Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

 

 

For the period ended September 30, 2008

 

 

 

OR

 

 

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

 

 

For the transition period from          to

 

 

 

Commission file number 1-33128

 

ONEBEACON INSURANCE GROUP, LTD.

(Exact name of Registrant as specified in its charter)

 

Bermuda

 

98-0503315

(State or other jurisdiction of
incorporation or organization)

 

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

 

 

 

601 Carlson Parkway
Minnetonka, Minnesota

 

55305

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code:  (952) 852-2431

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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   o

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated Filer x

 

Non-accelerated filer o

 

Smaller reporting

 

 

 

 

(Do not check if a smaller

 

company o

 

 

 

 

reporting company)

 

 

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes   o    No   x

 

As of October 29, 2008, 23,339,461 Class A common shares, par value of $0.01 per share, and 71,754,738 Class B common shares, par value of $0.01 per share, were outstanding.

 

 

 



Table of Contents

 

ONEBEACON INSURANCE GROUP, LTD.

 

PART I

FINANCIAL INFORMATION

 

 

 

 

ITEM 1.

Financial Statements (Unaudited)

 

 

 

 

 

Consolidated Balance Sheets:

 

 

September 30, 2008 and December 31, 2007

2

 

 

 

 

Consolidated Statements of Operations and Comprehensive (Loss) Income:

 

 

Three and nine months ended September 30, 2008 and 2007

3

 

 

 

 

Consolidated Statements of Common Shareholders’ Equity:

 

 

Nine months ended September 30, 2008 and 2007

4

 

 

 

 

Consolidated Statements of Cash Flows:

 

 

Nine months ended September 30, 2008 and 2007

5

 

 

 

 

Notes to Consolidated Financial Statements

6

 

 

 

ITEM 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

27

 

 

 

 

Results of Operations —For the three and nine months ended September 30, 2008 and 2007

28

 

 

 

 

Summary of Investment Results

36

 

 

 

 

Non-GAAP Financial Measures

43

 

 

 

 

Liquidity and Capital Resources

44

 

 

 

 

Critical Accounting Estimates

50

 

 

 

 

Forward Looking Statements

51

 

 

 

ITEM 3.

Quantitative and Qualitative Disclosures About Market Risk

52

 

 

 

ITEM 4.

Controls and Procedures

52

 

 

 

PART II

OTHER INFORMATION

 

 

 

 

ITEM 1.

Legal Proceedings

52

 

 

 

ITEM 1A.

Risk Factors

52

 

 

 

ITEM 2.

Unregistered Sales of Equity Securities and Use of Proceeds

53

 

 

 

ITEM 6.

Exhibits

53

 

 

 

SIGNATURES

 

54

 



Table of Contents

 

PART 1. FINANCIAL INFORMATION

 

ITEM 1. Financial Statements

 

ONEBEACON INSURANCE GROUP, LTD.

CONSOLIDATED BALANCE SHEETS

 

 

 

September 30,

 

December 31,

 

 

 

2008

 

2007

 

 

 

(Unaudited)

 

 

 

 

 

($ in millions, except
share and per share
amounts)

 

Assets

 

 

 

 

 

Investment Securities:

 

 

 

 

 

Fixed maturity investments, at fair value (amortized cost $2,338.3 and $2,914.4)

 

$

2,300.0

 

$

2,966.6

 

Common equity securities, at fair value (cost $820.7 and $685.3)

 

793.3

 

832.1

 

Convertible bonds, at fair value (amortized cost $286.5 and $380.7)

 

272.4

 

389.2

 

Short-term investments, at amortized cost (which approximates fair value)

 

531.7

 

327.4

 

Held-to-maturity investments (assets held in trust):

 

 

 

 

 

Fixed maturity investments, at amortized cost (estimated fair value $— and $306.9)

 

 

305.5

 

Short-term investments, at amortized cost (which approximates fair value)

 

 

0.1

 

Other investments, at fair value (cost $249.7 and $292.7)

 

292.5

 

348.6

 

Total investments

 

4,189.9

 

5,169.5

 

Cash

 

45.6

 

49.4

 

Reinsurance recoverable on unpaid losses

 

863.7

 

958.9

 

Reinsurance recoverable on unpaid losses—Berkshire Hathaway, Inc.

 

1,681.2

 

1,670.6

 

Reinsurance recoverable on paid losses

 

19.4

 

21.9

 

Premiums receivable

 

580.7

 

529.2

 

Securities lending collateral

 

211.8

 

438.9

 

Deferred acquisition costs

 

233.4

 

200.0

 

Ceded unearned premiums

 

71.9

 

68.1

 

Net deferred tax asset

 

172.1

 

23.5

 

Investment income accrued

 

26.7

 

33.7

 

Accounts receivable on unsettled investment sales

 

15.0

 

76.1

 

Other assets

 

301.0

 

301.7

 

Total assets

 

$

8,412.4

 

$

9,541.5

 

Liabilities

 

 

 

 

 

Loss and LAE reserves

 

$

4,408.0

 

$

4,480.3

 

Unearned premiums

 

1,108.4

 

1,005.9

 

Debt

 

731.9

 

757.7

 

Securities lending payable

 

215.8

 

438.9

 

Preferred stock subject to mandatory redemption—Berkshire Hathaway, Inc. (redemption value $— and $300.0)

 

 

278.4

 

Ceded reinsurance payable

 

97.6

 

102.8

 

Accounts payable on unsettled investment purchases

 

11.5

 

8.5

 

Other liabilities

 

465.8

 

562.5

 

Total liabilities

 

7,039.0

 

7,635.0

 

Common shareholders’ equity

 

 

 

 

 

Common shares and paid-in surplus (par value $0.01; authorized, 200,000,000 shares; issued and outstanding, 95,094,199 and 98,465,204 shares)

 

1,016.8

 

1,084.4

 

Retained earnings

 

355.3

 

641.0

 

Accumulated other comprehensive income, after-tax:

 

 

 

 

 

Net unrealized gains on investments

 

 

168.1

 

Net unrealized foreign currency translation gains

 

 

12.2

 

Other comprehensive income items

 

1.3

 

0.8

 

Total common shareholders’ equity

 

1,373.4

 

1,906.5

 

Total liabilities and common shareholders’ equity

 

$

8,412.4

 

$

9,541.5

 

 

See Notes to Consolidated Financial Statements including Note 11 – “Commitments and Contingencies”

 

2



Table of Contents

 

ONEBEACON INSURANCE GROUP, LTD.

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE (LOSS) INCOME

(Unaudited)

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

($ in millions, except per share amounts)

 

Revenues

 

 

 

 

 

 

 

 

 

Earned premiums

 

$

471.2

 

$

473.6

 

$

1,390.3

 

$

1,407.5

 

Net investment income

 

43.1

 

51.5

 

137.8

 

156.7

 

Net realized investment (losses) gains

 

(61.2

)

30.7

 

(59.2

)

142.7

 

Change in net unrealized investment gains

 

(294.7

 

(354.7

)

 

Net other revenues

 

4.4

 

10.8

 

10.6

 

16.3

 

Total revenues

 

162.8

 

566.6

 

1,124.8

 

1,723.2

 

Expenses

 

 

 

 

 

 

 

 

 

Loss and LAE

 

303.4

 

255.8

 

878.7

 

827.1

 

Policy acquisition expenses

 

92.6

 

74.9

 

261.6

 

231.5

 

Other underwriting expenses

 

74.3

 

66.4

 

223.6

 

246.9

 

General and administrative expenses

 

5.7

 

2.4

 

16.0

 

7.5

 

Accretion of fair value adjustment to loss and LAE reserves

 

3.0

 

4.0

 

9.0

 

12.0

 

Interest expense on debt

 

11.0

 

11.4

 

33.9

 

34.1

 

Interest expense—dividends on preferred stock subject to mandatory redemption

 

 

7.1

 

11.8

 

22.2

 

Interest expense—accretion on preferred stock subject to mandatory redemption

 

 

9.2

 

21.6

 

26.2

 

Total expenses

 

490.0

 

431.2

 

1,456.2

 

1,407.5

 

Pre-tax (loss) income

 

(327.2

135.4

 

(331.4

)

315.7

 

Income tax benefit (provision)

