In 2004, based on the Company’s internal actuarial review and an independent actuarial firm’s ground-up study of asbestos reserves, the Company strengthened its asbestos reserves by $90.5 million, or approximately 25% of net unpaid asbestos losses and ALAE at December 31, 2003. Changes in the reserve estimates for eight policyholders represented over 80% of such increase. While the Company experienced some increase in the number of claims for known policyholders, an increase in average severity of claim payments and a corresponding increase in defense costs were the principal reasons for the asbestos reserve strengthening. Some of the increase was attributable to rising asbestos-related bankruptcies in 2000 through 2002. Solvent defendants in many jurisdictions were left to pay some or the entire portion of the judgments or settlements that should have been paid by the bankrupt defendants. The large unexpected number of bankruptcies filed from 2000 to 2002 resulted in the claim severity increasing beginning in 2003 and continuing through 2004, outside of any known historical trend. In addition, the Company also received multiple allegations of reclassification of products claims (that are subject to an aggregate limit) as premises/operations claims (that are not subject to an aggregate limit).
Accident year loss and LAE ratios, as estimated at December 31, 2006 by line of business, net of per risk reinsurance but before the benefit of corporate aggregate reinsurance, are summarized as follows:
In 2005, the increase in investment income of $46.0 million, or 54.1%, was the result of a combination of higher earnings from HWIC of $9.8 million, an increase in interest income from fixed income securities of $9.6 million due primarily to higher amounts of fixed income securities, an increase in dividend income of $9.1 million, including a special dividend on one of the Company’s equity securities and an increase in interest income on cash collateral pledged for short-sale obligations of $8.6 million.
At Crum & Forster’s insurance subsidiaries, cash provided by operating activities primarily consists of premium collections, reinsurance recoveries and investment income. Cash provided from these sources is generally used for payment of losses and LAE, policy acquisition costs, operating expenses, ceded reinsurance premiums, income taxes and shareholder dividends, when permitted. Variability in cash provided by and used in operations can occur for many reasons, including changes in gross premiums written, changes in the Company’s underwriting results, natural or man-made catastrophes, settlements of large claims including asbestos and environmental claims, commutation of reinsurance contracts and the timing of recoveries from reinsurers, particularly as related to claim payments for natural or man-made catastrophes and asbestos and environmental claims.
The components of realized investment gains for the years ended December 31, 2006, 2005 and 2004 are summarized below:
Included in realized investment losses for the years ended December 31, 2006 and 2005 are $15,857 and $3,889, respectively, related to losses on other than temporary impairments of equity securities. The amount for 2006 includes a charge of $5,379 in respect of the Company’s investment in Advent Capital (Holdings) PLC (“Advent”), a related party. There were no impairments recorded in the year ended December 31, 2004.
The Company’s credit default swaps on securities issued by various U.S. companies in the banking, mortgage and insurance industries serve as economic hedges against declines in the fair value of the Company’s financial assets. During the year, the Company purchased $6,997 of credit default swaps, bringing the total cost of the credit default swaps to $77,621 at December 31, 2006 as compared to a cost of $70,624 at December 31, 2005. The fair value of the credit default swaps was $16,702 and $33,559 at December 31, 2006 and 2005, respectively.
The Company holds options on certain securities within its fixed income portfolio, which allow the Company to convert the fixed income securities to equity securities. These conversion options are accounted for under SFAS 133, which states that changes in the fair value attributable to embedded derivatives are required to be recognized in realized investment gains and losses on the consolidated statements of income. The cost attributed to these embedded options was $11,962 at December 31, 2006, and their estimated fair value was $7,372. For further details in respect of certain investment accounting adjustments, see Note 14 to the consolidated financial statements.
Advent Syndicate 780 (“Syndicate 780”), which is managed by Advent, a Fairfax affiliate, is a participant on the Company’s property catastrophe treaty with a 2% share up to certain limits. For the years ended December 31, 2006 and 2005, the Company ceded premiums of $769 and $821, respectively, to Syndicate 780 and had reinsurance recoverable balances of $890 and $3,076 at December 31, 2006 and 2005, respectively.