined voting power or total value of the company’s capital stock for an uninterrupted period of 30 days or more during any year. We believe that, because of the dispersion of share ownership among our shareholders and because of the restrictions in our bye-laws on ownership of our common shares, shareholders will not be subject to treatment as U.S. 10% shareholders of a controlled foreign corporation. In addition, because under our bye-laws no single shareholder is permitted to exercise 9.5% or more of the total combined voting power, we believe that our shareholders should not be viewed as U.S. 10% shareholders of a controlled foreign corporation for purposes of the controlled foreign corporation rules. We cannot assure shareholders, however, that these rules will not apply to our shareholders.

Related Person Insurance Income. If any Insurance Subsidiary’s related person insurance income determined on a gross basis were to equal or exceed 20% of its gross insurance income in any taxable year and direct or indirect insureds and persons related to such insureds were directly or indirectly to own more than 20% of the voting power or value of such Insurance Subsidiary’s capital stock, then a U.S. person who owns our common shares directly or indirectly on the last day of the taxable year most likely would be required to include in income for U.S. federal income tax purposes the U.S. person’s pro-rata share of such Insurance Subsidiary’s related person insurance income for the taxable year, determined as if such related person insurance income were distributed proportionately to such U.S. person at that date. Related person insurance income is generally underwriting profits and related investment income attributable to insurance or reinsurance policies where the direct or indirect insureds are direct or indirect U.S. shareholders or are related to such direct or indirect U.S. shareholders. We do not expect any Insurance Subsidiary will knowingly

 

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enter into insurance or reinsurance agreements in which, in the aggregate, the direct or indirect insureds are, or are related to, owners of 20% or more of our common shares. Currently, we do not believe that the 20% gross insurance income threshold has been met. However, we cannot assure shareholders that this is or will continue to be the case. Consequently, we cannot assure shareholders that a person who is a direct or indirect U.S. shareholder will not be required to include amounts in its income in respect of related person insurance income in any taxable year.

If a U.S. shareholder is treated as disposing of shares in a non-U.S. insurance corporation that has related person insurance income and in which U.S. persons own 25% or more of the voting power or value of the company’s capital stock, any gain from the disposition will generally be treated as dividend income to the extent of the U.S. shareholder’s portion of the corporation’s undistributed earnings and profits that were accumulated during the period that the U.S. shareholder owned the shares. In addition, such a shareholder will be required to comply with certain reporting requirements, regardless of the amount of shares owned by the direct or indirect U.S. shareholder. These rules should not apply to dispositions of our common shares because Alterra is not itself directly engaged in the insurance business and because proposed U.S. Treasury regulations applicable to this situation appear to apply only in the case of shares of corporations that are directly engaged in the insurance business. We cannot assure shareholders, however, that the IRS will interpret the proposed regulations in this manner or that the proposed regulations will not be promulgated in final form in a manner that would cause these rules to apply to dispositions of our common shares.

U.S. tax-exempt organizations who own our common shares may recognize unrelated business taxable income.

A U.S. tax-exempt organization may recognize unrelated business taxable income if a portion of our subpart F insurance income is allocated to the organization. In general, subpart F insurance income will be allocated to a U.S. tax-exempt organization if either we are a controlled foreign corporation and the tax-exempt shareholder is a U.S. 10% shareholder or there is related person insurance income and certain exceptions do not apply. Although we do not believe that any U.S. persons will be allocated subpart F insurance income, we cannot assure shareholders that this will be the case.

Changes in U.S. tax laws or new U.S. tax laws could subject us and/or U.S. persons who own our common shares to U.S. income taxation on our undistributed earnings.

The tax laws and interpretations regarding whether a company is engaged in a U.S. trade or business, is a passive foreign investment company, is a controlled foreign corporation, or has related party insurance income are subject to change, possibly on a retroactive basis. It is possible that the IRS may issue new regulations or pronouncements interpreting or clarifying such rules. We are not able to predict if, when or in what form any such guidance will be provided and whether such guidance will have a retroactive effect. In addition, the IRS may issue tax rules and regulations that could have a material adverse effect on our business.

We may become subject to taxes in Bermuda after March 31, 2035, which would have a significant and negative effect on our business and results of operations.

Under current Bermuda law, there is no income, corporate, profits, withholding, capital gains or capital transfer tax payable by Alterra or its Bermuda based subsidiaries. Each of these entities has obtained from the Minister of Finance under The Exempted Undertakings Tax Protection Act 1966, as amended, an assurance that, in the event that Bermuda enacts legislation imposing tax computed on profits, income, any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance, then the imposition of any such tax shall not be applicable to any of these entities, their operations or their shares, debentures or other obligations, until March 31, 2035. Given the limited duration of the Minister of Finance’s assurance, we cannot be certain that we will not be subject to any Bermuda taxes after March 31, 2035. Our business and results of operations would be significantly and negatively affected if we were to become subject to taxes in Bermuda.

The impact of Bermuda’s commitment to the Organization for Economic Cooperation and Development to eliminate harmful tax practices is uncertain and could adversely affect our tax status in Bermuda.

The Organization for Economic Cooperation and Development has published reports and launched a global dialogue among member and non-member countries on measures to limit harmful tax competition. These measures are largely directed at counteracting the effects of tax havens and preferential tax regimes in countries around the world. According to the OECD, Bermuda is a jurisdiction that has substantially implemented the internationally agreed tax standard and as such is listed on the OECD “white list.” However, we are not able to predict whether any changes will be made to this classification or whether any such changes will subject us to additional taxes.

 

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ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

GLOSSARY OF SELECTED INSURANCE INDUSTRY TERMS AND NON-GAAP FINANCIAL MEASURES

 

Acquisition cost ratio

   Acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned for property and casualty business.

Book value per share

   Book value per share is calculated as shareholders’ equity divided by the number of common shares outstanding at the balance sheet date.

Capacity

   The percentage of shareholders’ equity, or the dollar amount of exposure, that an insurer or reinsurer is willing or able to place at risk.

Case reserves

   Loss reserves established for individual claims (and as reported by our cedants in the case of reinsurance).

Combined ratio

   Combined ratio is calculated by dividing the sum of net losses and loss expense, acquisition costs and general and administrative expenses by net premiums earned for property and casualty business. A combined ratio below 100% indicates profitable underwriting prior to the consideration of investment income.

Diluted book value per share

   Diluted book value per share is calculated as shareholders’ equity divided by the number of common shares outstanding at the balance sheet date, after considering the dilutive effects of stock-based compensation and warrants, calculated using the treasury stock method.

Excess and surplus lines insurance

   Any type of coverage that cannot be placed with an insurer admitted to do business in a certain jurisdiction. Risks placed in excess and surplus lines markets are often unique, unusual or difficult to place in conventional markets due to a shortage of capacity.

General and administrative expense ratio

   General and administrative expense ratio is calculated by dividing the sum of general and administrative expenses by net premiums earned for property and casualty business.

Incurred but not reported, or IBNR

  

Incurred but not reported reserves, which include reserves for the following:

 

•    Pure incurred but not reported claims; and

 

•    Future development on known claims.

Loss ratio

   Loss ratio is calculated by dividing net losses and loss expenses by net premiums earned for property and casualty business.

Loss reserve

   For an individual loss, an estimate of the amount the insurer or reinsurer expects to pay for the reported claim. For total losses, estimates of expected payments for reported and unreported claims. These may include amounts for claims expenses.

Monthly net performance

   Monthly net performance is the total income generated by an investment in the form of interest or dividends and the change in value of that investment in the form of unrealized or realized gains and losses.

Net operating income

   Net income excluding after-tax net realized and unrealized gains or losses on non-hedge fund investments (this includes net realized and unrealized gains or losses on trading securities, net realized gains or losses on available for sale securities, net impairment losses recognized in earnings, earnings from equity method investments and changes in fair value of investment derivatives, catastrophe bonds and structured deposits), after-tax net foreign exchange gains or losses and after-tax merger and acquisition expenses.

Net operating return on average shareholders’ equity

   Net operating return on average shareholders’ equity is calculated by dividing the net operating income by the average shareholders’ equity. Average shareholders’ equity is calculated as the average of the quarterly average shareholders’ equity balances.

Non-admitted carrier

   A non-admitted carrier is not licensed by the state, but is allowed to do business in that state. Non-admitted carriers are not bound by most of the rate and form regulations imposed on standard market companies, allowing them the flexibility to change the coverage offered and the rate charged without time constraints and financial costs associated with the filing process.

 

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Rate of return

   Rates of return are calculated by dividing monthly net performance by the beginning net asset value of that month. One is then subtracted from the product and the result is multiplied by 100.

Return on average shareholders’ equity

   Return on average shareholders’ equity is calculated by dividing net income by the average of the beginning and ending shareholders’ equity. Average shareholders’ equity is calculated as the average of the quarterly average shareholders’ equity balances.

 

ITEM 2. PROPERTIES

We lease office space in Hamilton, Bermuda where our principal executive office is located. Additionally, we lease office space in the United States, Ireland, the United Kingdom and other jurisdictions sufficient for the operation of our insurance and reinsurance operations. We renew and enter into new leases in the ordinary course of business. For further discussion of our leasing commitments at December 31, 2011, see Note 19 of our audited consolidated financial statements.

 

ITEM 3. Legal Proceedings

We are, from time to time, a party to litigation and/or arbitration that arises in the normal course of our business operations. We are also subject to other potential litigation, disputes and regulatory or governmental inquiries.

Two lawsuits filed in the United States District Court for the Northern District of Georgia name Alterra Bermuda, along with approximately 100 other insurance companies and brokers, as a defendant. The claims in each case are that the defendants conspired to manipulate bidding practices for insurance policies in certain insurance lines and failed to disclose certain commission arrangements. The first of these cases was filed on April 4, 2006 by New Cingular Wireless Headquarter LLC and 16 other corporations. The complaint asserts statutory claims under the Sherman Antitrust Act, the Racketeer Influenced and Corrupt Organization Act, the antitrust laws of several states, as well as common law claims alleging breach of fiduciary duty and fraud. On October 16, 2006, the Judicial Panel on Multidistrict Litigation transferred the case to the U.S. District Court for the District of New Jersey for pretrial proceedings on a consolidated basis with other lawsuits raising smaller claims. The second case was filed on October 12, 2007 by Sears, Roebuck & Co. and two affiliated corporations. The complaint in this case charges Alterra Bermuda and certain other insurance company defendants with violations of the antitrust and consumer fraud laws of Georgia and other states and common law claims of inducement of breach of fiduciary duties, tortuous interference with contract, unjust enrichment and aiding and abetting fraud. The Judicial Panel on Multidistrict Litigation transferred this case to the U.S. District Court for the District of New Jersey for consolidated pretrial proceedings in November 2007. The two lawsuits were stayed for more than four years while the court addressed issues in related cases in which Alterra Bermuda was not a party. In October 2011, the District Court lifted the stay and allowed the two cases against Alterra Bermuda and other defendants to proceed. The plaintiffs in the two lawsuits are currently preparing amended complaints. We intend to continue to defend ourselves vigorously in these lawsuits but cannot at this time predict the outcome of the matters described above or estimate the potential costs related to defending the action. No liability has been established in our audited consolidated financial statements as of December 31, 2011.

While any proceeding contains an element of uncertainty, we currently do not believe that the ultimate outcome of all outstanding litigation, arbitrations and inquiries will have a material adverse effect on our consolidated financial condition, operating results and/or liquidity, although an adverse resolution of a number of these items could have a material adverse effect on our results of operations in a particular fiscal quarter or year.

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

(A) Market Information

The principal market for the trading of our common shares is the Nasdaq Global Select Market under the symbol ALTE. The following table sets forth for the periods indicated the high and low reported sale price of our common shares on the Nasdaq Global Select Market.

 

     2011      2010  
     High      Low      High      Low  

First Quarter

   $ 22.50       $ 20.35       $ 24.99       $ 21.24   

Second Quarter

   $ 23.62       $ 20.96       $ 23.63       $ 17.26   

Third Quarter

   $ 22.91       $ 17.33       $ 20.36       $ 17.02   

Fourth Quarter

   $ 23.97       $ 18.07       $ 22.04       $ 19.41   

(B) Holders

As of January 31, 2012, the number of holders of record of our common shares was 101.