 

116.9

 

(53.1

)

120.6

 

(110.6

)

Net (loss) income

 

(210.3

82.3

 

(210.8

)

205.1

 

Change in net unrealized gains and losses for investments held

 

 

19.5

 

 

85.2

 

Recognition of net unrealized gains and losses for investments sold

 

 

(19.1

)

 

(90.0

)

Change in foreign currency translation

 

0.3

 

(4.1

0.3

 

2.5

 

Change in other comprehensive income and loss items

 

0.5

 

(2.6

0.5

 

(1.3

)

Comprehensive net (loss) income

 

$

(209.5

)

$

76.0

 

$

(210.0

)

$

201.5

 

Basic and diluted earnings per share

 

 

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

 

 

Net (loss) income available to common shareholders

 

$

(2.21

$

0.82

 

$

(2.19

)

$

2.05

 

Diluted:

 

 

 

 

 

 

 

 

 

Net (loss) income available to common shareholders

 

$

(2.21

$

0.82

 

$

(2.19

)

$

2.05

 

 

 

 

 

 

 

 

 

 

 

Dividends declared and paid per common share

 

$

0.21

 

$

0.21

 

$

2.66

 

$

0.63

 

 

See Notes to Consolidated Financial Statements

 

3



Table of Contents

 

ONEBEACON INSURANCE GROUP, LTD.

CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS’ EQUITY

(Unaudited)

 

 

 

Common
shareholders’
equity

 

Common

shares and
paid-in
surplus

 

Retained
earnings

 

Accum. other
comprehensive
income,
after-tax

 

 

 

($ in millions)

 

 

 

 

 

 

 

 

 

 

 

Balances at January 1, 2008

 

$

1,906.5

 

$

1,084.4

 

$

641.0

 

$

181.1

 

Adjustment to adopt SFAS No. 159, after-tax

 

 

 

180.6

 

(180.6

)

Net loss

 

(210.8

)

 

(210.8

)

 

Accrued option expense

 

1.2

 

1.2

 

 

 

Repurchases and retirements of Class A common shares

 

(68.8

)

(68.8

)

 

 

Dividends

 

(255.5

)

 

(255.5

)

 

Other comprehensive income, after-tax

 

0.8

 

 

 

0.8

 

Balances at September 30, 2008

 

$

1,373.4

 

$

1,016.8

 

$

355.3

 

$

1.3

 

 

 

 

Common
shareholders’
equity

 

Common
shares and
paid-in
surplus

 

Retained
earnings

 

Accum. other
comprehensive
income,
after-tax

 

 

 

($ in millions)

 

 

 

 

 

 

 

 

 

 

 

Balances at January 1, 2007

 

$

1,777.2

 

$

1,115.9

 

$

474.4

 

$

186.9

 

Adjustment to adopt FIN 48

 

(0.3

)

 

(0.3

)

 

Net income

 

205.1

 

 

205.1

 

 

Accrued option expense

 

1.0

 

1.0

 

 

 

Issuance of common shares

 

0.3

 

0.3

 

 

 

Repurchases and retirements of Class A common shares

 

(5.8

)

(5.8

)

 

 

Dividends

 

(63.0

)

 

(63.0

)

 

Other comprehensive loss, after-tax

 

(3.6

 

 

(3.6

) 

Balances at September 30, 2007

 

$

1,910.9

 

$

1,111.4

 

$

616.2

 

$

183.3

 

 

See Notes to Consolidated Financial Statements

 

4



Table of Contents

 

ONEBEACON INSURANCE GROUP, LTD.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

 

Nine months ended
September 30,

 

 

 

2008

 

2007

 

 

 

($ in millions)

 

Cash flows from operations:

 

 

 

 

 

Net (loss) income

 

$

(210.8

)

$

205.1

 

Charges (credits) to reconcile net income to cash flows used for operations:

 

 

 

 

 

Net realized investment losses (gains)

 

59.2

 

(142.7

)

Change in net unrealized investment gains

 

354.7

 

 

Net realized gains from sale of common stock of subsidiary

 

(1.0

)

(11.3

)

Dividends paid on mandatorily redeemable preferred stock of subsidiaries

 

11.8

 

22.2

 

    Deferred income tax (benefit) provision

 

(149.1

)

44.7

 

Other operating items:

 

 

 

 

 

Net change in loss and LAE reserves

 

(72.3

)

(242.9

)

Net change in unearned premiums

 

102.5

 

60.8

 

Net change in ceded reinsurance payable

 

(5.2

)

25.4

 

Net change in premiums receivable

 

(51.5

)

(57.2

)

Net change in reinsurance recoverable on paid and unpaid losses

 

87.1

 

154.8

 

Net change in other assets and liabilities

 

(114.2

)

(18.4

)

Net cash provided from operations

 

11.2

 

40.5

 

Cash flows from investing activities:

 

 

 

 

 

Net maturities, purchases and sales of short-term investments

 

(203.3

)

(120.3

)

Purchases of short-term held-to-maturity investments

 

(7.1

)

 

Maturities of fixed maturity investments

 

312.6

 

543.3

 

Maturities of investments held-to-maturity

 

929.6

 

33.8

 

Sales of fixed maturity investments

 

558.8

 

986.5

 

Sales of common equity securities

 

179.9

 

221.6

 

Sales of convertible bonds

 

188.7

 

153.1

 

Sales of other investments

 

20.7

 

36.4

 

Purchases of fixed maturity investments

 

(956.7

)

(1,354.7

)

Purchases of common equity securities

 

(95.7

)

(205.3

)

Purchases of convertible bonds

 

(320.0

)

(207.4

)

Purchases of other investments

 

(22.5

)

(40.9

)

Sales of common stock of subsidiary, net of sales costs

 

4.2

 

47.2

 

Purchase of subsidiary

 

(7.3

)

 

Net change in unsettled investment purchases and sales

 

64.1

 

8.4

 

Net acquisitions of property and equipment

 

(0.6

)

(11.6

)

Net cash provided from investing activities

 

645.4

 

90.1

 

Cash flows from financing activities:

 

 

 

 

 

Redemption of mandatorily redeemable preferred stock of subsidiary

 

(300.0

)

(20.0

)

Repayment of debt

 

(2.0

)

(2.0

)

Repurchases and retirements of Class A common shares

 

(68.8

)

(5.8

)

Repurchases of debt

 

(22.3

)

 

Cash dividends paid to common shareholders

 

(255.5

)

(63.0

)

Dividends paid on mandatorily redeemable preferred stock of subsidiaries

 

(11.8

)

(22.2

)

Net cash used for financing activities

 

(660.4

)

(113.0

)

Net (decrease) increase in cash during period

 

(3.8

17.6

 

Cash balance at beginning of period

 

49.4

 

41.5

 

Cash balance at end of period

 

$

45.6

 

$

59.1

 

 

 

 

 

 

 

Supplemental cash flows information:

 

 

 

 

 

Interest paid

 

$

23.1

 

$

22.9

 

Net Federal income taxes paid

 

60.8

 

76.6

 

 

See Notes to Consolidated Financial Statements

 

5



Table of Contents

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1. Nature of Operations and Summary of Significant Accounting Policies

 

Basis of presentation

 

These interim consolidated financial statements include the accounts of OneBeacon Insurance Group, Ltd. (the “Company” or the “Registrant”) and its subsidiaries (collectively, “OneBeacon”) and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The OneBeacon operating companies are U.S.-based property and casualty insurance writers, most of which operate in a multi-company pool. OneBeacon offers a wide range of specialty, commercial and personal products and services sold primarily through select independent agencies and brokers.

 

OneBeacon was acquired by White Mountains Insurance Group, Ltd. (“White Mountains”) from Aviva plc (“Aviva”, formerly CGNU) in 2001 (the “OneBeacon Acquisition”). White Mountains is a holding company whose businesses provide property and casualty insurance, reinsurance and certain other products. During the fourth quarter of 2006, White Mountains sold 27.6 million or 27.6% of the Company’s common shares in an initial public offering. Prior to the initial public offering, OneBeacon was a wholly-owned subsidiary of White Mountains. As of September 30, 2008, White Mountains owned 75.5% of the Company’s common shares. Within this report, the term “OneBeacon” is used to refer to one or more entities within the consolidated organization, as the context requires. The Company is a Bermuda exempted limited company with its headquarters located at the Bank of Butterfield Building, 42 Reid Street, 6th Floor, Hamilton HM 12, Bermuda. The Company’s U.S. headquarters are located at 1 Beacon Lane, Canton, Massachusetts 02021, its principal executive office is located at 601 Carlson Parkway, Minnetonka, Minnesota 55305 and its registered office is located at Clarendon House, 2 Church Street, Hamilton HM 11, Bermuda. OneBeacon’s reportable segments are Primary Insurance Operations and Other Operations, as defined below.

