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| ACE > SEC Filings for ACE > Form 10-Q on 9-Nov-2009 | All Recent SEC Filings |
9-Nov-2009
Quarterly Report
The following is a discussion of our results of operations, financial condition, and liquidity and capital resources as of and for the three and nine months ended September 30, 2009. Our results of operations and cash flows for any interim period are not necessarily indicative of our results for the full year. This discussion should be read in conjunction with our Consolidated Financial Statements and related notes and our Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2008 (2008 Form 10-K) and in our quarterly report on Form 10-Q for the quarters ended March 31, 2009, and June 30, 2009. In addition, readers should review "Risk Factors" set forth in Item 1A. of Part I of our 2008 Form 10-K, as well as in Item 1A. of Part II of our quarterly report on Form 10-Q for the quarters ended March 31, 2009, and June 30, 2009, and in Item 1A. of Part II of this report.
Other Information
We routinely post important information for investors on our website (www.acelimited.com) under the Investor Relations section. We use this website as a means of disclosing material, non-public information and for complying with our disclosure obligations under Securities and Exchange Commission (SEC) Regulation FD (Fair Disclosure). Accordingly, investors should monitor the Investor Relations portion of our website, in addition to following our press releases, SEC filings, and public conference calls and webcasts. The information contained on, or that may be accessed through, our website is not incorporated by reference into, and is not a part of, this report.
Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Any written or oral statements made by us or on our behalf may include forward-looking statements that reflect our current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks, uncertainties, and other factors that could, should potential events occur, cause actual results to differ materially from such statements. These risks, uncertainties, and other factors (which are described in more detail elsewhere herein and in other documents we file with the SEC) include but are not limited to:
• developments in global financial markets, including changes in interest rates, stock markets, and other financial markets, increased government involvement or intervention in the financial services industry, the cost and availability of financing, and foreign currency exchange rate fluctuations (which we refer to in this report as foreign exchange), which could affect our statement of operations, investment portfolio, financial position, and financing plans;
• general economic and business conditions resulting from recent declines in the stock markets and tightening of credit and the depth and duration of the current recession;
• losses arising out of natural or man-made catastrophes such as hurricanes, typhoons, earthquakes, floods, or terrorism which could be affected by:
• the number of insureds and ceding companies affected;
• the amount and timing of losses actually incurred and reported by insureds;
• the impact of these losses on our reinsurers and the amount and timing of reinsurance recoverable actually received;
• the cost of building materials and labor to reconstruct properties following a catastrophic event; and
• complex coverage and regulatory issues such as whether losses occurred from storm surge or flooding and related lawsuits;
• actions that rating agencies may take from time to time, such as financial strength or credit ratings downgrades or placing these ratings on credit watch negative or the equivalent;
• global political conditions, the occurrence of any terrorist attacks, including any nuclear, radiological, biological, or chemical events, or the outbreak and effects of war, and possible business disruption or economic contraction that may result from such events;
• the ability to collect reinsurance recoverable, credit developments of reinsurers, and any delays with respect thereto and changes in the cost, quality, or availability of reinsurance;
• actual loss experience from insured or reinsured events and the timing of claim payments;
• the uncertainties of the loss-reserving and claims-settlement processes, including the difficulties associated with assessing environmental damage and asbestos-related latent injuries, the impact of aggregate-policy-coverage limits, and the impact of bankruptcy protection sought by various asbestos producers and other related businesses and the timing of loss payments;
• judicial decisions and rulings, new theories of liability, legal tactics, and settlement terms;
• the effects of public company bankruptcies and/or accounting restatements, as well as disclosures by and investigations of public companies relating to possible accounting irregularities, and other corporate governance issues, including the effects of such events on:
• the capital markets,
• the markets for directors and officers and errors and omissions insurance, and
• claims and litigation arising out of such disclosures or practices by other companies;