(C) Dividends

Alterra’s Board of Directors declared the following dividends during 2012, 2011 and 2010:

 

Date Declared

   Dividend
per share
     Dividend to be paid
to shareholders of
record on
   Payable On

February 8, 2012

   $ 0.14      February 22, 2012    March 7, 2012

November 1, 2011

   $ 0.14      November 15, 2011    November 29, 2011

August 2, 2011

   $ 0.14      August 16, 2011    August 30, 2011

May 3, 2011

   $ 0.12      May 17, 2011    May 31, 2011

February 8, 2011

   $ 0.12      February 22, 2011    March 8, 2011

November 2, 2010

   $ 0.12      November 16, 2010    November 30, 2010

August 3, 2010

   $ 0.12      August 17, 2010    August 31, 2010

May 20, 2010

   $ 2.50      June 2, 2010    June 16, 2010

May 3, 2010

   $ 0.10      May 24, 2010    June 4, 2010

February 9, 2010

   $ 0.10      February 23, 2010    March 9, 2010

For information regarding our cash dividends per common share on an annual basis see “Item 6—Selected Financial Data.” Any determination to pay cash dividends is at the discretion of our Board of Directors and is dependent upon the results of operations and cash flows, the financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends and other factors that our Board of Directors deems relevant.

Alterra’s ability to pay dividends depends on the ability of its subsidiaries to pay dividends to it. The payment of dividends and making of distributions by Bermuda legal entities are limited under Bermuda law. Alterra Bermuda is prohibited from declaring or paying dividends if it is in breach of its enhanced capital requirement, solvency margin or minimum liquidity ratio or if the declaration or payment of such dividend would cause such a breach. Where an insurer fails to meet its solvency margin or minimum liquidity ratio on the last day of any financial year, it is prohibited from declaring or paying any dividends during the next financial year without the approval of the BMA. Furthermore, Alterra Bermuda is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus unless it files with the BMA an affidavit stating that it will continue to meet its solvency margin or minimum liquidity ratio. Alterra Bermuda must obtain the BMA’s prior approval for a reduction by 15% or more of the total statutory capital as set forth in its previous year’s financial statements. In addition, as a long-term insurer, Alterra Bermuda may not declare or pay a dividend to any person other than a policyholder unless the value of the assets in its long-term business fund exceeds the liabilities of the its long-term business by the amount of the dividend and at least the prescribed minimum solvency margin.

 

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In addition, certain of our letter of credit facilities prohibits Alterra and Alterra Bermuda from paying dividends at any time that it is in default under the respective facility, which will occur if Alterra’s shareholders’ equity or Alterra Bermuda’s shareholder’s equity is less than a specified amount as well as in certain other circumstances.

(D) Securities Authorized for Issuance Under Equity Compensation Plans

Information with respect to securities authorized for issuance under our equity compensation plans is set forth under “Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

(E) Performance Graph

Set forth below is a line graph comparing the yearly dollar change in the cumulative total shareholder return on our common shares from December 31, 2006 through December 31, 2011 against the Total Return Index for the S&P 500 Index and the Nasdaq Insurance Index for the same period. The performance graph assumes $100 invested on December 31, 2006 in the common shares of Alterra, the S&P 500 Index and the Nasdaq Insurance Index. It also assumes that all dividends are reinvested.

 

LOGO

The performance reflected in the graph above is not necessarily indicative of future performance.

This graph is not “soliciting material,” is not deemed filed with the SEC and is not to be incorporated by reference in any filing by us under the Securities Act or the Exchange Act, whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.

(F) Unregistered Sales of Equity Securities and Use of Proceeds

We repurchase our shares from time to time through open market, privately negotiated transactions and Rule 10b5-1 stock trading plans. During the three months ended December 31, 2011, we repurchased 2,367,032 shares for $53.1 million. As of February 23, 2012, the aggregate amount available for share repurchases was $225.5 million.

The table below sets forth the information with respect to purchases made by or on behalf of Alterra or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Exchange Act) of our common shares during the three months ended December 31, 2011.

 

Period

   Total Number of
Shares Purchased
     Average Price
Paid per Share
     Total Number of
Shares  Purchased
as Part of
Publicly
Announced Plans
or Programs
     Approximate
Dollar Value
of Shares that
May Yet Be
Purchased
Under the Plans
or Programs
 

October 1, 2011 to October 31, 2011

     862      $ 18.97         —         $ 157.5 million   

November 1, 2011 to November 30, 2011

     1,131,029      $ 22.18         1,127,100      $ 132.5 million   

December 1, 2011 to December 31, 2011

     1,235,141      $ 22.70         1,235,013      $ 104.4 million   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total October 1, 2011 to December 31, 2011 (1)(2)

     2,367,032      $ 22.45         2,362,113      $ 104.4 million   

 

(1) On September 17, 2001, our Board of Directors approved a share repurchase plan providing for repurchase of our common shares. The repurchase plan has been increased from time to time at the election of our Board of Directors. The most recent increase was on February 8, 2012 when our Board of Directors authorized an additional $150.0 million in repurchases.

 

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(2) During the three months ended December 31, 2011, the Company purchased 4,919 of its common shares in connection with its employee benefits plans, including, as applicable, purchases associated with the exercise of options and the vesting of restricted stock and restricted stock unit awards. These purchases were not made pursuant to a publicly announced repurchase plan or program.

 

ITEM 6. SELECTED FINANCIAL DATA

The following table of selected financial data should be read in conjunction with our audited consolidated financial statements and the notes thereto and with “Item 5—Management’s Discussion and Analysis of Financial Condition and Results of Operations,” each contained herein.

 

     Year Ended December 31,  
     2011     2010 (a)     2009     2008     2007  
     (in millions of U.S. Dollars, except percentages and per share data)  

Gross premiums written

   $ 1,904.1      $ 1,410.7      $ 1,375.0      $ 1,254.3      $ 1,078.3  

Net premiums earned

     1,425.0       1,172.5       834.4       813.5       817.9  

Net investment income

     234.8       222.5       169.7       181.6       188.2  

Net realized and unrealized gains (losses) on investments

     (38.3     16.9       81.8       (235.0     183.8  

Net income (loss)

     65.3       302.3       246.2       (175.3     303.2  

Fixed maturities and cash

     7,528.2       7,483.2       4,944.3       4,603.3       4,060.9  

Other investments

     286.5       378.1       318.1       753.7       1,061.7  

Total assets

     10,185.8       9,917.3       7,339.7       7,252.0       6,538.5  

Property and casualty losses

     4,216.5       3,906.1       3,178.1       2,938.2       2,333.9  

Life and annuity benefits

     1,190.7       1,275.6       1,372.5       1,367.0       1,203.5  

Senior notes and bank loans

     440.5       440.5       90.5       466.4       429.8  

Shareholders’ equity

     2,809.2       2,918.3       1,564.6       1,280.3       1,583.9  

Book value per share

     27.51       26.30       28.01       22.94       27.54  

Diluted book value per share

     26.91       25.99       27.36       22.46       25.59  

Diluted earnings per share

     0.61       3.17       4.26       (3.10     4.75  

Cash dividends per share

     0.52       2.94       0.38       0.36       0.32  

Return on average shareholders’ equity

     2.3     12.3     17.6     (12.3 )%      20.4

 

(a) Includes the results of the former Harbor Point companies from May 12, 2010. Additional information about the Amalgamation with Harbor Point can be found in Note 5 to our audited consolidated financial statements included herein.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is a discussion and analysis of our results of operations for the year ended December 31, 2011 compared to the year ended December 31, 2010 and for the year ended December 31, 2010 compared to the year ended December 31, 2009, and also a discussion of our financial condition as of December 31, 2011. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report on Form 10-K.

Key Performance Indicators

The financial measures that we believe are most meaningful in analyzing our performance and assessing whether we are achieving our objectives are growth in book value per share, net operating income, combined ratio, return on average shareholders’ equity and net operating return on average shareholders’ equity. The table below shows the key performance indicators as of December 31, 2011 and 2010 and for the years ended December 31, 2011, 2010 and 2009.

 

     As of
December  31,
2011
     As of
December 31,
2010
 

Book value per share (1)

   $ 27.51      $ 26.30  

Diluted book value per share (1)

   $ 26.91      $ 25.99  

 

     Year Ended December 31,  
   2011     2010     2009  
     (in millions of U.S. Dollars, except percentages)  

Net operating income (2)

   $ 96.6     $ 251.7     $ 208.9  

Combined ratio (3)

     98.2     85.7     88.1

Return on average shareholders’ equity (4)

     2.3     12.3     17.6

Net operating return on average shareholders’ equity (2)(4)

     3.4     10.2     14.9

 

(1) Book value per share is calculated as shareholders’ equity divided by the number of common shares outstanding. Diluted book value per share is calculated as shareholders’ equity divided by the number of diluted common shares outstanding using the treasury stock method.
(2) Net operating income and net operating return on average shareholders’ equity are non-GAAP financial measures as defined by SEC Regulation G. See “Non-GAAP financial measures” for reconciliation to the nearest U.S. GAAP financial measure.
(3) Combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned for property and casualty business.
(4) Return on average shareholders’ equity and net operating return on average shareholders’ equity are calculated by dividing net income and net operating income, respectively, by average shareholders’ equity (determined using the average of the quarterly average shareholders’ equity balances for the year).

We consider growth in book value per share to be the most important financial performance measure in assessing whether we are meeting our business objectives. During the year ended December 31, 2011, our book value per share on a basic and diluted basis increased by 4.6% and 3.5%, respectively. We also distributed $0.52 per share in cash to our shareholders, which provided tangible value to shareholders and reduced our excess capital. We believe that a comparison of book value per share and diluted book value per share from December 31, 2010 to December 31, 2011 should be adjusted for these distributions to fully reflect the return generated for shareholders. Adding back $0.52 per share to our December 31, 2011 diluted book value per share of $26.91 would result in $27.43 per share, an increase of 5.5% over December 31, 2010. The increase in diluted book value per share, as adjusted, was principally due to a combination of positive operating results, unrealized gains on our investment portfolio and share repurchases at a discount to diluted book value per share.

Property catastrophe losses resulting from natural disasters in Thailand in the fourth quarter, in the United States in the second and third quarters, and in Japan, New Zealand and Australia in the first quarter, had a significant effect on our results of operations for the year ended December 31, 2011. We incurred losses from these events of $253.4 million, net of reinsurance and reinstatement premiums, for the year ended December 31, 2011. These events are currently estimated to have caused industry losses exceeding $100.0 billion dollars; however, our strategy of diversified underwriting and a measured catastrophe risk appetite resulted in what we believe was a manageable level of property catastrophe losses and limited the capital impact to 8.7% of our shareholders’ equity as of December 31, 2010.

We seek to manage and monitor our exposure so that the estimated maximum impact of a catastrophic event in any geographic zone is less than 25% of our beginning of year shareholders’ equity for a modeled 1 in 250 year event. As of December 31, 2011, our aggregate exposure was below this target. We continue to monitor the pricing environment and believe we have the capital and operational flexibility to adjust our aggregate exposure should market conditions change over the course of 2012.

Despite the incurred losses from catastrophe events, our net operating income was $96.6 million for the year ended December 31, 2011, with a combined ratio of 98.2%. The catastrophe losses principally affected our reinsurance and Alterra at Lloyd’s segments. Our reinsurance segment still reported positive underwriting income for the year ended December 31, 2011. Net favorable development on prior year loss reserves was $153.3 million for the year ended December 31, 2011, reducing the combined ratio by 10.8 percentage points. The net favorable development was principally in our insurance and reinsurance segments.

 

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We continued to actively manage our capital during the year by taking advantage of select opportunities to purchase our common shares in the market. We spent $223.3 million to repurchase 10.3 million shares during the year at an average price of $21.67 per share, a 16.6% discount to our December 31, 2010 diluted book value per share. As of December 31, 2011, our remaining share repurchase authorization was $104.4 million. Subsequently, on February 8, 2012, our board of directors increased our share repurchase authorization by $150.0 million. We expect to continue to consider share repurchases as an effective tool to manage capital in a soft cycle and to increase book value per share for our shareholders.

We target a long-term net operating ROE of the risk free rate plus 10% over the cycle. For the year ended December 31, 2011, our net operating ROE and return on average shareholders’ equity fell short of our target primarily due to the significant property catastrophe event losses in the year and historically low fixed income investment yields.