 

OneBeacon’s Primary Insurance Operations segment includes the results of substantially all of its insurance operations. OneBeacon’s Other Operations segment consists of the Company and its intermediate holding companies.

 

All significant intercompany transactions have been eliminated in consolidation. These interim financial statements include all adjustments, consisting of a normal recurring nature, considered necessary by management to fairly present the financial position, results of operations and cash flows of OneBeacon.  These interim financial statements may not be indicative of financial results for the full year and should be read in conjunction with the Company’s 2007 Annual Report on Form 10-K. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Refer to the Company’s 2007 Annual Report on Form 10-K for a complete discussion regarding OneBeacon’s significant accounting policies. Certain amounts in the prior period financial statements have been reclassified to conform to the current presentation.

 

Recently Adopted Changes in Accounting Principles

 

Fair Value Measurements

 

On January 1, 2008, OneBeacon adopted Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides a revised definition of fair value, establishes a framework for measuring fair value and expands financial statement disclosure requirements for fair value information. Under SFAS 157, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an “exit price”). The Statement establishes a fair value hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). The fair value hierarchy in SFAS 157 prioritizes fair value measurements into three levels based on the nature of the inputs. Quoted prices in active markets for identical assets or liabilities have the highest priority (“Level 1”), followed by observable inputs other than quoted prices, including prices for similar but not identical assets or liabilities (“Level 2”) and unobservable inputs, including the reporting entity’s estimates of the assumptions that market participants would use, having the lowest priority (“Level 3”). See Note 5 for further financial statement disclosure required pursuant to SFAS 157.

 

OneBeacon uses brokers and outside pricing services to assist in determining fair values. For investments in active markets, OneBeacon uses the quoted market prices provided by the outside pricing services to determine fair value. The outside pricing services used by OneBeacon have indicated that they will only provide prices where observable inputs are available. In circumstances where quoted market prices are unavailable, OneBeacon utilizes fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables and other relevant inputs.

 

6



Table of Contents

 

OneBeacon’s process to validate the market prices obtained from the outside pricing sources include, but are not limited to, periodic evaluation of model pricing methodologies and analytical reviews of certain prices. OneBeacon also periodically performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price.

 

For investments in limited partnerships, hedge funds and private equity interests, net asset value is deemed to approximate fair value. In circumstances where the secondary market for such investments is not active, OneBeacon’s policy is to adjust net asset value to reflect the effect of illiquidity. Where appropriate, the fair value of assets and liabilities measured at fair value would be adjusted for the effect of counterparty credit risk.

 

Fair Value Option

 

On January 1, 2008, OneBeacon adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 allows companies to make an election, on an individual instrument basis, to report financial assets and liabilities at fair value. The election must be made at the inception of a transaction and may not be reversed. The election may also be made for existing financial assets and liabilities at the time of adoption. Unrealized gains and losses on assets or liabilities for which the fair value option has been elected are reported in revenues.

 

OneBeacon has made the fair value election for its portfolio of available-for-sale securities and its investments in limited partnerships, hedge funds and private equity interests.  See Note 5 for further discussion. Upon adoption, OneBeacon recorded an adjustment of $180.6 million to reclassify net unrealized gains, after tax, and net unrealized foreign currency translation gains, after tax, related to investments from accumulated other comprehensive income to opening retained earnings.  Subsequent to adoption, OneBeacon’s portfolio of available-for-sale securities was reclassified as trading and changes in fair value are reported in revenues before the effect of tax. See Note 5 for further discussion. The Company believes that making the election results in reporting its investment results on a basis consistent with one of its operating principles, namely to manage investments for total return.

 

Recent Accounting Pronouncements

 

Business Combinations and Non-controlling Interests

 

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141R”) and SFAS No. 160, “Noncontrolling Interests—an amendment to ARB 51” (“SFAS 160”). SFAS 141R requires the acquiring company to recognize the fair value of all assets acquired and liabilities assumed at their fair values at the acquisition date, with certain exceptions including income taxes which will continue to be accounted for under SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). This represents a basic change in approach from the old cost allocation method originally described in SFAS 141. In addition, SFAS 141R changes the accounting for step acquisitions since it requires recognition of all assets acquired and liabilities assumed, regardless of the acquirer’s percentage of ownership in the acquiree. This means that the acquirer will measure and recognize all of the assets, liabilities and goodwill, not just the acquirer’s share. Assets and liabilities arising from contractual contingencies are to be recognized at the acquisition date, at fair value. Non-contractual contingencies are to be recognized when it is more likely than not that they meet the Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements (A Replacement of FASB Concepts Statement No. 3—Incorporating an Amendment of FASB Concepts Statement No. 2)” criteria for an asset or liability. Previously under SFAS 141, recognition of preacquisition contingencies was deferred until the criteria in SFAS No. 5, “Accounting for Contingencies,” (“SFAS 5”) had been met. Changes in the amount of deferred taxes arising from a business combination are to be recognized in either income or through a change in contributed capital, depending on the circumstances. Previously under SFAS 109, such changes were recognized through goodwill. Acquisition related costs, such as legal fees and due diligence costs would be expensed and would not be recognized as part of goodwill. The classification of insurance and reinsurance contracts are re-evaluated at the acquisition date only if their terms were changed in connection with the acquisition.

 

SFAS 160 requires all companies to account for minority interests in subsidiaries as equity, clearly identified and presented separately from parent company equity. Once a controlling interest has been acquired, any subsequent acquisitions or dispositions of noncontrolling interest that do not result in a change of control are to be accounted for as equity transactions. Assets and liabilities acquired are measured at fair value only once; at the original acquisition date, i.e., the date at which the acquirer gained control. When a subsidiary is deconsolidated, any retained noncontrolling equity investment is to be measured at fair value with the gain or loss on the deconsolidation being measured using fair value rather than the carrying amount of the retained ownership interest.

 

SFAS 141R and SFAS 160 are effective for fiscal years beginning after December 15, 2008 and shall be applied prospectively. OneBeacon is in the process of evaluating the potential effect of adoption of SFAS 141R and SFAS 160.

 

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Derivatives and Hedging Activities

 

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an Amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 requires disclosure of the following:  objectives for using derivative instruments in terms of underlying risk and accounting designation, the fair values of derivative instruments and their gains and losses in a tabular format, and information about credit-risk-related contingent features. SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008. OneBeacon is in the process of evaluating the potential effect of adoption of SFAS 161.

 

Participating Securities Granted in Share-Based Payment Transactions

 

In June 2008, the FASB issued FASB Staff Position (“FSP”) EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Transactions are Participating Securities.” The FSP addresses whether instruments granted in share-based payment transactions should be considered participating securities prior to vesting. The FSP requires that such instruments that hold unforfeitable rights to dividends or dividend equivalents, regardless of whether paid or unpaid, should be considered participating securities and accordingly should be included in the calculation of earnings per share under the two-class method instead of the treasury stock method. Unvested restricted stock issued under employee incentive compensation plans containing such dividend participation features would be considered participating securities. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those years. Upon adoption, all prior period earnings per share data must be adjusted retrospectively to conform to the provisions of the FSP. Early application is not permitted. OneBeacon is currently evaluating the potential impact of adopting this FSP.