• uncertainties relating to governmental, legislative and regulatory policies, developments, actions, investigations and treaties, which, among other things, could subject us to insurance regulation or taxation in additional jurisdictions or affect our current operations;
• the actual amount of new and renewal business, market acceptance of our products, and risks associated with the introduction of new products and services and entering new markets, including regulatory constraints on exit strategies;
• the competitive environment in which we operate, including trends in pricing or in policy terms and conditions, which may differ from our projections and changes in market conditions that could render our business strategies ineffective or obsolete;
• acquisitions made by us performing differently than expected, our failure to realize anticipated expense-related efficiencies or growth from acquisitions, or the impact of acquisitions on our pre-existing organization;
• risks associated with our re-domestication to Switzerland, including possible reduced flexibility with respect to certain aspects of capital management and the potential for additional regulatory burdens;
• the potential impact from government-mandated insurance coverage for acts of terrorism;
• the availability of borrowings and letters of credit under our credit facilities;
• the adequacy of collateral supporting funded high deductible programs;
• changes in the distribution or placement of risks due to increased consolidation of insurance and reinsurance brokers;
• material differences between actual and expected assessments for guaranty funds and mandatory pooling arrangements;
• changing rates of inflation and other economic conditions, for example, recession;
• the amount of dividends received from subsidiaries;
• loss of the services of any of our executive officers without suitable replacements being recruited in a reasonable time frame;
• the ability of our technology resources to perform as anticipated; and
• management's response to these factors and actual events (including, but not limited to, those described above).
The words "believe," "anticipate," "estimate," "project," "should," "plan," "expect," "intend," "hope,", "feel", "will likely result," or "will continue," and variations thereof and similar expressions, identify forward-looking statements. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. We undertake no obligation to publicly update or review any forward-looking statements, whether as a result of new information, future events or otherwise.
Overview
ACE Limited is the holding company of the ACE Group of Companies. ACE opened its business office in Bermuda in 1985 and continues to maintain significant operations in Bermuda. ACE Limited, which is now domiciled in Zurich, Switzerland, and its direct and indirect subsidiaries (collectively, the ACE Group of Companies, ACE, the Company, we, us, or our) comprise a global insurance and reinsurance organization, with operating subsidiaries in more than 50 countries serving the needs of commercial and individual customers in more than 140 countries. We serve the P&C insurance needs of businesses of all sizes in a broad range of industries. We also provide specialized insurance products such as personal accident, supplemental health, and life insurance to individuals in select countries. Our reinsurance operations include both P&C and life companies. At September 30, 2009, ACE had total assets of $77.8 billion and shareholders' equity of $18.7 billion.
Our product and geographic diversification differentiates us from the vast majority of our competitors and has been a source of stability during periods of industry volatility. Our long-term business strategy focuses on sustained growth in book value achieved through a combination of underwriting and investment income. By doing so, we provide value to our clients and shareholders through the utilization of our substantial capital base in the insurance and reinsurance markets.
Redomestication to Zurich, Switzerland
In July 2008, our shareholders approved proposals submitted by our Board of Directors to transfer our domicile from the Cayman Islands to Zurich, Switzerland, our new jurisdiction of incorporation (the Continuation). As a result of the Continuation, we are deregistered in the Cayman Islands and are now subject to Swiss law. In connection with the Continuation, we changed the currency in which the par value of our Ordinary Shares was stated from U.S. dollars to Swiss francs. Upon the effectiveness of the Continuation, our Ordinary Shares became Common Shares. All Common Shares are registered shares with a current par value of CHF 32.20 each.
Notwithstanding the change of the currency in which the par value of Common Shares is stated, we continue to use U.S. dollars as our reporting currency for preparing our Consolidated Financial Statements. For the foreseeable future, we expect to pay dividends as a repayment of share capital in the form of a reduction in par value or qualified paid-in capital, which is not subject to Swiss withholding tax. Refer to "Liquidity" and "Capital Resources" below for more information, including changes to the process by which we make distributions in the form of par value reductions.
