The loss and loss expense ratio is calculated by dividing the losses and loss expenses incurred by the net premiums earned for the Insurance and Reinsurance segments.
In contrast, aviation is an example where pricing is falling on the primary insurance business, mostly as a result of continued good experience, but where the excess loss pricing is relatively higher.
On August 4, 2006, the Company completed the sale of approximately 37% of its financial guaranty reinsurance and insurance businesses (the “Transferred Business”) through the IPO of 23.4 million common shares of SCA at $20.50 per share. SCA was formed in Bermuda during March 2006 for the sole purpose of acting as the holding company for the Transferred Business.
During 2006, there have been a number of changes in the Company’s segment and management structure.
The Company’s methodology applies the initial expected loss ratio to earned premium during the period from its entire in-force book of business (after exclusion of the effect on earned premium of refunding and full limit losses because no more risk exists on these related policies). Significant changes to any variables on which the Company’s initial expected loss ratio is based, over an extended period of time, will likely result in an increase or decrease in such ratio. For example, a shift in business written for sectors with high default rates would likely increase the Company’s expected loss ratio, while a shift for sectors with low default rates would likely decrease the expected loss ratio. Additionally, increases in default rates relative to the Company’s insured portfolio and in actual loss experience or decreases in statistical recovery rates and in actual recovery experience would increase the Company’s expected loss ratio, while the inverse would likely decrease the expected loss ratio.
As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security’s unrealized loss represents an other than temporary decline. However, this factor on its own does not dictate whether or not the Company recognizes an impairment charge. The Company believes its ability to hold such securities is supported by positive and sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment obligations arising from its underwriting operations without selling such investments. In this regard, cash flow from operating activities was $2.4 billion and $5.0 billion in 2006 and 2005, respectively.
affecting net premiums written and partially offset by 2005 hurricane ceded reinstatement premiums recognized and earned in 2005.
ment included reserve releases of $94.4 million in property lines and $91.1 million in casualty lines, partially offset by $96.5 million, $3.0 million and $72.8 million of prior year adverse development in certain professional, marine and aviation, and other lines of business, respectively. Property reserve releases resulted from favorable experience in the 2005 accident year for both attritional and catastrophe losses. Casualty releases were largely in Europe including $69.2 million related to casualty business acquired from Winterthur combined with continued favorable development of the business re-underwritten post acquisition. The professional adverse development relates primarily to the Bermuda portfolio. This development is split into the 2002 and prior periods for D&O and 2004 and subsequent periods for employment practices liability as new types of actions based on employment demographics have emerged. Adverse development from the 2005 hurricanes impacted marine, but was offset by favorable development in aviation reserves. Other adverse development resulted primarily from discontinued lines such as surety and political risk, combined with an unrecoverable reinsurance balance from an accident and health line reinsurer. The gross prior year favorable development for the Insurance segment was $371.4 million. This gross favorable development exceeds the corresponding net development as gross reported losses in casualty have developed more favorably than net losses. Lower gross reported loss amounts reflect reductions in several large recoverable losses on older years and an absence of new large losses, with consequent reductions to reinsurance recoveries.
The following tables present the prior year favorable or adverse development of the Company’s gross and net loss and loss expense reserves for its reinsurance operations:
Other includes weather and energy risk management products, alternative risk transfer products, and financial guaranty.
Operating expenses increased by 20.7% in the year ended December 31, 2006, as compared to the same period in 2005, due to compensation expenses related to the transfer of additional employees and other costs associated with the SCA IPO. Operating expenses decreased by 2.1% in the year ended December 31, 2005, as compared to the same period in 2004, due to lower compensation costs.
In 2004, net realized gains on investments were $246.5 million which includes $265.9 million of gross realized losses on fixed income and $48.8 million of gross realized losses on equity securities. Gross realized losses in 2004 included $6.4 million of provisions for declines in fair value considered to be other than temporary.
The table below represents a reconciliation of the Company’s general and financial operations, unpaid losses and loss expenses for the year ended December 31, 2006:
Cash flows related to financing activities include the payment of dividends, share related transactions, the issue or repayment of debt and deposit liability transactions. In 2006, the Company had net payments of $734.2 million related to deposit liability contracts. In 2005, the Company received $2.0 billion of net cash relating to new deposit liability contracts. In 2006, dividends paid were $277.7 million for ordinary shares and $40.3 million for preferred shares. In 2006, the Company also received $342.2 million related to the sale of a portion of its interest in SCA through a primary offering.
Deposit liabilities on the Company’s Consolidated Balance Sheet at December 31, 2006 were $7,857,827. The difference from the amount included above relates to the discount on payments due in the future. The payment related to these liabilities varies primarily based on interest rates. The ultimate payments associated with these liabilities could differ from the Company’s estimate. See Item 8, Note 12 to the Consolidated Financial Statements, “Deposit Liabilities,” for further information.