 

NOTE 2. Acquisitions and Dispositions

 

During the third quarter of 2008, OneBeacon acquired Entertainment Brokers International Insurance Services (“EBI”), an insurance agency specializing in the entertainment, sports and leisure industries, for $8.0 million.  As of September 30, 2008, $7.3 million was paid in cash with the remaining $0.7 million paid in cash in October 2008.  In connection with the purchase of EBI, which was accounted for as an acquisition under the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations,” OneBeacon recorded the identifiable assets and liabilities of EBI at their fair value at acquisition date.  Significant assets and liabilities acquired include premiums and commissions receivable of $16.6 million and premiums and commissions payable of $16.1 million. After allocating the purchase price to identifiable tangible assets and liabilities, OneBeacon also recorded an adjustment to allocate the remaining acquisition cost to an intangible asset of $9.5 million which represents the value of business in force at the acquisition date.  The amortization associated with the intangible asset will be amortized over a 10-year period in proportion to the timing of the discounted cash flows used to value the business.

 

During the first quarter of 2008, OneBeacon sold one of its inactive licensed subsidiaries, Midwestern Insurance Company, to National Guaranty Insurance Company for $4.2 million in cash and recorded a pre-tax gain of $1.0 million through net other revenues.

 

During the third quarter of 2007, OneBeacon sold one of its inactive licensed subsidiaries, American Employers’ Insurance Company to Sparta Insurance Company for $47.7 million in cash and recorded a pre-tax gain of $11.3 million through net other revenues, which included a deposit of $0.5 million received in the first quarter of 2007.

 

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NOTE 3. Reserves for Unpaid Loss and LAE

 

The following table summarizes the loss and LAE reserve activities of OneBeacon’s insurance subsidiaries for the three and nine months ended September 30, 2008 and 2007:

 

 

 

Three months ended September 30,

 

Nine Months Ended September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

($ in millions)

 

Gross beginning balance

 

$

4,425.5

 

$

4,696.6

 

$

4,480.3

 

$

4,837.7

 

Less beginning reinsurance recoverable on unpaid losses

 

(2,571.9

)

(2,765.5

)

(2,629.5

)

(2,842.6

)

Net loss and LAE reserves

 

1,853.6

 

1,931.1

 

1,850.8

 

1,995.1

 

Loss and LAE incurred relating to:

 

 

 

 

 

 

 

 

 

Current year losses

 

324.2

 

272.3

 

911.7

 

868.3

 

Prior year losses

 

(20.8

(16.5

)

(33.0

)

(41.2

)

Total incurred loss and LAE

 

303.4

 

255.8

 

878.7

 

827.1

 

Accretion of fair value adjustment to net loss and LAE reserves

 

3.0

 

4.0

 

9.0

 

12.0

 

Loss and LAE paid relating to:

 

 

 

 

 

 

 

 

 

Current year losses

 

(133.5

)

(131.0

)

(319.5

)

(331.6

)

Prior year losses

 

(163.4

)

(164.7

)

(555.9

)

(607.4

)

Total loss and LAE payments

 

(296.9

)

(295.7

)

(875.4

)

(939.0

)

Net ending balance

 

1,863.1

 

1,895.2

 

1,863.1

 

1,895.2

 

Plus ending reinsurance recoverable on unpaid losses

 

2,544.9

 

2,699.6

 

2,544.9

 

2,699.6

 

Gross ending balance

 

$

4,408.0

 

$

4,594.8

 

$

4,408.0

 

$

4,594.8

 

 

During the three months ended September 30, 2008, OneBeacon experienced $20.8 million of favorable development on prior accident year losses mainly due to lower than expected severity on non-catastrophe losses primarily related to professional liability in specialty lines and package business in commercial lines.  During the three months ended September 30, 2007, OneBeacon experienced $16.5 million of favorable development on prior accident year loss reserves due to lower than expected severity on non-catastrophe losses. The favorable development was primarily related to automobile liability in traditional personal lines and at AutoOne, general liability in commercial lines and professional liability and tuition reimbursement in specialty lines.

 

During the nine months ended September 30, 2008, OneBeacon experienced $33.0 million of favorable development on prior accident year loss reserves due to lower than expected severity on non-catastrophe losses and favorable development on a prior accident year catastrophe. The favorable non-catastrophe development was primarily related to professional liability in specialty lines and package business in commercial lines partially offset by adverse development at AutoOne and in run-off. During the nine months ended September 30, 2007, OneBeacon experienced $41.2 million of favorable development on prior accident year loss reserves due to lower than expected severity on non-catastrophe losses. The favorable development was primarily related to professional liability and tuition reimbursement in specialty lines, property and general liability in commercial lines and automobile liability in traditional personal lines and at AutoOne.

 

In connection with purchase accounting for the OneBeacon Acquisition, loss and LAE reserves and the related reinsurance recoverables were adjusted to fair value on the balance sheets. The net reduction to loss and LAE reserves is being recognized through an income statement charge ratably with and over the period the claims are settled. Accordingly, OneBeacon recognized $3.0 million and $9.0 million of such charges for the three and nine months ended September 30, 2008, respectively, and $4.0 million and $12.0 million of such charges for the three and nine months ended September 30, 2007, respectively. As of September 30, 2008, the outstanding pre-tax unaccreted adjustment was $8.4 million.

 

NOTE 4. Reinsurance

 

In the normal course of business, OneBeacon’s insurance subsidiaries seek to limit losses that may arise from catastrophes or other events by reinsuring with third party reinsurers. OneBeacon remains liable for risks reinsured even if the reinsurer does not honor its obligations under reinsurance contracts.

 

Effective July 1, 2008, OneBeacon renewed its property catastrophe reinsurance program through June 30, 2009.  The program provides coverage for OneBeacon property business including automobile physical damage, as well as acts of terrorism unless committed on behalf of a foreign interest (or utilizing nuclear, biological, chemical or radiological devices).  Under the program, the first $150 million of losses resulting from any single catastrophe are retained and $650 million of the next $700 million of losses resulting from the catastrophe are reinsured.  Any loss above $850 million would be retained. In the event of a catastrophe,

 

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OneBeacon’s property catastrophe reinsurance program is reinstated for the remainder of the original contract term by paying a reinstatement premium that is based on the percentage of coverage reinstated and the original property catastrophe coverage premium.

 

At September 30, 2008, OneBeacon had $19.4 million of reinsurance recoverables on paid losses and $2,754.0 million (gross of $209.1 million in purchase accounting adjustments, as described in Note 3) that will become recoverable if claims are paid in accordance with current reserve estimates. The collectibility of balances due from OneBeacon’s reinsurers is critical to OneBeacon’s financial strength because reinsurance contracts do not relieve OneBeacon of its primary obligation to its insureds. OneBeacon is selective with its reinsurers, placing reinsurance with only those reinsurers having a strong financial condition. OneBeacon monitors the financial strength of its reinsurers on an ongoing basis. As a result, uncollectible amounts have historically not been significant. The following table provides a listing of OneBeacon’s top reinsurers for its primary insurance operations, excluding industry pools and associations and affiliates of OneBeacon, based upon recoverable amounts, the percentage of total reinsurance recoverables and the reinsurers’ A.M. Best ratings.

 

($ in millions)

 

Balance at 
September 30, 2008

 

% of total

 

A.M. Best
Rating(1)

 

National Indemnity Company and General Reinsurance Corporation (2)

 

$

2,001.4

 

72

%

A

++

Tokio Marine and Nichido Fire (3)

 

56.4

 

2

%

A

++

Munich Reinsurance America

 

45.2

 

2

%

A

+

QBE Insurance Corporation

 

41.5

 

2

%

A

 

Swiss Re

 

27.1

 

1

%

A

+

 


(1)

 

A.M. Best ratings as detailed above are: “A++” (Superior, which is the highest of fifteen ratings), “A+” (Superior, which is the second highest of fifteen ratings), and “A” (Excellent, which is the third highest of fifteen ratings).

 

 

 

(2)

 

Includes $320.2 million of Third Party Recoverables, which NICO would pay under the terms of the NICO Cover if they are unable to collect from third party reinsurers. OneBeacon also has an additional $277.7 million of Third Party Recoverables from various reinsurers, the majority of which are rated “A” or better by A.M. Best.

 

 

 

(3)

 

Excludes $46.7 million of reinsurance recoverables from various reinsurers that are guaranteed by Tokio Marine and Nichido Fire under the terms of a 100% quota share reinsurance agreement between Houston General Insurance Company and Tokio Marine and Nichido Fire.