The Combined Insurance Acquisition
On April 1, 2008, ACE acquired all of the outstanding shares of Combined Insurance Company of America (Combined Insurance) and certain of its subsidiaries from Aon Corporation for $2.56 billion. Combined Insurance is an underwriter and distributor of specialty individual accident and supplemental health insurance products targeted to middle-income consumers and small businesses in North America, Europe, Asia Pacific, and Latin America. ACE recorded the Combined Insurance acquisition using the purchase method of accounting. Our consolidated operating results include the results of Combined Insurance from April 1, 2008.
Investment in Assured Guaranty Ltd.
Assured Guaranty Ltd. (AGO), a Bermuda-based holding company, provides, through its operating subsidiaries, credit enhancement products to the public finance, structured finance, and mortgage markets. On July 1, 2009, AGO acquired Financial Security Assurance Holdings Ltd. from Dexia Holdings Inc., a subsidiary of Dexia S.A. The purchase price included approximately $546 million in cash and approximately 22.3 million AGO common shares, according to AGO's public filings. AGO financed the cash portion of the purchase price partly through a June 2009 issuance of 38.5 million common shares before the exercise of any overallotment option (June 2009 issuance), according to AGO's public filings. Prior to the June 2009 issuance, ACE included its investment in AGO in Investments in partially-owned insurance companies using the equity method of accounting. Effective with the June 2009 issuance, ACE was deemed to no longer exert significant influence over AGO for accounting purposes and accounts for the investment in AGO as an available-for-sale equity security. ACE accounted for AGO's June 2009 issuance, and resulting dilutive effect, as if we had sold a proportionate share of the investment. ACE recorded two adjustments in the third quarter of 2009 related to its investment in AGO. The first adjustment was a $44 million loss recorded in Other (income) expense which reflects the true-up of ACE's proportionate share of AGO's second quarter 2009 net income accounted for using the equity method of accounting, principally due to higher than anticipated unrealized losses recorded by AGO. AGO's unrealized losses resulted from an increase in the value of its fair value liabilities because of improvements in AGO's credit spread. The second adjustment was a $10 million gain recorded in Net realized gains (losses) which reflects the true-up of a realized loss recognized in the second quarter of 2009 related to a dilutive common share issuance by AGO. In light of the $44 million decrease in carrying value of ACE's investment in AGO as described above, ACE reduced its previously recognized realized loss related to AGO's dilutive common share issuance from $67 million to $57 million. As of September 30, 2009, the fair value of ACE's investment in AGO was $372 million and $37 million of unrealized gain on this investment is reflected in Accumulated other comprehensive income.
Market Conditions
With stabilization of the global economy and recovering financial markets and industry capital, more competitive market conditions are emerging. Although for the quarter ended September 30, 2009, we experienced a modest increase in rates globally, rates for business written in the early part of the third quarter were more favorable than for business written late in the quarter.
During the quarter ended September 30, 2009, we continued to focus our efforts on building ACE's capabilities - expanding our product offerings, our underwriting and geographic presence, and special initiatives centered on certain customer segments and our distribution. Our revenues were adversely impacted by a strong U.S. dollar and the recession's impact on pricing and demand for coverage. Nevertheless, we reported growth in lines where more than price matters - our relative financial strength compared to competitors continued to produce business gains, and we have also benefited from growth in those areas of the market that have experienced underwriting losses and prices have risen adequately thus creating opportunity for ACE. These include professional lines, political risk, offshore energy, property catastrophe, and aviation.