In the normal course of business, the Company seeks to reduce the potential amount of loss arising from claims events by reinsuring certain levels of risk assumed in various areas of exposure with other insurers or reinsurers. Reinsurance premiums ceded are expensed (and any commissions recorded thereon are earned) on a monthly pro-rata basis over the period the reinsurance coverage is provided. Prepaid reinsurance premiums represent the portion of premiums ceded applicable to the unexpired term of policies in force. Reinstatement premiums ceded are recorded at the time a loss event occurs. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Provisions are made for estimated unrecoverable reinsurance.
The Company presents certain credit derivative transactions in the consolidated statements of income to include certain components of the change in fair value in “gross premiums written,” “net premiums earned” and “net losses and loss expenses incurred”, and in the consolidated balance sheet, certain components of the fair value in “unearned premiums” and “unpaid loss and loss expenses.” This presentation is applicable only to credit default swaps issued by the Company that are investment grade and that the Company intends, and has the ability, to hold to maturity, and is consistent with practices in the financial guaranty insurance industry for reporting the results of such instruments.
The Financial lines segment includes (i) structured indemnity and structured credit products managed through the Company’s financial solutions operations, as well as, (ii) guaranteed investment contracts and funding agreements, (iii) political risk insurance, (iv) weather and energy management products, (v) the earnings on the
Interest expense excludes interest expense related to life operations, shown separately.
The following table shows an analysis of intangible assets broken down between goodwill, intangible assets with an indefinite life and intangible assets with a definite life for the years ended December 31, 2006, 2005 and 2004:
See Note 19(b), “Commitments and Contingencies - Other Investments,” for further information regarding commitments related to other investments.
Strengthening of $34.7 million within other specialty lines was caused primarily by increases in reported losses for specialty lines of business currently in run-off including certain Lloyd’s business, discontinued programs business, and surety. A net release of $112.5 million for global risks lines of business was driven by the reduction in case reserves for pre-2002 claims primarily relating to casualty business written out of Europe including business acquired from Winterthur.
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $0.8 billion, $1.7 billion and $3.0 billion for the years ended December 31, 2006, 2005 and 2004, respectively.
In June 2004, the Company replaced its principal revolving credit and letter of credit facility that had amounted to $2.5 billion with two facilities - one $2.0 billion facility with a tenor of three years and a $1.0 billion facility with a tenor of 364 days. Of the aggregate amount of $3.0 billion, $600 million was available as revolving credit and up to $3.0 billion was available in the form of letters of credit, with the combined total not to exceed $3.0 billion. As at December 31, 2004 approximately $1.9 billion of the 3-year facility was in use in the form of letters of credit while the 364-day facility was unutilized at that date.
The following table summarizes these instruments and the effect on net income in the years ended December 31, 2006, 2005 and 2004:
The change in fair value recorded for the weather and energy derivatives was a gain of $28.7 million, $17.8 million and $2.0 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Restricted stock awards issued under the 1991 and 1999 Performance Incentive Programs vest as set forth in the applicable award agreements. These shares contained certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability. The award recipients generally have the rights and privileges of a shareholder as to the restricted stock, including the right to receive dividends and the right to vote such restricted stock. The recipients are not entitled to receive delivery of a stock certificate prior to vesting, nor may any restricted stock be sold, transferred, pledged, or otherwise disposed of prior to the satisfaction of all vesting requirements. As the shares are issued, deferred compensation equivalent to the fair market value on the date of the grant is charged to shareholders’ equity and subsequently amortized over the vesting period. See Note 21(e), “Share Capital - Restricted Stock”, for additional disclosures of restricted stock awards.
Non-vested restricted stock awards as of December 31, 2006 and for the year then ended for the Company were as follows:
A contributory defined benefit pension plan exists in Germany, but has been closed to new entrants since December 1996. Membership comprises fifty-one active participants, nine pensioner participants (receiving payments) and fourteen terminated and vested participants. Benefits are based on length of service and compensation defined in the trust deed. Specifically, after ten years of service, participants are entitled to 10% of the final pensionable earnings per year plus a 3% increase for each additional year of service. The maximum benefit after 30 years of service is 18% of pensionable earnings plus 60% above income threshold. Final earnings definition determined by average annual gross income of the last three years of service. The projected benefit obligation, accumulated benefit obligation and fair value of assets for this plan were $12.3 million, $10.3 million and nil, respectively, as at December 31, 2006.
As of December 31, 2006, net operating loss carry forwards in the U.K. were approximately $531.0 million (inclusive of cumulative currency translation adjustments) and have no expiration. As of December 31, 2006, net operating loss carry forwards in Switzerland were approximately $908.2 million and will expire in future years through 2013.