 

In connection with the OneBeacon Acquisition, Aviva caused OneBeacon to purchase two reinsurance contracts: a reinsurance contract with National Indemnity Company (“NICO”) for up to $2.5 billion in old asbestos and environmental (“A&E”) claims and certain other exposures (the “NICO Cover”) and an adverse development cover from General Reinsurance Corporation (“GRC”) for up to $570.0 million, comprised of $400.0 million of adverse development on losses occurring in years 2000 and prior (the “GRC Cover”) in addition to $170.0 million of reserves ceded as of the date of the OneBeacon Acquisition. The NICO Cover and GRC Cover, which were contingent on and occurred contemporaneously with the OneBeacon Acquisition, were put in place in lieu of a seller guarantee of loss and LAE reserves and are therefore accounted for as a seller guarantee under GAAP in accordance with Emerging Issues Task Force Technical Matter Document No. D-54. NICO and GRC are wholly-owned subsidiaries of Berkshire Hathaway, Inc. (“Berkshire”).

 

In September 2008, OneBeacon completed a study of its A&E exposures. Based on the results of the study, OneBeacon increased its best estimate of its incurred losses ceded to NICO by $83.4 million, net of underlying reinsurance, to $2.2 billion. Due to the NICO Cover, there was no impact to income or equity from the change in the estimate. See Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” — specifically Asbestos and Environmental Exposures in the Primary Insurance Operations segment discussion for a detailed discussion of the results of this study.

 

Under the terms of the NICO Cover, NICO receives the economic benefit of reinsurance recoverables from certain of OneBeacon’s third party reinsurers (“Third Party Reinsurers”) in existence at the time the NICO Cover was executed (“Third Party Recoverables”). As a result, the Third Party Recoverables serve to protect the $2.5 billion limit of NICO coverage for the benefit of OneBeacon. As described above, OneBeacon estimates that on an incurred basis, net of Third Party Recoverables, as of September 30, 2008 it has used approximately $2.2 billion of the coverage provided by NICO. Approximately $1.1 billion of these incurred losses have been paid by NICO through September 30, 2008. Since entering into the NICO Cover, $41.6 million of the $2.2 billion of utilized coverage from NICO related to uncollectible Third Party Recoverables. To the extent that actual experience differs from OneBeacon’s estimate of ultimate A&E losses and Third Party Recoverables, future losses could utilize some or all of the protection remaining under the NICO Cover.

 

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Pursuant to the GRC Cover, OneBeacon is not entitled to recover losses to the full contract limit if such losses are reimbursed by GRC more quickly than anticipated at the time the contract was signed. OneBeacon intends to only seek reimbursement from GRC for claims which result in payment patterns similar to those supporting its recoverables recorded pursuant to the GRC Cover. The economic cost of not submitting certain other eligible claims to GRC is primarily the investment spread between the rate credited by GRC and the rate achieved by OneBeacon on its own investments. This cost, if any, is expected to be nominal.

 

NOTE 5. Investment Securities

 

OneBeacon’s invested assets are comprised of securities and other investments held for general investment purposes and assets held in an irrevocable grantor trust account. Refer to the Company’s 2007 Annual Report on Form 10-K for a complete discussion regarding the trust account.

 

Prior to adoption of SFAS 159, OneBeacon’s fixed maturity investments and common equity securities, held for general investment purposes, excluding convertible bonds which are described below, were classified as available-for-sale and reported at fair value. Net unrealized investment gains and losses on available-for-sale securities were reported net, after-tax, as a separate component of shareholders’ equity. Changes in net unrealized investment gains and losses, after-tax, were reported as a component of other comprehensive income. Upon adoption of SFAS 159 on January 1, 2008, the portfolio of fixed maturity investments and common equity securities, excluding convertible bonds, held for general investment purposes were reclassified as trading. Trading securities are reported at fair value as of the balance sheet date as determined by quoted market prices when available. Realized and unrealized investment gains and losses on trading securities are reported, pre-tax in revenues. See Recently Adopted Changes in Accounting Principles of Note 1 for further discussion.

 

OneBeacon has elected the fair value option under SFAS 159 for its investments in convertible bonds effective January 1, 2008. Convertible bonds are carried at fair value with changes therein recorded in revenues as unrealized investment gains or losses. See Recently Adopted Changes in Accounting Principles of Note 1 for further discussion. Prior to adoption of SFAS 159, OneBeacon recorded its convertible bonds in accordance with SFAS No. 155, “Accounting for Certain Hybrid Instruments, an amendment to Statements No. 133 and 140” (“SFAS 155”). Under SFAS 155, OneBeacon had accounted for the convertible bonds on a fair value basis with changes in fair value recorded through revenues as realized investment gains or losses.

 

The fixed maturity investments held in the trust account were classified as held-to-maturity as OneBeacon had the ability and intent to hold the investments until maturity. Securities classified as held-to-maturity were recorded at amortized cost.

 

Short-term investments consist of money market funds, certificates of deposit and other securities which, at the time of purchase, mature or become available for use within one year. Certain of the investments purchased to fund the trust matured within one year and were therefore reflected as short-term investments. In addition, some of the interest payments on the assets in the trust were reinvested in short-term investments. Short-term investments are carried at amortized cost, which approximated fair value as of September 30, 2008 and December 31, 2007.

 

Other investments include limited partnerships, hedge funds and private equity interests. Prior to January 1, 2008, changes in OneBeacon’s interest in other investments accounted for using the equity method were included in net realized investment gains (losses). Changes in OneBeacon’s interest in other investments not accounted for under the equity method were reported, net of tax, as a component of common shareholders’ equity with changes therein reported, after-tax, as a component of other comprehensive income. Upon adoption of SFAS 159 on January 1, 2008, OneBeacon measures its investments in limited partnerships, hedge funds and private equity interests at fair value with changes therein reported in revenues on a pre-tax basis. See Recently Adopted Changes in Accounting Principles of Note 1 for further discussion.

 

OneBeacon participates in a securities lending program as a mechanism for generating additional investment income on its fixed maturity and common equity portfolios. Under the security lending arrangements, certain of its fixed maturity and common equity investments are loaned to other institutions for short periods of time through a lending agent. OneBeacon maintains control over the securities it lends, retains the earnings and cash flows associated with the loaned securities and receives a fee from the borrower for the temporary use of the asset. Collateral, in the form of cash and United States government securities, is required at a rate of 102% of the fair value of the loaned securities, is controlled by the lending agent and may not be sold or re-pledged. The lending agent manages the investment of the cash collateral. The fair value of the securities lending collateral is recorded as both an asset and liability on the balance sheet, however, other than in the event of default by the borrower, this collateral is not available to OneBeacon and will be remitted to the borrower by the lending agent upon the return of the loaned securities. Because of these restrictions, OneBeacon considers its securities lending activities to be non-cash transactions. An indemnification agreement with the lending agent protects OneBeacon in the event a borrower becomes insolvent or fails to return any of the securities on loan.

 

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Investment securities are regularly reviewed for impairment based on criteria that include the extent to which cost exceeds market value, the duration of the market decline, the financial health of and specific prospects for the issuer and the ability and intent to hold the investment to recovery. Investment losses that are determined to be other than temporary are recognized in revenues through net realized investment gains (losses). Realized gains and losses resulting from sales of investment securities are accounted for using the weighted average method. Premiums and discounts on fixed maturity investments are accreted to income over the anticipated life of the investment.