Consistent with the first half of 2009, in the third quarter we continued to experience more favorable pricing on reinsurance-related risks compared to insurance-related risks and also more favorable pricing on business sourced through the retail market compared with the wholesale market. Our reinsurance business grew in the
third quarter of 2009, as we continued to attract business based on our financial strength and clients' capital needs. With respect to our insurance business, the market continued to improve, although not in all classes. We have experienced modest growth in our global retail P&C business - ACE USA and ACE International - and declines in our London and U.S. wholesale business. In North America, U.S. retail rates increased and renewal retentions were stable as our investment of resources into lines such as directors and officers (D&O), errors and omissions (E&O), excess casualty, environmental and medical all reported growth. Our North American risk management business experienced a decline in business due to the recession's impact on exposure and increased competition. Our U.S. wholesale business, excluding crop, reported higher rates but lower retention as competitive conditions continued in excess and surplus casualty and professional lines. Crop premiums declined primarily due to a decline in commodity prices. Our international P&C business reported growth in all regions as rates increased slightly and we benefitted from clients looking for financial strength as opposed to simply a price advantage. This was particularly evident in our financial lines offerings. Although our international wholesale business has experienced competitive conditions, rates in our portfolio increased modestly and we began to see a significant improvement in aviation pricing for the fourth quarter. Our A&H business continues to be impacted by the recession driven by a slow-down in growth and increased lapse rates as consumers adjust to less available credit, overall decreased travel, and employers reducing employee benefits including accident insurance.
Refer also to "Overview" in our "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 2008 Form 10-K.
Fair Value Measurements
We partially adopted the provisions (specific provisions described below) included in Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures, on January 1, 2008. We fully adopted the provisions effective January 1, 2009. These provisions define fair value as the price to sell an asset or transfer a liability in an orderly transaction between market participants and establishes a three-level valuation hierarchy in which inputs into valuation techniques used to measure fair value are classified.
The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. Inputs in Level 1 are unadjusted quoted prices for identical assets or liabilities in active markets. Level 2 includes inputs other than quoted prices included within Level 1 that are observable for assets or liabilities either directly or indirectly. Level 2 inputs include, among other items, quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, and inputs other than quoted prices that are observable for the asset or liability such as interest rates and yield curves. Level 3 inputs are unobservable and reflect our judgments about assumptions that market participants would use in pricing an asset or liability. A financial instrument's categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
While the Company obtains values for the majority of the investment securities it holds from one or more pricing services, it is ultimately management's responsibility to determine whether the values obtained and recorded in the financial statements are representative of fair value. We periodically update our understanding of the methodologies used by our pricing services in order to validate that the prices obtained from those services are consistent with the GAAP definition of fair value as an exit price. Based on our understanding of the methodologies used by our pricing services, all applicable investments have been valued in accordance with GAAP valuation principles. We do not typically adjust prices obtained from pricing services.
At September 30, 2009, our Level 3 assets represented four percent of our assets that are measured at fair value and two percent of our total assets. Our Level 3 liabilities represented 14 percent of our liabilities that are measured at fair value and one percent of our total liabilities at September 30, 2009. During the quarter ended September 30, 2009, we transferred $32 million into our Level 3 assets. Refer to Note 9 to the Consolidated Financial Statements for a description of the valuation measurements used for our financial instruments carried or disclosed at fair value by valuation hierarchy (Levels 1, 2, and 3) as well as a roll-forward of Level 3 financial instruments for the three and nine months ended September 30, 2009 and 2008.
Guaranteed minimum income benefits (GMIB) derivatives
Under life reinsurance programs covering living benefit guarantees, we assume the risk of GMIBs associated with variable annuity (VA) contracts. Our GMIB reinsurance product meets the definition of a derivative for accounting purposes and is therefore carried at fair value. We believe that the most meaningful presentation of these derivatives is to reflect cash inflows or revenue as net premiums earned, and to record estimates of the average modeled value of future cash outflows as incurred losses. Accordingly, we recognize benefit reserves consistent with the provisions of ASC Topic 944, Financial Services-Insurance, related to accounting and reporting by insurance enterprises for certain non-traditional long-duration contracts and for separate accounts. Changes in the benefit reserves are reflected as policy benefits expense, which is included in life underwriting income. The incremental difference between fair value and benefit reserves is reflected in Accounts payable, accrued expenses, and other liabilities in the balance sheet and related changes in fair value are reflected in Net realized gains (losses) in the consolidated statement of operations. We intend to hold these derivative contracts to maturity (i.e., the expiration of the underlying annuities through lapses, annuitization, or death). At maturity, the cumulative gains and losses will net to zero (excluding cumulative hedge gains or losses) because, over time, the insurance liability will be increased or decreased to equal our obligation. For a sensitivity discussion of the effect of changes in interest rates, equity indices and other assumptions on the fair value of GMIBs, and the resulting impact on our net income, refer to Item 3. Refer to Note 2 j) to the Consolidated Financial Statements, under Item 8 of our 2008 Form 10-K, for further description of this product and related accounting treatment.