The markets in which we operate historically have been cyclical. During periods of excess underwriting capacity, competition can result in lower pricing and less favorable policy terms for insurers and reinsurers. During periods of reduced underwriting capacity, pricing and policy terms are generally more favorable for insurers and reinsurers. We believe that the industry has been in a period of excess underwriting capacity, and while 2011’s property catastrophe events likely eroded some of that capacity, there was not sufficient pressure on the industry to improve pricing in 2011. The industry is also operating in a low interest rate environment, which makes it more difficult to generate significant investment income growth. Both of these factors generally result in lower net operating income, return on average shareholders’ equity and net operating return on average shareholders’ equity.

Although there remains uncertainty regarding the timing, location and scale of a favorable turn in the market, we believe that the industry is showing signs of improvement for 2012. However, we intend to maintain our underwriting discipline while actively managing our expenses. We expect our gross written premiums for the year ending December 31, 2012 to be consistent with the year ended December 31, 2011, and we expect to write more premiums in our short-tail lines of business than our long-tail casualty lines of business.

Drivers of Profitability

Revenues

We derive operating revenues from premiums from our insurance and reinsurance businesses. Additionally, we recognize returns from our investment portfolios.

Insurance and reinsurance premiums are a function of the amount and type of contracts written as well as prevailing market prices and conditions. Property and casualty premiums are earned over the terms of the underlying coverage. Life and annuity reinsurance premiums are generally earned when the premium is due from policyholders. Each of our insurance and reinsurance contracts contain different pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying contracts, data received from clients and from premium audits. Changes in premium estimates are expected and may result in significant adjustments in any period. These estimates change over time as additional information regarding the underlying business volume of our clients is obtained. There is often a delay in the receipt of updated premium information from clients due to the time lag in preparing and reporting the data to us. After review by our underwriters and finance staff, we increase or decrease premium estimates as updated information from our clients is received.

Our net investment income is a function of the average invested assets and the average yield that we earn on those invested assets. The investment yield on our fixed maturities investments is a function of market interest rates as well as the credit quality and duration of our fixed maturities portfolio. Our net realized and unrealized gains or losses on investments includes realized gains and losses on our fixed maturity securities and changes in fair value of our trading securities and other investments. We recognize the realized gains and losses at the time of sale, and they, along with the changes in fair value of our trading securities, reflect the results of changing market values and conditions, including changes in market interest rates and changes in the market’s perception of the credit quality of our fixed maturities holdings. The change in fair value of other investments is principally a function of the success of the funds in which we are invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies and general economic and investment market conditions.

Expenses

Our principal expenses are losses and benefits, acquisition costs, interest expense and general and administrative expenses. Losses and benefits are based on the amount and type of insurance and reinsurance contracts written by us during the current reporting

 

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period and information received during the current reporting period from clients pertaining to contracts written in prior years. We record losses and benefits based on actuarial estimates of the expected losses and benefits to be incurred on each contract written. The ultimate losses and benefits depend on the actual costs to settle these liabilities. We increase or decrease losses and benefits estimates as actual claim reports are received. Our ability to make reasonable estimates of losses and benefits at the time of pricing our contracts is a critical factor in determining profitability.

Acquisition costs consist principally of ceding commissions paid to ceding clients and brokerage expenses. These typically represent a negotiated percentage of the premiums on insurance and reinsurance contracts written. Acquisition costs are stated net of ceding commissions associated with premiums ceded to our quota share partners on our insurance and reinsurance business. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers. We defer and amortize these costs over the period in which the related premiums are earned.

Interest expense principally reflects interest on any bank loans and interest on our senior notes. Interest expense also includes the net interest charge on funds withheld from reinsurers under reinsurance and retrocessional contracts. Interest expense on funds withheld from other reinsurers under reinsurance and retrocessional contracts will vary principally due to changes in the balance of funds withheld. In addition, interest expense also includes interest on deposit contracts.

General and administrative expenses are principally employee salaries, incentive compensation and related personnel costs, office rent, amortization of leasehold improvements, information technology expenditures and other operating costs. These costs generally do not vary with the amount of premiums written.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with U.S. GAAP, which require management to make estimates and assumptions. We believe that the following accounting policies affect the significant judgments and estimates used in the preparation of our consolidated financial statements.

Reserve for property and casualty losses

The liability for property and casualty losses is the largest and most complex estimate in our consolidated balance sheet. The liability for losses, including loss adjustment expenses, represents estimates of the ultimate cost of all losses incurred but not paid as of the balance sheet date. The reserves are estimated on an undiscounted basis. We utilize a variety of standard actuarial methods to estimate our reserves. Although these actuarial methods have been developed over time, assumptions about anticipated size of loss and loss emergence patterns are subject to fluctuations. We review our estimate of reserves on a quarterly basis and consider all significant facts and circumstances then known. Newly reported loss information from clients or insureds is the principal contributor to adjustments to our loss reserve estimates. These adjustments are recognized in the period in which they are determined, and therefore can impact that period’s results either favorably (when reserve estimates established in prior periods prove to be redundant) or adversely (when reserve estimates established in prior periods prove to be deficient).

We categorize our loss reserves into two types: case reserves and incurred but not reported reserves, or IBNR.

The table below shows our reserves as of December 31, 2011 and 2010 by type and by segment.

 

     As of December 31, 2011           As of December 31, 2010  
     Case      IBNR      Total           Case      IBNR      Total  

In millions of U.S. Dollars

      

Insurance

                    

Casualty

   $ 316.7      $ 870.4      $ 1,187.1         $ 279.9      $ 914.5      $ 1,194.4  

Property

     104.6        43.7        148.3           70.5        70.8        141.3  
  

 

 

    

 

 

    

 

 

       

 

 

    

 

 

    

 

 

 
     421.3        914.1        1,335.4           350.4        985.3        1,335.7  
  

 

 

    

 

 

    

 

 

       

 

 

    

 

 

    

 

 

 

Reinsurance

                    

Casualty

     523.8        1,132.7        1,656.5           481.3        1,216.3        1,697.6  

Property

     255.4        193.4        448.8           165.9        177.5        343.4  
  

 

 

    

 

 

    

 

 

       

 

 

    

 

 

    

 

 

 
     779.2        1,326.1        2,105.3           647.2        1,393.8        2,041.0  
  

 

 

    

 

 

    

 

 

       

 

 

    

 

 

    

 

 

 

U.S. Specialty

                    

Casualty

     56.7        124.6        181.3           39.1        97.0        136.1  

 

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Property

     70.1        56.1        126.2        26.1        69.8        95.9  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     126.8        180.7        307.5        65.2        166.8        232.0  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Alterra at Lloyd’s

                 

Casualty

     43.2        169.6        212.8        87.3        122.0        209.3  

Property

     120.8        134.8        255.6        26.7        61.4        88.1  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     164.0        304.4        468.4        114.0        183.4        297.4  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,491.3      $ 2,725.3      $ 4,216.6      $ 1,176.8      $ 2,729.3      $ 3,906.1  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
                 

Casualty

   $ 940.4      $ 2,297.3      $ 3,237.7      $ 887.6      $ 2,349.8      $ 3,237.4  

Property

     550.9        428.0        978.9        289.2        379.5        668.7  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,491.3      $ 2,725.3      $ 4,216.6      $ 1,176.8      $ 2,729.3      $ 3,906.1  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Case Reserves. Case reserves are established for individual claims that have been reported to us or, in the case of reinsurance, have been reported by our cedants.

For our insurance operations, we are generally notified of insured losses by our insureds and/or their brokers. Based on this information, we establish case reserves by estimating the expected ultimate losses from the claim (including any administrative costs associated with settling the claim). Our claims personnel use their knowledge of the specific claim along with internal and external experts, including underwriters, actuaries and legal counsel, to estimate the expected ultimate losses.

For our reinsurance operations, case reserves are generally established based on reports received from ceding companies and/or their brokers. For excess of loss contracts, we are typically notified of insurance losses on specific contracts and record a case reserve for the estimated expected ultimate losses from the claim. For proportional contracts, we typically receive aggregated claims information and record a case reserve based on that information. As with insurance business, we evaluate this information and estimate the expected ultimate losses.

IBNR. IBNR reserves are reserves that are statistically estimated for losses that have occurred but not yet been reported to us. Consistent with industry practice, we utilize a variety of standard actuarial methods together with management judgment to estimate IBNR. The loss reserve selection from these methods is based on the loss development characteristics of the specific line of business and contracts, which take into consideration coverage terms, type of business, maturity of loss data, reported claims and paid claims. We do not necessarily utilize the same actuarial method or group of actuarial methods for all contracts within a line of business or segment as variations between contracts result in a number of different methods or groups of methods being appropriate.

There is normally a time lag between when a loss event occurs and when it is actually reported to us. These actuarial methods that we use to estimate losses have been designed to address the lag in loss reporting as well as the delay in obtaining information that would allow us to more accurately estimate future payments. There is also often a time lag between reinsurance clients establishing case reserves and re-estimating their reserves, and notifying us of the new or revised case reserves. As a result, reporting lag is more pronounced in our reinsurance contracts than in our insurance contracts due to the reliance on insurers to report their claims to us. On reinsurance transactions, the reporting lag will generally be 60 to 90 days after the end of a reporting period, but can be longer in some cases. Based on the experience of our actuaries and management, we select loss development factors and trending techniques to mitigate the problems caused by reporting lags. We regularly evaluate and update our loss development and trending factor selections using client specific and industry data.

The principal actuarial methods we use to perform our quarterly loss reserve analysis may include one or more of the following methods:

Initial Expected Loss Ratio Method. To estimate ultimate losses under the expected loss ratio method, we multiply earned premiums by an expected loss ratio. The expected loss ratio is selected utilizing industry data, historical client data, frequency-severity and rate level forecasts and professional judgment. This method is often useful when there is limited historical data due to few losses being incurred.

Paid Loss Development Method. This method estimates ultimate losses by calculating past paid loss development factors and applying them to exposure periods with further expected paid loss development. The paid loss development method assumes that losses are paid at a rate consistent with the historical rate of payment. It provides an objective test of reported loss projections because paid losses contain no reserve estimates. For many lines of business, claim payments are made slowly and it may take many years for claims to be fully reported and settled.

 

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Reported Loss Development Method. This method estimates ultimate losses by using past reported loss development factors and applying them to exposure periods with further expected reported loss development. Since reported losses include payments and case reserves, changes in both of these amounts are incorporated in this method. This approach provides a larger volume of data to estimate ultimate losses than paid loss methods. Thus, reported loss patterns may be less varied than paid loss patterns, especially for coverages that have historically been paid out over a long period of time but for which claims are reported relatively early and case loss reserve estimates established.

Bornhuetter-Ferguson Paid and Reported Loss Methods. These methods are a weighted average of the initial expected loss ratio and the relevant development factor method. The weighting between the two methods depends on the maturity of the business. This means that for the more recent years a greater weight is placed on the initial expected loss ratio, while for the more mature years a greater weight is placed on the development factor methods. These methods avoid some of the distortions that could result from a large development factor being applied to a small base of paid or reported losses to calculate ultimate losses. This method will react slowly if actual paid or reported loss experience develops differently than historical paid or reported loss experience because of major changes in rate levels, retentions or deductibles, the forms and conditions of coverage, the types of risks covered or a variety of other factors.

Outstanding to IBNR Ratio Method. This method is used in selected cases typically for very mature years that still have open claims. This method assumes that the estimated future loss development is indicated by the current level of case reserves.

Frequency-Severity Method. This method is based on assumptions about the number of claims that will impact a contract and the average ultimate size of those claims. On excess of loss contracts, reported claims in lower layers provide insight to the expected number of claims that will likely impact the upper layers.

The selection of appropriate actuarial methods to establish reserves may change over time as the underlying loss information becomes more seasoned. Our actuarial projections are based upon an assessment of known facts and circumstances, historical data, estimates of future trends in claims severity and frequency, changes in social attitudes, political and economic conditions, including the effects of inflation, and judicial theories of liability factors, including the actions of third parties, which are beyond our control.

We rely on data reported by clients when calculating reserves. The quality of the data varies from client to client. Our actuarial and claims management teams periodically analyze our clients’ loss data to ascertain its quality and credibility. This process may involve comparisons with submission data and industry loss data, claims audits and inquiries about the methods of establishing case reserves associated with large industry events.

Our reserving methodologies use a loss reserving model that calculates a point estimate for our ultimate losses. Although we believe that our assumptions and methodologies are reasonable, we cannot be certain that our ultimate payments will not vary, potentially materially, from the estimates we have made.