 

OneBeacon’s net investment income is comprised primarily of interest income associated with OneBeacon’s fixed maturity investments, dividend income from its equity investments and interest income from its short-term investments. Net investment income for the three and nine months ended September 30, 2008 and 2007 consisted of the following:

 

 

 

Three months ended

 

Nine months ended

 

 

 

September 30,

 

September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

($ in millions)

 

Investment income:

 

 

 

 

 

 

 

 

 

Fixed maturity investments

 

$

38.4

 

$

44.7

 

$

120.8

 

$

139.2

 

Short-term investments

 

2.0

 

4.8

 

8.0

 

12.9

 

Common equity securities

 

4.2

 

3.5

 

13.3

 

10.3

 

Convertible bonds

 

1.6

 

1.9

 

4.8

 

5.0

 

Other investments

 

0.9

 

0.8

 

2.1

 

2.0

 

Total investment income

 

47.1

 

55.7

 

149.0

 

169.4

 

Less investment expenses

 

(4.0

)

(4.2

)

(11.2

)

(12.7

)

Net investment income, pre-tax

 

$

43.1

 

$

51.5

 

$

137.8

 

$

156.7

 

 

The composition of net realized investment (losses) gains consisted of the following:

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

($ in millions)

 

Fixed maturity investments

 

$

(39.5

)

$

5.2

 

$

(53.1

)

$

15.0

 

Common equity securities

 

(19.1

)

7.5

 

(4.7

)

86.4

 

Convertible bonds

 

(3.6

)

6.8

 

(5.4

)

10.2

 

Other investments

 

1.0

 

11.2

 

4.0

 

31.1

 

Net realized investment (losses) gains, pre-tax

 

$

(61.2

)

$

30.7

 

$

(59.2

)

$

142.7

 

 

OneBeacon recognizes declines in fair value deemed to be other-than-temporary impairments as realized losses. During the three and nine months ended September 30, 2008 OneBeacon recognized realized losses of $63.3 million and $110.7 million for declines in fair value deemed to be other than temporary. The $63.3 million of realized losses from other-than-temporary impairments recognized during the three months ended September 30, 2008 included the following investments: $10.2 million on preferred stocks held with Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”), and in the fixed income, common equity and convertible bond portfolios $7.2 million on USB Capital IX, $13.8 million on Post Properties, Inc., $5.3 million on Wachovia, $8.8 million relating to American International Group (“AIG”) and its subsidiaries, $7.9 million relating to Gold Fields Limited and $4.8 million relating to CIT Group, Inc. The $110.7 million of realized loss from other-than-temporary impairments recognized during the nine months ended September 30, 2008 also included $7.8 million on Meredith Corporation, $6.0 million on BAC Capital Trust XIV, $4.2 million on Pfizer, Inc. and an additional $5.0 million relating to Wachovia and $6.2 million relating to CIT Group, Inc. Impairment charges taken were reclassified from change in net unrealized investment gains to net realized investment (losses) gains. Effective January 1, 2008, upon adoption of SFAS 159, for all investment securities for which the fair value election has been made, all changes in fair value are included in revenues. During the three and nine months ended September 30, 2007, OneBeacon recognized $3.4 million and $5.5 million, respectively, of pre-tax other-than-temporary impairment charges.

 

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The components of OneBeacon’s ending net unrealized investment losses, excluding the impact of unrealized foreign currency translation gains (losses), on its trading investment portfolio as of September 30, 2008, were as follows:

 

 

 

September 30,

 

 

 

2008

 

 

 

($ in millions)

 

Investment securities:

 

 

 

Gross unrealized investment gains

 

$

146.1

 

Gross unrealized investment losses

 

(187.0

)

Net unrealized losses from investment securities

 

(40.9

)

Income taxes attributable to such losses

 

14.4

 

Total net unrealized investment losses, after-tax

 

$

(26.5

)

 

The components of OneBeacon’s ending net unrealized investment gains, excluding the impact of unrealized foreign currency translation gains (losses), on its available-for-sale investment portfolio as of December 31, 2007, prior to adopting SFAS 159, were as follows:

 

 

 

December 31,

 

 

 

2007

 

 

 

($ in millions)

 

Investment securities:

 

 

 

Gross unrealized investment gains

 

$

269.2

 

Gross unrealized investment losses

 

(32.9

)

Net unrealized gains from investment securities

 

236.3

 

Income taxes attributable to such gains

 

(81.6

)

Total net unrealized investment gains, after-tax

 

$

154.7

 

 

In connection with the initial public offering, two irrevocable grantor trusts were established to economically defease the Company’s mandatorily redeemable preferred stock.  The assets of each trust were solely dedicated to payments of dividends and redemption amounts on the mandatorily redeemable preferred stock.  The assets held in the trusts included fixed maturity and short-term investments which were classified and accounted for as held-to-maturity. During the second quarter of 2008, trust assets were utilized to redeem the $300.0 million Berkshire Hathaway, Inc. (“Berkshire”) Preferred Stock (“Berkshire Preferred Stock”). During the second quarter of 2007, trust assets were utilized to redeem the $20.0 million Zenith Insurance Company (“Zenith”) Preferred Stock (“Zenith Preferred Stock”). Refer to the Company’s 2007 Annual Report on Form 10-K for a complete discussion of the economic defeasance of the Company’s mandatorily redeemable preferred stock. The carrying value, gross unrealized investment gains and losses, and estimated market values of OneBeacon’s fixed maturity held-to-maturity investments, carried at amortized cost, as of December 31, 2007 were as follows:

 

 

 

December 31, 2007

 

 

 

Carrying
value

 

Gross
unrealized
gains

 

Gross
unrealized
losses

 

Net foreign
currency
gains

 

Estimated
market
value

 

 

 

($ in millions)

 

U.S. Government obligations

 

$

305.5

 

$

1.4

 

$

 

$

 

$

306.9

 

Total fixed maturity investments

 

$

305.5

 

$

1.4

 

$

 

$

 

$

306.9

 

 

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The cost or amortized cost, gross unrealized investment gains and losses, and carrying values of OneBeacon’s fixed maturity investments as of September 30, 2008 and December 31, 2007, were as follows:

 

 

 

September 30, 2008

 

 

 

Cost or
amortized
cost

 

Gross
unrealized
gains

 

Gross
unrealized
losses

 

Net foreign
currency
gains (losses)

 

Carrying
value

 

 

 

($ in millions)

 

U.S. Government and agency obligations

 

$

419.5

 

$

6.4

 

$

(3.2

)

$

 

$

422.7

 

Debt securities issued by industrial corporations

 

925.9

 

5.3

 

(21.6

)

(2.6

)

907.0

 

Municipal obligations

 

7.8

 

0.1

 

 

 

7.9

 

Asset-backed securities

 

839.9

 

4.4

 

(13.6

)

 

830.7

 

Foreign government obligations

 

50.9

 

0.4

 

(2.7

)

 

48.6

 

Preferred stocks

 

94.3

 

10.2

 

(26.8

)

5.4

 

83.1

 

Total fixed maturity investments

 

$

2,338.3

 

$

26.8

 

$

(67.9

)

$

2.8

 

$

2,300.0

 

 

 

 

December 31, 2007

 

 

 

Cost or
amortized
cost

 

Gross
unrealized
gains

 

Gross
unrealized
losses

 

Net foreign
currency
gains

 

Carrying
value

 

 

 

($ in millions)

 

U.S. Government and agency obligations

 

$

490.3

 

$

18.3

 

$

(0.1

)

$

 

$

508.5

 

Debt securities issued by industrial corporations

 

1,089.7

 

14.0

 

(12.9

)

7.8

 

1,098.6

 

Municipal obligations

 

8.1

 

0.4

 

 

 

8.5

 

Asset-backed securities

 

1,061.4

 

12.0

 

(1.7

)

 

1,071.7

 

Foreign government obligations

 

133.4

 

0.7

 

(0.1

)

 

134.0

 

Preferred stocks

 

131.5

 

7.5

 

(2.1

)

8.4

 

145.3

 

Total fixed maturity investments

 

$

2,914.4

 

$

52.9

 

$

(16.9

)

$

16.2

 

$

2,966.6

 

 

Prior to adoption of SFAS 159, OneBeacon accounted for the convertible bonds on a fair value basis with changes in fair value recorded through revenues as realized investment gains or losses.  The cost or amortized cost, gross unrealized investment gains and losses, and carrying values of OneBeacon’s common equity securities, convertible bonds and other investments as of September 30, 2008 and December 31, 2007, were as follows:

 

 

 

September 30, 2008

 

 

 

Cost or
amortized
cost

 

Gross
unrealized
gains

 

Gross
unrealized
losses

 

Net foreign
currency
gains

 

Carrying
value

 

 

 

($ in millions)

 

Common equity securities

 

$

820.7

 

$

52.0

 

$

(80.5

)

$

1.1

 

$

793.3

 

Convertible bonds

 

$

286.5

 

$

1.4

 

 

(15.5

)

$

 

$

272.4

 

Other investments

 

$

249.7

 

$

65.9

 

$

(23.1

)

$

 

$

292.5

 

 

 

 

December 31, 2007

 

 

 

Cost or
amortized
cost

 

Gross
unrealized
gains

 

Gross
unrealized
losses

 

Net foreign
currency
gains

 

Carrying
value

 

 

 

($ in millions)

 

Common equity securities

 

$

685.3

 

$

158.3

 

$

(13.9

)

$

2.4

 

$

832.1

 

Other investments

 

$

292.7

 

$

58.0

 

$

(2.1

)

$

 

$

348.6

 

 

The cost of other investments as of December 31, 2007 includes $48.8 million related to the equity changes in OneBeacon’s interest in other investments accounted for using the equity method which, prior to the adoption of SFAS 159, were included in realized investment gains or losses.