The fair value of GMIB reinsurance is estimated using an internal valuation model which includes current market information and estimates of policyholder behavior from the perspective of a theoretical market participant. All of our treaties contain claim limits, which are factored into the valuation model. The fair value depends on a number of factors, including interest rates, current account value, market volatility, expected annuitization rates and other policyholder behavior, and changes in policyholder mortality. The model and related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based upon additional experience obtained related to policyholder behavior and availability of more timely market information, such as market conditions and demographics of in-force annuities. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these derivative products, actual experience may differ from the estimates reflected in our Consolidated Financial Statements, and the differences may be material.
The most significant policyholder behavior assumptions include lapse rates and annuitization rates using the guaranteed benefit (GMIB annuitization rate). Assumptions regarding lapse rates and GMIB annuitization rates differ by treaty but the underlying methodology to determine rates applied to each treaty is comparable. The assumptions regarding lapse and GMIB annuitization rates determined for each treaty are based on a dynamic calculation that uses several underlying factors.
A lapse rate is the percentage of in-force policies surrendered in a given calendar year. All else equal, as lapse rates increase, ultimate claim payments will decrease. The GMIB annuitization rate is the percentage of policies for which the policyholder will elect to annuitize using the guaranteed benefit provided under the GMIB. All else equal, as GMIB annuitization rates increase, ultimate claim payments will increase, subject to treaty claim limits.
Key factors affecting the lapse rate assumption include investment performance and policy duration. We generally assume that lapse rates increase with policy duration with a significant increase in rates after the end of the surrender charge period. As investment performance of underlying fund investments declines, and guarantees become more valuable, lapse rates are anticipated to decrease thereby increasing the expected value of claims on minimum guarantees and thus, benefit reserves and the incremental fair value liability.
Key factors affecting the GMIB annuitization rate include investment performance and the level of interest rates after the GMIB waiting period. As investment performance of underlying fund investments declines, the monthly income available to a policyholder who annuitizes their account value falls; this makes the GMIB more valuable.
As the GMIB becomes more valuable, our modeling assumes that annuitization rates will increase, resulting in higher benefit reserves and fair value liability. The same is true in an environment where long-term interest rates are decreasing.
Based on our quarterly reserve review, no changes were made to actuarial or behavioral assumptions.
During the quarter ended September 30, 2009, we recorded $65 million of realized losses for GMIB reinsurance, primarily due to a significant narrowing of A-rated credit spreads (A-rated credit spreads are a proxy for ACE's own credit spreads and a narrowing implies a reduction of the discount rate of future cash flows), partially offset by a rising equity market. During the nine months ended September 30, 2009, we recorded $218 million of realized gains for GMIB reinsurance, primarily due to a rising equity market and increased interest rate levels, partially offset by narrowing A-rated credit spreads and the receipt of premium (which increases the fair value). This excludes realized losses of $144 million during the quarter ended September 30, 2009, and $300 million during the nine months ended September 30, 2009, on derivative instruments held to partially offset the risk in the variable annuity guarantee reinsurance portfolio. These derivatives do not receive hedge accounting treatment. Refer to "Net Realized Gains (Losses)" for a breakdown of the realized gains on GMIB reinsurance and the realized losses on the derivatives for the quarters ended September 30, 2009, and 2008.
ACE Tempest Life Re employs a strategy to manage the financial market and policyholder behavior risks embedded in the reinsurance of variable annuity guarantees. Risk management begins with underwriting a prospective client and guarantee design, with particular focus on protecting ACE's position from policyholder options that, because of anti-selective behavior, could adversely impact our obligation.
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