We believe that the provision for outstanding losses and benefits is adequate to cover the ultimate net cost of losses incurred to the balance sheet date, but the provision is necessarily an estimate and could potentially be settled for a significantly greater or lesser amount. These estimates are reviewed regularly and any adjustments to the estimates are recorded in the period they are determined. See Item 1A—Risk Factors—Our losses and loss adjustment expenses and benefits may exceed our loss and benefit reserves, which could significantly increase our liabilities and reduce our net income and could have a significant and negative effect on our financial condition and results of operations.

Our development of prior period loss reserves, net of reinsurance, has been less than 6.0% in each of the three years ending December 31, 2011, 2010 and 2009 and an average of 3.9% over the past ten years. Based on this experience, we currently believe that it is reasonably likely that net loss reserves could change 4.0% from currently reported amounts. This change could be higher or lower depending on client reported data and changes in our assessment of known facts and circumstances. As of December 31, 2011, a 4.0% change in net loss reserves would impact our net income and shareholders’ equity by $127.3 million.

The uncertainty and degree of judgment used in our estimate of loss reserves varies depending on the nature of the contract and the line of business. For the purposes of the following discussion, we consider the losses for the following lines of business to be included within property losses: agriculture, aviation, marine & energy, property and other. We consider losses for the accident & health, auto, credit, excess liability, financial institutions, general casualty, international casualty, medical malpractice, professional liability, surety, whole account and workers compensation lines of business to be classified as casualty losses.

 

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Casualty losses are generally long-tailed, which means that there can be a significant delay between the occurrence of a loss and the time it is settled by the insurer. These losses are also more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. In addition, the casualty business generally has a longer reporting lag and payment pattern than property business. Due to these factors, the estimation of loss reserves for casualty business generally involves a higher degree of judgment than for short-tailed business.

Property losses are generally short-tailed and are usually known and paid within a relatively short period of time after the underlying loss event has occurred. Our estimates for losses resulting from catastrophic events are based upon a combination of internal and external catastrophe models, as well as client- and location-specific assessments and reports, where available. These estimates are developed immediately after the loss event, and the loss estimates are subsequently refined based on broker advices and client notifications.

Losses and benefits recoverable from reinsurers

We reinsure or retrocede portions of certain risks for which we have accepted liability. In these transactions, we cede to a counterparty reinsurer or retrocessionaire all or part of the risk we have assumed. This purchase of reinsurance does not legally discharge our liability with respect to the obligations that we have insured or reinsured.

The determination of the amount of losses and benefits recoverable from reinsurers requires an estimate of the amount of loss reserves to be ceded to our reinsurers. This consists of recoverable amounts related to both our case and IBNR reserves. The reinsurance recoveries are estimated on a contract by contract basis by applying the terms of any applicable reinsurance coverage to our reserve estimates.

We evaluate and monitor the financial strength of each of our counterparties. Some reinsurance and retrocessional agreements give us the right to receive additional collateral or to terminate the agreement in the event of deterioration in the financial strength of the counterparty.

As of December 31, 2011, 85.9% of our losses recoverable were with reinsurers rated “A” or above by A.M. Best and 8.4% were rated “A-”. The remaining 5.7% were with “NR-not rated” reinsurers. Grand Central Re Limited, or Grand Central Re, a Bermuda domiciled reinsurance company in which we have a 7.5% equity investment, is our largest “NR-not rated” retrocessionaire and accounted for 3.3% of our losses recoverable as of December 31, 2011. As security for outstanding loss obligations, we retain funds from Grand Central Re amounting to 214.1% of its loss recoverable obligations. Of the remaining amount with “NR-not rated” retrocessionaires, we retain collateral equal to 84.0% of the losses and benefits recoverable. Our losses and benefits recoverable are not due for payment until the underlying loss has been paid. As of December 31, 2011, 95.6% of our losses and benefits recoverable were not due for payment.

Disputes

In connection with our ongoing analysis of our loss reserves, we review loss notifications and reports received from our clients to confirm that submitted claims are covered under the contract terms. Disputes with clients arise in the ordinary course of business due to coverage issues such as classes of business covered and interpretation of contract wording. We typically resolve any disputes through negotiations that could vary from a simple exchange of email correspondence to arbitration with a panel of experts. Our contracts generally provide for dispute resolution through arbitration. We are not currently involved in any coverage disputes that we believe would, individually or in the aggregate, have a material adverse effect upon our business or results of operations.

Property and casualty loss reserve development

The following table presents the development of balance sheet property and casualty loss reserves calculated in accordance with U.S. GAAP, as of December 31, 2002 through December 31, 2011. This table does not present accident or policy year development data. The top line of the table shows the gross reserves at the balance sheet date for each of the indicated years and is reconciled to the net reserve by adjusting for reinsurance recoverables. This represents the estimated amount of net claims and claim expenses arising in the current year and all prior years that are unpaid at the balance sheet date, including IBNR reserves. The table also shows the re-estimated amount of the previously recorded reserves as adjusted for new information received as of the end of each succeeding year.

 

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The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “net cumulative redundancy (deficiency)” represents the aggregate change to date from the original estimate on the third line of the table “reserve for property and casualty losses, originally stated, net of reinsurance.” The “gross cumulative redundancy (deficiency)” represents the aggregate change to date from the original gross estimate on the top line of the table. The table also shows the cumulative net paid amounts as of successive years with respect to the net reserve liability.

 

In thousands of U.S. Dollars   2002     2003     2004     2005     2006     2007     2008     2009     2010     2011  
    (1)                             (3)     (4)(5)           (6)        

Gross reserve for property and casualty losses

  $ 617,404      $ 991,687      $ 1,455,099      $ 2,006,032      $ 2,335,109      $ 2,333,877      $ 2,938,171      $ 3,178,094      $ 3,906,134      $ 4,216,538   

Reinsurance recoverable (2)

    (80,407     (163,348     (293,512     (409,229     (496,173     (537,864     (810,113     (964,818     (921,032     (1,035,004

Reserve for property and casualty losses originally stated, net of reinsurance

    536,997        828,339        1,161,587        1,596,803        1,838,936        1,796,013        2,128,058        2,213,276        2,985,102        3,181,534   

Cumulative net paid losses,

                   

1 year later

    106,706        119,269        217,637        169,008        361,702        184,223        368,539        574,725        576,018     

2 years later

    165,539        257,182        321,533        501,837        504,462        385,859        828,767        937,445        —       

3 years later

    244,578        333,238        545,653        608,195        658,719        772,828        1,130,600        —          —       

4 years later

    309,183        502,167        611,463        731,446        1,015,269        1,000,865        —          —          —       

5 years later

    420,454        553,107        693,893        1,069,689        1,192,441        —          —          —          —       

6 years later

    458,930        597,605        980,718        1,206,724        —          —          —          —          —       

7 years later

    484,443        807,621        1,081,952        —          —          —          —          —          —       

8 years later

    577,227        870,980        —          —          —          —          —          —          —       

 

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9 years later

    614,752        —          —          —          —          —          —          —          —       

Reserves re-estimated as of

                   

1 year later

    554,795        826,799        1,296,558        1,585,834        1,774,591        1,689,054        2,040,403        2,102,672        2,844,832     

2 years later

    563,469        975,441        1,277,712        1,533,584        1,679,434        1,628,832        1,986,002        1,995,973        —       

3 years later

    666,781        977,590        1,229,303        1,475,583        1,628,019        1,573,336        1,896,907        —          —       

4 years later

    676,365        945,186        1,205,584        1,433,523        1,563,724        1,497,278        —          —          —       

5 years later

    655,532        932,423        1,184,617        1,380,775        1,486,714        —          —          —          —       

6 years later

    652,881        924,962        1,158,483        1,337,031        —          —          —          —          —       

7 years later

    653,148        916,677        1,151,436        —          —          —          —          —          —       

8 years later

    641,828        912,932        —          —          —          —          —          —          —       

9 years later

    634,817        —          —          —          —          —          —          —          —       

Net cumulative (deficiency) redundancy

    (97,820     (84,593     10,151        259,772        352,222        298,735        231,151        217,303        140,270     

Gross cumulative (deficiency) redundancy

    (115,899     (98,842     33,232        356,272        474,223        416,457        316,499        289,419        160,550     

 

(1) Adjusted for reclassification of a contract to a deposit liability.
(2) The difference between the reinsurance recoverable included above and that reflected in the reconciliation of losses and loss adjustment expenses in Note 7 to the consolidated financial statements relates to net deferred charges on retroactive reinsurance.
(3) Gross and net reserve for property and casualty losses includes, for the first time, Alterra E&S, which we acquired in April 2007.
(4) Gross and net reserve for property and casualty losses includes, for the first time, Alterra America, which we acquired in June 2008.
(5) Gross and net reserve for property and casualty losses includes, for the first time, Alterra Capital UK, which we acquired in November 2008.
(6) Gross and net reserve for property and casualty losses includes, for the first time, Harbor Point, which we acquired in May 2010.

 

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During 2011, our re-estimated balance sheet reserves for 2002 and each subsequent balance sheet decreased as a result of net favorable development on a large number of contracts from varied underwriting years and lines of business. The more significant development included:

 

   

Net favorable development for the insurance segment of $66.9 million of which $21.0 million was recognized on general casualty and $15.7 million on professional liability lines of business, primarily on the 2005 and 2006 years, and $30.2 million on the short tail property and aviation lines of business from the 2010 and 2009 years;

 

   

Net favorable development for the reinsurance segment of $80.6 million, excluding the development associated with changes in reinsurance premium estimates described below. We recorded net favorable development on long tail lines of business, including $11.6 million from workers’ compensation primarily on the 2001 year, $8.2 million on professional liability primarily on 2009 and prior years offset by unfavorable development of $7.9 million on medical malpractice primarily on 2010 and 2009 years. We recorded net favorable development on short tail lines of business, including $27.1 million on property primarily on 2010 and prior years and $11.2 million on aviation primarily on the 2008 and 2007 years;

 

   

Net favorable development for our Alterra at Lloyd’s segment of $17.3 million, principally recognized on the financial institutions and property lines of business;

 

   

Net unfavorable development for our U.S. specialty segment of $11.5 million, including $6.7 million and $4.2 million of net unfavorable development on the general casualty and property lines of business, respectively, relating to our contract binding business, the renewal rights for which we sold during the year;

 

   

Net unfavorable development of $14.3 million arising from increases in reinsurance premium estimates. Changes in premium estimates occur on prior year contracts each year as we receive additional information on the underlying exposures insured and the associated loss is recorded, at the original loss ratio, concurrently with the premium adjustment. The unfavorable development was partially offset by an increase in earned premium net of acquisition costs of $12.9 million; and

 

   

Net favorable development of $1.2 million arising from decreases in premium estimates in our insurance segment.

Our balance sheet reserves for 2002 and each subsequent balance sheet date through 2004 in the above tables shows the effects of the development on two specific contracts recorded in 2005. The development on these two contracts in the years subsequent to 2004 has not been significant. The first contract increased 2002 reserves by $50.2 million, with the recording of such increased losses triggering additional premiums and interest on additional premiums of $49.3 million, which are not reflected in the table above. The second contract increased 2002 reserves by $49.6 million, 2003 reserves by $64.8 million and 2004 reserves by $15.3 million, for a total increase of $129.7 million. The adverse development triggered additional premiums and interest on such additional premiums of $105.3 million, which are not reflected in the table above.

Changes in loss estimates principally arise from changes in underlying reported, incurred and paid claims data on contracts. Other assumptions used in our process, such as inflation, change infrequently in the reserving process and we do not perform a sensitivity analysis of changes in these assumptions. Given the variety of assumptions and judgments involved in establishing reserves for losses and benefits, we have not designed and maintained a system to capture and quantify the financial impact of changes in each of our underlying individual assumptions and judgments.

For additional information on our reserves, including a reconciliation of losses and loss adjustment expense reserves for the years ended December 31, 2011, 2010 and 2009, refer to Note 7 of our audited consolidated financial statements included herein.

Life and annuity benefit reserve process

Our life and annuity reinsurance benefit and claim reserves are compiled by our actuaries on a reinsurance contract-by-contract basis and are computed on a discounted basis using standard actuarial techniques and cash flow models. We establish and review our life and annuity reinsurance reserves regularly based upon cash flow projection models utilizing data provided by clients and actuarial models. We establish and maintain our life and annuity reinsurance reserves at a level that we estimate will, when taken together with future premium payments and investment income expected to be earned on associated premiums, be sufficient to support all future cash flow benefit obligations and third party servicing obligations as they become payable.