 

14



Table of Contents

 

Fair value measurements at September 30, 2008

 

As described above, OneBeacon adopted SFAS 157 on January 1, 2008. SFAS 157 established a hierarchy of fair value measurements based upon the nature of the inputs as follows:

 

Level 1 – Valuations based on quoted prices in active markets for identical assets;

 

Level 2 – Valuations based on observable inputs that do not meet the criteria for Level 1, including quoted prices in inactive markets and quoted prices in active markets for similar, but not identical instruments; and

 

Level 3 – Valuations based on unobservable inputs.

 

As of September 30, 2008, approximately 90% of the investment portfolio recorded at fair value was priced based upon observable inputs.

 

Fair values for securities for which quoted prices are unavailable are estimated based upon reference to observable inputs other than quoted prices, such as benchmark interest rates, market comparables, broker quotes and other relevant observable inputs. In circumstances where observable inputs are adjusted to reflect management’s best estimate of fair value, such fair value measurements are considered a lower level measurement in the SFAS 157 fair value hierarchy.

 

Other investments, which are comprised of limited partnerships, hedge funds and private equity interests for which the SFAS 159 fair value option has been elected, are carried at fair value based upon OneBeacon’s proportionate interest in the underlying partnership’s or fund’s net asset value, which is deemed to approximate fair value.  These investments are not publicly traded and, accordingly, quoted market prices are not available.  In circumstances where the partnership net asset value is deemed to differ from fair value due to illiquidity or other factors, net asset value is adjusted accordingly. As of September 30, 2008, other investments represented approximately 7% of the investment portfolio recorded at fair value.  At September 30, 2008, OneBeacon did not adjust the net assets values used to determine fair value.

 

The fair value measurements at September 30, 2008 and their related inputs are as follows:

 

 

 

Fair value at
September 30, 2008

 

Level 1 Inputs

 

Level 2 Inputs

 

Level 3 Inputs

 

 

 

($ in millions)

 

Fixed maturity investments

 

$

2,300.0

 

$

422.7

 

$

1,795.5

 

$

81.8

 

Common equity securities

 

793.3

 

761.2

 

 

32.1

 

Convertible bonds

 

272.4

 

 

272.4

 

 

Short-term investments

 

531.7

 

531.7

 

 

 

Other investments

 

292.5

 

 

 

292.5

 

Total

 

$

4,189.9

 

$

1,715.6

 

$

2,067.9

 

$

406.4

 

 

15



Table of Contents

 

The changes in Level 3 fair value measurements for the nine months ended September 30, 2008 are as follows:

 

 

 

Fixed
maturity
investments

 

Common
equity
securities

 

Convertible
bonds

 

Other
investments

 

Total

 

 

 

($ in millions)

 

Balance at January 1, 2008

 

$

169.2

 

$

70.3

 

$

19.3

 

$

348.6

 

$

607.4

 

Total net realized and unrealized gains (losses)

 

(4.6

)

0.3

 

 

(9.9

)

(14.2

)

Purchases and sales, net

 

 

 

 

0.1

 

0.1

 

Transfers in (out) of Level 3, net

 

(53.5

)

(36.3

)

(17.1

)

 

(106.9

)

Balance at March 31, 2008

 

$

111.1

 

$

34.3

 

$

2.2

 

$

338.8

 

$

486.4

 

Total net realized and unrealized gains (losses)

 

(18.2

)

1.5

 

 

17.7

 

1.0

 

Purchases and sales, net

 

10.1

 

0.6

 

 

1.6

 

12.3

 

Transfers in (out) of Level 3, net

 

(4.9

)

 

(2.2

)

 

(7.1

)

Balance at June 30, 2008

 

$

98.1

 

$

36.4

 

$

 

$

358.1

 

$

492.6

 

Total net realized and unrealized gains (losses)

 

(12.1

)

(4.8

)

 

(65.7

)

(82.6

)

Purchases and sales, net

 

0.1

 

 

 

0.1

 

0.2

 

Transfers in (out) of Level 3, net

 

(4.3

)

0.5

 

 

 

(3.8

)

Balance at September 30, 2008

 

$

81.8

 

$

32.1

 

$

 

$

292.5

 

$

406.4

 

 

The majority of the transfers out of Level 3 within fixed maturity investments during the three months ended March 31, 2008 represent securities for which observable inputs were unavailable as of December 31, 2007 mainly because the securities were relatively new issuances and/or limited market data was available. Such securities were manually priced using a combination of market inputs such as benchmark interest rates, market comparables and/or broker quotes. With respect to common equity securities, as a result of efforts to adopt SFAS 157 and 159, OneBeacon was able to obtain additional information on the underlying common equity securities for a limited partnership that it consolidates in its financial statements. These common equity securities which are priced based on quoted prices were transferred out of Level 3 into Level 1 during the three months ended March 31, 2008. There were no significant transfers in (out) of Level 3 during the three months ended June 30, 2008 or the three months ended September 30, 2008.

 

The following table summarizes the change in net unrealized gains or losses for assets designated as Level 3 at September 30, 2008:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, 2008

 

September 30, 2008

 

 

 

($ in millions)

 

Fixed maturity investments

 

$

(2.0

)

$

(25.7

)

Common equity securities

 

(3.6

)

(2.1

)

Convertible bonds

 

 

 

Short-term investments

 

 

 

Other investments

 

(70.6

)

(65.9

)

Total

 

$

(76.2

)

$

(93.7

)

 

16



Table of Contents

 

The changes in fair value for the three months ended September 30, 2008 are as follows:

 

 

 

Net unrealized losses (1)(2)

 

Net foreign currency
translation losses (1)

 

Total changes in fair
value reflected in
revenues (1)(2)

 

 

 

($ in millions)

 

Fixed maturity investments

 

$

(37.5

)

$

(17.1

)

$

(54.6

)

Common equity securities

 

(160.6

)

(0.8

)

(161.4

)

Convertible bonds

 

(7.3

)

 

(7.3

)

Short-term investments

 

(0.1

)

(0.7

)

(0.8

)

Other investments

 

(70.6

)

 

(70.6

)

Total

 

$

(276.1

)

$

(18.6

)

$

(294.7

)

 


(1)

 

Includes changes in net deferred gains and losses on sales of investments between OneBeacon and entities under White Mountains’ common control of $(1.1) million, pre-tax.

(2)

 

Includes unrealized losses related to OneBeacon’s securities lending program of $4.0 million, pre-tax, for the three months ended September 30, 2008.

 

The changes in fair value for the nine months ended September 30, 2008 are as follows:

 

 

 

Net unrealized losses (1)(2)

 

Net foreign currency
translation gains (losses) (1)

 

Total changes in fair
value reflected in
revenues (1)(2)

 

 

 

($ in millions)

 

Fixed maturity investments

 

$

(78.7

)

$

(13.9

)

$

(92.6

)

Common equity securities

 

(173.0

)

(1.4

)

(174.4

)

Convertible bonds

 

(22.4

)

 

(22.4

)

Short-term investments

 

(0.1

)

0.7

 

0.6

 

Other investments

 

(65.9

)

 

(65.9

)

Total

 

$

(340.1

)

$

(14.6

)

$

(354.7

)

 


(1)

 

Includes changes in net deferred gains and losses on sales of investments between OneBeacon and entities under White Mountains’ common control of $(2.1) million, pre-tax.

(2)

 

Includes unrealized losses related to OneBeacon’s securities lending program of $4.0 million, pre-tax for the nine months ended September 30, 2008.