Since the development of our life and annuity reinsurance reserves is based upon cash flow projection models, we make estimates and assumptions based on cedant experience and industry mortality tables, longevity, expense and investment experience, including a provision for adverse deviation. The assumptions used to determine policy benefit reserves are best estimate assumptions that are determined at the inception of the contracts and are locked-in throughout the life of the reinsurance contract unless a premium

 

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deficiency develops. The assumptions are reviewed no less than annually and are un-locked if they result in a material reserve change. We establish these estimates based upon transaction specific historical experience, information provided by the ceding company and industry experience studies. Actual results could differ materially from these estimates. As the experience on the contracts emerges, the assumptions are reviewed by management. We determine whether actual and anticipated experience indicates that existing policy reserves, together with the present value of future gross premiums, are sufficient to cover the present value of future benefits, settlement and maintenance costs and to recover unamortized acquisition costs. If such a review produces reserves in excess of those currently held then the lock-in assumptions are revised and an additional life and annuity benefit reserve is recognized at that time.

There have been no material reserve adjustments to our life and annuity reinsurance benefit reserves during the years ended December 31, 2011, 2010 and 2009.

Because of the many assumptions and estimates used in establishing reserves and the long-term nature of reinsurance contracts, the reserving process, while based on actuarial science, is inherently uncertain.

Valuation of Investments

We invest in a trading portfolio of fixed maturities securities, an available for sale portfolio of fixed maturities securities and a held to maturity portfolio of fixed maturities securities. We record the trading and available for sale portfolios at fair value on our balance sheet. For our trading portfolio, the unrealized gain or loss associated with the difference between the fair value and the amortized cost of the investments is recorded in net income. For our available for sale portfolio, the unrealized gain or loss (absent credit losses) is recorded in accumulated other comprehensive income in the shareholders’ equity section of our consolidated balance sheet.

In an effort to match the expected cash flow requirements of our long term liabilities, we invest a portion of our fixed maturity investments in long duration securities. Because we intend to hold a number of these long duration securities to maturity, we classify those securities as held to maturity in our consolidated balance sheet and record these securities at amortized cost. As a result, we do not record changes in the fair value of this portfolio, which should reduce the impact on shareholders’ equity of fluctuations in fair value of those investments.

Our other investments comprise our investments in hedge funds, investments in structured deposits and various derivative instruments, all of which are recorded at fair value. Other investments also include private equity investments in which we have significant influence and are accounted for under the equity method.

We measure fair value in accordance with Accounting Standards Codification, or ASC, 820, Fair Value Measurements. The guidance dictates a framework for measuring fair value and a fair value hierarchy based on the quality of inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

Level 1—Quoted prices for identical instruments in active markets.

Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.

Level 3—Model derived valuations in which one or more significant inputs or significant value drivers are unobservable.

When the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 and 2) and unobservable (Level 3).

The use of valuation techniques may require a significant amount of judgment. During periods of market disruption, including periods of rapidly widening credit spreads or illiquidity, it may be difficult to value certain of our securities if trading becomes less frequent or market data becomes less observable.

Fixed Maturities

Fixed maturities are subject to fluctuations in fair value due to changes in interest rates, changes in issuer specific circumstances such as credit rating and changes in industry specific circumstances such as movements in credit spreads based on the market’s perception of industry risks. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolio is to tailor the maturities of the portfolio to the timing of expected loss and benefit payments. At maturity, absent any credit loss, fixed maturities’ amortized cost will equal their fair value and no realized gain

 

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or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell any available for sale investments before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period.

We perform regular reviews of our available for sale and held to maturity fixed maturities portfolios and utilize a process that considers numerous indicators in order to identify investments that are showing signs of potential other than temporary impairments. These indicators include the length of time and extent of the unrealized loss, any specific adverse conditions, historic and implied volatility of the security, failure of the issuer of the security to make scheduled interest payments, expected cash flow analysis, significant rating changes and recoveries or additional declines in fair value subsequent to the balance sheet date. The consideration of these indicators and the estimation of credit losses involve significant management judgment.

Any other-than-temporary impairment, or OTTI, related to a credit loss is recognized in earnings, and the amount of the OTTI related to other factors (e.g. interest rates, market conditions, etc.) is recorded as a component of other comprehensive income. If no credit loss exists but either we have the intent to sell the fixed maturity security or it is more likely than not that we will be required to sell the fixed maturity security before its anticipated recovery, then the entire unrealized loss is recognized in earnings. In periods after the recognition of an OTTI loss on fixed maturity securities, we account for such securities as if they had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the net impairment loss recognized in earnings.

We recognized other than temporary impairment charges through earnings of $2.9 million, $2.6 million and $3.1 during the years ended December 31, 2011, 2010 and 2009, respectively.

Fair value prices for all securities in our fixed maturities portfolio are independently provided by our investment custodians, investment accounting service provider and/or our investment managers, which each utilize internationally recognized independent pricing services. We record the unadjusted price provided by the investment custodian or the investment accounting service provider after an internal validation process. Our validation process includes, but is not limited to: (i) comparison of prices between two independent sources, with significant differences requiring additional price sources; (ii) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark with significant differences identified and investigated); (iii) evaluation of methodologies used by external parties to calculate fair value; and (iv) comparing the price to our knowledge of the current investment market.

The independent pricing services used by our investment custodians, investment accounting service provider and investment managers obtain actual transaction prices for securities that have quoted prices in active markets. Each pricing service has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing service uses observable market inputs, including reported trades, benchmark yields, broker/dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from market sources to determine a reasonable fair value. In addition, pricing services use valuation models, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage-backed and asset-backed securities. The ability to obtain quoted market prices is reduced in periods of decreasing liquidity, which generally increases the use of matrix pricing methods and generally increases the uncertainty surrounding the fair value estimates. This could result in the reclassification of a security between levels of the hierarchy.

Other Investments

Our hedge fund portfolio comprises a portfolio of limited partnership and stock investments in trading entities, or funds, which invest in a wide range of financial products. Investments in the funds are carried at fair value. The change in fair value is included in net realized and unrealized gains on investments and recognized in net income. The units of account that we fair value are our interests in the funds and not the underlying holdings of such funds. Thus, the inputs we use to value our investments in each of the funds may differ from the inputs used to value the underlying holdings of such funds. These funds are stated at fair value, which ordinarily will be the most recently reported net asset value as advised by the fund manager or administrator, where the fund’s underlying holdings can be in various quoted and unquoted investments. We believe the reported net asset value represents the fair value market participants would apply to an interest in the fund. The fund managers value their underlying investments at fair value in accordance with policies established by each fund, as described in each of their financial statements and offering memoranda. Based upon information provided by the fund managers, as of December 31, 2011, we estimate that over 72% of the underlying assets in the funds are publicly traded securities or have broker quotes available.

We have designed ongoing due diligence processes with respect to funds and their managers. These processes are designed to assist us in assessing the quality of information provided by, or on behalf of, each fund and in determining whether such information continues to be reliable or whether further review is necessary. Certain funds do not provide full transparency of their underlying holdings; however, we obtain the audited financial statements for every fund annually, and regularly review and discuss the fund performance with the fund managers to corroborate the reasonableness of the reported net asset values. While reported net asset value is the primary input to the review, when the net asset value is deemed not to be indicative of fair value, we may incorporate adjustments to the reported net asset value. Such adjustments may involve significant management judgment.

 

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As of December 31, 2011, certain of our funds had either imposed a gate on redemptions or segregated a portion of the underlying assets into a side-pocket (whereby the funds are assigned to a separate memorandum capital account or designated account). A gate refers to funds which provide for periodic redemptions, however, in accordance with the funds’ governing documents, a fund with a gate has the ability to deny or delay a redemption request. Based on the review process applied by management on such funds, a reduction of $2.5 million was made to the net asset value reported by one fund manager as of December 31, 2011 (2010—$3.2 million) to adjust the carrying value of the fund to our best estimate of fair value.

Additional information about the fair values of our hedge fund portfolio can be found in Note 4 to our audited consolidated financial statements included herein.

Our structured deposit has a fair value that is based on a publicly quoted index. Our derivatives holdings comprise convertible bond equity call options, interest rate linked derivative instruments, credit derivatives and foreign currency forward contracts. The fair value of the equity call options is determined using an Option Adjusted Spread model, the significant inputs for which include equity prices, interest rates and benchmark yields. The other derivative instruments trade in the over-the-counter derivative market, or are priced based on broker/dealer quotes or quoted market prices for similar securities. Fair values of our catastrophe bonds are based on dealer quotes and, if available, trade prices.

A review of fair value hierarchy classifications is conducted on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification for certain financial assets and liabilities. Reclassifications impacting Level 3 of the fair value hierarchy are reported as transfers in/out of the Level 3 category as of the beginning of the quarter in which the reclassifications occur.

Premium recognition

We follow ASC, 944 – Financial Services – Insurance in determining the accounting for our insurance and reinsurance products. Assessing whether or not the contracts we write meet the conditions for risk transfer requires judgment. The determination of risk transfer is based, in part, on the use of actuarial and pricing models and assumptions.

Insurance premium recognition

Our insurance premiums are recorded at the inception of each contract based upon contract terms. The amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is made to the minimum and/or deposit premium if there are changes in underlying exposures insured based on information received from our clients. Premiums are earned on a pro rata basis over the coverage period.

Reinsurance premium recognition

Our reinsurance premiums are recorded at the inception of each contract based upon contract terms and information received from ceding clients and brokers. For excess of loss contracts, the amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between this premium and final premium are generally small. An adjustment is made to the minimum and/or deposit premium, when notified, if there are changes in underlying exposures insured. For quota share or proportional reinsurance contracts, gross premiums written are normally estimated at inception based on information provided by cedants and/or brokers. We generally record such premiums using the client’s initial estimates, and then adjust them as more current information becomes available, with such adjustments recorded as premiums written in the period they are determined. We believe that the ceding clients’ estimate of the volume of business they expect to cede to us usually represents the best estimate of gross premium written at the beginning of the contract. As the contract progresses, we monitor actual premium received in conjunction with correspondence from the ceding client in order to refine our estimate. Variances from original premium estimates are normally greater for quota share contracts than excess of loss contracts. Premiums are earned on a pro rata basis over the coverage period. The pre-tax impact to net income may be mitigated by related acquisition costs and losses.

During the years ended December 31, 2011, 2010 and 2009, we wrote the following amounts of reinsurance premiums on a quota share or proportional basis and excess of loss basis:

 

In millions of U.S. Dollars

   2011      2010      2009  

Quota share/proportional

   $ 538.7      $ 256.1      $ 258.4  

Excess of loss

     534.1        385.0        313.3  
  

 

 

    

 

 

    

 

 

 

Total

   $ 1,072.8      $ 641.1      $ 571.7  

 

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The net adjustments to gross premiums written as a result of changes in premium estimates were an increase of $37.3 million, for the year ended December 31, 2011 and decreases of $24.8 million and $10.9 million, for the years ended December 31, 2010 and 2009, respectively. Such adjustments are generally the result of changing market conditions experienced by our clients.

Additional premiums

Certain reinsurance contracts that we write are retrospectively rated and we are entitled to additional premium should losses exceed pre-determined, contractual thresholds. These additional premiums are based upon contractual terms and management judgment is involved with respect to the estimated amount of losses that we expect to be ceded to us. Additional premiums are recognized at the time loss thresholds specified in the contract are exceeded and are earned over the remaining coverage period, or are earned immediately if the period of risk coverage has passed. Changes in estimates of losses recorded on contracts with additional premium features will result in changes in additional premiums based on contractual terms.

Additional premiums assumed and ceded, related net losses and the net impact on operating results for the years ended December 31, 2011, 2010 and 2009 are as follows:

 

In million of U.S. Dollars

   2011     2010     2009  

(Decrease) increase in gross premiums written

   $ (0.3   $ (6.0   $ 10.0  

Decrease (increase) in premiums ceded

     —          0.9       (1.5

Decrease in net losses

     7.4        10.8       —     
  

 

 

   

 

 

   

 

 

 

Increase in income before tax

   $ 7.1     $ 5.7     $ 8.5  

For each of the years ended December 31, 2011, 2010 and 2009, additional premiums relate to contracts where the coverage period had expired. Therefore, these additional premiums, representing revisions to our initial estimate of ultimate premiums as a result of changes in the estimate of loss reserves, were fully earned since the exposure period had ended. As of December 31, 2011, the majority of retrospectively rated contracts have been settled and, therefore, we expect such adjustments to have an immaterial impact on future periods.

Reinstatement premiums

Certain contracts we write, particularly property catastrophe reinsurance contracts, provide for reinstatements of coverage. Reinstatement premiums are the premiums for the restoration of the insurance or reinsurance limit of a contract to its full amount after a loss occurrence by the insured or reinsured. The purpose of optional and required reinstatements is to permit the insured / reinsured to reinstate the insurance coverage at a pre-determined price level once a loss event has penetrated the insured layer. In addition, required reinstatement premiums permit the insurer / reinsurer to obtain additional premiums to cover the additional loss limits provided.

We accrue for reinstatement premiums resulting from losses recorded. Such accruals are based upon contractual terms and the only element of management judgment involved is with respect to the amount of losses recorded. Changes in estimates of losses recorded on contracts with reinstatement premium features will result in changes in reinstatement premiums based on contractual terms. Reinstatement premiums are recognized at the time we record losses and are earned on a pro-rata basis over the coverage period. Reinstatement premiums assumed and ceded for the year ended December 31, 2011 were $36.9 million and $6.3 million, respectively. Reinstatement premiums assumed and ceded were not material for the years ended December 31, 2010 and 2009.

Premiums receivable

For quota share, or proportional, contracts, we are entitled to receive premium as the ceding client collects the premium under contractual reporting and payment terms, which are usually quarterly. Premiums are usually collected over a two year period on our quota share or proportional contracts. For excess of loss contracts, premium is generally paid in contractually stipulated installments with payment terms ranging from payment at the inception of the contract to four quarterly payments. As a result of recognizing the estimated gross premium written at the inception of the policy and collecting that premium over an extended period, we include a premium receivable asset on our balance sheet. We actively monitor our premium receivable asset to consider whether we need an allowance for doubtful accounts. As part of this process, we consider the credit quality of our cedants and monitor premium receipts versus expectations. We also seek to include a right of offset in the contract terms. Since commencing our operations, premiums receivable written off have not been material and, currently, no material premiums receivable are significantly beyond their due dates or in dispute.

 

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Results of Operations

We monitor the performance of our underwriting operations in five segments:

 

   

Insurance—We offer property and casualty excess of loss insurance from our offices in Bermuda, Dublin and the United States primarily to Fortune 1000 companies. Principal lines of business are aviation, excess liability, professional lines and property.

 

   

Reinsurance—We offer property and casualty quota share and excess of loss reinsurance from our Bermuda, Bogota, Buenos Aires, Dublin, London and United States offices to insurance companies worldwide. Principal lines of business are agriculture, auto, aviation, credit/surety, general casualty, marine & energy, medical malpractice, professional liability, property, whole account and workers’ compensation.

 

   

U.S. specialty—We offer property and casualty insurance coverage from offices in the United States primarily to small- to medium- sized companies. Principal lines of business are general liability, marine, professional liability and property.

 

   

Alterra at Lloyd’s—We offer property and casualty quota share and excess of loss insurance and reinsurance from our London, Dublin and Zurich offices, primarily to medium- to large- sized international clients. We also provide reinsurance to clients in Latin America, operating locally in Rio de Janeiro, using Lloyd’s admitted status. This segment comprises our proportionate share of the underwriting results of the Syndicates, and the results of our managing agent, Alterra at Lloyd’s. The Syndicates underwrite a diverse portfolio of specialty risks, including accident & health, aviation, financial institutions, international casualty, marine, professional liability, property and surety.

 

   

Life and annuity reinsurance—We previously offered reinsurance products focusing on blocks of life and annuity business, which took the form of co-insurance transactions whereby the risks are reinsured on the same basis as the original policies. We have decided not to write any new life and annuity contracts for the foreseeable future.

We also have a corporate function that includes our investment and financing activities and all other items not allocated to the segments, including interest expense and corporate general and administrative expenses.

We manage our invested assets on an aggregated basis, and do not allocate investment income and realized and unrealized gains on investments to the property and casualty segments. Because of the longer duration of liabilities on life and annuity reinsurance business, investment returns are important in evaluating the profitability of this segment; accordingly, we allocate investment returns from the consolidated portfolio to this segment. The allocation is based on a notional allocation of invested assets from the consolidated portfolio using durations that are determined based on estimated cash flows for the life segment. The balance of investment returns from this consolidated portfolio is allocated to the corporate function for the purposes of segment reporting.

We monitor the performance of all of our segments other than life and annuity reinsurance on the basis of underwriting income, loss ratio, acquisition ratio, general and administrative expense ratio and combined ratio. We monitor the performance of our life and annuity reinsurance business on the basis of income before taxes for the segment, which includes revenue from net premiums earned, allocated net investment income and realized and unrealized gains on investments, and expenses from claims and policy benefits, acquisition costs and general and administrative expenses.

Effective January 1, 2011, we redefined two of our operating and reporting segments based on changes to our internal reporting structure. Insurance business written by Alterra Insurance USA, which was previously reported within the U.S. specialty segment, has been reclassified to the insurance segment. Alterra Insurance USA is a managing general underwriter for Alterra E&S and Alterra America, as well as various third party insurance companies, and is our principal insurance underwriting platform for retail distribution in the United States. Segment disclosures for comparative periods have been revised to reflect this reclassification.

Net investment income and net realized and unrealized gains (losses) on investments are discussed within the investing activities section of this report and not within the segment sections of this report. See “Investing Activities.”

 

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Consolidated Results of Operations - For the years ended December 31, 2011, 2010 and 2009

The following is a discussion and analysis of our consolidated results of operations for the years ended December 31, 2011, 2010 and 2009, which are summarized below:

 

     2011     % change     2010     % change     2009  
     (In millions of U.S. Dollars)  

Gross premiums written

   $ 1,904.1       35.0   $ 1,410.7       2.6   $ 1,375.0  

Reinsurance premiums ceded

     (472.1     27.2     (371.1     (22.8 )%      (480.5
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums written

   $ 1,432.0       37.7   $ 1,039.6       16.2   $ 894.5  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums earned

   $ 1,425.0       21.5   $ 1,172.5       40.5   $ 834.4  

Net investment income

     234.8       5.6     222.4       31.1     169.7  

Net realized and unrealized (losses) gains on investments

     (38.3     (326.6 )%      16.9       (79.3 )%      81.8  

Net impairment losses recognized in earnings

     (2.9     11.5     (2.6     (16.1 )%      (3.1

Other income

     5.3       10.4     4.8       60.0     3.0  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     1,623.9       14.8     1,414.0       30.2     1,085.8  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net losses and loss expenses

     945.6       44.4     654.8       32.7     493.6  

Claims and policy benefits

     59.4       (8.9 )%      65.2       (35.5 )%      101.1  

Acquisition costs

     261.1       39.3     187.5       93.5     96.9  

Interest expense

     43.7       54.4     28.3       32.9     21.3  

Net foreign exchange losses (gains)

     1.3       N/A        (0.1     (98.3 )%      (5.8

Merger and acquisition expenses

     —          (100.0 )%      (48.8     54.9     (31.5

General and administrative expenses

     257.0       16.5     220.6       43.2     154.0  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total losses and expenses

     1,568.1       41.6     1,107.5       33.5     829.6  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before taxes

     55.8       (81.8 )%      306.5       19.6     256.2  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income tax (benefit) expense

     (9.5     (326.2 )%      4.2       (58.0 )%      10.0  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 65.3       (78.4 )%    $ 302.3       22.8   $ 246.2  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss ratio (a)

     66.5       56.1       62.4

Acquisition cost ratio (b)

     18.3       16.0       12.1

General and administrative expense ratio (c)

     13.4       13.6       13.6

Combined ratio (d)

     98.2       85.7       88.1

 

(a) The loss ratio is calculated by dividing net losses and loss expenses by net premiums earned for the property and casualty business.
(b) The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned for the property and casualty business.
(c) The general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned for the property and casualty business.
(d) The combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned for the property and casualty business.

Premiums. Gross premiums written for the year ended December 31, 2011 increased by 35.0% compared to the prior year. The principal reason for the increase was the additional reinsurance premiums written as a result of the Amalgamation, which were not included in the comparative period prior to May 12, 2010. In addition, favorable market conditions in the property and auto lines of business in the reinsurance segment resulted in increased premiums written in these lines. We also continued to expand our product offerings in Alterra at Lloyd’s and our operations in Latin America generated increased levels of premiums written in the year ended December 31, 2011. Our insurance and U.S specialty segments also had modest growth in premiums written during the year primarily due to pricing increases and new business in certain lines of business as well as increased product offerings.

The growth in gross premiums written for the year ended December 31, 2011 was primarily in short-tail lines of business resulting in a change in mix of gross premiums written from 50.7% short-tail lines and 49.3% long-tail lines for the year ended December 31, 2010 to 56.4% short-tail lines and 43.6% long-tail lines.

Gross premiums written for the year ended December 31, 2010 increased by 2.6% compared to the prior year. Our reinsurance segment was impacted in 2010 by the addition of premiums written by the former Harbor Point companies. Gross premiums written also increased in our U.S. specialty and Alterra at Lloyd’s segments as a result of our new product offerings, the addition of new underwriting teams, and our expansion into Latin America. These increases, and those resulting from the Amalgamation, were principally offset by decreases in the level of premiums written in our insurance, reinsurance (excluding Harbor Point) and life and

 

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annuity reinsurance segments. The lower premium volume in our insurance and reinsurance segments reflect expected reductions across several lines of business due to competitive market conditions, resulting in reduced writings because pricing did not meet our risk/return thresholds.

The decrease in our life and annuity segment was principally due to no new contracts being written in this segment during the years ended December 31, 2011 and 2010, compared to one contract written in the year ended December 31, 2009. We made the decision in 2010 not to write any new life and annuity contracts for the foreseeable future.

A discussion of pro forma reinsurance segment results including Harbor Point in the 2010 and 2009 comparative figures is in the section entitled Reinsurance Segment on a pro forma basis. On a pro forma basis, gross premiums written and net premiums earned for the years ended December 31, 2010 and 2009 would have been as follows:

 

     2011      % change     2010 (1)      % change     2009 (1)  
     (In millions of U.S. Dollars)  

Gross premiums written

   $ 1,904.1        6.1   $ 1,794.1        (7.8 )%    $ 1,946.4  

Net premiums earned

   $ 1,425.0        2.4   $ 1,391.4        0.6   $ 1,382.8  

 

(1) The above pro forma financial information for the years ended December 31, 2010 and 2009 is provided for informational purposes only and presents a summary of the combined gross premiums written and net premiums earned of the Company and the former Harbor Point companies assuming the Amalgamation occurred on January 1, 2010 and January 1, 2009, respectively.

On a pro forma comparative basis, gross premiums written for the year ended December 31, 2011 would have increased by 6.1%. The increase would have been principally due to growth in our Alterra at Lloyd’s segment resulting from expansion of our platform, partially offset by decreases in several lines of business in our reinsurance segment due to challenging market conditions and increased competition.

On a pro forma basis, the gross premiums written for the year ended December 31, 2010 would have decreased by 7.8%. This decrease would have principally been driven by lower premium volumes in our insurance and reinsurance segments, along with a decrease in our life and annuity reinsurance segment.

The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 24.8% compared to 26.3% for the year ended December 31, 2010. The decrease in the percentage of reinsurance premiums ceded compared to the prior year was principally due to the Amalgamation and the reduction in the amount of business ceded by our reinsurance segment. This was partially offset due to the 100% retrocession of the business written through our contracted general agent distribution channel (our “contract binding” business) in our U.S. specialty segment starting from August 1, 2011 (see section entitled U.S. Specialty), along with the impact of additional ceded reinstatement premiums in our Alterra at Lloyd’s segment. We continually monitor our need for reinsurance based on aggregate risk exposures.

The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2010 was 26.3% compared to 34.9% for the year ended December 31, 2009. The decrease was principally due to the inclusion of the former Harbor Point business from May 12, 2010 at a lower ratio of ceded to written premiums, and the cancellation of a significant property quota share treaty in our U.S. specialty segment. The cancellation of the property quota share treaty in our U.S. specialty segment reduced reinsurance premiums ceded by $20.6 million.