 

In addition to the investment portfolio described above, OneBeacon has $26.6 million of liabilities recorded at fair value in accordance with SFAS 157 and included in other liabilities.  These liabilities relate to securities that have been sold short by a limited partnership that OneBeacon invests in and is required to consolidate under GAAP.  All of the liabilities included in the $26.6 million have been deemed to have a Level 1 designation.

 

Securities Lending

 

OneBeacon participates in a securities lending program whereby it loans investment securities to other institutions for short periods of time. OneBeacon receives a fee from the borrower in return for the use of its assets and its policy is to require collateral equal to approximately 102% of the fair value of the loaned securities, which is held by a third party. All securities loaned can be redeemed on short notice. The total market value of OneBeacon’s securities on loan at September 30, 2008 was $215.8 million with corresponding collateral of $211.8 million, resulting in an unrealized loss of $4.0 million.

 

17



Table of Contents

 

NOTE 6. Debt

 

OneBeacon’s debt outstanding as of September 30, 2008 and December 31, 2007 consisted of the following:

 

 

 

September 30, 2008

 

December 31, 2007

 

 

 

($ in millions)

 

Senior unsecured notes (“Senior Notes”), at face value

 

$

676.0

 

$

700.0

 

Unamortized original issue discount

 

(0.9

)

(1.1

)

Senior Notes, carrying value

 

675.1

 

698.9

 

Mortgage note on real estate owned

 

40.8

 

40.8

 

Atlantic Specialty Note

 

16.0

 

18.0

 

Bank Facility

 

 

 

Total debt

 

$

731.9

 

$

757.7

 

 

Senior Notes

 

In May 2003, OneBeacon U.S. Holdings, Inc. (“OBH”), formerly known as Fund American Companies, Inc., a wholly-owned subsidiary of the Company, issued $700.0 million face value of senior unsecured debt through a public offering, at an issue price of 99.7% (the “Senior Notes”). The Senior Notes bear an annual interest rate of 5.875%, payable semi-annually in arrears on May 15 and November 15, until maturity on May 15, 2013, and are fully and unconditionally guaranteed as to the payment of principal and interest by White Mountains. OBH incurred $7.3 million in expenses related to the issuance of the Senior Notes (including the $4.5 million underwriting discount), which have been deferred and are being recognized into interest expense over the life of the Senior Notes. Taking into effect the amortization of the original issue discount and all underwriting and issuance expenses, the Senior Notes have an effective yield to maturity of approximately 6.0% per annum. At September 30, 2008, OBH was in compliance with all of the covenants under the Senior Notes.  During the third quarter of 2008, OneBeacon repurchased $24.0 million of the outstanding Senior Notes for $22.3 million, which resulted in a $1.6 million gain on extinguishment of debt.

 

White Mountains has provided and, pursuant to a separation agreement, continues to provide an irrevocable and unconditional guarantee as to the payment of principal and interest on the Senior Notes.  Refer to “Note 18. Related Party Disclosures” of the Company’s 2007 Annual Report on Form 10-K.

 

Refer to “Note 6. Debt” of the Company’s 2007 Annual Report on Form 10-K for a description of other debt.

 

18



Table of Contents

 

NOTE 7. Segment Information

 

OneBeacon’s segments consist of the following: (1) Primary Insurance Operations; and (2) Other Operations. OneBeacon has made its segment determination based on consideration of the following criteria: (i) the nature of the business activities of each of the Company’s subsidiaries and affiliates; (ii) the manner in which the Company’s subsidiaries and affiliates are organized; (iii) the existence of primary managers responsible for specific subsidiaries and affiliates; and (iv) the organization of information provided to the Board of Directors. Significant intercompany transactions among OneBeacon’s segments have been eliminated herein. Financial information for OneBeacon’s segments follows:

 

 

 

Primary
Insurance
Operations

 

Other
Operations

 

Total

 

 

 

($ in millions)

 

Three months ended September 30, 2008

 

 

 

 

 

 

 

Earned premiums

 

$

471.2

 

$

 

$

471.2

 

Net investment income

 

42.4

 

0.7

 

43.1

 

Net realized investment (losses) gains

 

(61.3

)

0.1

 

(61.2

)

Change in net unrealized investment gains

 

(294.4

)

(0.3

)

(294.7

)

Net other revenues

 

2.9

 

1.5

 

4.4

 

Total revenues

 

160.8

 

2.0

 

162.8

 

Loss and LAE

 

303.4

 

 

303.4

 

Policy acquisition expenses

 

92.6

 

 

92.6

 

Other underwriting expenses

 

74.3

 

 

74.3

 

General and administrative expenses

 

3.3

 

2.4

 

5.7

 

Accretion of fair value adjustment to loss and LAE reserves

 

 

3.0

 

3.0

 

Interest expense on debt

 

0.9

 

10.1

 

11.0

 

Interest expense on preferred stock subject to mandatory redemption

 

 

 

 

Total expenses

 

474.5

 

15.5

 

490.0

 

Pre-tax loss

 

$

(313.7

)

$

(13.5

)

$

(327.2

)

Three months ended September 30, 2007

 

 

 

 

 

 

 

Earned premiums

 

$

473.6

 

$

 

$

473.6

 

Net investment income

 

45.2

 

6.3

 

51.5

 

Net realized investment gains (losses)

 

31.2

 

(0.5

)

30.7

 

Change in net unrealized investment gains

 

 

 

 

Net other revenues (expenses)

 

11.2

 

(0.4

)

10.8

 

Total revenues

 

561.2

 

5.4

 

566.6

 

Loss and LAE

 

255.8

 

 

255.8

 

Policy acquisition expenses

 

74.9

 

 

74.9

 

Other underwriting expenses

 

66.4

 

 

66.4

 

General and administrative expenses

 

1.1

 

1.3

 

2.4

 

Accretion of fair value adjustment to loss and LAE reserves

 

 

4.0

 

4.0

 

Interest expense on debt

 

0.8

 

10.6

 

11.4

 

Interest expense on preferred stock subject to mandatory redemption

 

 

16.3

 

16.3

 

Total expenses

 

399.0

 

32.2

 

431.2

 

Pre-tax income (loss)

 

$

162.2

 

$

(26.8

)

$

135.4

 

 

19



Table of Contents

 

 

 

Primary
Insurance
Operations

 

Other
Operations

 

Total

 

 

 

($ in millions)

 

Nine months ended September 30, 2008

 

 

 

 

 

 

 

Earned premiums

 

$

1,390.3

 

$

 

$

1,390.3

 

Net investment income

 

126.7

 

11.1

 

137.8

 

Net realized investment losses

 

(57.9

)

(1.3

)

(59.2

)

Change in net unrealized investment gains

 

(352.9

)

(1.8

)

(354.7

)

Net other revenues

 

9.9

 

0.7

 

10.6

 

Total revenues

 

1,116.1

 

8.7

 

1,124.8

 

Loss and LAE

 

878.7

 

 

878.7

 

Policy acquisition expenses

 

261.6

 

 

261.6

 

Other underwriting expenses

 

223.6

 

 

223.6

 

General and administrative expenses

 

9.0

 

7.0

 

16.0

 

Accretion of fair value adjustment to loss and LAE reserves

 

 

9.0

 

9.0

 

Interest expense on debt

 

2.7

 

31.2

 

33.9

 

Interest expense on preferred stock subject to mandatory redemption

 

 

33.4

 

33.4

 

Total expenses

 

1,375.6

 

80.6

 

1,456.2

 

Pre-tax loss

 

$

(259.5

)

$

(71.9

)

$

(331.4

)

Nine months ended September 30, 2007

 

 

 

 

 

 

 

Earned premiums

 

$

1,407.5

 

$

 

$

1,407.5

 

Net investment income

 

139.6

 

17.1

 

156.7

 

Net realized investment gains (losses)

 

143.0

 

(0.3

)

142.7

 

Change in net unrealized investment gains

 

 

 

 

Net other revenues (expenses)

 

17.8

 

(1.5

)

16.3

 

Total revenues

 

1,707.9

 

15.3

 

1,723.2

 

Loss and LAE

 

827.1

 

 

827.1

 

Policy acquisition expenses

 

231.5

 

 

231.5

 

Other underwriting expenses

 

246.9

 

 

246.9

 

General and administrative expenses

 

2.3