Net premiums earned is a function of the earning of gross premiums written and reinsurance premiums ceded over the last several quarters and, therefore, changes in net premiums earned generally lag quarterly increases and decreases in gross premiums written and reinsurance premiums ceded. As a result, net premiums earned tend to be less volatile than gross premiums written and reinsurance premiums ceded. The increase in net premiums earned for the year ended December 31, 2011 compared to the prior year was principally due to the incremental earnings as a result of the Amalgamation. In addition, organic growth in our Alterra at Lloyd’s segment contributed to the increase in net premiums earned. The increase in net premiums earned for the year ended December 31, 2010 compared to the year ended December 31, 2009 was principally due to the incremental earnings as a result of the Amalgamation.

Net investment income. Net investment income for the year ended December 31, 2011 increased by 5.6% compared to the prior year. The increase in net investment income was principally attributable to the increase in cash and invested assets as a result of the Amalgamation, with some additional benefit from shifting cash into higher yielding fixed maturity securities. Our average investment yield was 3.09% for the year ended December 31, 2011 compared to 3.39% and 3.56% for the years ended December 31, 2010 and 2009, respectively. The yields available in the current fixed maturity market generally are lower than the average yield on our existing portfolio. Due to the anticipated continuing low-yield market environment, we expect continued downwards pressure on our investment yield.

 

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Net realized and unrealized gains (losses) on investments. Net realized and unrealized gains and losses on investments may vary significantly from period to period. For the year ended December 31, 2011, the principal component of the net loss was a $25.0 million loss on a catastrophe bond with exposure to the Japan earthquake and tsunami, compared to an increase in fair value of catastrophe bonds of $0.4 million in the prior year period. The year ended December 31, 2011 also included a decrease in fair value of our hedge funds of $11.8 million compared to an increase of $14.3 million in the prior year period, and a decrease in fair value of derivatives of $13.6 million compared to a decrease of $12.0 million in the prior year period.

The principal components of the decrease in net realized and unrealized gains and losses on investments from the 2009 year to the 2010 year were hedge fund and derivative returns. The increase in fair value of hedge funds for the year ended December 31, 2010 was $14.3 million compared to an increase of $75.8 million for the year ended December 31, 2009. Also contributing to the decrease year-over-year was a $10.4 million loss on an interest rate forward transaction entered into in the second quarter of 2010 in contemplation of a possible long term debt issuance.

Other income. During the year ended December 31, 2011, Alterra E&S sold the renewal rights to our contract binding business. We recognized a net gain on sale of $0.8 million, which included the derecognition of goodwill of $1.0 million. Commencing August 1, 2011, until the earlier of the date the purchaser or Alterra E&S elects and February 1, 2013, the contract binding business will be written by Alterra E&S and we will cede 100% of the premiums and losses to the purchaser. Under the terms of the sale, we are entitled to additional contingent consideration should gross premiums written by the contract binding business exceed a specified threshold while the quota share reinsurance agreement is still in effect. Also included in other income in the year ended December 31, 2011 are fees earned for the management of New Point Re IV.

Net losses and loss expenses. The loss ratio increased by 10.4 percentage points for the year ended December 31, 2011 compared to the year ended December 31, 2010. Significant items impacting the 2011 loss ratio were:

 

   

Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, for the year ended December 31, 2011 of $153.3 million compared to $105.5 million for the year ended December 31, 2010;

 

   

Net favorable loss development for the year ended December 31, 2011 was principally the result of net favorable development in our property, workers compensation, general casualty, professional liability, aviation and whole account lines of business, partially offset by net unfavorable development in the medical malpractice line of business in our reinsurance segment and in the general liability line in our U.S. specialty segment. The unfavorable reserve development in our U.S. specialty segment principally related to the contract binding business, for which we sold the renewal rights for all renewals after August 1, 2011;

 

   

Excluding the net favorable loss development, the loss ratio was 77.3% for the year ended December 31, 2011 compared to 65.1% for the year ended December 31, 2010. The increase in the loss ratio for the year ended December 31, 2011 compared to the prior year was principally due to the increase in significant property catastrophe losses in 2011; and

 

   

For the year ended December 31, 2011, our results included incurred losses net of reinsurance of $269.5 million compared to $54.9 million related to significant property catastrophe events and significant per-risk losses. The significant property catastrophe event net losses for the year ended December 31, 2011 included losses resulting from the Australia floods, Cyclone Yasi, the New Zealand earthquake, the Japan earthquake and tsunami, tornadoes and flooding in the United States, Hurricane Irene and the Thailand floods. For the year ended December 31, 2010, our results included net losses of $54.9 million for property catastrophe events, including losses resulting from the Chile earthquake, Europe Windstorm Xynthia and Australia hailstorms.

The loss ratio decreased by 6.3 percentage points for the year ended December 31, 2010 compared to the year ended December 31, 2009. Significant items impacting the 2010 loss ratio were:

 

   

Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, for the year ended December 31, 2010 of $105.5 million compared to $78.3 million for the year ended December 31, 2009;

 

   

Net favorable loss development for the year ended December 31, 2010 was principally the result of net favorable development in our workers’ compensation, property, general casualty, professional liability and whole account lines of business, partially offset by net unfavorable development on marine & energy lines, compared to net favorable development on professional liability, property and general casualty lines offset by net unfavorable development on marine & energy lines in the year ended December 31, 2009;

 

   

Excluding the net favorable loss development, the loss ratio was 65.1% for the year ended December 31, 2010 compared to 72.3% for the year ended December 31, 2009. The decrease in the loss ratio for the year ended December 31, 2010 compared to the prior year was principally due to the inclusion of net premiums earned from Harbor Point since May 12, 2010 at a significantly lower loss ratio, which reduced the average loss ratio despite the increase in property catastrophe losses discussed below. The loss ratio for the year ended December 31, 2010 on the net premiums earned related to the Harbor Point portfolio of contracts did not include any significant property catastrophe losses, other than from the New Zealand earthquake, as most of the significant property catastrophe loss events occurred prior to the Amalgamation;

 

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The loss ratio for the year ended December 31, 2010 benefitted from the $14.4 million amortization of the fair value adjustment made to the acquired Harbor Point net loss reserves at the date of the Amalgamation. This fair value adjustment is being amortized over a weighted average period of 4.0 years; and

 

   

The decrease in loss ratio described above was partially offset by an increase in net losses related to property catastrophe events and significant per-risk losses. For the year ended December 31, 2010, our results included net losses of $54.9 million related to property catastrophe events and significant per-risk losses. For the year ended December 31, 2009, our results included net losses of $8.9 million for such events.

Our loss estimates for the property catastrophe losses are based on proprietary modeling analyses, industry assessments of exposure, claims information obtained from our clients and brokers to date, and a review of in-force contracts. Our actual losses from these events may vary materially from the estimates due to the inherent uncertainties in making such determinations resulting from several factors, including the preliminary nature of available information, the potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques employed and the application of such techniques, the contingent nature of business interruption exposures, the effects of any resultant demand surge on claims activity, and the attendant coverage issues.

Claims and policy benefits. We did not write any new life and annuity reinsurance contracts in the years ended December 31, 2011 and 2010. We wrote one new life and annuity reinsurance contract in the year ended December 31, 2009. We do not intend to write any new life and annuity reinsurance contracts in our life and annuity reinsurance segment in the foreseeable future.

Acquisition costs. Our acquisition cost ratio for the year ended December 31, 2011 increased by 2.3 percentage points compared to the prior year. The increase in the acquisition cost ratio was principally due to changes in the mix of business written. The insurance and reinsurance contracts we write have a wide range of acquisition cost ratios. Our relative mix of insurance and reinsurance business has moved towards more reinsurance, with 66.9% of net premiums earned being from reinsurance business for the year ended December 31, 2011 compared to 60.4% for the year ended December 31, 2010. This resulted in an increase in the acquisition cost ratio as reinsurance business tends to have higher acquisition costs compared to insurance. A decrease in the level of reinsurance purchased across our segments also contributed to the increase in the ratio for the year ended December 31, 2011. As we retain more business in our segments, we receive less ceding commission income to offset our brokerage and commission costs, which increases our acquisition cost ratio.

Our acquisition cost ratio for the year ended December 31, 2010 increased by 3.9 percentage points compared to the year ended December 31, 2009. The increase in the acquisition cost ratio was principally due to changes in the mix of business written, partially influenced by the additional net premiums earned from the former Harbor Point companies. The Harbor Point portfolio of contracts contained a higher proportion of quota share contracts, which generally carry higher acquisition cost ratios than excess of loss contracts. A decrease in the level of reinsurance purchased across all of our segments, but in particular our U.S. specialty segment, also contributed to the increase in the ratio for the year ended December 31, 2010.

Interest expense. Interest expense includes interest on funds withheld from reinsurers, interest on our senior notes outstanding and accretion of deposit liability contracts. Interest expense for the year ended December 31, 2011 increased by $15.4 million compared to the year ended December 31, 2010, and increased by $7.0 million for the year ended December 31, 2010 compared to the year ended December 31, 2009. The increase in both periods was principally a result of the issuance of senior notes in September of 2010. In addition, an adjustment to the deposit liability on a certain contract based on new information received resulted in an increase in interest expense in 2011. For the year ended December 31, 2010, an increase in funds withheld interest for one of our largest reinsurers contributed to the increase over the year ended December 31, 2009.

Merger and acquisition expenses. Merger and acquisition expenses for the year ended December 31, 2010 comprised advisory, legal and other professional fees, the acceleration of stock based compensation expense and other merger related expenses related to the Amalgamation. These expenses were offset by the negative goodwill gain of $95.8 million recognized from the Amalgamation. Merger and acquisition expenses for the year ended December 31, 2009 comprised advisory, legal and other professional fees related to the proposed transaction with IPC Holdings Limited and IPC Limited, which was terminated in June 2009, offset by a $50.0 million termination fee received.

General and administrative expenses. General and administrative expenses for the year ended December 31, 2011 increased by $36.4 million compared to the year ended December 31, 2010. The increase was principally due to the increased size of the Company following the Amalgamation. The year ended December 31, 2011 was the first full fiscal year of post-Amalgamation level expenses. Expansion of our underwriting teams, growth in Latin America and regulatory changes in Europe also contributed to the increase in general and administrative expenses in the period. These increases were partially offset by decreases in incentive based compensation. The increase in net earned premiums resulted in a small decrease in our general and administrative expense ratio for the year ended December 31, 2011 compared to the year ended December 31, 2010.

 

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General and administrative expenses for the year ended December 31, 2010 increased by $66.6 million compared to the year ended December 31, 2009. The increase was principally related to the additional general and administrative expenses of the former Harbor Point companies. In addition, there was an increase in performance based compensation expense as a result of a larger cash component of the 2010 performance based compensation than in 2009. However, the corresponding increase in net earned premiums as a result of the Amalgamation resulted in no change in our general and administrative expense ratio for the year ended December 31, 2010 compared to the year ended December 31, 2009.

Income tax expense (benefit). Corporate income tax expense or benefit is generated through our foreign operations outside of Bermuda, principally in the United States, Europe and Latin America. The effective tax rate was negative 17.0% for the year ended December 31, 2011 compared with 1.4% in the year ended December 31, 2010 and 3.9% in the year ended December 31, 2009. Our effective income tax rate, which we calculate as income tax expense or benefit divided by net income or loss before taxes, may fluctuate significantly from period to period depending on the geographic distribution of pre-tax net income or loss in any given period between different jurisdictions with different tax rates. The geographic distribution of pre-tax net income or loss can vary significantly between periods principally due to the mix of business written and earned during the period, the geographic location of investment income and realized and unrealized investment gains and losses and the geographic location of net losses and loss expenses incurred.

Our effective tax rate changed significantly for the year ended December 31, 2011 due principally to two factors. Our results for the year ended December 31, 2011 contained a significant amount of property catastrophe losses and the distribution of these losses was heavily weighted towards jurisdictions with a higher tax rate. Further contributing to the change in effective tax rate was the release of a valuation allowance related to deferred tax assets in our U.S. subsidiaries, which had the effect of increasing the tax benefit for the year.

The Company’s income before taxes, income tax expense (benefit) and effective income tax rate for the years ended December 31, 2011, 2010 and 2009 were:

 

(In millions of U.S. Dollars)

   2011     2010     2009  

Income before taxes

   $ 55.8      $ 306.5      $ 256.2  

Income tax (benefit) expense

   $ (9.5   $ 4.2      $ 10.0  

Effective income tax rate

     (17.0 )%      1.4     3.9

Insurance Segment

 

     December 31, 2011     % change     December 31, 2010     % change     December 31, 2009  
     (Expressed in millions of U.S. Dollars)  

Gross premiums written

   $ 410.3       2.7   $ 399.6       (10.7 )%    $ 447.3  

Reinsurance premiums ceded

     (200.1     10.7     (180.7     (17.3 )%      (218.6
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums written

   $ 210.2       (4.0 )%    $ 218.9       (4.3 )%    $ 228.7  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums earned

   $ 210.8       (10.2 )%    $ 234.7       7.9   $ 217.5  

Net losses and loss expenses

     (105.8     (24.5 )%      (140.1     (0.2 )%      (140.4

Acquisition costs

     (0.4     (89.2 )%      (3.7     N/A        1.2  

General and administrative expenses

     (37.7     9.3     (34.5     23.7     (27.9

Other income

     1.0       (23.1 )%      1.3       (18.8 )%      1.6  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Underwriting income

   $ 67.9       17.7   $ 57.7       11.0   $ 52.0  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
          

Loss ratio (a)

     50.2       59.7       64.6

Acquisition cost ratio (b)

     0.2       1.6       (0.6 )% 

General and administrative expense ratio (c)

     17.9       14.7       12.8

Combined ratio (d)

     68.2       76.0       76.9

 

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(a) The loss ratio is calculated by dividing net losses and loss expenses by net premiums earned.
(b) The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned.
(c) The general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned.
(d) The combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned.

 

     2011      % of
Premium
Written
    % Ceded     2010      % of
Premium
Written
    % Ceded     2009      % of
Premium
Written
    % Ceded  
     (Expressed in millions of U.S. Dollars)  

Gross Premiums Written by Type of Risk:

                     

Aviation

   $ 32.4        7.9      31.3    $ 39.9        10.0      50.0    $ 69.8        15.6      48.3 

Excess liability

     116.6        28.4      47.0      113.6        28.4      44.9      133.3        29.8      49.2 

Professional liability

     184.4        45.0      51.6      183.0        45.8      47.4      179.9        40.2      51.3 

Property

     76.9        18.7      52.1      63.1        15.8      36.5      64.3        14.4      42.0 
  

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

   
   $ 410.3        100.0      48.8    $ 399.6        100.0      45.2    $ 447.3        100.0      48.9 
  

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

   

Short tail lines (a)

   $ 109.3        26.6      $ 103.0        25.8      $ 134.1        30.0   

Long tail lines (b)

     301.0        73.4        296.6        74.2        313.2        70.0   
  

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

   
   $ 410.3        100.0      $ 399.6        100.0      $ 447.3        100.0   
  

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

   

 

(a) Short tail includes aviation and property lines of business.
(b) Long tail includes excess liability and professional liability lines of business.

Premiums. Gross premiums written for the year ended December 31, 2011 increased by 2.7% compared to the prior year. Significant factors affecting 2011 gross premiums written were:

 

   

An increase in property gross premiums written, principally due to improved pricing conditions; and

 

   

Competitive pricing conditions in professional liability, excess liability and aviation resulted in flat or decreased levels of business written. Our objective is to continue to be selective in our renewals and new business writings, focusing on business that we believe meet our rate of return requirements.

Gross premiums written decreased in the year ended December 31, 2010 by 10.7% compared to the year ended December 31, 2009. Significant factors affecting 2010 gross premiums written were:

 

   

A decrease in gross premiums written in the aviation line for the year ended December 31, 2010. This decrease was partially offset by an increase in aviation business written in our Alterra at Lloyd’s segment as many of the policies previously written in our insurance segment were renewed by Alterra at Lloyd’s; and

 

   

A decrease in gross premiums written in our excess liability line for the year ended December 31, 2010 due to fewer attractive opportunities.

The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2011 was 48.8%, compared to 45.2% and 48.9%, respectively, in the years ended December 31, 2010 and December 31, 2009. The amount of reinsurance that we purchase can vary significantly by line of business. The increase in the percentage of reinsurance premiums ceded is principally due to changes in the mix of business and an increase in the percentage of quota share reinsurance purchased on our property line of business to manage our aggregate exposures. A contributing factor to the decrease in 2010 was the reduction in property reinsurance premiums ceded to Harbor Point, which became fully eliminated intercompany transactions after the Amalgamation. We replaced those reinsurance premiums ceded with third parties over the course of the normal renewal periods.

Net premiums earned is a function of the earning of gross premiums written and reinsurance premiums ceded over the last several quarters and, therefore, changes in net premiums earned generally lag quarterly increases and decreases in gross premiums written and reinsurance premiums ceded. As a result, net premiums earned tend to be less volatile than gross premiums written and reinsurance premiums ceded.

 

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Net losses and loss expenses. The loss ratio for the year ended December 31, 2011 decreased by 9.5 percentage points compared to the year ended December 31, 2010. The net favorable and (unfavorable) development of prior year reserves in the years ended December 31, 2011, 2010 and 2009 by line of business was as follows:

 

     2011      2010     2009  
     (In millions of U.S. Dollars)  

Aviation

   $ 8.9      $ 8.3     $ 7.7  

Excess liability

     21.0        8.3       7.0  

Professional liability

     15.7        22.1       21.0  

Property

     21.3        6.5       5.6  
  

 

 

    

 

 

   

 

 

 
     66.9        45.2       41.3  

Loss development resulting from premium adjustments

     1.2        (2.8     (2.4
  

 

 

    

 

 

   

 

 

 
   $ 68.1      $ 42.4     $ 38.9  
  

 

 

    

 

 

   

 

 

 

Significant items impacting the 2011 loss ratio were:

 

   

Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, in the year ended December 31, 2011 of $66.9 million compared to $45.2 million in the year ended December 31, 2010;

 

   

Net favorable loss development in the year ended December 31, 2011 reflected better than expected loss emergence across all lines of business, most significantly in the property, excess liability and professional liability lines. Favorable loss development principally emerged on the 2009 and 2010 years for the property line of business and on the 2005 and 2006 years for excess liability and professional liability lines of business;

 

   

Excluding the net favorable loss development, the loss ratio was 81.9% for the year ended December 31, 2011 compared to 79.0% for the year ended December 31, 2010. The increase was principally due to higher losses related to property catastrophe and significant per-risk losses during the year ended December 31, 2011 compared to the year ended December 31, 2010; and

 

   

For the year ended December 31, 2011, our results included net losses of $15.4 million related to property catastrophe events and significant per-risk losses compared to $12.1 million for the year ended December 31, 2010. A portion of these losses fall within our attritional loss ratio, as we expect a certain level of property losses in each period. Large events during the year ended December 31, 2011 included losses resulting from the Australia floods, Cyclone Yasi, the New Zealand earthquake, the Japan earthquake and tsunami, tornadoes and flooding in the United States and Hurricane Irene.

The loss ratio for the year ended December 31, 2010 decreased by 4.9 percentage points compared to the year ended December 31, 2009. Significant items impacting the 2010 loss ratio were:

 

   

Net favorable loss development of prior year reserves, excluding the effect of premium adjustments, in the year ended December 31, 2010 of $45.2 million compared to $41.3 million in the year ended December 31, 2009;

 

   

Net favorable loss development in the year ended December 31, 2010 reflected better than expected loss emergence across all lines of business, most significantly in the professional liability line. Favorable loss development principally emerged on the 2009 year for aviation, 2004 year for excess liability, 2004, 2005 and 2006 years for professional liability, and on the 2008 and 2009 years for the property line of business;

 

   

Excluding the net favorable loss development, the loss ratio was 79.0% for the year ended December 31, 2010 compared to 83.6% for the year ended December 31, 2009. The decrease was principally due to better current year loss experience in our aviation line of business during the year ended December 31, 2010; and

 

   

For the year ended December 31, 2010, our results included net losses of $12.1 million related to property catastrophe events and significant per-risk losses. Large events during the year ended December 31, 2010 included the Chile earthquake and flooding in Australia. These losses were contained within our annual loss expectations for the property line of business. There were no significant property catastrophe events and significant per-risk losses occurring in the year ended December 31, 2009.

Changes in premium estimates for contracts that incepted before 2011 resulted in a decrease in prior year loss reserves of $1.2 million in 2011 and an increase in prior year loss reserves of $2.8 million in 2010 and $2.4 million in 2009.

Acquisition costs. Acquisition costs are presented net of ceding commission income associated with reinsurance premiums ceded. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers. Acquisition costs generally fluctuate based on shifts in business mix year over year.

General and administrative expenses. General and administrative expenses for the year ended December 31, 2011 increased $3.2 million compared to the year ended December 31, 2010. The increase was principally due to increased headcount and expenses associated with expanding our underwriting infrastructure within Alterra Insurance USA. These increases, together with the decrease in net premiums earned, resulted in a higher general and administrative expense ratio for the year ended December 31, 2011 compared to the prior year.

 

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General and administrative expenses for the year ended December 31, 2010 increased $6.6 million compared to the year ended December 31, 2009. The increase was principally due to increased performance based compensation expense resulting from improved underwriting results compared to the prior year, and a shift to a larger cash component and fewer stock-based awards.

Reinsurance Segment

The underwriting results of the former Harbor Point companies have been included within the reinsurance segment for the period from May 12, 2010. As a result, a comparison of 2011 results with 2010 and 2009 results is not meaningful. For this reason, we have included certain financial information for the reinsurance segment on a combined pro forma basis for informational purposes only as if the Amalgamation had occurred on January 1, 2009. See the section entitled Reinsurance Segment on a pro forma basis for a presentation of the combined pro forma information.

 

     2011     % change     2010     % change     2009  
     (Expressed in millions of U.S. Dollars)  

Gross premiums written

   $ 869.7       70.9   $ 509.0       4.1   $ 489.0  

Reinsurance premiums ceded

     (83.1     29.6     (64.1     (19.9 )%      (80.0
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums written

   $ 786.6       76.8   $ 444.9       8.8   $ 409.0  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net premiums earned

   $ 824.0       31.3   $ 627.6       61.8   $ 387.9  

Net losses and loss expenses

     (528.0     51.8     (347.8     36.7     (254.5

Acquisition costs

     (182.3     39.1     (131.1     84.4     (71.1

General and administrative expenses

     (79.3     20.2     (66.0     107.5     (31.8

Other income

     1.2       N/A        —          N/A        —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Underwriting income (loss)

     35.6       (57.0 )%      82.7       171.1     30.5  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss ratio (a)

     64.1       55.4       65.6

Acquisition cost ratio (b)

     22.1       20.9       18.3

General and administrative expense ratio (c)

     9.6       10.5       8.2

Combined ratio (d)

     95.8       86.8       92.1

 

(a) The loss ratio is calculated by dividing net losses and loss expenses by net premiums earned.
(b) The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned.
(c) The general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned.
(d) The combined ratio is calculated by dividing the sum of net losses and loss expenses, acquisition costs and general and administrative expenses by net premiums earned.

 

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Table of Contents
      2011      % of
Premium
written
    % Ceded     2010      % of
Premium
written
    % Ceded     2009      % of
Premium
written
    % Ceded  
            (Expressed in millions of U.S Dollars)                                  

Gross Premiums Written by Type of Risk:

                     

Agriculture

   $ 30.7        3.5     0.4   $ 29.2        5.7     2.4   $ 89.6        18.3     2.5

Auto

     99.8        11.5     —       32.9        6.5     —       —           —       —  

Aviation

     16.0        1.8     18.6     31.3        6.1     6.7     34.7        7.1     13.5

Credit/surety

     34.9        4.0     —       2.2        0.4     —       —           —       —  

General casualty

     73.8        8.5     1.9     48.4        9.5     1.0     29.2        6.0     7.9

Marine & energy

     24.0        2.8     0.5     16.4        3.2     0.2     18.3        3.7     0.3

Medical malpractice

     37.4        4.3     1.0     51.4        10.1     7.4     67.5        13.8     4.1

Other

     3.1        0.4     0.2     2.8        0.6     —       2.3        0.5     0.3

Professional liability

     159.5        18.3     —       110.4        21.7     —       71.5        14.6     —  

Property

     319.7        36.8     24.3     148.1        29.1     40.0     87.0